Defining, Estimating and Using Credit Term Structures Part 1. Consistent
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A Collateral Theory of Endogenous Debt Maturity
Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. A Collateral Theory of Endogenous Debt Maturity R. Matthew Darst and Ehraz Refayet 2017-057 Please cite this paper as: Darst, R. Matthew, and Ehraz Refayet (2017). \A Collateral Theory of Endogenous Debt Maturity," Finance and Economics Discussion Series 2017-057. Washington: Board of Gov- ernors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2017.057. NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. A Collateral Theory of Endogenous Debt Maturity∗ R. Matthew Darsty Ehraz Refayetz May 16, 2017 Abstract This paper studies optimal debt maturity when firms cannot issue state contingent claims and must back promises with collateral. We establish a trade- off between long-term borrowing costs and short-term rollover costs. Issuing both long- and short-term debt balances financing costs because different debt maturities allow firms to cater risky promises across time to investors most willing to hold risk. Contrary to existing theories predicated on information frictions or liquidity risk, we show that collateral is sufficient to explain the joint issuance of different types of debt: safe “money-like” debt, risky short- and long- term debt. -
Collateralized Debt Obligations – an Overview by Matthieu Royer, PRMIA NY Steering Committee Member Vice President – Portfolio Coordination, CALYON in the Americas
Collateralized Debt Obligations – an overview By Matthieu Royer, PRMIA NY Steering Committee Member Vice President – Portfolio Coordination, CALYON in the Americas What commonly is referred to as “Collateralized debt obligations” or CDOs are securitization of a pool of asset (generally non-mortgage), in other words a securitized interest. The underlying assets (a.k.a. collateral) usually comprise loans or other debt instruments. A CDO may be called a collateralized loan obligation (CLO) or collateralized bond obligation (CBO) if it holds only loans or bonds, respectively. Investors bear the “structured” credit risk of the collateral. Typically, multiple tranches (or notes) of securities are issued by the CDO, offering investors various composite of maturity and credit risk characteristics. Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDO's collateral otherwise underperforms/migrates/early amortize, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. This is referred to as the “Cash Flow Waterfall”. Senior and mezzanine tranches are typically rated by one or more of the rating agencies, with the former receiving ratings equivalent of “A” to “AAA” and the latter receiving ratings of “B” to “BBB”. The ratings reflect both the expected credit quality of the underlying pool of collateral as well as how much protection a given tranch is afforded by tranches that are subordinate to it (i.e. acting as credit enhancement). The sponsoring organization of the CDO establishes a special purpose vehicle to hold collateral and issue securities. -
Treasury Yields and Corporate Bond Yield Spreads
Treasury yields and corp orate b ond yield spreads: An empirical analysis Gregory R. Du ee Federal Reserve Board Mail Stop 91 Washington, DC 20551 202-452-3055 gdu [email protected] First version January 1995 Currentversion May 1996 previously circulated under the title The variation of default risk with Treasury yields Abstract This pap er empirically examines the relation b etween the Treasury term structure and spreads of investment grade corp orate b ond yields over Treasuries. I nd that noncallable b ond yield spreads fall when the level of the Treasury term structure rises. The extentof this decline dep ends on the initial credit quality of the b ond; the decline is small for Aaa- rated b onds and large for Baa-rated b onds. The role of the business cycle in generating this pattern is explored, as is the link b etween yield spreads and default risk. I also argue that yield spreads based on commonly-used b ond yield indexes are contaminated in two imp ortant ways. The rst is that they are \refreshed" indexes, which hold credit ratings constantover time; the second is that they usually are constructed with b oth callable and noncallable b onds. The impact of b oth of these problems is examined. JEL Classi cation: G13 I thank Fischer Black, Ken Singleton and seminar participants at the Federal Reserve Board's Conference on Risk Measurement and Systemic Risk for helpful comments. Nidal Abu-Saba provided valuable research assistance. All errors are myown. The analysis and conclusions of this pap er are those of the author and do not indicate concurrence by other memb ers of the research sta , by the Board of Governors, or by the Federal Reserve Banks. -
Guarantee and Embedded Options
Guarantee and embedded options Gary Finkelstein, Emma McWilliam, Paul de Beus, Rob van Leijenhorst, Steve Nagle Lotte Maas, Jiajia Cui Contact address: Contact address: Ernst & Young Life Actuarial Practice Ernst & Young Actuaries Rolls Buildings Euclideslaan 1 Fetter Lane 3584 BL Utrecht EC4A 1NH P.O. Box 3053 London 3502 GB Utrecht UNITED KINGDOM THE NETHERLANDS Tel: +44-20-7951-0176 Tel.: +31 –30-259-2224 Fax: +44-20-7951-8010 Fax: +31 –30-259-2118 email: [email protected] Email: [email protected] This Version: 27 June, 2003 Abstract Recent economic events, the changing attitude of regulators, and a possible global change in reporting to shareholders have put the options and guarantees included in today’s insurance products at the top of the list of management’s concerns. Indeed, many senior insurance executives around the world have indicated that they regard the identification, pricing, management, and valuation of guarantees and options embedded in insurance contracts as the most important and difficult financial challenge they face. On too many occasions over the years, insurance company executives have been surprised by the financial costs of embedded guarantees and options that were not properly understood. An understanding of options and guarantees has become essential to the sound financial management of insurance companies. This paper provides an introduction to the valuation of guarantees and options embedded in life insurance products. It explains the link between investment guarantees and embedded options, and consequently their measurement on a market-value basis. It also explores the implications of guarantees and options for asset and liability valuation, product pricing, and managing balance-sheet volatility. -
LIBOR Transition Faqs ‘Big Bang’ CCP Switch Over
RED = Final File Size/Bleed Line BLACK = Page Size/Trim Line MAGENTA = Margin/Safe Art Boundary NOT A PRODUCT OF BARCLAYS RESEARCH LIBOR Transition FAQs ‘Big bang’ CCP switch over 1. When will CCPs switch their rates for discounting 2. €STR Switch Over to new risk-free rates (RFRs)? What is the ‘big bang’ 2a. What are the mechanics for the cash adjustment switch over? exchange? Why is this necessary? As part of global industry efforts around benchmark reform, Each CCP will perform a valuation using EONIA and then run most systemic Central Clearing Counterparties (CCPs) are the same valuation by switching to €STR. The switch to €STR expected to switch Price Aligned Interest (PAI) and discounting discounting will lead to a change in the net present value of EUR on all cleared EUR-denominated products to €STR in July 2020, denominated trades across all CCPs. As a result, a mandatory and for USD-denominated derivatives to SOFR in October 2020. cash compensation mechanism will be used by the CCPs to 1a. €STR switch over: weekend of 25/26 July 2020 counter this change in value so that individual participants will experience almost no ‘net’ changes, implemented through a one As the momentum of benchmark interest rate reform continues off payment. This requirement is due to the fact portfolios are in Europe, while EURIBOR has no clear end date, the publishing switching from EONIA to €STR flat (no spread), however there of EONIA will be discontinued from 3 January 2022. Its is a fixed spread between EONIA and €STR (i.e. -
Chapter 06 - Bonds and Other Securities Section 6.2 - Bonds Bond - an Interest Bearing Security That Promises to Pay a Stated Amount of Money at Some Future Date(S)
Chapter 06 - Bonds and Other Securities Section 6.2 - Bonds Bond - an interest bearing security that promises to pay a stated amount of money at some future date(s). maturity date - date of promised final payment term - time between issue (beginning of bond) and maturity date callable bond - may be redeemed early at the discretion of the borrower putable bond - may be redeemed early at the discretion of the lender redemption date - date at which bond is completely paid off - it may be prior to or equal to the maturity date 6-1 Bond Types: Coupon bonds - borrower makes periodic payments (coupons) to lender until redemption at which time an additional redemption payment is also made - no periodic payments, redemption payment includes original loan principal plus all accumulated interest Convertible bonds - at a future date and under certain specified conditions the bond can be converted into common stock Other Securities: Preferred Stock - provides a fixed rate of return for an investment in the company. It provides ownership rather that indebtedness, but with restricted ownership privileges. It usually has no maturity date, but may be callable. The periodic payments are called dividends. Ranks below bonds but above common stock in security. Preferred stock is bought and sold at market price. 6-2 Common Stock - an ownership security without a fixed rate of return on the investment. Common stock dividends are paid only after interest has been paid on all indebtedness and on preferred stock. The dividend rate changes and is set by the Board of Directors. Common stock holders have true ownership and have voting rights for the Board of Directors, etc. -
3. VALUATION of BONDS and STOCK Investors Corporation
3. VALUATION OF BONDS AND STOCK Objectives: After reading this chapter, you should be able to: 1. Understand the role of stocks and bonds in the financial markets. 2. Calculate value of a bond and a share of stock using proper formulas. 3.1 Acquisition of Capital Corporations, big and small, need capital to do their business. The investors provide the capital to a corporation. A company may need a new factory to manufacture its products, or an airline a few more planes to expand into new territory. The firm acquires the money needed to build the factory or to buy the new planes from investors. The investors, of course, want a return on their investment. Therefore, we may visualize the relationship between the corporation and the investors as follows: Capital Investors Corporation Return on investment Fig. 3.1: The relationship between the investors and a corporation. Capital comes in two forms: debt capital and equity capital. To raise debt capital the companies sell bonds to the public, and to raise equity capital the corporation sells the stock of the company. Both stock and bonds are financial instruments and they have a certain intrinsic value. Instead of selling directly to the public, a corporation usually sells its stock and bonds through an intermediary. An investment bank acts as an agent between the corporation and the public. Also known as underwriters, they raise the capital for a firm and charge a fee for their services. The underwriters may sell $100 million worth of bonds to the public, but deliver only $95 million to the issuing corporation. -
Understanding the Z-Spread Moorad Choudhry*
Learning Curve September 2005 Understanding the Z-Spread Moorad Choudhry* © YieldCurve.com 2005 A key measure of relative value of a corporate bond is its swap spread. This is the basis point spread over the interest-rate swap curve, and is a measure of the credit risk of the bond. In its simplest form, the swap spread can be measured as the difference between the yield-to-maturity of the bond and the interest rate given by a straight-line interpolation of the swap curve. In practice traders use the asset-swap spread and the Z- spread as the main measures of relative value. The government bond spread is also considered. We consider the two main spread measures in this paper. Asset-swap spread An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating-coupon will be a spread over Libor (see Choudhry et al 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk.1 Asset swaps may be transacted at par or at the bond’s market price, usually par. This means that the asset swap value is made up of the difference between the bond’s market price and par, as well as the difference between the bond coupon and the swap fixed rate. -
Bond Liquidity and Dealer Inventories: Insights from US and European Regulatory Data
52 Financial Conduct Authority Occasional Paper Securities and Exchange Commission DERA Working Paper February 2020 Bond liquidity and dealer inventories: Insights from US and European regulatory data Plamen Ivanov, Alexei Orlov and Michael Schihl Occasional Paper 52 / DERA Working Paper Bond liquidity and dealer inventories Occasional Paper 52 / DERA Working Paper Abstract Most corporate bond research on liquidity and dealer inventories is based on the USD- denominated bonds transactions in the US reported to TRACE. Some of these bonds, however, are also traded in Europe, and those trades are not subject to the TRACE reporting require- ments. Leveraging our access to both TRACE and ZEN, the UK's trade reporting system which is not publicly available, we find an overlap of about 30,000 bonds that are traded both in the US and in Europe. This paper examines how using the CUSIP-level information from TRACE and ZEN affects the computation of bond liquidity metrics, dealer inventories, and the relationship between the two. We find that in the combined dataset, the weekly volume traded and number of trades are significantly higher than in TRACE: e.g., the average unconditional number of trades in investment-grade (high-yield) bonds is 17% (20%) higher and the average uncondi- tional volume traded is 15% (17%) higher when we incorporate the information from ZEN. We find a strong positive relationship between inventories and liquidity, as proxied by the trading activity metrics (i.e., number of trades, zero trading days, or par value traded) in TRACE data, and this result carries over to the combined dataset. -
Convertible Bond Investing Brochure (PDF)
Convertible bond investing Invesco’s Convertible Securities Strategy 1 Introduction to convertible bonds A primer Convertible securities provide investors the opportunity to participate in the upside of stock markets while also offering potential downside protection. Because convertibles possess both stock- and bond-like attributes, they may be particularly useful in minimizing risk in a portfolio. The following is an introduction to convertibles, how they exhibit characteristics of both stocks and bonds, and where convertibles may fit in a diversified portfolio. Reasons for investing in convertibles Through their combination of stock and bond characteristics, convertibles may offer the following potential advantages over traditional stock and bond instruments: • Yield advantage over stocks • More exposure to market gains than market losses • Historically attractive risk-adjusted returns • Better risk-return profile • Lower interest rate risk Introduction to convertibles A convertible bond is a corporate bond that has the added feature of being convertible into a fixed number of shares of common stock. As a hybrid security, convertibles have the potential to offer equity-like returns due to their stock component with potentially less volatility due to their bond-like features. Convertibles are also higher in the capital structure than common stock, which means that companies must fulfill their obligations to convertible bondholders before stockholders. It is important to note that convertibles are subject to interest rate and credit risks that are applicable to traditional bonds. Simplified convertible structure Bond Call option Convertible Source: BofA Merrill Lynch Convertible Research. The bond feature of these securities comes from their stated interest rate and claim to principal. -
Bonds and Their Valuation
Chapter 7 Bonds and Their Valuation Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk 7‐1 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is a bond? • A long‐term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. 7‐2 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Bond Markets • Primarily traded in the over‐the‐counter (OTC) market. • Most bonds are owned by and traded among large financial institutions. • The Wall Street Journal reports key developments in the Treasury, corporate, and municipal markets. Online edition lists trading for each day the most actively‐traded investment‐grade, high‐yield, and convertible bonds. 7‐3 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Key Features of a Bond • Par value: face amount of the bond, which is paid at maturity (assume $1,000). • Coupon interest rate: stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest. • Maturity date: years until the bond must be repaid. • Issue date: when the bond was issued. • Yield to maturity: rate of return earned on a bond held until maturity (also called the “promised yield”). 7‐4 © 2012 Cengage Learning. -
Bond Valuation Reading
Bond valuation A reading prepared by Pamela Peterson Drake ___________________________________________________________ O U T L I N E 1. Valuation of long-term debt securities 2. Issues 3. Summary ___________________________________________________________ 1. Valuation of long-term debt securities Debt securities are obligations to repay an amount borrowed, along with some compensation for the time value of money and risk. The borrowers may be corporations, the government, or governmental agencies. The lenders may be corporations, governments, pension funds, mutual funds, or individual investors. Long-term debt securities, such as notes and bonds, are promises by the borrower to repay the principal amount. Notes and bonds may also require the borrower to pay interest periodically, typically semi- annually or annually, and generally stated as a percentage of the face value of the bond or note. We refer to the interest payments as coupon payments or coupons and the percentage rate as the coupon rate. If these coupons are a constant amount, paid at regular intervals, we refer to the security paying them as having a straight coupon. A debt security that does not have a promise to pay interest we refer to as a zero-coupon note or bond. The value of a debt security today is the present value of the promised future cash flows -- the interest and the maturity value.1 Therefore, the present value of a debt is the sum of the present value of the interest payments and the present value of the maturity value: Present value of a bond = present value of interest payments + present value of maturity value To calculate the value of a debt security, we discount the future cash flows -- the interest and maturity value -- at some rate that reflects both the time value of money and the uncertainty of receiving these future cash flows.