Chapter 4: Special asset classes (1)

Question 1

Money market

Answer 1

A virtual market place made up of electronic communications between banks, dealers and major corporations. Most money market instruments are issued at a discount and redeemed at par

Question 2

Available money market instruments for lending

Answer 2

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

Question 3

Treasury bills

Answer 3

Short-term investments, issued by the national government. They offer the lowest default risk amongst money market instruments

Question 4

Commercial paper

Answer 4

Short-term unsecured notes issued directly by a company. The rate of interest on a commercial paper will generally be slightly higher than that on an equivalent Treasury bill, the size of the margin depending on the company’s credit rating.

Question 5

Repos

Answer 5

A form of secured lending whereby an investor buys stock (usually Treasury bills) from a dealer who agrees to repurchase them again at a later date at an agreed (higher) price.

Question 6

Government agency securities

Answer 6

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

Question 7

Bank time deposits

Answer 7

Bank deposits with a specified term. If the investor wants to access their investments before the maturity date they may be allowed to do so, but a penalty will be imposed.

• Interest-bearing inter-bank overnight borrowing
• Certificates of Deposits

Question 8

Certificate of Deposit (CD)

Answer 8

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

Question 9

Interest-bearing interbank overnight borrowing

Answer 9

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.

Question 10

Bankers’ acceptances and eligible bills

Answer 10

A form of tradeable invoice that has been accepted (i.e. guaranteed) by a bank

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

Question 11

Money market instruments form of borrowing

Answer 11

• issuing commercial paper
• issuing eligible bills
• term loans
• evergreen credit
• revolving credit
• bridging loans
• international bank loans

Question 12

Evergreen credit

Answer 12

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.

Question 13

Revolving credit

Answer 13

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

Question 14

Bridging loan

Answer 14

Advances to be paid from specified income

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

Question 15

Non-recourse factoring

Answer 15

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.

Question 16

Recourse factoring

Answer 16

• 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.

Question 17

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

Answer 17

• 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

Question 18

Credit spread

Answer 18

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

Question 19

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

Answer 19

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)

Question 20

Credit derivatives and the most common types

Answer 20

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

Question 21

Credit default swap

Answer 21

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.

Question 22

Credit-linked notes

Answer 22

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

• Useful way of stripping and repackaging credit risk

Question 23

Credit spread options

Answer 23

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.

Question 24

Swap

Answer 24

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.

Question 25

‘Plain vanilla’ Interest rate swap

Answer 25

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.

Question 26

Warehousing swaps

Answer 26

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

Question 27

Variations on vanilla interest rate swap

Answer 27

• 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.

Question 28

Zero coupon swaps

Answer 28

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.

Question 29

Constant maturity swap (CMS)

Answer 29

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.

Question 30

Currency swaps

Answer 30

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.

Question 31

Total return swaps

Answer 31

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.

Question 32

RPI and LPI swaps

Answer 32

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.

Question 33

Cross currency swaps or currency coupon swaps

Answer 33

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

Question 34

Dividend swaps

Answer 34

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

Question 35

Variance or volatility swaps

Answer 35

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

Question 36

Asset swaps

Answer 36

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

Question 37

Commodity swaps

Answer 37

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

Question 38

Swaptions

Answer 38

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 regarded as a bond option.
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.

Question 39

Classification of swaptions

Answer 39

• 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.

Question 40

Puttable vs callable bond

Answer 40

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.

Question 41

Forward-rate agreement (FRA)

Answer 41

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

Question 42

Private debt

Answer 42

AKA private placement
Refers to loan capital issued by companies that is not publically listed and traded on a stock exchange. Has covenant features similar to a bank loan and often used as an alternative to bank funding. It is:

• not actively traded
• generally meduium to long term
• issued by small and medium sized companies that don’t wish to incur the expense of a public issue

Question 43

Covenants

Answer 43

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