The Case of Constant Funding Level

In a calm credit environment, one the world is not going to see for a long time after the financial crisis of 2007 to 2009, funding costs, particularly for borrowers in good standing, are roughly constant and tend to have very low variance and they tend to come true. This means not only that

but also that

meaning that when at time Tn the asset swap spread corresponding to a bond issued at that moment became certain, it was approximatively equal to the value we were expecting earlier at time Tn-1. This environment offers no particular challenges or risks.

The Case of Funding Level Lower Than Expected

There are many situations in finance where one hears the expression “the spot does not follow the forward.” This is particularly frequent in the FX world[1] but it can be applied here as well. The expression means that when something actually takes place it does so in a way that differs consistently from its previously expected value. The expression is also usually intended in a favorable sense. In our context it would mean that

The above means that when the time comes to issue a new bond, the actual asset swap spread is lower than what we had expected previously. If this is the case, the value set forwas too conservative: it was set for a certain series of funding levels and these turned out to be lower than expected. The profit we are going to make is higher than initially foreseen.

The Case of Funding Level Higher Than Expected

It is not difficult to imagine the opposite of the previous scenario and envisage the situation where


that is, when the time comes to issue the refinancing debt, the asset swap level is higher than we had anticipated.

This is the simplest expression of the danger of refinancing risk. We set a spread for the loan, which should lead to a profit based on the assumption of a certain funding level term structure; however, the actual funding levels turn out to be much higher leading to a smaller than expected (or negative) P.

This situation is particularly treacherous and is easily compounded by external factors such as leverage, liquidity, and contagion. During the Euro sovereign crisis of 2010 to 2012 an important issue was the difference between insolvent countries like Greece, where[2] in any scenario was never going to be enough to lead to a positive P, and countries essentially solvent like Spain and Italy, where the positive value of P was jeopardized simply by the fact that in a credit and liquidity crisisfollows Equation 7.16 to a dramatic level. Banks [7] offers a thorough analysis of the relationship (with examples from important financial crisis) between the problems of liquidity occurring during a credit crisis and funding.

  • [1] The consistency with which the spot USD/JPY rate did not follow the forward was at the origin of the famous “Yen carry trades,” which we mentioned in Section 6.4.2.
  • [2] The spread has been defined here as a loan spread, in a qualitative argument it can be extended to mean income in general.
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