Chapter 4: Specialist asset classes

Question 1

i. Characteristics of financial instruments available for short-term lending

State:
1. How are money market rates are often quoted.

2. the two factors that influence the spread of money market rates.

Answer 1

1. MM interest rates are quoted relative to LIBOR (London Inter Bank Offer Rate)
2. Two factors that influence spreads:
   - default risk
   - market liquidity

Question 2

i. Characteristics of FIASL

List the six different types of mm instruments and state which three are the most important.

Answer 2

1. Treasury bills
2. Local government bills/government agency bills
3. Commercial paper
4. Repos
5. Banker’s acceptance and eligible bills
6. Certificate of deposit/bank time deposits

The three most important and major instruments are:
- Treasury bills
- Commercial paper
- repo agreements

Question 3

i. Characteristics of FIASL

List ways in which in investors can access MM instruments?

Answer 3

1. Deal on their own account
   - suitable for large firms
2. Invest funds in a MM fund which are small and offer diversification.
   - suitable for smaller investors
3. Hire an investment firm to trade on their behalf.
   - suitable for large investors who do not have expertise to deal in mm

Question 4

i. Characteristics of FIASL

Define the main features of the market for Treasury bills.

Answer 4

• issued by government, so very secure
• Typically issued in 3-month (91 day), 6-month (182 day) and one-year forms
• usually issued by auction…
  -… where competitive and non-competitive bids may be entered…
  with the latter filled at the average price of successful competitive bids
• Deep and liquid secondary market, ie very marketable.

Question 5

i. Characteristics of FIASL

Explain what is meant by commercial paper.

Answer 5

• Short-term unsecured notes issued directly by company (overriding need for financial intermediation)
• Issued at a discount (and redeemed at par), usually for a term of a few months, but typically presented to issuer (or to dealer) for repurchase
• Bearer document and single-name instrument
• Default risk means effective rate of interest slightly higher than on Treasury bonds
• Size of margin reflects company’s credit rating
• companies issuing must meet certain minimum criteria

Question 6

i. Characteristics of FIASL

What does the following mean and what the implications of the combination of these two:
1. Bearer document
2. Single name instrument

Answer 6

1. Single bearer
   - A bearer document is a negotiable instrument where ownership is simply by physical possession.
   - Whoever holds the physical document is considered the legal owner and can present it for payment at maturity.
2. Single-Name Instrument:
   - A single-name instrument means there’s only one party obligated to repay the debt represented by the commercial paper.

Implications :
1. Security:
- the security of the investment rests solely on the creditworthiness of the issuing company.
2. Benefits and risks:
- Bearer documents can be easier to transfer and negotiate compared to registered instruments
- Higher returns that TB
- The lack of additional security and reliance on a single issuer significantly increases the risk of default.

Question 7

i. Characteristics of FIASL

Explain what is meant by a repo.

Answer 7

• It is an agreement whereby one party agrees to sell stocks (government bonds or TB) with a simultaneous agreement to repurchase it at a later date at an agreed price
• Holders of government bonds and other high quality assets can use repos as a short-term financing tool, whist maintaining their underlying economic exposure to these assets.
• rep rate = repurchase price - selling price

Question 8

i. Characteristics of FIASL

Explain what is meant by a ‘reverse repo’.

Answer 8

• it is the counterparty/opposite side to the repo agreement
• it is a form of secured lending as cash is being lent for the duration of the repo by the party buying the stock, with the security as collateral .

Question 9

i. Characteristics of FIASL

Explain what is meant by government agency bills.

Answer 9

• Near-government sector of the market which issues and trades securities that are almost as risk-free as Treasury bills (e.g., nationalized industries, local authorities)
• similar to TB and secondary liquid markets also exist
  1. but not quit as marketable as TBs and slightly higher level of risk
  2. but risk margin not significant

Question 10

i. Characteristics of FIASL

Define the main features of the bank time deposits.

Answer 10

• Bank deposits with specified term
• Banks major providers and borrowers
• Interbank borrowing and Certificates of Deposits (Negotiable term deposit) are typical securities involved
• CDs main features:
  1. bearer document
  2. secondary market exists
  3. typical 1 to 3 months
  4. Domestic and international CDs exist in many currencies

Question 11

i. Characteristics of FIASL

Explain what is meant by:

1. Banker’s acceptance bill.
2. Eligible bill.

Answer 11

1. Banker’s acceptance bill
   tradable IOUs, company supplies goods or services and will have invoice accepted by a bank (who thereby guarantees payment at the due date). The bill can then be traded in a secondary market to raise immediate cash, at a discount.
2. Eligible bill
   - A bill of exchange drawn by the seller on the buyer and endorsed by the seller’s bank. Upon acceptance by the buyer, the endorsed bill becomes a short-term debt instrument
   - The seller’s bank may discount the bill for the seller, essentially advancing them the face value minus a discount fee.
   - This provides immediate cash flow for the seller, while the bank holds the bill until maturity and collects payment from the buyer

Question 12

Characteristics of FIASB

Give five forms of short-term borrowing from banks.

Answer 12

TRIBE
1. Term loans - borrowing fixed amounts for fixed term
2. Revolving credit - similar to evergreen credit, but with a fixed maturity of up to 3 years
-There is a commitment fee you pay
3. International loans - borrowing from a bank or syndicate of banks overseas
4. Bridging loans - very short-term loans to bridge gap until long-term finance becomes available
5. Evergreen credit - An overdraft facility, with no fixed term
- May have commitment fee
- bank may required period payment of loan to prevent long-term borrowing

Question 13

Characteristics of FIASB

Give four issues that differentiate between different types of bank loan.

Answer 13

1. Commitment - whether there is a prior commitment by lender to advance funds when required (often requiring payment of commitment fee to lender)
2. maturity - term of which lending made
3. rate of interest - may be either fixed or floating
4. Security - whether loan is secured against assets

Question 14

i. Characteristics of Corporate debt

Give examples of corporate debt

Answer 14

1. Debentures
2. Loan stock
3. preference shares

Question 15

i. Characteristics of Corporate debt

What are the two primary additional risks?

Answer 15

1. Default risk - the risk that the issuer will not be able to make payment of the interest or redemption payments, either on the due date or at all.
2. Liquidity risk (strictly marketability risk)

• the risk that a holder of the bond will not be able to realise value for it in certain market conditions
• This might be because the bond has certain unusual terms or covenants
• or because the issue is small and unlikely to be attractive to major investors

These risks are not necessarily independent

Question 16

i. Characteristics of Corporate debt

List the four components that comprise of the excess of the yield on corporate bonds over treasury bonds

Answer 16

1. Compensation for expected defaults
2. The possibility that investors may expect future defaults to exceed historical levels
3. Compensation for the risk of higher defaults, ie. credit risk premium
4. A residual that includes the compensation for liquidity risk - typically refereed to as an illiquidity premium

Quantifying this involves techniques such as the use of option pricing models using equity volatility to estimate the risk of default and the use of credit default swaps to estimate market premium for credit risk.

Question 17

i. Characteristics of Credit derivatives

Describe the term credit derivative.

List the two most common types of credit derivatives

Answer 17

Credit derivative - contracts where the payment depends partly upon the creditworthiness of one (or more) commercial (or sovereign) bond issuers

Common types of Credit derivatives
1. Credit Default Swaps
2. Credit Spread options

collateralised debt obligation can also be used to transfer credit risk

Question 18

i. Characteristics of Credit derivatives

Explain how a credit default swap works.

Answer 18

• Contract that provides payment if particular credit event (usually default) occurs
• The term of the CDS contract could be the same as the term of the bond (but does not need to be)
• Party buying protection pays regular premium to party selling protection
• if credit event occurs within term of contract, payment made from seller to buyer
• if credit event does not occur, buyer receives no payment but has benefited from protection
• Settled via cash payment equal to fall in the market price of the defaulted security (cash settlement) or exchange of cash and security (physical settlement)
• In either case, if value of defaulted bond is equal to recovery R, then net payment on default equals 100 - R
• The buyer is still exposed to the credit risk of the issuing bank

Question 19

i. Characteristics of Credit derivatives

How might the premium paid under CDS be calculated?

Answer 19

1. Using a cashflow model where you value the expected loss due to credit events on reference bond and the fee is set to cover expected losses with some margin for profit
2. or using yield difference between reference bond and risk-free bond of the same term
   - factors to take into consideration (for negotiations when setting final CDS premium) are…
   -…Credit ratings
   -…recovery rate expectations
   -…overall market sentiment towards company’s creditworthiness

Question 20

Why are banks and institutional investors the largest users of CDSs?

Answer 20

1. They may have reach internal credit limit with a particular client but wish to maintain relationship with the can use CDS to reduce aggregate exposure to the client. (main users are banks)
2. Speculation on Defaults
3. Protecting Existing Investments
4. Spread Risk Across Borrowers and thus diversify portfolio and potentially reduce overall portfolio risk
5. Manage Exposure to Specific Sectors

Question 21

i. Characteristics of Credit derivatives

State what is meant by a credit-linked note.

Answer 21

• Consists of basic security plus embedded credit default swap
• For example, long position in risk-free security plus short-position credit default swap
• Provides payments linked to credit experience of reference bond underlying credit default swap
• Can be used to transfer credit risk from holder of risky reference bond to holder of credit-linked note.

Question 22

i. Characteristics of Credit derivatives

State what is meant by a credit-spread option.

Answer 22

It is an option on the spread between yields earned on two assets. The payoff is provided when the spread exceeds a certain level (the strike spread). The payoff could be calculated by taking the difference between the value of the bond with the strike spread and the market value of the bond.

Question 23

i. Characteristics of Credit derivatives

Explain with aid of a simple example how a credit spread option works

Answer 23

• Option on spread between yields earned on two assets, which provides a payoff when spread exceeds some level (strike spread)
• payoff calculated as the difference between the value of the bond with strike spread and the market value of the bond
• e.g. might give holder right, but not obligation, to sell corporate bond on strike date and at a price corresponding to strike spread of 1% above corresponding government yield
• Offers protection against widening of credit spread beyond strike spread
• And you can potentially profit from this widening spread even if you don’t own the corporate bond directly.

Question 24

i. Characteristics of Swaps and swaptions

Explain how a plain vanilla interest rate swap (par swap) works.

Answer 24

• Company B agrees to pay Company A cashflows equal to interest at predetermined fixed rate on notional principal for number of years
• At the same time, A agrees to pay B cashflows equal to interest at floating rate on same principal over same period
• Floating rate payment at any date based on value of floating rate at previous cashflow date
• Net interest payments exchanged on each payment date
• Principal no exchanged
• currencies of the two sets of cashflows are the same

Question 25

i. Characteristics of Swaps Explain how a Swap is arranged

Answer 25

- No direct contact - each trader deals with a financial intermediary which makes a profit from the pair of offsetting transactions(such as a bank) - spread is often to compensate bank for default risk (in practice default risk is collatelarised) -warehouse swaps - companies don't contact bank at the same time to take opposite positions on swap, thus bank prepared to enter without having an offsetting swap (in this case bank assesses risks and hedge them)

Question 26

i. Characteristics of (currency) swaps Explain how a currency swap works.

Answer 26

- Involves exchanging of principal and interest payments in one currency for principal and interest payments in another currency. - Principal specified in both currencies - usually chosen to be approximately equal based on current exchange rate - Principal amounts usually exchanged at beginning and end swap as companies usually want to borrow the currencies involved

Question 27

i. Characteristics of swaps Describe the use and valuation of total return swaps.

Answer 27

- Total return from one asset (or group of assets ) swapped for total return on another e.g return on corporate bonds swapped for LIBOR plus spread - Enable diversification by swapping one type of exposure for another without physically swapping the underlying assets - In the absence of credit risk, value total return swap is the difference between values of assets generating returns on each side off swap - Normally structured to be worth zero initially. - Other uses of TRS include customization, capital efficiency and risk management and off-balance sheet transactions

Question 28

i. Characteristics of (other variations of) swaps Describe how seven other variations of swaps are structured.

Answer 28

1. Zero-coupon swap - each individual payment is traded separately. 2. Amortising swap - principal reduces in predetermined way 3. Step-up swap - principal increases in predetermined way 4. Deferred or forward swap - swap agreed now but doesn't start until some future date 5. Contant maturity swap - where the floating leg of one swap is for a longer maturity than the frequency of payments 6. Extendable swap - one party has option to extend life of swap beyond specified period 7. puttable swap - one party has option to terminate swap early

Question 29

i. Characteristics of (other variations of) swaps Describe how five other variations of swaps are structured.

Answer 29

1. RPI and LPI swap - swapping fixed rate for 'index' return 2. Cross-currency or currency coupon swap - swapping - swapping fixed interest rate in one currency for floating ratee in another currency 3. Dividend swap - exchanging the dividends received on a reference pool of equities in return for a fixed rate 4. Variance or volatility swap - exchanging fixed rate in return for experienced variance or volatility of price changes of reference asset. 5. Asset swap - exchanging the fixed cashflows due from a bond or other fixed income asset in return for floating interest rate.

Question 30

i. Characteristics of swaptions Explain what a swaption is and also how it might be used

Answer 30

- Provides purchaser with right, but not obligation, to enter into certain swap at certain time in future - Can be viewed as an option to swap a fixed rate bond for a principal amount - Can also be used to provide guarantee that fixed rate of interest paid on a loan at some future time will not exceed some level - This means company able to benefit from favorable interest rate movements while acquiring protection from unfavorable variations. - Can be useful for insurers wishing to offer policyholders option of fixed rate product (guaranteed annuity options) - Can also be used to place limit on a floating rate by providing the company the option to swap floating rate for a fixed rate.

Question 31

i. Characteristics of FRA Explain what is meant by FAR.

Answer 31

Forward contract where parties agree that certain interest rate will apply to a certain principal amount during a specified future time period. (interest swap can be regarded as a pf of FRAs)

Question 32

Explain the difference between puttable and callable bonds

Answer 32

- Puttable bonds - give the holder option to redeem them early (ie sell them back to issuer) at predetermined price on specified dates in future - callable bonds - give the issuer the option to redeem them early (ie buy them back from holder) at predetermined price on specified dates in future

Question 33

i. Characteristics of private deb List six key features of private debt

Answer 33

1. unlisted and hence unmarketable 2. not actively traded 3. covenant features similar to bank loan and often used as alternative to bank funding 4. usually marketed to small number of long-term "buy and hold" investors 5. mostly issued in fixed-rate US dollar-denominated transactions 6. usually medium to long-term (over three years), for amounts ranging from$10m to $300m-$400m

Question 34

i. characteristics of private debt Give three reasons for issuing private debt and two disadvantages of issuing private debt

Answer 34

Reasons: 1. Frees up credit lines with relationship banks 2. does not incur full credit rating 3. avoids other costs of obtaining and maintaining public listing disadvantages: 1. Need to cede covenants to investors 2. pays higher than public listed debt, due to lack of: - information - marketability