bonds

Bonds : 

1 Bonds BARYAL KHAN (Pakistan) (00923013791119)

Brief Overview : 

2 Brief Overview Bonds, Management issues and Risks for a bank A T account for a bank, its reserve requirement and its capital Securitisation, Asset backed securities Credit Default Swaps and Collateralised Debt Obligations

What is a Bond : 

3 What is a Bond A contractual obligation by a borrower (a company or Government) to repay an investor the principal amount borrowed and to pay interest periodically at some defined rate agreed at the outset. Key Features Maturity Coupon Principal

Example : 

4 Example Germany 4.25% 7th April 2014 Annual payment Final payment Price 103.2 Yield of 3.62% (See Bloomberg)

Is this a fair price? : 

5 Is this a fair price? PV and FV Risk free investment… annual interest rate If r = 4% p.a. 1 → 1.04 PV(1.04) = 1 @ r = 4%

Valuing a Bond : 

6 Valuing a Bond Price of a bond is the sum of the discounted future cash flows.

Valuing a Bond : 

7 Valuing a Bond What is the discount rate = market determined, affected by perceived risk As discount rates ↑ the price ↓ Inverse relationship between price and yield

Valuing a Bond : 

8 Valuing a Bond Clearly higher rates lead to a fall in price Also note: Bond price → par as bond → maturity.

Interest Rates : 

9 Interest Rates Sensitivity of bond prices to interest rate changes? Longer dated bonds - more sensitive Lower coupon bonds - more sensitive

What effects bond prices? : 

10 What effects bond prices? Interest rates Coupon and Maturity Credit ratings, (Moodys, S&P etc.) Economic Environment Flight to quality?

Management issues and Risks for a bank : 

11 Management issues and Risks for a bank Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Liquidity Risk Interest-rate Risk

A T account for a bank and its reserve requirement : Ample Excess Reserves : 

12 A T account for a bank and its reserve requirement : Ample Excess Reserves Excess reserves Deposit outflow does not necessitate change in balance sheet

Liquidity Management: Shortfall in Reserves : 

13 Liquidity Management: Shortfall in Reserves Reserves = legal requirement Shortfall must be eliminated Excess reserves = insurance against costs associated with deposit outflows

What does a bank do if it has a liquidity problem, that is a short fall in reserves? : 

14 What does a bank do if it has a liquidity problem, that is a short fall in reserves? Borrow Securities Sale Borrow from the CB Reduce loans

Capital Adequacy Management: Preventing Bank Failure When Assets Decline : 

15 Capital Adequacy Management: Preventing Bank Failure When Assets Decline Bank Capital = assets minus liabilities, acts as a cushion against insolvency

Asset Management: Four Tools : 

16 Asset Management: Four Tools Manage default risk Purchase low risk securities Diversify, (?) Trade off: liquidity v maximising return on assets

Financial Innovation and the increase in Off-Balance-Sheet Activities : 

17 Financial Innovation and the increase in Off-Balance-Sheet Activities Loan sales Fee income Trading activities and risk management techniques Futures, options, interest-rate swaps, foreign exchange Speculation

Real Assets Versus Financial Assets : 

18 Real Assets Versus Financial Assets Real Assets Assets used to produce goods and services Financial Assets Claims on real assets

Securitisation : 

19 Securitisation Transform illiquid asset (s) into a security Mortgage → Mortgage pool → Mortgage backed Security (MBS) → Tranches with different credit ratings, (Moodys, S&P etc.) → Sell in Secondary Mortgage Market.

Asset Backed Securities (ABS) : 

20 Asset Backed Securities (ABS) Similar to MBS, a financial security backed by assets. For example: loans, leases, credit card debt, a company's receivables, royalties etc. are all bundled into ABS’s Have become a popular alternative to investing in corporate debt.

Figure 1.2 Asset-backed Securities Outstanding : 

21 Figure 1.2 Asset-backed Securities Outstanding

An example: Collateralised Debt Obligations : 

22 An example: Collateralised Debt Obligations CDO’s = type of ABS, CDOs offer different types of debt and credit risk. These are referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays

Collateralised Debt Obligations : 

23 Collateralised Debt Obligations See: http://www.investopedia.com/articles/07/subprime-blame.asp?viewall=1.

Growth of Subprime Mortgages : 

24 Growth of Subprime Mortgages

What if the counterparty defaults?Credit Default Swaps : 

25 What if the counterparty defaults?Credit Default Swaps Like an insurance policy Buyer receives credit protection, Seller guarantees creditworthiness of underlying Risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Credit Default Swaps : 

26 Credit Default Swaps On default of security, CDS buyer is entitled to the full value of the bond But what happens if the seller of the bond becomes insolvent!! Example: AIG, US$ 441 billion exposure, (see The Economist) Lehmans, collapse of bank will trigger about US$400 billion of protection payouts, (see FT)

CDO’s : 

27 CDO’s Over The Counter (OTC) Unregulated First CDS; Morgan Stanley in 1995 Mid 2007 ≈ US$45 trillion, (according to the International Swaps and Derivatives Association ) That is > twice value of US stock market Sept 2008 ≈ US$62 trillion, (see The Economist) Speculators

Summary : 

28 Summary Bonds, Management issues and Risks for a bank A T account for a bank, its reserve requirement and its capital Securitisation, Asset backed securities Credit Default Swaps and Collateralised Debt Obligations

Final Comment : : 

29 Final Comment : Back in 2006 Warren Buffett called derivatives “Weapons of mass financial destruction...”

Suggested reading : 

30 Suggested reading Bloomberg, 2008, “Government Bonds”[online] at; http://www.bloomberg.com/markets/rates/germany.html, accessed 9th Oct. Brealey, Myers & Allen, “Principles of Corporate Finance” 2007 9th ed. McGraw Hill London, chap 2, 4 and 8 Bodie, Z., Kane, A. & Marcus, A.J., 2008, “Investments “ 8th ed. McGraw Hill London, chap. 1-3 Fabozzi, F.J. & Choudhry, M 2004, “The Handbook of European Structured Financial Products” John Wiley and Sons, 2004, chap2-4 Mishkin, F (2007): “The Economics of Money, Banking and Financial Markets”, 8th Edition, New York: Addison Wesley – Pearson chap 8-11 SEC, 2008, “SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting”; [online] at; http://www.sec.gov/news/press/2008/2008-234.htm, accessed 10th Oct. 2008 The Economist, 2008 Sept 18th, “Derivatives A Nuclear Winter?”[online]at http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12274112 accessed 10th Oct. 2008 The Financial Times, 2008 Oct. 9th, page 40,“Rising CDS action increases the strain”

Useful Web links : 

31 Useful Web links http://www.investopedia.com/ http://www.investinginbonds.com/ http://www.investorguide.com/ http://finance.yahoo.com http://money.cnn.com/markets/bondcenter http://www.federalreserve.gov/ http://www.ft.com/home/europe http://www.forbes.com/ http://invest-faq.com/ http://bigcharts.marketwatch.com / http://www.globalfinancialdata.com/ http://morningstar.com/ http://www.duke.edu/~charvey/Classes/wpg/glossary.htm http://www.ifsra.ie http://www.ustreas.gov/