Recommended Materials:
- Books:
- Fixed Income Analysis, 2nd. ed. by Frank J. Fabozzi. (this is the book we used in FIN 542).
- Options, Futures, and other Derivatives (8th edition) , by John Hull.
- I expect you to subscribe to The Wall Street Journal and read it daily.
- The Economist is also recommended reading.
- Financial Modeling Using Excel and VBA, by Chandan Sengupta. (Available electronically through the library.)
- Advanced Modeling in Finance using Excel and VBA, by Mary Jackson and Mike Staunton.
Institutional and Intellectual Context of the course:
The entire world-wide financial system entered a crisis of historical proportions in the late summer of 2007. While there were clear signs in the mortgage sector in the last half of 2007,
- The collapse of Bear-Stearns in March, 2008 was the first sign of the collapse of the traditional investment sector.
- On September 8, the Federal Reserve placed the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac under conservatorship.
- On September 15, 2008, Lehman Brothers filed for Chapter 11 Bankruptcy protection. With assets of $639 billion, this was the largest bankruptcy in American history.
- On September 16, 2008, the Federal Reserve implemented an $85 billion rescue package for insurance giant AIG.
- On September 19, the US Treasury announced a $50 billion guaranty program for money market funds.
- On October 1, 2008, the US Congress passed a $700 billion bank bailout program TARP (Troubled Asset Relief Program). This was proposed by the Treasury Secretary and Fed chairman as a plan to buy mortgage and other asset-backed debt from banks, but has been operationalized as purchase of preferred stock (and capital infusion) into major financial institutions.
During this frenzy, the Fed and other central banks have aggressively cut interest rates and injected liquidity into the financial system. Nevertheless, credit spreads reached historical levels. Banks were afraid to lend because they did not know the quality of the borrowers' balance sheets. In recognition of this, on October 7, 2008, the Fed created its Commercial Paper Funding Facility, through which it lends directly to Tier-1 commercial paper borrowers (PIMCO serves as the asset manager for this program). The Federal Reserve announced a Money Market Investor Funding Facility on October 21, 2008, to tie-in with the Treasury guaranty and insure liquidity of money market funds.
Amidst this turmoil, credit spreads increased significantly from historic low levels in the spring of 2007. Credit markets had suffered from a combination of overly optimistic expectations about asset values and economic conditions and institutional failures related to misaligned incentives, greed, and lack of transparency. Furthermore, these conditions have a feedback-loop with the macroeconomy so that the current recession is worse as a result of the ``credit crisis'' and the recession has prevented a faster improvement in credit markets.
Two years ago attention was focused on Europe, sovereign debt, and the future of the Euro. The sovereign debt of Greece, and perhaps Portugal, Spain, Italy, and Eire was at risk of default. Recent joint action by the US Federal Reserve and the European Central Bank was designed to ease European bank access to dollars. This paper explains the demand for dollar assets by European banks, and how they were met prior to the crisis. The spreads on these countrties' debt have dropped dramatically, but, as this post from Professor Jim Hamilton shows, it is not clear why.
As we enter 2015 the financial aspects of the 2008 crisis are still with us in the form of accommodative central bank policies, which leave us with historically low interest rates. However the price of risk has fallen to pre-crisis levels. Furthermore after a year of relative quiet concerning sovereign risk, and the possibility of breaking up the Euro zone, fears about Greece and other Euro zone countries have resurfaced. Here is a nice summary of capital market conditions in late 2008, from the US Department of Treasury, Office of Debt Management. (November 4, 2008). Notice the warning signs of unhealthy credit conditions.
Here is the situation as of Q-IV, 2012.
The US Treasury's 5-Year Retrospective Summary of the Financial Crisis. (Prepared in September, 2013.)
The financial crisis has brought credit markets to the forefront of our economy. This class looks at these markets, the instruments that trade in them, and the risk and return profiles of these instruments.
Additionally, we examine the so-called shadow banking system which is where the credit crisis occurred. Financing of proprietary positions relies on the repo market--not traditional banking relationships. Unlike the traditional banking system, the shadow banking system is largely unregulated, and fell outside of the FED's purview, for the most part.
As we move through the course, we will look at instruments, trading strategies, and models. Furthermore, we will analyze the recent financial crisis as a semester-long case study of the institutional environment leading up to the crisis. You will master:
- Institutional Features:
- Details of the contract or instrument.
- Details of the market(s) in which it trades.
- Who trades this and why.
- The Shadow Banking System: The repo markets, counterparty exposure, and systemic risk
- Since this is a course on financial modeling, you will fill up your toolbox with
models. This is the list of models you will learn:
- Merton's Model for credit spreads.
- Extensions to Merton's Model:
- Practical applications: KMV
- With continuous default possible (Barrier Options): Black-Cox Model
- Where the firm value has jumps.
Context of the course within the curriculum:
This course assumes that you have taken FIN 542 -- ``Fixed Income.''
This course is complementary to several other courses in our Finance curriculum. Specifically:
- FIN 542 Introduction to Fixed Income. This is a pre-requisite, as it provides a foundation of understanding of instruments and markets in the fixed income milieu.
- FIN 523A and 523B -- Applied Portfolio Management. FIN 523 entails the management of a ``balanced fund'' that has a benchmark that includes both fixed income and equity. Students involved with the fixed income component must take this class. In Applied Portfolio Management, you put to work the skills and tools developed in this class.
- FIN 521 -- Investment Analysis. FIN 521 provides a framework for understanding risk and return in financial markets.
- FIN 522 -- Derivatives. FIN 522 develops more deeply students' ability to evaluate derivative securities. The emphasis in FIN 522 is on equity derivatives. There is overlap in terms of the mathematical tools used in modeling financial securities.
- FIN 525 -- Empirical Modeling. FIN 525 is concerned with estmating model parameters from financial data. So, in this class we will take parameters as given, and learn about the properties of models, in FIN 525 you estimate those parameters. Also, many of the important properties of interest rates are manifest in empirical models such as GARCH.
- FIN 544 -- Interest Rate Models. This course focuses is on the properties of treasury securities and their derivatives. These securities do not have any default risk or prepayment risk. If we think about corporate bonds, a natural way to proceed is to view them as a treasury plus a default piece--that depends on the fortunes of the issuer.
Conduct of Course and Grading:
Each class (after the first class), will start with a 25-minute quiz that relates to the in-class problems, lectures, or readings from the previous class. The remainder of the class time will be divided between working in-class problems and interactive lecture. You may drop your lowest quiz (except the last), and the remaining will each count 1/13 of your final course grade.
