Chapter 3: Specialist asset classes (1)

Question 1

Money market investments (6)

Answer 1

1. Treasury bills
2. Commercial paper
3. Repos
4. Government agency securities
5. Bank time deposits
6. Bankers’ acceptance and eligible bills

Question 2

Treasury bills: (2)

Answer 2

1. these are short-term investments, issued by the national government.
2. they offer the lowest default risk amongst money market instruments

Question 3

Commercial paper: (2)

Answer 3

1. consists of unsecured notes issued directly by companies.
2. the rate of interest on commercial paper will generally be slightly higher than that on an equivalent Treasury bill, the size of margin depending on the company’s credit rating.

Question 4

Repos (Investment)

Answer 4

a repo (or repurchase agreement) is a form of secured lending whereby an investor buys treasury bills from a dealer who, in turn, agrees to buy them back again at a later date at a specified (higher) price.

Question 5

Government agency securities

Answer 5

bills issued by a near government sector of the market.

Question 6

Bank time deposits

Answer 6

bank deposits with a specified term.

If the investor wants to access their investment before the maturity date he may be allowed to do so, but a penalty will be imposed, e.g. the interest rate might be reduced.

Question 7

Bankers’ acceptances and eligible bills

Answer 7

a form of tradable invoice that has been accepted by a bank.

Question 8

Options for companies looking to borrow in the money markets. (6)

Answer 8

1. issuing commercial paper
2. issuing eligible bills
3. arranging a term loan from a bank
4. arranging a line of credit with the bank (evergreen or revolving)
5. arranging a bridging loan from a bank
6. arranging international bank loans

Question 9

The excess yield on corporate bonds over government bonds is made up of: (4)

Answer 9

1. compensation for expect defaults
2. Investors may expect future defaults to exceed historical levels
3. a credit risk premium
4. a liquidity risk premium

Question 10

Credit default swap

Answer 10

A credit default swap provides a payment if a particular credit event occurs, e.g. the issuer of a bond defaults

Question 11

Credit spread option

Answer 11

A credit spread option is an option on the spread between the yields earned on two assets, which provides a payoff if the spread exceeds some level (the strike spread).

Question 12

Swap

Answer 12

A swap is an agreement between two parties to exchange cashflows in the future.

Question 13

Describe how an interest rate swap can be valued

Answer 13

An interest rate swap can be valued as a long position in one bond compared to a short position in another bond, or as a portfolio of forward rate agreements

Question 14

Currency swap

Answer 14

A currency swap involves exchanging principal and interest payments in one currency for principal and interest payments in another currency.

Question 15

Other types of swaps (12)

Answer 15

1. amortising swaps
2. step-up swaps
3. deferred swaps or forward swaps
4. constant maturity swaps
5. RPI swaps and LPI sawps
6. cross-currency swaps or currency coupon swaps
7. extendable swaps
8. puttable swaps
9. equity swaps
10. commodity swaps
11. asset swaps
12. volatility and variance swaps

Question 16

Swaption

Answer 16

A swaption gives one party the right to enter into a certain swap at a certain time in the future on terms specified now.

Question 17

Forward

Answer 17

A forward is an over-the-counter agreement to buy (or sell) an asset at a certain future time for a certain price.

Question 18

Forward rate agreement (FRA)

Answer 18

A forward rate agreement is a forward contract where the parties agree that a certain interest rate will apply to a certain principal amount during a specified future time period.

Question 19

Private debt: (2)

Answer 19

1. private debt refers to bonds that are not listed and traded on the stock exchange.
2. private debt generally has covenant features similar to a bank loan and is often used as an alternative to bank funding.

Question 20

Categories of corporate debt: (3)

Answer 20

1. debentures
2. loan stock
3. preference shares

Question 21

Zero coupon swaps

Answer 21

where each individual payment under the par swap is traded separately.

Question 22

amortising swaps

Answer 22

where the principal reduces in a predetermined way

Question 23

step-up swaps

Answer 23

where the principal increases in a predetermined way

Question 24

deferred swaps or forward swaps

Answer 24

where the swap does not commence immediately and so the parties do not begin to exchange interest payments unit some future date.

Question 25

constant maturity swaps (CMS)

Answer 25

where the floating leg of the swap is for a longer maturity than the frequency of payments.

(e.g. the floating leg might be a 5 year market interest rate but paid, and reset to current market levels, every 6 months.)

Question 26

extendable swaps

Answer 26

where one party has the option to extend the life of the swap beyond a specified period.

Question 27

puttable swaps

Answer 27

where one party has the option to terminate the swap early.

Question 28

Examples of credit events: (5)

Answer 28

1. bankruptcy
2. a rating downgrade
3. cross-default - a cross-default on a bond means that a credit event on another security of the issuing firm will also be considered as a credit event on the bond in question.
4. repudiation - when the debt issuer simply chooses to cancel all of the outstanding interest payments and the capital repayment of the debt.
5. failure to pay a particular coupon.

Question 29

The two ways to settle a claim under a credit default swap:

Answer 29

1. A pure cash payment, representing the fall in the market price of the defaulted security.
2. The exchange of both cash and a security (physical settlement). The protection seller pays the buyer the full notional amount and receives, in return, the defaulted security.

Question 30

Features of private debt: (4)

Answer 30

1. not actively traded
2. generally medium-term to long-term
3. issued by small and medium-sized companies that do not wish to incur the expense of a public issue.
4. generally have covenant features