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F105 Finance & Investment > Chapter 4: Special asset classes (1) > Flashcards

Chapter 4: Special asset classes (1) Flashcards

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1
Q

Money market

A

A virtual market place made up of electronic communications between banks, dealers and major corporations.

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2
Q

Ways to access the money makets.

A
  • directly on own account
  • hire a professional investment management firm
  • via a money market fund
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3
Q

Factors influencing the spreads of money market rates

A
  • default risk
  • market liquidity
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4
Q

Explain: Most money market securities operate on a discount basis.

A

It means they don’t pay explicit interest but rather generate returns by the difference between the purchase price and the maturity proceeds.
(Use depreciation formula from matric)

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5
Q

Available money market instruments for lending

A
  • Treasury bills
  • commercial paper
  • repos
  • government agency securities
  • bank time deposits and certificate deposits
  • bankers’ acceptances and eligible bills
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6
Q

Treasury bills

A

Bills issued by the government.

  • Usually issue is by auction - competititive and non-competitive bids entered.
  • Deep and liquid secondary market for Treasury bills.
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7
Q

Commercial paper

A

Short-term unsecured notes issued directly by a company.
Issued at a discount, usually for a term of a few months, but can typically be presented to the issuer for repurchase.

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8
Q

Main features of commercial paper

A
  • bearer document
  • terms at issue: few days to several months
  • single-name instrument - security is provided only by company issuing the paper
  • companies raising finance using commercial paper need to meet minimum criteria.
  • effective rate of interest paid slightly higher than equivalent rate on a risk free investment. Size of margin depends on company’s credit rating.
  • rating agencies publish ratings for commercial paper.
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9
Q

Repos

A

An agreement whereby one party sells stock to another with a simultaneous agreement to repurchase it at a later date at an agreed price.

  • Holders of government bonds and other high quality assets use repos as short-term financing tool whilst maintaining underlying economic exposure to these assets.
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10
Q

‘Reverse repo’

A

Opposite side of the repo agreement, i.e. an agreement whereby one party buys stock from another with a simultaneous agreement to sell it back at a later date at an agreed price.

  • form of secured lending - cash lent for duration of the repo by party buying the stock, with the security as collateral.
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11
Q

Government agency securities

A

Near-government sector of the market which issues and trades securities that are almost as risk-free and liquid as Treasury bills - liquid secondary market typically exists in such bills and notes.

Risks:

  • not as marketable as Treasury bills
  • national government may allow the agency to default
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12
Q

Bank time deposits and list typical securities involved

A

Bank deposit that has a specific term.
Interest-bearing inter-bank overnight borrowing and Certificates of Deposits are typical securities involved.

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13
Q

Certificate of Deposit (CD) definition and main features

A

CD is like a negotiable term deposit - want to realise investment before maturity date - can sell CD to another investor.

Main features:

  • bearer documents
  • secondary market exists but less marketable than for Treasury bills and government agency securities
  • typical maturity terms range from 1 to 3 months
  • domestic and international CDs exist in many currencies
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14
Q

Interest-bearing interbank overnight borrowing

A

Short-term lending and borrowing of funds between banks, typically for one day.
Occurs in the interbank market, where banks lend to and borrow from each other to manage liquidity and ensure they meet regulatory reserve requirements.

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15
Q

Bankers’ acceptances and eligible bills

A

Form if tradeable IOUs, whereby a company that has supplied goods or services to client will have invoices ‘accepted’ by a bank (guarantees payment at due date)

  • Can be traded on a secondary market to raise immediate cash, at a discount.
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16
Q

Money market instruments form of borrowing

A
  • term loans
  • evergreen credit
  • revolving credit
  • bridging loans
  • international bank loans
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17
Q

Evergreen credit

A

Permission to borrow up to a specified limit, with no fixed maturity

  • involves paying a commitment fee
  • periodically repaying all outstanding amounts to ensure doesn’t become long term borrowing.
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18
Q

Revolving credit

A

Similar evergreen credit, but with a fixed maturity of up to 3 years

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19
Q

Bridging loan

A

Advances to be paid from specified income

  • Used to pay for specific item in the interim period before long-term finance is obtained.
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20
Q

Non-recourse factoring

A

Where the supplier sells on its trade debts to a factor in order to obtain cash payments of the accounts before their actual due date.
Factor takes credit risk & responsibility for credit analysis of new accounts and payment collection.

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21
Q

Recourse factoring

A
  • Copy of invoice sent to factor
  • Gives supplying company money up front equal to percentage of invoices it sends out
  • Credit risk stays with supplying company - still responsible for collecting debts
  • Supplying company gets paid by customer - passess money on to the factor.
  • Loan secured against the invoices.
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22
Q

Issues that differentiate between different types of loans (the interest rate charged on them)

A
  • Commitment - whether there’s prior commitment by lender to advance funds when required - commitment fee to lender.
  • Maturity
  • Rate of interest - may be fixed or floating
  • Security - whether loan is secured against assets
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23
Q

Primary additional risks for corporate bonds (thus resulting in higher yields compared to government bonds)

A
  • Default risk
  • Liquidity risk (strictly marketability risk) - risk that holder of the bond will not be able to realise value for it in certain market conditions
24
Q

Credit spread

A

Difference in yield between two debt securities of the same maturity but different credit quality.

25
Q

Yield spread on corporate bonds over Treasury bonds is decomposed into:

A
  1. Compensation for expected defaults
  2. Possibility that investors expect future defaults to exceed historic levels
  3. Compensation for the risk of higher defaults (credit risk premium)
  4. Residual that incl. compensation for liquidity risk (illiquidity premium)
26
Q

Credit derivatives and the most common types

A

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

  • Way of managing credit risk

Most common types:

  • credit default swaps
  • credit-linked note
  • credit spread options
27
Q

Credit default swap

A

A contract that provides a payment if a particular event occurs (e.g. bankruptcy, rating downgrade or cross-default).

If credit event occurs within the term, payment is made from seller to buyer.
If credit event doesn’t occur within the term, buyer receives no monetary payment but has benefited from protection.

28
Q

Ways to settle a claim under a credit default swap

A
  1. Cash settlement representing the fall in the market value of the defaulted security.
  2. Physical settlement (exchange of both cash and a security) - protection seller pays the buyer the full notional amount and receives, in return, the defaulted security.
29
Q

Credit-linked notes

A

Consists of a basic security plus an embedded credit default swap.

  • Useful way of stripping and repackaging credit risk
30
Q

Credit spread options

A

An option on the spread between the yield earned on two assets which provides payoff when the spread exceeds some level (the strike spread).

  • Payoff could be calculated as the difference between the value of the bond with the strike spread and the market value of the bond.
31
Q

Swap

A

An agreement between two parties to exchange cashflows in the future. The agreement defines the dates when cashflows are to be paid and way they are to be calculated.

32
Q

‘Plain vanilla’ Interest rate swap

A

AKA par swap

  • Company B agrees to pay Company A cashflows equal to interest at a predetermined fixed rate on a notional principal for a number of years.
  • Company A agrees to pay Company B cashflows equal to interest at a floating rate on the same notional principal for the same period.
  • Currencies are the same.
  • Principal is not exchanged.
33
Q

Effect of a swap on the nature of an asset or liability

A

Swaps can be used to transform the nature from an asset/liability from one earning a fixed rate of interest into one earning a floating rate of interest (or vice versa).

34
Q

How is a swap arranged?

A
  • Deal with financial intermediary.
  • Financial intermediary remunerated by the difference between the value of a pair of offsetting transactions, providing neither party defaults.
  • Intermediary has two separate contracts with either party => one party defaults the intermediary still has to honor contract to other.
  • Spread earned is to compensate it for this default risk; outstanding risk usually collateralized with securities - minimizing default risk.
35
Q

Warehousing swaps

A

Entering a swap without having an offsetting swap with another counterparty in place.

36
Q

Valuing interest rate swaps

A

Assuming no possibility of default, valued as a long position in one bond and a short position in another bond. Also valued as a portfolio of forward rate agreements.

37
Q

Variations on vanilla interest rate swap

A
  • Zero coupon swaps
  • Amortising swaps - principal reduces in predetermined way
  • Step-up swaps - principal increases in predetermined way
  • Deferred swaps or forward swaps - parties don’t begin exchanging interest payments until some future date
  • Constant maturity swap (CMS)
  • Extendable swaps - one party has the option of extending the life of the swap.
  • Puttable swaps - one party has the option to terminate the swap early.
38
Q

Zero coupon swaps

A

A zero-coupon swap involves the fixed side of the swap being paid in one lump sum when the contract reaches maturity.
The variable side of the swap still makes regular payments, as they would in a plain vanilla swap.

39
Q

Constant maturity swap (CMS)

A

A swap where the floating leg of the swap is for a longer maturity than the frequency of the payments.
E.g. the floating leg may be a 5 year market interest rate but paid, and reset to current market levels, every 6 months. The fixed leg is the same as before.

40
Q

Currency swaps

A

Involves exchanging principal and interest payments in one currency for principal and interest payments in another currency. Principal amounts usually exchanged at the beginning and end of the life of the swap.

41
Q

Total return swaps

A

Receiver receives the total return on a reference asset, in return for paying the reference floating rate plus or minus an adjustment.
Adjustment allows for the net effect of hedging costs, financing costs and dealing spreads.

42
Q

RPI and LPI swaps

A

Swapping a fixed rate for ‘index’ return.
RPI swap - one set of payments linked to the level of the retail price index (RPI)
LPI (limited price indexation) swap - payments linked to RPI but capped at a maximum rate.

43
Q

Cross currency swaps or currency coupon swaps

A

Exchanging a fixed interest rate in one currency for floating interest rate in another currency.

44
Q

Dividend swaps

A

Exchanging dividends received on reference pool of equities in return for a fixed rate.

45
Q

Variance or volatility swaps

A

Exchanging fixed rate in return for the experienced variance or volatility of price changes of a reference asset.

46
Q

Asset swaps

A

Exchange fixed cashflows due from a bond or other fixed income asset in return for a floating interest rate.

47
Q

Commodity swaps

A

One set of cashflows exchanged for another based on current market price of a commodity.

48
Q

Swaptions and what can be used for

A

AKA option on swaps
Provides one party with the right to enter into a certain swap at a certain time in the future.

Can be used:

  • provide guarantee to companies that the fixed rate of interest they’ll pay on a loan at some future time won’t exceed a certain level.
  • Company able to benefit from favourable interest rate movements & protection from unfavourable movements.
  • Useful for insurers - offer policyholders the option of a fixed rate product.

An option to exchange fixed rate bond for the principal amount of the swap - put option in the case of receiving floating and paying fixed, a call option in the other direction.

49
Q

Classification of swaptions

A
  • European swaption - right, but not obligation, to enter into a swap at the strike rate at a fixed expiry date in the future.
  • American swaption - right, but not obligation, to enter into a swap at the strike rate at any date up to the expiry date.
  • Bermudan swaption - right, but not obligation, to enter into a swap at the strike rate at multiple fixed dates.
50
Q

Puttable vs callable bond

A

Puttable bond - Allows the holder to demand early redemption at a predetermined price at certain times in the future.
Callable bond - Allows the issuing firm to buy back the bond at a predetermined price at certain times in the future.

51
Q

Forward-rate agreement (FRA)

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.

52
Q

Private debt

A

AKA private placement
A debt capital market transaction that generally has covenant features similar to a bank loan and is often used as an alternative to bank funding.

53
Q

Covenants

A

Requirements or restrictions placed on the borrower when a loan is undertaken. Provide degree of security to the lender.

54
Q

Typical features of private debt

A
  • not actively traded
  • marketed to smaller number of long-term ‘buy and hold’ investors
  • most issues are fixed-rate US dollar-denominated transactions
  • medium to long-term maturities (>3 years)
  • issued by small to medium sized companies who don’t wish to incur the expense of a public issue.
  • private debt investors - very focused on covenant protection since illiquid markets = unable to sell investment in event of credit downturn.
55
Q

Reasons for issuing private debt

A
  • able to issue capital market debt without acquiring a formal long-term debt rating

From a treasurer’s perspective:

  • major capital source with relatively competitive pricing
  • offers alternative to borrowing from a bank = free up credit lines with relationship banks
  • refinance existing term loans from banks - rather not go to trouble of obtaining credit rating

F105 Finance & Investment (21 decks)

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