Chapter 3: Specialist Asset Classes Flashcards
How money market interest rates are often quoted
the 2 factors that influence the spread the spread of money market rates
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
List six types of money market instruments and state which three are the most important
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
Describe the main features of 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 and very marketable
What is commercial paper
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
Explain what is meant by Repo
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
What is reverse repo
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
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 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
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 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
Describe the term credit derivative
List the 2 most common types of credit derivatives
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
Explain how a credit default swap works
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
What is meant by credit linked note
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
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 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
Explain how a plain vanilla interest rate swap works
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
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 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
Describe the use and valuation of total return swaps
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
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
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.
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
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.
Explain what a swaption is also how it might be used
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
What is meant by a forward rate agreement
Forward contract where parties agree that a certain rate will apply to a certain principle amount a specified time in the future
The difference puttable and callable bonds
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
List 6 key features of private debt
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
Give 3 reasons for issuing private debt and 2 disadvantages of issuing private debt
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
