2. Specialist Asset Classes

8/13/2019 2. Specialist Asset Classes

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Specialist Asset Classes

Core Reading Unit 5

Short-term debt instruments

Are zero-coupon bonds which pay the

holder their face value at a specified date

Are sold by borrowers at a discount to their

-

Can be traded freely between investors in

the Money Market after their issue

Initial term to redemption usually 1 year

Return on short-term debt instruments

Return is given by discount to face value treated

as interest for tax purposes

Size of discount depends on term to redemption,

liquidity and default risk.

London Inter Bank Offered Rate (LIBOR) is

average interest rate on loans between major banks

LIBOR is calculated in 10 major currencies for

maturities of up to one year these are benchmark

interest rates for short-term borrowing


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Issuers of short-term debt instruments

National Governments (Treasury Bills)

Government agencies (notes issued by local

Banks (Certificates of Deposit)

Companies (Commercial Paper)

Short-term borrowing by companies

Commercial paper is only suitable forcompanies with excellent credit ratings

Most companies depend on banks for short-term finance

Banks may provide short-term loans or

evergreen credit which allows borrowing upto a fixed limit for an indefinite period

The interest charged on short-term debt may befixed or floating

Working capital management The time delay between producing goods and

obtaining the money from selling them creates

the need for short-term finance

n ncrease n stoc s or tra e e tors wou

increase the need for short-term borrowing

An increase in trade creditors would reduce

the need for short term borrowing


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Question 1

Discuss the need for short-term finance of thefollowing businesses:

an automobile manufacturer

a major supermarket chain

an insurance company

a bank

Corporate bonds

Are interest-bearing securities issued bycompanies as a form of long-term finance

They offer higher yields than government bondsbecause of default risk and lower liquidity

Rating agencies classify bonds according todefault risk main division is betweeninvestment grade and sub investment grade

Bonds secured against assets of the borrower(debenture stock) would offer a lower yield thanunsecured debt of the same borrower

Private debt

Alternative form of corporate debt issued bycompanies to long-term investors

Cannot be traded in a secondary market andusually held until redemption

Contracts include strong investor covenantsrules that prohibit the company from actions thatmight increase default risk, e.g. issuing a higher-ranking class of debt

Unlike corporate bonds, private debt can be issuedwithout a credit rating from a rating agency


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Question 2

How would the credit spread between a corporatebond and a government bond be affected by:

the size of the company?

the industry the company operated in?

a successful rights issue of ordinary shares

by the company?

Credit default swaps

Are insurance contracts where A pays regularpremiums to B in exchange for a payment if aspecified bond defaults

The payment could either be:

- the fall in the bonds price below face value

- the face value of the bond in exchange forthe bond itself

A bank may require CD swaps if it is heavilyexposed to the debt of a particular client

Total return swaps

The holder of a risky asset exchanges its total

return over each period for a floating interest rate

from the protection seller

as well as income if it is negative, the protection

seller must pay it to the holder of the risky asset

The protection seller is a speculator who wants a

leveraged position in the risky asset

The initial value of the swap is zero


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Credit spread options

An option whose payoff is based on the creditspread on a bond (relative to a risk-free bond)

If the option is exercised when the credit spreadis above (or below) some strike value, the issuerof the option makes a payment to the holder

The payment may be defined as the differencebetween the actual price of the bond and its priceat the strike value of the credit spread

Credit spread options protect the holder againstvolatile credit spreads

Question 3

A bank makes a loan to a long-standing

commercial client. The size of this loan is

several times larger than its next biggest

commerc a oan.

Compare the credit default swap with the totalreturn swap as methods of reducing the banks

exposure to this clients credit risk.

Swaps

An agreement to exchange future cash-flows fromdifferent assets

Interest rate swap: exchange fixed interest

payments with floating-rate interest payments on

the same nominal rinci al

Currency swap: exchange both interest and

principal payments on loans issued in different

currencies

The loans exchanged have the same initial value so

the value of the swap is initially zero


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Bond options

A bond option is the right to buy/sell a specifiedbond at a specified price and time in the future

A bond o tion is financiall e uivalent to an

interest rate swaption

Bond options (or swaptions) could be used by life

companies to match liabilities for deferred

annuity contracts

Question 4

A bank raises funds by issuing 25-year

fixed-interest bonds. It uses these funds to

offer 25-year fixed-interest mortgages to its

retail customers, who ma re- a the loan

early if they wish.

Explain the interest rate risk faced by thebank and specify what kind of derivative

could be used to hedge against this risk.

Asset-backed securities

Income-generating assets can be pooled in aSpecial Purpose Vehicle (SPV) which thensells bonds to investors to give them a share ofthe income

s ena es qu assets to e converte ntosecurities which can be traded in a secondarymarket

The creation of the SPV ensures that theoriginal holder of the income-generating assetshas no claim on those assets if it goes bankrupt


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Types of asset-backed security

Mortgage-backed securities

Credit card receivables

Car loans repayments

Student loan repayments

Future royalties on music sales

Collateralised Debt Obligations (CDOs)

These are asset-backed securities where theincome is divided into different tranches to createsecurities with different risk/return properties

The senior debt is investment grade bonds which

The mezzanine debt is sub investment gradebonds ranking below the senior debt

The equity tranche receives the residual cash-flows after the debt tranches have been serviced

Private equity

This is equity finance which cannot be traded in

a secondary market

Hence the shares are unlisted and have no

quoted market price

Private equity is thought to be appropriate for

high risk ventures unsuitable for non-specialist

investors


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Main types of private equity

Venture capital seed capital for aproposed new venture that has yet to

generate revenues or profits

Buyouts the equity capital of a large

company which has delisted following its

acquisition by private investors

Leveraged buyouts

Leveraged buyouts have been used to acquire

listed companies and transform them into

private companies

The funds used for the acquisition are private

equity plus a large issue of debt

Hence the new private company has a highly

geared capital structure

Private equity firms

Private equity firms are limited liability partnerships

investing in the private equity of different companies

They are said to offer returns which are higher (on

average) and less correlated with the equity market

an un s or s e s ares

However their performance data may be affected by

survivorship bias

Private equity funds are investment trust companies

which invest in private equity firms they provide

greater liquidity and diversification


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Question 5

Compare how a companys financial position

would be affected by:

--

special purpose vehicle (SPV);

(ii) issuing bonds to finance a leveraged

buy-out (LBO).

Hedge funds

Hedge funds are pooled investment funds aimed

at wealthy private clients and institutional

investors

the general public, hence have more freedom in

their investment strategies

Hedge fund managers charge fees which are

higher and more linked to performance than

retail fund managers

Hedge fund characteristics

High levels of borrowing and short-selling

Pursuit of arbitrage opportunities

Significant use of derivatives

Willingness to invest in unusual assets, e.g.

commodities


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Types of hedge fund

Global funds seek to profit frominternational trends

Event driven funds aim to profit fromar trage opportun t es ar s ng n mergers,acquisitions and bankruptcies

Market-neutral funds aim to makepositive returns whether the equity market isrising or falling by holding long and shortpositions in different stocks

Claims for hedge funds

Higher average returns than other funds but

data may be unreliable because of survivorship

and selection biases

Low correlation of returns with equity market

but absence of market prices for illiquid assets

may cause correlations to be understated High alpha investments but distribution of

returns are negatively skewed, making standard

risk/return models unreliable

Currencies Some investment funds seek to make returns

by speculating on exchange rate movements

They can do this by trading in currency

forward contracts in which s ecified

currencies can be exchanged at a specified

future date at a pre-determined exchange rate

Profits and losses arise if the actual exchange

rate at the settlement date (the spot rate) is

different from the agreed forward rate


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Infrastructure

Are assets traditionally created and maintainedby governments (e.g. roads, hospitals, prisons)

Private investors may be invited to finance the

construction of such assets in return for a share

of their revenues or payments from the State

The income from such investments is relatively

stable and predictable the main risk is in the

cost of construction

Commodities

Commodities are internationally traded goodssuch as raw materials or agricultural products

Commodity funds speculate on their pricemovements b tradin in commodit futures

Commodity funds claim to offer investors

diversification and a hedge against inflation

However commodity markets are highly volatileand commodity prices have often fallen in realterms

Structured products

A structured product is an asset synthesizedfrom derivatives and zero-coupon bonds

The use of derivatives enables structuredproducts to meet customised risk/returnobjectives for retail investors

For example, an equity call option and a zerocoupon bond (maturing at the same date) createa guaranteed equity product this guaranteesthe investors capital while providing a positivereturn linked to the upside in the equity market

2. Specialist Asset Classes

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