Do you remember when you were younger and had to do chores? If your parents thought you did a good job, you'd usually get an allowance. So began the process of service-payment exchange; you'd conduct the chore and they'd pay you the allowance. However, if you did not complete an assigned chore, you did not receive any payment. Unfortunately in the real world, this is not the case. Insurance giant, American International Group (AIG), has proven to be an exception from the general "service-payment exchange" rule. During this current financial crisis, a series of bailouts have been given to various companies, AIG included. However, it seems that AIG continues to get a stream of bailouts. Why is this so? What are they doing that keeps in them in the need of additional funds? Most importantly, is it fair to keep bailing out a company that has not made any improvements? These are all questions that the general public wants answered.
From the statements above, it can be inferred that I disagree with the AIG bailouts. I must admit, I'm not happy about it. Yet, I do understand why the US continues to do so. Being in various risk management and insurance classes, I've had the chance to discuss AIG's circumstance and what it means for the general public and the future of this financial situation. As mentioned before, AIG is an insurance powerhouse. It is one of the largest insurance corporations in the country and holds a vast amount of the policies thereof. During its positive reign, AIG made an major impact on the insurance industry and the country as a whole. Although it sounds cliche, if AIG were to completely fail, the rest of us would be directly or indirectly affected. The company is very complex and involved with other companies in various ways. It's downfall could create a "domino affect" of failure in the insurance industry and any company that is heavily tied to it. Not only that, but if the US stopped funding AIG, it would lead to the downfall of the healthy sectors inside AIG. What some people fail to realize is that the entire AIG company is not hurting, just a specific area. In fact, AIG's life insurance sector is still prominent and successful. Taking away funds from AIG as a whole would indirectly take away from its flourishing sector.
Although I understand why the bailouts continue to go to AIG, I am not happy about it, nor do I believe it is fair. Fair would be providing minor bailouts for those smaller companies who have acted responsibly. We should help those who have taken necessary steps to aid this financial crisis, place themselves in a better position, but just need a little financial boost. Instead, we are throwing $30 billion on top of the $150 billion to AIG, a company that persists on doing whatever it wants. Senator John McCain supported Bush in the $700 billion bailout, yet he is still shocked at how AIG gave 1/3 of the original $150 billion to companies such as Goldman Sachs and Merrill Lynch. I'm sorry, but isn't Goldman Sachs another company who received a US bailout? Isn't Merrill Lynch a firm that was just acquired by Bank of America? It seems as if AIG is just throwing this money around, when instead, they should be finding ways to create money from its bailout funds. However, the company is still heading down the wrong lane. With a lost of $61.7 billion in the last quarter, another bailout was necessary. McCain isn't the only one upset about the AIG situation. US Federal Reserve Chairman Ben Bernanke is not happy about the circumstance either, but he must still defend the country's decision. Simply put, Bernanke states, "There was no other alternative. We really had no choice" AIG has a strong relationship with banks worldwide, and a failure for the company could lead to a disaster around the globe.
This AIG bailout situation is placing us in a bad position. So many firms and small businesses in need of a financial break, and yet we still provide giants like AIG with billions of dollars. It will be only a matter of time before Americans get tired of paying more tax money to help the irresponsible companies out. It was said by some that AIG was "too big to fail." Well now we all know different. No matter the size of the company, no matter how rich the company, no matter how popular the company, horrible financial choices will lead to disaster. The country is already in a deficit of trillions of dollars; if we continue to bailout out companies like AIG, who knows what this number could grow to.
Sources:
1. Puzzanghera, Jim. "Why AIG is Still Getting Rescue Funds, According to LA Times." Insurance News Net. LA Times. 9 March 2009. 9 March 2009 <http://www.insurancenewsnet.com/article.asp?a=top_news&id=104037>.
2. Reuters. "US had no choice." Straits Times. 4 March 2009. 9 March 2009 <http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_345649.html>.
3. Scaliger, Charles. "AIG, Bailouts, and the Banks." New American. 9 March 2009. 9 March 2009 <http://www.thenewamerican.com/economy/commentary-mainmenu-43/866-aig-bailouts-and-the-banks>.
Tuesday, March 10, 2009
US On an Economic Rollercoaster
The United States economy has been through a lot during the past few years. For those of us in our younger years, it's hard to believe that an economic crisis such as this could ever occur during our lifetime. From the things we've heard about the Great Depression, it would be our hope that the US wouldn't get close to that again. However, when a nation's financial system is in need of bailouts in the range of trillions of dollars, it's hard not to believe that our recession is only to get worse. Yet the famous billionaire Warren Buffet thinks the opposite. Buffet takes an optimistic view on the situation and believes that "America's best days are still to come." How can this be? How is it possible for the US to regain its powerful position again? Is it just wishful thinking? Buffet states that he realizes the US economy did "fall off a cliff", but still believes that the US has the ability to regain its position and move forward on this economic wave.
As a realist, Buffet has acknowledged some activities that are most likely to occur in the future, such as higher unemployment and an inflation. These things seem more evident has large corporations continue to let go masses of people. Still, through all of the negative events that happen, Buffet remains true to his opinion that we shall see success in the future. Addressing the financial system, he notices that more citizens are improving their spending and saving techniques. Being the owner of over 60 companies including the large car insurance company, GEICO, he noticed that while his jewelry industry suffered a loss, GEICO became more popular as people wanted to save more money. But is that enough? Is switching to another car insurer to save around $500 a year enough to make Americans feel more secure? No. Buffet believes that Americans must have faith in the entire nation's banking system. "Most banks are in good shape. The banking system largely will cure itself," says Buffet. But most banks like who? How are we (as Americans) supposed to feel when banks such as Washington Mutual, Merrill Lynch, and even Wachovia can go under? Can we really have hope that a better economic stance is coming soon?
Keith Fitz-Gerald of NuWire Investor takes the opposing view of Buffet. Instead of a better economic situation to head our way, Gerald believes that the US's recession is worse than Japan's "Lost Decade". (Japan's "Lost Decade" represents the economic turmoil during the 1990s that Japan experienced. This turmoil included a rising unemployment rate, failing financial systems, homelessness, and a Japanese stock market crash). Gerald states that the current US situation is nothing more than a replay of the "Lost Decade", maybe worse. If we take a look at the following similarities between the two eras, it's hard not to believe what he says.
1. Rising unemployment rate
2. Failing financial systems
3. At the beginning of each country's recession, large deficit. (In fact, US had a larger deficit than Japan)
4. Economic problems starting long before results actually appeared
So who do we believe? Do we look at our current situation and follow in Fitz-Gerald's thinking? We can see how our economic and financial instability is a mere future representation of Japan's "Lost Decade". For a long time, we've noticed the downward spiral of the US economy. Having to bailout major corporations and implementing a billion dollar stimulus plan, both of these requiring citizens to cough up more money. Or should we be thinking positively like Mr. Buffet? Start thinking about the future and how the tables can be turned with a little hope and faith? Of course he is speaking as a billionaire who might be able to sustain his financial status during this economic time, but his attitude does remind me of a popular saying; "As low as we are now, there's nowhere else to go but UP!"
Sources:
1. Associated Press. "Warren Buffet says economy fell off a cliff." Contra Costa Times. 9 March 2009. 9 March 2009 <http://www.contracostatimes.com/business/ci_11872501?nclick_check=1>.
2. Fitz-Gerald, Keith. "US Recession Could Be Worse Than Japan's Lost Decade." NuWire Investor. 3 March 2009. 9 March 2009 <http://www.nuwireinvestor.com/articles/us-recession-could-be-worse-than-japans-lost-decade-52647.aspx>.
As a realist, Buffet has acknowledged some activities that are most likely to occur in the future, such as higher unemployment and an inflation. These things seem more evident has large corporations continue to let go masses of people. Still, through all of the negative events that happen, Buffet remains true to his opinion that we shall see success in the future. Addressing the financial system, he notices that more citizens are improving their spending and saving techniques. Being the owner of over 60 companies including the large car insurance company, GEICO, he noticed that while his jewelry industry suffered a loss, GEICO became more popular as people wanted to save more money. But is that enough? Is switching to another car insurer to save around $500 a year enough to make Americans feel more secure? No. Buffet believes that Americans must have faith in the entire nation's banking system. "Most banks are in good shape. The banking system largely will cure itself," says Buffet. But most banks like who? How are we (as Americans) supposed to feel when banks such as Washington Mutual, Merrill Lynch, and even Wachovia can go under? Can we really have hope that a better economic stance is coming soon?
Keith Fitz-Gerald of NuWire Investor takes the opposing view of Buffet. Instead of a better economic situation to head our way, Gerald believes that the US's recession is worse than Japan's "Lost Decade". (Japan's "Lost Decade" represents the economic turmoil during the 1990s that Japan experienced. This turmoil included a rising unemployment rate, failing financial systems, homelessness, and a Japanese stock market crash). Gerald states that the current US situation is nothing more than a replay of the "Lost Decade", maybe worse. If we take a look at the following similarities between the two eras, it's hard not to believe what he says.
1. Rising unemployment rate
2. Failing financial systems
3. At the beginning of each country's recession, large deficit. (In fact, US had a larger deficit than Japan)
4. Economic problems starting long before results actually appeared
So who do we believe? Do we look at our current situation and follow in Fitz-Gerald's thinking? We can see how our economic and financial instability is a mere future representation of Japan's "Lost Decade". For a long time, we've noticed the downward spiral of the US economy. Having to bailout major corporations and implementing a billion dollar stimulus plan, both of these requiring citizens to cough up more money. Or should we be thinking positively like Mr. Buffet? Start thinking about the future and how the tables can be turned with a little hope and faith? Of course he is speaking as a billionaire who might be able to sustain his financial status during this economic time, but his attitude does remind me of a popular saying; "As low as we are now, there's nowhere else to go but UP!"
Sources:
1. Associated Press. "Warren Buffet says economy fell off a cliff." Contra Costa Times. 9 March 2009. 9 March 2009 <http://www.contracostatimes.com/business/ci_11872501?nclick_check=1>.
2. Fitz-Gerald, Keith. "US Recession Could Be Worse Than Japan's Lost Decade." NuWire Investor. 3 March 2009. 9 March 2009 <http://www.nuwireinvestor.com/articles/us-recession-could-be-worse-than-japans-lost-decade-52647.aspx>.
Friday, February 20, 2009
Reserves: What, Why, and How?
The topic of reserves is extremely important. For different types of firms, having a sufficient amount of reserves is critical for future business. In order to see why reserves has a great impact on future endeavors of various companies, we can explore the "what", "why" and "how" of the term.
What are reserves?
The definitions alters a little depending on the type of firm it is. For banks, it is the amount of money that is physically held within each branch of banks. Most banks have to keep a minimum number (reserve requirement) that will enable them to handle the financial transactions throughout the day. For insurance companies, it is similar, but varies on the payout structure. Insurance companies' reserves are the amount of money it holds so that it will be able to pay future policy benefits. The reserves are usually equal to future benefits minus future premiums to be collected. In essence, the generalized definition of reserves is the amount of money a firm keeps on hand so they can handle future business activities.
Why do firms keep reserves?
The purpose of keeping reserves follows the definition, to be able to conduct future activities. Banks use deposits to handle business activities such as investments and loans to other firms. This is a form of them borrowing money from its customers. However, customers will occasionally make withdrawals. That process is the form of customers getting their loan to the banks repaid. The banks must have an amount of money on hand to conduct withdrawals. This same notion applies for insurance companies. Insurance companies issue out various types of policies. They have some that pay in the event of a death and those that pay in the event of survival. In either case, should the policy holder fulfill his or her requirement, a benefit must be paid out. Insurance companies must have an amount that is sufficient enough to handle multiple benefit payments (Remember, insurance companies have MANY policy holders.)
How do reserves diminish risk?
Having a sufficient amount of reserves on hand can keep firms in great standing. For example, banks that issue loans issue them in the thoughts that those loans will not be defaulted on. In our current economic crisis and our housing market, it is evident that this is not the case. Banks that have a large enough amount of reserves can still conduct daily transactions and other business endeavors, even in the event their issued loans are not repaid. If not, those banks will actually have to borrow more money, maybe even from another bank. And one thing we continue to learn is that people are less willing to lend you money when you need. In addition, they are less willing to lend you money when you have a higher default risk. Therefore, having a safety net of reserves helps in decreasing your chances of default risk. Plus, it helps decrease the risk of that firm going bankrupt.
Looking at the three elements above, it is clear that the idea of reserves is critical to firms. It helps businesses better position themselves for future business activities while creating a safety net in the case of financial trouble. And judging from our wave of ups and downs in the economy, it is better to be safe than sorry.
(Information for this posted was gathered from current and previous classes. They include RMi 4350, AS 4350, FI 4000)
What are reserves?
The definitions alters a little depending on the type of firm it is. For banks, it is the amount of money that is physically held within each branch of banks. Most banks have to keep a minimum number (reserve requirement) that will enable them to handle the financial transactions throughout the day. For insurance companies, it is similar, but varies on the payout structure. Insurance companies' reserves are the amount of money it holds so that it will be able to pay future policy benefits. The reserves are usually equal to future benefits minus future premiums to be collected. In essence, the generalized definition of reserves is the amount of money a firm keeps on hand so they can handle future business activities.
Why do firms keep reserves?
The purpose of keeping reserves follows the definition, to be able to conduct future activities. Banks use deposits to handle business activities such as investments and loans to other firms. This is a form of them borrowing money from its customers. However, customers will occasionally make withdrawals. That process is the form of customers getting their loan to the banks repaid. The banks must have an amount of money on hand to conduct withdrawals. This same notion applies for insurance companies. Insurance companies issue out various types of policies. They have some that pay in the event of a death and those that pay in the event of survival. In either case, should the policy holder fulfill his or her requirement, a benefit must be paid out. Insurance companies must have an amount that is sufficient enough to handle multiple benefit payments (Remember, insurance companies have MANY policy holders.)
How do reserves diminish risk?
Having a sufficient amount of reserves on hand can keep firms in great standing. For example, banks that issue loans issue them in the thoughts that those loans will not be defaulted on. In our current economic crisis and our housing market, it is evident that this is not the case. Banks that have a large enough amount of reserves can still conduct daily transactions and other business endeavors, even in the event their issued loans are not repaid. If not, those banks will actually have to borrow more money, maybe even from another bank. And one thing we continue to learn is that people are less willing to lend you money when you need. In addition, they are less willing to lend you money when you have a higher default risk. Therefore, having a safety net of reserves helps in decreasing your chances of default risk. Plus, it helps decrease the risk of that firm going bankrupt.
Looking at the three elements above, it is clear that the idea of reserves is critical to firms. It helps businesses better position themselves for future business activities while creating a safety net in the case of financial trouble. And judging from our wave of ups and downs in the economy, it is better to be safe than sorry.
(Information for this posted was gathered from current and previous classes. They include RMi 4350, AS 4350, FI 4000)
Thursday, February 19, 2009
What is Model Risk?
What is model risk? When discussed in class, Professor Grace stated the summarized definition of "when a firm isn't looking at what's really going on due to them being stuck on a particular model, even if that model is not the correct one." Riccardo Rebonato comprised a definition as well. It simply states that model risk occurs after observing a set of prices for hedging instruments, and receiving a different result after using different yet similar models. Because of the mix-match of results, financial losses are incurred.
There are different types of model risk. 1)Wrong Model- This is when the wrong model is chosen to measure a particular project, returns, or a set of data. 2)Model Implementation- During the process of applying the chosen model, different complications can occur such as using wrong data, estimated values, or other technical errors. 3)Model Usage- This happens when a model is used improperly.
Why is model risk important? What affects does it have on a firm? Looking from its definition, model risk can cause many financial losses. For example, financial institutions rely greatly on models for their investment projects, investment returns, and other data. They use results from created models to determine their moves in the industry. Because most moves require great amount of resources (both money and time), it is critical that they models they used are correct and portray the correct future outcomes. If model risk is high, firms won't only lose financially, but could potentially lose their reputation.
Model risk is very important. Because of all the factors that it affects, firms allocate a lot of money towards model risk management. Once firms are better at choosing the correct models and implementing at the appropriate time, they will decrease their model risk and keep potential monetary and reputable losses low.
(Sources for this post are from "Theory and Practice of Model Risk Management" by Riccardo Rebonato and Wikipedia: "Model Risk".)
There are different types of model risk. 1)Wrong Model- This is when the wrong model is chosen to measure a particular project, returns, or a set of data. 2)Model Implementation- During the process of applying the chosen model, different complications can occur such as using wrong data, estimated values, or other technical errors. 3)Model Usage- This happens when a model is used improperly.
Why is model risk important? What affects does it have on a firm? Looking from its definition, model risk can cause many financial losses. For example, financial institutions rely greatly on models for their investment projects, investment returns, and other data. They use results from created models to determine their moves in the industry. Because most moves require great amount of resources (both money and time), it is critical that they models they used are correct and portray the correct future outcomes. If model risk is high, firms won't only lose financially, but could potentially lose their reputation.
Model risk is very important. Because of all the factors that it affects, firms allocate a lot of money towards model risk management. Once firms are better at choosing the correct models and implementing at the appropriate time, they will decrease their model risk and keep potential monetary and reputable losses low.
(Sources for this post are from "Theory and Practice of Model Risk Management" by Riccardo Rebonato and Wikipedia: "Model Risk".)
Tuesday, February 17, 2009
How will the Stimulus Plan affect me?,...cont.
I recently discussed some aspects of the stimulus bill that has been popular lately. Upon logging online today, I saw that President Obama is planning to go through with the plan is getting ready for the process of signing the bill. Once signed, the Stimulus Plan will be working with a $787 billion package that will spread out among many areas in the nation. Now that a number has been set to the package, we can start seeing how much money will be allocated to particular projects and what these values will mean to us.
1. Taxes- Advantages of tax breaks are provided for families that send a child to college, buy a new car, buy a new home, or make their current home more energy efficient. For individuals, we can expect to see about $13 more in our checks.
2. Health Insurance- With the recent layoffs during the nations reception, a lot of former employees have had problems with health care. Under COBRA, coverage for former employees will continue for the following 18 months. After the implementation of the stimulus package, those who lost their jobs and had to incur the extra cost of expensive health care will now have 65% of their costs handled by the government for the first 9 months.
3. Infrastructure- About $90 billion will be allocated towards repairing roads, repaving highways, and reinforcing bridges. With more construction activities occurring, it is the government's hope that additional job opportunities will be created.
4. Energy- For those who want to be more energy efficient and save money in the long-run, taking on energy focused activities will result in tax breaks. (i.e. energy efficient windows in the home, solar panel roof, other related activities). Also, $300 million will go for rebates to encourage consumers to buy more efficient appliances.
5. Schools- One key goal is to keep teachers employed. To do this, the plan is to allocate $54 billion (where $39 billion will go towards kindergarten to 12 grade) to prevent state budget cuts. Additionally, $25 billion will go to "No Child Left Behind" to help fund teachers' salaries and special education programs.
6. National Debt- Because of this grand total amount, $787 billion, the country will be in more debt. The increase in debt will mean higher taxes and fewer government services that will not only affect our generation, but the next one as well.
7. Environment- $9.2 billion will go towards environmental projects under the EPA (Environmental Projection Agency). The projects they will conduct is expected to produce approximately 200,000 jobs. These projects include national park renovations, road repairs, and improving drinking water systems.
8. Police- $3.7 billion will go towards police programs and hiring new officers. $1 billion is to bring back the program COPS (Community Oriented Policing Systems), a program that was eliminated under the Bush Administration. This program paid police officers' salaries and reduced crime in the 1990s. The bill will also provide an amount to youth mentoring programs, aid victims of crimes, fight Internet crimes against children, and help law enforcement on the Mexican border.
9. Higher Education- Under the plan, the Pell Grant maximum amount will increase to $5,350 from $4,731 starting July 1 and to $5,550 in 2010-2011. An additional 800,000 students will be able to qualify for the grant under the new amount of funds. Also, $32 billion will be allocated towards higher education.
10. The Poor- There are approximately 37 million American who live in poverty. With the stimulus plan in affect, those who get food stamps will now receive more. Those who receive unemployment checks and expect an additional $25/check in addition to a longer check receiving period. People who receive Supplemental Security Income will get a one-time $250.
Although each of these areas are greatly important and might affect all of us differently, as college students, upcoming graduates, and professors, I "bolded" the ones I felt have the most direct affect on us. No matter what, this Stimulus bill is going to impact us heavily in the near future.
(Information for this blog was mainly from "How the stimulus bill affects you" by the Associated Press on February 16, 2009 at 2:40pm. Here is the website for more information. http://articles.moneycentral.msn.com/Investing/Extra/how-the-stimulus-bill-could-affect-you.aspx?page=1>1=33009)
1. Taxes- Advantages of tax breaks are provided for families that send a child to college, buy a new car, buy a new home, or make their current home more energy efficient. For individuals, we can expect to see about $13 more in our checks.
2. Health Insurance- With the recent layoffs during the nations reception, a lot of former employees have had problems with health care. Under COBRA, coverage for former employees will continue for the following 18 months. After the implementation of the stimulus package, those who lost their jobs and had to incur the extra cost of expensive health care will now have 65% of their costs handled by the government for the first 9 months.
3. Infrastructure- About $90 billion will be allocated towards repairing roads, repaving highways, and reinforcing bridges. With more construction activities occurring, it is the government's hope that additional job opportunities will be created.
4. Energy- For those who want to be more energy efficient and save money in the long-run, taking on energy focused activities will result in tax breaks. (i.e. energy efficient windows in the home, solar panel roof, other related activities). Also, $300 million will go for rebates to encourage consumers to buy more efficient appliances.
5. Schools- One key goal is to keep teachers employed. To do this, the plan is to allocate $54 billion (where $39 billion will go towards kindergarten to 12 grade) to prevent state budget cuts. Additionally, $25 billion will go to "No Child Left Behind" to help fund teachers' salaries and special education programs.
6. National Debt- Because of this grand total amount, $787 billion, the country will be in more debt. The increase in debt will mean higher taxes and fewer government services that will not only affect our generation, but the next one as well.
7. Environment- $9.2 billion will go towards environmental projects under the EPA (Environmental Projection Agency). The projects they will conduct is expected to produce approximately 200,000 jobs. These projects include national park renovations, road repairs, and improving drinking water systems.
8. Police- $3.7 billion will go towards police programs and hiring new officers. $1 billion is to bring back the program COPS (Community Oriented Policing Systems), a program that was eliminated under the Bush Administration. This program paid police officers' salaries and reduced crime in the 1990s. The bill will also provide an amount to youth mentoring programs, aid victims of crimes, fight Internet crimes against children, and help law enforcement on the Mexican border.
9. Higher Education- Under the plan, the Pell Grant maximum amount will increase to $5,350 from $4,731 starting July 1 and to $5,550 in 2010-2011. An additional 800,000 students will be able to qualify for the grant under the new amount of funds. Also, $32 billion will be allocated towards higher education.
10. The Poor- There are approximately 37 million American who live in poverty. With the stimulus plan in affect, those who get food stamps will now receive more. Those who receive unemployment checks and expect an additional $25/check in addition to a longer check receiving period. People who receive Supplemental Security Income will get a one-time $250.
Although each of these areas are greatly important and might affect all of us differently, as college students, upcoming graduates, and professors, I "bolded" the ones I felt have the most direct affect on us. No matter what, this Stimulus bill is going to impact us heavily in the near future.
(Information for this blog was mainly from "How the stimulus bill affects you" by the Associated Press on February 16, 2009 at 2:40pm. Here is the website for more information. http://articles.moneycentral.msn.com/Investing/Extra/how-the-stimulus-bill-could-affect-you.aspx?page=1>1=33009)
Sunday, February 15, 2009
What is Credit Risk?
What is the meaning and significance of credit risk? Well, the first answer is that credit risk is "a risk that a counter party will fail to meet a contractual payment obligation." An example would be short selling. I borrow $55 to go and buy stock. My bet is that the stock price will fall, allowing me to make a profit. However, if the price increases, I am still obligated to repay the $55 plus interest back to the lender. The chance that I might not be able to repay the lender means they have a level of credit risk. Credit events (situations where credit risk is evident) would be companies declaring bankruptcy or failure to make bond payments. In reference to bond payments, people can use bond ratings to measure the amount of credit risk and the probability a company will default on a bond. The same holds true for estimating the probability of firms going bankrupt. The ratings transition matrix has a host of numbers that helps firms determine the probability that they will go move from one rating category to the next.
One might think, "Lending and borrowing is done everyday, it's a way of life. Since it's hard to really operate with out the two, how does one protect himself from credit risk?" The answer is yes. Just as their are derivatives to help firms hedge from price risk, there are credit derivatives used to transfer credit risk from a firm. One financial structure is called a CDO, collateralized debt obligation. Using a CDO allows one to take a group of risky bonds and create new claims, where some are less risky than the original bonds. Another derivative is a CDS, credit default swap. As mentioned earlier, a default is when a borrower can not repay its debt to the lender. A CDS makes a payment when a firm experiences a credit event, thereby protecting the purchaser (protection buyer) in the event of a default.
Taking all of these things into account, we see that credit risk is more prevalent than we think. In a simple borrow-and-lend exchange amongst friends, their is a level of credit risk there. And even in that case, smart friends would ask for some collateral or promise of something else in case of default. The same way this informal situation shows protecting actions, this is the same manner firms behave when placed in a credit event.
(The information for this posting was read about in previous classes. However, I received more knowledge from the book "Credit Risk. Derivatives Market." by Robert McDonald.)
One might think, "Lending and borrowing is done everyday, it's a way of life. Since it's hard to really operate with out the two, how does one protect himself from credit risk?" The answer is yes. Just as their are derivatives to help firms hedge from price risk, there are credit derivatives used to transfer credit risk from a firm. One financial structure is called a CDO, collateralized debt obligation. Using a CDO allows one to take a group of risky bonds and create new claims, where some are less risky than the original bonds. Another derivative is a CDS, credit default swap. As mentioned earlier, a default is when a borrower can not repay its debt to the lender. A CDS makes a payment when a firm experiences a credit event, thereby protecting the purchaser (protection buyer) in the event of a default.
Taking all of these things into account, we see that credit risk is more prevalent than we think. In a simple borrow-and-lend exchange amongst friends, their is a level of credit risk there. And even in that case, smart friends would ask for some collateral or promise of something else in case of default. The same way this informal situation shows protecting actions, this is the same manner firms behave when placed in a credit event.
(The information for this posting was read about in previous classes. However, I received more knowledge from the book "Credit Risk. Derivatives Market." by Robert McDonald.)
How Does the Stimulus Affect Me?
For the past year or so, I've been hearing a lot of the "Stimulus Plan". I must say that I did not know much about it. Is it a stimulus check coming to me personally? Or, is it a check that comes to an agency (state or federal government, non-profit government organizations, etc)? In either case, the thinking behind the plan is the same, this "Stimulus Plan" is to "stimulate" the economy. According to Obama's mindset, implementing this plan will issue stimulus checks to various agencies. Those agencies will then use those checks to conduct projects, such as road building, that will not only improve roads and the cities they're in, but create job opportunities. Key objectives of this plan is to decrease unemployment while improving the economy. By having the government borrow money and then spend it on the aforementioned projects, the overall result should be for new money to come into the government.
What does this have to do with me? From speaking with various students, the possibility of individuals receiving stimulus check is not as small as we think. In fact, many are asking questions and giving suggestions on what individuals should do pending they receive a check. One major piece of advice that is going around is to keep the money in the US. What I mean by this is for people to take their checks and spend them in stores where the money will stay in our country. As much as we'd love to, taking our checks to Wal-Mart does not keep the money in the US, but instead, sends it overseas (primarily China). Nothing against Wal-Mart, but most of their products are Chinese imports. What economists are suggesting is for people to spend their checks in "mom-and-pop" stores. Family owned businesses, restaurants, local establishments. This stimulates the local economy as we allow entrepreneurs' (i.e. recent graduates such as myself) establishments to grow. Furthermore, as small businesses begin to increase, more employment opportunities are created, AND that business can give back to the community.
I never knew much about this plan, but as I read and learned more, I see that it affects me in more ways than one. Coming on graduation in a few months and with the current state of the economy, job scarcity is a major concern. Should the bill be passed to implement the "Stimulus Plan", various organizations will received a check and possibly be placed in a better position to offer more jobs. On the other side, universities are in line to receive stimulus checks as well. Even though they cannot use it to on facility reconstruction and related activities, schools can use the monetary advances to increase the level education (by hiring more, expertise educators) and provide additional education resources for students. Either way, I see that this plan has benefits that I'd like to partake of, and I plan to keep watching as the bill moves along in this process.
(Ideas of this post were taken from the article "Heckonomics: The Stimulus: What the heck is it, and how's it supposed to work?" by Timothy P. Carney on January 21, 2009)
What does this have to do with me? From speaking with various students, the possibility of individuals receiving stimulus check is not as small as we think. In fact, many are asking questions and giving suggestions on what individuals should do pending they receive a check. One major piece of advice that is going around is to keep the money in the US. What I mean by this is for people to take their checks and spend them in stores where the money will stay in our country. As much as we'd love to, taking our checks to Wal-Mart does not keep the money in the US, but instead, sends it overseas (primarily China). Nothing against Wal-Mart, but most of their products are Chinese imports. What economists are suggesting is for people to spend their checks in "mom-and-pop" stores. Family owned businesses, restaurants, local establishments. This stimulates the local economy as we allow entrepreneurs' (i.e. recent graduates such as myself) establishments to grow. Furthermore, as small businesses begin to increase, more employment opportunities are created, AND that business can give back to the community.
I never knew much about this plan, but as I read and learned more, I see that it affects me in more ways than one. Coming on graduation in a few months and with the current state of the economy, job scarcity is a major concern. Should the bill be passed to implement the "Stimulus Plan", various organizations will received a check and possibly be placed in a better position to offer more jobs. On the other side, universities are in line to receive stimulus checks as well. Even though they cannot use it to on facility reconstruction and related activities, schools can use the monetary advances to increase the level education (by hiring more, expertise educators) and provide additional education resources for students. Either way, I see that this plan has benefits that I'd like to partake of, and I plan to keep watching as the bill moves along in this process.
(Ideas of this post were taken from the article "Heckonomics: The Stimulus: What the heck is it, and how's it supposed to work?" by Timothy P. Carney on January 21, 2009)
Sunday, February 8, 2009
Recession...leading to Risk Management?
The recession is nothing new to us. In fact, we know that it has been happening for quite some time now. The time now is coming when companies are realizing that this state of economic crisis has a major effect on business and needs to be handled. It's because of this that firms have increased their interest in Enterprise Risk Management. The Association of Insurance and Risk Managers conducted a survey and noticed that 450 of its corporate members increased their focus on ERM during the past 2 years. In addtion to the economy, firms are trying to pick apart which recent investments might have turned out to be a disadvantage rather than the opposite. In finance, we are taught that good investment projects are those with a Net Present Value greater than 0. This is still true; however firms are starting to employ risk management background employees to help determine whether a project should actually be implemented, even if it's NPV >0.
The current economic state has proven that better risk management needs to be in place. From having to bail out various companies, ranging from insurance firms to financial firms, we should see that not everything that glitters for a moment is gold for a lifetime. To better understand and truly discern which investments are beneficial, we have to look at the long run. Professor Grace once said that, "Risk management is not a technique for the short run. Nor is it something that you can look at in the middle and say, 'No, it's not working. Let's change it now.' Instead, it is something that you implement in the beginning for a long term." So I say to those firms who are still doing good and want to stay that way, determine the value that risk management can create for you and let it do just that. Do it before the recession wave catches YOU!
(The article I got this topic and some stats from was titled "Recession forces risk risk management rethink" by Samantha Pearson. It was posted on Feb. 8, 2009 on Financial Times.com.)
The current economic state has proven that better risk management needs to be in place. From having to bail out various companies, ranging from insurance firms to financial firms, we should see that not everything that glitters for a moment is gold for a lifetime. To better understand and truly discern which investments are beneficial, we have to look at the long run. Professor Grace once said that, "Risk management is not a technique for the short run. Nor is it something that you can look at in the middle and say, 'No, it's not working. Let's change it now.' Instead, it is something that you implement in the beginning for a long term." So I say to those firms who are still doing good and want to stay that way, determine the value that risk management can create for you and let it do just that. Do it before the recession wave catches YOU!
(The article I got this topic and some stats from was titled "Recession forces risk risk management rethink" by Samantha Pearson. It was posted on Feb. 8, 2009 on Financial Times.com.)
Saturday, February 7, 2009
Value at Risk or Beta: Which is BetteR?
Professor Grace once asked us a question on which company was riskier: a company with a VaR of $2 bil and a Beta of 1, or a compnay with a VaR of $2 mil and a Beta of 2? Well, which one is it? Answer: It all depends on which view you're looking from AND which measure of risk you're using. Those looking in terms of VaR would say that company #1 is riskier than the second. Those looking at Beta would say the opposite. We'll look at each view and then compare and contrast the two measuring options.
First we look at VaR, which stands for Value at Risk. What is Value at Risk exactly? There are many definitions, but the concept is the same. Computing a firm's Value at Risk allows them to answer the following questions: "What is my exposure for tomorrow, especially if tomorrow is my worst day?" and "What is the worst lost that could occur x% of the time?" In addition, firm's will be able to make the statement, "We are X% certain that we will not lose more than $V in the next N days!" But if we must give some definitions of the term, here are a few: 1) the value of loss to the firm, and 2)an attempt to provide a single number summarizing the total risk in a portfolio. Firms that calculate their VaR are able to find the distribution of their returns and see what their worst possible lost is for a given percentage level so that they can implement the appropriate risk management techniques. For example, banks use VaR to determine how much capital is needed to bear future risks (also known as reserves). One could calulate the VaR using this formula:
VaR (C%) = u +/- sigma * zc . C% represents the percentage (level of confidence) the firm wants to be sure about. With that, zc is the corresponding z-score for the confidence level. u is the mean while sigma is the standard deviation (or volitality). All of these components help companies determine their Value at Risk.
Now, we'll examine Beta. Beta is another way to measure risk. However, it doesn't look at a percentage level; instead, it looks at a relationship between the firm and the market. First, let's determine how to calculate Beta.
Beta = Cov(X,Y)/Var(Y). (Before I go any further, please note that the denominator is the variance of firm Y, not the value at risk of firm Y). Cov(X,Y) represents the covariance between firms X & Y. This basically let's us see how closely related the two firms are, as well as their movement with each other. (This is done by dividing the covariance by the product of both firms' standard deviation; this in turn gives you the correlation). Doing the formula gives you the Beta, the sensitivity changes in X related to the changes in Y. Basically, the sensitivity between X and Y. Another formula would be rs-rf = alpha + Beta(rm-rf); however, this is used in relation with CAPM. From the first formula, we mentioned the word "sensitivity" and how this formula allows you to see the sensitivity between the two variables. This is important because firms can determine their sensitivity in relation to the market. Firms with a Beta>1 are sensitive to the market. This means that whenever the market moves, and in the same direction, that firm will move just the same. For example, Home Depot with a Beta=2 will a movement twice as much as the market. Therefore, if the market's price moves up 10%, Home Depot's will move 20%. For firms that have a Beta=1, they are considered neutral. Meaning, they are in exact alliance with the market. If the market moves up one, they move up one, if the market moves down .17894, that firm moves down exactly .17894. Lastly, if a firm has a Beta<1,>
So, back to the original question, which firm is riskier? With all the information given, some might have changed their answer. However, the answer is still the same. When a firm's VaR is high, they have greater risks. When their Beta increases and gets higher, they have a greater risk. Therefore, the two measuring tools share one common aspect; WHENEVER THEY ARE HIGH, THE COMPANY HAS A LOT OF RISK. So for the question asked, your answer may forever differ from mine because....it all depends on which view we're using!
First we look at VaR, which stands for Value at Risk. What is Value at Risk exactly? There are many definitions, but the concept is the same. Computing a firm's Value at Risk allows them to answer the following questions: "What is my exposure for tomorrow, especially if tomorrow is my worst day?" and "What is the worst lost that could occur x% of the time?" In addition, firm's will be able to make the statement, "We are X% certain that we will not lose more than $V in the next N days!" But if we must give some definitions of the term, here are a few: 1) the value of loss to the firm, and 2)an attempt to provide a single number summarizing the total risk in a portfolio. Firms that calculate their VaR are able to find the distribution of their returns and see what their worst possible lost is for a given percentage level so that they can implement the appropriate risk management techniques. For example, banks use VaR to determine how much capital is needed to bear future risks (also known as reserves). One could calulate the VaR using this formula:
VaR (C%) = u +/- sigma * zc . C% represents the percentage (level of confidence) the firm wants to be sure about. With that, zc is the corresponding z-score for the confidence level. u is the mean while sigma is the standard deviation (or volitality). All of these components help companies determine their Value at Risk.
Now, we'll examine Beta. Beta is another way to measure risk. However, it doesn't look at a percentage level; instead, it looks at a relationship between the firm and the market. First, let's determine how to calculate Beta.
Beta = Cov(X,Y)/Var(Y). (Before I go any further, please note that the denominator is the variance of firm Y, not the value at risk of firm Y). Cov(X,Y) represents the covariance between firms X & Y. This basically let's us see how closely related the two firms are, as well as their movement with each other. (This is done by dividing the covariance by the product of both firms' standard deviation; this in turn gives you the correlation). Doing the formula gives you the Beta, the sensitivity changes in X related to the changes in Y. Basically, the sensitivity between X and Y. Another formula would be rs-rf = alpha + Beta(rm-rf); however, this is used in relation with CAPM. From the first formula, we mentioned the word "sensitivity" and how this formula allows you to see the sensitivity between the two variables. This is important because firms can determine their sensitivity in relation to the market. Firms with a Beta>1 are sensitive to the market. This means that whenever the market moves, and in the same direction, that firm will move just the same. For example, Home Depot with a Beta=2 will a movement twice as much as the market. Therefore, if the market's price moves up 10%, Home Depot's will move 20%. For firms that have a Beta=1, they are considered neutral. Meaning, they are in exact alliance with the market. If the market moves up one, they move up one, if the market moves down .17894, that firm moves down exactly .17894. Lastly, if a firm has a Beta<1,>
So, back to the original question, which firm is riskier? With all the information given, some might have changed their answer. However, the answer is still the same. When a firm's VaR is high, they have greater risks. When their Beta increases and gets higher, they have a greater risk. Therefore, the two measuring tools share one common aspect; WHENEVER THEY ARE HIGH, THE COMPANY HAS A LOT OF RISK. So for the question asked, your answer may forever differ from mine because....it all depends on which view we're using!
Tuesday, February 3, 2009
JQ/Practice Question-Risk Mgnt and Value Equation
For our practice exam, Professor Grace asked us to answer what risk management would do the value of a firm equation. I then noticed that it was also a JQ. So I'm taking it that this is really important. Therefore, I'll break down each component and tell how risk management will affect the equation.
First, let's assume that the appropriate risk management technique has been implemented, and it was performed correctly. So with better risk management, the following will occur:
1. The probability of a firm going bankrupt will decrease. Therefore, the bankruptcy costs will also decrease.
2. As the probability of bankruptcy decreases for a firm, their credibility and reputation begin to look better to lenders. (As Professor Grace said, when you need money the most, that's when people do not want to lend it to you. This is especially true when a company has a higher risk of going bankrupt and losing the money that was lent to them. I believe this is called default risk). Thus, a smaller bankruptcy probability and lower bankruptcy costs will lead to a better interest rates from lenders. This interest rate will be smaller, making the denominator (1+r)^t smaller
The combination of these two factors (low bankruptcy cost and lower interest rate, therefore lower denominator) makes the overall equation and value of the firm increase. One might notice that we didn't mention NCF (Net Cash Flows). This is equal to (Revenues-Costs). With the implementation of risk management techniques, costs will increase. (Paying for insurance, hedging, etc). However, if done correctly and with good financial forecasting, Revenues might also increase, thereby balancing out the numerator of the equation.
Hope this helps.
First, let's assume that the appropriate risk management technique has been implemented, and it was performed correctly. So with better risk management, the following will occur:
1. The probability of a firm going bankrupt will decrease. Therefore, the bankruptcy costs will also decrease.
2. As the probability of bankruptcy decreases for a firm, their credibility and reputation begin to look better to lenders. (As Professor Grace said, when you need money the most, that's when people do not want to lend it to you. This is especially true when a company has a higher risk of going bankrupt and losing the money that was lent to them. I believe this is called default risk). Thus, a smaller bankruptcy probability and lower bankruptcy costs will lead to a better interest rates from lenders. This interest rate will be smaller, making the denominator (1+r)^t smaller
The combination of these two factors (low bankruptcy cost and lower interest rate, therefore lower denominator) makes the overall equation and value of the firm increase. One might notice that we didn't mention NCF (Net Cash Flows). This is equal to (Revenues-Costs). With the implementation of risk management techniques, costs will increase. (Paying for insurance, hedging, etc). However, if done correctly and with good financial forecasting, Revenues might also increase, thereby balancing out the numerator of the equation.
Hope this helps.
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