Chapter 3 Flashcards
(159 cards)
1
Q
What are specialist financial instruments?
A
Financial instruments available for short-term lending and borrowing, corporate debt and credit, derivatives, swaps and swaptions, private debt.
These instruments are often viewed as complementary to traditional asset classes held by institutional investors.
2
Q
What is the money market?
A
A virtual marketplace for short-term lending and borrowing, involving electronic communications between banks, dealers, and major corporations.
It operates on a wholesale level with transactions often exceeding hundreds of millions of pounds.
3
Q
List three ways investors can access the money markets.
A
- Directly on their own account
- Hire a professional investment management firm
- Via a money market fund
4
Q
What is the distinction between domestic and international money markets?
A
Domestic money markets consist of funds in a currency deposited in that currency’s domestic market, while international money markets consist of funds in a currency deposited in banks outside that currency’s domestic market.
This means international deposits are not subject to domestic regulations.
5
Q
What is LIBOR?
A
The London Inter Bank Offered Rate, often used as a benchmark for money market interest rates.
Rates can be quoted as a percentage over LIBOR.
6
Q
True or False: Money market securities generally have a higher risk of default than corporate bonds.
A
False
Money market instruments typically have lower default risk due to their short-term nature and issuer credit quality.
7
Q
What is a Treasury bill?
A
A short-term government security typically issued in 3-month, 6-month, and one-year forms, sold at a discount and redeemable at face value at maturity.
The major issuer of money market instruments is usually the national government.
8
Q
What is commercial paper?
A
Short-term unsecured notes issued directly by a company, generally sold at a discount and typically maturing in a few months.
It bypasses the need for financial intermediaries.
9
Q
What are repos?
A
Agreements where one party sells stock to another with a simultaneous agreement to repurchase it at a later date at an agreed price.
Repos are used as a short-term financing tool while maintaining economic exposure to the assets.
10
Q
Define reverse repo.
A
The opposite side of a repo agreement, representing secured lending where cash is lent with the stock serving as collateral.
It involves the party buying the stock.
11
Q
What are government agency securities?
A
Securities issued by near-government sectors that are almost as risk-free and liquid as Treasury bills, such as nationalized industries or local authorities.
They typically have a liquid secondary market.
12
Q
Fill in the blank: Money market instruments operate on a _______ basis.
A
discount
13
Q
What is a major feature of money market instruments?
A
They generally do not pay explicit interest but generate returns through the difference between purchase price and maturity proceeds.
14
Q
What is the relationship between government agency securities and Treasury bills?
A
Government agency securities are similar to Treasury bills but are not as marketable.
This results in a slightly higher interest rate for government agency securities.
15
Q
What is one reason for the higher interest rate on government agency securities?
A
A slightly higher level of risk due to the possibility of national government allowing the agency to default.
16
Q
How are government agency bills issued and redeemed?
A
Issued at a discount and redeemed at par.
17
Q
What is a bank time deposit?
A
A major provider of funds to the markets, allowing banks to borrow when facing a shortage of funds.
18
Q
What are the typical maturity terms for Certificates of Deposit (CDs)?
A
Typical maturity terms range from 1 to 3 months.
19
Q
What are the main features of Certificates of Deposit (CDs)?
A
- Bearer documents
- Less liquid secondary market than Treasury bills
- Negotiable term deposits
20
Q
What are bankers’ acceptances?
A
A form of tradable IOUs where a bank guarantees payment at the due date.
21
Q
What are some forms of short-term borrowing by companies?
A
- Term loans
- Evergreen credit
- Revolving credit
- Bridging loans
- International bank loans
22
Q
What is evergreen credit?
A
Permission to borrow up to a specified limit with no fixed maturity, similar to an overdraft.
23
Q
What is revolving credit?
A
Similar to evergreen credit but with a fixed maturity of up to 3 years.
24
Q
What is a bridging loan?
A
Advances to be repaid from specified income, used for a specific item before long-term finance is obtained.
25
What are the primary risks associated with corporate bonds?
* Default risk
* Liquidity risk
26
What does a credit rating indicate?
The creditworthiness of a bond.
27
What is the typical categorization system for credit ratings?
* AAA
* AA
* A
* BBB
* BB
* etc.
28
What is the average probability of default within the next 5 years for a corporate bond rated AAA?
About 0.1%.
29
What is the relationship between corporate bonds and Treasury bonds regarding yield?
Corporate bonds typically yield more than comparable Treasury bonds.
30
What components make up the excess yield on corporate bonds over Treasury bonds?
* Default risk
* Liquidity risk
* Credit spread
* Historical default losses
31
What is typically higher, returns from investing in corporate bonds or Treasury bonds?
Returns from investing in corporate bonds
32
What can actual default losses be calculated from?
Historical data
33
What are the four components of the excess yield on corporate bonds over Treasury bonds?
* Compensation for expected defaults
* Compensation for the risk of higher defaults (credit risk premium)
* Compensation for liquidity risk (illiquidity premium)
* Residual component
34
What is a credit risk premium?
Compensation for the risk of higher defaults
35
What is the purpose of quantifying the decomposition of excess yield?
It is a major area of current research
36
What techniques are being considered to estimate the risk of default?
* Option pricing models using equity volatility
* Credit default swaps
37
What are credit derivatives?
Contracts where the payoff depends partly upon the creditworthiness of one or more bond issuers
38
What are the two most common types of credit derivatives?
* Credit default swaps
* Credit spread options
39
What is a credit default swap?
A contract that provides a payment if a particular credit event occurs
40
What are examples of credit events?
* Bankruptcy
* Rating downgrade
* Cross-default
41
What does the term 'recovery' refer to in credit events?
The proportion recovered of the money loaned
42
What happens if a credit event occurs within the term of a credit default swap?
A payment is made from the seller to the buyer
43
What are the two ways to settle a claim under a credit default swap?
* Pure cash payment
* Exchange of both cash and a security (physical settlement)
44
Who have historically been the largest users of credit default swaps?
Banks
45
What is a credit-linked note?
A basic security plus an embedded credit default swap
46
What is a credit spread option?
An option on the spread between the yields earned on two assets
47
What is the significance of a 'strike spread' in credit spread options?
It provides a payoff when the spread exceeds a specified level
48
In a plain vanilla interest rate swap, who pays fixed interest?
Company B pays fixed interest
49
In a plain vanilla interest rate swap, who pays floating interest?
Company A pays floating interest
50
What is the notional principal used for in swaps?
It is used only for the calculation of interest payments
51
What does the phrase 'plain vanilla' refer to in the context of swaps?
The most basic form of interest rate swap
52
What is the role of LIBOR in many interest rate swaps?
It is often the floating rate used for payments
53
What is the typical duration of a plain vanilla interest rate swap as discussed in the example?
5 years
54
What is the fixed interest rate in the example of a plain vanilla interest rate swap?
6% per annum
55
What is the effect of a swap contract on liabilities?
It transforms the nature of the liabilities.
56
How does Company B use the swap?
To transform a floating-rate loan into a fixed-rate loan.
57
What transformation does Company A achieve through the swap?
Transforms a fixed-rate loan into a floating-rate loan.
58
What is the fixed rate paid by Company B to Company A?
6% per annum.
59
Calculate the net effect of cashflows for Company B under the swap.
-(LIBOR + ½%) + LIBOR - 6% = -6½%.
60
At what floating interest rate will Company A be a net borrower under the swap?
6.6%.
61
What is the role of a financial intermediary in arranging swaps?
To facilitate the swap and earn a profit from the difference in transactions.
62
What is the net borrowing rate for Company A after the swap?
LIBOR + 0.35% per annum.
63
What is the profit made by the bank as an intermediary in the swap?
$100,000 per annum.
64
Why does the bank earn a profit in the swap arrangement?
Due to the spread earned from the difference in rates between the two companies.
65
What is not exchanged in an interest rate swap?
The principal.
66
List variations on the vanilla interest rate swap.
* Zero coupon swaps
* Amortising swaps
* Step-up swaps
* Deferred swaps
* Constant maturity swaps
* Extendable swaps
* Puttable swaps.
67
What is a currency swap?
An exchange of principal and interest payments in one currency for those in another currency.
68
In a currency swap, when are principal amounts usually exchanged?
At the beginning and at the end of the swap's life.
69
What are Company A's cashflows under a 3-year currency swap with Company B?
Paying £50 million at 5% per annum and receiving $75 million at 4% per annum.
70
What can a currency swap transform?
Borrowings in one currency into borrowings in another currency.
71
How can a currency swap be valued?
As a position in two bonds.
72
What is the fixed borrowing rate for Company A?
5% pa fixed
73
What rate can Company A transform its borrowing into dollars?
4% pa fixed
74
How can the value of a currency swap be determined?
From interest rates in the two currencies and the spot exchange rate
75
What are the sterling and dollar interest rates in the example given?
* Sterling interest rate: 4.50% pa
* Dollar interest rate: 3.75% pa
76
What is a total return swap?
An agreement where the receiver receives total return on a reference asset in exchange for paying a reference floating rate plus or minus an adjustment
77
What types of assets are total return swaps available on?
* Equity
* Credit
* Interest rate
* Currency
* Commodity
78
What is an RPI swap?
A swap linking payments to the level of the retail price index
79
What is an LPI swap?
A swap linking payments to the RPI, capped at a maximum rate, usually between 0% and 5% pa
80
What do cross-currency swaps involve?
Exchanging a fixed interest rate in one currency for a floating interest rate in another currency
81
What is a dividend swap?
Exchanging the dividends received on a reference pool of equities for a fixed rate
82
What is a variance or volatility swap?
Exchanging a fixed rate for the experienced variance or volatility of price changes of a reference asset
83
What are commodity swaps?
Exchanging one set of cashflows for another based on the current market price of a particular commodity
84
What is a swaption?
An option on swaps providing the right to enter into a certain swap at a certain time in the future
85
What is the difference between a European and an American swaption?
A European swaption can be exercised at a fixed expiry date, while an American swaption can be exercised at any date up to the expiry date
86
What is the advantage of using a swaption for a company?
Provides a guarantee that the fixed rate of interest on a future loan will not exceed a certain level
87
What is the equivalent of a swaption when paying fixed and receiving floating?
A put option
88
Why does a callable bond generally offer a higher yield than an identical bond without options?
Because it includes the option for the issuer to buy back the bond at a predetermined price, which adds risk for the investor
89
What is a forward contract?
An agreement to buy or sell an asset at a certain future time for a certain price
90
What is the delivery price in a forward contract?
The price chosen so that the value of the forward contract to both sides is zero at the time it is entered into
91
What is a forward-rate agreement (FRA)?
A forward contract where the parties agree on a certain interest rate for a certain principal amount during a specified future time period
92
How can an interest rate swap be regarded in relation to forward-rate agreements?
As a portfolio of forward-rate agreements
93
What is a forward contract?
A forward contract is an agreement to buy or sell an asset at a predetermined future date for a price that is agreed upon today.
94
What was the purpose of the 5-year swap between Companies A and B?
The swap involved an agreement to exchange five sets of cashflows at the end of each of the next five years.
95
What is the value of FRA to Company A when the forward rate is less than 6%?
value of FRA to A > 0
96
What does it mean when the value of FRA to A equals 0?
It occurs when the forward rate equals 6%.
97
What is the value of FRA to Company A when the forward rate is greater than 6%?
value of FRA to A < 0
98
What is private debt?
Private debt refers to loan capital issued by companies that is not publicly listed and traded on a stock exchange.
99
What are covenants in the context of private debt?
Covenants are requirements or restrictions placed on the borrower when a loan is undertaken, aimed at providing security for the lender.
100
What are the two types of covenants?
* Positive covenant: a requirement to do something
* Negative covenant: a requirement not to do something
101
How does private debt differ from traditional public debt?
Private debt is not actively traded and is marketed to a smaller number of long-term investors.
102
What is the typical issue size for private debt compared to public debt?
Private debt issues are typically smaller than those in the public debt market.
103
What is the typical currency denomination for private debt?
Most issues are fixed-rate US dollar-denominated transactions.
104
What is the usual maturity range for private debt?
Private debt is typically issued for long-term maturities longer than three years.
105
Why do private debt investors focus on covenant protection?
They may be unable to sell their private debt investments in the event of a credit downturn.
106
What is a disadvantage of issuing private debt compared to public debt?
Issuers may cede covenants to investors.
107
What is the purpose of funding in private debt transactions?
To determine the levels at which the all-in cost of private debt makes economic sense for the company.
108
What is a 'make whole' premium in private debt?
A cost incurred when repaying private debt early, usually around 50 basis points.
109
What are Treasury bills?
Short-term investments issued by the national government, offering the lowest default risk among money market instruments.
110
What is commercial paper?
Unsecured notes issued directly by companies.
111
What is a repo (repurchase agreement)?
A form of secured lending where an investor buys Treasury bills from a dealer who agrees to buy them back at a later date at a specified higher price.
112
What are government agency securities?
Bills issued by a near-government sector of the market.
113
What are bank time deposits?
Bank deposits with a specified term, where accessing the investment early may incur penalties.
114
What are some options for companies looking to borrow in the money markets?
* Issuing commercial paper
* Issuing eligible bills
* Arranging a term loan from a bank
* Arranging a line of credit with a bank
* Arranging a bridging loan from a bank
* Arranging international bank loans
115
What are the risks associated with corporate bonds?
* Default risk
* Liquidity risk
116
What is the excess yield on corporate bonds over government bonds made up of?
* Compensation for expected default risk
* Compensation for liquidity risk
117
What are the two main risks associated with corporate bonds?
Default risk and liquidity risk
## Footnote
These risks are not necessarily independent.
118
What components make up the excess yield on corporate bonds over government bonds?
* Compensation for expected defaults
* Credit risk premium
* Illiquidity premium
119
What is the purpose of credit derivatives?
To manage exposure to credit risk
120
What does a credit default swap provide?
A payment if a particular credit event occurs, such as a bond issuer defaulting
121
Define a swap.
An agreement between two parties to exchange cashflows in the future
122
What is a plain vanilla interest rate swap?
An agreement where one party pays fixed interest and receives floating interest on the same notional principal
123
In a currency swap, what is exchanged?
Principal and interest payments in one currency for principal and interest payments in another currency
124
List types of swaps.
* Amortising swaps
* Step-up swaps
* Deferred swaps
* Constant maturity swaps
* RPI swaps
* Cross-currency swaps
* Extendable swaps
* Puttable swaps
* Equity swaps
* Commodity swaps
* Asset swaps
* Volatility and variance swaps
125
What is a swaption?
A contract that gives one party the right to enter into a certain swap at a specified future time
126
True or False: A swaption can be regarded as a bond option.
True
127
What is a forward?
An over-the-counter agreement to buy or sell an asset at a certain future time for a certain price
128
What is a forward-rate agreement (FRA)?
A forward contract where parties agree on a certain interest rate for a specified future time period
129
What is private debt?
Bonds that are not listed and often used as an alternative to bank funding
130
What are the characteristics of private debt?
* Not actively traded
* Generally medium-term to long-term
* Issued by small and medium-sized companies
131
What is a bank time deposit?
A bank deposit with a specified term that may impose penalties for early withdrawal
132
What are the two types of factoring?
* Non-recourse factoring
* Recourse factoring
133
What is non-recourse factoring?
When the supplier sells trade debts to a factor, who takes credit risk and collects payments
134
What is recourse factoring?
The supplier retains credit risk and is responsible for collecting debts after receiving upfront payment from the factor
135
What are liquid assets?
Current assets such as stocks and debtors
136
Why do bond investors demand higher returns from riskier bonds?
Because they are typically risk-averse and expect higher returns to compensate for greater uncertainty
137
What is LIBOR?
The London Interbank Offered Rate, the interest rate at which banks lend to each other
138
What does LIBOR indicate?
The short-term spot interest rate for fixed-term deposits between Eurocurrency banks
139
True or False: LIBOR rates are risk-free.
False
140
What is the net effect of Company A's cashflows in a swap agreement?
- (LIBOR + ¼)%
141
How does the bank profit from a swap agreement?
The bank receives floating payments at LIBOR from Company A
142
What is the net floating rate for Company A in the cashflow combination?
LIBOR + ¼% pa.
143
How much profit does the bank make on the floating rate?
Neither a profit nor a loss
144
What is the bank's profit on the fixed rate?
0.2%
145
What is the total profit of the bank?
0.2% pa.
146
Why is the principal not exchanged in an interest rate swap?
It is the same absolute amount in the same currency on both sides.
147
What is the present value of the sterling payments received by Company A?
B£ = 50.371
148
What is the present value of the dollar payments received by Company A?
B$ = 75.254
149
What is the current sterling value of the dollar bond?
53.371
150
What is the net present value of the swap to Company A?
-£3.00 million
151
What does a swaption provide to its holder?
The option of entering a swap agreement at a specified future date.
152
How does a swaption differ from a forward swap?
A swaption is an option, while a forward swap is a commitment.
153
What is equivalent to selling a fixed interest bond in a swaption?
Paying fixed and receiving floating.
154
What does the value of a floating rate bond equal on the day it is issued?
The principal amount.
155
What does a callable bond generally offer compared to a non-callable bond?
A higher yield.
156
What is a key disadvantage of a private debt issue compared to a public issue?
Higher return required by investors due to greater risks.
157
Fill in the blank: Possible examples of financial covenants include a minimum ratio of current assets to _______.
current liabilities
158
Fill in the blank: A limit on the total level of higher or equal ranking _______ is a financial covenant.
borrowing
159
Fill in the blank: Financial covenants may include limits on the payment of _______ to retain sufficient funds.
dividends
