problem set 1 Flashcards
- Describe the process by which a banker’s acceptance is created.
Many banker’s acceptances arise from international trade transactions and the underlying letters of credit (or time drafts) that are used to finance trade in goods that have yet to be shipped from a foreign exporter to a domestic importer. Foreign exporters often prefer that banks act as guarantors for payment before sending goods to domestic importers, particularly when the foreign supplier has not previously done business with the domestic importer on a regular basis. The domestic bank insures the international transaction by stamping “Accepted” on a trade draft between the exporter and the importer, signifying its obligation to pay the foreign exporter (or its bank) on a specified date should the importer fail to pay for the goods. Foreign exporters can then hold the banker’s acceptance until the date specified on the trade draft or, if they have an immediate need for cash, can sell the acceptance before that date at a discount from the face value to a buyer in the money market (e.g., a bank). In this case, the ultimate bearer will receive the face value of the banker’s acceptance on maturity.
What are the differences between T-bills, T-notes, and T-bonds?
T-bills have an original maturity of less than one year. Treasury notes have original maturities from over 1 to 10 years. T-bonds have original maturities from over 10 years. T-bills are sold on a discount basis from face value. T-notes and T-bonds pay coupon interest (semiannually). T-bills have very little risk because they are short-term. T-notes and bonds have more risk than T-bills. Their longer maturities result in wider price fluctuations than money market instruments as interest rates change (and thus are subject to interest rate risk).
T-bills are money market instruments. T-notes and T-bonds are capital market instruments.
What are the advantages and disadvantages of investing in TIPS bonds?
The principal value of a TIPS bond can increase (or decrease) every six months by the amount of U.S. inflation (or deflation) as measured by the percentage change in the consumer price index (CPI). This principal is called the inflation-adjusted principal. TIPS bonds are used by investors who wish to earn a rate of return on their investments that keeps up with the inflation rate over time. TIPS will reduce the negative effects of inflation.
The TIPS yield may be viewed as a real yield. The spread between the yields of TIPS and non-TIPS of the same maturity is the market’s consensus estimate of average annual inflation over the period. TIPS may appear attractive to investors fearing inflation.
The yields of TIPS are lower than the yields of regular Treasury bonds. The periodic principal adjustments are taxable as interest. People who own TIPS may have to pay more taxes in some periods. TIPS may provide a large pay-off at maturity (due to an increase in the principal value). But they may end up being negative cash-flow securities for taxable investors in some periods. Consequently, TIPS may not be an appropriate investment for someone looking for significant current income.
What is a convertible bond? Is a convertible bond more or less attractive to a bond holder than a nonconvertible bond?
Convertible bonds are bonds that may be exchanged for another security of the issuing firm (e.g., common stock) at the discretion of the bond holder. If the market value of the securities the bond holder receives with conversion exceeds the market value of the bond, the bond holder can return the bonds to the issuer in exchange for the new securities and make a profit. As a result, conversion is an attractive feature to bond holders. It gives the bond holder an investment opportunity (an option) that is not available with nonconvertible bonds. As a result, the yield on a convertible bond is usually lower than that on a nonconvertible bond.
- What is a callable bond? Is a call provision more or less attractive to a bond holder than a noncallable bond?
A call provision allows the issuer to require the bond holder to sell the bond back to the issuer at a given (call) price - usually set above the par value of the bond. The difference between the call price and the face value on the bond is the call premium. Bonds are usually called in when interest rates drop so that the issuer can gain by calling in the old bonds (with higher coupon rates) and issuing new bonds (with lower coupon rates). A call provision is an unattractive feature to bond holders, since the bond holder may be forced to return the bond to the issuer before he or she is ready to end the investment and the investor can only reinvest the funds at a lower interest rate. As a result, callable bonds have higher yields (generally between 0.05 and 0.25 percent) than comparable non-callable bonds
- Which type of bond do you think will give a higher yield, a bond with a sinking fund provision or a bond without a sinking fund provision? Why?
(Assume the two bonds have the same characteristics, except the sinking fund feature).
When a bond has a sinking fund provision, this means that the issuer should provide funds before maturity, to make sure that he can pay back the full amount borrowed at maturity. The issuer can provide the funds to the trustee by making frequent payments to a sinking fund
A bond with a sinking fund provision is safer (less risky) to the bond holder than a fund without a sinking fund provision. The issuer is very likely to pay the full amount of the principal at maturity, since he has already set aside some money in the sinking fund. The sinking fund provision reduces the probability of default at maturity date. So I expect the yield on a bond with a sinking fund provision to give a lower yield than a fund without a sinking fund provision.
I expect the bond without a sinking fund provision to have a higher yield than the bond with a sinking fund provision. The bond which does not have a sinking fund provision is more risky.
- What is the interest rate spread? What does it measure?
The interest rate spread is the difference between the rate of return on a bond and the return on a similar maturity Treasury security.
The interest rate spread measures the return premium a bond earns to compensate for default risk, and for liquidity risk, and for any special provisions on the bond.
- Does the interest rate spread measure the same thing that a Moody’s rating would measure? Explain.
No, the interest rate spread does not measure the same thing that a Moody’s rating would measure.
A Moody’s rating will measure default risk. Moody’s ranks bonds based on the probability that the issuer will default. Moody’s will assign a letter grade to each bond. The highest quality is an Aaa bond. The lowest quality is a D bond.
The interest rate spread does not measure only default risk. The interest rate spread measures the default risk and the liquidity risk, and reflects special features of the bond. The interest rate spread is a more comprehensive measure of the overall risk of a bond than a Moody’s rating.
It is possible for spreads and credit ratings to sometimes appear to conflict with each other. Consider a bond issued by company that is financially sound but trades very infrequently. The likelihood of default is low. The Moody’s rating of this bond will be high. But this bond has high liquidity risk. An interest rate spread reflects default risk, liquidity risk, and other features of the bond. Because of the high liquidity risk, the interest rate spread on this bond will be high. The difference between the yield on this bond and the yield on a comparable Treasury Security will be large. This reflects the high liquidity risk of this bond.
- What causes changes in interest rate spreads? Explain.
Interest rate spreads change when default risk increases. When there is less likelihood of the issuer’s returning the principal of the bond at maturity, default risk increases and the interest rate spread will increase.
Interest rate spread will change when liquidity risk changes. If the firm trades infrequently in the market, liquidity risk is large and the interest rate spread will be large.
When the rating of a bond falls (for example from AAA to AA- (according to Standard and Poor’s or Fitch Ratings) this means that default risk is higher. So investors will require a higher spread to compensate them for the extra risk on the bond.
When there is a change in tax status of a bond, the spread on that bond will change. If a bond tends to increase taxes of a bond holder, the spread on that bond will be high. This is to compensate the bond holder for higher taxes.
When the characteristics of a bond are less desirable for a bond holder, the bond will have a larger spread to compensate the bond holder for costs related to these characteristics. When the characteristics of a bond are more desirable to the bondholder, the spread on that bond will be relatively small. The bond holders do not need a large spread to be induced to hold that bond. For example a callable bond will have a relatively large spread (the call feature is not desirable to a bond holder). A bond with a stock warrant will have a relatively small spread (the stock warrant is a desirable feature to the bond holder). A convertible bond will have a relatively small spread, (because the convertible feature is attractive to bond holders).
Economic conditions can cause the spreads to change. During recessions bond holders do not feel very “secure” about holding bonds. The default risk increases when economic conditions are bad. So bond holders want to be compensated for the increased risk. They require higher spreads to compensate them for the larger risk. Interest rate spreads will be larger during recessions.
- Is the interest rate charged on commercial paper higher than the interest rate charged on loans? Explain.
No, the interest rate charged on commercial paper is lower than the interest rate charged on loans.
Companies with strong credit ratings can generally borrow money at a lower interest rate by issuing commercial paper than by borrowing via loans from banks.
Commercial paper is an unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements.
Banks usually let their “favorite customers” borrow by using commercial paper. The bank usually knows the company that is issuing commercial paper quite well. The bank has scrutinized the company’s books: they have looked at their financial data and their credit records. These companies will borrow from the same bank via commercial papers several times. These companies are “repeat customers” to the bank. So the bank’s risk on commercial paper is lower than the bank’s risk on a regular loan. Thus the bank does not require a high yield on commercial paper.
- During a financial crisis, will the amount of commercial paper on the market increase? Explain.
No.
During a financial crisis ratings of corporations will be downgraded. Companies will become more risky. So less companies will be able to issue commercial paper. During a financial crisis there will be less commercial paper on the market.
- Is there a secondary market for banker’s acceptances? Explain.
Yes, there is a secondary market for banker’s acceptances.
A banker’s acceptance is a guarantee from the bank to the seller of some goods, that the buyer will pay for the goods in time. And if the buyer defaults on his promise, the bank will take responsibility for paying the amount.
If the seller of the goods needs cash before the payment is due, he can sell the banker’s acceptance to someone else. The bearer (holder) of the banker’s acceptance will receive the promised funds at maturity.
Often banker’s acceptances are bundled together and traded in secondary markets. They can be traded in lots of $100,000 or $500,000.
- Is the risk of default on banker’s acceptances high? Explain.
No, the risk of default on bankers’ acceptances is very low.
The holder of a banker’s acceptance has bought a security that is fully backed by a commercial bank guarantee. There is a form of double protection in a banker’s acceptance. Both the buyer of goods and the buyer’s bank must default on the transaction before the holder of the banker’s acceptance is subject to risk.
The holder is also protected by the value of the goods he is selling. He has now a debtor’s claim to this value. We can view these goods as collateral for the transaction. If the company or the bank does not pay for the goods, the holder of the banker’s acceptance may decide not to deliver these goods.
Financial institutions help with problems of liquidity and price risk.”
Is this statement true or false? Explain.
This statement is true.
Certain assets that fund users (companies) issue, like mortgages or stocks or bonds are not very liquid.
Individual savers will not hold these assets. Individual savers want to hold more liquid assets; they want to hold assets that can be easily transformed to cash. So banks will buy illiquid assets from users of funds (companies), and they will provide more liquid assets to providers of funds (individual savers). They provide saving accounts and checking accounts to individual savers. The savers can put their money in these accounts. The function of financial institutions is to provide more liquid assets.
Often claims issued by financial institutions have more liquidity than claims issued by users of funds.
A checking or saving account is more liquid than corporate stock. A financial institution reduces liquidity risk for the individual saver, but transforms the risk to its own balance sheet.
A financial institution reduces price risk for the individual saver. They invest in many high risk relatively less liquid assets. They have the ability to diversity away some of their price risk. They reduce their price risk by holding many different securities in their portfolio.
As long as the returns on different investments are not positively correlated, by spreading their investments across a number of assets, they can diversify away significant amounts of their portfolio risk.
An individual saver cannot diversify his price risk, like a financial institution can. The size of his wealth is smaller. He cannot diversify as much as financial institution can. The individual saver will have a relatively undiversified portfolio. He will have more risk than a financial institution.
The financial institution will be able to offer the individual saver certain products with less risk, like checking accounts, saving accounts, or shares in a fund.
- “Financial institutions are asset transformers.”
What does this statement mean? Explain.
Financial institutions change assets issued by corporations into less risky assets that individual savers are willing to hold.
They transform the primary securities issued by fund users (companies) into secondary securities that they issue like a deposit account, an insurance policy, or a share in a fund. The fund suppliers (individual savers) will buy these secondary securities from the issuing financial institution.
These secondary securities are more liquid than the primary securities. So individual savers are willing to hold them. These secondary securities have less price risk than the primary securities. Financial institutions are able to diversify. They buy many primary securities. So their total portfolio has less price risk than each individual primary security. They are able to sell the individual savers secondary securities that have less price risk than each individual primary security that they own.
