Chapter 3: Specialist asset classes Flashcards
- How money market interest rates are often quoted
- the 2 factors that influence ethe spread the spread of money market rates
Money market interest rates
- Money market interest rates often quoted relative to LIBOR
- Two factors that influence spreads of money market rates
- Default risk
- market liquidity
List six types of money market instruments and state which three are the most important
- T Bills
- Commerical paper
- Repos
- Government agency securities
- Bank time deposits/certificates of deposit
- bankers acceptances and eligible bills
In most markets T Bills, commerical paper and repo aggreements are major forms of money market investent
Describe the main freature sof the market of T Bills
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 anad very marketable
What is commerical paper
Commerical paper
- Short term unsecured notes issued didrectly by company (overriding need for financial intermediation)
- Issued at discount (and redeemed at par), usually for term of few months but can typically be presented to usser (or dealer) for repurchase
- bearer document and single name instrument security provided only by company issuing paper
- Default risk means effective rate of interest slighytly higher than Tbills
- Size of margin reflects company’s credit rating
Explain what is meant by repo
Repos
- A repo is an agreement whereby one party sells stok to oantoher 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
What is reverse repo
A reverse repo is the opposite side of repo agreement. This is a form of secured ledning as cash is being lent for the duration of the repo by the party buying the stock, with security as collateral
Give 5 forms of short term borrowing from banks
- 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
Give 4 issues that differentiate between different types of bank loan
- Commitment - whether there is prior commitment by lender to adcance 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
LIst the four components that comprises the excess of the yield on corporate bonds over treasury bonds
- Compensation for expected defaults
- The possibility that investors may expect futuure defaults to exceed historic levels
- compensaton 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
Quantifiying 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
Desscribe the term credit deerivative
List the 2 most common tupes of credit derivatives
- Contracts where the pay offs depends partly upon the creditworthiness of one (or more ) commerical (or sovereign) bond issuers.
- The two most common types
- Credit default swaps
- credit spread options
Explain how a credit default swap works
- Contract that provides payment if particular if credit event (usually defaul) 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 bia 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 revovery R, then net payment on default equals 100- R
What is meant by credit linked note
- Consists of basic seurity plus embedded credit default swap
- for example, long position in risk free seurity plus short position in credit default swap
- Provides payments linked to credit experiene 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
Explain with the aid of a simple example how a credit spread option works
- Option on spread between yields earned on 2 assets, which provides payoff when spread exceeds some level
- Payoff = value of bond with strike spread - market value of bond held.
- eg might give holder right, but not obligation, to sell corporate bond on strike date and at price correspoding to strike spread of 1% above corresponding government bond yield
- Offers protection against widening of credit spread beyond strike spread
exercise if actual spread above strike spread
bond credit spread reflects the difference in yield between a gov bond and a corporate bond. Measure of additional yield that investors demand for a bond with higher risk to attract capital
widening of spread means the market value of the bond is dropping .
Explain how a plain vailla interest rate swap works
- Company B agrees to pay company A cashflows equal to interst at predetermined fixed rate on notional principla 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 payment 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
Explain how a currency swap works
- Involves exchange of principal and interest payments in one currency for principal and interest payments in another currency
- Principal specidied in both currencies - usually chosen to be approximately equal based on current exhange rate
- Principal amounts usually exchanged at befinning and end of swap - as companies usually want to borrow the currencies involved