When 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.
Posts Tagged ‘credits’
Callable bond equivalents
Monday, December 7th, 2009Winners and Losers
Thursday, 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.
Interest rate risk
Monday, 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.