Chapter 3: Specialist asset classes

Question 1

1. How money market interest rates are often quoted
2. the 2 factors that influence ethe spread the spread of money market rates

Answer 1

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

Question 2

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

Answer 2

• 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

Question 3

Describe the main freature sof 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 anad very marketable

Question 4

What is commerical paper

Answer 4

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

Question 5

Explain what is meant by repo

Answer 5

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

Question 6

What is reverse repo

Answer 6

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

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 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

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 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

Question 10

Desscribe the term credit deerivative

List the 2 most common tupes of credit derivatives

Answer 10

• 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

Question 11

Explain how a credit default swap works

Answer 11

• 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

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 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

Question 13

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

Answer 13

• Option on spread between ields earned on 2 assets, which provides payoff when spread exceeds some level
• Payoff calculated as difference btween value of bond with strike spread anda market value of bond
• eg might give holder right, but not obligation, to sell corporate bond 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

Question 14

Explain how a plain vailla iinterest rate swap works

Answer 14

• 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

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 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

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 dfference between values of assets generating returns on each side of swap
• normally structured to be woth 0 intially

Question 17

State how the following types of swap are structured

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

Answer 17

1. Zero coupon swap - each individual payment is traded seperately
2. Amortising swap - principal reduces in predetermined way
3. Step up swaps - principal increase in predtermined way
4. deferred or forward swap - swap agreed now but doesn’t start until some future date
5. Constant maturity swap - where the floating leg of the swap is for longer matruirty than the frequency of payments
6. extendable swap - one party has the option to extend life of swap beyond specified period
7. puttable swap - one party has the option to terminate 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 fixed rate for index return
• Cross currency or currency coupon swap - swapping fixed interest rate in one currency for floating interest rate in another currency
• Dividend swap - exchanging the dividends recieved on a reference pool of equities in return for a fixed rate
• Variance or volatilty swap - exchange a fixed rate in return for the experience varaince or volatilty of price changes of a reference asset
• Asset swap - exchanging the fixed cashflow due from a bond or other fixed income asset in return for gloating interest rates

Question 19

Explain what a swaption is also how it might be used

Answer 19

• Provides purchaaser with right, but not obligation, to enter into certain swap at certain time in future
• Can be used to provide guarantee that fixed rate of interest paid on a loan at some future time will not exceed some level
• This means company able to benefit from favourable interest rate movements while acquiring protecting fro unfavourable variations
• Can be useful for insurers wishing to offer policyholders option of fixed rate product (eg guaranteed annuity options)

Question 20

What is meant by a forward rate agreement

Answer 20

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

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 predermined 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 ter “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