Ch 3 - Specialist Asset Classes (1) Flashcards
Factors influencing spreads of money market rates:
Default risk
Market liquidity
Money market investments include:
Treasury Bills
Commercial Paper
Repos
Government Agency Securities (also Local Authority Bills)
Bills of Exchange - Banker’s acceptance + Eligible bills
Bank Time Deposits - CDs
Term and call deposits
Options for Companies borrowing in the MM:
Commercial paper Eligible bills Term loan from a bank Line of credit with a bank - Evergreen vs Revolving Bridging loan from a bank International bank loans Factoring - non-recourse and recourse
Issues that differentiate between different types of loans include:
Commitment
Maturity
Rate of interest
Security
Treasury Bills
Short-term investments, issued by the national government
Issue process of T-bills
Issue is by auction
Competitive and non-competitive bids
Latter are then filled at the average price of the successful competitive bids
Competitive - Submits a tender specifying the discount rate. May get no bills or not full allocation
Non-competitive – guaranteed to receive full amount of bills requested. But upper limit of bids is less than competitive
Commercial Paper
Short-term unsecured notes, issued directly by a company.
Bearer document. Can be presented to issuer for repurchase (thus, a liquid secondary market exists)
Thus company needs good credit rating and meet certain minimum standards
Repos
A repurchase agreement is a form of secured lending whereby one party sells stock (T-bills and gov bonds usually) to another with a simultaneous agreement to repurchase it at a later date at an agreed price
No secondary market
Government Agency Securities
Bills (or notes) issued by a near-government sector of the market
Bankers’ Acceptance
Form of tradable invoice (IOU) that has been accepted (i.e. guaranteed) by a bank
Invoice is “accepted” by the bank and guarantees payment at due date
Bill can be traded in the secondary market to raise immediate cash, at a discount
Evergreen line of credit
Borrow up to a specified limit with no fixed maturity
Just like an overdraft facility
Borrower may need to pay a commitment fee to the bank for the option to borrow when it wants to
Revolving line of credit
Similar to evergreen but with fixed maturity of up to 3 years
Pay a commitment fee on the full agreed amount of borrowing, whether or not it is all used
Interest is only paid on the amount actually borrowed
Bridging loan
Used to pay for a specific item in the interim period before long-term finance is obtained (or sale of existing obligation - such as a house)
Non-recourse factoring
Supplier sells on its trade debts to a factor to get cash before due date
Factor takes credit risk and responsibility for credit analysis
Recourse factoring
Effectively a loan which is secured against the invoices
Copy of invoice is sent to factor who then gives supplying company cash up front
Credit risk still remains with supplying company. Because the supplying company passes on money to factor when it is paid. Company must buy back any uncollected invoices
Categories of Corporate Debt:
Debentures
Loan stock
Preference shares
Credit spread
Excess yield on corporate bonds over Treasury bonds
Credit spread can typically be decomposed into four components:
Compensation for expected defaults
Investors may expect future defaults to exceed historic levels
Credit risk premium – risk of higher defaults
Compensation for liquidity risk – typically referred to as an illiquidity premium
Credit event (def + 5 examples)
Events that trigger payments under credit derivatives
Bankruptcy
Rating downgrade
Cross-default
Default on particular coupon
Repudiation
Why do banks and institutional investors like credit default swaps?
Lenders who have reached their internal credit limit with a particular client, but wish to maintain their relationship with that client, can use credit default swaps to reduce their aggregate exposure to the client
Institutional investors use them to reduce credit exposure to the underlying bond issuers
Credit-Linked Note:
Is a CDS embedded with a traditional bond (provides the protection payment upfront - hence “Funded”)
Credit Spread Options:
Is an option on the spread between the yields earned on two assets, which provides a payoff when the spread exceeds some level (the strike spread) at a strike date
Therefore provides protection against a widening of credit spreads
Swaps
Is an agreement between two parties to exchange a specified series of cashflows over a specified period in the future, based on an agreed principle amount.
Defines the dates when the cashflows are to be paid and the way they are to be calculated.
Zero-coupon swaps
A zero coupon swap (with both legs paid at maturity) is an agreement to exchange a fixed for floating rate over one or more periods, with the payments being made at the end of the final period
Amortising swaps
Where parties swap cashflows on a notional principal amount that decreases over time. The notional principal is tied to an underlying financial instrument with a declining (amortizing) principal balance, such as a mortgage.
Step-up swaps
Principle increases in a predetermined way
Deferred swaps or forward swaps
Swap doesn’t start immediately
Constant maturity swaps (CMS)
Floating leg of the swap is of longer maturity than the frequency of payments
Extendable swaps
One party has the option to extend the life of the swap beyond a specified period
Uses of currency swaps
Transform
- can be used to transform borrowings in one currency into borrowings in another
- transform nature of assets and liabilities
Asset
-Hedging with currency swaps and/or currency futures can also be used to make currencies an asset in their own right (allow managers to separate currency and country investment decisions)
Speculation
-Outright speculation on currencies (but this is super risky!)
Longer term
-Generally available for longer terms than forward agreements so are more useful in hedging longer-term liabilities
Disadvantages of currency swaps
CURB FEMinism - for forwards - but just have CUB FEMinism for swap
Counterpart credit risk
Unknown
- Difficulty of hedging unknown future income
- They can only easily hedge a level/known income stream
Bid-offer
-Extra cost of the bid-offer spread compared with a straight spot currency transaction
Favourable
-Removing the possibility of favourable currency movements (i.e. Market risk)
Expensive
-Are only available on fairly large principle amounts - expensive for small amounts
Mismatching
-Mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials
Total return swaps
Receiver to receive the total return (income + capital gain) on a reference asset, in return for paying the reference floating (or fixed) rate plus or minus an adjustment
Adjustment will allow for net effect of hedging costs, financing costs and dealing spreads
OR
Is an agreement between two parties to exchange the total return from one asset (or group of assets) for the total return on another. In particular, the underlying assets are often bond or equity indices
Two main uses of total return swaps
Diversification without actually trading the underlying (i.e. helps with Portfolio Transition)
To enable a financial institution to avoid breaches of internal credit limits to exposure to a particular type of asset (usually where the underlying assets are corporate bonds)
RPI swaps
Links one set of payments to the level of the retail price index
LPI swaps
Payments are again linked to the RPI, but at a capped maximum rate
Cross-currency swaps or currency coupon swaps
Combination of IRS and currency swap
Exchange a fixed interest rate in one currency for a floating interest rate in another currency
Dividend swaps
Exchanging the dividends received on a reference pool of equities in return for a fixed rate
Variance/Volatility swaps
Exchanging a fixed rate in return for the experienced variance or volatility of price changes of a reference asset
Asset swaps
Swap fixed cashflows from a fixed income asset in return for floating interest rates
Commodity swaps
One set of cashflows is exchanged for another based on the current market price of a particular commodity
Main features of a swap to consider when constructing/selling one:
Range of principle amounts that it would offer
Range of terms
Frequency of the swap payments
Currency of the payments
The interest rate on which floating would be based
Margin over the floating rate required to generate the bank’s required profit
Features of the underlying
Profitability for a bank designing a swap (factors to consider before putting on the market):
Margins on the floating rate that it is able to charge/pay to clients (charges should be higher than paid)
Likely volume of sales
The costs of designing and marketing the swap
Risks
Swaption
Provides one party with the right, but not an obligation, to enter into a certain swap at a certain time in the future on specified terms.
You pay a premium for this option.
Receiver swaption/Call swaption
You receive fixed
Usually used when expect interest rates to decrease (thus bond prices increase)
Payer swaption/Put swaption
You pay fixed
Usually used when expect interest rates to increase (thus bond price decreases)
Puttable bond
Holder (fixed rate receiver) can demand early redemption at certain times
Exercised when interest rates go up
Callable bond
Allows the issuing firm (payer of the fixed rate) to buy back the bond at a predetermined price at certain times in the future
Exercised when interest rate goes down
FRA
Forward contract where the parties agree that a certain interest rate will apply to a certain principle amount during a specified future time period
Private debt
Loan capital (bond) issued by companies that are not publicly listed and traded on a stock exchange
Also called private placement
Is a debt capital market transaction that generally has covenant features similar to a bank loan
Covenants
Are requirements or restrictions placed on the borrower and aim to provide a degree of security for the lender
Positive covenant = requirement to do something
Negative covenant = requirement not to do something
Features of Private Debt
Small number of investors
No secondary market
Thus, less liquid/marketable than publicly issued debt
Issued by small and medium-sized companies
Term is longer than 3 years
Can be repaid early
Reasons for issuing private debt (4)
Can issue capital market debt without acquiring a formal long-term debt rating (less admin but possibly more costly)
Alternative to borrowing from a bank
Relatively competitive pricing
Often used to refinance existing term loans from banks but don’t want the trouble and expense of obtaining a credit rating
Note: Can improve covenant bargaining position (or pricing) by obtaining a private rating from an external rating agency
