http://www.irisheconomy.ie/index.php/2009/05/27/the-risk-capital-bank-lending-multiplier/ Thu, 17 May 2012 00:13:07 +0000 http://wordpress.org/?v=2.6.3 http://www.irisheconomy.ie/index.php/2009/05/27/the-risk-capital-bank-lending-multiplier/#comment-21059 Valerio Sat, 17 Oct 2009 15:55:15 +0000 http://www.irisheconomy.ie/?p=2419#comment-21059 Gregory, I suggest considering the following quantity for the 'reward-variability' ratio: annualized maximal Sharpe Ratio of the economy (say 0.7) x correlation between the risk taken (by NAMA/taxpayer) and the kernel that prices assets held by Irish taxpayers (this needs to be estimated or reflected upon). This would give you the amount of equity-equivalent risk capital you are comitting per annum. If, as you suggest, you use 0.2 as the 'reward-variability' ratio in this calculation, you are implicitly assuming that NAMA risk exposure has a correlation of ca. 0.29 (= 0.2/0.7) with the kernel, which to me seems too low (if things go wrong, i.e. in real bad states of the world, the irish economy would be so hooked up to NAMA that correlation would be close to one, I think). So, your estimate of risk capital 'absorption' of NAMA (Eur 4 billion) might be a bit on the low side. Does it sound right? Gregory,
I suggest considering the following quantity for the ‘reward-variability’ ratio: annualized maximal Sharpe Ratio of the economy (say 0.7) x correlation between the risk taken (by NAMA/taxpayer) and the kernel that prices assets held by Irish taxpayers (this needs to be estimated or reflected upon).
This would give you the amount of equity-equivalent risk capital you are comitting per annum. If, as you suggest, you use 0.2 as the ‘reward-variability’ ratio in this calculation, you are implicitly assuming that NAMA risk exposure has a correlation of ca. 0.29 (= 0.2/0.7) with the kernel, which to me seems too low (if things go wrong, i.e. in real bad states of the world, the irish economy would be so hooked up to NAMA that correlation would be close to one, I think). So, your estimate of risk capital ‘absorption’ of NAMA (Eur 4 billion) might be a bit on the low side. Does it sound right?

]]> http://www.irisheconomy.ie/index.php/2009/05/27/the-risk-capital-bank-lending-multiplier/#comment-8176 Gregory Connor Thu, 28 May 2009 05:32:39 +0000 http://www.irisheconomy.ie/?p=2419#comment-8176 By volatility I mean the standard deviation of return. The reward-to-variability ratio (also called the Sharpe Ratio) is the annual expected return minus the riskfree return divided by annual standard deviation of return. William Sharpe is the one who used the informal term variability rather than standard deviation or volatility in his terminology. Most people call it the Sharpe Ratio. Obviously with a loan book especially a book of troubled loans the concept of the standard deviation of annual return is a bit difficult to measure. It would be necessary to get current market value of the loans, and consider the uncertainty about end of year market value after whatever happens during the year in terms of value discovery, add in the random cash flows during the year, to get realized return and hypothesize about how much uncertainty there is in that random return. It is important to consider that "thought experiment" to get a sense of how much risk the Irish state is taking on in this NAMA programme. When the Irish state takes on a large risky asset in exchange for cash, in uncertain times such as these, it is providing risk capital even if the NAMA exchange is "fair" in terms of cash value. Reward-to-variability ratio times standard deviation of return is one hypothetical way of measuring the "amount" of risk capital provided in such a transaction. Admittedly, this does not work that well for the blanket guarantee of bank borrowing since empirically reward-to-variability ratios tend to undervalue insurance-type instruments. By volatility I mean the standard deviation of return. The reward-to-variability ratio (also called the Sharpe Ratio) is the annual expected return minus the riskfree return divided by annual standard deviation of return. William Sharpe is the one who used the informal term variability rather than standard deviation or volatility in his terminology. Most people call it the Sharpe Ratio. Obviously with a loan book especially a book of troubled loans the concept of the standard deviation of annual return is a bit difficult to measure. It would be necessary to get current market value of the loans, and consider the uncertainty about end of year market value after whatever happens during the year in terms of value discovery, add in the random cash flows during the year, to get realized return and hypothesize about how much uncertainty there is in that random return. It is important to consider that “thought experiment” to get a sense of how much risk the Irish state is taking on in this NAMA programme. When the Irish state takes on a large risky asset in exchange for cash, in uncertain times such as these, it is providing risk capital even if the NAMA exchange is “fair” in terms of cash value. Reward-to-variability ratio times standard deviation of return is one hypothetical way of measuring the “amount” of risk capital provided in such a transaction. Admittedly, this does not work that well for the blanket guarantee of bank borrowing since empirically reward-to-variability ratios tend to undervalue insurance-type instruments.

]]> http://www.irisheconomy.ie/index.php/2009/05/27/the-risk-capital-bank-lending-multiplier/#comment-8159 Antoin O Lachtnain Wed, 27 May 2009 19:55:14 +0000 http://www.irisheconomy.ie/?p=2419#comment-8159 What exactly do you mean by 'annual volatility'? What do you mean by variability? What exactly do you mean by ‘annual volatility’? What do you mean by variability?

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