Chapter 3: Specialist Asset Classes

Question 1

How money market interest rates are often quoted

the 2 factors that influence the spread the spread of money market rates

Answer 1

Money market interest rates

Money market interest rates often quoted relative to LIBOR (London Inter Bank Observed Rate)

Two factors that influence spreads of money market rates
+Default risk
+market liquidity

Question 2

List six types of money market instruments and state which three are the most important

Answer 2

T Bills
Commercial paper
Repos
Government agency securities
Bank time deposits/certificates of deposit
bankers acceptances and eligible bills
In most markets T Bills, commercial paper and repo agreements are major forms of money market investment

Question 3

Describe the main features of the market of T Bills

Answer 3

T Bills

Issued by he government so very secure
typically issued in 3 months, 6 months and one year forms
usually issued by auction
Deep and liquid market and very marketable

Question 4

What is commercial paper

Answer 4

Commercial paper

Short term unsecured notes issued directly by company (overriding need for financial inter mediation)

Issued at discount (and redeemed at par), usually for term of few months but can typically be presented to user (or dealer) for repurchase

bearer document and single name instrument security provided only by company issuing paper

Default risk means effective rate of interest slightly higher than Treasury Bills

Size of margin reflects company’s credit rating

Question 5

Explain what is meant by Repo

Answer 5

Repos

A repo is an agreement whereby one party sells stock to antoher with a simultaneous agreement to repurchase it at a later date at an agreed price

holders of government bonds and other high quality assets can be use repos as a short term financing tool, whilst maintaining their underlying economic exposure to these assets

Question 6

What is reverse repo

Answer 6

A reverse repo is the opposite side of repo agreement. This is a form of secured lending as cash is being lent for the duration of the repo by the party buying the stock, with security as collateral

Question 7

Give 5 forms of short term borrowing from banks

Answer 7

Term loans - Borrowing fixed amount for fixed term
Revolving credit - Similar to evergreen credit, but with a fixed maturity of up to 3 years
International bank loans - Borrowing from a bank or syndicate of banks overseas
Briding loans - Very short term loans to bridge the gap until the long term finance becomes available
Evergreen credit - An overdraft facility with no fixed maturity

Question 8

Give 4 issues that differentiate between different types of bank loan

Answer 8

Commitment - whether there is prior commitment by lender to advance funds when required (often requiring payment of commitment fee to lender)

Maturity - term for which lending made

Rate of interest - may by either fixed of floating

Security - whether loan is secured against assets

Question 9

List the four components that comprises the excess of the yield on corporate bonds over treasury bonds

Answer 9

Compensation for expected defaults

The possibility that investors may expect future defaults to exceed historic levels

compensation for the risk of the higher defaults, ie a credit risk premium

A residual that includes the compensation for the liquidity risk - typically referred to as an illiquidity premium

Quantifying this involves techniques such as the uses of option pricing models using equity volatility to estimate the risk of default and the use of credit default swaps to estimate the market premium for credit risk

Question 10

Describe the term credit derivative

List the 2 most common types of credit derivatives

Answer 10

Contracts where the pay offs depends partly upon the creditworthiness of one (or more ) commercial (or sovereign) bond issuers.

The two most common types
Credit default swaps
credit spread options

Question 11

Explain how a credit default swap works

Answer 11

Contract that provides payment if particular if credit event (usually default) occurs

Party buying protection pays regular premium to party selling protection

If credit event occurs within term of contract, payment made from seller to buyer

if credit event doesn’t occurs within term of contract, buyer receives no payment but has benefited from protection

settled via cash payment equal to fall in market price of defaulted security (cash settlement) or exchange of cash and security (physical settlement)

in either case, if value of defaulted bond is equal to recovery R, then net payment on default equals 100- R

Question 12

What is meant by credit linked note

Answer 12

Consists of basic seurity plus embedded credit default swap

for example, long position in risk free security plus short position in credit default swap

Provides payments linked to credit experience of reference bond underlying the credit default swap

can be used to transfer credit risk from holder of risky reference bond to holder of credit linked note

Question 13

Explain with the aid of a simple example how a credit spread option works

Answer 13

Option on spread between yields earned on 2 assets, which provides payoff when spread exceeds some level

Payoff calculated as difference between value of bond with strike spread and market value of bond

eg might give holder right, but not obligation, to sell corporate bond strike date and at price corresponding to strike spread of 1% above corresponding government bond yield

Offers protection against widening of credit spread beyond strike spread

Question 14

Explain how a plain vanilla interest rate swap works

Answer 14

Company B agrees to pay company A cashflows equal to interest at predetermined fixed rate on notional principal for number of years

at the same time, company A agrees to pay company B cashflows equal to interest at floating rate on same notional principal over same period

Floating rate payments at any date based on value of floating interest rate at previous cashflow date

net interest payments exchanged on each payment date

Principal not exchanged

Question 15

Explain how a currency swap works

Answer 15

Involves exchange of principal and interest payments in one currency for principal and interest payments in another currency

Principal specialised in both currencies - usually chosen to be approximately equal based on current exchange rate

Principal amounts usually exchanged at beginning and end of swap - as companies usually want to borrow the currencies involved

Question 16

Describe the use and valuation of total return swaps

Answer 16

Total return from one asset (or group of assets) swapped for total return

Eg returns on corporate bond swapped for LIBOR plus spread

enable diversification by swapping one type exposure another without physically swapping underlying assets

in absence of credit risk, value of total return swap is difference between values of assets generating returns on each side of swap

normally structured to be worth zero initially

Question 17

State how the following types of swap are structured

Zero coupon swap
amortising swap
step up swap
deferred or forward swap
constant maturity swap
extendable swap
puttable swap

Answer 17

Zero coupon swap each individual payments are traded separately

Amortising swap i.e. principle reduces in a predefined way

Step up swap-principle increases in a predefined way

deferred swap - swap is agreed now but does not start until a future date

constant maturity swap- where the floating leg is for a longer maturity that the frequency of payments

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

puttable swap -one party has the option to terminate the swap early.

Question 18

State how the following types of swap are structured

RPI and LPI swap
cross-currency or currency coupon swap
dividend swap
variance or volatility swap 
asset swap

Answer 18

RPI and LPI swap -swapping a fixed leg for an index return

cross-currency or currency coupon swap- swapping fixed interest rate in one currency for floating interest rate in another currency

Dividend swap receiving cashflows on a based on dividens received on a reference pool for a fixed return

Volaitility of variance swap -exchanging a fixed rate in return for the experienced volatility on the price of a reference asset

Asset swap -Exchanging the fixed cashflows from a bond or other fixed interest asset for a floating interest rate.

Question 19

Explain what a swaption is also how it might be used

Answer 19

Provides the purchase the right bot not the obligation to enter into a future swap at a certain time in the future

Can be used to guarantee that a fixed rate on a loan will not exceed a certain level sometime in the future

This means the company may be able to benefit from fixed interest rate movements while acquiring protection from unfavourable variations

Can be useful for insurers trying to offer policyholders fixed rate products

Question 20

What is meant by a forward rate agreement

Answer 20

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

Question 21

The difference puttable and callable bonds

Answer 21

Puttable bonds give holder option to redeem them early (ie sell the back to issuer) at predetermined price on specified dates in future

Callable bonds give issuer option to redeem them early (ie buy the back from holder) at predetermined price on specified dates in future

Question 22

List 6 key features of private debt

Answer 22

Unlisted and unmarketable

Not actively traded

convenant features similar to bank loan and often used as alternative to bank funding
usually marketed to small number of long term “buy and hold” investors

Mostly issued in fixed rate US dollar denominated transactions
usually medium to long term(over three years), for amounts ranging from £10m to 400m

Question 23

Give 3 reasons for issuing private debt and 2 disadvantages of issuing private debt

Answer 23

Reasons for issuing

Free up credit lines with relationship banks

Doesn’t incur cost of full credit rating

avoids other costs of obtaining and maintaining public listing

Disadvantages

Need to cede covenants to investors

pays higher yield than publicly listed debt