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ImportanceofMarkets
Marketstructureisimportanttoriskmanagers mainlythroughitsimpactonliquidity. Asuccessfulmarketbringstogethermany buyersandsellers,reducestransacBonscosts. Marketstructurecanimpactrisk:
OTCtradeshavegreatercreditriskbutlowerbasis risk.
Liquidity
LiquidityistheabilitytotransactquicklywithoutaecBng prices. Liquidityisenhancedwhen: contractsarehomogeneous marketsareeecBvelylinkedtogether posiBonsaresmall LiquidityisapotenBalproblemwhen: productsarediverse marketsarefragmented posiBonsarelarge
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FinancialExchangesvs.OTCMarkets
FinancialExchanges: righttotradelimitedtomembers detailedandexplicitrulesregardingconductoftrade contractsarestandardized exchangesprovidepriceinformaBon,facilitatetrade seLlement OTC:AnynonexchangetradeiscalledOTC(Overthecounter) BuyerandsellercannegoBatetradedetails InvestorsdonothaveprotecBonofexchangerulesand procedures.
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ServicesOeredbyExchangesvs.OTC Equivalents
1. SeTngstandardsfortradednancialproducts.(OTCmarkets oVenuseISDAmasteragreementsastemplates). 2. ProvidingpriceinformaBon.(OnOTCmarkets,mustgetprice quotesfromdierentdealers). 3. ProtecBngagainstcounterpartyrisk.(Clearinghouseis counterpartyforalltransacBons).(OTCmarketsaLemptto reducecounterpartyriskbyrestricBngparBcipaBontohigh creditqualityinvestors,e.g.AAorabove). 4. Matchingbuyersandsellers(electroniconallexchanges exceptNYSE).(OTCmarketscompetewithindependent ElectronicCrossingNetworks,whichneithersetpricesnor carryinventory,tomatchbuyersandsellers).
OTCMarkets:TradiBonal Structure
DealersquotebidandaskpricestoprospecBve buyersandsellers. Normalmarketsizeisthemaximumsizeof transacBonatwhichadealerispreparedto transactatthestatedbid/askprices. Dealersmakeprotfromorderow,both throughbidaskspreadandfromanBcipaBng shorttermpricemovesbasedontheir privilegedaccesstoorders. Dealersalsobearriskfromholdinginventory, andfromthepossibilityofbeing"pickedo" byinvestorswithsuperiorinformaBon. MajorOTCmarketsincludethosefordebt, FOREX,somederivaBves,andtheNASDAQ.
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MeasuresofLiquidityinaDealerMarket
Stock Market Cap $mill. 1 NMS Bid $thous. 200.0 1 9.43 2.50 Ask Spread % 0.21 33%
9.45 3.50
FundingandLiquidity
ManyderivaBvesecuriBes(e.g.swaps,forwards) requirenoexchangeofprincipalandthereforeno (orliLle)moneyupfront(nothingbeyondan iniBalmargin). TakinganequivalentposiBoninacashmarket wouldrequirealargeamountoffunding. ThistendstopushtradingacBvityandprice formaBonontoderivaBvesmarkets.
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FinancialMarkets
Commonlydividedintothefollowingtwo components. MoneyMarkets:Maturity<1year. CapitalMarkets
EquityMarket DebtMarket(FixedIncomeInstruments) DerivaBveSecuriBes
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BasicTerminology
Term:periodofBmeoverwhichborrowingoccurs.Endofthetermiscalled thematuritydate. Principal:Amountrepaidonmaturitydate.Principal=FaceValue=ParValue InterestRate:Amountborrowerpaysthelenderfortheuseofthemoney, usuallyexpressedasanannualpercentage. Yield:eecBveinterestrateofthebond Issuer:government,localgovernment,corporaBons,supranaBonal organizaBon Marketability:Whetherornotownershipcanbetransferred. Security:Collateralthatcanbeseizedintheeventoffailuretopay. CallorPutFeatures:Provisionsthatallowtheborrowertorepay(call)orthe lendertodemandpayment(put)beforematurity.
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Sometypesofbonds
Bulletbonds:payregularinterestatxedrate Zerocouponbonds:dontpayregularinterest FloaBngRatenotes:interestratelinkedtoanexternalreference IndexLinkedbonds:couponpayments(andpossiblyprincipal repayment)linkedtoanexternalreferenceasinaBon,prices SecuriBzedbonds BondswithembeddedopBons
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ExampleofaBondanditsAssociatedCash Flows
ConsideranEurobondoffacevalue1millionUSDwith maturityin5yearspaying4%attheendofeachyear,itscash owis:
Cash flow (mill. us $) Issuer receives bond price ($1m if issued at par)
Time (years) 0
BondCharacterisBcs
Issuer'sname,type,countryoforigin. Bondmarket,denominaBon. Collateral(bondsvs.debentures). Couponrate,type,frequency. Yield,Price(issuanceoraVer),RaBng (Moody's,S&P). PricequoBngmethod(cleanvs.dirty). Announcementdate,interestaccrual date,seLlementdate.
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MoneyMarketInstruments
CreditFaciliBes
Creditlinesmadeavailabletocorporateclients,methodsof borrowingtailoredtosuitclientneeds. Amountborrowedisexible(belowsomepresetlimit),but corporaBonpaysasmallcommitmentfeeonunusedporBon offunds. Othermethodsofshorttermcorporateborrowing:
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RepoMarkets
"Repo"isshortforasaleandrepurchaseagreement. Itisausefulwayofremovingcreditriskfromshortterm funding. Onepartysellsasecurity(e.g.agov'tbond)toanother party,withanagreementtobuyitbackinthenearfuture ataslightlyhigherprice. ThedealhasliLlecreditriskbecauseifthereisadefault, thelendersimplykeepsthesecuriBes. BecauseoftheeliminaBonofcreditrisk,theinterestrate chargedisclosetotheriskfreerate.
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RepoMarkets:Terminology
Ifyouborrow$100,andpledgesecuriBeswitha currentmarketpriceof$110,your"haircut"is10%. TheoppositesideofaRepocontractiscalledareverse repo.Inthiscase,youbuyaparBcularsecurity,andsell itbackintheverynearfutureforahigherprice. Overnightrepo:termofoneday Termrepo:Term>1day.
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Example
U.S.GovtTBills
IssuedinweeklyaucBons 3maturiBes:4,13and26weeks PricequoBngconvenBon:%ofpar(in32nds ofapercent). YieldquoBngconvenBon:discountyields basedona360dayyear.
U.S.GovtTBills
Generalformulaforbondpricewithagiven quotedyield:
n P = F 1 y 360
Example
AU.S.govtTBillquotedat5.25%yieldwith 61daysunBlmaturityandafacevalueof 100,000hasthefollowingprice:
61 P = 100,000 1 0.0527 = 99,107 360
EecBveAnnualYield
Theyieldthatwouldbeobtainedoverayearif thereturnobtainedovertheholdingperiod wouldconBnue(andbecompounded)overa wholeyear. Itisthevalueofrsuchthat:
F 365 / n = 1+ r P
CanadianGovtTBills
MaturiBes1,3,6,12months. Usessimpleinterestanda365dayyearfor quoBngyields. QuoBngconvenBonforyieldsisdierent:
P= F n 1 + y 365
Example
ACanadiangovtTBillquotedat5.25%yield with61daysunBlmaturityandafacevalueof 100,000hasthefollowingprice:
P= 100,000 61 1 + 0.0527 360 = 99,127
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Bonds
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USAgencyBonds
FederalNaBonalMortgageAssociaBon(FannieMae) FederalHomeLoanBankSystem FederalHomeLoanMortgageCorporaBon(Freddie Mac) FarmCreditSystem ResoluBonFundingCorporaBon StudentLoanMarkeBngAssociaBon(SallieMae) TennesseeValleyAuthority Debtisnotnecessarilyguaranteedbythegovernment. Containsacreditpremium.
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PricingQuotaBons
Bondscanbequotedby: Price:
CleanPrice:DirtyPriceAccruedInterest Usuallyquotedintermsof%ofparvalue.
Example
HowmuchwouldyoupayforUSTreasurybonds withtotalnoBonal$1,000,000quotedat9914? Answer: 9914means99+14/32=99.4375. Totalprice=$1,000,000(0.994375)=$994,375.00
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STRIPS
STRIPS(SeparateTradingofRegisteredInterest andPrincipal) SeparaBonoftheinterestandprincipal repaymentofabondthattypicallypayscoupons (i.e.USgovernmentbonds). Canbuyeithertheinterestcomponent(principal strips)ortheprincipalrepayment(couponstrips). Notasliquidascouponbearingbonds.
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CorporateBonds
Typically<20yearsinlength. Corporateborrowerstendtopreferlongerborrowing periods. ShorterbondsareoVenpreferredbyinvestors. LongerbondshavehigherinterestratepricesensiBvity thandootherwiseidenBcalshortertermbonds. Mostcorporatebondshavecall/putfeatureswhich meanthattheymay'expire'beforethematuritydate.
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SinkingFunds
Highcreditqualityborrowersmaynotneedtospecifyhowabondissue willberepaid. Lowerqualityborrowersmaymakeexplicitprovisions. Asinkingfundisaringfencedamountofcashusedtobuybacka proporBonofthebondissueeachyear. Ittendstoreducecreditrisk,becausefundshavebeenputasidefor repaymentofthedebt. Typically,bondsareredeemedbyloLery,andatpar(i.e.facevalue). Sinkingfundalso:
Createsliquidityinsecondarymarket Reducescreditrisk(smallerpaymentatbondmaturity)
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CallProvision
Inmanycorporatebonds,theissuerhastherightto'call'thebond, exchangingthebondforaxedredempBonprice. Frequently,thebondscanbecalledaVeraxedcoolingoperiod(say 510years),onaxedsetofdates. CallSchedule:Givesthecallpriceateachdate(oVenthecallpriceisthe parvalue). Thismightenablethecompanytorenanceatcheaperrates. ItrepresentsanegaBvefeatureforthebondholder.
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OtherEmbeddedOpBons
Putablebonds:investorhastherighttosellback thebondtotheissueratparatspecieddates. ConverBbleBonds:Canbeexchangedforaxed numberofsharesofthebondissuer.
ConversionraBo:numberofsharesthebondcanbe exchangedfor. Conversionprice:FaceValue/ConversionRaBo Representsanadvantagetoinvestorsifratesrise.
FloaBngRateNotes
CouponpaymentsdependonaoaBnginterestrate. FloaBngRateBonds:Indexedtoashorttermreference withmaturitylessthanoneyear. VariableRateBonds(AdjustableRateBonds):Indexed toalongertermreference(e.g.yieldon10yearUS TreasuryBonds). Usually,resetfrequency=couponpaymentfrequency. InverseFloaters:Couponmovesintheopposite direcBonofthereferenceindex.
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LIBOR
LONDON INTER BANK OFFER RATE
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InaBonIndexedBonds
IssuedbygovernmentstypicallytargeBnglow inaBonrates. Usefulfor: HedgesagainstinaBonrates. DiversicaBonofpor}olios(indexlinkedbonds tendtobeweaklycorrelatedwithotherassets suchasstocks,xedcouponbondsandcash). Insurancecompaniesandpensionfundswishing tohedgeinaBonlinkedliabiliBes.
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Yield
Theyield(tomaturity)ofabondistheinterestrate thatwillmakethepresentvalueofthecashows fromthebondequaltoitscurrentprice. Itisdeterminedby:
gov'tyields creditspread liquidity supplyanddemandfactors
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PricingBulletBonds
Onacoupondate:
1 F P = cF + k n (1 + y ) k =1 (1 + y )
P:Price c:couponrate y:yield F:Facevalue n:numberofperiods
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PricingBulletBonds,cont
AlternaBveformula:
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Example
Priceatreasurybondwithfacevalue $1000whichpaysa10%coupon, redempBonin10yearsfromnow,which payssemiannualcoupons.Assumethe interestratewithsemiannual compoundingisequalto5%perannum.
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Example
SoluBon:Couponpaymentsare$50every6 months.Thereare20ofthem.Theinterest rateperperiodis2.5%.
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1 F P = cF + k i n i (1 + y ) k =1 (1 + y )
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Cleanvs.DirtyPrices
Forabondbetweencoupondates,(FacevalueF,perperiodcoupon ratec) y:yield(expressedasaperperiodrate D:#ofdaysbetweencouponpayments d:#ofdayssincelastcouponpayment n:numberofremainingcouponpayments DirtyPrice: n
cF F d PD = (1 + y ) D + k n (1 + y ) (1 + y ) k =1
CleanPrice:
d PC = PD AI = PD cF D
CleanpricequotesareoVenpreferredastheyaremorestable.
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