Banks have to differentiate between legal and economic duration. Most banks will allow early withdrawal of time deposits but impose a penalty charge. Many short-term deposits in the form of demand and savings deposits have legal terms that are much shorter than their economic term. Many savings type deposits offer a fixed rate of return (or only change the rate infrequently). In the event of a modest increase in interest rates most depositors will leave these funds in their savings accounts. As rates rise, however, there is a shift away from demand and savings type deposits into term deposits offering higher rates. This alters the economic duration of such liabilities.
Putable bond equivalents
December 12th, 2009Callable bond equivalents
December 7th, 2009When a bank makes a loan this is equivalent to the borrower issuing a bond. Many loans allow the borrower the option to repay its loan before term. This is equivalent to the borrower owning a call option. Many people complain when they decide to repay a loan early about the bank charging them a penalty fee. To them it seems grossly unfair. Penalty charges are completely understandable. The bank wishes to discourage early repayment and also has to be compensated for the value of the option it has written to the borrower.
The most obvious example of prepayment risks is that of fixed rate mortgages. These loans are long term and hence have long duration. When interest rates fall borrowers have a potential incentive to pay off their current loan and refinance it with a loan at the then prevailing lower interest rates. They are likely to do so when the savings from lower financing costs are greater than the costs of refinancing.
Crafting Business Unit Strategy to Create Value
December 4th, 2009Crafting business unit strategy is a prerequisite for effective business performance management, even though it is not part of the process itself. We will not give a full description of strategic planning here, but rather point out how discounted cash flow analyses, such as those developed in value driver analysis, can greatly assist management in choosing a business unit strategy.
Applying valuation to strategy can produce significant insights:
• The retail banking division of a money center bank had been following a “harvest” strategy and taking cash out of the business. The division’s new chief operating officer wanted to switch to an aggressive growth strategy to regain market share. This strategy had a price tag of $100 million for refurbishing branch bank facilities, installing automatic teller machines, better training for tellers, and a new advertising campaign. While the bank’s CEO originally rejected the new strategy because it would lead to reduced return on equity in the first year, he changed his mind when a DCF valuation showed that the value of the aggressive growth strategy was 124 percent higher than that of the harvest strategy.
• A consumer products company determined that pursuing accelerated category growth had twice the potential value increase and a fraction of the downside compared with expanding the brand into new products.
Another benefit of making a direct link between strategy and valuation is that this explicitly links the strategy development process with other efforts to make value happen. If the business unit strategy process is not set up with a value creation focus, then performance management will be less meaningful, as its goals may not be congruent with the chosen strategy.
Refinancing risk
December 1st, 2009If the owners of bonds decide to sell the bond back to the issuer it is likely to be because interest rates have increased. (Another reason why bondholders might choose to put the bonds back is because they doubt the ability of the issuer to repay the principal at maturity.) The issuer is exposed to the risk that they will have to refinance the debt at a higher financing cost. The issuer is also exposed to the risk that it can not refinance the debt and will be unable to meet its obligations.
In this case the issuer of the bond has sold a put option to the buyer of the bond. The value of the underlying instrument will fall as interest rates rise increasing the value of the put option.
The duration to be used for assets and liabilities with embedded options has to be adjusted to take account of their presence. The duration then estimated is referred to as effective duration.
Price compression
November 28th, 2009The second factor is that, as interest rates fall, the market will increasingly price in the expectation that the issuer will call in the bond at the specified price. As a result the price of the bond will not increase as interest rates fall but will be truncated and tend towards the call price.
The value of the call option will rise when interest rates are falling (price of underlying instrument is rising) and when interest rate volatility increases (more volatile price of underlying instrument).
Winners and Losers
November 26th, 2009Whether M&A activity benefits the economy is often debated by economists, politicians, journalists, and people in the street. The reality is that there are as many answers as there are deals and vantage points from which to argue. A merger may be good for shareholders of both the acquiring and acquired companies but bad for the economy if it creates a monopoly position detrimental to consumers. An individual who loses his or her job or a town that loses its main plant to merger cutbacks are not immediately (and may never be) better off than they were. Conversely, real improvements in efficiency can lead to higher quality and less costly products. The economy overall is likely to be more vibrant, opportunity-rich, and create more jobs if resources are continuously moved out of lower value uses into more profitable ones.
That said, our main concern is creation of value for shareholders. Anyone considering an acquisition needs to understand the basic fact that many corporate acquisitions fail to increase shareholder value. The market for corporate control is fairly efficient: easy, good deals are hard to come by, if they exist at all. Most successful deals result from highly disciplined deal making—and sometimes just good luck.
Two broad types of research provide this warning. Academic studies typically look at the ex ante market reaction to the announcement of a deal, taking into account not only expected costs and benefits of the deal, but also the market’s expectation of whether the deal will actually be consummated. This approach assumes the market is smart and able to size up the price paid, potential synergies, and integration ability of the managements involved to arrive at an unbiased estimate of the likelihood of a deal adding to the value of a company. Another analytical approach is ex post, assessing merger programs after their completion—looking back to see how what did happen compares with what had been hoped for.
Reinvestment risk
November 22nd, 2009If the issuer calls the bond it is likely to be because interest rates have fallen. The owner of the bond is exposed to reinvestment risk because it will receive lower returns when it reinvests the cash paid out by the issuer to redeem the bonds.
Callable and Putable Bonds
November 20th, 2009A callable bond gives the issuer of a bond an option to call, or redeem, a bond before its formal term. A putable bond allows the holder of the bond to sell it back to the issuer before term. We can express the value of these two types of bond in the following way:
Value of callable bond = Value of equivalent straight bond ? Value of call option
Value of putable bond = Value of equivalent straight bond + Value of put option
Callable bonds are affected by what is called negative convexity. As yields fall and the price starts to approach the call price the price–yield curve flattens. The reason for this is simple. If yields fall further the issuer is likely to call in the bond in which case holders will only receive $10 000.
This situation is reversed with putable bonds. If prices of an equivalent straight bond fall below the put price the price of the putable bond will remain at the put price as the holder has the right to sell the bond back to the issuer at this price.
This truncation effect occurs with callable bonds because the bond’s price–yield curve has negative convexity as the price approaches the call price.
Interest rate risk
November 16th, 2009In this series of posts we are concentrating on interest rate risk, arguably second only to credit risk in importance to most banks. The value of banks’ assets and liabilities are highly sensitive to changes in the level of interest rates. Forecasting shifts in yield curves accurately and with a high degree of confidence is difficult. These shifts may be parallel, but rarely are, where yields change by an equal amount at all maturities or non-parallel. If bank asset liability management were a simple matter then people working in Treasury would get paid a lot less. There are three methods available and used for the assessment of interest rate risk:
Duration matching. Duration matching involves analyzing the price sensitivity of assets and liabilities to changing interest rates. We will focus on the techniques associated with duration matching. Gap analysis. Gap analysis is essentially a method based on placing assets and liabilities into one of a number of different “time buckets” determined by when they are due to be repriced. Sensitivity analysis. This method involves subjecting a portfolio to a wide range of possible changes in interest rates and assessing the potential impact of each scenario. Management has to assign a probability to each scenario.
None of these methods is without its problems. One of the fundamental issues faced is that of balancing a perceived need to maintain stable reported earnings with maximizing economic value. In practice management at most commercial banks prioritize earnings stability.
Professional managers
November 14th, 2009Individuals whose job it is to manage these specialists, put in place control systems to shield the bank from unexpected losses and take action to position the bank to either take advantage of forecast long-term trends or to minimize earnings volatility whatever the change in interest or exchange rates. The economists and strategists are the people to talk with when you want a view on what is likely to happen in the world economy and to exchange rates over the next 12 months. These people are usually highly educated, with master’s degrees and doctorates very much the norm. The traders rely on these people for their insight into wider developments that may have an impact on the prices of instruments that they trade. It is an odd mix of street traders and cerebral academic types.