VII . ARBITRAGE AND HEDGING WITH FIXED INCOME INSTRUMENTS AND CURRENCIES
All About Fixed Income Instruments
-
Upload
guest241aa3 -
Category
Economy & Finance
-
view
12.625 -
download
0
description
Transcript of All About Fixed Income Instruments
Understanding Fixed Income Instruments
Welcome To The World Of Risk Free rather Lower Risk and moderate returns
You are safe but no assurance on that safety
Quite a pickle – Isn’t It?
We see why?????
2
Understanding Fixed Income Instruments
Conventions Debt securities – Issued by borrowers to
obtain liquidity or capital for their short term or long term needs
Promised payment events – Interest payment & Repayment of fixed amount
Secured & Unsecured Risk prone – Not absolute risk free Mid 2009 Debt market valued at $30
Trillion
3
Understanding Fixed Income Instruments
Types Of Bonds
4
Understanding Fixed Income Instruments
Features Of Bonds Coupon Rate
“6s of 12/10/2009” – 6% Coupon maturing @...
Monthly (MBS & ABS), Semi-Annually Zero-Coupon Bonds Accrual Securities Deferred Coupon Bonds Floating Rate Securities
Reference Rate + Quoted Margin 1-month LIBOR+100 basis points
5
Understanding Fixed Income Instruments
Accrual Securities
Buyer Seller
Jan 09 Jan 10 Jun 10 Jan 11 Jun 11Jun 09$ 5 $ 5
$ 5 $ 5
$ 5
Accrued Interest
Par Value of $100 - Semi Annual Interest Of 5%
Dirty Price – Trading Cum-Coupon
Clean Price – Trading Ex-Coupon
6
Understanding Fixed Income Instruments
Calculating Accrued Interest Three pieces info needed:
No of days in the accrued interest period No Of days in the coupon period Dollar amount of the coupon payment
AI is calculated as
Day count conventions
7
Understanding Fixed Income Instruments
Features Of Bonds – Contd’ Maturity Date
Time period over receipt of interest payments Yield on a Bond Price Of the Bond
Price Of the Bond is calculated as
Sum Of the Present values of all expected coupon payments & Principal @ Par
C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value
8
Understanding Fixed Income Instruments
Features Of Bonds – Contd’ Yield – returns which investor gets by
holding the bond till maturity Current Yield Vs Adjusted Current
Yield
A bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%
9
Understanding Fixed Income Instruments
Price Vs Yield
Price of a Bond & Yield of a Bond are inversely related When the Coupon rate is less than the
required Yield, the price is less than the par value
When price is greater than the par value, the coupon rate is greater than the required yield
YTM - The discount rate that equates a bond’s price with the present value of its future cash flows.
10
Understanding Fixed Income Instruments
Risk Associated With Bonds Interest Rate Risk
Price Of a bond falls when interest rates rise Floating Rate Securities
Credit Risk Default, Downgrade
Contractual Risk Callable Bonds
Inflation Risk Increase in inflation – Purchasing power
11
Understanding Fixed Income Instruments
Types Of Bonds Callable Bonds - A bond that can be redeemed
by the issuer prior to its maturity. main cause of a call is a decline in interest rates
Convertible Bonds – A bond that can be converted into a predetermined amount of the company's equity at certain times during its life
Eurodollar Bonds - U.S.-dollar denominated bond issued by an overseas company and held in a foreign institution outside both the U.S. and the issuer's home nation Chinese bank held dollar-denominated bonds issued by a
Japanese company, this would be considered a eurodollar bond.
12
Understanding Fixed Income Instruments
Types Of Bonds
Eurobond is an international bond that is denominated in a currency not native to the country where it is issued
Yankee Bond - A bond denominated in U.S. dollars that is publicly issued in the U.S. by foreign banks and corporations
Bulldog Bond - A sterling denominated bond that is issued in London by a company that is not British
13
Understanding Fixed Income Instruments
Types Of Bonds
Maple Bond - A bond denominated in Canadian dollars that is sold in Canada by foreign financial institutions
Matilda/Kangaroo Bond - An bond denominated in the Australian dollar and issued on the Australian market by a foreign entity
Samurai Bond - Yen-denominated bond issued in Tokyo by a non-Japanese company
14
Understanding Fixed Income Instruments
Fixed Income Products Treasury Bills – Maturities with 6,12 & 18
months duration Issued by the Treasury of the state Always issued at discount
Government Bonds - Medium & long term bonds – known as bonos & obligaciones Maturities of 10, 15 & 30 Years Fixed Interest rate through annual coupons
15
Understanding Fixed Income Instruments
Fixed Income Products
Commercial Paper - An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range
any longer than 270 days Certificate of deposit or CD is a time deposit, a
financial product commonly offered to consumers by banks, thrift institutions, and credit unions Held until maturity
16
Understanding Fixed Income Instruments
Fixed Income Products Repo – Repurchase
Agreements (Not necessarily FI product)
Is a contract in which a security is sold with an agreement to repurchase the security at a higher price
17
Understanding Fixed Income Instruments
Fixed Income Products
Reverse Repo is a contract in which a security is borrowed with an agreement to replace the security at a higher price
Secured lending and borrowing
Repo
18
Understanding Fixed Income Instruments
Fixed Income Products Commercial Paper – Zero Coupon bonds
issued at discount Short term with maturities 1,3,6,12 & 18
months Placed in the primary market through
competitive auctions Convertible/Exchangeable Bonds
Enables a financial asset to be transformed into other
19
Understanding Fixed Income Instruments
Fixed Income Derivatives
20
Understanding Fixed Income Instruments
MBS A mortgage-backed security (MBS) is
an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property. Residential mortgage-backed security (RMBS) Commercial mortgage-backed security Collateralized mortgage obligation Stripped mortgage-backed securities Interest-only stripped mortgage-backed securities Principal-only stripped mortgage-backed securities
21
Understanding Fixed Income Instruments
Weapons Of Financial Destruction
Collateralized Debt Obligation Process Of Securitization
22
Understanding Fixed Income Instruments
Interest Rate Swap Interest rate swap is a derivative in
which one party exchanges a stream of interest payments for another party's stream of cash flows
Fixed for floating/Vanilla Interest Rate Swaps
Often use LIBOR as reference rates Hedging/Speculation on interest & FX
rates
23
Understanding Fixed Income Instruments
Interest Swaps – Illustrated
Time 6-Month Fixed Rate Floating Rate Swap
0 2.80% –100.0 –100.0 00.5 3.40% 2.3 1.4 0.91 4.40% 2.3 1.7 0.6
1.5 4.20% 2.3 2.2 0.12 5.00% 2.3 2.1 0.2
2.5 5.60% 2.3 2.5 –0.23 5.20% 2.3 2.8 –0.5
3.5 4.40% 2.3 2.6 –0.34 3.80% 102.3 102.2 0.1
Cash Flows During the Life of
a Hypothetical USD 100MM 4.6% Four-Year Swap
24
Understanding Fixed Income Instruments
Interest Rate Caps An interest-rate cap is an OTC derivative
in which the buyer receives payments at the end of each period in which the interest rate (reference rate/LIBOR) exceeds the agreed strike rate (Cap rate)
3-year, USD 200MM notional cap 6-month Libor - index rate,
struck at 7.5%. Protects from int. rate rises
25
Understanding Fixed Income Instruments
Interest Rate Floors An interest rate floor is a derivative in
which the buyer of the floor receives money if on the maturity the reference rate fixed is below the agreed strike price of the floor
Protects holder from declines in short-term interest
3-year, USD 200MM notional cap 6-month Libor - index rate,
struck at 7.5%.
26
Understanding Fixed Income Instruments
Swaption A swaption is an option granting its
owner the right but not the obligation to enter into an underlying swap
the term "swaption" typically refers to options on interest rate swaps A payer swaption gives the owner of the swaption the
right to enter into a swap where they pay the fixed leg and receive the floating leg.
A receiver swaption gives the owner of the swaption the right to enter into a swap where they will receive the fixed leg, and pay the floating leg.
27
Understanding Fixed Income Instruments
Swaption designed to give the holder the benefit of
the agreed-upon strike rate if the market rates are higher American swaption, in which the owner is allowed to
enter the swap on any day that falls within a range of two dates.
European swaption, in which the owner is allowed to enter the swap only on the maturity date.
Bermudan swaption, in which the owner is allowed to enter the swap only on certain dates that fall within a range of the start (roll) date and end date.
28
Understanding Fixed Income Instruments
29