Bonds

BARYAL KHAN

(Pakistan) (00923013791119)

Brief Overview
1. Bonds, 2. Management issues and Risks for a bank 3. A T account for a bank, its reserve requirement and its capital 4. Securitisation, 5. Asset backed securities 6. Credit Default Swaps and Collateralised Debt Obligations
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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
Germany 4.25% 7th April 2014 Annual payment Final payment Price 103.2 Yield of 3.62%
(See Bloomberg)

Is this a fair price?

PV and FV Risk free investment annual interest rate If r = 4% p.a. 1 1.04
t

PV(1.04) = 1 @ r = 4%

Valuing a Bond
C1 C2 1,000 CN PV ... 1 2 N (1 r) (1 r) (1 r)
Price of a bond is the sum of the discounted future cash flows.

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

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

What effects bond prices?

1. 2. 3. 4. Interest rates Coupon and Maturity Credit ratings, (Moodys, S&P etc.) Economic Environment Flight to quality?

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Management issues and Risks for a bank

Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Liquidity Risk Interest-rate Risk
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A T account for a bank and its reserve requirement : Ample Excess Reserves
Bank A before deposit outflow
Assets Reserves Loans Securities Liabilities $20M Deposits $80M Bank Capital $10M $100M $10M

Bank A after deposit outflow

Assets Reserves Loans Securities Liabilities $10M Deposits $80M Bank Capital $10M $90M $10M

Excess reserves Deposit outflow does not necessitate change in balance sheet
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Liquidity Management: Shortfall in Reserves

Bank B before deposit outflow Assets Reserves Loans Securities Liabilities $10M Deposits $90M Bank Capital $10M $100M $10M Bank B after deposit outflow Assets Reserves Loans Securities Liabilities $0 Deposits $90M Bank Capital $10M $90M $10M

Reserves = legal requirement Shortfall must be eliminated Excess reserves = insurance against costs associated with deposit outflows
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What does a bank do if it has a liquidity problem, that is a short fall in reserves? 1. 2. 3. 4. Borrow Securities Sale Borrow from the CB Reduce loans

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Capital Adequacy Management: Preventing Bank Failure When Assets Decline

Bank A High Bank Capital Assets Reserves Loans Liabilities $10M Deposits $90M Bank Capital $90M Reserves $10M Loans Bank B Low Bank Capital Assets Liabilities $10M Deposits $90M Bank Capital $96M $4M

Bank A High Bank Capital Assets Reserves Loans Liabilities $10M Deposits $85M Bank Capital $90M Reserves $5M Loans

Bank B Low Bank Capital Assets Liabilities $10M Deposits $85M Bank Capital $96M -$1M

Bank Capital = assets minus liabilities, acts as a cushion against insolvency

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Asset Management: Four Tools

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

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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

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Real Assets Versus Financial Assets

Real Assets Assets used to produce goods and services

Financial Assets Claims on real assets

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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.
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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 ABSs Have become a popular alternative to investing in corporate debt.

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Figure 1.2 Asset-backed Securities Outstanding

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An example: Collateralised Debt Obligations

CDOs = 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

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Collateralised Debt Obligations

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

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Growth of Subprime Mortgages

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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.

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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!!
1. 2. Example: AIG, US$ 441 billion exposure, (see The Economist) Lehmans, collapse of bank will trigger about US$400 billion of protection payouts, (see FT)
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CDOs
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
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Summary
1. Bonds, 2. Management issues and Risks for a bank 3. A T account for a bank, its reserve requirement and its capital 4. Securitisation, 5. Asset backed securities 6. Credit Default Swaps and Collateralised Debt Obligations
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Final Comment :
Back in 2006 Warren Buffett called derivatives

Weapons of mass financial destruction...

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Suggested reading
1. 2. 3. 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=hptextfeatu re&story_id=12274112 accessed 10th Oct. 2008 The Financial Times, 2008 Oct. 9th, page 40,Rising CDS action increases the strain
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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/

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