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.
Archive for December, 2009
Putable bond equivalents
Saturday, December 12th, 2009Callable bond equivalents
Monday, 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
Friday, 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
Tuesday, 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.