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Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps

Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps. Chapter 23. © 2003 South-Western/Thomson Learning. Learning Objectives. How asset-backed securities work and why they were created Most common types of asset-backed securities

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Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps

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  1. Asset-Backed Securities, Interest-Rate Agreements, and Currency Swaps Chapter 23 © 2003 South-Western/Thomson Learning

  2. Learning Objectives • How asset-backed securities work and why they were created • Most common types of asset-backed securities • Benefits and risks associated with use of asset-backed securities • How interest-rate swaps, caps, floors, and collars can be used to reduce interest-rate risk • How and why currency swaps are used to manage exchange-rate risk

  3. Anatomy of Securitization • Asset-Backed Securities • Securities that result from process of securitization • Seven main sets of players • Borrowers • Loan originator • Special-purpose trust • Rating agency • Credit enhancer • Underwriter • Investors

  4. Exhibit 23–1 The Anatomy of an Asset-Backed Security Offering Source: Adapted from Leon T. Kendall and Michael Fishman (1996), A Primer on Securitization, The MIT Press, Cambridge, Massachusetts, p.3.

  5. Anatomy of Securitization • Special Purpose Trust • Corporate agent • Buys financial obligations from loan originator • Works with security underwriter, credit enhancer and rating agency to issue asset-backed securities • Sometimes responsible for loan-servicing responsibilities • Due Diligence • Investigative process • Used by lender, investor or investment banker to ensure that borrower’s or security issuer’s financial statements are accurate

  6. Anatomy of Securitization • Credit Enhancer • Insurance company or bank • Guarantees a security issue • Offers a letter of credit in its support, for a fee • Credit-worthiness can also be enhanced by • Establishing a reserve account • Over-collateralization

  7. Anatomy of Securitization • Superior / Subordinated Debt Structures • Framework that allows securities to be sold in at least two different classes or tranches • One is lower rated, higher yielding and higher risk • Other is higher rated, lower yielding and lower risk • Tranche • Particular class or part of securitization issue • Some parts may be backed only by principal payments, others only by interest payments • As result, parts of various offerings also differ in terms • Default risk • Average repayment time • Coupon yield

  8. Securitization Benefits to Borrowers, Issuers, and Investors • Securitization increases the funds available for • Home equity • Auto finance • Credit card • Commercial lending • Student loans • Manufactured housing • Costs of borrowing are lower than through traditional intermediated (indirect) finance

  9. Securitization Benefits to Borrowers, Issuers, and Investors • Two possible disadvantages to borrowers • If potential borrower fails to meet established criteria for loan intended for securitization, possible that lender will • Reject application • Charge the applicant a substantially higher loan fee or interest rate • The profitability of ABSs has made some lenders more aggressive in pursuing loan business

  10. Trends in Common Types of Asset-Backed Securities • Home Equity Loans • Type of mortgage • Allows borrower to use equity of one’s home as backing for a loan or revolving line of credit • Auto Finance • Credit Cards • Commercial Loans • Student Loans • Manufactured Housing • Small Business Loans

  11. Interest-Rate Swaps • Interest-Rate Swaps • Financial instruments • Allow financial institutions to trade their interest payment streams to better match payment inflows and outflows • Derivative Instruments • Financial contracts (forwards, futures, options and swaps) • Whose values are “derived” from the values of other underlying instruments such as • Foreign exchange • Bonds • Equities • Index

  12. Interest-Rate Caps, Floors and Collars • Interest-Rate Cap • Seller of cap agrees, for a fee, to compensate the cap buyer when an interest-rate index exceeds a specified strike rate • Strike Rate • Agreed-upon rate in an interest agreement • Interest-Rate Floor • Seller of cap agrees, for a fee, to compensate cap buyer when an interest-rate index falls below a specified strike rate • Interest-Rate Collars • Created when one simultaneously buys an interest-rate cap and sells an interest-rate floor

  13. Exhibit 23–5 A Simple Interest Rate Cap

  14. Exhibit 23–6 A Simple Interest Rate Floor

  15. Currency Swaps • Currency Swaps • One party agrees to trade periodic payments, over a specified period of time, in a given currency, with another party who agrees to do the same in a different currency

  16. Exhibit 23–7 Structure and Potential Benefits of a Currency Swap

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