Specialist asset classes (1) (Swaps (types (Zero coupon- each payment…
Specialist asset classes (1)
Money market interest rates
Often quoted relative to LIBOR (London Inter Bank Offered Rate)
Two factors that influence spreads of money market rates:
1) default risk
2) market liquidity
Money market instruments
Issued by government, so very secure
Typically issued in 3m (91-day), 6m (182-day) and 1y forms
Usually issued by auction
Deep and liquid secondary market, i.e. very marketable
Short-term unsecured notes issued directly by company
Issued at discount (redeemed at par) usually for term of few months but can be typically presented to issuer (or to dealer) for repurchase
Bearer document and single-name instrument- security provided only by company issuing paper
Default risk means effective rate of interest slightly higher than on Treasury bills
Size of margin reflects company's credit rating
An agreement whereby one party sells stock to another with a simultaneous agreement to repurchase it at a later date at an agreed price
Holders of gov bonds and other high quality assets can use repos as a short-term financing tool, whilst maintaining their underlying economic exposure to these assets.
Reverse repo is the opposite side of a repo agreement. Form of secured lending s cash is being lent for the duration of the repo by the party buying the stock, with the security as collateral
Government agency securities
Bank time deposits/ certificates of deposits
Bankers' acceptances and eligible bills
Forms of short-term borrowing from banks (TRIBE)
Term loans- fixed amount for fixed term
Revolving credit- similar to evergreen credit, but with fixed maturity of up to 3 years
International bank loans- borrowing from a bank or syndicate overseas.
Bridging loans- very short-tern loans to bridge the gap until long-term finance becomes available
Evergreen credit- an overdraft facility, with no fixed maturity
Issues that differentiate between different types of bank loan
rate of interest (fixed/floating)
XS of yield on corps over gilts
compensation for expected defaults
Investors may expect future defaults to exceed historic levels
Compensation for the risk of higher defaults, i.e. credit risk premium
A residual that includes the compensation for the liquidity risk i.e. illiquidity premium
Contracts where the payoff depends partly upon the creditworthiness of one (or more) commercial (or sovereign) bond issuers
Two most common types
credit spread options
Option on spread between yields earned on two assets, which provides payoff when spread exceeds some level (the strike spread)
Payoff= difference between value of bond with strike spread and market value of bond
Offers protection against widening of credit spread beyond strike spread
Credit default swaps (CDS)
contract that provides payment id a particular credit event (usually default) occurs
Buyer pays regular premium to seller
If credit event occurs in term, payment made from seller to buyer.
Settled via cash payment equal to fall in market price of defaulted security (cash settlement) or exchange of cash and security (physical settlement).
If value of defaulted bond = R, then net payment on default = 100- R
Consists of basic security + embedded CDS
Provides payments linked to credit experience of reference bond underlying CDS
e.g. long position in a risk-free security + short position in CDS
Can be used to transfer credit risk from holder of risky reference bond to holder of credit-linked note
Vanilla interest rate
Fixed/floating based on notional pricipal
Net payments exchanged on each payment date
Principal not exchanged
Exchange of principal and interest payments in one currency for principal and interest payments in another.
Principal specified on both currencies- usually chosen to be approx equal based on current FX rate
Principal usually exchanged at beginning and end of swap- as companies usually want to borrow the involved currencies.
Total return from one asset swapped for total return on another
In absence of credit risk, value= difference between values of assets
Zero coupon- each payment traded separately
Amortising swap- principal reduces in predetermined way
Step-up swap- principal increases in predetermined way
Deferred or forward swap- swap agreed now but doesn't start until some future date
Constant maturity swap- floating lef is for longer maturity than frequency of payments
Extendable swap- one party has option to extend life of swap
Puttable swap- one party has option to terminate swap early.
RPI and LPI swap
Swapping fixed for index return
Cross-currency or currency coupon swap- fixed interest in one currency for floating interest in another
Dividend swap- exchanging dividends received on a reference pool of equities in return for a fixed rate
Variance or volatility swap- fixed rate for the experience rate or volatility of price changes of a reference asset
Asset swap- fixed cashflows from fixed income asset in return for floating interest rate
Option to enter into swap at future date!
Companies can benefit from favourable interest rate movements while acquiring protection from unfavourable variations.
Can be useful for insurers wishing to offer policyholders option of fixed rate product (e.g. guaranteed annuity options)
Forward Rate Agreement (FRA)
Forward contract where parties agree that certain interest rate will apply to a certain principal amount during a specified future time period
Puttable and callable bonds
Puttable- give holder option to sell them back to issuer at predetermined price on specified dates in the future.
Callable- give issuer option to buy them back from holder at predetermined price on specified dates in the future.
not actively traded
covenant features similar to bank loan and often used as alternative to bank funding
usually marketed to small number of long-term "buy and hold" investors
mostly issued in fixed-rate US dollar-denominated transactions
Usually medium to long-term (> 3yrs), for amounts ranging from £10m to £300m-400m.
unlisted hence unmarketable
Frees up credit lines with relationship banks
doesn't incur cost of full credit rating
avoids other costs of obtaining and maintaining public listing
Need to cede covenants to investors
Pays higher yield than publicly listed debt