Derivatives - An Introduction

 

Introduction

Today we will learn the basics of derivatives securities and derivatives markets. Lets get started with the difinations.

• Derivatives
• A security that gets its values on the basis of some other assets.
• These other assets are referred to underlying assets, from which derivative effectively derives its price from.
• Other assets are stocks, bonds, currency, could be even weather and these are known as asset classes. Below are two types of other assets:
• Consumption
• Crude
• Silver
• Copper/Tin
• Gold
• Financial
• Equity Share
• Bond
• Futures
• Gold
• Derivatives example could be nifty futures where the underlying is nifty 50 index
• Nifty 50 Index 
• The Nifty 50 index is a stock market index in India, representing the top 50 large-cap companies listed on the National Stock Exchange (NSE) of India. 
• It reflects the overall performance of the Indian stock market and serves as a benchmark for many investors. 
• Nifty Futures 
• Nifty futures are contracts that give you the right to buy or sell the Nifty 50 index at a predetermined price on a specified future date. 
• They allow investors to speculate on or hedge against future changes in the Nifty 50 index. 
• How It Works Underlying Asset: 
• The Nifty 50 index is the underlying asset of the Nifty futures. 
• Its value changes based on the performance of the 50 companies included in the index. 
• Futures Contract: A Nifty futures contract is an agreement to buy or sell the Nifty 50 index at a future date for a price agreed upon today. 
• For example, if the current value of the Nifty 50 index is 18,000, you might enter into a futures contract to buy the index at a price of 18,200, with the contract settling in a month. 
• Practical Implications Speculation: 
• Traders might use Nifty futures to bet on the direction of the Nifty 50 index. 
• If they expect the index to rise, they might buy futures contracts, hoping to sell them at a higher price later. 
• Conversely, if they expect the index to fall, they might sell futures contracts, hoping to buy them back at a lower price. 
• Hedging: 
• Investors holding a portfolio of stocks that are part of the Nifty 50 index might use Nifty futures to hedge against potential losses. 
• For example, if the index is expected to drop, they might sell Nifty futures to offset losses in their portfolio. 
• Imagine you believe the Nifty 50 index, currently at 18,000, will rise over the next month. 
• You decide to buy a Nifty futures contract with a price of 18,200, expiring in one month.  
• Scenario 1: If, at expiration, the Nifty 50 index is 18,500, you can sell the futures contract at this higher price, making a profit. 
• Scenario 2: If the Nifty 50 index falls to 17,800, you will incur a loss since the value of the futures contract is lower than the price you paid.
• Hedging is a double edged sword, but it helps in fixing your cashflow. Also could be said as it helps you in predetermining your cash flow.
• Hedging is do what you are more afraid of, if you believe prices will go down then sell futures/forwards.
• Derivatives elimate undercertainity and used for the purpose of hedging. Eliminating uncertainity is hedging which means removing risk. Riks does not means no loss it just means there is uncertainity.
• Derivatives helps in preventing uncertainity/risk using forwards or futures.
• The price is locked in today for a transaction that shall take place in the future.
• Derivatives are leverage instruments, <>.
• Derivatives Types
• Linear
• Movement of derivative is proportional to value of underlying, means have a linear payoff that is directly related to the value of the underlying.
• Eg: Futures, Forwards, Swaps
• Forward Commitments
• It becomes a commitment which has to be fullfilled
• The contracts specify the buying or selling of an underlying asset for a stated price at a stated time in the future.
• They are essentially zero sum games wehre one party wins the same amount that the other party loses.
• Non Linear
• Movement in derivatives security is non proportional to movement of underlying asset.
• Eg: Options
• Call option
• Put option
• Contigency claims
• Whether this option will be excerised or not is contigent / dependent
• Involve the option purchaser (holder) having right but not being obligated to buy or sell an underlying asset at a stated time in the future.
• Payoff hence is nonlinear in relation to the value of the underlying.

Derivatives Markets and Securities

Exchange trading

• Traditional derivatives exchanges use both an open outcry system and electronic systems to match buyers with sellers.
• Exchanges are regulated and organized in such a way that credit risk is eliminated.
• The open outcry system
• Is more traditional system, which involves traders indicating their trades through hand signals and shouting.
• Electronic trading system
• Represents most of the trading done today, does not involves a physical exchange location, but rather involves matching buyers and sellers electronically via computers.
• Eg: NASDAQ
• Algorithm trading is a form of electronic trading which executes trades without human involvement.
• Clearing house

Over the counter market - OTC

• Differs from a traditional exchange in that the end users and dealers would contact each other either directly or through a broker, dealers frequently use interdealer brokers to transact with other dealers and often called as market makers.
• A network of dealers
• They help in making the markets
• Act as opposite party in the transaction
• Dealer maintains bid and offer prices in a security and stands ready to buy or sell lots of the given security.
• Dealers often use interdealer brokers to transact with other dealers.
• Inter Dealer Broker - (IDB) is a specialized financial intermediary that facilitates trading and transactions between broker dealers or financial institutions rather than between individual investors.
• Examples
• ICAP: One of the largest inter-dealer brokers in the world, providing services in various financial markets. 
• TP ICAP: A major IDB that operates across a range of asset classes, including fixed income, derivatives, and commodities. 
• BGC Partners: Another leading IDB offering brokerage services in multiple markets.
• Decentralized trading platform, without a central physical location, where the market participants use a host of communication channels to trade with one another without a formal set of regulations.
• The communication channel could be telephone, email or software applications.
• In an OTC market, it's possible for two participants to exchange products/securities privately without others being aware of the terms, including the price.
• OTC markets are much less transparent than exchange trading.
• Stocks traded in an OTC market could belong to a small company that's yet to satisfy the conditions for listings on the exchange.
• The OTC markets are also popular for large trades than traditional exchanges.
• Advantages are fewer restrictions and regulations, freedom to negotiate deals and cost effective for corporations.
• Downside the disadvantages are increased credit risk when it comes to nonstandardized transactions and less transparency.
• CCP Central Counterparty
• Quote Market: A market where quotes are provided for buying and selling securities, which can be found in both OTC and centralized exchanges.
• In a quote market, market participants receive quotes indicating the price at which a security can be bought or sold. Quotes typically include the bid price (price at which buyers are willing to purchase) and the ask price (price at which sellers are willing to sell).

Forward Contract

• A forward contract, is a non standardized contract between two parties that specifies the price and the quantity of an asset to be delivered in the future.
• They are traded in the OTC market.
• One party takes the long position and agrees to buy the underlying asset at a specified price on the specified date, while the other party takes the short position and agrees to sell the asset on the same date at the same price.
• For example, here it enters into a contract which allows it to buy the stock after 3 months at a price locked today.

Future Contract

• A standarized, legally binding agreement between two parties that specifies the price at which to trade a given asset (commodity or financial instrument) at a specified future date.
• Future contracts can be traded on exchanges (CME, CBOE, etc.)

Future vs Forward Contracts

• Futures
• Regulated, clearing house, is an interposed party between the buyer and the seller which ensures the performance of the contract. 
• Standardised
• In essence, future contracts has no credit risk.
• Marking to market, since the clearing house must monitor the credit risk between the buyer and seller. It performs daily marking to market. This is the settlement of the gains and losses on the contract on a daily basis. It avoids the accumulation of large losses over time.
• Margins, daily settlements may not provide a buffer strong enough to avoid future losses. For this reason, each party is required to post collateral that can be seized in the event of default. The initial margin must be posted when initiating the contract. If the equity in the account falls below the maintenance margin, the relevant party is required to provide additional funds to cover the initial margin.
• Forwards
• OTC
• Non Standardised
• Credit risk is involved.
• No MTM and settled at expiry
• Non initial margin

Derivatives Payoff

Option Contract

• Option Contract, an agreement between two parties to transact on an underlying security at a predetermined price called the strike/exercise price prior to some date called the expiration date. 
• The option gives the holder a right but not the obligation to buy/sell the underlying at an agreed upon date at the strike price.
• Types of Options:
• Categorized based on when can they be exercised.
• American-style:
• Option contract can be exercised any time between issue date and on the actual expiration date.
• Physical and cash settlement any time.
• European-style
• Option contract may be exercised only on the actual expiration date.
• Physical settlement only in the end and but cash settlement could be any time.
• Bermudian
• Option contract may be exercised only at multiple dates.
• American options will be worth more than European options when the right to early exercise is valuable, and they will have equal value when it is not.
• Notes:
• Call = Buy
• Put = Sell
• Long = Buy
• Short = Sell
• So = Start Price
• ST = Expiry Price
• St = Price in mid
• x|k = Strike Price
• Co = Price of buying bond
• Premium = Cost involed buying option

Call Option Payoff

• A call option gives the holder the right but not the obligation to buy the underlying asset at the strike price prior the expiration date. 
• The call option holder is betting that the price of the underlying will rise.
• Buying a call option on an asset is like borrowing money to buy the asset, in that it allows big risks to be taken with a small initial investment. The gains and losses are accentuated.
• Call Option Buyer
• The call option buyer purchases the right, but not the obligation, to buy an underlying asset (like a stock) at a specified strike price before or at the expiration date.
• Call Option Buyer could also be called as Long Party.
• Eg:
• There is option which is currently priced at $60, and the prediction is 3 months later the price will move to $80.
• Assume to buy call option there are below strike prices available:
• $65
• $75
• $80
• You decided to buy for $65, but note there always cost involved in buying options. Premium here is $8.25.
• Transactions happen always at strike price, this price is locked and you will transact only with this price, but the buyer has a right either exercise this or not based on the actual situation after 3 months.
• Below are few possible prices the ST price will turn out to be true. 
• Note: expectation is price to rise
• Case 1: ST > x|k
• ST = $100
• x|k = $65
• Right to buy for $65, where the actual price is $100
• Payoff = 100-65 = $35
• Profit = Payoff - Initial Premium Paid
• 35 - 8.25 = 26.75
• Here since we are getting profit of $26.75 we will exercise the call option.
• Note: Always one rule we would need to follow
• Buy Cheap
• Sell High
• As here it is cheap we would buy and exercise this call option
• Profits are unlimited here.
• Case 2: ST < x|k
• ST = $50
• x|k = $65
• Right to buy for $65, where the actual price is $50
• Payoff = 50-65 = -$15
• Profit = Payoff - Initial Premium Paid
• -15 - 8.25 = -21.25
• Here if we execerise we will have loss of $-21.25 hence we will not exercise this and eventually loss on the premium of 8.25 for which we have bought the option.
• Note here the maximum loss could occur to us if we exercise the option is limited, assume the price goes to 0 the loss would be as below:
• Right to buy for $65, where the actual price is $0
• Payoff = 0-65 = -$65
• Profit = Payoff - Initial Premium Paid
• -65 - 8.25 = -73.25
• Hence the maximum loss would be -73.25
• Losses are limited here.
• Case 3: ST = x|k
• ST = $65
• x|k = $65
• Right to buy for $65, where the actual price is as well $65
• Payoff = 65-65 = $0
• Profit = Payoff - Initial Premium Paid
• 0 - 8.25 = -8.25
• Here there is a $8.25 initial premium loss, either way, we will have the same loss so we may or may not exercise the call option. 
• Strike Price = Stock Price: There will be a premium loss either way at the expiry.
• Case 4: ST > x|k = BEP
• ST = $73.25
• x|k = $65
• Right to buy for $65, where the actual price is as well $73.25
• Payoff = 73.25-65 = $8.25
• Profit = Payoff - Initial Premium Paid
• 8.25 - 8.25 = -8.25
• Here there is no loss no gain, this we call as Breakeven Point and we would exercise the call option.
• Case 5: ST > x|k
• ST = $70
• x|k = $65
• Right to buy for $65, where the actual price is as well $70
• Payoff = 70-65 = $5
• Profit = Payoff - Initial Premium Paid
• 5 -8.25 = -3.75
• Here there is loss of $3.75 even though we would exercise this call option, if not we will loss the premium which is $8.25. 
• Note: Though this is OTM here we would exercise, from SO == x|k to BEP we would have losses but we will stil exercise the call option. 
• OTM = Out of The Money : ST < x|k
• ATM = At the Money : ST == x|k
• ITM = In the Money : ST > x|k
• Visualization

Credits: https://www.strike.money/wp-content/uploads/2023/10/4-2-1024x650.jpg

• Call Option Seller
• The call option seller, or writer, sells the call option and thus gives the buyer the right to purchase the underlying asset at the strike price. The seller receives the premium paid by the buyer.
• Call Option Seller could also be called as Short Party.
• Eg:
• You decided to sell call option for $80. Premium here is $2.25.
• Below are few possible prices the ST price will turn out to be true. 
• Note: expectation is price to fall
• Case 1: ST > x|k
• ST = $100
• x|k = $80
• Right to sell for $80, where the actual price is $100
• Payoff = 100-80 * = $25
• Profit = Initial Premium Paid - Payoff
• 2.25 - 25 = -22.25
• Here the seller will not exercise the call option as there is loss of $22.25. 
• Hence he would not get 2.25 premium as the option is not exercised.
• Hence he would loose 2.25 premium as the option is not exercised.
• Losses are unlimited here.
• Case 2: ST < x|k
• ST = $50
• x|k = $80
• Right to sell for $80, where the actual price is $50
• Payoff = 50-80 = -$30
• Profit = Initial Premium Paid - Payoff
• 2.25 - ( -30) = $32.25 (from book below this looks like formula)
• 30 - 2.25 = 27.75 (from my understanding the call option seller would have also got this option from market rite)
• Note here the maximum profit could occur to us if we exercise the option is limited, assume the price goes to 0 the loss would be as below:
• Right to sell for $80, where the actual price is $0
• Payoff = 80-0 = $80
• Profit = Initial Premium Paid - Payoff
• 2.25 - (-$80) = 82.25
• Hence the maximum profit would be 77.75
• Profits are limited here.
• Case 3: ST = x|k
• ST = $80
• x|k = $80
• Right to sell for $80, where the actual price is as well $80
• Payoff = 80-80 = $0
• Profit = Payoff - Initial Premium Paid
• 0 - 2.25 = -2.25
• Here there is a $2.25 initial premium loss, either way, we will have the same loss so we may or may not exercise the call sell option. 
• Strike Price = Stock Price: There will be a premium loss either way at the expiry.
• Case 4: ST > x|k = BEP
• ST = $82.25
• x|k = $80
• Right to sell for $80, where the actual price is as well $82.25
• Payoff = 80-82.25 = $2.25
• Profit = Payoff - Initial Premium Paid
• 2.25 - 2.25 = 0
• Here there is no loss no gain, this we call as Breakeven Point and we would exercise the call option.
• Case 5: ST > x|k
• ST = $70
• x|k = $80
• Right to buy for $70, where the actual price is as well $70
• Payoff = 70-65 = $5
• Profit = Payoff - Initial Premium Paid
• 5 -8.25 = -3.75
• Here there is loss of $3.75 even though we would exercise this call option, if not we will loss the premium which is $8.25. 
• Note: Though this is OTM here we would exercise, from SO == x|k to BEP we would have losses but we will stil exercise the call option. 
• Visualization

Credits: https://www.strike.money/wp-content/uploads/2023/10/5-2-1024x650.jpg

Put Option Payoff

• A put option, on the other hand gives the holder the right but not the obligation to sell the underlying asset at the strike price prior to the expiration date. 
• The put option holder is betting that the price of the underlying will decrease.
• Put Option Buyer
• Eg:
• You decided to buy put option for $30. Premium here is $5.
• Below are few possible prices the ST price will turn out to be true. 
• Note: expectation is price to fall
• Case 1: ST < x|k
• ST = $20
• x|k = $30
• Right to buy for $30, where the actual price is $20
• Payoff = 30-20 = $10
• Profit = Payoff - Initial Premium Paid
• 10 - 5 = 5
• Here since we are getting profit of $5 we will exercise the put option.
• Note here the maximum profit is limited, assume the price goes to 0 the profit would be as below:
• Right to buy for $30, where the actual price is $0
• Payoff = 30-0 = $30
• Profit = Payoff - Initial Premium Paid
• 30 - 5 = 25
• Hence the maximum profit would be 25
• Profits are unlimited here.
• Case 2: ST > x|k
• ST = $40
• x|k = $30
• Right to buy for $30, where the actual price is $40
• Payoff = 30-40 = -$10
• Profit = Payoff - Initial Premium Paid
• -10 - 5 = -15
• Here if we execerise we will have loss of $15 hence we will not exercise this and eventually loss on the premium of 5 for which we have bought the option.
• Note here the maximum loss could occur is limited which will be the premium amount, in our scenario its $5.
• Losses are limited here.
• Case 3: ST = x|k
• ST = $30
• x|k = $30
• Right to buy for $30, where the actual price is as well $30
• Payoff = 30-30 = $0
• Profit = Payoff - Initial Premium Paid
• 0 - 5 = -5
• Here there is a 5 initial premium loss, either way, we will have the same loss so we may or may not exercise the put option. 
• Strike Price = Stock Price: There will be a premium loss either way at the expiry.
• Case 4: ST < x|k = BEP
• ST = $25
• x|k = $30
• Right to buy for $30, where the actual price is $25
• Payoff = 30-25 = $5
• Profit = Payoff - Initial Premium Paid
• 5 - 5 = 0
• Here there is no loss no gain, this we call as Breakeven Point and we would exercise the put option.
• Case 5: ST < x|k
• ST = $28
• x|k = $30
• Right to buy for $30, where the actual price is $28
• Payoff = 30-28 = $2
• Profit = Payoff - Initial Premium Paid
• 2 - 5 = -3
• Here there is loss of $3 even though we would exercise this put option, if not we will loss the premium which is $5.
• Visualization

Credits: http://futuresoptionsetc.com/2011/03/short-put-option-how-to-trade-short-put.html

• Put Option Seller
• 
  
• Visualization

Credits: http://futuresoptionsetc.com/2011/03/short-put-option-how-to-trade-short-put.html

Forward Contract Payoff

A forward contract is a financial agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. Unlike futures contracts, forward contracts are customized and traded over-the-counter (OTC).

Key Elements:

• Forward Price: The price at which the asset will be bought or sold in the future.
• Contract Date: The date when the agreement is made.
• Settlement Date: The future date when the asset will be exchanged.

Payoff Structure

The payoff for a forward contract is straightforward: it depends on the difference between the forward price (agreed upon in the contract) and the spot price (market price) at the settlement date.

Formula for Payoff:

• For the Buyer: $\text{Payoff}=\text{Spot Price (ST)}-\text{Forward Price}$
  
• For the Seller: $\text{Payoff}=\text{Forward Price}-\text{Spot Price(ST)}$
  

Example

Let’s use an example involving a forward contract on a stock.

• Current Stock Price: $50
• Forward Price (Agreed Upon): $55
• Settlement Date: 1 month from now

Scenario 1: Stock Price Rises

• Stock Price at Settlement Date: $60

Buyer’s Payoff:

• Payoff Calculation: Spot Price - Forward Price
• Payoff: $60 - $55 = $5 per share
• The buyer makes a profit of $5 per share because they can buy the stock at $55 and sell it at the market price of $60.

Seller’s Payoff:

• Payoff Calculation: Forward Price - Spot Price
• Payoff: $55 - $60 = -$5 per share
• The seller incurs a loss of $5 per share because they have to sell the stock at $55 while it’s worth $60 in the market.

Scenario 2: Stock Price Falls

• Stock Price at Settlement Date: $50

Buyer’s Payoff:

• Payoff Calculation: Spot Price - Forward Price
• Payoff: $50 - $55 = -$5 per share
• The buyer incurs a loss of $5 per share because they would have been better off buying the stock at the current market price rather than at the higher forward price of $55.

Seller’s Payoff:

• Payoff Calculation: Forward Price - Spot Price
• Payoff: $55 - $50 = $5 per share
• The seller makes a profit of $5 per share because they can sell the stock at $55 while it’s only worth $50 in the market.

Summary

• Buyer of Forward Contract: Benefits when the spot price at settlement is higher than the forward price. Loses when the spot price is lower.
• Seller of Forward Contract: Benefits when the spot price at settlement is lower than the forward price. Loses when the spot price is higher.

Forward contracts are useful for hedging or speculating, and understanding their payoffs helps in assessing potential risks and rewards. If you have more questions or need further examples, just let me know!

Derivatives Traders

Hedging Strategies

• Hedging typically reduces the risk with forward contracts or optons.
• By using forward contracts with no cost, the trader is attempting to neutralize risk by fixing the price the hedger will pay or receive for the underlying asset.
• Option contracts in contrast are more of an insurance policy that require the payment of a premium, but will protect against downside risk while keeping some of the upside.

Speculative Strategies

• Speculating are effectively betting on future price movements, is about taking calculated risks based on predictions of future market movements. 
• It can lead to substantial profits if the predictions are accurate but also poses significant risks if the market moves contrary to the speculator’s expectations.
• The goal is to profit from expected price movements in the market.
• Speculators take positions based on their forecasts of future prices, aiming to buy low and sell high or sell high and buy low, depending on the asset and their expectations.
• How Speculating Works
• Forward Contracts: 
• Agreements to buy or sell an asset at a future date at a price agreed upon today. 
• Speculators might buy forward contracts if they believe the asset's price will rise or sell forward contracts if they expect it to fall.
• Options:
• Contracts giving the right, but not the obligation, to buy or sell an asset at a predetermined price before a certain date. 
• Speculators use call options if they expect the price to rise or put options if they expect it to fall.
• Futures Contracts:
• Standardized contracts to buy or sell an asset at a future date at a price agreed upon today.
• Like forward contracts, but traded on exchanges.
• Futures are used for speculating on price changes in a similar way to forwards.
• Example of Speculation Using Forward Contracts Assumptions:
• Current Stock Price: $50
• Forward Price: $55
• Settlement Date: 3 months from now 
• Scenario 1: Price Increase  
• Speculator’s Prediction: The stock price will rise above $55. 
• Action: The speculator buys a forward contract to buy the stock at $55. 
• Outcome: If the stock price rises to $60 at settlement: 
• Profit Calculation: Spot Price - Forward Price = $60 - $55 = $5 per share. 
• Result: The speculator makes a profit of $5 per share.
• Scenario 2: Price Decrease
• Speculator’s Prediction: The stock price will fall below $55. 
• Action: The speculator sells a forward contract to sell the stock at $55.
• Outcome: If the stock price falls to $45 at settlement:
• Profit Calculation: Forward Price - Spot Price = $55 - $45 = $10 per share. 
• Result: The speculator makes a profit of $10 per share.

Arbitrage Opportunities

• Arbitrageurs take offsetting positions in financial instrutments to lock in a riskless profit on the assumption that there are mispricings in the same asset in different markets.
• No net investment and position profit.
• Arbitrageurs are frequent users of derivatives.
• Arbitrage opportunites typically do not last long as supply and demand forces will adjust prices to quickly eliminate the arbitrage situation.
• Example Arbitrage of stock trading on two exchanges 
• Assume stock DEF trades on the New York Stock Exchange (NYSE) and the Tokyo Stock Exchange (TSE). 
• The stock currently trades on the NYSE for $27 and on the TSE for ¥2,880. 
• Given the current exchange rate is $0.009 per 1 yen, determine if an arbitrage proit is possible.
• Value in dollars of DEF on TSE = ¥2,880 × $0.009/¥ = $25.92
• Arbitrageur could purchase DEF on TSE for $25.92 and sell on NYSE for $27.
• Proit per share = $27 − $25.92 = $1.08

Risks Using Derivatives

• Derivatives are versatile and can be used for hedging, arbitrage and pure speculations.
• If however the bet one makes starts going in the wrong direction, the results can be catasprohic (e.g. Barrings Bank)
• Controls need to be carefully established and monitored within both financial and nonfinancial corporations to prevent misuse of derivatives.
• Risk limits should be set and adherence to risk limits should be monitored.

Credits and References

• https://www.youtube.com/watch?v=-5t3z7kos58
• GARP, Schweser and Bionic Turtle Notes
• https://www.investopedia.com/
• http://chat.openai.com/ #shout out to the examples helped in learning the concepts in depth.

Anatomy of the Great Financial Crisis of 2007 - 2009

Financial Crisis Overview

• The 2007-2008 financial crisis was one of the most severe economic downturns since the Great Depression. It originated in the United States but quickly spread to become a global financial crisis.
• The financial crisis of 2007 to 2009
• country of origin - US.
• caused by a complicated mix of relaxed lending practices, subprime lending, easy access to credit, inflated housing prices, and an interconnected banking and global financing system.
• heavily impacted sectors were investment banking, insurance, real estate and other financial markets in the US.
• Interest rates were historically low during this period in the US, leading below options for investors:
• real estate
• bonds
• gold
• Housing Bubble and Subprime Mortgages:
• One of the primary factors was the housing bubble that had been building for years. Easy lending standards, low interest rates, and excessive risk-taking by financial institutions led to a surge (to increase suddenly and by a large amount) in housing prices (when the demand grows the price increases).
• Low Interest Rates: 
• In the early 2000s, the Federal Reserve (Fed), the central bank of the US, lowered interest rates to stimulate the economy after the dot-com bubble burst. 
• This made it cheaper for people to borrow money, including for mortgages (loans to buy houses).
• Easy Lending: 
• Financial institutions loosened their lending standards, making it easier for people to qualify for mortgages, even if they couldn't afford them. 
• This was fueled by the expectation that house prices would always go up.
• Subprime mortgages: 
• Are loans extended to borrowers with poor credit histories, became widespread. 
• Subprime mortgages were known for delinquent payments.
• A payment is considered delinquent if it is not made by the due date specified in the loan agreement or billing statement. 
• For example, if you have a credit card bill due on the 15th of the month and you don't make the payment until the 20th, your payment is delinquent.
• Some of the mortgages were:
• Low fixed teaser rate: Typically structured subprime loan with a teaser-year relatively low fixed interest rate. which then reverts to a much higher (and possibly unaffordable) variable rate for the remaining years of the mortgage. Eg: a 30yr was split into 2-28 adjustable rate mortgages.
• When the house price continued to soar, the borrowers were able to refinance to a similar or even better product at the end of the teaser period or sell the house for profit.
• As house prices declined, many of these borrowers themselves in a situation of negative equity (mortgage loan exceeding the value of the house) and opted to default on their obligations.
• Resulted in an increased number of foreclosures and oversupply of properties which further depressed house prices.
• 100% Loan to value: No upfront payment is required and therefore no equity cushion to mitigate losses for the lender in the event of default.
• Interest only: Only servicing the interest cost during the life of the mortgage without reducing the outstanding principal.
• Ninga loans: Loans to borrowers with no income, no job, and no assets.
• Liar loans: Loans for which little evidence was collected to confirm employment and income claims of the applicant.
• The subprime mortgage market experienced significant losses and liquidity issues, contributing to the broader financial turmoil.
• Securitization:
• Financial innovation, securitization is a financial process where a pool of assets, typically loans or other debt obligations are bundled together into a big group when banks want to free up some cash so they can make more loans to other people. Instead of waiting for all those loans to be paid back over many years. 
• This pool of assets is then divided into tradable securities, which are sold to investors for higher yields, thus reducing the credit risk borne by the originators.
• MBS - mortgage-backed securities
• Financial institutions took these risky subprime mortgages and bundled them together into complex financial instruments called MBS. 
• These were then sold to investors worldwide. 
• The idea was to spread the risk among many investors and throughout the financial system.
• The pools of mortgages are transferred to a Special Purpose Vehicle (SPV).
• SPV - special purpose vehicle
• SPV is a legal entity created for a specific, often temporary, purpose. 
• SPVs are commonly used for isolating financial risk, raising capital, or managing assets. 
• They can be structured in various ways, such as limited liability companies (LLCs), trusts, or corporations, and are often used in complex financial transactions like securitization, project financing, or off-balance sheet financing. 
• SPVs are particularly useful for mitigating risk because they allow companies to ring-fence certain assets or liabilities from the rest of the business.
• OTD - originate to distribute
• Origination: The financial institution acts as the originator, meaning they identify potential borrowers, assess their creditworthiness, and ultimately approve and grant loans. 
• Distribution: Instead of holding onto the loans they originate (originate-to-hold model), the institution then sells these loans to other investors in the secondary market. This process is called distribution.
• Many banks originate mortgages but then sell them to investors through MBS.
• SIVs - structured investment vehicles
• A Structured Investment Vehicle (SIV) is a special-purpose financial entity designed to profit from the credit spread between short-term and long-term debt. 
• Borrowing Short-Term: SIVs primarily raise funds by issuing short-term debt instruments like commercial paper. These instruments typically have maturities ranging from a few days to a few years and offer relatively low interest rates.
• Investing Long-Term: The funds raised are then used to purchase long-term assets.
• The core idea behind SIVs is to exploit the difference (spread) between the interest rates paid on short-term borrowings and the interest earned on long-term investments. Ideally, the returns from the long-term assets held by the SIV would be enough to cover the cost of short-term debt and generate a profit.
• Risk of Mismatch: 
• The reliance on short-term funding to finance long-term assets creates a maturity mismatch. 
• If there's a sudden loss of confidence in the SIV or the market for the assets they hold, it can be difficult to roll over short-term debt, potentially leading to liquidity problems.
• Opacity and Complexity: 
• The complex structures and off-balance sheet nature of SIVs made it difficult to assess the underlying risks they held.
• This lack of transparency contributed to the financial crisis of 2007.
• Vulnerability to Market Downturns: 
• If the value of the long-term assets held by the SIV declines (e.g., due to defaults on mortgages during the housing crisis), it can erode their profitability and potentially lead to insolvency. 
• Some SIVs heavily invested in subprime mortgage-backed securities (MBS) in the lead-up to the 2007 crisis.
• When the housing market collapsed, and defaults on subprime mortgages soared, the value of these MBS plummeted. 
• This caused significant losses for SIVs and contributed to the wider financial crisis.
• In summary, Mortgage-Backed Securities (MBS) are created through securitization, which involves transferring assets to a Special Purpose Vehicle (SPV) and issuing securities backed by those assets. The originate-to-distribute (OTD) model involves originating loans and then selling them off to investors. Structured Investment Vehicles (SIVs) raise funds through short-term debt issuance and invest in longer-term assets while using the spread between the two to generate profits.
• Complex Financial Instruments:
• Financial innovation led to the creation of complex financial instruments like collateralized debt obligations (CDOs). 
• CDO
• The pool of debt is divided into tranches based on credit quality.
• Senior
• Junior
• Equity 
• The senior tranches are considered the safest because they have the first claim on the cash flows generated by the underlying assets first and observe losses last. 
• They receive payments first and are typically rated AAA or AA. 
• Junior tranches, on the other hand, are riskier and have higher potential returns but are more likely to suffer losses if the underlying assets perform poorly.
• The junior tranches of multiple CDO structures were often bundled together and repacked as CDO-Squared - a CDO whose cash flows are backed by other CDO tranches, rather than mortgage.
• It is clear that the structure is very opaque and complex to value, even during normal times and even for sophisticated investors who did not have the expertise to understand what they were buying.
• These instruments were intended to spread risk and provide insurance against default but ultimately amplified the crisis when the housing market collapsed.
• Deregulation and Financial Industry Practices:
• Deregulation of the financial industry, including the repeal of the Glass-Steagall Act, allowed banks to engage in riskier activities like investment banking and speculative trading.
• Financial institutions engaged in risky lending practices, such as offering subprime mortgages with adjustable-rate terms and low teaser rates, which became unaffordable for borrowers when interest rates rose.
• Rating Agencies Failure:
• Credit rating agencies failed to accurately assess the risk associated with mortgage-backed securities and other complex financial products. 
• They assigned high ratings to many securities backed by subprime mortgages, leading investors to believe they were safe investments.
• Leverage and Overextension:
• Financial institutions were highly leveraged, meaning they had borrowed significant amounts of money to finance their operations. 
• When the value of their assets (like mortgage-backed securities) declined, they faced liquidity problems and could not meet their obligations.
• Systemic Risk and Interconnectedness:
• The interconnectedness of financial institutions meant that problems in one sector of the economy quickly spread to others. 
• The failure of large financial institutions like Lehman Brothers and the near-collapse of others like AIG sent shockwaves throughout the global financial system.
• Government Policies and Responses:
• Government policies, such as the Community Reinvestment Act and the Federal Reserve's low-interest rate policies, played a role in encouraging risky lending practices and fueling the housing bubble.
• Responses to the crisis included government bailouts of financial institutions, the implementation of stimulus packages to support the economy, and regulatory reforms aimed at preventing similar crises in the future, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act.
• Short-Term Funding:
• Banks traditionally operate by borrowing money from depositors or other sources and then lending that money out over longer periods, often in the form of mortgages or business loans. The assumption is that the deposits will be available for withdrawal when needed.
• Banks increasingly financed their long-term assets through short-term liabilities, which gave rise to a maturity mismatch between the duration of the assets and the liabilities, which exposed banks to significant liquidity risk.
• Note - Interest Rate Calculation:
• Normal Rate = Real Risk-Free Rate + Inflation
• Short Term Interest Rate = Normal Rate + Liquidity Rate + Default Premium
• Long Term Interest Rate = Short Term Interest Rate + Maturity Premium
• However, during the lead-up to the financial crisis, many banks increasingly financed their long-term assets, such as mortgage-backed securities and other investments, using short-term liabilities, such as commercial paper and repurchase agreements.
• Commercial Paper
• Short Term, unsecured form of financing primarily used by high-quality issuers.
• Asset-Backed Commercial Paper - ABCP - is a special case whereby the commercial paper is backed by some form of collateral, such as credit card loans or mortgages.
• Repurchase Agreements
• Short-term funding is used by many financial institutions.
• In a repo, a bank will sell an asset but will also simultaneously agree to buy back the asset in the future at a slightly higher price.
• The difference between the repurchase price and the sale price is the interest rate for the duration known as the repo rate.
• The sold assets act as collateral, if the borrower fails to pay at maturity the lender is entitled to keep or sell collateral without going through the bankruptcy courts.
• Depending on the quality of the bonds, the haircut is determined at the outset to reduce the credit risk, e.g. the lender is willing to pay $90 for an asset worth $100, then the haircut is 10%.
• This strategy can be profitable under normal circumstances because short-term borrowing tends to have lower interest rates than long-term borrowing. However, it creates a vulnerability known as maturity mismatch.
• As house and mortgage-backed security prices declined, lenders started questioning the quality of the assets residing within SIV structures and became reluctant to extend further short-term loans. This eventually led to a complete shutdown of the ABCP and repo market by August 2007. 
• If a bank cannot roll over its short-term liabilities or sell assets quickly enough, it may face liquidity problems and potentially even insolvency.
• Many hedge funds were unable to roll over their debt forcing them to start selling their CDO investments and other higher-quality assets to meet margin calls.
• Haircuts increased from 0% to 45% in September 2008 following the Lehman default.
• Systemic Risk:
• The LIBOR-overnight index swap (OIS) spread, an indicator of the overall health of the financial system, rose from 0% pre-crisis to over 3.6% at the peak of the crisis.
• A higher LIBOR-OIS spread indicates higher perceived credit risk and reluctance to lend in the interbank market.
• Higher haircuts and inability to borrow forced institutions to deleverage by selling some of their positions, which further depressed prices and eroded the equity of those institutions forcing them to seek help from the governments or competitors or if all else failed, file for bankruptcy.
• The events of the crisis illustrate the idea of systemic risk, or risk of system failure resulting in the shutdown of the entire financial markets due to vulnerabilities, such as asset-liability maturity mismatch.
• The lesson learned is that even when a bank believes it has sufficient capital, overreliance on short-term funding sources is very dangerous because this type of funding can disappear overnight during times of crisis.
• The Bubble Bursts:  
• Rising Interest Rates: 
• The Fed eventually raised interest rates to combat inflation. 
• This made it more expensive for people to maintain their mortgage payments. 
• Foreclosures:
• As borrowers with subprime mortgages started defaulting, a wave of foreclosures began. 
• This meant a massive number of houses flooded the market, driving down housing prices. 
• Losses on MBS: 
• The value of MBS plummeted(drop straight down at high speed) as the underlying mortgages went bad.
• This caused huge losses for financial institutions and investors who held them.
• Contagion and Global Crisis:
• Financial System Freeze: 
• Financial institutions became wary of lending to each other, fearing they might be holding bad assets.
• This froze the credit markets, making it difficult for businesses and consumers to access loans.
• Global Impact:
• The crisis in the US financial system quickly spread worldwide, as many countries and institutions were heavily invested in US mortgages and MBS.

Central Bank Intervention

• During the 2007-2008 financial crisis, the large U.S. investment bank, Lehman Brothers declared bankruptcy which triggered a massive loss of confidence and froze the interbank lending market.
• Other investment banks, which avoided outright failure, were either bought by competitors or converted to bank holding companies regulated by the Federal Reserve. A bank holding company (BHC) is a corporation that owns and controls one or more banks. They don't directly offer banking services themselves but act as a parent company for subsidiary banks. 
• Institutions became very cautious, hoarding (the act of collecting large amounts of something and keeping it for yourself, often in a secret place) excess reserves and unwilling to lend those reserves to other cash-strapped (they do not have enough money to buy or pay for the things they want or need) institutions.
• Two of the large MBS issuers in the US, Fannie Mae and Freddie Mac were nationalized.
• The large financial service and insurance company, American International Group (AIG), was bailed out to prevent further systemic issues.
• Specific government interventions implemented in theUS during the crisis include the following:
• Term Auction Facility - TAF - provides funding to the depository institutions.
• Primary Dealer Credit Facility - PDCF - Fed lending to primary dealers via repos.
• Troubled Asset Relief Program - TARP - purchasing toxic assets from financial institutions starting Oct 2008
• Federal Reserve and central banks around the world intervened in various ways to stabilize financial markets and prevent a complete collapse of the global financial system by providing liquidity support and lowering interest rates. Some of the key interventions included:
• Lowering Interest Rates:
• Central banks, such as the Federal Reserve in the United States, the European Central Bank, and others, aggressively lowered interest rates to stimulate borrowing and spending. 
• By reducing borrowing costs, central banks aimed to encourage banks to lend to businesses and consumers, thereby supporting economic activity.
• Liquidity Support:
• Central banks provided liquidity support to financial institutions facing funding difficulties. 
• This support came in the form of emergency lending facilities, where banks could borrow funds from the central bank against collateral/high-quality illiquid assets. 
• These measures helped alleviate liquidity strains in the banking sector and prevented widespread bank failures.
• Government Bailouts:
• In some cases, governments intervened directly to rescue failing financial institutions. 
• This involved injecting capital into troubled banks to shore up their balance sheets and prevent insolvency. 
• Governments also provided guarantees on bank liabilities to restore confidence in the financial system.
• Fiscal Stimulus:
• Governments implemented fiscal stimulus packages to support economic growth and mitigate the impact of the crisis. 
• These measures included tax cuts, increased government spending on infrastructure projects, and social welfare programs aimed at boosting demand and employment.
• Funding:
• Providing funding to purchase asset-backed commercial paper.
• Discount Window:
• Allowing investment banks and securities firms to borrow from the Fed via the discount window, to provide short-term loans to eligible depository institutions facing temporary liquidity shortfalls.
• Regulatory Reforms:
• In the aftermath of the crisis, governments implemented regulatory reforms to strengthen oversight of the financial sector and prevent future crises. 
• This included measures such as the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States, which introduced stricter regulations on banks and financial markets.
• Overall, government interventions during the financial crisis were aimed at stabilizing financial markets, restoring confidence, and supporting economic recovery. While these measures helped prevent a complete meltdown of the global financial system, they also led to significant increases in government debt and raised questions about the long-term sustainability of fiscal and monetary policies.

Credits and References

• https://s.yimg.com/ny/api/res/1.2/e8Ld2mes52y_8OK.xYoisA--/YXBwaWQ9aGlnaGxhbmRlcjt3PTY0MDtoPTQyNg--/https://media.zenfs.com/en-US/homerun/coin_rivet_596/b90141ac6c8f74cbcb6d6d22dc38e911
• FRM 2023 Notes
• Reading 10
• https://chatgpt.com/
• https://gemini.google.com/