Cite three examples of bubbles that we can find in financial history (from 1000 to 2000).
- Dutch tulip bubble (1593);
- Dotcom bubble (1995-2000);
- Subprime bubble (2000-2007).
What is the definition of stock market crash?
A sudden dramatic decline of stock prices across a significant cross-section of stock market resulting in significant loss of paper wealth.
What are the conditions for a market crash to occur?
- A prolonged period of rising stock prices and excessive economic optimism (bubble).
- A market where P/E ratios exceed long-term averages.
- An extensive use of margin debt and leverage by market participants.
Explain how the financial crisis of 2008 arose.
- Incentives to access home ownership.
- Low-interest-rate environment (decrease in Fed rates).
- Relaxation of lending requirements.
- Rise in real estate prices between 2000 and 2006 with more households borrowing for home ownership.
Explain why we consider that the increase in real estate prices prior to the 2008 financial crisis was a bubble.
- A prolonged period of rising housing prices (from 2000 to 2006) and excessive economic optimism.
- Extensive use of debt to access home ownership.
What is the profile of a subprime borrower?
- Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquency in the last 24 months.
- Judgement, foreclosure, repossession, or charge-off in the previous 24 months.
- Bankruptcy in the last 5 years.
- Relatively high probability of default as evidenced by FICO score of 660 or below.
- Debt service to income ratio of 50% or greater.
Between 2000 and 2006-07, what financial technique contributed to systemic risk and to the bubble burst? Explain briefly how it works.
The technique is securitization:
1. Creation of mortgage portfolios that are sold as a new financial product to investors: ABSs (asset-backed securities).
2. Each ABS is then divided into three tranches: the senior, the mezzanine, and the junior (or equity).
3. Senior tranches are rated AAA, mezzanines are rated BBB, and equities aren’t rated.
4. Creation of ABS CDOs (collateralized debt obligations): Mezzanine tranches are divided again into three sub-tranches, the senior ones being rated AAA.
5. AAA ratings of many tranches hid their actual risk.
What is an ABS? Give one example of it.
A security created from the cash flows of financial assets such as loans, bonds, credit card receivables, mortgages, auto loans, and aircraft leases. Examples: CDO, CDS.
ABSs are split into several tranches: which ones? Explain how they differ from each other.
The senior tranche, the mezzanine tranche, and the junior (or equity) tranche. The first are rated AAA, the second BBB, and the third aren’t rated. The first have low return and low risk, the second have medium return and medium risk, and the third have high return but high risk. Many investors are willing to buy the first, fewer are willing to buy the second, and very few are willing to buy the third.
Explain how the AAA-rated tranche of an ABS could be different from a similarly rated bond, in terms of risks.
Often a tranche is thin and the probability distribution of the loss is quite different from that on the bond. If a loss occurs, there is a high probability that it will be 100%. A 100% loss is much less likely for a bond.
What is the difference between an ABS and an ABS CDO?
An ABS is a set of tranches created from a portfolio of loans, bonds, credit card receivables, and so on. An ABS CDO is an ABS created from particular tranches(e.g., the BBB-rated tranches) of a number of different ABSs.
What is a senior/mezzanine/junior tranche of an ABS?
As far as seniority goes, a senior tranche is at the top of the ABS; a mezzanine tranche is in the middle; a junior tranche is at the bottom. In the order of priority, in case of the occurrence of loss, senior tranches come before mezzanine tranches, and the latter before junior tranches. Investors in the senior tranche must be repaid first; then those in the mezzanine tranche; then only those in the junior tranche.
What are the five lessons of the 2008 financial crisis for risk managers?
- Be aware of potentially irrational trends and make sure your top management is aware too.
- Normal market conditions are not the same as stressed market conditions, so data and parameters set in normal market conditions will not apply in times of crisis.
- No risk no return: if two tranches are risk-free (AAA-rated) but do not serve the same return, something is missing.
- Be aware of ratings: what are the assumptions and models behind?
- Transparency is key on financial markets: you must understand the instrument you invest in.
Define ERM (enterprise risk management)
“ERM is a process, effected by an entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.”
What does ERM (enterprise risk management) imply?
- Importance of board involvement.
- ERM is part of corporate strategy.
- Adverse events must be identified.
- The enterprise must identify its risk appetite and manage risks in a consistent way.
What are the two types of ERM (enterprise risk management)? Explain them briefly.
Top-down ERM and bottom-up ERM. In top-down approaches, risk limits are set at the senior management or board level for the whole organization. In bottom-up approaches, risk limits are set for the different business units.
Why should an enterprise be worried about its risk appetite? What are its implications?
Because the risk appetite of a company defines the loss it is ready to experience in the worst-case scenario. Its implications concern risk concentration for each kind of assets/businesses/events, i.e., it sets the limits of risk exposure to each.
What are the main risks a company is exposed to (first taxonomy)?
- Market risk.
- Credit (or counterparty) risk.
- Liquidity risk.
- Operational risk.
- Country, regulatory, and legal risk.
Define the main risks a company is exposed to.
- Market risk: Exposure of a company to a detrimental evolution of interest rates or prices.
- Credit (or counterparty) risk: Risk of loss resulting from a borrower’s failure to meet his debt obligations, and more generally to meet any contractual obligations.
- Liquidity risk: The impossibility to meet one’s cash flow obligations.
- Operational risk: The risk of losses that affect business activities.
- Country, regulatory, and legal risk: Risk that affects the direct environment in which the company operates.
Define market/credit/liquidity/operational/country risk. Provide a concrete/real-life example.
- Market risk: Exposure of a company to a detrimental evolution of interest rates or prices. Example: Stock market bubble (housing bubble).
- Credit (or counterparty) risk: Risk of loss resulting from a borrower’s failure to meet his debt obligations, and more generally to meet any contractual obligations.
- Liquidity risk: The impossibility to meet one’s cash flow obligations.
- Operational risk: The risk of losses that affect business activities.
- Country, regulatory, and legal risk: Risk that affects the direct environment in which the company operates. Example: Fed’s decrease or increase of interest rates.
What is strategic risk management?
When strategic decisions are made (level of risk appetite major potential risks identified, etc.), strategic risk management consists in identifying each assumption made and its consequences in the worst-case scenarios.
What are the possible reactions in strategic risk management? Explain them briefly.
- Avoid: exit the project.
- Reduce: take action to reduce the probability of the adverse event and/or its impact
- Adjust: change strategy to decrease the faced risk.
- Share or insure: share or hedge (a portion of) the risk.
- Accept: take no action.
