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<!doctype html>
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<title>Operational and Integrated Risk Management | Chapter 6 | Liquidity and Leverage</title>
<meta name="description" content="Financial Risk Manager Part 2 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<section>
<h1>Chapter 6</h1>
<h3>Liquidity and Leverage</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Introduction</h2>
<ul>
<li>Transactions liquidity - the ease of exchanging an asset for other assets</li>
<li>Funding liquidity - the ability to finance assets continuously at an acceptable rate</li>
</ul>
</section>
<section>
<h2>Funding Liquidity Risk</h2>
<ul>
<li>Maturity transformation - Providing long-term funding finaced with short-term funding (maturity mismatch)</li>
<li>Liquidity transformation - providing liquidity and payment services</li>
<li>Bank liquidity - make loans financed by deposits (fractional-reserve bank)</li>
</ul>
</section>
<section>
<h2>Structured Credit and Off-Balance-Sheet Funding</h2>
<ul>
<li>Provide matched funding for assets in a collateral pool</li>
<li>Two major types of off-balance-sheet vehicles:</li>
<ul>
<li>Asset-backed commercial paper conduits</li>
<li>Structured investment vehicles (SIVs)</li>
</ul>
</ul>
</section>
<section>
<h2>Markets for Collateral</h2>
<ul>
<li>Securities used as collateral are often lent yet again to another party, a process known as rehypothecation</li>
<li>Market structure</li>
<ul>
<li>Haircut - ensures full value of collateral is not lent</li>
<li>Margin lending - lending used to finance a security transaction in which the loan is collateralized by the security</li>
<li>Repurchase agreements - matched pairs of the spot sale and forward repurchase of a security</li>
<li>Securities lending - lending a security to another party in exchange for a fee/rebate</li>
<li>Total return swaps - one party pays a fixed fee and receives the total return on a specified security</li>
</ul>
</ul>
</section>
<section>
<h2>Leverage and Forms of Credit</h2>
<ul>
<li>Leverage ratio: L = A/E = (E+D)/E = 1+D/E</li>
<li>Leverage amplified sensitivity to changes in cash flow</li>
</ul>
</section>
<section>
<h2>Transactions Liquidity Risk</h2>
<ul>
<li>An asset is liquid if it resembles money and that its value is certain</li>
<li>Causes of transaction liquidity risk:</li>
<ul>
<li>Cost of trade processing</li>
<li>Inventory management by dealers</li>
<li>Adverse selection</li>
<li>Differences of opinion</li>
</ul>
<li>Characteristics of market liquidity:</li>
<ul>
<li>Tightness - cost of a round-trip transaction</li>
<li>Depth - how large an order is required to move the market</li>
<li>Resiliency - length of time for which an order moves the market from equilibrium</li>
</ul>
</ul>
</section>
<section>
<h2>Liquidity Risk Measurement</h2>
<ul>
<li>Measuring funding liquidity risk</li>
<ul>
<li>Asset-liability management</li>
</ul>
<li>Measuring transactions liquidity risk</li>
<ul>
<li>Transaction cost liquidity risk</li>
<li>Adverse price impacts (LVaR)</li>
</ul>
</ul>
</section>
<section>
<h2>Liquidity and System Risk</h2>
<ul>
<li>Fuding liquidity and solvency</li>
<ul>
<li>Liquidity is the ability to meet immediate demand for cash</li>
<li>Solvency is when equity capital is positive or assets > liabilities</li>
<li>Illiquidity may lead to insolvency and vice-versa</li>
</ul>
<li>Funding and market liquidity</li>
<ul>
<li>Periods of illiquidity may lead to mark-to-market losses which can compromise a firm's solvency</li>
</ul>
<li>Systemic risk</li>
<ul>
<li>Disruptions in financial market infrastructure can lead to a chain of illuidity and/or insolvency</li>
</ul>
</ul>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
</section>
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