Ch 3 - Specialist Asset Classes (1)

Question 1

Factors influencing spreads of money market rates:

Answer 1

Default risk

Market liquidity

Question 2

Money market investments include:

Answer 2

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

Question 3

Options for Companies borrowing in the MM:

Answer 3

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

Question 4

Issues that differentiate between different types of loans include:

Answer 4

Commitment
Maturity
Rate of interest
Security

Question 5

Treasury Bills

Answer 5

Short-term investments, issued by the national government

Question 6

Issue process of T-bills

Answer 6

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

Question 7

Commercial Paper

Answer 7

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

Question 8

Repos

Answer 8

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

Question 9

Government Agency Securities

Answer 9

Bills (or notes) issued by a near-government sector of the market

Question 10

Bankers’ Acceptance

Answer 10

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

Question 11

Evergreen line of credit

Answer 11

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

Question 12

Revolving line of credit

Answer 12

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

Question 13

Bridging loan

Answer 13

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)

Question 14

Non-recourse factoring

Answer 14

Supplier sells on its trade debts to a factor to get cash before due date

Factor takes credit risk and responsibility for credit analysis

Question 15

Recourse factoring

Answer 15

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

Question 16

Categories of Corporate Debt:

Answer 16

Debentures

Loan stock

Preference shares

Question 17

Credit spread

Answer 17

Excess yield on corporate bonds over Treasury bonds

Question 18

Credit spread can typically be decomposed into four components:

Answer 18

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

Question 19

Credit event (def + 5 examples)

Answer 19

Events that trigger payments under credit derivatives

Bankruptcy

Rating downgrade

Cross-default

Default on particular coupon

Repudiation

Question 20

Why do banks and institutional investors like credit default swaps?

Answer 20

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

Question 21

Credit-Linked Note:

Answer 21

Is a CDS embedded with a traditional bond (provides the protection payment upfront - hence “Funded”)

Question 22

Credit Spread Options:

Answer 22

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

Question 23

Swaps

Answer 23

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.

Question 24

Zero-coupon swaps

Answer 24

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

Question 25

Amortising swaps

Answer 25

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. 

Question 26

Step-up swaps

Answer 26

Principle increases in a predetermined way

Question 27

Deferred swaps or forward swaps

Answer 27

Swap doesn't start immediately

Question 28

Constant maturity swaps (CMS)

Answer 28

Floating leg of the swap is of longer maturity than the frequency of payments

Question 29

Extendable swaps

Answer 29

One party has the option to extend the life of the swap beyond a specified period

Question 30

Uses of currency swaps

Answer 30

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

Question 31

Disadvantages of currency swaps

Answer 31

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

Question 32

Total return swaps

Answer 32

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

Question 33

Two main uses of total return swaps

Answer 33

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)

Question 34

RPI swaps

Answer 34

Links one set of payments to the level of the retail price index

Question 35

LPI swaps

Answer 35

Payments are again linked to the RPI, but at a capped maximum rate

Question 36

Cross-currency swaps or currency coupon swaps

Answer 36

Combination of IRS and currency swap Exchange a fixed interest rate in one currency for a floating interest rate in another currency

Question 37

Dividend swaps

Answer 37

Exchanging the dividends received on a reference pool of equities in return for a fixed rate

Question 38

Variance/Volatility swaps

Answer 38

Exchanging a fixed rate in return for the experienced variance or volatility of price changes of a reference asset

Question 39

Asset swaps

Answer 39

Swap fixed cashflows from a fixed income asset in return for floating interest rates

Question 40

Commodity swaps

Answer 40

One set of cashflows is exchanged for another based on the current market price of a particular commodity

Question 41

Main features of a swap to consider when constructing/selling one:

Answer 41

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

Question 42

Profitability for a bank designing a swap (factors to consider before putting on the market):

Answer 42

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

Question 43

Swaption

Answer 43

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.

Question 44

Receiver swaption/Call swaption

Answer 44

You receive fixed Usually used when expect interest rates to decrease (thus bond prices increase)

Question 45

Payer swaption/Put swaption

Answer 45

You pay fixed Usually used when expect interest rates to increase (thus bond price decreases)

Question 46

Puttable bond

Answer 46

Holder (fixed rate receiver) can demand early redemption at certain times Exercised when interest rates go up

Question 47

Callable bond

Answer 47

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

Question 48

FRA

Answer 48

Forward contract where the parties agree that a certain interest rate will apply to a certain principle amount during a specified future time period

Question 49

Private debt

Answer 49

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

Question 50

Covenants

Answer 50

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

Question 51

Features of Private Debt

Answer 51

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

Question 52

Reasons for issuing private debt (4)

Answer 52

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