Chapter 3 Market Structures II - PowerPoint PPT Presentation

Loading...

PPT – Chapter 3 Market Structures II PowerPoint presentation | free to download - id: 240fb2-OWQwZ



Loading


The Adobe Flash plugin is needed to view this content

Get the plugin now

View by Category
About This Presentation
Title:

Chapter 3 Market Structures II

Description:

In their purest form products in each category share some fundamental ... surrounded by members of the euro zone (Andorra, Monaco, San Marino, the Vatican) ... – PowerPoint PPT presentation

Number of Views:95
Avg rating:3.0/5.0
Slides: 100
Provided by: res7
Learn more at: http://www.wiley.com
Category:

less

Write a Comment
User Comments (0)
Transcript and Presenter's Notes

Title: Chapter 3 Market Structures II


1
  • Chapter 3 - Market Structures II

2
This Lecture
This Lecture
  • Financial Market Typology
  • Non-tradadable and non-transferable
    products
  • Securities
  • Derivatives

3
  • In their purest form products in each category
    share some fundamental characteristics that
  • distinguish them from others
  • define a unique set of opportunities and risks

4
In markets for traditionally non-tradable and
non- transferable products compared
to returns risks are too high to be borne by
non-specialists. This holds for both wholesale
and retail markets
5
  • Wholesale markets
  • large amounts traded
  • high flexibility
  • short maturities
  • high standardisation

6
  • Retail markets
  • low standardisation
  • long maturities
  • individual performance matters
  • high information requirements

7
In securities markets techniques and
mechanisms prevail allowing a distribution of
risks among a wider public.
8
In markets for derivatives transactions are
forward looking, allowing an unbundling and
separate trading of risks related to a financial
product, which asks for compensation via a
higher expected return the role of
leverage
9
(No Transcript)
10
Non-tradadables and non-transferables
  • are among the earliest and most common forms of
    financial relations
  • establish individual borrower-lender
    relations
  • unwinding the transaction or ...
  • stepping in for another counter-party is only
    possible at high cost, if at all.

11
Non-tradadables and non-transferables
12
Nontradadables and non-transferables
  • With rising securitisation the importance of
    traditional money and credit or loan markets
    decreased in recent years.
  • Two main reasons
  • steady shift to off-balance-sheet instruments
    in reaction to capital rules for
    internationally operating banks
  • growing number of high-quality customers
    issuing commercial paper and certificates of
    deposits.
  • Advantages?

13
Nontradadables and non-transferables
  • Issuing short-term securities instead of
    borrowing from banks
  • allows to diversify borrowing
  • to reduce borrowing costs
  • to reduce borrowers dependence on bank loans
  • to circumvent credit limits

14
Nontradadables and non-transferables
  • In credit or loan markets securitisation is more
    difficult than in short-term markets.
  • These markets are characterised by
  • less transparency
  • higher risks
  • a more diverse clientele.

15
Nontradadables and non-transferables
  • In credit or loan markets
  • individual borrowers are evaluated carefully
  • often, repayment is guaranteed by collateral
  • the role of mortgages

16
Nontradadables and non-transferables
  • Until the emergence of credit derivatives credit
    markets were (and in many ways still are) among
    the
  • least liquid
  • most complicated to price
  • most costly financial markets

17
Nontradadables and non-transferables
In contrast to the money and credit markets, the
importance of the foreign exchange market grew in
recent years. Why?
18
Nontradadables and non-transferables
  • The foreign exchange market is a hybrid. As a
    rule
  • transactions are very large
  • most transactions are very short-term by
    nature
  • it is a money market rather than a credit
    market although very long maturities are
    obtainable
  • it is an interbank or wholesale market rather
    than a retail market although there is a
    remarkable share of customer trading.

19
Nontradadables and non-transferables
In 2002, the euro replaced national currencies in
12 countries
  • Irish punt
  • Portuguese escudo
  • Finnish markka
  • Austrian schilling
  • Greek drachma
  • Belgian/Luxembourg franc
  • French franc
  • German mark
  • Italian lira
  • Dutch guilder
  • Spanish peseta

20
Nontradadables and non-transferables
  • The use of the euro is not limited to the 12 EU
    member states. Euro territories include
  • territories outside Europe French overseas
    departments, the Portuguese Azores, Madeira and
    the Spanish Canary Islands
  • third countries surrounded by members of the
    euro zone (Andorra, Monaco, San Marino, the
    Vatican)
  • other areas that have the euro as official
    means of payments examples Montenegro,
    Kosovo

21
Nontradadables and non-transferables
  • In addition, some 30 countries have exchange rate
    regimes involving the euro in one way or the
    other
  • countries whose currency is pegged to the euro
    such as Denmark (participating in the Exchange
    Rate Mechanism of the EMS), Cyprus, Macedonia
  • countries with euro(formerly D-mark)-based
    currency boards (Bosnia-Herzegovina, Bulgaria,
    Estonia)
  • countries whose currency is pegged to a basket
    of currencies including the euro or one of the
    currencies it replaced (examples Hungary,
    Iceland, CFA zone)
  • countries having adopted a system of managed
    floating using the euro informally as a
    reference currency (Czech Republic, Slovakia,
    Slovenia).

22
Nontradadables and non-transferables
  • The hybrid nature of the foreign exchange market
    has its roots in history
  • in the beginning demand and supply in the
    market was largely determined by foreign trade
  • cross-border capital flows were long
    restricted
  • it was only when currencies became convertible
    for both trade and financial transactions and
    capital flows were liberalised that cross-border
    portfolio investments and professional
    foreign-exchange dealing, which dominate the
    market today, began to become more important
  • one explanation for the growth of the foreign
    exchange market in recent years is investors
    re- orientation they increasingly regard forex
    as an asset class

23
Nontradadables and non-transferables
In international financial markets the euro has
become a serious rival to the US dollar. In some
eastern European countries such as the Czech
Republic and Hungary it captures a dominant
market share. One reason why in the
following table it is still outweighed by the
US dollar in other countries such as Poland
and Russia is the fact that in the past these
countries had a high debt denominated in
dollar.
24
As two currencies are involved in each
transaction, the sum in individual currencies is
twice the total reported turnover. Source Bank
for International Settlements Triennial Central
Bank Survey Foreign Exchange and Derivatives
Market Activity in 2001, Basle, March 2001, Annex
Table E.4.
25
Nontradadables and non-transferables
Since the introduction of the European System of
Central Banks (ESCB) there has been a common
monetary policy and a common money market in
Europe, consisting of three market segments
26
Nontradadables and non-transferables
Money Market Segments in the Euro Area
Unsecured deposits
Repos
Swaps
27
Nontradadables and non-transferables
Unsecured deposit market banks exchange
short-term liquidity without collateral Repo
market banks exchange short-term liquidity
offering collateral Swap market participants
exchange fixed for floating interest rate
payments
28
Securities
  • In securities markets, techniques and mechanisms
    prevail allowing a distribution of risks among a
    wider public
  • assets and liabilities are traded
  • anonymity is the rule
  • ownership may change frequently
  • publication and listing requirements secure
    that the information investors need for
    decision making is provided

29
Securities
  • Trading takes place over the counter (OTC) or on
    organised exchanges. The latter have two
    important functions
  • as a ready market for securities, they ensure
    their liquidity and thus encourage people to
    channel savings into corporate investment
  • as a pricing mechanism, they allocate capital
    among firms with prices assumed to reflect the
    true investment value of a company's stock
    (i.e. the present worth of the stream of
    expected income per share).

30
Securities

Primary markets new securities are issued for
cash Secondary markets existing securities
are sold by one investor to another
31
Securities

Fixed-income markets claims on some nominal
amount of debt are traded Equity markets the
provider of the money becomes one of the owners
of the firm
32
Securities fixed-income markets
33
Securities fixed-income markets
  • Treasury bills
  • short-term securities issued by governments
  • throughout the euro area unevenly distributed
    supply four significant and relatively mature
    markets in Belgium, France, Italy and Spain
  • in Germany (whose securities play a benchmark
    role in other market segments) outstanding
    volumes and issuance of Bubills remain
    comparatively small


34
Securities fixed-income markets
  • CDs and CP
  • often tailor-made to meet investors needs
  • before the arrival of the euro rarely used
  • only by very large internationally operating
    European firms
  • often replacing bank loans in some countries
    banks are the main buyers of CP


35
Securities fixed-income markets
  • CDs and CP
  • In recent years, there has been a changing trend
    in issuing activities. The main reasons are
  • the influence of the euro on firms financial
    environment
  • the rise in mergers and acquisitions partly
    financed by CP issuance
  • the attractiveness of the euro market which
    has encouraged non-residents to participate
  • the overall tendency towards securitisation and
    a rising preference for collateralised
    lending


36
Securities fixed-income markets
  • Bonds
  • With the introduction of the euro, the second
    largest market worldwide for long- and
    medium-term bonds emerged in the region.
  • although declining gradually in almost all
    European countries government bonds are the
    most important segment
  • only large firms with high ratings issue
    corporate bonds
  • compared to the US market there is still a
    considerable growth potential


37
Securities fixed-income markets
38
Securities fixed-income markets
  • Bonds
  • compared to short-term debt risks are high
  • in particular the risk of default
  • in order to assess these risks bonds are rated
    by investment advisory firms or rating
    agencies


39
Securities fixed-income markets
  • Bonds
  • The biggest rating agencies worldwide are
  • Moodys Investors Service
  • Standard Poors Corporation
  • Fitch


40
Securities fixed-income markets
Bonds Ratings range from investment-grade
rating to junk bonds. Firms that have sunk
from investment-grade to junk are also called
fallen angels. Becoming a fallen angel
strongly affects a firms refinancing cost
In particular institutional investors follow
asset-allocation rules that prevent them from
buying bonds below investment grade.

41
Securities fixed-income markets
  • Bonds
  • serve many purposes in national and
    international markets
  • Investors hold them because of their low risk
    profile and long maturities.
  • Government bonds are widely used as hedging
    instruments, in the expectation that their
    development may compensate for losses in other
    markets.
  • Investment funds often take short positions on
    some types of bonds betting that their price will
    fall and, at the same time, take long positions
    on other securities whose prices should rise.
  • Macro funds which base investments on expected
    changes in global economies instead of focusing
    on individual firms and industries, speculate in
    currency, equity and bond movements.
  • Developments in bond markets also affect
    mortgage funds as the amount of income owners of
    mortgage securities receive changes with
    fluctuations in bond yields.
  • In addition, there are managed futures funds,
    which use statistical models to track market
    trends their performance also depends on bond
    market developments.


42
Securities fixed-income markets
  • Bonds
  • Government bonds usually serve as benchmarks
  • Advantages of benchmark status
  • reduced borrowing cost
  • markets for benchmark securities are
    characterised by
  • low risks, high efficiency and high liquidity


43
Securities fixed-income markets
  • Bonds
  • Government debt is special
  • considered as essentially risk free
  • trading is facilitated by the often large
    amount of debt outstanding
  • large borrowing needs and long life enable
    governments to offer a wide range of maturities
  • in advanced economies well-developed repo and
    derivatives markets exist for government
    securities allowing participants to take short
    and long positions reflecting their
    expectations of future interest rate movements


44
Securities fixed-income markets
  • Bonds
  • Securities with benchmark status provide some
    positive externalities. They
  • serve as orientation for pricing and quoting
    yields on other securities
  • serve as hedging instruments
  • are the most common form of collateral in
    financial markets
  • are regarded as safe havens by investors
    during periods of financial turmoil
  • their infrastructure (legal and regulatory
    framework, trade execution arrangements,
    clearing and settlement systems) enhances the
    development of non-government markets


45
Securities fixed-income markets
  • Bonds
  • For longer maturities, there is a private repo
    market bridging the gap between the money and
    the bond markets
  • longer-term liquidity is provided in exchange
    for securities
  • market participants are banks, corporations
    and institutional investors


46
Securities fixed-income markets
  • Convertible bonds
  • have a bond structure, but offer the option of
    being converted into equity if share prices
    reach a certain level. Convertibles allow
    companies
  • to raise money by issuing equity without
    tapping the stock market directly (which might
    upset existing shareholders)
  • to reduce their interest payments on debt
  • Major investors in convertibles are
    international hedge funds


47
Securities fixed-income markets
Hedge funds buy the convertibles and sell the
debt component, keeping the call option. They
then sell the company's shares short they do
not own the securities they sell, but plan to buy
them at a later stage giving it a hedge against
movements in the share price. As the share price
moves up and down, the fund adjusts its short
position, a tactic known as delta hedging. The
hedge fund makes money if the shares turn out to
be more volatile than was assumed by the issuer
of the convertible
48
Securities fixed-income markets
  • Convertible bonds
  • a special form which has become increasingly
    popular is known as quasi-commercial paper
  • This comes with a put option allowing
    investors to force companies to repurchase the
    bonds at their original price at a fixed future
    date.
  • Disadvantage When issuers' prospects worsen
    and share prices fall, the likelihood of
    conversion of debt into equity declines and
    bondholders become less willing to keep the
    bonds. This means additional strains in a
    situation where a company's need for cash is
    growing and sources are drying up.


49
Securities fixed-income markets
  • Asset-backed securities (ABS)
  • a way to raise funds from the bond market by
  • securitising "receivables",
  • claims of seller firms that arise from the sale
    of goods and services and present future
    streams of payments.
  • Examples
  • credit card revenues
  • residential mortgages
  • loans made to customers
  • barrels of maturing whisky


50
Securities fixed-income markets
  • Asset-backed securities (ABS)
  • Securitisation takes place by
  • transfering the assets into a special purpose
    vehicle (SPV) which is separate from the
    original owner of the assets
  • the SPV guarantees that coupons will be paid
    and the capital investment returned
  • the credit quality of the bond issue depends
    on the SPV, not on the financial strength of the
    underlying issuer
  • the SPV is supposed to be bankruptcy remote
    because it is separate from the companys
    operating business


51
Securities fixed-income markets
Asset-backed securities (ABS) To
demonstrate the principle

assets
Originator
SPV
cash flows
cash flows
rating agencies
The quality of the assets can be enhanced by
insurance which guarantees cash flows. This would
allow rating agencies to apply a higher rating.
securities
Investors
insurer
52
Securities fixed-income markets
  • Asset-backed securities (ABS)
  • Advantages
  • otherwise illiquid assets are made liquid
  • ABS transactions are highly rated and often
    assigned a Triple A rating
  • they offer investors an additional level of
    security from owning a bond backed by assets
    and
  • higher interest payments than on similarly
    rated bonds ...
  • thereby broadening the pool of potential
    investors


53
Securities fixed-income markets
  • Asset-backed securities (ABS)
  • were one of the most dynamic markets in the US
    for almost 30 years.
  • However, critics point at recent downgrades, in
    particular of collateralised debt obligations
    (CDOs) backed by bonds, loans or derivatives
    with poor performance.


54
Securities fixed-income markets
  • Asset-backed securities (ABS)
  • Other worries concerned
  • securities backed by franchise loans
  • aircraft leases
  • mutual fund fees
  • healthcare receivables
  • and securities backed by complex or unusual
    assets in general.


55
Securities fixed-income markets
Asset-backed securities (ABS) In
Europe, their success so far has been
limited. Exception the Pfandbrief market

56
Securities fixed-income markets
  • Asset-backed securities (ABS) Pfandbriefe
  • bonds backed by mortgages or local government
    loans
  • usually issued by state-controlled savings
    banks and mortgage institutions
  • highly rated, combining low levels of risk with
    high returns
  • in bond market statistics counted as part of
    the corporate bond sector
  • originating in Germany from where it spread to
    other European countries
  • there is a Jumbo Pfandbrief with a minimum
    issuance volume of 500 million


57
Securities fixed-income markets
Asset-backed securities (ABS)
Pfandbriefe End of 2000, the Pfandbrief market
had become the largest bond market in Europe
exceeding the total amount of sovereign debt
outstanding of France, Germany and Italy
combined.

58
Securities equity markets
In equity markets the provider of the money
becomes one of the owners of the
firm. There are different forms of
ownership

59
Securities equity markets
60
Securities equity markets
Private equity Venture capital
firms financial intermediaries that pool their
partners resources, using the funds to help
entrepreneurs start up new businesses
61
Securities equity markets
Private equity Leveraged buyouts Leveraged
geared up refers to the relationship between
the companys own funds and borrowed
money the purchase of a company is financed
with a small proportion of share capital and a
large proportion (80 or more) of
debt. Consequence Interest charges absorb
most of the debt and pressures are considerable
to dispose of parts of the businesses to raise
cash, thereby reducing borrowings, as quickly as
possible.
62
Securities equity markets
Private equity In Europe the concept of
private equitiy is only slowly gaining ground.
The main sources of private equity funds are
pension funds, insurance companies and banks,
mostly from the US.
63
Securities equity markets
  • Organised exchanges
  • There is a long tradition of international or
    cross-border equity investing in Europe.
  • Investor advantages
  • expected value gains resulting from
    inefficient or segmented markets in foreign
    countries
  • diversification in order to reduce risk for a
    given level of returns (or increase returns for
    a given level of risk)

64
Securities equity markets
  • Organised exchanges
  • Competition between major stock exchanges is
    fierce to attract foreign listings in order to
    increase trading volumes and business
    opportunities to exploit scale economies.
  • Companies motives for listing on more than one
    exchange
  • securing cheap capital for new investment
  • preparing for foreign acquisitions
  • enhancing their reputation

65
Securities
66
Securities
  • A hybrid subordinated debt
  • In a company's capital structure subordinated
    debt ranks between shareholder funds and senior
    debt, that is, for interest and repayment it
    comes after all other borrowings of the
    company.
  • Advantages
  • Rating agencies and regulators treat it as
    shares rather than debt, thus supporting the
    firms capital base
  • For investors it promises higher returns than
    senior debt of comparable credit quality.
  • Disadvantage
  • For issuers it is a more expensive source of
    funding than senior debt.

67
Derivatives
Derivatives differ from both credit and from
capital market instruments, in that they are
financial contracts whose value is closely
related to, and largely determined by, the value
of a related instrument. This can be a
security, but also a currency, an index, a
commodity or any other item the contracting
parties agree upon. There are three broad
categories
68
Derivatives
69
Derivatives
  • Common to all derivatives is that they
  • are forward-looking transactions tied to an
    underlying instrument or as, for example, in
    the case of stock index futures to a bundle
    of instruments
  • allow an unbundling of price risks
  • allow investors to exploit the effects of
    leverage

70
Derivatives

Traditionally, forward contracts are traded over
the counter. Since the early 1970s, there have
also been organised futures exchanges. The first
was the International Money Market of the Chicago
Mercantile Exchange (CME), established in 1972.
In Europe, the leading ones are the London
International Financial Futures Exchange (LIFFE)
and Eurex.
71
Derivatives
  • Futures
  • are standardised exchange-traded forward
    contracts with comparatively few fixed amounts
    and maturities.
  • Futures exist for a wide variety of financial
    and non- financial products. Examples are
  • currencies
  • stock market indices
  • pork bellies
  • oil platforms
  • weather conditions ...
  • Both forwards and futures have advantages and
    disadvantages

72
Derivatives
73
Derivatives

A swap is an exchange of two financial
instruments for a specific period and a reversal
of that exchange at the end of the
period. Example In the foreign exchange
market it may consist either of a combination of
a spot and a forward leg or of two forward trades
with differing maturities In a yen/dollar
foreign exchange swap a dealer may buy the yen
for delivery in two days at an agreed spot rate,
simultaneously selling it back for delivery in a
week, a month, or three months.
74
Derivatives

Swaps may be used to exploit comparative
advantages that individual participants have in
different markets. Example a Spanish firm
facing a higher interest cost for borrowing in
the US dollar market than a German firm, while
the German firm may only receive less favourable
conditions than the Spanish one in the euro
market. In this case, it may pay for both of them
to borrow in the currency in which they face the
lower cost and then simply exchange currencies
for the period of the contracts Opportunities
like the one descibed may arise in segmented
markets
75
Derivatives
  • Swaps
  • Explanations for segmented markets
  • inefficiency
  • lack of transparency
  • saturation
  • Investors tend to hold a portfolio of assets
    from a broad range of borrowers, setting limits
    to the share for individual ones. An issuer who
    has not saturated the market in this sense may
    enjoy better conditions than another.

76
Derivatives

Swaps may be used for hedging purposes.
Again, the foreign exchange market may serve
as an example
77
Derivatives
Figure 3.6 Hedging with a Foreign Exchange Swap
78
Derivatives

Options are contracts sold for a premium that
give the buyer the right, but not the
obligation, to buy (in case of a call option) or
sell (in case of a put option) a financial asset
in the future at a specified price. In
contrast to other financial instruments, options
are so- called contingent claims based on the
insurance principle with an asymmetry in the
related risks. The worst that can happen to
the buyer of a call option is that the premium
is lost if the option is not exercised. In
contrast, for the seller who has the obligation
to deliver if the option is exercised, in
principle, the risk is unlimited if the
underlying asset must be bought in the market.

79
Derivatives

Options Option trading has inherent
uncertainties that distinguish it from other
derivatives markets resulting from the way in
which options are valued
80
Derivatives
  • Options
  • Standard approaches in one form or another rely
    on a formula developed by Black, Merton and
    Scholes in the early 1970s.
  • According to this formula the value of a stock
    option, for example, depends on
  • the share price today
  • its volatility
  • a risk-free interest rate
  • time to maturity
  • the strike price at which the option is
    exercised and
  • the probability that it will be exercised as
    described by a normal distribution function.

81
Derivatives

Options In principle, all components of the
formula can be observed except
volatility. Difficulties result from the fact
that, as a rule, financial time series have a
non-constant variance the standard measure of
volatility. Daily, monthly and yearly data,
and data for different time periods, give a
different picture of volatility.
82
Derivatives
  • Options
  • One solution is to calculate "implied
    volatilities" derived from observed options
    prices of other market participants.
  • Disadvantages
  • Implied volatilities do not always exist
  • and if they do they may include price
    components, such as transaction costs or risk
    premiums, that are hard to judge.
  • Another problem is that for implied
    volatilities there is a phenomenon known as the
    "volatility smile

83
Derivatives
Options that are far in or out of the money
with the exercise price highly above or below the
asset's value have much higher implied
volatilities
84
Derivatives
  • The late 1990s saw a dramatic rise in the volume
    of two kinds of derivatives in European markets
  • interest rate swaps and
  • credit derivatives

85
Derivatives

Interest rate swaps are contracts that allow
parties to exchange streams of interest
payments. The pricing of swaps is typically
based on the London-InterBank Offered Rate,
LIBOR and for euro-denominated instruments on
the EURIBOR.
86
Derivatives
  • Interest rate swaps
  • Explanations of market rise
  • the introduction of the euro and the resulting
    process of integration and standardisation.
  • Interest rate swaps increased by more than 60
    percent during the first year after the
    introduction of the euro.
  • the rising interest of market participants in
    off- balance-sheet instruments.
  • Swaps spare capital in not consuming large
    amounts of credit limits and, as a consequence,
    are increasingly replacing deposits as a source
    of funding and as a means of establishing hedge
    positions in fixed-income instruments.
  • deficiencies of traditional hedge instruments.

87
Derivatives

Interest rate swaps Swaps are increasingly
used as benchmarks Occasional squeezes in
German government bond futures contracts and
other events demonstrated that the features
accounting for the uniqueness of government
bonds quality and liquidity may cause their
prices and those of other credit products to
move out of sync, during periods of financial
turmoil in particular. This reinforced the
search for new hedging vehicles and made market
participants increasingly turn to derivative
products to construct yield curves one obvious
solution was interest rate swaps.
88
Derivatives

Interest rate swaps as benchmarks In principle,
an interest rate swap is a contractual agreement
between two counter parties to exchange a fixed
rate instrument for a floating rate instrument.
No principal amount changes hands. Instead,
basically, a series of payments is calculated
by applying a fixed interest rate to a
notional principal amount, and another stream
of payments using a floating rate of interest,
and then both are exchanged.
89
Derivatives
  • Interest rate swaps as benchmarks
  • Advantages
  • credit risk in contrast to benchmark
    government debt which usually has a triple-A
    credit rating banks in the LIBOR contributor
    panels are mostly rated double A.
  • This can be an advantage swap rates tend to
    move more closely with prices of other credit
    products, including during periods of financial
    turmoil.
  • absence of an underlying asset there are no
    limits to entering into swap contracts.
  • As a consequence, reverse price movements due to
    supply and demand imbalances are rare.

90
Derivatives
  • Interest rate swaps as benchmarks
  • Disadvantages
  • liquidity Debt issued by the government of an
    industrial country is still one of the most
    liquid instruments.
  • As a consequence, transaction costs for hedging
    with government securities are often lower than
    those associated with other hedges, in
    particular over shorter periods where the risk
    of widening spreads between government and
    non- government securities (credit spread risk)
    is low.
  • credit risk the counter party in a swap
    transaction may default at the end of the
    agreement.

91
Derivatives

Credit derivatives are the other instrument of
growing importance in Europe. The most common
form is the credit default swap. A credit
default swap is a contract which enables one
party to buy protection against the risk of
default of an asset paying a fee or premium for
the cover, until a credit event occurs or if
this does not happen until maturity.
92
Derivatives
  • Credit derivatives
  • A credit event can be
  • bankruptcy
  • failure to pay interest or debt
  • restructuring of obligations
  • In practice, documentation of these instruments
    and of what counts as credit events is still
    fraught with uncertainties.

93
Derivatives
  • Credit derivatives
  • One of the fastest-growing markets is the one
    for collateralised debt obligations (CDO), a
    form of ABS which come in two variants
  • traditional "cash flow" CDOs are securities
    backed by pools of debt such as high-yield
    corporate bonds and loans. They are still the
    dominant variety in the US.
  • In Europe, synthetic CDOs dominate, with London
    as the market leader.

94
Derivatives

Credit derivatives traditional CDOs As a
rule, a special-purpose entity (SPE) is set up,
which issues securities to investors, using the
money to establish a portfolio of assets. The
returns these assets generate are passed through
to the investors. The securities are broken
up into different tranches representing
different levels of risk and reward. As a
broad range of assets of different quality are
required for diversification purposes, the top
tranche of a CDO may achieve a triple-A credit
rating even though the individual assets have a
far lower ranking.
95
Derivatives

Credit derivatives synthetic CDOs CDOs using
credit derivatives instead of bonds and loans.
In the simplest form, the SPE issues notes to
investors and sells credit protection on a
notional "reference pool" of assets. The
buyer of the credit protection pays a premium to
the SPE that is passed through to the investors.
96
Derivatives
  • Credit derivatives synthetic CDOs
  • One explanation for London's worldwide dominance
    in this area is that, compared to the US, in
    Europe the market for bonds from which a CDO pool
    can be assembled is much smaller and more
    transparent.
  • Other advantages
  • high degree of flexibility. Instead of being
    sold to a large number of investors, synthetic
    CDOs are increasingly customised for one big
    client such as an insurance company or pension
    fund, who wants exposure to credit markets or to
    hedge its bond portfolio
  • investors' influence over the assets held in
    the portfolios compared to traditional CDOs
    with synthetic CDOs, investors are much more
    involved in the profile of the risks they are
    assuming and the selection of credits in the
    reference portfolios.

97
  • Summary
  • Distinguishing between non-tradable and
    non-transferable products, securities and
    derivatives allows for the unique set of
    opportunities and risks in each of these
    categories.
  • Markets for non-tradables include traditional
    money and credit markets and the foreign
    exchange market.
  • In securities markets, government bonds play a
    special role, serving as benchmarks for other
    debt instruments.
  • While fixed-income markets establish
    borrower-lender relations, in equity markets the
    providers of funds become capital owners.
  • Derivatives are traded over the counter and on
    centralised exchanges with each form having its
    own advantages and disadvantages.
  • Forwards, swaps and options differ with respect
    to market liquidity, flexibility and expected
    risks and returns.
  • In recent years, there has been a dramatic rise
    of interest rate swaps and credit derivatives
    which indicates changing market structures and
    preferences.

98
Key Words
  • Securitisation - the transformation of illiquid
    financial assets into marketable products.
  • Bank for International Settlements - a
    financial international organisation
    headquartered in Basel, Switzerland, which was
    established under the Hague agreements of 1930.
    Initially responsible for the collection,
    administration and distribution of reparations
    from Germany it is today primarily the central
    bank's bank. It provides gold and foreign
    exchange transactions for them and holds central
    bank reserves. In addition, it offers a forum
    of cooperation among member central banks,
    produces research and statistics, and organises
    seminars and workshops focused on international
    financial issues. In offering services to
    committees established and working at the BIS,
    it also functions as an international "think
    tank" for financial issues.
  • Capital rules - determine the amount of its own
    money a bank needs relative to its total assets
    (capital adequacy ratios).
  • Off-balance-sheet instruments - financial
    products traded by banks which affect bank
    profits but are not visible on banks balance
    sheets.
  • Collateral - assets pledged as security for a
    loan.

99
Key Words
  • Mortgage - a long-term loan secured by
    real-estate.
  • Leverage - the relationship between borrowed
    money and equity money. For companies, leverage
    is calculated by dividing long-term debt by
    shareholders equity. For investors, leverage
    means buying on margin or using derivatives such
    as options, to enhance return on value without
    increasing investment.
  • Hedge Funds - private investment funds that take
    highly leveraged speculative positions or
    engage in arbitrage.
  • Investment-grade securities - securities with
    low risk/high ratings.
  • Junk bonds - bonds with low ratings
  • Repos - repurchase agreements, whereby
    securities are sold to the bank under an
    agreement that they be bought back after a
    stipulated time.
  • Collateralised debt obligations (CDOs) -
    asset-backed securities whose underlying
    collateral is typically a portfolio of bonds
    (corporate or sovereign) or bank loans but may
    also include a combination of bonds, loans and
    securitized receivables, asset-backed securities,
    tranches of other collateralized debt
    obligations, or credit derivatives based on any
    of the former.
About PowerShow.com