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F105 Investment Principles > Ch 3 - Specialist Asset Classes (1) > Flashcards

Ch 3 - Specialist Asset Classes (1) Flashcards

1
Q

Factors influencing spreads of money market rates:

A

Default risk

Market liquidity

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2
Q

Money market investments include:

A

Treasury Bills
Commercial Paper
Repos
Government Agency Securities (also Local Authority Bills)
Bills of Exchange - Banker’s acceptance + Eligible bills
Bank Time Deposits - CDs
Term and call deposits

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3
Q

Options for Companies borrowing in the MM:

A 
Commercial paper
Eligible bills
Term loan from a bank 
Line of credit with a bank - Evergreen vs Revolving
Bridging loan from a bank 
International bank loans 
Factoring - non-recourse and recourse
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4
Q

Issues that differentiate between different types of loans include:

A

Commitment
Maturity
Rate of interest
Security

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5
Q

Treasury Bills

A

Short-term investments, issued by the national government

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6
Q

Issue process of T-bills

A

Issue is by auction

Competitive and non-competitive bids

Latter are then filled at the average price of the successful competitive bids

Competitive - Submits a tender specifying the discount rate. May get no bills or not full allocation

Non-competitive – guaranteed to receive full amount of bills requested. But upper limit of bids is less than competitive

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7
Q

Commercial Paper

A

Short-term unsecured notes, issued directly by a company.
Bearer document and single name instrument. Can be presented to issuer for repurchase (thus, a liquid secondary market exists)

Thus company needs good credit rating and meet certain minimum standards

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8
Q

Repos

A

A repurchase agreement is a form of secured lending whereby one party sells stock (T-bills and gov bonds usually) to another with a simultaneous agreement to repurchase it at a later date at an agreed price

No secondary market

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9
Q

Government Agency Securities

A

Bills (or notes) issued by a near-government sector of the market

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10
Q

Bankers’ Acceptance

A

Form of tradable invoice (IOU) that has been accepted (i.e. guaranteed) by a bank

Invoice is “accepted” by the bank and guarantees payment at due date

Bill can be traded in the secondary market to raise immediate cash, at a discount

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11
Q

Evergreen line of credit

A

Borrow up to a specified limit with no fixed maturity

Just like an overdraft facility

Borrower may need to pay a commitment fee to the bank for the option to borrow when it wants to

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12
Q

Revolving line of credit

A

Similar to evergreen but with fixed maturity of up to 3 years

Pay a commitment fee on the full agreed amount of borrowing, whether or not it is all used

Interest is only paid on the amount actually borrowed

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13
Q

Bridging loan

A

Used to pay for a specific item in the interim period before long-term finance is obtained (or sale of existing obligation - such as a house)

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14
Q

Non-recourse factoring

A

Supplier sells on its trade debts to a factor to get cash before due date

Factor takes credit risk and responsibility for credit analysis

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15
Q

Recourse factoring

A

Effectively a loan which is secured against the invoices

Copy of invoice is sent to factor who then gives supplying company cash up front

Credit risk still remains with supplying company. Because the supplying company passes on money to factor when it is paid. Company must buy back any uncollected invoices

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16
Q

Categories of Corporate Debt:

A

Debentures

Loan stock

Preference shares

These are ranked in order of security of debt

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17
Q

Credit spread

A

Excess yield on corporate bonds over Treasury bonds

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18
Q

Credit spread can typically be decomposed into four components:

A

Compensation for expected defaults

Investors may expect future defaults to exceed historic levels

Credit risk premium – risk of higher defaults

Compensation for liquidity risk – typically referred to as an illiquidity premium

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19
Q

Credit event (def + 5 examples)

A

Events that trigger payments under credit derivatives

Bankruptcy

Rating downgrade

Cross-default

Default on particular coupon

Repudiation

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20
Q

Why do banks and institutional investors like credit default swaps?

A

Lenders who have reached their internal credit limit with a particular client, but wish to maintain their relationship with that client, can use credit default swaps to reduce their aggregate exposure to the client

Institutional investors use them to reduce credit exposure to the underlying bond issuers

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21
Q

Credit-Linked Note:

A

Is a CDS embedded with a traditional bond (provides the protection payment upfront - hence “Funded”)

22
Q

Credit Spread Options:

A

Is an option on the spread between the yields earned on two assets, which provides a payoff when the spread exceeds some level (the strike spread) at a strike date

Therefore provides protection against a widening of credit spreads

23
Q

Swaps

A

Is an agreement between two parties to exchange a specified series of cashflows over a specified period in the future, based on an agreed principle amount.

Defines the dates when the cashflows are to be paid and the way they are to be calculated.

24
Q

Zero-coupon swaps

A

A zero coupon swap (with both legs paid at maturity) is an agreement to exchange a fixed for floating rate over one or more periods, with the payments being made at the end of the final period

25
Q

Amortising swaps

A

Where parties swap cashflows on a notional principal amount that decreases over time. The notional principal is tied to an underlying financial instrument with a declining (amortizing) principal balance, such as a mortgage. 

26
Q

Step-up swaps

A

Principle increases in a predetermined way

27
Q

Deferred swaps or forward swaps

A

Swap doesn’t start immediately

28
Q

Constant maturity swaps (CMS)

A

Floating leg of the swap is of longer maturity than the frequency of payments

29
Q

Extendable swaps

A

One party has the option to extend the life of the swap beyond a specified period

30
Q

Uses of currency swaps

A

Transform

  • can be used to transform borrowings in one currency into borrowings in another
  • transform nature of assets and liabilities

Asset
-Hedging with currency swaps and/or currency futures can also be used to make currencies an asset in their own right (allow managers to separate currency and country investment decisions)

Speculation
-Outright speculation on currencies (but this is super risky!)

Longer term
-Generally available for longer terms than forward agreements so are more useful in hedging longer-term liabilities

31
Q

Disadvantages of currency swaps

A

CURB FEMinism - for forwards - but just have CUB FEMinism for swap

Counterpart credit risk

Unknown

  • Difficulty of hedging unknown future income
  • They can only easily hedge a level/known income stream

Bid-offer
-Extra cost of the bid-offer spread compared with a straight spot currency transaction

Favourable
-Removing the possibility of favourable currency movements (i.e. Market risk)

Expensive
-Are only available on fairly large principle amounts - expensive for small amounts

Mismatching
-Mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials

32
Q

Total return swaps

A

Receiver to receive the total return (income + capital gain) on a reference asset, in return for paying the reference floating (or fixed) rate plus or minus an adjustment

Adjustment will allow for net effect of hedging costs, financing costs and dealing spreads

OR

Is an agreement between two parties to exchange the total return from one asset (or group of assets) for the total return on another. In particular, the underlying assets are often bond or equity indices

33
Q

Two main uses of total return swaps

A

Diversification without actually trading the underlying (i.e. helps with Portfolio Transition)

To enable a financial institution to avoid breaches of internal credit limits to exposure to a particular type of asset (usually where the underlying assets are corporate bonds)

34
Q

RPI swaps

A

Links one set of payments to the level of the retail price index

35
Q

LPI swaps

A

Payments are again linked to the RPI, but at a capped maximum rate

36
Q

Cross-currency swaps or currency coupon swaps

A

Combination of IRS and currency swap

Exchange a fixed interest rate in one currency for a floating interest rate in another currency

37
Q

Dividend swaps

A

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

38
Q

Variance/Volatility swaps

A

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

39
Q

Asset swaps

A

Swap fixed cashflows from a fixed income asset in return for floating interest rates

40
Q

Commodity swaps

A

One set of cashflows is exchanged for another based on the current market price of a particular commodity

41
Q

Main features of a swap to consider when constructing/selling one:

A

Range of principle amounts that it would offer

Range of terms

Frequency of the swap payments

Currency of the payments

The interest rate on which floating would be based

Margin over the floating rate required to generate the bank’s required profit

Features of the underlying

42
Q

Profitability for a bank designing a swap (factors to consider before putting on the market):

A

Margins on the floating rate that it is able to charge/pay to clients (charges should be higher than paid)

Likely volume of sales

The costs of designing and marketing the swap

Risks

43
Q

Swaption

A

Provides one party with the right, but not an obligation, to enter into a certain swap at a certain time in the future on specified terms.

You pay a premium for this option.

44
Q

Receiver swaption/Call swaption

A

Holder of the swaption chooses to pay fixed interest and receives floating

Usually used when expect interest rates to decrease (thus bond prices increase)

45
Q

Payer swaption/Put swaption

A

Holder has option to pay floating and receive fixed

Usually used when expect interest rates to increase (thus bond price decreases)

46
Q

Puttable bond

A

Holder (fixed rate receiver) can demand early redemption at certain times

Exercised when interest rates go up

47
Q

Callable bond

A

Allows the issuing firm (payer of the fixed rate) to buy back the bond at a predetermined price at certain times in the future

Exercised when interest rate goes down

48
Q

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

49
Q

Private debt

A

Loan capital (bond) issued by companies that are not publicly listed and traded on a stock exchange

Also called private placement

Is a debt capital market transaction that generally has covenant features similar to a bank loan

50
Q

Covenants

A

Are requirements or restrictions placed on the borrower and aim to provide a degree of security for the lender

Positive covenant = requirement to do something

Negative covenant = requirement not to do something

51
Q

Features of Private Debt

A

Small number of investors

No secondary market

Thus, less liquid/marketable than publicly issued debt

Issued by small and medium-sized companies

Term is longer than 3 years

Can be repaid early

52
Q

Reasons for issuing private debt (4)

A

Can issue capital market debt without acquiring a formal long-term debt rating (less admin but possibly more costly)

Alternative to borrowing from a bank

Relatively competitive pricing
- flexible terms
- reduced regulatory requirements
- direct negotiations (no intermediation costs)

Often used to refinance existing term loans from banks but don’t want the trouble and expense of obtaining a credit rating

Note: Can improve covenant bargaining position (or pricing) by obtaining a private rating from an external rating agency

F105 Investment Principles (20 decks)

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