Chapter 6 - Derivative instruments

Question 1

Describe the key features of callable bonds

Answer 1

• Bonds which have the potential to be “called” and
  repaid by the issuer earlier than the specified maturity
  date.
• The decision to repay early is made by the issuer
  and may only be made in accordance with the
  original terms and conditions of the bond
• Some callable bonds have call protection which gives
  a specified time after issue during which the bonds
  cannot be called
• In calling the bond the issuer will typically repay the
  face value but may also have to pay a premium

Question 2

Describe the key features of puttable bonds

Answer 2

• Bonds which have the potential to be sold back by
  the holder to the issuer earlier than the specified
  maturity date.
• The decision to redeem early is made by the holder
  and may only be made in accordance with the
  original terms and conditions of the bond
• Most puttable bonds include clauses that they can
  only be sold back to the issuer a specific set of dates
  as detailed in the original offering documentation.

Question 3

What is the role of a Gilt Edged Market Maker

Answer 3

Gilt Edged Market Makers (GEMMs):

• Primary dealers in the UK Gilt market
• Trade in conventional gilts, index-linked gilts or both
• Competing market makers
• Providing liquidity in the primary market

* Registered as market makers on a recognised 
  investment exchange (RIE)

• Authorised by the FCA

* Only institutions able to bid directly in debt 
  management Office (DMO) gilt auctions

• Must quote firm two way prices for all gilts in which
  they deal
• Provide the DMO with market intelligence and
  turnover figures

Question 4

What is the role of Inter Dealer Brokers

Answer 4

Inter Dealer Brokers:

• Broking firms endorsed by the DMO
• Deal exclusively with GEMMs (Guilt-Edge Markert Makers)
• Act as principal to all gilt trades acting as intermediaries between GEMMs
• Therefore allow GEMMs to unwind unwanted long or short gilt positions
• Trades are undertaken anonymously
• Not allowed to take unmatched positions

Question 5

Outline the key features of an Index–Linked gilt

Answer 5

First issued in 1981

Both coupons and redemption payment are altered in line with the Retail Price Index (RPI)

Trade on a real clean price basis

Question 6

What is Interest Yield

Answer 6

• The annual return expressed as a percentage of the
  bonds price
• Shows income generated by the bond as a
  percentage but ignores gains/losses if held to
  maturity
• Ignores tax paid by the investor

Question 7

What is Gross Redemption Yield

Answer 7

• The interest yield adjusted to take into account
  gains/losses if held to maturity
• More accurate measure of pre-tax return than interest
  yield
• Ignores tax paid by the investor

Question 8

Outline the key features and characteristics of Eurobonds and the rationale behind why
they are issued

Answer 8

Features:
 Bearer type debt instruments

 Unsecured (no security attached)

 Not just issued in Euros but in a currency outside the country of the issuer (eg Barclays Bank plc US$ denominated Eurobond issue)

Characteristics:

 May have fixed or floating coupons

 Provide anonymity to purchasers (no central register of ownership)

 Over the counter (OTC) products with no central exchange or register

 Dealing effected over phones and computer terminals

 Dual currency bonds exist where they are issued in one currency and redeemed in another

 Country of currency of issue will have no jurisdiction (control) over the bond issue

 Typically medium to long term (10 to 15 years) when issued

Rationale:

 Issuers may not be able to raise finance in their own country (perhaps because of government barriers imposed generally)

 Issuers may wish to access markets with less onerous regulatory requirements/lower tax rates

 Currency of Eurobond is more stable than issuer’s home currency

 Eurobonds help to finance development of emerging markets

 The absence of the requirement to run a central register will mean lower costs for the issuer

 Useful means for a parent company to finance overseas subsidiaries

Question 9

Outline the various risks associated with investing in bonds

Answer 9

 Default risk – bonds are an IOU or promise to pay. The issuer might be unable to pay either one or more coupons or the redemption proceeds.

 Issue specific risk – some bonds have call features which enable the issuer to repay them before the scheduled maturity date. Although this will be stated in the bond prospectus from the outset, the investor may have wrongly assumed the bond will run until maturity.

 Market risk - the bond markets are affected by a number of factors. The prices of bonds
generally can fluctuate as was seen in 2008.

 Inflation - high levels of inflation will erode the real return (purchasing power) of the interest
and repayment cash flows from the bond.

 Interest rate risk - the majority of bonds are issued with a fixed coupon. The fixed coupon will be less attractive if market interest rates rise and comparatively higher returns become available elsewhere - the value of the bond may then fall.

 Maturity risk - bonds that have longer to run tend to be riskier than short dated bonds due to the increased uncertainty that increased the timescale brings.

 Event risk – circumstances surrounding the issuer and its capital structure may affect the value of a bond.

 Fiscal and Currency risk - the tax treatment of bonds may be altered by the government. Whenever an investor buys a bond in other than their base currency they have the additional risk that the currency of the bond may weaken relative to their base currency

Question 10

The price of an option premium has two components. Name these two components

Answer 10

Intrinsic value - This is the profit that an option would realize if it were exercised immediately

Time Value - This is more expensive the further away the expiry date is, as the writer is exposed to risk for longer period of time. Calculates as Time Value = Premium - Intrinsic value