1. May 24, 2012 Faculty of Business Administration and Economics Yield Spreads, Value of Bonds, and Implications for Liquidity Management Prof. Dr. Mario Strassberger Finance and Financial Services Slide 1 Conference “International Competition in Banking: Theory and Practice” May 24-25, 2012, Ukrainian Academy of Banking, Sumy

2. May 24, 2012Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications Structure of the Talk 1Introduction 2 Design and Data 3 Results 4 Conclusion Slide 2

3. May 24, 2012 1 Introduction Bond portfolios in financial institutes - Means of liquidity reserve - Assuring refinancing with the Central Bank, i.e. ECB Considerable losses to the value of bond portfolios during the crisis Requirements and recommendations for liquidity risk of the banking supervision (Basel Committee 2008, 2009; CEBS 2008) One of the key demands: Maintenance of an adequate level of liquidity  What dos “adequate” mean?  Reliable estimation of haircuts on bond values Slide 3Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

4. May 24, 2012 2 Design and Data (1) Bloomberg Fair Market Curves™ - Sector: EUR Composite - Credit qualities: AAA, AA, A and BBB - Maturities: 1Y, 3Y, 5Y, 7Y, 10Y, 15Y and 20Y - Benchmark: Government Curve Two data sets - Jan 04 – Jul 07 (Set 1, 1,308 observations) - Aug 07 – Dec 10 (Set 2, 1,249 observations) Yield spread at time Slide 4Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

5. May 24, 2012 2 Design and Data (2) Example of time series Slide 5Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

6. May 24, 2012 2 Design and Data (3) Example of time series Slide 6Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

7. May 24, 2012 2 Design and Data (4) 1) Estimating exp. spreads and p -quantiles of the spread distr. (Set 1) Identifying max. observed spreads (Set 2) 2) Calculating relative changes in Present Value of zero bonds caused by spread expansions and interpreting as haircut Slide 7Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

8. May 24, 2012 3 Results (1) Slide 8Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications 1Y3Y5Y7Y10Y15Y20Y AAA12.1416.8118.9418.5921.3620.1031.36 AA17.0824.0325.3825.2829.8535.6142.32 A23.7234.4139.0040.7248.8659.7767.92 BBB38.2557.3970.9378.8794.61110.20132.63 Table 1 Expected yield spreads in basis points 1Y3Y5Y7Y10Y15Y20Y AAA26.8623.4132.4630.1340.1936.9249.96 AA32.1038.6045.5643.0152.7252.1179.65 A43.7352.4462.0560.6177.5299.78105.08 BBB81.49105.69116.76111.51129.35170.48260.66 Table 2 99.99%-quantile of the yield spread distributions in basis points Considering Set 1

9. May 24, 2012 3 Results (2) Spreads up to 13 times higher than expected (regular market cond.) Increase in spreads mainly driven by liquidity premiums Slide 9Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications Considering Set 2 1Y3Y5Y7Y10Y15Y20Y AAA200.60156.50299.40144.10142.90121.9075.20 AA215.60174.80320.90183.70195.00144.65137.98 A285.00267.80335.20265.00272.00266.40214.90 BBB391.08398.50412.60432.20461.20403.30444.40 Table 3 Maximum observed yield spreads in basis points

10. May 24, 2012 3 Results (3) Slide 10Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

11. May 24, 2012 3 Results (4) Haircuts of up to 25% for investment grade bonds Ex ante underestimation of spreads and haircuts (regular market cond.) Slide 11Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications Calculated haircuts 1Y3Y5Y7Y10Y15Y20Y AAA-1.04-2.55-8.91-5.96-8.40-10.37-6.01 AA-1.09-2.75-9.36-7.45-11.22-11.05-12.62 A-1.43-4.21-9.37-10.35-14.81-19.80-18.65 BBB-1.92-6.07-10.69-15.72-22.98-26.73-35.17 Table 4 Haircuts on zero bonds in %

12. May 24, 2012 4 Conclusion Maintaining an adequate level if liquidity holding portfolios of liquid securities + individual additional charge on liquidity reserve (up to 1/3 more in present value than needed to assure liquidity)  Increasing importance to minimise estimation errors of bond haircuts Liquidity shock could persist for several months  Additional discount on actual market value to ex ante account for a crisis Slide 12Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications