Global liquidity regulation , supervision and risk management

A good read on liquidity risk measures  and latest BCBS guide lines for liquidity risk management.

Liquidity and VaR

Lot of focus has been shifted on liquidity risk management. Basel committee also planning to recommended that holding period of VaR calculation  should be based on asset classes and time required to unwind the positions. It is understood that liquidity affects risk management because if markets are not liquid than it will take more time to unwind the positions. Interestingly risk management also affects the liquidity. Tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity. This paper provides a model of the interaction between risk-management practices and market liquidity. 

Indian Money market instruments - Repo & Call

Repurchase Agreement (Repo) is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.
The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.

It can be seen from the definition above that there are two legs to the same transaction in a repo/ reverse repo. The duration between the two legs is called the ‘repo period’. Predominantly, repos are undertaken on overnight basis. Settlement of repo transactions happens along with the outright trades in government securities. Repo that are not overnight termed as Term Repo.

Earlier repo securities in corporate debt allowed except CPs, CDs and NCDs maturing in less than one year. But from Jan 2013 RBI also permitted repo these securities. Only listed corporate debt securities that AA or above rated are eligible to be used for repo.

However volume in "Repo in corporate debt" is very less. This can be due to sharp haircut ,10% -12%-15%, while in CBLO haircuts are 5%. Also in  "Repo in corporate debt" market pricing is not based on online platform but lender needs to find out the borrower while in CBLO market pricing is determined through online ask - bid spreads.

RBI has permitted select entities (scheduled commercial banks excluding RRBs and LABs, PDs, all-India FIs, NBFCs, mutual funds, housing finance companies, insurance companies) to undertake repo in both the repo market.

Call/Notice/Term  Money - 

The call/notice/term money market is a market for trading very short term liquid financial assets that are readily convertible into cash at low cost. The money market primarily facilitates lending and borrowing of funds between banks and entities like Primary Dealers. An institution which has surplus funds may lend them on an uncollateralized basis to an institution which is short of funds. 

The period of lending may be for a period of 1 day which is known as call money and between 2 days and 14 days which is known as notice money. Term money refers to borrowing/lending of funds for a period exceeding 14 days. The interest rates on such funds depends on the surplus funds available with lenders and the demand for the same which remains volatile.

This market is governed by the Reserve Bank of India which issues guidelines for the various participants in the call/notice money market. The entities permitted to participate both as lender and borrower in the call/notice money market are Scheduled Commercial Banks (excluding RRBs), Co-operative Banks other than Land Development Banks and Primary Dealers.

Scheduled commercial banks are permitted to borrow to the extent of 125% of their capital funds in the call/notice money market, however their fortnightly average borrowing outstanding should not exceed more than 100% of their capital funds (Tier I and Tier II capital). At the same time SCBs can lend to the extent of 50% of their capital funds on any day, during a fortnight but average fortnightly outstanding lending should not exceed 25 per cent of their capital funds.

Co-operative Banks are permitted to borrow upto 2% of their aggregate deposits as end of March of the previous financial year in the call/notice money market.

Primary Dealers can borrow on average in a reporting fortnight up to 225% of the total net owned funds (NOF) as at end-March of the previous financial year and lend on average in a reporting fortnight up to 25% of their NOF.

The trades are conducted both on telephone as well as on the NDS Call system, which is an electronic screen based system set up by the RBI for negotiating money market deals between entities permitted to operate in the money market. The settlement of money market deals is by electronic funds transfer on the Real Time Gross Settlement (RTGS) system operated by the RBI. The repayment of the borrowed money also takes place through the RTGS system on the due date of repayment.

Arbitrage b/w CBLO and repo market  

There can be arbitrage opportunity for market participants who have access of both the markets. If repo rate is less than CBLO rate than banks or PDs can borrow in repo market and lend that money in CBLO market for almost risk free return. 

If CBLO rate is less than reverse repo rate than banks can borrow in CBLO market and park that money with RBI at reverse repo rate for risk free return.

So for no arbitrage CBLO rate should be in between of repo and reverse repo rate. Now reverse repo rate is always 100 basis point less than repo rate.

Corporate Bond Market in India issues and challenges

A good read on issues and challenges of Indian corporate bond market that is under developed.

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Indian Money market instruments -CBLO

Collateralised borrowing and lending obligation (CBLO) is another money market instrument operated by the Clearing Corporation of India Ltd. (CCIL), for the benefit of the entities who have either no access to the inter bank call money market or have restricted access in terms of ceiling on call borrowing and lending transactions. CBLO is a discounted instrument available for the maturity period ranging from one day to ninety days (up to one year as per RBI guidelines). 

In order to enable the market participants to borrow and lend funds, CCIL provides the Dealing System through Indian Financial Network (INFINET), a closed user group to the Members of the Negotiated Dealing System (NDS) who maintain Current account with RBI and through Internet for other entities who do not maintain Current account with RBI.
CCIL becomes Central Counterparty to all CBLO trades and guarantees settlement of CBLO trades.
Membership to the CBLO segment is extended to entities who are RBI- NDS members, viz., Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions, Insurance Companies, Mutual Funds, Primary Dealers, etc. Associate Membership to CBLO segment is extended to entities who are not members of RBI- NDS, viz., Co-operative Banks, Mutual Funds, Insurance companies, NBFCs, Corporates, Provident/ Pension Funds, etc.

By participating in the CBLO market, CCIL members can borrow or lend funds against the collateral of eligible securities. Eligible securities are Central Government securities including Treasury Bills, and such other securities as specified by CCIL from time to time. Borrowers in CBLO have to deposit the required amount of eligible securities with the CCIL based on which CCIL fixes the borrowing limits. CCIL matches the borrowing and lending orders submitted by the members and notifies them. While the securities held as collateral are in custody of the CCIL, the beneficial interest of the lender on the securities is recognized through proper documentation.

Different types of CBLO 

CBLO Normal Market -  It facilitates borrowing and lending by members on an online basis.

CBLO Auction Market - It facilitates borrowing and lending by members through submission of bids and offers.

CBLO features

• This RBI approved Money Market instrument is backed by Gilts as collateral.
• It creates an obligation to repay the borrowed money along with interest on a fixed date. Also it provides a right to the lender to receive money lent with interest on a fixed future date.
• CBLO is tradable and CCIL acts counterparty to transaction.
• It is traded on screen that provides right amount of anonymity to a trade for counter parties.

Eligible Securities

Central Government Securities including Treasury Bills as specified by CCIL.

ECB dilemma on monetary policy and QE

Investors bought peripheral government bond in anticipation of QE program, asset purchase program, will be initiated by European central bank (ECB). However latest Europe economy data has shown that economy has expanded by just 0.2% lead by 0.8% Germany expansion.
Many investors now expects that ECB to lower the interest rate and launch the long term refinancing operations (LTRO) rather than starting an asset purchase scheme at its June meeting, Euro slips as periphery bond yields rise.

These speculations prompted a sell-off this week in peripheral bond markets, sending yields higher. ECB already has zero deposit rates and inflation around 0.7% that is less than half of its 2%long run  target. Top short term priority of ECB is to avoid deflation, ECB: An appropriate monetary policy.

Why traders should take interest in football worldcup

I read a interesting article on FT, Why bond traders should watch World Cup . Some of the points that Ralph are making-

1) There will be millions of online betting transactions conducted by football fans. This can be a good  laboratory for testing how human market function. It has also been researched that human run market can be very efficient.

2) It is safe to assume that all betters will have all information at same time so there will not be any information asymmetry once match starts. Odds change during a match; the nearer the final whistle, the more predictable the result. 

In India online betting is not legal so I can't be the one of the learner from this huge opportunity. 

Banking book & Trading book

"Book" in banking is very widely used term. Book is nothing but smallest trades organizing entity that holds some particular trades. Books gets created based on different criteria such as trader, accounting treatment, risk methodology treatment , legal entity and etc. All books are normally arranged in hierarchy.
Classification of banking book and trading book is very important for risk and accounting treatment. BCBS committee guidelines have different risk computation treatment for banking and trading book.

Trading book should contains all trades that are traded with intent of making profit through market price movement, hold for short term resale, lock in arbitrage profit or to hedge other trading book positions. Trading books needs to be valued at fair value daily, mark to market daily.Under BCBS guidelines capital charge for trading book gets calculated using VaR, SVaR and IRC.The value-at-risk for assets in the trading book is calculated at a 99% confidence level based on a 10-day time horizon.
Banking book should contains all positions that have been taken with intent of holding them till m

aturity. Banking books does not need to be valued at fair value daily, no mark to market daily. Assets can be on balance sheet at their historic values. Capital charge for banking book gets calculated from RWA (risk weighted assets).The value-at-risk for assets in the banking book are calculated at a 99.9% confidence level on a one-year horizon.

Currently there are no specific rules are defined to classify trades into banking and trading books. It has been left to banks to decide the intent of trading and classify the trade accordingly. Until Basel 2 guidelines there was a huge capital advantage in keeping trade in trading book instead of banking book. It is like shifting the banking book loan to trading book bond and reducing capital. But after IRC requirement in Basel 2.5 guidelines it has come significantly down. A detailed comparison of baking book and trading book capital charges are compared using one sample portfolio in Swing Basel document.

BCBS is reviewing the trading book framework. It has released updated consultative document on the same, Fundamental review of the trading book.

Before BCBS come with  defined rules for banking book and trading book boundary, currently different banks have setup their on policy to do the same. On larger view below methodology gets followed to classify the book as banking and trading.

Banking Book or Trading Book decision

  

Basel Market Risk Models by Risk and Product Type

Ireland's borrowing cost

Good reads on what is latest on euro zone crisis. After four year of Greece bailout, Ireland’s ten year borrowing costs dropped below the UK’s. 

Europe's crisis Treadmill &  A Bond Bubble In Peripheral Europe ?

Alibaba IPO

Alibaba s initial public offer could the biggest IPO ever, after many months of speculation, on May 6th Alibaba unveiled its prospectus to list in New York.. Alibaba, a ecommerce  firm, controls more than eighty percent  online market of China. Alibaba could be valued close to 200 bn and it can raise 15 to 20 bn from this initial public offer. Yahoo will also get the windfall from this IPO as Yahoo owns ~24% stake in the Alibaba and as per the contract Yahoo will have to sell the shares in IPO. Market pundits have estimated Alibaba is bigger than combine Ebay and Amazon. Jack Ma, founder of Alibaba, already been getting recognized as rival of silicon valley, a economist report.

Issuer rating vs issue rating

Credit agencies rate both specific issues and issuer. These two ratings can be different, one BB rated issuer can issue a BBB rated bond. Now I face the question which ratings needs to be used to price the credit risk and why ?  

Definition of issuer rating from S&P
A Standard & Poor's issuer credit rating is a forward-looking opinion about an obligor's overall creditworthiness in order to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation.

Definition of issue rating from S&P

A Standard & Poor's issue credit rating is a forward-looking opinion about the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program (including ratings on medium-term note programs and commercial paper programs). It takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. The opinion reflects Standard & Poor's view of the obligor's capacity and willingness to meet its financial commitments as they come due, and may assess terms, such as collateral security and subordination, which could affect ultimate payment in the event of default. 

In short, an issuer rating generally indicates the likelihood that a company may default with regard to all its financial obligations. An issue rating, however, is based on a blend of default risk and the priority of a creditor's claim in bankruptcy associated with the specific debt being rated. Secured debt has the higher recovery rates than non secured debts in situation of issuer defaults so normally secured debt get higher rating. 

To price credit risk it is better to use the issuer's rating as issuer is default on all its obligations even if it defaults on one of its obligation. Issue specific rating or covenants are more relevant in situation of financial liquidations.  

Normally we have Senior secured , senior unsecured , subordinated secured and subordinated unsecured type of debts. Senior debt refers to debt that is in first-lien position and in event of a default and subsequent liquidation, the senior lender has first priority in getting its investment, followed by subordinated debt and followed by equity holders.Subordinated debt, also known as mezzanine or junior debt is a second-level of debt.

Convertible Bonds

At work my colleague asked me questions related to convertible bond. I have never given serious attention to this product apart form my CFA studies.

Today I read about this product's basic structure , its valuation and who are the biggest trader, and why. In layman term it is a bond with an option to subscriber to convert bond into equity share of issuer, at predefined price and conversion ratio.

                                          Convertible bond = Long debt + call option on equity 

Convertible bond behave as equity positions when convertible option is deep into the money ,share price is quite high from strike,and it behave as bond when convertible option is deep out of the money , share price is quite low from strike.

This is an very powerful product for investors as it provides principal protection and equity benefit if firm will do good. Historically these instruments have given returns close to equity indexes but with very less volatility ,Convertible Bonds: Stock-like Returns With Less Risk.

Hedge fund uses convertible bonds in combination with short sell of underlying equity to do the gamma trading. Funds short sell more equity when equity price rises because when prices rises than delta of the convertible option increases  and they cover some short sale by buying equity while prices of the equity going down because delta of convertible option will be reducing while prices going down. Effectively they are buying low and selling high.
Most hedge fund manger 
Convertible arbitrage strategy looks all season strategy but it gets hurt badly in liquidity crisis. New issues of convertible bonds has been decreased since 2006 but demand of these coverts have been going strong. There is more opportunities for convertible bond arbitrager in higher volatility time ,convertible-bond-arbitrage-looks-set-revive-volatility-creates-opportunities. 

Analyzing Global Trends

I have enrolled in a interesting course "Analyzing Global Trends" by Wharton university on  Coursera.
Excited to go through some thought provoking lectures and discussions !

Credit Default Swap - III

In last two post on CDS I have written about CDS basics and replication of CDS using the money and bond market instruments. Now we are prepared to understand the CDS pricing.
Premium of new CDS referencing a non distressed entity determine by the arbitrage relationship with cash spreads of that entity.In couple of last years CDS market has evolved as a very high liquid market and it has become mainstream market place to price credit risk. Even banks have started using the CDS spreads to decide the loan interest rates for their borrowers. This has helped banks to reduce monitoring of their borrowers, the-transformation-of-banking-tying-loan-interest-rates-to-borrowers-credit-default-swap-spreads.

CDS premiums should be determined by the following factors:

• The default probability of the reference entity;
• The expected recovery rate of the deliverable obligations;
• The maturity of the swap;
• The default probability of the protection seller, as well as the default correlation between the protection seller and the reference entity.
• discount curve

Like Interest rate swap, a CDS should have 0 present value at inception of the swap. Value of both the legs ,premium paying leg and contingent payment leg, of CDS should be equal. The premium is set at a level

that equates the PVs of the two leg. After inception, however, as expectations change, the PVs of the two legs will be different.If the on-market CDS quotes for a reference entity have tightened, protection sellers
will have a positive mark-to-market (“MTM”), and vice versa when premiums widen. In either case, the market price of this off-market (seasoned) CDS is different from its contract premium.

Quantitative model do not get used for on the run CDS pricing as premium depends on the arbitrage relationship with cash spread and demand supply factors. Quantitative models normally used to price off the run CDS, taking inputs from market quotes. 

Default Probability -

Both the legs have uncertain cash flows: premium are paid until the default of reference entity or maturity , payment of (1-recovery rate)*notional happens only in event of default. So to price the CDS we require the default probabilities. These default probabilities are calibrated from market quotes of premiums.

Credit Triangle - 

Probability of default , recovery rate and premium make a credit triangle. We can calculate third variable with given values of  two variables using below equation. CDS premium includes hazard rate and loss given default (1-recovery rate) so to calculate the hazard rate we need to figure out what is the value of recovery rate. Hazard rate in this equation is default probability of reference entity in that time period so it means that reference entity has survived all previous period and get defaulted in this period only.

                                  Premium =  Hazard rate*(1- recovery rate)

Normally recovery rate for the investment grade security (senior unsecured) assumed as 40%. This has now become market standard. Recovery swap market is thin, in future it is possible that recovery rate can be observed from quotes of this market.

In the credit triangle, For a given premium, higher recovery rate assumptions mean higher default

probabilities. On the other hand, given the same recovery rate assumption, higher premiums obviously mean higher default probabilities.

With recovery rate assumption hazard rate can be calculated from the cds market quote. Such hazard rate will be required for each period, like term structure of hazard rate. PV of premium leg will be calculated using hazard rate term structure and discount curve. 

A term structure of non-conditional default probabilities, which is effectively the difference in survival probabilities between two adjacent periods is required to calculate the PV of contingent default payment leg.

With Hazard rate ,term structure of default probabilities and discount curve we can price the off the run CDS using the same quantitative model.

Assumptions in the model

1) Recovery is a fixed percentage of par (40% for IG issues), independent of the model and constant over time

2) The interest rate (i.e., the discount rate) and default processes are independent of each other

3) Hazard rates are constant in one particular period.

Different mRWA for different banks for same hypothetical portfolios

I was reading about the regulatory consistency assessment program of Basel committee. The assessment program is conducted on three levels:
 1: Ensuring the timely adoption of Basel III;
 2: Ensuring regulatory consistency with Basel III; and
 3: Ensuring consistency of risk-weighted asset (RWA) outcomes

For the third assessment committee conducted RWA analysis, separately for banking and trading book , for designed hypothetical portfolios. Many big global banks participated in this exercise.  The hypothetical test portfolio exercise indicated that, using a hypothetical diversified portfolio consisting primarily of simple long and short positions, there can be a substantial difference between the bank reporting the lowest mRWAs (Market risk RWA) and the bank reporting the highest.

VaR , stressed VaR and IRC was calculated and reported for these portfolio. RWA for trading assets gets calculated from VaR and stressed VaR. As graphed in below figure there is huge variability in mRWA numbers for participated banks.

 

The X axis here shows the various portfolios, and the Y axis shows the VaR of those portfolios – which more or less linearly determines RWAs – calculated by different banks, normalized to 100%. Take portfolio 18, a credit portfolio. The different banks computed a VaR for this portfolio ranging from, say, 0.4x to 1.5x This portfolio was: long protection on Itraxx index. How much capital should you have to support this portfolio ? Banks have report RWA from this portfolio in range of 0.4x to 15.x. So actually it looks like a guess work as we can't say which bank's model is better than other.

Reasons behind this wide dispersion - 
1) Time series data period that is used in historical simulation method. Banks that are using 4 years historical data tend to have higher var then that are using 3 years historical data
2) How 10 day holding period var is getting calculated. There are two method to calculate the 10 day var first is directly calculating 10 day var using 10 day returns or scaling 1 day var to 10 day by multiplying square root of 10.
3) Aggregation approach of positions and general and specific risk.
4)Valuation model ( Full valuation ,Partial revaluation or sensitivities approximation)
5) Risk factor granularity

Centralization of  Calculation-
Author in his blog post  suggested to have centralized VaR calculation approach. All banks will use the same approach and models. I do not agree on this, it will be like going back to Basel 1 standard approach. Internal methods have been institutionalized to give benefit to banks that can develop robust and good risk engines. From the blog of Streetsmart professor-
"We want to diversify model risk, not concentrate it. Centralized calculation concentrates it. I actually see an evolutionary benefit in the wide range of model risk weights. That represents a diverse ecosystem of entities with divergent views that is less vulnerable to a single shock. Yeah, that shock will crater some banks, but not all of them."

Credit Default Swap- ||

In last post, Credit Default Swap - I, we discussed the basics of CDS and how we can replicate risk and return profile of CDS using the bond , repo and asset swap market instruments.

Following transaction needs to be done for replicating the short CDS portfolio.

1) Buy a par bond, the one which currently trading at par.
2) Fund purchase of  above bond using the repo transaction (long on credit risk without need of extra liquidity)
3) Asset swap spread transaction to exchange the fixed coupon with floating rate (Libor + spreads). This transaction will hedge the interest rate risk of bond. Bond + asset swap spread portfolio will have exposure to only credit risk of bond.


                

Funding Cost differences- 
Funding cost in repo market depend on the market participants. Funding cost can be less than Libor for a top quality borrower or it can be less than Libor for others. These cost differentials result in a breakdown of the one-to-one relationship, and introduce a theoretical range around the cash spread within which CDS may trade.

CDS spread from the above replication portfolio for top quality borrower  = (Libor +ASW Spread) - (Libor - Repo spread)
CDS spread from the above replication portfolio for other borrower = (Libor +ASW Spread) - (Libor + Repo spread)

Consider the following example:

• One AAA rated firm funds at L-10bp;
• One single-A rated firm funds at L+10bp.

CDS spread for the AAA rated firm =  ASW Spread + 10bp
CDS spread for the A rated firm =  ASW Spread - 10bp

If we assume funding cost for all other market participant is in between of funding cost of  these two market participants than these two spreads will be the boundary spreads of the CDS. Arbitrage trading will keep CDS spreads in this range.

The AAA firm buys the bond and buys protection. It borrows at Libor-10bp, buys the bond yielding L+ASWbp, and pays ASWbp for protection, thereby locking in a 10bp profit with zero net exposure to the bond. . This arbitrage comes from its sub-Libor funding cost advantage.
The single-A firm sells CDS protection outright. It earns ASW bp, whereas if it borrows to buy the bond, it earns only ASW-10bp. It avoids the Libor-plus funding cost disadvantage, and effectively achieves funding at Libor through the CDS position.

So the AAA firm buys protection from the single-A one. The supply-demand equilibrium between them determines the actual level of CDS premium. In any case, these arbitrage activities keep the CDS premium within a certain range of cash spread,linking the two markets.

As we can see, these arbitrage activities are driven by differences in funding costs, where higher-rated entities are protection buyers and lower-rated entities protection sellers.Nevertheless, we cannot generalise that all protection buyers in the CDS market have higher credit quality than protection sellers, because people participate in the market for reasons other than funding cost arbitrage. For example, banks, no matter whether rated AAA or A, can be net buyers of protection for purposes of managing their regulatory or
economic capital.

Discounted bonds - 
The above relationship breaks with discounted bonds ( bonds getting traded at below par value). For discounted bonds, protection seller will have far more risk than bond buyer because loss will be notional - recovery value while for bond buyer loss will be market value (discounted value) - recovery value in case of default. Points up front method gets used in these cases where protection buyer will pay one time up front payment apart from regular premium.

History of financial crises

I never realized before reading History of finance in five crisis essay, published by economist news paper, that today's fiance world is mainly shaped by the crisis and slumps.

After almost every crisis new policies were crafted , new institutions were setup , new tools were discovered to make the system more robust and to avoid the future crisis but crisis and slumps were repeated and repeated.  Even today we can't say that a new financial crisis will not happen. 

From the economist essay, The core of finance is  "finance does just two simple things. It can act as an economic time machine, helping savers transport today’s surplus income into the future, or giving borrowers access to future earnings now. It can also act as a safety net, insuring against floods, fires or illness. By providing these two kinds of service, a well-tuned financial system smooths away life’s sharpest ups and downs, making an uncertain world more predictable. In addition, as investors seek out people and companies with the best ideas, finance acts as an engine of growth" 

But in modern world finance is much beyond than this. If it fails than it left behind a legacy of unemployment people , debt and year or decades of  no growth.

Today we can't imagine banking regulation without central bank but invention of central bank was also outcome of one of such crisis, History of the Federal Reserve. Same trend is still continue and after the 2008 sub prime crisis, new laws are already passed and some more are getting ready.
But question remains same whether another crisis will unfold in future or not.