Bond & Derivative Markets Department of Accounting & Finance

1. Bond & Derivative Markets Department of Accounting & Finance Instructor: S. Spyrou sspyrou@aueb.gr 210-8203169

3. Libor • Libor (London InterBank Offer Rate) • The rate at which the big banks in London borrow each other money • It is used as a base rate for many financial instruments • For example, the fixing of US Dollar Libor is determined by • Bank of America, Bank of Tokyo, Barclays Bank, BNP Paribas, Citibank, Credit Agricole, Credit Suisse, Deutsche Bank, HSBC, JP Morgan Chase, Lloyds Bank, Royal Bank of Scotland, among others

4. Libor • Liborrates are calculated for 10 different currencies → US $, Yen, Euro, SFr, BP Pound, Swedish Krn, Danish Krn, New Zealand $, Australian $, Kanadian $, • For 15 different time periods → overnight, 1 week, 2 weeks, 1 to 12 months • Published daily 11:30 am. (London Time)by Thomson Reuters • Derivative products worth over 350 trillion US$ have prices connected to Libor.

7. BOND MARKETS • The bond market (credit market, or fixed income market) is a market where participants can issue new debt (Primary market) or buy and sell debtsecurities (Secondary market) • The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures. • Size : As of 2009, the size of the worldwide bond market is an estimated $82.2 trillion (outstanding U.S. bond market debt was $31.2 trillion) according to Bank of International Settlements (BIS) • Average daily trading volume in the U.S: $822 billion (mainly between broker-dealers and large institutions, OTC market). • References to the "bond market" usually refer to the government bond market, because of its size, liquidity, relative lack of credit risk and, therefore, sensitivity to interest rates.

8. Capitalization (US $, billion)

9. Capitalization (US $, billion)

11. Bonds • Debt security where the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. • A bond is a formal contract to repay borrowed money with interest at fixed intervals. • Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. • Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders).

12. Bond Markets • Domestic Bond: A company issues a bond in the country of origin (e.g. IBM issues a bond in the USA); the bond is denominated in the home currency, and is subject to the home country regulatory, legal, tax, environment • International Bond: A company issues a bond in another country (e.g. IBM issues a bond in Japan); the bond is denominated in the foreign currency, and is subject to the foreign country regulatory, legal, tax, environment • Eurobond: A company issues and sells a bond to investors in many different countries simultaneously; the issue is organized by a syndication of banks with one bank a the lead manager. The bond is a “bearer bond”, can be denominated in any currency, the market is self-regulated, and the issuing period is fast. The market is wholesale (World Bank, European Investment Bank, UK government, large international banks and organizations) and, usually, for medium-term bonds.

13. Bond Definitions • Par Value, Face Value, Nominal, Principal: the amount that has to be repaid at the end of the life of a bond. • Issue price: the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. • Maturity date: the date on which the issuer has to pay back the holders the nominal amount. • The coupon rate: the interest rate that the issuer pays to the bond holders. Coupon payments are calculated on the Par Value. • CouponFrequency: how often the coupon payments take place (once a year, twice a year, monthly, etc).

14. Bond Definitions • Fixed coupon bonds: they pay a fixed coupon at every coupon payment date (e.g. 10%) • Floating rate coupon bonds: they pay a floating coupon based on some reference rate (e.g. Libor+2%) • Zero coupon bonds: they pay no coupon, but the issue price is very low (e.g. 5-year zero with an issue price of $200 and a Par of $1000) • MortgageBonds: the issuer uses assets (buildings, land, etc) as collateral • Guaranteed Bonds: bonds that are secured by other organisations or firms

15. Bond Definitions • Debentures: Bonds that have no guarantee or collateral and the bond holders are treated as general creditors of the firm, in case of bankruptcy • Subordinated debentures: the bond holders are satisfied AFTER the general creditors of the firm, in case of bankruptcy • Market price: the bond price in the secondary market, which may be at a premium or a discount compared to the nominal price (e.g. with a Par of $100 a bond may trade at $95 (discount) or at $105 (premium)) • Putable Bonds: the bondholder has the right to ask for a payment of the Par value from the issuer at specified prices and specified dates, BEFORE the actual maturity • Callable bonds: the issuer has the right to ask to pay the Par value to the bondholders at specified prices and specified dates, BEFORE the actual maturity

16. Bond Definitions: Example of Callable Bond«Bond with a Par Value of $100 and a coupon rate of 6%,that matures on the 10th of January 2020, and that is callable in every coupon payment date between 2005 and 2015 according to the following schedule:»

17. Bond Definitions • Conversion Feature: the bond holder has the right but not the obligation to convert the bond to stocks at the maturity of the bond according to a pre-specified conversion ratio, instead of receiving the Par Value • Asset-Backed Securities: bonds that are guaranteed by other loans, or personal property • Bonds with a SinkingFundProvision: the issuers retires gradually the bond from the market before maturity Example: Bond with a face value of $100,000,000 Ευρώ, coupon rate 6%, maturity in 15 years, and a sinking fund of 20% between years 11-15. In each of the last 5 years the issuer will retire $20,000,000 Ευρώ (20% of 100,000,000)

19. Price Quotation • In practice traders quote each other the bond market prices as a percentage (%) of their par value • For example, a market price of 95.5 means that the bond trades at 95.5% of its Par value

21. Accrued Interest • Traders also quote the clean (flat) bond prices, i.e. prices without accruedinterest • When clearing takes place, however, accrued interest is estimated and added to the final price • clean price = dirty price - accrued interest • dirty price = clean price + accrued interest

22. Estimation of Accrued Interest • Accrued Interest (AI) is estimated as: AI = C (Ζ/Ν) • Z = Days since last coupon payment to the deal • Ν = Days of interest period • C = Coupon payment

23. Estimation of Accrued InterestExample • You buy a Bond with a coupon rate of 8% and a Par value of 100 Euro, that pays interest semi-annually. • The last coupon payment was 38 days ago (year = 360). • The market price was 98 • How much will you pay at the end of the day? • Ν = 180, C = 4 Euro, Z = 38 • AI = 4 (38/180) = 0,8444 Euro • You will pay 98,8444 Euro

24. Securitization • Securitization is the issue of securities (bonds) that are based on future cash flows from assets (usually loans) that are pulled together • It is basically the sale of existing loans from banks and other organizations • Consider a bank that has 20,000 mortgage loans to customers: the bank can pull together these loans to one portfolio (the “reference portfolio”) and sell it to another company (the “special purpose vehicle”, SPV). • The SPV then issues and sells to investors a bond that is secured (in terms of coupon payments and the repayment of the principal) by the mortgages of the reference portfolio. • Important point: the bank not only receives cash but also transfers the credit risk involved in the loans.

27. Securitization • The originator initially owns the assets engaged in the deal. Usually this firm can raise new capital by (i) loans, (ii) bonds, (iii) stocks. However, stocks dilute the ownership, while loans and bonds may be expensive and subject to interest rate risk. • Consider a bank that “pools”together a large portfolio of loans and then transfers this portfolio to the a Special Purpose Vehicle (SPV), i.e. a tax-exempt company or trust formed for the specific purpose of funding the assets. • When the portfolio is transferred the SPV, the “issuer” issues tradable securities to fund the purchase. • The issuer is "bankruptcy remote," , i.e. if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. • Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.

28. Securitization • Credit rating agencies rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision. • Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee. • The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system. • Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. • Floating rate securities may be backed by both amortizing and non-amortising assets in the floating market. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR).

29. SecuritizationMain Advantages to Issuer • Reduce funding costs: For example, a company with a low credit rating but with highly creditworthy cash flows via securitization is able to borrow at lower rates. • Locking in profits: When future cash flows are securitized, the level of profits has now been locked in for that company. • Transfer risks:via securitization a firm is able to transfer risks to investors that want to bear it • Admissibility: Securitization turns an admissible future surplus flow into an admissible immediate cash asset. • Liquidity: When a future cash flow is securitized, it is available for immediate spending or investment.

30. SecuritizationMain Disadvantages to Issuer • Reduced portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk. • Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees , administration, etc. • Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

31. Securitization • In 2008 there was an estimated outstanding value of $10.24 trillion in the United Statesand $2.25 trillion in Europe. • In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe.

32. Catastrophe bonds (cat bonds) • Insurance firms need to share some of the huge risks they face from major catastrophes, thus, they may (and do) issue bonds that the payment depends on specific physical events. • Consider for instance, an insurance company that issues and sells bonds to investors (through an investment bank or through securitization). • These bonds pay a high coupon rate to investors (Libor + 3 to 20%) and the face value IF a specific catastrophic event DOES NOT occur. • If a specific catastrophic event DOES occur the principal would be forgiven and the insurance company would use this money to pay their claim-holders.

33. Catastrophe bonds (cat bonds) • Investors include hedge funds, catastrophe-oriented funds, and asset managers. • They are often structured as floating ratebonds whose principal is lost if specified trigger conditions are met. The triggers are linked to major natural catastrophes. • Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.

34. Catastrophe bonds (cat bonds) • Consider a hypothetical Insurance firm I that has a large portfolio of insurable risks from earthquakes in Japan. • Firm I could create a Special Purpose Vehicle with an investment bank to issue a 5-year Cat Bond • Investors buying this bond would receive a floating coupon rate, say Libor + 15%. • If an earthquake does not occur within the next 5 years, investors will enjoy a good returns • If an earthquake occurs within the next 5 years, firm I will keep the principal to pay insurance claims

35. Catastrophe bonds (cat bonds) • Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. • A catastrophe bond is rated based on its probability of default due to a qualifying catastrophe triggering loss of principal. • This probability is determined with the use of catastrophe models. • Most catastrophe bonds are rated below investment grade (BB and B category ratings) • The various rating agencies have recently moved toward a view that securities must require multiple events before occurrence of a loss in order to be rated investment grade.

36. Catastrophe bonds (cat bonds) • The idea of securitizing these type of risks developed after Hurricane Andrew in the US and the large insurance claims that prevailed (early 1990s) • Between 1998 and 2001 this market was growing at a rate of 2 billion $ a year; however after 2001 this rate more than doubled. • Since they have very low correlation with economic activity and any other investment asset they are often used by investors looking for portfolio diversification • It is a wholesale market; major players are Mutual Funds, Hedge Funds, professional maney managers, insurance organizations, large pension funds, investment banks (e.g. BNPParibas, GoldmanSachs, LehmanBrothers, SwissRe Capital Markets, etc).

37. Financial crisis in the US (2007) • Low interest rates → ↑ demand for loans to buy houses • Rising house prices • Extremely high lending in the USA & financing engineering • Banks first lend aggressively and then used securitization to transfer credit risk; they used accounting valuation methods such as “mark – to – market” which led to valuation at the (inflated) market prices • Banks created Credit Default Swaps (CDS) which allowed the transfer of risks, on top of securitization • Evaluation of credit and default risks with methodologies such as Value at Risk, VaR, tends to push loans on a parallel direction to the economics cycles

39. Financial crisis in the US (2007) • Massive loans and securitization • Rising house prices thought enough to “secure” the loans • However, consider a bank that gives a loan knowing that the loan will be transferred to an SPV soon • The bank has NO MOTIVE to evaluate prudently the credit risk • Subprime loansor subprime mortgages led to the subprime crisis (mortgages to high risk clients with the house as a collateral)

41. Financial crisis in the US (2007) • ΤIn 2004 Fedstarted to increase the central interest rate a move that affected all rates (in 2007 interest rates stood at 5.25%; from just 1% in 2004) • The US economy stopped growing as fast as before • Unemployment rose • Difficulties to service loans (especially subprimes) • The subprime market rose from 9% of total loans in 2003, to 24% of total loans in 2007 (competition drove banks to provide these loans; they could also transfer these to SPVs). • Banks provided loans with an attractive rate during the first 3 years which turned to a not-so-attractive rate thereafter

42. Financial crisis in the US (2007) • House prices started to correct • Many borrowers could not repay loans • Repossessions • Securitized bonds could not pay investors • Insurance companies received claims • Banks simply did not have enough money to service losses from non-performing loans • In May 2008 Bear Stearns is sold to J.P. Morgan; In Sept 2008 Lehman Brothersdefaults (with assets worth of $700 billions) • Bank stock prices fell • ……………………………(the rest is history)………………………………

44. Credit Default Swap (CDS) • A credit default swap (CDS) is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default. • In the event of default the buyer of the CDS receives money (usually the face value of the loan), and the seller of the CDS receives the defaulted loan (and with it the right to recover the loan at some later time). • Note that anyone can purchase a CDS; a buyer does not need to hold the loan instrument and may have no direct insurable interest in the loan. • The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

46. Credit Default Swap (CDS) • In some cases (not often) the “credit event” may even be the loan restructuring or the downgrade of the credit rating of a company • In case of a “credit event” (e.g. a loan default) the buyer may: • Deliver to the seller the bond and receive the face value of the bond (physical settlement), Or (ii) Receive from the seller the difference between the face value of the bond and the current market price of the bond, which may be very low (cash settlement).

47. Credit Default Swap (CDS) • The price that the buyer pays is referred as a (spread) and is the annual periodic payment to the seller • For example, Investor A buys from Bank B a 3-year CDS contract on the bond of Company C (BONDC). • A owns BONDC of $1,000,000 • Assume that the current CDS spread on BONDC is 0.4% (i.e. 40 basis points; 1 bp = 0.01%) • Thus, A will pay to B $4,000 annually (i.e. 0.4% of $1,000,000) • The payments will continue for 3 years (until the contract matures) or until Company C defaults (in which case A will receive $1,000,000).

48. Credit Default Swap (CDS) • Generally, the level of the spread is considered as an indication of the probability of default; spreads are traded continuously in the market and reflect the changing conditions and market beliefs. • For example, consider BONDC above. • If negative news arrive in the market about company C the spread may rise to, say, 0.8%. • In that case a new buyer of a 3-year CDS on BONDC will be required to pay $8,000 as an insurance. • Of course, Investor A now owns a more valuable contract and he/she may sell it back to the market and receive the difference.

49. Credit Default Swap (CDS) • Note that, historically, only about 0.2% of firms with a credit rating above ΒΒΒ eventually default; thus, in the vast majority of CDS there is never a payment of the face value. • Consider Hedge Fund F that believes that Company X will default. • F buys a 3-year CDS on bonds of X from Bank B at 570 bp (5,7%) for $10,000,000. • If X defaults in one year F will have paid to B $570,000 but will get back $10,000,000. • The Bank will loose $9,430,000 (unless she has hedged this risk) • If X does not default F will have paid $1,710,000 to the Bank • In that case the Bank has a profit of $1,710,000.