Hi Max. I truly appreciate you getting our discussion off to such a great start

Question

Hi Max. I truly appreciate you getting our discussion off to such a great start this week! You brought up a very good point about interconnection risk. When dealing with derivative instruments, this is something that management should consider.

Class, here’s a fun web field trip. Do a bit of research and see if you can find an example of a company or event where interconnection risk played a role? What happened in the example? Should things have happened differently in an ideal world? Why or why not?

Explanation / Answer

Interconnection risk: For example, a market event that affects the value of a specific type of derivative instrument may also affect derivative instruments in other markets because of cross-market price correlations. Such an event can have a significant impact on a bank's holdings as well as the holdings of the bank's counterparties.

Practical Example:

Ignoring Interconnected risk leads to destruction of Texas bank in earlier years.

Texas was home to more banks than any other state in America. In during 1970s period US supported Israel in Arab-Israel war due to that Organisation and Petroleum Export countries initiated ban on Oil trading in US which leads to inrease in oil price by more than $100 at the end of 2000. There after removal of ban oil prices reduced by more than 65% which leads to recession of Texas banks and thereafter texas banks started concentrated on the real estate market for growth. However due to Economical Situations there was a down on Real estate markets leads to texas bank recession again.

Conclusion: Many Texas banks failed to see the correlation between real estate prices and the profitability of the oil industry. Similarly banks lending to less-developed countries failed to see the link between world commodity prices and the LDC debt repayment capacity.

Steps to be taken:

Banks should regularly evaluate alternative market situations using scenario or what-if analyses. For example, a scenario analysis might assess the results of various twists and shifts of the yield curve, as well as changes in the relationships among yield curves for various interest rates.

Thats why Interconnected risk plays major role since it has impact on the counter party financial position also.

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