Fin 320- Structure Of Interest Rates

Front 1

First Fact of Financial Structures

Back 1

1. Stocks are not the most important source of external financing for businesses.

Front 2

Second Fact of Financial Structures

Back 2

2. Issuing marketable debt and equity securities is not the primary away in which businesses finance their operations.

Front 3

Third Fact of Financial Structures

Back 3

3. Indirect finance, which involves the activities of financial intermediaries, is many times more importat than direct finance, in which businesses raise funds directly from lenders in financial markets

Front 4

Fourth Fact of Financial Structures

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4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

Front 5

Fifth Fact of Financial Structures

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5. The financial system is among the most heavily regulated sectors of the economy.

Front 6

Sixth Fact of Financial Structures

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6. Only large, well-established corporations have easy access to securities markets to finance their activities.

Front 7

Seventh Fact of Financial Structures

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7. Collateral is a prevalent feature of debt contracts for both households and businesses.

Front 8

Eighth Fact of Financial Structures

Back 8

Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

Front 9

Lemon's Problem [Adverse Selection]

Back 9

1. If we can't distinguish between "good" and "bad" (lemons) used cars, we are willing to pay only an AVERAGE of good and bad car values.
2. Result: Good cars won't be sold, and the used car market will not function efficiently.

Front 10

Structure of Interest Rates Learning objectives

Back 10

1. Identify the characteristics of debt securities that cause their yields to vary
2. Understand how each characteristic affects the yields of debt securities
3. Estimate the appropriate yield for a debt security
4. Define a credit default swap (CDS), one of the most popular types of credit derivatives
5. Describe the features of a typical CDS
6. Calculate the various cash flows in a CDS
7. List key features of the CDS market
8. Discuss how CDS premium can be used estimate default premium

Front 11

Structure of interest rates.
Why should we care? (4)

Back 11

The yields offered by debt securities vary according to a particular structure.
Some debt securities have higher yields than others.
Investors need to understand why yields vary
Make better investment decisions
Companies and government agencies need to understand why yields vary
Decide how much return (yield) to offer when they sell new debt securities

Front 12

Characteristics of debt securities

Back 12

Debt securities have different yields because they have different characteristics.
In general, securities with unfavorable characteristics will offer higher yields (rewards) to attract investors.

Front 13

What characteristics of debt securities do we consider? (5)

Back 13

1. Credit (default) risk
2. Liquidity
3. Tax status
4. Special provisions
5. Term to maturity

Front 14

What is default?

Back 14

Failure of the debt security issuer to make the promised payments to the holder of the security.

Front 15

Default risk

Back 15

To the investor, default risk is the uncertainty in cash flows arising from the possibility that the issuer fails to make promised payments.
With the exception of the U.S. government, all issuers have default risk.
Some issuers have greater default risk than others.
Default risk is an undesirable characteristic!

Front 16

Other things being equal, securities with a higher degree of default risk have to offer higher yields to be _____.

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Preferred

Front 17

Default risk is especially relevant for longer-term securities.
One popular way of measuring credit risk is to use bond ratings assigned by credit rating agencies.
How are these usually rated?

Back 17

The higher the rating, the lower the perceived credit risk.
Different rating agencies can assign different ratings to the same debt security. Differences are usually small.

Front 18

Credit rating agencies measure default risk of: (3)

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1. Large corporate bond issues
2. Municipal bond issues
3. International sovereign bond issues

Well-known credit rating agencies:
Moody’s
Standard & Poor’s (S&P for short)
Fitch
Duff & Phelps

Front 19

Some financial institutions (e.g., banks) are legally required to invest only in investment-grade securities. What does "investment-grade" mean?

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Baa or better (Moody’s)
BBB or better (S&P)

Front 20

What is a liquid security?

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A security that can be easily converted into cash without a loss in value.

Front 21

Liquidity is a desirable characteristic. Why?

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Investors prefer a security with higher liquidity to a security with lower liquidity.

Front 22

Other things being equal, a security with lower liquidity has to offer a higher yield to be ______.

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Preferred

Front 23

Liquid securities are those with: (2)

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1. Short maturities
2. Active secondary markets

Front 24

What are investors more concerned with, after-tax income or before-tax on earned debt securities?
[Tax status]

Back 24

after-tax income

Front 25

Other things being equal, taxable securities have to offer a higher before-tax yield than tax-exempt securities to be preferred. What does a extra yield depend on?

Back 25

Extra yield depends on investors’ tax rates.

Front 26

After-tax yield Equation

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Yat = Ybt (1 – T)

Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate

Investors retain only a percentage (1 – T) of the before-tax yield once taxes are paid.

Front 27

Special provisions (2)

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1. Call feature
2. Convertibility clause

Front 28

What is a bond with a callable feature called?

Back 28

Callable bond

Front 29

What is a bond with the Convertibility feature called?

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A bond with this feature is a convertible bond.
Gives bondholder the right to convert the bond into a specified number of common stock shares of the issuer.
Perceived as a desirable characteristic.
Other things being equal, investors will accept a lower yield on securities that contain the convertibility feature.

Front 30

Differences in terms to maturity can lead to differences in yields to _____.

Back 30

Maturity

Front 31

What is the term structure of interest rates mean?

Back 31

Relationship between terms to maturity and yields to maturity across bonds

Front 32

Yield curve

Back 32

Graphical depiction of the term structure
3 common shapes: upward sloping (rising), downward sloping (inverted), flat

Front 33

Longer maturity securities have higher yields than shorter maturity securities.

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Upward, concave up Y-axis: Yield X-axis: Maturity

Front 34

Shorter maturity securities have higher yields than longer maturity securities.

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Downward, concave down. Y-axis: Yield X-axis: Maturity

Front 35

All securities have the same yield.

Back 35

Flat line left to right. Y-axis: Yield X-axis: Maturity

Front 36

Please verbally describe the process for estimating a debt security’s yield.

[Estimating a debt security’s yield (1)]

Back 36

Start with the risk-free rate for the bond’s maturity.
This is usually the yield on a Treasury security with the same maturity.
Make adjustments to this risk-free rate to capture various characteristics (“yield spread”).
Control for the effect of maturity by matching the Treasury security’s maturity to that of the debt security.

Front 37

Estimating a debt security’s yield (2)

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Yn = Rf,n + yield spread

= Rf,n + DP + LP + TA + CALLP + COND
Where
Yn = yield of an n-day debt security
Rf,n = yield of an n-day Treasury (risk-free) security
DP = default premium
LP = liquidity premium
TA = adjustment due to the difference in tax status
CALLP = call feature premium
COND = convertibility discount

Front 38

What is a A credit default swap (CDS)?
[Credit default swap: Basics 1]

Back 38

Contract that provides insurance against risk of default by a particular firm (“reference entity”)
Default by reference entity is called a “credit event”
The buyer of the CDS obtains insurance against default.
Also called “protection buyer”
The seller of the CDS sells this insurance.
Also called “protection seller”

Front 39

Specifically, CDS buyer obtains the right to sell a particular bond issued by the company for its par value when a default occurs
The particular bond is the “reference obligation”
CDS’s notional principal is the total par value of the bond that receives protection

[Credit default swap: Basics 2]
[Credit default swap: Basics 2]

Back 39

Specifically, CDS buyer obtains the right to sell a particular bond issued by the company for its par value when a default occurs
The particular bond is the “reference obligation”
CDS’s notional principal is the total par value of the bond that receives protection

Front 40

CDS premium

[Credit default swap: Basics 3]

Back 40

Fee paid periodically (e.g., yearly, quarterly) by CDS buyer to CDS seller for protection
Quoted in basis points per $100 notional amount of reference obligation
Premium is paid by CDS buyer until:
End of CDS’s life (no default) OR
Occurrence of a default
If default occurs, CDS is settled 
(i.e., buyer is paid) by either delivery or cash

Front 41

Physical delivery settlement
[Credit default swap: Basics 4]

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CDS buyer delivers bonds to CDS seller in exchange for par value

Front 42

Cash settlement

[Credit default swap: Basics 4]

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Calculation agent polls bond dealers to determine mid-market price, Q, of the reference obligation some X number of days after the credit event.
Cash paid to CDS buyer from CDS seller is 
= (100 – Q)% of notional principal

Front 43

Trade in over-the-counter markets
Terms are negotiable. What is the maturity range for CDS and principal-notion?
[Credit default swap: Basics 5]

Back 43

CDS maturity range from few months to 10 years or more. Most common maturity is 5 yrs
Notional principal ranges from few millions to a billion dollars, average is between $25-$50 mn

Front 44

Typical CDS buyers

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Banks, investment banks, hedge funds

Front 45

Typical CDS sellers

Back 45

Banks, insurance companies

Front 46

LMN used CDS premium as a direct measure of default component. Why?
[The LMN study (1)]

Back 46

CDS premium is the reward that CDS seller demands for bearing credit risk of bond issuer

Default component is exactly that – the portion of a bond’s yield that represents the reward for bearing credit risk

Front 47

The LMN study (2)

Back 47

Data: CDS premiums for 5-yr contracts and corresponding corporate bond prices for 68 firms
Sample firms vary in credit rating from AAA to BB
Study period: Mar 2001 – Oct 2002

Front 48

Key findings
[The LMN study (3)]

Back 48

1) Default premium accounts for a large fraction of the yield spread across all credit ratings
2) Default premium increases as credit rating decreases (why?)
3) Nondefault component of yield spread is affected by bond liquidity. Liquidity premium is present in yield spread

Front 49

Another CDS problem (2)

Back 49

What is the notional principal of the CDS?
Calculate the premium paid each quarter.
Suppose Shaky Corp defaulted on June 15, 2002. What is the net payment to the CDS buyer if he delivers all his bonds? Assume the number of days between April 23, 2002 and June 15, 2002 is 52 days.

Front 50

Another CDS problem (1)

Back 50

Suppose that on January 23, 2002, a protection buyer wishes to buy 5 years of protection against the default of Shaky Corp’s 7.75% bond maturing April 1, 2007. The buyer owns 10,000 of these bonds, each with a face value of $1,000.
The buyer buys a 5-year CDS with a notional principal equal to the total face value of all his bonds.
The CDS premium is 1.69% per annum with quarterly payments.
The CDS is settled by delivery in the event of a default.
For simplicity, assume a 360-day year with 30-days per month.

Front 51

Structure of Interest Rates Chapter Summary

Back 51

Characteristics that affect interest rates / yields of debt securities are:
Credit (default) risk, liquidity, tax status, special provisions and maturity.
In general, bonds with unfavorable characteristics need to offer higher yields to attract investors.
To estimate the yield on a debt security
Start with the risk-free rate (yield on Treasury security with same maturity)
Make adjustments to risk-free rate to capture various characteristics.
Credit default swap (CDS) is a contract that insures against the default of a bond issuer
CDS buyer pays premium to CDS seller and in exchange gets protection from default. If a default occurs, CDS buyer receives payment from CDS seller
CDS contracts are negotiable and trade in over-the-counter markets
CDS premium provides an estimate of the default premium in yield spread