Asset-Liability Management

Life insurers and pension funds have obligations to policy holders and beneficiaries and hold fixed income assets to meet those obligations. Asset-liability management matches the duration of assets to duration of liabilities to minimise risks from interest rate changes. However, this rule can lead to upward sloping demand curves for fixed income assets and can lead to overshooting of long-term interest rates.

Boom and Bust Driven by Value-at-Risk

An example of a hedge fund illustrates a long-short strategy that maximises expected returns subject to a Value-at-Risk strategy. Balance sheet capacity depends on the measured volatility of asset returns and the book equity of the long-short hedge fund. The principles are illustrated by the case of Long Term Capital Management (LTCM).

Nature of Financial Risk

Risk is endogenous. The brief opening and then the closing of the Millennium Bridge in London in 2000 illustrates how market prices play a dual role: they are simultaneously a reflection of market participants’ actions as well as an imperative for their actions.

Securitization and the Financial System

Mortgage securitisations rose rapidly in the early 2000s through the private label securitisation vehicles that packaged subprime mortgages. The size of the asset-backed securities sector in the United States traces well the overall leverage of the financial system in the run-up to the Great Financial Crisis.

Financial System

In a financial system of interlocking balance sheets, the assets of creditors are the liabilities of debtors. A change in the value of underlying assets can ripple through the financial system through valuation changes on balance sheets. Tarski’s fixed point theorem guarantees the existence of consistent valuations. Under mild regularity conditions, there is a unique fixed point. Comparative statics analysis can be used to show how systemic risk propagates.

A Fresh Start

Monetary policy that aims only at real variables may neglect important financial stability considerations. A joined-up approach that takes together real activity and financial stability considerations will need to be employed in order not to repeat the experience of the Great Financial Crisis.

Dynamic Hedging

Dynamic hedging can replicate the payoffs of state-contingent assets such as options. Delta hedging aligns the portfolio of risky and safe assets in line with the delta of the option. However, when risk is endogenous, delta hedging can inject feedback loops into market prices, so that delta hedging can lead to large market moves. The 1987 stock market crash is brought in as an illustration.

Value-at-Risk and Capital

Value-at-Risk rule keeps the probability of insolvency constant by adjusting leverage. When asset prices change, this rule implies that the demand curve is upward sloping, and can set off margin spirals

Case of Northern Rock

The UK bank Northern Rock suffered a bank run in 2007. Withdrawal of retail deposits was covered extensively in the media, but Northern Rock’s failure was due to the silent run on wholesale funding in the summer of 2007 that preceded the retail depositor run. The securitisation vehicles of Northern Rock left it particularly vulnerable to the deleveraging by wholesale creditors in 2007, and poses many pertinent questions for the management of financial risks in an era when banking and capital markets are intertwined.

Lending Booms

A system of interlinked balance sheets of intermediaries that follow the Value-at-risk rule has the feature that an increase in house prices transmits valuation changes through the value of debt instruments. The analysis uses the Vasicek credit risk model for the diversification of individual credit risks in the loan portfolio. Leverage and wholesale funding is key to understanding lending booms.