Intro Flashcards
Forward contract
The contract requires one party to buy the
underlying at a fixed price at a certain date
in the future
Derivatives pricing on active vs illiquid exchanges
Derivatives which trade on an active exchange
market are easy to “mark to market”
For derivatives in illiquid markets, with no clear
market price, derivative valuation models are
needed
Why do firms use derivatives
Firms use derivatives to hedge away
financial risks. Bad outcomes can cause knock on effects such
as financial distress
or to speculate
why did fixed income derivatives arise
due to large interest rate changes in the seventies
Most fixed income derivative products are traded OTC.
What is the zero rate
A zero rate (or spot rate), for maturity T is the rate of interest earned on an investment that provides a payoff only at time T
What rate do banks borrow at
LIBOR which is slightly above treasury rate due to (small) risk of default
What is LIBOR
London Inter Bank Offer Rate
LIBOR is the interest rate that banks in London are
willing to lend Eurodollars to another London bank.
* Eurodollars are dollars deposits outside the US. The
market is much less regulated than in the US.
* LIBOR is the average rate quoted from the two
middle quartiles of quoting banks. Rates for various
maturities are quoted noon each day.
What are credit ratings
Ratings provide an insight in the default likelihood of individual firms or governmental institutions allowing an appropriate interest rate to be set
interest rate increase exponentially as credit rating risk increases
Fixed income markets
Corporations and the government borrow money using the fixed income markets
2/3 of market value of all securities outstanding are fixed income
Types of Fixed Income Instruments
- Treasury Securities
– Bonds and notes issued by the government - Domestic Commercial Debt Instruments
– Corporate bonds
– Commercial paper (short term borrowing)
– PtoP lending (see article in additional materials)
How does: time to maturity, coupon, yield effect interest rate sensitivity
Long term bonds are more sensitive than short term bonds
Low (Zero) coupon bonds are more sensitive than high coupon
bonds
Bonds at lower yields are more sensitive than at higher yields
What does duration measure
Duration measures sensitivity to yield changes
A bond with a greater duration receives its cashflows
later and therefore is more sensitive to changes in the
yield
Limitations of the duration method
The assumption of parallel shifts in the
yield curve does not always hold – However it is a reasonable first approximation over the short term
Duration method is that it only is accurate for small changes in yields
Define liability matching
Purchase assets that payoff the exact amount required to match its liabilities in the future
An alternative to this procedure is to hedge by duration
matching
how are coupons set on a floating rate bond, e.g. every 3 months
at t=0 the LIBOR rate is known for the next 3 month period, the first coupon is set to this rate
at t=0.25 the next coupon is set to the current 3 month LIBOR rate
what is debt service
A firms debt service is the future interest payments the firm has to make on its borrowing
There is generally an optimal mix of fixed and floating debt for a firm at a particular point
What is FRA
A derivate instrument which can be used to change the companies exposure to interest rate exposure
an alternative is the Eurodollar futures contract
what can a firm with too much floating rate debt do
- buy back floating rate debt, issue fixed rate debt
- hedge the interest rate debt using interest rate derivatives (cheaper option)
define junk bonds
bonds with a credit rating of BB or lower
