Question 1: Discuss the major causes of the 2007 Global Financial Crisis?
According to Welch (2011, 10), the 2007 Global Financial crisis occurred due to the numerous issues. They include high risk borrowing and lending practices, and poor fiscal choices related to government expenses and revenues. Other causes of the 2007 Global Financial Crisis were trade imbalances in the international market and the real estate bubble.
High risk borrowing and lending practices
Between the years 2000 and 2006, the Bush administration made it a priority to increase first time home ownership in America. This program mainly targeted low income earners and single parents. The program provided low interest loans with no money down to people who wanted to purchase their first homes. Notable institutions providing such services included “Bank of America” and Citigroup (Tuckman, B. 2011, 13). One needed an income as low as 20000 dollars to qualify. The 2003 war in Iraq caused a slowdown in the American economy and a decrease in Budget surpluses. This in turn resulted in an increase in interest rates and consequent increases in mortgage rates and payments. The increased mortgage payments led to people defaulting as they could not pay the now variable interest rate. Rates on credit cards also increased, forcing people to take second equities on their mortgage. Unfortunately, they discovered that their homes were now less than they anticipated. This then led to the defaults in both mortgage and credit card payments. The banks responded with increasingly risky lending practices such as second or third credit cards (Howell, C. 2008, 3). ). In time, the poor financial practices forced the US banks to sell their debt to foreign banks like AG Zurich, Barclays bank and RMB Scotland. When the housing bubble burst, all those local and foreign entities with sub prime mortgages investments suffered financial distress. This led to the 2007 global crisis.
Poor fiscal choices relating to government expenses and revenue
In some critical areas, the US government continues to make poor fiscal choices. The examples include large scale road construction projects, social programs, printing money, raising the debt ceiling and tax increases. The road in Alaska provides the best example of poor fiscal choices. The federal government gave money to build a road “to nowhere” and also allocated funds for costly oil exploration. These uneconomic developments known as “Pork Barrel projects” divert money from places where it could create maximum benefits. Several other military projects for new generation aircraft carriers could be attributed to poor financial choices by policy makers too. Coupled with increased spending on wars in Iraq and Afghanistan, these contributed to the 2007 global downturn. The military spending made America’s exports decrease and then led to a trade deficit. The trade deficit, in turn, led to less dollars circulating in the global trade. Research shows that increased spending on social programs does not add revenue to the federal coffers. By 2007, the US was spending a significant amount of its revenue from exports on social welfare programs. Money raised from internal taxation also went towards Medicare subsidies to those who could not afford it; these included veteran and union benefits and Social Security payments. Rather than come up with private schemes that could take away the financial burden, the government continued to increase the payments made. Thus, autoworkers gained in increased benefits while large automakers like GM filed for bankruptcy. Increasing costs and decreasing revenues led the government to print money to finance these costly interventions. The dollar’s value fell and international trade suffered as more countries bought dollars “on the cheap” only to hoard them.
Trade Imbalances in International trading
The rise of China as a major global trading player caused alarm at first. American companies soon caught on and outsourced manufacturing to China; this was to save on costs. This outsourcing led to a trade deficit in favor of China. As time went by, Chinese held more actual dollars in their reserve than the US federal government. The latter opted to “borrow” back these dollars from Chinese (Michie, R. 2008, 19). This caused the ratio between the amounts of money owed by America to its revenue to increase. America’s reduced manufacturing, debts to China and inability to raise capital for expenditure led to a decline in global trade. This decline means less money in the traditional market and more money in the hands of emerging markets like China. These emerging markets tend to hoard dollars to shore up their foreign exchange reserves or fund populist programs.
The real estate bubble
As mentioned earlier, banks fund the real estate market through facilitating generous mortgage terms. When people cannot pay their mortgages, the US banks tend to intervene by buying toxic loans (sub prime mortgages).When this intervention fails, the banks usually sell the part of those mortgages to foreign entities to avoid issuing decreased dividends to shareholders. In the case of the institutions like Citi Group, Bank of America and Merrill Lynch, that transfer occurred to speculative foreign investors. These investors stretched out mortgage payments, anticipating long term higher overall principal amount payments. Problems arose when companies began laying off people and those could not make their mortgage payments. The “contagion” spread and both foreign and local entities made losses. Since governments had to cover these losses financially, there was an increase in taxes. The taxes served to immediately provide the access to revenue, but when too high, they caused companies to incur losses and layoffs. The latter, in turn, led to reduced manufacturing and profit margins around the world, and thus a global financial downturn.
Question 2: Quantitative easing has not achieved anything major objective since the start of the Global Financial Crisis. Discuss [10 Marks]
Quantitative easing refers to a monetary policy used by central banks around the world to stimulate economy. Governments employ this unconventional financial structure when standard monetary regulations and policies prove ineffective (Mishkin, F. 2010, 11). Central bank (or in the case of America, the Federal Reserve) implements this easing by purchasing financial assets from private institutions and commercial banks to increase the monetary base. Quantitative easing has not achieved any significant objective for the following reasons. First, every time one buys T-Bills and “adds dollars to the financial system”, the extra dollar decreases the value of existing currency. This is akin to printing money which causes currency to lose value as the supply of goods remains static. If one printed money and then kept goods production at the same level, a buyer would need more money to get a single item as the system “mops” up excess currency. One can say that quantitative easing causes the increase in inflation and also disrupts market forces action. When the federal government floods the financial system with money to stabilize bubbles, it creates an artificial climate. This climate leads to a deceptively quick recovery which then causes people to spend more money. This is done in the belief that the federal government will eventually take care off all debts. This easing does not consider that the real estate market should come into equilibrium slowly and on its own. In other words, quantitative easing prevents people from buying cheap houses. If market forces prevail, growth in the housing market naturally occurs and home value prices surge. Quantitative easing can also cause speculators to engage in currency speculation (Kienitz, J.2010, &). This could lead to rising commodity prices as the investors make use of the readily available investment opportunities. The US dollar competes in the global market against stronger currencies like the Euro and the Sterling Pound. With increased quantitative easing, the US dollar loses value, causing American exports to be cheaper. While this makes the exports more attractive (leading to more sales), the dollar’s weakness means that imports like oil become more expensive. Since petroleum products form a major portion of the US exports, America will pay more for oil than Germany or Britain which use strong currencies. This high oil import bill passes onto a consumer who pays high prices at the pump. Quantitative easing may also cause the US dollar to look volatile, much like the Chinese Yuan. No nation will want to trade with another when the currency swings up and down as a result of Treasury bill buying and other interventions. Monetizing debt is another way to describe quantitative easing. America’s high debts (17 trillion) and ever rising debt ceiling cause nations like China to shy away from “buying” that debt. By giving corporations, individuals and foreigners a chance to buy treasury bills, the Federal Reserve in effect confirms that it cannot finance its debts. Sooner or later, the investors figure out that the US cannot finance its debt. This causes those investors to abandon their ‘donations’ and the US government then encounters future difficulties while seeking new (Haughen, R.2010, 11).One should note that a country’s credit rating drops when they cannot find lenders or creditors. The US in such a case can only attract new lenders by offering higher interest rates. They will lead locals to pay more in taxes to cover the revenue shortfall. One can see that very little benefit arises from quantitative easing. In short, quantitative easing gives false hope to the American consumer leading to more spending and new “bubbles”.
Question 3:
Mary and Barry are fund managers at Wallenberg Bank. The CEO has asked them to consider the purchase of the following bonds credited AAA:
- Vodafone 5% 2025
- Reliance 7.5% 2020
Mary and Barry are analyzing the interest rate risk of the two bonds. Mary thinks that Vodafone 5% 2025 has greater interest rate risk than the Reliance 7.5% 2020 because of its lower coupon rate. Barry argues that Reliance 7.5% 2020 possesses greater interest rate risk because of its longer term to maturity.
- Of the two fund managers, who is correct with respect to his or her analysis and why?
[5 Marks]
To answer this question, one needs to be aware of certain bond characteristics. Firstly, the closer a bond approaches maturity, the closer it will trade to its redemption or given trade value. This occurs because the interest date no longer plays a significant role. Secondly, economic conditions, inflation fears and actions by the Federal Reserve cause the interest rate to move up or down. Rising rates cause the bond value to decrease while falling rates do the opposite. With a longer maturity period, the interest rates may rise or fall several times (Fabozzi, F.2008, 15).Therefore, a longer maturity period leads to greater interest rates and overall price volatility. Long-term bonds suffer cash flow fluctuations caused by the volatile interest rates. This could lead to a major sudden drop in a bond’s value. Barry, therefore, made a correct assessment.
Question 4: Imagine you are the CEO. How would you advise Mary and Barry to determine which bond has higher interest rate risk? [5 Marks]
The writer would advice them to look at certain factors like prevailing behaviors of rates, investor demand, credit risks, expected inflation, business conditions, government borrowing and relative liquidity. When interest rates rise, bond prices decline and vice versa. Investor should look at interest rate volatility (the margin between rises and declines when making an investment). Bonds with volatile interest rates can earn one a good profit margin (Danthine, J.2011, 13). Another factor to look at is a company’s credit risk. The businesses with a good reputation will pay off bonds at maturity and show low interest rates. One can find out a company’s reputation from bond rating services; the better the reputation, the lower the interest rate risk. The writer would advise the two to avoid bonds with longer maturities, as the increased future risks lead to investors demanding higher interest rates. Business conditions in the company also play a key role. The company with high profit margins, significant growth and numerous shareholders will offer bonds with lower interest rates. In contrast, a company on shaky financial grounds will offer long-term bonds to create a buffer zone to recoup losses. These long-term bonds tend to show greater movements in interest rates than short-term bonds (Copeland, T & Weston, F. 2011, 37).
Question 5: Duration is a useful measure of interest rate risk. However, it is fraught with major weaknesses. There are other better measures. Discuss. [10 Marks]
There are two other measures namely Macaulay duration, modified duration and convexity. Duration, a categorical variable, assumes that certain conditions are constant. When those change, the calculation suffers inaccuracies. Another thing worth noting is that equal durations do not necessarily mean equal returns. Durations work well when constructing portfolios, however portfolios with the same duration may not necessarily provide equal return figures. Thus if one looks at a hypothetical example of a 10 year treasury returning 15.6 percent from November 2000 to November 2001, they notice the following. A portfolio of 30 year and 2 year treasuries within the same duration as the 10 year one, produces a return of 11.7 percent. This translates into a difference of 350 basic points. Durations come in various forms. Apart from the effective and modified duration, other durations are bear, bull, spread, curve and total curve durations. Each works best in certain situations.
Macaulay Duration: It measures the years required to recover a bond’s true cost. It takes into account future principal payments and all values of coupons. One derives the result in years.
Effective duration: This encompasses an advanced form of modified duration. It works best with callable security portfolios. Effective duration uses coupon, bond yield, call features and final maturity to calculate the bond’s price sensitivity to interest rate change (Collins, P. 2011, 12)
Modified duration
This follows the concept that bond prices and interest rates move in diametrically opposite directions. The formula determines the effect that one percent change or 100 points changes in interest rates will have on the bond’s price. Modified duration provides the measurable change in the security value of the bond in response to changing interest rates.
N = coupon periods number per year
YTM =- Year to Maturity.
Convexity
Convexity uses the formula
Unlike duration, convexity measures the 2nd derivative or curvature of how the bond’s price varies with the interest rate. That is, how the bond’s duration changes as transformations occur in the interest rate. To make this calculation, one assumes that changes in interest rate occur evenly.
Question 6: Given the following data, calculate duration, modified duration and convexity:
Macaulay duration is defined as:
(1)
t = period in which the coupon is received.
C = periodic (usually semiannual) coupon payment
y = the required yield or periodic yield to maturity.
n = number periods
M = maturity value (in Dollars.)
P = bond market price.
For the following rates: Duration
- Treasury 6%, with a 30-year term to maturity and a 9% discount rate = (1.06)30 – 0.09 = 6.45338-0.09= 3633
- Treasury 6%, with a 15-year term to maturity and a 9% discount rate = (1.06)15 – 0.09=3.226 – 0.09= 3.1366
- Treasury 6%, with a 10-year term to maturity and a 9% discount rate = (1.06)10– 0.09=2.1511- 0.09= 0611
- Treasury 6%, with a 30-year term to maturity and a 6% discount rate= (1.06)30 – 0.06=
- Treasury 6%, with a 30-year term to maturity and a 3% discount rate= (1.06)30 – 0.03= 6.45338- 0.03= 6.42338
- Comment on your results above. The discount rate appears to be too high to sustain the duration.
| Modified Duration Formula where: | |||||||
| Dm = Modified Duration DMac = Macaulay Duration y = yield to maturity k = number of annual payments.
Calculating Convexity.
|
|||||||
Consider a bond selling at par with a coupon rate of 5% and 10-years to maturity.
- What is the price of this bond is the required yield is 12%? 2000 dollars
Bond increase here is 1.05% per year. In ten years
- What is the price of the bond if the required yield rises from 12% to 13% and by what percentage does the price of the bond change? 3000 dollars.
- What is the price of the bond if the required yield is 3%? 750 dollars.
- What is the price of the bond if the required yield rises from 3% to 4% and by what percentage does the price of the bond change? 900 dollars
- From your answers above what do you conclude about the relative price volatility of bonds?
The higher value bonds tend to show marked price volatility.
References
Collins, P. 2011. Securities, Markets, and Transactions: A Guide to the New Environment. New York, NY; Wiley. p 9-14.
Copeland, T & Weston, F. 2011. Financial Theory and Corporate Policy. New York, NY: Prentice Hall. p 33-40.
Danthine, J. 2011. Intermediate Financial Theory, Second Edition (Academic Press Advanced Finance Series). Los Angeles, CA: Academic Press. p 10-18.
Fabozzi, F. 2008. Securities Finance: Securities Lending and Repurchase Agreements.Chicago, IL: Mc-Graw & Hill. p 11-17.
Haugen, R. 2010. Modern Investment Theory (5th Edition). New York, NY: Prenctice Hall. p 8-17.
Howell, C. 2008. Trade and the state. Princeton, N.J.: Princeton University Press. p 2-4.
Kienitz, J. 2010. Financial Modelling: Theory, Implementation and Practice with MATLAB Source. New York, NY: Wiley. p 5-9
Michie, R. 2008. The Global Securities Market. New York, NY: Oxford University Press. p 3-22.
Mishkin, F. 2010. Financial Markets and Institutions (7th Edition) Series. New York,NY: Prentice Hall. p 7-15.
Penman, S. 2009. Financial Statement Analysis and Security Valuation. New York, NY: McGraw & Hill. p 22-29.
Schipper, K. 2012. Financial Accounting: An Introduction to Concepts, Methods and Uses. New York, NY: Springer. p 34 -46.
Tuckman, B. 2011. Fixed Income Securities: Tools for Today’s Markets. New York, NY: Wiley Press. p 12-17.
Welch, I. 2011. Corporate Finance Paperback. Princeton, NJ: Princeton University Press. p 2-13.