Financial Markets and institutions exam 2

An investor initially purchased securities at a price of $9,913,314, with an agreement to sell them back at a price of $10,000,000 at the end of a 90-day period. What is the repo rate?

((1000000-9913314)/9913314) * 360/90

An investor purchases 120-day commercial paper with a par value of $300,000 for a price of $289,000. What is the annualized commercial paper yield?

((Par value - price)/ price) * 360/days

nYou pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its annualized yield (BEY)?

((maturity price- current price)/current price) * 365/days

If the repo rate is 5½%, then the total interest paid is...

(5½%)(1/360)$25 million = $3819.44.

Commercial banks affect on the money market

-Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk ¨Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default ¨Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuer's financial condition is limited -Measuring risk ¨Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates

Types of CD's

-Domestic CDs are issued within a country by a domestic bank or other depository institution. -Foreign CDs are issued within a country by a domestic branch of a foreign depository institution. For example, a Yankee CD is a CD issued in the United States by a foreign bank. -Euro CDs are issued outside a country but are denominated in that country's currency.

Duration

-Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. -A good measure of interest rate risk that takes into account both of these factors simultaneously is DURATION -Duration measures the period of time required to recover the initial investment on a bond. Longer the duration the more sensitive it is to interest rate movements -is a measure of bond price volatility that considers both the coupon rate and the term to maturity. All else equal: ¨Higher coupon rates-- shorter duration - receive more of cf earlier in form of higher coupon payments. ¨Longer maturity-- longer duration - cf are received later in time

Institutional uses of the money market

-Financial institutions purchase money market securities to earn a return and maintain adequate liquidity -Institutions issue money market securities when experiencing a temporary shortage of cash -Money market securities enhance liquidity: ¨Newly-issued securities generate cash ¨Institutions that previously purchased securities will generate cash upon liquidation ¨Most institutions hold either securities that have very active secondary markets or securities with short-term maturities

Creating a banker acceptance

-Importer initiates purchase from foreign exporter, payable in future. -Importer needs financing; exporter needs assurance of payment in future. -Importer's bank writes irrevocable letter of credit for exporter ¨Specifies purchase order. Authorizes exporter to draw time draft on bank

Valuation of Money Market Securities

-Indicators of future money market security prices ¨Economic growth is monitored since it signals changes in short-term interest rates and the required return from investing in money market securities nEmployment nGDP nRetail sales nIndustrial production nConsumer confidence Indicators of inflation

Why are interbank rates important?

-Interbank rates are important because they affect the cost of loans in the wider economy, for both businesses and individuals. Rates have been high during the financial crisis as banks have hoarded cash and worried that other lenders might collapse and not pay them back. -Though the interbank lending rates have fallen from previous highs in the wake of large interest rate cuts around the world and central bank liquidity provisions, all three rates remain above the levels markets think benchmark interest rates will be in three months

Characteristics of money market instruments

-Low default risk. -Short maturity. High marketability

What is a Repo 105?

-Repo 105 transactions, repurchase agreements in which Lehman lent out mortgage securities for a short period of time in exchange for cash minus 5 percent of their value plus interest

What are the benefits of issuing debt

-Tax advantage -2. Discipline - may be a conflict of interest between managers and stockholders in that managers will not max shareholder wealth without a prod (debt).

Money markets

-The Money Markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations, FIs and governments -Only High-Quality Entities can borrow in the Money Markets and individual issues are large -Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon -- Provide liquidity to investors -The Money Markets essentially serve to allocate the nation's supply of liquid funds among major short-term lenders and borrowers

TED spread

-The TED spread measures the difference between the yield on the 3-month Treasury Bill (T-bill) and the value of the eurodollar futures contract—which is based on the 3-month LIBOR rate. Or tp put it another way, the TED spread is the difference between the interest rate on short-term US government debt and the interest rate on interbank loans Used as an indicator of credit risk

Run on Repo

-The increase in haircuts means that there is a shortage of collateral. n -There is an excess demand for U.S. Treasuries because of the flight to quality generally. n -After Lehman Brothers failure, the haircuts continued to increase and some assets became unacceptable in repo. -The interbank market was paralyzed

Economic role of Money Markets

-The money market is a market for liquidity ¨Liquidity is stored in MM by investing in MM securities. ¨Liquidity is bought in MM by issuing securities (borrowing). -Provides a place for Fed's reserve transactions (open market operations) Indicator of economic condition In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits. Banks also have an information advantage on the credit-worthiness of participants

What role did repos play in financial crisis?

-The severity of the financial crisis was not caused by homeowners borrowing too much money. It was caused by giant financial institutions borrowing too much money, much of it from each other on the repurchase (repo) market. This matters, because we can't prevent the next crisis by fixing mortgages. We have to fix repos

Types of repos

-Triparty repos go thru a custody bank -Biparty repos - two parties deal directly with each other -Term Repo is a RP that is not overnight. -Open Repo is a RP that has no maturity. It is typically an overnight repo that is automatically rolled over into another overnight repo until one of the parties closes. -Dollar repos is a RP that permits the borrower to repurchase with securities similar, but not identical to the securities initially sold.

SOFR

-Whereas the past scandal involving major banks' manipulation of Libor laid bare a central problem with the rate — that it is based on only a small number of actual transactions — SOFR is based on overnight reverse repurchase agreements that offer a deep and liquid market with far more transactions to use as a base.

What are covered bonds?

A covered bond is a bond that offers double layer protection to investors by using the collateral of a defaulting company to makeup payment shortfalls on the covered bond. Payments are made on time and are not accelerated assuming there is enough collateral in the cover pool.

2. Why securitize catastrophe risk? Are there other alternatives?

A lot of insurers are often strongly geographically concentrated which offers reinsurers the possibility of diversification through CAT bonds by reinsuring primaries on a global basis. Since reinsurers have gained this benefit, they have stretched the industry across multiple countries.

1. Has SOFR performed well thru the covid crisis?

According to John Williams who is the president of the New York branch of the Federal Reserve, the SOFR program has been doing well in place of LIBOR. He later stated that ""his bank "publishes a number of overnight secured and unsecured funding rates, and during this tumultuous period, they all moved in concert, anchored by the rates set by the Federal Reserve."".

1 What are catastrophe bonds? Describe how they work? How do they relate to the process of securitization?

CATS are a standardized way of bringing insurance risk into the markets. The bond is sold to an investor and the money is then put into a risk free asset to earn returns, which when combined with an insurance companies premium, allow the bond to pay a substantial spread compared to money market returns. They relate to the process of securitization because the insurance has no security to be sold until the catastrophe bond is introduced.

1. Why do companies have revolving credit facilities? How do they use them?

Companies have revolving credit facilities because it allows them to obtain short term money to cover their needs. These facilities are a part of a broader funding toolkit which can include things such as bonds and commercial paper. These companies use it by drawing down the line of credit to have cash on the balance sheet when it is needed most. They use the cash for outstanding credit obligations.

1. Why would a company potentially seek funding by way of its revolving credit facilities as opposed to the bond market?

Companies may seek funding through revolving credit facilities because sometimes the bond markets close during times of financial panic which is why it can be easier for companies to get money in times of stress.

Bankers acceptances

Guarantees from a bank stating that a firm has ordered goods and a payment will be made at the receipt of the goods, which the firm sells at a discount immediately to generate cash -Time draft - order to pay in future. -Drafts are drawn on and/or accepted by commercial bank. -Direct liability of bank. -Mostly relate to international trade. -Secondary market - dealer market. -Discounted in market to reflect yield. -Standard maturities of 30, 60, or 90 days -max of 180 ¨Indicate that a bank accepts responsibility for a future payments ¨Are commonly used for international trade transactions -An unknown importer's bank may serve as the guarantor -Exporters frequently sell an acceptance before the payment date ¨Have a return equal to the difference between the discounted price paid and the amount to be received in the future ¨Have an active secondary market facilitated by dealers.

Why do investors like covered bonds? What makes them Secure?

Investors like covered bonds because it takes away some of the risk. They are able to buy high yielding bonds with lower risk because the bonds are covered by collateral. Investors may also like them because it means that banks are taking on risk as well, unlike mortgage backed securities. What makes them secure is the cash pool that is promised to investors in case the person defaults on their mortgage.

Why are investors interested in CATS? What are some of the "triggers" used to issue a payment in the event of loss?

Investors may be interested in CATS because interest rates are stable even when interest rates are low on traditional bonds. Institutional investors may also be interested in this type of bond to help diversify a portfolio to help prevent economic and market risks Triggers include: Indemnity- insurers own losses Parametric- Earthquake magnitude, hurricane damage PCS- Estimates of industrywide losses paid after a catastrophe occurs Modeled losses- Measures of catastrophes intensity are input into a model to estimate the impact of that loss on the industry.

1. What does LIBOR stand for? What is SOFR? Why are they important?

LIBOR stands for London inter- Bank Offered Rate. Libor is the basic lending interest rate that is used between the banks of London. It can also be used to set the interest rate on other loans. SOFR stands for the Secured Overnight Financing Rate and is used as an alternative to LIBOR. SOFR is used by banks to define an interest rate on US dollar denominated loans instead of euros. The federal reserve has wanted to replace LIBOR so the solution they came up with was the SOFR. These two rates are important because it provides a good idea of what rates should be across countries. It also helps determine the financial health of other banks and how much these banks should be trusted.

1. Why would a company potentially prefer to raise money in the bond market as opposed to drawing down on its revolving credit facility?

Many companies prefer to go to the bond market to raise money because they do not want to have to be tested for financial strength every quarter. When they raise money through bonds, they only have to be tested upon maturity.

1. What is happening with nominal and real bond yields?

Nominal yields have been pushed down to extremely low levels. The Treasury is currently at .7%. This makes the real yield on TIPS negative. This is because the treasury has cut yields to nearly zero and it wants inflation to rise above 2% over the next few years. Nominal- inflation= Real Yield.

What are pandemic bonds? Who created them? What problems have they posed in terms of payouts? Risk diversification?

Pandemic bonds were created by the world bank and are a form of insurance for poorer countries incase of another outbreak. They were created after Ebola in 2014 by the world bank. The problem with these bonds are that even with 1.6 million cases and a high growth rate of cases, somehow the countries in need of aid are unable to draw funds from these bonds. The world bank also requires data on the number of cases which can be difficult information for 3rd world countries to reliably receive. Investors have been somewhat disappointed because this is the type of bond that should typically hedge against something like coronavirus but it has not done a great job.

What are some of the risks/perils securitized?

People who are invested in CATS are subject to two types of risk which are insurance risk and credit risk associated with the collateral account. Investors need to be sure that the constraints on the collateral account provide sufficient protection so they can be assured of a return on their principal.

Define the term "securitization". What types of assets are securitized? Any esoteric assets? Who are the payers? How has the ability to package loans into securities changed the mortgage market? What parties and steps are involved in securitizing or otherwise repackaging a mortgage? What is the current state of the securitization market?

Securitization is the creating of a security backed by debt. The debt usually comes from a loan or a line of credit. There are securities backed by mortgages as well as securities backed by credit cards. There are many esoteric assets which is part of the reason the economy collapsed during the financial crisis. The payers are separate entities that that are willing to take on the risk for a better return. This takes the debt off of the issuing companies balance sheet. An issuing company first has to create the debt which can be something like a mortgage. The debt is then sent to a different entity who creates a mortgage backed security in this instance and sells that security to different investors based on their risk tolerance. Bond issuances have been increasing recently because it has become cheaper for companies to issue debt and it is an easy way for them to make money.

1. Explain the trend in corporate bond spreads since March?

Since March, the spread that between corporate bonds and treasuries has dropped by a large margin. Currently the corporate bond spread is below thee 10 year average.

1. What is a TIPS? Explain how do they work?

TIPS stands for Treasury Inflation-Protected Securities and are pegged to the CPI. The price is then adjusted to account for inflation and the treasury pays interest payments on the new face value. The payments will continue to rise as long as inflation continues to rise. At maturity, the investor will receive the original face value of the bond and all of the inflation adjustments since the bond was issued.

Why might the FDIC be against covered bonds?

The FDIC is currently against covered bonds because they believe that the risk is not equal. They claim that investors are guaranteed their money at the expense of the Deposit Insurance Fund.

Is there a difference between a pass-thru and a CMO? Has the ability to securitize loans affected the loan underwriting process? Support your answer.

The difference between a pass through and a CMO is that a CMO provides a higher certainty of cash flow compared to a pass through. The main reason for this is because the structure of a CMO is made up of many different pools of mortgages which redirect the cash flow of principal and interest of the mortgage. The ability to securitize loans has affected the underwriting process especially after the financial crisis. Underwriting became much looser before 2008 because companies believed they could pool together loans to diversify them so it didn't matter if everyone paid on time, they believed that overall they would make money from the people who did pay it back. Laws have since become more strict.

steps of securitization process

The entity that originally holds the assets (the originator) initiates the process by selling the assets to a legal entity, an SPV (Special Purpose Vehicle), specially created to limit the risk of the final investor vis-à-vis the issuer of the assets. An SPV is also referred to as a "conduit." Then, depending on the situation, the SPV either issues the securities directly or resells the pool of assets to a "trust" that, in turn, issues the securities(the trust is actually used for several securitization transactions and therefore oversees several SPVs). An SPV is more of a legal framework than an element that plays an active part in the transaction. The most important role is played by the arranger, typically a bank, who sets up the transaction and evaluates the pool of assets,the way in which it will be fed, the characteristics of the securities to be issued, and the potential structuring of the fund. The object of the structuring is to model the characteristics of the securities such that they correspond to the needs of the final investor. Instead of simply paying the final investor the revenue generated by the assets, the amortization rules for the security are defined in advance. Some ABSs are able to be "topped up," meaning that the pool of assets can be refed during the life of the security. This makes it possible to refinance short-term debts (such as credit-card debt) with long-term bonds. Finally, the arranger plays an important role in distributing the securities to the final investors (distribution). Quite often, the securities are not issued on an exchange, but are distributed over-the-counter to a small number of investors. The trio of actors comprising the "originator, SPV,and arranger" constitutes the "Originate-to-Distribute" model, which has thrived over the course of the past few years. An important distinction must be made between "traditional" securitization, where the assets are actually sold to the SPV ("true sale"), and what is known as "synthetic" securitization, where the originator retains ownership of the assets and transfers only the risk to the SPV, via a credit derivative. This transaction brings no liquidity to the assignor, but enables himto externalize the risk associated with holding the securitized assets.

How did the Fed deal with/avoid the freeze in securitization markets during the financial /covid crisis?

The fed has tried to avoid the freeze in both the 2008 financial crisis and the current COVID epidemic by using the tools they have available to help boost consumer confidence. In 2008 the Fed provided short term loans to companies that needed them. They believed if large financial companies went under, it would largely decrease consumer confidence and make everything worse than it was. Currently the fed is cutting interest rates and engaging in open market operations to help keep the economy afloat and increase confidence in the marketplace. So far, they have done a good job of this but they are running out of tools and things may soon change.

How does securitization benefit each of the parties involved in the process (i.e. the mortgage borrower and lender, the investment bank securitizing or packaging the loan, and the investors who buy the packaged security)?

The issuer of the original debt benefits because when they sell the debt to an investment bank, the debt is taken off of their balance sheet. The person who originally assumed the debt is now able to use money to purchase whatever they need, and the investment bank can sell the now securitized debt to investors who are willing to take in risk.

1. What has happened to bond issuance? What impact have low rates had on equities? Explan

The number of bond issuances by companies has spiked recently because it has become cheaper for companies to issue them. Low rates have also caused stocks to rise and have stayed high since the end of march. This may be because low yields have pulled down the discount rate.

Discounting

When an investor pays less for a security than it will be worth when it matures

What is a "haircut"

haircut is most commonly used when referencing the percentage difference between an asset's market value and the amount that can be used as collateral for a loan. There is a difference between these values because market prices change over time, which the lender needs to accommodate for. For example, if a person needs a $10,000 loan and wants to use their $10,000 stock portfolio as collateral, the bank is likely to recognize the $10,000 portfolio as worth only $5,000 in collateral. The $5,000 or 50% reduction in the asset's value, for collateral purposes, is called the haircut.

Cost advantages of money markets

money markets are not as regulated as banks, reserve requirements make banks more costly, and regulation on the amount of interest banks could pay to depositors

Risks of money market securities

nBecause of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk ¨Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default ¨Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuer's financial condition is limited -Measuring risk ¨Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates

What types of companies should issue debt

nFirms operating in industries with volatile earnings and cash flows have ____leverage.... ¨Mattel ¨Regulated utility nIf an external agency provides protection against bankruptcy then the firm has ____ leverage nAssets of firm are not easily divisible and sold --- Direct costs of bankruptcy - level of debt...(leverage) is _____ ¨Firm with extensive real estate holdings vs firm that derives value from brand name (e.g., Coke) n Indirect costs of bankruptcy -- Firms that produce products that require long term servicing and support have ____leverage

What LIBOR

nLIBOR (previously BBA LIBOR) is a benchmark rate, which some of the world's leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank OfferedRate and serves as the first step to calculating interest rates on various loans throughout the world nThe LIBOR serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. nThe official LIBOR interest rates are announced once per working day at around 11:45 a.m. In the past, the BBA/ICE published LIBOR rates for 5 more currencies (Swedish krona, Danish krone, Canadian dollar, Australian dollar and New Zealand dollar) and 8 more maturities (2 weeks, 4, 5, 7, 8, 9, 10 and 11 months). Thus, there are a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate (usually referred to as the "current LIBOR rate").

Important facts

repo market has grown into the largest financial market in the world, surpassing stocks, bonds, and even foreign-exchange. -One important issue is that repo's settle on the trade date, not three days later like most other trades. -The price at which the security will be sold back to the original owner will be higher than the price at which it was sold, with the difference representing the cost of financing (more soon) -The original owner of the security, however, continues to receive the coupon payments on the instrument.

Money market security examples

§Treasury bills (T-bills) §Commercial paper §Negotiable certificates of deposit §Repurchase agreements §Federal funds §Banker's acceptances

Negotiable Certificates of Deposit

¨Are issued by large commercial banks and other depository institutions as a short-term source of funds ¨Have a minimum denomination of $100,000 - normal is @1 million ¨Are often purchased by nonfinancial corporations ¨Are sometimes purchased by money market funds ¨Have a typical maturity between two weeks and one year ¨Have a secondary market -NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety -Premiums are generally higher during recessionary periods -NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price -If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate

What is a T-Bill

¨Are issued by the U.S. Treasury ¨Are sold weekly through an auction ¨Sold on discount basis. ¨Maturities up to one year. ¨Minimum denomination is usually $10,000, but smaller investors can invest in multiples of $1,000 through the Treasury Direct Program offered by the Fed. ¨Are attractive to investors because they are backed by the federal government and are free of default risk ¨Are liquid ¨Can be sold in the secondary market through government security dealers -Treasury bills are priced on a bank discount rate basis, a traditional yield calculation -You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate

nFactors that affect the risk-free rate

¨Inflationary expectations ¨Economic growth ¨Money supply ¨Budget deficit

what is commercial paper? What are the two major types

¨Is a short-term debt instrument issued by well-known, creditworthy firms ¨Is typically unsecured ¨Is issued to provide liquidity to finance a firm's investment in inventory and accounts receivable ¨Is an alternative to short-term bank loans ¨Has a minimum denomination of $100,000 ¨Has a typical maturity between 20 and 270 days ¨Is issued by financial institutions such as finance companies and bank holding companies ¨Has no active secondary market ¨Is typically not purchased directly by individual investors -The yield on commercial paper is slightly higher than on a T-bill -The nominal return is the difference between the price paid and the par value TWO MAJOR TYPES -Direct paper is issued mainly by large finance companies and bank holding companies directly to the investor. -Dealer paper, or industrial paper, is issued by security dealers on behalf of their corporate customers (mainly nonfinancial companies and smaller financial companies).

What is a Repo?

¨One party sells securities to another with an agreement to repurchase them at a specified date and price nEssentially a loan backed by securities ¨A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them ¨Bank, S&Ls, and money market funds often participate in repos ¨Transactions amounts are usually for $10 million or more ¨Common maturities are from 1 day to 15 days and for one, three, and six months ¨There is no secondary market for repos ¨Collateral may be "rehypothecated".- The same securities are being lended out for shorter and shorter periods. The securities are bad because they are backed by bad mortgages. ¨Repo collateral: securitized products. ¨A government securities dealer buys $25 million worth of the 6¾ T-notes of 8/15/2005 to hold overnight. -Where does the dealer get the funds to finance his position? ¨The dealer could use his own funds, borrow from a bank, etc... ¨But the repo market is typically the cheapest source of financing. So, let's assume the dealer uses the T-notes as collateral and enters into a repo -The interest rate is called the repo rate. A REPO IS A COLLATERALIZED LOAN

Fed Funds rate

¨The federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate -The rate is influenced by the supply and demand for funds in the federal funds market -The Fed adjusts the amount of funds in depository institutions to influence the rate -All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions -The fed funds rate is typically slightly higher than the T-bill rate ¨Two depository institutions communicate directly through a communications network or through a federal funds broker ¨The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institution's reserve account by the amount of the loan ¨Commercial banks are the most active participants in the federal funds market ¨Most loan transactions are or $5 million or more and usually have one- to seven-day maturities