International Fixed Income

1. International Fixed Income Topic VB: Emerging Markets-Description

2. Review from last time: Numerical Example • Consider a 5.5% 2-yr semi-annual coupon bond. • Now suppose that this bond has the following characteristics: • guaranteed principal • nonguaranteed interest, with default probability each 6-mth period of P=.15 • First, price the guaranteed part, and then the nonguaranteed component.

3. Recall the Data from Class First, the guaranteed part: Second, the Brady Bond: The way to value this bond is to realize today’s value is the discounted value of all future expected cash flows. These cash flows only occur if there is no default, i.e., if (1-p) occurs.

4. Brady Bond Mathematics Thus, the price of the Brady Bond is 89.72+6.99=96.71

5. What About the Strip Spread? Given the interest rates of 5.54%, 5.45%, 5.47% and 5.5%; solve for the strip spread s. Note that this is one equation and one unknown, but needs to be done on a computer. What is S? S=36.42%!

6. Outline • Emerging Markets • Stylized Facts • Case Study

7. I. 1997 Share of World Economy GDP ($ trillions) Land Area (mm. km) Pops. (billions)

8. Emerging Markets • Only a subset of these emerging market countries offer investable debt securities. • In fixed income, emerging debt markets refer to this subset: (see next page)

10. Types of Debt (1997)

11. Who Holds This Debt? (1996)

12. Debt Volume (1997)

13. 1997 Brady Bond Universe $ vs. non-$ Guarantees Types

14. Types of Risks for $-denominated Bonds • Interest rate risk: pays $ $ risk • Credit risk (recall the strip spread) • Economic fundamentals (e.g., GNP) • Solvency (e.g., meeting debt obligations) • Serviceability (e.g., foreign exchange reserves) • Political considerations • Willingness to pay

15. Bond Price Sensitivity Recall that $-investments in international fixed income had three components: [yield] - [dur x (Dr)] - %DS(Fn/$) There many not be foreign exchange risk now, but sovereign risk implies [yield] - [dur x (Dr$)] - [dursx (DSpd)] Durs represents the duration with respect to a credit spread change.

16. II. Stylized Facts about Emerging Debt Market Returns • Look at JP Morgan Emerging Market Bond Indices (see handout) • Monthly data, 1/1993 - 3/2000 • Estimate • means • volatilities • durations & credit risk duration

17. Emerging Market Debt: Means Annualized

18. Emerging Market Debt: Vol Annualized

19. Emerging Market Debt: Vol Annualized

20. Selective Correlations

21. Conclusions • Emerging markets trade much more like equity returns in terms of returns/risk. Why? • Most of the volatility is due to credit risk, i.e., $ interest rate risk plays only a small role. Why? • Given this, correlations seem to be particularly high. Why?

22. III. Case Study • Did investors foresee the collapse of the Mexican peso in 1994? • Look at short-term debt instruments over 1993-94 time period: • cetes (23% of mkt): peso-denominated • tesobonos (55% of mkt): $-denominated albeit w/ capital controls

23. Mexican Bond Premiums Let T be the Tesobono rate, C be the Cetes rate and r be the US rate. It’s possible to show that, in $ terms,

24. Premiums (91 days)

25. What about the 182-day Cetes and Tesebonos? • Assuming the expectations hypothesis, could we have looked prior to September-November of 1994, and inferred devaluation risk from the longer maturity bonds? • The answer is no - there was no sign of a currency premium on longer versus shorter bonds.

26. Cetes & Currency