Exercise 2.

1 The pricing equations are Stocks Bonds

~ dt E0 t 1 ~ r ~ s t
t t

ct D0 ~ ~ t t 1 r s
t t

Below we shall briefly describe only the most direct impact of the factors in the first column of the table on the price of stocks and bonds. Indirectly, these factors may affect securities prices in many ways.

Factor Real Interest Rates

Inflation Companys competitiveness Business cycle Political instability Oil prices, consumer confidence, regulation Traders risk aversion

Influence rt which are the sum or real nominal risk free rates ~ interest rates and inflation rate rt (see above) nominal risk free rates ~ If a firm becomes less competitive, its ability to generate income and to repay its debt may decline. This in turn may ~ cause d t to go down and ~ st to go up. All All All

~ st

Exercise 2.3: Financial crises due to poor risk management.

US Savings and Loans (1980s): this type of bank was highly regulated with a ceiling on the interest rate paid on deposits (deposit rates). Most of their mortgages were fixed rate. When the Fed raised interest rates, depositors left Savings and Loans institutions to get higher interest on other banks that were not so tightly regulated and could offer higher deposit rates. To pay depositors, Savings and Loans had to liquidate mortgages but their present value (or market value) was being eroded by the higher interest in the market and by the fact that the interest received on their mortgages was fixed and lower than market rates. Congress then agreed to deregulate Savings and Loans, but these banks ended up taking too much risk and making the situation even worse. Result, losses that cost US taxpayers about 125 billion dollars. (see http://en.wikipedia.org/wiki/Savings_and_Loan_scandal for more details) Barings (1995): A trader, Nick Leeson, generated huge losses from long positions on the Nikkei 225 index futures contract combined with short positions in options. The fundamental reason behind this debacle was due to lack of segregation of duties between trading desks and back office. In other words, there was not proper and independent risk management function within the bank. LTCM (1999): The company had developed complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) usually with U.S., Japanese, and European government bonds. The basic idea was that over time the value of long-dated bonds issued a short time apart would tend to become identical. The scheme finally unravelled in August and September 1998 when the Russian government defaulted on their government bonds (GKOs). Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital. (Source: http://en.wikipedia.org/wiki/LTCM ) Enron (2002): the seeds of Enron's demise were sown years before criminal behaviour took root The more fundamental causes appear to have been matters of organizational design, in particular, bonus plans that paid managers to increase reported earnings. To achieve higher earnings managers had to take on more risk. Poor internal risk controls then led to a vicious circle of creative accounting and fraud that ultimately caused the collapse of the company. (Source: The real reasons Enron failed by Bennett Stewart in Journal of Applied Corporate Finance, Vol. 18, Issue 2, pp. 116-119, Spring 2006). See also http://en.wikipedia.org/wiki/Enron Subprime and Sovereign Crises: see Part 1 notes.