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Fixed Income(Bonds)
 Bond
A bond is a debt security, in which the authorized 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.

Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender
(creditor), and the coupon is the interest.

Bonds provide the borrower with external funds to finance long-term investments, or, in
the case of government bonds, to finance current expenditure.

Certificates of deposit (CDs) or commercial paper are considered to be money market

instruments and not bonds.
 Difference b/w Bond and Stock
Primary

Bonds and stocks are both Another difference is that

securities, but the major bonds usually have a defined
difference between the two term, or maturity, after
is that (capital) stockholders which the bond is
have an equity stake in the redeemed, whereas stocks
company (i.e., they are may be outstanding
owners), whereas indefinitely
bondholders have a creditor
stake in the company (i.e.,
they are lenders).

Secondary
 Features of Bonds
Features
• Nominal, principal or face amount — the amount on which the issuer pays interest, and which, most
commonly, has to be repaid at the end of the term.
• 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. The net proceeds that the issuer receives are thus the issue price,
less issuance fees.
• Maturity date — the date on which the issuer has to repay the nominal amount. As long as all payments have
been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time
until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any
length of time, although debt securities with a term of less than one year are generally designated money
market instruments rather than bonds. Most bonds have a term from 1 year to up to 30 years.
• coupon — the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the
life of the bond. It can also vary with a money market index, such as LIBOR.
• coupon dates — the dates on which the issuer pays the coupon to the bond holders. In the U.S. and also in the
U.K. and Europe, most bonds are semi-annual, which means that they pay a coupon every six months.
• Optionality — Occasionally a bond may contain an embedded option; that is, it grants option-like features to
the holder or the issuer:
• Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates.
These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par.
• Putability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity
date on the put dates.
• Convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.
• Exchangeable bond allows for exchange to shares of a corporation other than the issuer.
 Corporate Bond
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its
business.

The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their
issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity  1 – 270 days.)

Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own
currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities do not fit
in either category.
Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs like Bonds.com and
MarketAxess, and the coupon (i.e. interest payment) is usually taxable.

Sometimes this coupon can be zero with a high redemption value.

However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed
markets takes place in decentralized, dealer-based, over-the-counter markets.

Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date
(Callable Bond). Other bonds, known as convertible bonds, allow investors to convert the bond into equity.
 Corporate Bond -Risks
Default Risk: The risk for company to default

Interest Rate Risk: If interest rate decline the issuer may redeemed the bond and issue new bonds at lower
interest rate.

Liquidity Risk: There may not be a continuous secondary market for a bond, thus leaving an investor with
difficulty in selling at, or even near to, a fair price. This particular risk could become more severe in
developing market, where a large amount of junk bonds belong, such as China, Vietnam, Indonesia, etc.

Supply Risk: Heavy issuance of new bonds similar to the one held may depress their prices.

Inflation Risk: Inflation reduces the real value of future fixed cash flows. An anticipation of inflation, or
higher inflation, may depress prices immediately.

Tax Change Risk: Unanticipated changes in taxation may adversely impact the value of a bond to investors
and consequently its immediate market value.
 Treasury Securities
• A United States Treasury security is government debt issued by the United
States Department of the Treasury.

• Treasury securities are the debt financing instruments of the United States
Federal government, and they are often referred to simply as Treasuries.

• There are four types of marketable treasury securities:

– Treasury bills,
– Treasury notes,
– Treasury bonds, and
– Treasury Inflation Protected Securities (TIPS).

• All of the marketable Treasury securities are very liquid and are heavily
traded on the secondary market.
 Treasury Bills (T-Bills)
• Treasury bills (or T-Bills) mature in one year or
less.

• Like zero-coupon bonds, they do not pay interest

prior to maturity; instead they are sold at a
discount of the par value to create a positive yield
to maturity.

• Many regard Treasury bills as the least risky

investment available to U.S. investors.
 Treasury Notes (T-Notes)
• Treasury notes (or T-Notes) mature in one to
ten years.

• They have a coupon payment every six

months, and are commonly issued with
maturities dates between 1 to 10 years, with
denominations of $1,000.
 Treasury Bonds (T-Bonds)
• Treasury bonds (T-Bonds, or the long bond)
have the longest maturity, from twenty years
to thirty years.

• They have a coupon payment every six

months like T-Notes, and are commonly
issued with maturity of thirty years. The
secondary market is highly liquid.
Treasury Inflation-Protected Securities
(TIPS)
• Treasury Inflation-Protected Securities (or TIPS) are the inflation-
indexed bonds issued by the U.S. Treasury.

• The principal is adjusted to the Consumer Price Index (CPI), the

commonly used measure of inflation.

• When the CPI rises, your principal adjusts upward. If the index falls,
your principal adjusts downwards.

• The coupon rate is constant, but generates a different amount of

interest when multiplied by the inflation-adjusted principal, thus
protecting the holder against inflation.

• TIPS are currently offered in 5-year, 10-year and 30-year maturities.

 Zero-Coupon Bond
• A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower
than its face value, with the face value repaid at the time of maturity. It does not make periodic interest
payments, or have so-called "coupons," hence the term zero-coupon bond.

• When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon
bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds, and any type of
coupon bond that has been stripped of its coupons.

• In contrast, an investor who has a regular bond receives income from coupon payments, which are usually
made semi-annually. The investor also receives the principal or face value of the investment when the
bond matures.

• Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond
holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the
majority of zero coupon bonds pay a set amount of money known as the face value of the bond.

• Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates
typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond
markets. Short-term zero coupon bonds generally have maturities of less than one year and are called
bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.
Derivatives
 Derivative
• A derivative is a financial instrument whose value depends on other, more basic,
underlying variables. Such a variable is called an "underlying" and can be a traded
asset, for example, a stock or commodity, but can also be something which is
impossible to trade, such as the temperature (in the case of weather derivatives),
unemployment rate, or any kind of (economical) index.

• A derivative is essentially a contract whose payoff depends on the behavior of

some benchmark. The most common derivatives are futures, options, and swaps.

• Derivatives are usually broadly categorized by:

– the relationship between the underlying asset and the derivative (e.g., forward, option,
swap);
– the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives,
interest rate derivatives, commodity derivatives or credit derivatives);
– the market in which they trade (e.g., exchange-traded or over-the-counter); and
– their pay-off profile.

• Derivatives can be used for speculating purposes ("bets") or to hedge

("insurance").
 Derivatives – Purpose
Derivatives are used by investors to:

• provide leverage, such that a small movement in the underlying value can
cause a large difference in the value of the derivative;

• speculate and make a profit if the value of the underlying asset moves the
way they expect (e.g., moves in a given direction, stays in or out of a
specified range, reaches a certain level);

• hedge or mitigate risk in the underlying, by entering into a derivative

contract whose value moves in the opposite direction to their underlying
position and cancels part or all of it out;

• obtain exposure to the underlying where it is not possible to trade in the

underlying (e.g., weather derivatives);
 Leverage
• The use of various financial instruments or borrowed
capital, such as margin, to increase the potential return
of an investment. The amount of debt used to finance
a firm's assets. A firm with significantly more debt than
equity is considered to be highly leveraged.

• Leverage can be created through options, futures,

margin and other financial instruments.
For example, say you have $1,000 to invest. This amount
could be invested in 10 shares of Apple stock, but to increase
leverage, you could invest the $1,000 in five options
contracts. You would then control 500 shares instead of just
10.
 Leverage cont…
• Most companies use debt to finance operations. By doing so, a company
increases its leverage because it can invest in business operations without
increasing its equity.
For example, if a company formed with an investment of $5 million from
investors, the equity in the company is $5 million - this is the money the company
uses to operate. If the company uses debt financing by borrowing $20 million, the
company now has $25 million to invest in business operations and more
opportunity to increase value for shareholders.

• Leverage helps both the investor and the firm to invest or operate.
However, it comes with greater risk.
–If an investor uses leverage to make an investment and the investment moves
against the investor, his or her loss is much greater than it would've been if the
investment had not been leveraged - leverage magnifies both gains and losses.
–In the business world, a company can use leverage to try to generate
shareholder wealth, but if it fails to do so, the interest expense and credit risk of
default destroys shareholder value.
 Hedging
• Derivatives allow risk related to the price of the underlying asset to be transferred
from one party to another.
For example, a wheat farmer and a miller could sign a futures contract to exchange a
specified amount of cash for a specified amount of wheat in the future. Both parties have
reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller,
the availability of wheat. However, there is still the risk that no wheat will be available
because of events unspecified by the contract, such as the weather, or that one party will
default on the contract. Although a third party, called a clearing house, insures a futures
contract, not all derivatives are insured against counter-party risk.

• From another perspective, the farmer and the miller both reduce a risk and
acquire a risk when they sign the futures contract: the farmer reduces the risk that
the price of wheat will fall below the price specified in the contract and acquires
the risk that the price of wheat will rise above the price specified in the contract
(thereby losing additional income that he could have earned). The miller, on the
other hand, acquires the risk that the price of wheat will fall below the price
specified in the contract (thereby paying more in the future than he otherwise
would have) and reduces the risk that the price of wheat will rise above the price
specified in the contract. In this sense, one party is the insurer (risk taker) for one
type of risk, and the counter-party is the insurer (risk taker) for another type of
risk.
 Hedging cont…
• Hedging also occurs when an individual or institution buys an asset (such as a
commodity, a bond that has coupon payments, a stock that pays dividends, and so
on) and sells it using a futures contract. The individual or institution has access to
the asset for a specified amount of time, and can then sell it in the future at a
specified price according to the futures contract. Of course, this allows the
individual or institution the benefit of holding the asset, while reducing the risk
that the future selling price will deviate unexpectedly from the market's current
assessment of the future value of the asset.

• Derivatives traders at the Chicago Board of Trade.

• Derivatives can serve legitimate business purposes. For example, a corporation

borrows a large sum of money at a specific interest rate. The rate of interest on the
loan resets every six months. The corporation is concerned that the rate of interest
may be much higher in six months. The corporation could buy a forward rate
agreement (FRA), which is a contract to pay a fixed rate of interest six months after
purchases on a notional amount of money. If the interest rate after six months is
above the contract rate, the seller will pay the difference to the corporation, or
FRA buyer. If the rate is lower, the corporation will pay the difference to the seller.
The purchase of the FRA serves to reduce the uncertainty concerning the rate
increase and stabilize earnings.
 Speculation and Arbitrage
• Derivatives can be used to acquire risk, rather than to
insure or hedge against risk. Thus, some individuals
and institutions will enter into a derivative contract to
speculate on the value of the underlying asset, betting
that the party seeking insurance will be wrong about
the future value of the underlying asset.

• Individuals and institutions may also look for arbitrage

opportunities, as when the current buying price of an
asset falls below the price specified in a futures
contract to sell the asset.
 Derivatives Contacts - Types
In broad terms, there are two groups of derivative contracts, which are
distinguished by the way they are traded in the market:

•Over-the-counter (OTC) derivatives:

– Contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements, and exotic options are almost always
traded in this way.
– The OTC derivative market is the largest market for derivatives, and is largely
unregulated with respect to disclosure of information between the parties,
since the OTC market is made up of banks and other highly sophisticated
parties, such as hedge funds.
– Reporting of OTC amounts are difficult because trades can occur in private,
without activity being visible on any exchange. According to the Bank for
International Settlements, the total outstanding notional amount is US$684
trillion (as of June 2008). Of this total notional amount:
• 67% are interest rate contracts,
• 8% are credit default swaps (CDS),
• 9% are foreign exchange contracts,
 Derivatives Contracts – Types cont…
• 2% are commodity contracts,
• 1% are equity contracts, and
• 12% are other
– Because OTC derivatives are not traded on an exchange, there is no central
counter-party. Therefore, they are subject to counter-party risk, like an
ordinary contract, since each counter-party relies on the other to perform.

• Exchange-traded derivative contracts (ETD):

– Derivatives instruments that are traded via specialized derivatives exchanges or
other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
– A derivatives exchange acts as an intermediary to all related transactions, and takes
Initial margin from both sides of the trade to act as a guarantee.
– The world's largest derivatives exchanges (by number of transactions) are the:
• Korea Exchange (which lists KOSPI Index Futures & Options),
• Eurex (which lists a wide range of European products such as interest rate & index
products), and
Derivatives Contracts – Types cont…
• CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and
the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile
Exchange).
– According to BIS, the combined turnover in the world's derivatives exchanges
totaled USD 344 trillion during Q4 2005.
– Some types of derivative instruments also may trade on traditional exchanges.
For instance, hybrid instruments such as convertible bonds and/or convertible
preferred may be listed on stock or bond exchanges. Also, warrants (or
"rights") may be listed on equity exchanges.
 Common Derivatives
There are 3 major types derivatives:

•Futures/Forwards are contracts to buy or sell an asset on or before a future date at a

price specified today. A futures contract differs from a forward contract in that the
futures contract is a standardized contract written by a clearing house that operates
an exchange where the contract can be bought and sold, whereas a forward contract
is a non-standardized contract written by the parties themselves.

•Options are contracts that give the owner the right, but not the obligation, to buy (in
the case of a call option) or sell (in the case of a put option) an asset. The price at
which the sale takes place is known as the strike price, and is specified at the time the
parties enter into the option. The option contract also specifies a maturity date. In the
case of a European option, the owner has the right to require the sale to take place on
(but not before) the maturity date; in the case of an American option, the owner can
require the sale to take place at any time up to the maturity date. If the owner of the
contract exercises this right, the counter-party has the obligation to carry out the
transaction.

•Swaps are contracts to exchange cash (flows) on or before a specified future date
based on the underlying value of currencies/exchange rates, bonds/interest rates,
commodities, stocks or other assets.
 Derivative - Classes
The overall derivatives market has five major
classes of underlying asset:
• interest rate derivatives (the largest)
• foreign exchange derivatives
• credit derivatives
• equity derivatives
• commodity derivatives
 Options
• The buyer of the option gains the right, but not the obligation, to engage in that
transaction, while the seller incurs the corresponding obligation to fulfill the
transaction.

• An option which provide the right to buy something is called a call; an option
which provide the right to sell is called a put.

• The reference price at which the underlying may be traded is called the strike price
or exercise price. The process of activating an option and thereby trading the
underlying at the agreed-upon price is referred to as exercising it.

• Most options have an expiration date. If the option is not exercised by the
expiration date, it becomes void and worthless.

• In return for granting the option, called writing the option, the originator of the
option collects a payment, the premium, from the buyer.

• An option can usually be sold by its original buyer to another party.

 Options - Specifications
Option contracts may be quite complicated; however, at minimum, they usually
contain the following specifications:

•whether the option holder has the right to buy (a call option) or the right to sell (a
put option),
•the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock),
•the strike price, also known as the exercise price, which is the price at which the
underlying transaction will occur upon exercise,
•the expiration date, or expiry, which is the last date the option can be exercised,
•the settlement terms, for instance whether the writer must deliver the actual asset
on exercise, or may simply tender the equivalent cash amount, and
•the terms by which the option is quoted in the market to convert the quoted price
into the actual premium – the total amount paid by the holder to the writer of the
option.
 Options – Types
The Options can be classified into following types:

•Exchange-traded options – (also called "listed options") have standardized

contracts, and are settled through a clearing house with fulfillment
guaranteed by the credit of the exchange. Exchange-traded options include:
– stock options,
– commodity options,
– bond options and other interest rate options
– stock market index options or, simply, index options and,
– options on futures contracts
– callable bull/bear contract

•Over-the-counter – (OTC options, also called "dealer options") are traded

between two private parties, and are not listed on an exchange.
 Options – Types cont…
The terms of an OTC option are unrestricted and may be individually
tailored to meet any business need. In general, at least one of the
counterparties to an OTC option is a well-capitalized institution. Option
types commonly traded over the counter include:
–interest rate options,
–currency cross rate options, and
–options on swaps or swaptions.

• Other option types – Another important class of options, particularly in

the U.S., are employee stock options, which are awarded by a company to
their employees as a form of incentive compensation.
 Option styles
Different styles of options include:

•European option – an option that may only be exercised on expiration.

•American option – an option that may be exercised on any trading day on or

before expiry.

•Bermudan option – an option that may be exercised only on specified dates

on or before expiration.
 Options Positions
• Long Call – Trader who believes that a stock's price will increase might buy the
right to purchase the stock (a call option) rather than just purchase the stock itself.
He would have no obligation to buy the stock, only the right to do so until the
expiration date.
– If the stock price at expiration is above the exercise price by more than the premium
(price) paid, he will profit.
– If the stock price at expiration is lower than the exercise price, he will let the call
contract expire worthless, and only lose the amount of the premium.
A trader might buy the option instead of shares, because for the same amount of
money, he can control (leverage) a much larger number of shares.

• Long Put – Trader who believes that a stock's price will decrease can buy the right
to sell the stock at a fixed price (a put option). He will be under no obligation to
sell the stock, but has the right to do so until the expiration date.
– If the stock price at expiration is below the exercise price by more than the premium
paid, he will profit.
– If the stock price at expiration is above the exercise price, he will let the put contract
expire worthless and only lose the premium paid.
 Options Positions cont…
• Short Call – Trader who believes that a stock price will decrease, can sell
the stock short or instead sell, or "write," a call. The trader selling a call
has an obligation to sell the stock to the call buyer at the buyer's option.
– If the stock price decreases, the short call position will make a profit in the
amount of the premium.
– If the stock price increases over the exercise price by more than the amount of
the premium, the short will lose money, with the potential loss unlimited.

• Short Put – Trader who believes that a stock price will increase can buy
the stock or instead sell, or "write", a put. The trader selling a put has an
obligation to buy the stock from the put buyer at the put buyer's option.
– If the stock price at expiration is above the exercise price, the short put
position will make a profit in the amount of the premium.
– If the stock price at expiration is below the exercise price by more than the
amount of the premium, the trader will lose money, with the potential loss
being up to the full value of the stock.
 Options Moneyness
• The intrinsic value (or "monetary value") of an option is the value of exercising it
now. Thus if the current (spot) price of the underlying security is above the agreed
(strike) price, a call has positive intrinsic value (and is called "in the money"), while
a put has zero intrinsic value.

• The time value of an option is a function of the option value less the intrinsic
value. It equates to uncertainty in the form of investor hope. It is also viewed as
the value of not exercising the option immediately.

– ATM: At-the-money – An option is at-the-money if the strike price is the same as

the spot price of the underlying security on which the option is written. An at-the-
money option has no intrinsic value, only time value.

– ITM: In-the-money – An in-the-money option has positive intrinsic value as well as

time value. A call option is in-the-money when the strike price is below the spot
price. A put option is in-the-money when the strike price is above the spot price.

– OTM: Out-of-the-money – An out-of-the-money option has no intrinsic value. A

call option is out-of-the-money when the strike price is above the spot price of the
underlying security.
 Forward Contracts
• Forward contract or simply a forward is a non-standardized contract
between two parties to buy or sell an asset at a specified future
time at a price agreed today. It costs nothing to enter a forward
contract. The party agreeing to buy the underlying asset in the
future assumes a long position, and the party agreeing to sell the
asset in the future assumes a short position. The price agreed upon
is called the delivery price, which is equal to the forward price at
the time the contract is entered into.

• The forward price of such a contract is in contrast to a spot price,

which is the price to buy or sell an asset today. The difference
between the spot and the forward price is the forward premium or
forward discount, generally considered in the form of a profit, or
loss, by the purchasing party.
 Forward Contracts cont…
• Forwards, like other derivative securities, can be used to hedge risk
(typically currency or exchange rate risk), as a means of speculation, or to
allow a party to take advantage of a quality of the underlying instrument
which is time-sensitive.

• Forward contracts are very similar to futures contracts, except they are
not exchange-traded, or defined on standardized assets. Forwards also
typically have no interim partial settlements or "true-ups" in margin
requirements like futures - such that the parties do not exchange
additional property securing the party at gain and the entire unrealized
gain or loss builds up while the contract is open.

• However, being traded OTC, forward contracts specification can be

customized and may include mark-to-market and daily margining. Hence,
a forward contract arrangement might call for the loss party to pledge
collateral or additional collateral to better secure the party at gain.
 Forward Contracts cont…
• For example: Bob wants to buy a house a year from now. At the
same time, suppose that Andy currently owns a $100,000 house
that he wishes to sell a year from now. Both parties could enter into
a forward contract with each other. Suppose that they both agree
on the sale price in one year's time of $104,000. Andy and Bob have
entered into a forward contract. Bob, because he is buying the
underlying, is said to have entered a long forward contract.
Conversely, Andy will have the short forward contract.

• At the end of one year, suppose that the current market valuation
of Andy's house is $110,000. Then, because Andy is obliged to sell
to Bob for only $104,000, Bob will make a profit of $6,000. To see
why this is so, one needs only to recognize that Bob can buy from
Andy for $104,000 and immediately sell to the market for $110,000.
Bob has made the difference in profit. In contrast, Andy has made a
potential loss of $6,000, and an actual profit of $4,000.
 Forward Contracts cont…
• The initial price of Andy's house is $100,000 and that Bob enters
into a forward contract to buy the house one year from today. But
since Andy knows that he can immediately sell for $100,000 and
place the proceeds in the bank, he wants to be compensated for
the delayed sale. Suppose that the risk free rate of return R (the
bank rate) for one year is 4%. Then the money in the bank would
grow to $104,000, risk free. So Andy would want at least $104,000
one year from now for the contract to be worthwhile for him - the
opportunity cost will be covered.
 Futures
• Futures contract is a standardized contract between two parties to exchange a
specified asset of standardized quantity and quality for a price agreed today (the
futures price or the strike price) but with delivery occurring at a specified future
date, the delivery date.

• The contracts are traded on a futures exchange. The party agreeing to buy the
underlying asset in the future, the "buyer" of the contract, is said to be "long", and
the party agreeing to sell the asset in the future, the "seller" of the contract, is said
to be "short”.

• The terminology reflects the expectations of the parties -- the buyer hopes the
asset price is going to increase, while the seller hopes for a decrease. Note that the
contract itself costs nothing to enter.

• In many cases, the underlying asset to a futures contract may not be traditional
"commodities" at all – that is, for financial futures, the underlying asset or item
can be currencies, securities or financial instruments and intangible assets or
referenced items such as stock indexes and interest rates.
 Futures cont…
• While the futures contract specifies an exchange taking place in the future, the purpose of
the futures exchange is to minimize the risk of default by either party. Thus the exchange
requires both parties to put up an initial amount of cash, the margin. Additionally, since the
futures price will generally change daily, the difference in the prior agreed-upon price and the
daily futures price is settled daily also. The exchange will draw money out of one party's
margin account and put it into the other's so that each party has the appropriate daily loss or
profit. If the margin account goes below a certain value, then a margin call is made and the
account owner must replenish the account. This process is known as marking to market. Thus
on the delivery date, the amount exchanged is not the specified price on the contract but the
spot value (since any gain or loss has already been previously settled by marking to market).

• A closely related contract is a forward contract. A forward is like a futures in that it specifies
the exchange of goods for a specified price at a specified future date. However, a forward is
not traded on an exchange and thus does not have the interim partial payments due to
marking to market. Nor is the contract standardized, as on the exchange.

• Unlike an option, both parties of a futures contract must fulfill the contract on the delivery
date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures
contract, then cash is transferred from the futures trader who sustained a loss to the one
who made a profit. To exit the commitment prior to the settlement date, the holder of a
futures position can close out its contract obligations by taking the opposite position on
another futures contract on the same asset and settlement date. The difference in futures
prices is then a profit or loss.
 Futures – Standardization
Futures contracts ensure their liquidity by being highly standardized, usually
by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude
oil to a short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term interest
rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can
be delivered. In the case of physical commodities, this specifies not only the
quality of the underlying goods but also the manner and location of delivery.
• The delivery month.
• The last trading date.
• Other details such as the commodity ticker, the minimum permissible price
fluctuation.
 Future cont…
• For Example: Consider a futures contract with a $100 price: Let's say that
on day 50, a futures contract with a $100 delivery price (on the same
underlying asset as the future) costs $88. On day 51, that futures contract
costs $90. This means that the "mark-to-market" calculation would
require the holder of one side of the future to pay $2 on day 51 to track
the changes of the forward price ("post $2 of margin"). This money goes,
via margin accounts, to the holder of the other side of the future. That is,
the loss party wires cash to the other party.
 Swap
• Swap is a derivative in which two counterparties agree to exchange one stream of
cash flows against another stream. These streams are called the legs of the swap.
The swap agreement defines the dates when the cash flows are to be paid and the
way they are calculated. Usually at the time when the contract is initiated at least
one of these series of cash flows is determined by a random or uncertain variable
such as an interest rate, foreign exchange rate, equity price or commodity price.

• The cash flows are calculated over a notional principal amount, which is usually
not exchanged between counterparties.

• Swaps can be used to hedge certain risks such as interest rate risk, or to speculate
on changes in the expected direction of underlying prices.

• Today, swaps are among the most heavily traded financial contracts in the world:
the total amount of interest rates and currency swaps outstanding is more thаn
$426.7 trillion in 2009, according to International Swaps and Derivatives
Association (ISDA).
 Swaps cont…
• Most swaps are traded over-the-counter (OTC), "tailor-made" for the
counterparties. Some types of swaps are also exchanged on futures
markets such as the:
– Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market,
– the Chicago Board Options Exchange,
– IntercontinentalExchange, and
– Frankfurt-based Eurex AG

• The Bank for International Settlements (BIS) publishes statistics on the

notional amounts outstanding in the OTC derivatives market. At the end of
2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross
world product.

• However, since the cash flow generated by a swap is equal to an interest

rate times that notional amount, the cash flow generated from swaps is a
substantial fraction. The majority of this (USD 292.0 trillion) was due to
interest rate swaps.
 Types of Swaps
There are five generic types of swaps:
1.Interest rate swaps – The most common type of swap is a “plain Vanilla”
interest rate swap. It is the exchange of a fixed rate loan to a floating rate
loan. The life of the swap can range from 2 years to over 15 years. The reason
for this exchange is to take benefit from comparative advantage. Some
companies may have comparative advantage in fixed rate markets while other
companies have a comparative advantage in floating rate markets. When
companies want to borrow they look for cheap borrowing i.e. from the
market where they have comparative advantage. However this may lead to a
company borrowing fixed when it wants floating or borrowing floating when
it wants fixed. This is where a swap comes in. A swap has the effect of
transforming a fixed rate loan into a floating rate loan or vice versa.
For example, party B makes periodic interest payments to party A based on a
variable interest rate of LIBOR +70 basis points. Party A in return makes periodic
interest payments based on a fixed rate of 8.65%. The payments are calculated
over the notional amount. The first rate is called variable, because it is reset at the
beginning of each interest calculation period to the then current reference rate,
such as LIBOR.
 Types of Swaps cont…
• Currency Swap – involves exchanging principal and fixed rate interest
payments on a loan in one currency for principal and fixed rate interest
payments on an equal loan in another currency. Just like interest rate
swaps, the currency swaps also are motivated by comparative advantage.
Currency swaps entail swapping both principal and interest between the
parties, with the cashflows in one direction being in a different currency
than those in the opposite direction.

• Commodity Swap – is an agreement whereby a floating (or market or

spot) price is exchanged for a fixed price over a specified period. The vast
majority of commodity swaps involve crude oil.

• Equity Swap – is a special type of total return swap, where the underlying
asset is a stock, a basket of stocks, or a stock index. Compared to actually
owning the stock, in this case you do not have to pay anything up front,
but you do not have any voting or other rights that stock holders do.
 Types of Swaps cont…
• Credit Default Swap (CDS)
– is a swap contract in which the buyer of the CDS makes a series
of payments to the seller and, in exchange, receives a payoff if a
credit instrument - typically a bond or loan - goes into default
(fails to pay).
– Less commonly, the credit event that triggers the payoff can be
a company undergoing restructuring, bankruptcy or even just
having its credit rating downgraded.
– CDS contracts have been compared with insurance, because the
buyer pays a premium and, in return, receives a sum of money if
one of the events specified in the contract occur.
– Unlike an actual insurance contract the buyer is allowed to
profit from the contract and may also cover an asset to which
the buyer has no direct exposure.
 Interest Rate Swap
• An interest rate swap is a derivative in which one party exchanges a stream of
interest payments for another party's stream of cash flows. Interest rate swaps are
very popular and highly liquid instruments.

• Interest rate swaps can be used by hedgers to manage their fixed or floating assets
and liabilities.

• In an interest rate swap, each counterparty agrees to pay either a fixed or floating
rate denominated in a particular currency to the other counterparty. The fixed or
floating rate is multiplied by a notional principal amount (say, USD 1 million). This
notional amount is generally not exchanged between counterparties, but is used
only for calculating the size of cashflows to be exchanged.

• The most common interest rate swap is one where one counterparty A pays a fixed
rate (the swap rate) to counterparty B, while receiving a floating rate (usually
pegged to a reference rate such as LIBOR). According to usual market convention,
the counterparty paying the fixed rate is called the "payer" (while receiving the
floating rate), and the counterparty receiving the fixed rate is called the "receiver"
(while paying the floating rate).
Interest Rate Swap cont…
 Interest Rate Swap – Types
• Fixed-for-floating rate swap, same currency – Party B pays/receives fixed
interest in currency A to receive/pay floating rate in currency A indexed to
X on a notional amount N for a term of T years.
For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a
notional USD 1 million for 3 years. The party that pays fixed and receives floating
coupon rates is said to be long the interest swap because it is expressed as a bond
convention (as prices fall, yields rise). The part interested to pay fixed and receive
floating is bullish on interest rate and so long his position and thus, buy floating
rate. Interest rate swaps are simply the exchange of one set of cash flows for
another.

• Fixed-for-floating swaps in same currency are used to convert a fixed rate

asset/liability to a floating rate asset/liability or vice versa.
For example, if a company has a fixed rate USD 10 million loan at 5.3% paid
monthly and a floating rate investment of USD 10 million that returns USD 1M
Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this swap,
the company would pay a floating rate of USD 1M Libor+25 bps and receive a
5.5% fixed rate, locking in 20bps profit.
 Interest Rate Swap – Types
• Fixed-for-floating rate swap, different currencies – Party B pays/receives fixed
interest in currency A to receive/pay floating rate in currency B indexed to X on a
notional N at an initial exchange rate of FX for a tenure of T years.
For example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M
(TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for
3 years. For nondeliverable swaps, the USD equivalent of JPY interest will be paid/received
(according to the FX rate on the FX fixing date for the interest payment day). No initial
exchange of the notional amount occurs unless the Fx fixing date and the swap start date fall
in the future.

• Fixed-for-floating swaps in different currencies are used to convert a fixed rate

asset/liability in one currency to a floating rate asset/liability in a different
currency, or vice versa.
For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a
floating rate investment of JPY 1.2 billion that returns JPY 1M Tibor + 50 bps monthly, and
wants to lock in the profit in USD as they expect the JPY 1M Tibor to go down or USD/JPY to
go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in
different currency where the company pays floating JPY 1M Tibor+50 bps and receives 5.6%
fixed rate, locking in 30bps profit against the interest rate and the fx exposure.
 Interest Rate Swap – Types
• Floating-for-floating rate swap, same currency – Party B pays/receives
floating interest in currency A indexed to X to receive/pay floating rate in
currency A indexed to Y on a notional N for a tenure of T years.
For example, you pay JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on
a notional JPY 1 billion for 3 years.

• Floating-for-floating rate swaps are used to hedge against or speculate on

the spread between the two indexes widening or narrowing.
For example, if a company has a floating rate loan at JPY 1M LIBOR and the
company has an investment that returns JPY 1M TIBOR + 30 bps and currently the
JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net
profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down
(relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative
to the TIBOR) and wants to insulate from this risk, they can enter into a float-float
swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY
LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of
running with a current 40 bps gain and index risk.
 Interest Rate Swap – Types
• Floating-for-floating rate swap, different currencies – Party B
pays/receives floating interest in currency A indexed to X to
receive/pay floating rate in currency B indexed to Y on a notional N
at an initial exchange rate of FX for a tenure of T years.
For example, you pay floating USD 1M LIBOR on the USD notional 10
million quarterly to receive JPY 3M TIBOR monthly on a JPY notional 1.2
billion (at an initial exchange rate of USD/JPY 120) for 4 years.

• Fixed-for-fixed rate swap, different currencies – Party B

pays/receives fixed interest in currency A to receive/pay fixed rate
in currency B for a term of T years.
For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive
USD 5.36% on the USD equivalent notional of 10 million at an initial
exchange rate of USDJPY 120.
Credit Derivatives
 Credit Derivative
• Credit derivative is a securitized derivative whose value is derived from the credit
risk on an underlying bond, loan or any other financial asset, the credit risk is on
an entity other than the counterparties to the transaction itself. This entity is
known as the reference entity and may be a corporate, a sovereign or any other
form of legal entity which has incurred debt. Credit derivatives are bilateral
contracts between a buyer and seller under which the seller sells protection
against the credit risk of the reference entity.

• The parties will select which credit events apply to a transaction and usually
consist of one or more of the following:
– bankruptcy (the risk that the reference entity will become bankrupt)
– failure to pay (the risk that the reference entity will default on one of its obligations such
as a bond or loan)
– obligation default (the risk that the reference entity will default on any of its obligations)
– obligation acceleration (the risk that an obligation of the reference entity will be
accelerated e.g. a bond will be declared immediately due and payable following a
default)
– restructuring (the risk that obligations of the reference entity will be restructured)
 Credit Derivative cont…
• Where credit protection is bought and sold
between bilateral counterparties, this is known as
an unfunded credit derivative.

• If the credit derivative is entered into by a

financial institution or a special purpose vehicle
(SPV) and payments under the credit derivative
are funded using securitization techniques, such
that a debt obligation is issued by the financial
institution or SPV to support these obligations,
this is known as a funded credit derivative.
 Credit Default Swap (CDS)
• Credit default swap (CDS) is a swap contract and agreement
in which the protection buyer of the CDS makes a series of
payments (often referred to as the CDS "fee" or "spread")
to the protection seller and, in exchange, receives a payoff
if a credit instrument (typically a bond or loan) experiences
a credit event.

• A "credit default swap" (CDS) is a credit derivative contract

between two counterparties – the buyer makes periodic
payments to the seller, and in return receives a payoff if an
underlying financial instrument defaults or experiences a
similar credit event. The CDS may refer to a specified loan
or bond obligation of a “reference entity”, usually a
corporation or government.
 Credit Default Swap (CDS) cont…
• A credit default swap is a bilateral contract between the buyer and seller of
protection:
– The CDS will refer to a "reference entity" or "reference obligor", usually a corporation or
government. The reference entity is not a party to the contract.
– The protection buyer makes quarterly premium payments—the "spread"—to the
protection seller.
– If the reference entity defaults, the protection seller pays the buyer the par value of the
bond in exchange for physical delivery of the bond, although settlement may also be by
cash or auction.
– A default is referred to as a "credit event" and includes such events as
• failure to pay,
• restructuring, and
• bankruptcy.
– Most CDSs are in the $10–$20 million range with maturities between one and 10 years.

• A holder of a bond may “buy protection” to hedge its risk of default.

• Also, investors can buy and sell protection without owning any debt of the
reference entity. These “naked credit default swaps” allow traders to speculate on
debt issues and the creditworthiness of reference entities. Naked CDS constitute
most of the market in CDS.
 Credit Default Swap (CDS) cont…
• Credit default swaps have existed since the early 1990s, but the market increased
tremendously starting in 2003. By the end of 2007, the outstanding amount was
$62.2 trillion, falling to $38.6 trillion by the end of 2008.

• Credit default swaps have many variations. In addition to the basic, single-name
swaps, there are basket default swaps (BDS), index CDS.

• In addition to corporations or governments, the reference entity can include a

special purpose vehicle issuing asset backed securities.

• Credit default swaps are not traded on an exchange and there is no required
reporting of transactions to a government agency.

• During the 2007-2010 financial crisis the lack of transparency became a concern to
regulators, as was the trillion dollar size of the market, which could pose a
systemic risk to the economy.
 Credit Default Swap (CDS) cont…
• For example, an investor buys a CDS from Bank A, where the reference entity is
Corp A. The investor (the buyer of protection) will make regular payments to Bank
A (the seller of protection). If Corp A defaults on its debt, the investor will receive a
one-time payment from Bank A, and the CDS contract is terminated. A default is
referred to as a "credit event" and include such events as failure to pay,
restructuring and bankruptcy.

• If the investor actually owns Corp A debt, the CDS can be thought of as hedging.
But investors can also buy CDS contracts referencing Corp A debt without actually
owning any Corp A debt. This may be done for speculative purposes, to bet against
the solvency of Corp A in a gamble to make money if it fails.

• If the reference entity (Corp A) defaults, one of two kinds of settlement can occur:
– Physical Settlement – the investor delivers a defaulted asset to Bank A for payment of
the par value;
– Cash Settlement – Bank A pays the investor the difference between the par value and
the market price of a specified debt obligation (even if Corp A defaults there is usually
some recovery, i.e. not all your money will be lost).
 Credit Default Swap (CDS) cont…
• The "spread" of a CDS is the annual amount the protection buyer must pay
the protection seller over the length of the contract, expressed as a
percentage of the notional amount.
For example, if the CDS spread of Corp A is 50 basis points, or 0.5% (1 basis point
= 0.01%), then an investor buying $10 million worth of protection from Bank A
must pay the bank $50,000 per year. These payments continue until either the
CDS contract expires or Corp A defaults. Payments are usually made on a quarterly
basis.

• Most CDS’s are in the $10–20 million range with maturities between one
and 10 years. Five years is the most typical maturity.

• All things being equal, at any given time, if the maturity of two credit
default swaps is the same, then the CDS associated with a company with a
higher CDS spread is considered more likely to default by the market, since
a higher fee is being charged to protect against this happening.
Credit Default Swap (CDS) cont…
Credit Default Swap (CDS) cont…
Credit Default Swap (CDS) cont…
Credit Default Swap (CDS) cont…
 Credit Default Swap (CDS) cont…
• When entering into a CDS, both the buyer and seller of
credit protection take on counterparty risk:
– The buyer takes the risk that the seller will default. If Bank
A and Corp. A default simultaneously ("double default”).
– The seller takes the risk that the buyer will default on the
contract, depriving the seller of the expected revenue
stream.

• In future, in the event that regulatory reforms require

that CDS be traded and settled via a central
exchange/clearing house, such as ICE, TCC, there will
no longer be 'counterparty risk', as the risk of the
counterparty will be held with the central
exchange/clearing house.
 Total Return Swap (TRS)
• Total return swap (also known as Total Rate of Return Swap) is a
contract between two counterparties whereby they swap periodic
payments for the period of the contract – one party receives the
total return (interest payments plus any capital gains or losses for
the payment period) from a specified reference asset, while the
other receives a specified fixed or floating cash flow that is not
related to the creditworthiness of the reference asset. The
payments are based upon the same notional amount. The reference
asset may be any asset, index or basket of assets.

• The TRS is simply a mechanism that allows one party to derive the
economic benefit of owning an asset without use of the balance
sheet, and which allows the other to effectively "buy protection"
against loss in value due to ownership of a credit asset.
 Credit Linked Note (CLN)
• Credit linked note (CLN) is a form of funded credit derivative. It is structured as a
security with an embedded credit default swap allowing the issuer to transfer a
specific credit risk to credit investors. The issuer is not obligated to repay the debt
if a specified event occurs.

• It is issued by a special purpose company or trust, designed to offer investors par

value at maturity unless the referenced entity defaults. In the case of default, the
investors receive a recovery rate.

• The trust will also have entered into a default swap with a dealer. In case of
default, the trust will pay the dealer par minus the recovery rate, in exchange for
an annual fee which is passed on to the investors in the form of a higher yield on
their note.

• The purpose of the arrangement is to pass the risk of specific default onto
investors willing to bear that risk in return for the higher yield it makes available.
The CLNs themselves are typically backed by very highly-rated collateral, such as
U.S. Treasury securities.
 Equity Derivatives
• Equity derivative is a class of derivatives
whose value is at least partly derived from one
or more underlying equity securities.

• Options and futures are by far the most

common equity derivatives, however there
are many other types of equity derivatives
that are actively traded.
 Equity Derivatives – Types
• Equity Options are the most common type of equity derivative - they
provide the right, but not the obligation, to buy (call) or sell (put) a
quantity of stock (1 contract = 100 shares of stock), at a set price (strike
price), within a certain period of time (prior to the expiration date).

• Warrant is a security that entitles the holder to buy stock of the

company that issued it at a specified price, which is much lower than
the stock price at time of issue. Warrants are frequently attached to
bonds or preferred stock as a sweetener, allowing the issuer to pay
lower interest rates or dividends. They can be used to enhance the
yield of the bond, and make them more attractive to potential buyers.

• Convertible Bonds are bonds that can be converted into shares of

stock in the issuing company, usually at some pre-announced ratio. It is
a hybrid security with debt- and equity-like features.
 Equity Derivatives – Types cont…
• Single-stock Futures are exchange-traded futures contracts based on an
individual underlying security. Another difference is that holders of long
positions in single stock futures typically do not receive dividends and
holders of short positions do not pay dividends. Single-stock futures may
be cash-settled or physically settled by the transfer of the underlying
stocks at expiration.

• Stock Market Index Futures are futures contracts used to replicate the
performance of an underlying stock market index. They can be used for
hedging against an existing equity position, or speculating on future
movements of the index. Indices for futures include well-established
indices such as S&P, FTSE, DAX.

• Equity Swap, is an agreement between two parties to swap two sets of

cash flows. The cash flows will be the price of an underlying stock value
swapped, for instance, with LIBOR. One party gains exposure to a share
price without buying or selling the underlying share making it relatively
cost efficient as well as making it relatively easy to transact.
Agency Securities
 Agency Securities
• Agency debt is a security, usually a bond, issued by a U.S. government-sponsored
agency.

• The offerings of these agencies are backed by the government, but not guaranteed
by the government since the agencies are private entities.

• Such agencies have been set up in order to allow certain groups of people to
access low cost financing e.g. students and home buyers.

• Some prominent issuers of agency securities are:

– Student Loan Marketing Association (Sallie Mae),
– Federal National Mortgage Association (Fannie Mae), and
– Federal Home Loan Mortgage Corporation (Freddie Mac)

• Agency securities are usually exempt from state and local taxes, but not federal
tax. Agency debt is also called an agency security.
 Fannie Mae
• The Federal National Mortgage Association, commonly
known as Fannie Mae, was founded in 1938 during the
Great Depression as part of the New Deal.

• It was set up as a government-sponsored enterprise (GSE),

but it converted into a publicly traded company in 1968.

• The corporation's purpose is to expand the secondary

mortgage market by securitizing mortgages in the form of
mortgage-backed securities (MBS), allowing lenders to
reinvest their assets into more lending and in effect
increasing the number of lenders in the mortgage market.
 Fannie Mae cont…
• Fannie Mae made money partly by borrowing for low rates, and lending at higher
rates. It borrowed by selling bonds, and lent by creating mortgage backed
securities which it held on its own books.

• Since its implied government guarantee meant it could borrow at very low rates, it
earned a higher profit than did the non-government companies doing the same
work. By August, 2008, Fannie Mae's mortgage portfolio was in excess of $700
billion.

• Fannie Mae also earned a significant portion of its income from guaranty fees it
received as compensation for assuming the credit risk on the mortgage loans
underlying its single-family Fannie Mae MBS held in its retained portfolio.

• Investors, or purchasers of Fannie Mae MBSs, are willing to let Fannie Mae keep
this fee in exchange for assuming the credit risk; that is, Fannie Mae's guarantee
that the scheduled principal and interest on the underlying loan will be paid even
if the borrower defaults.
 Fannie Mae cont…
• Fannie Mae buys loans from approved mortgage sellers, either for cash or in
exchange for a mortgage-backed security that comprises those loans and that, for
a fee, carries Fannie Mae's guarantee of timely payment of interest and principal.
The mortgage seller may hold that security or sell it.

• Fannie Mae may also securitize mortgages from its own loan portfolio and sell the
resultant mortgage-backed security to investors in the secondary mortgage
market, again with a guarantee that the stated principal and interest payments will
be timely passed through to the investor.

• By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and
other financial institutions with fresh money to make new loans. This gives the
United States housing and credit markets flexibility and liquidity.

• In order for Fannie Mae to provide its guarantee to mortgage-backed securities it

issues, it sets the guidelines for the loans that it will accept for purchase, called
"conforming" loans. Mortgages that don't meet the guidelines are called
"nonconforming”.
 Freddie Mac
• The Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, is
a public government sponsored enterprise (GSE).

• The FHLMC was created in 1970 to expand the secondary market for mortgages in
the US. Along with other GSEs, Freddie Mac buys mortgages on the secondary
market, pools them, and sells them as a mortgage-backed security to investors on
the open market.

• This secondary mortgage market increases the supply of money available for
mortgage lending and increases the money available for new home purchases.

• Freddie Mac's primary method of making money is by charging a guarantee fee on

loans that it has purchased and securitized into mortgage-backed security bonds.
Investors, or purchasers of Freddie Mac MBS, are willing to let Freddie Mac keep
this fee in exchange for assuming the credit risk, that is, Freddie Mac's guarantee
that the principal and interest on the underlying loan will be paid back regardless
of whether the borrower actually repays.
 Sallie Mae
• Sallie Mae (originally the Student Loan Marketing
Association) is a publicly traded U.S. corporation
whose operations are originating, servicing and
collecting on student loans.

• Managing more than $180.4 billion in debt for

more than 10 million borrowers, the company
primarily provided federally guaranteed student
loans originated under the Federal Family
Education Loan Program (FFELP).
 Farmer Mac
• The Federal Agricultural Mortgage Corporation, also known as Farmer Mac, is a
stockholder-owned, publicly-traded company.

• It serve as a secondary market in agricultural loans such as mortgages for

agricultural real estate and rural housing. The company purchases loans from
agricultural lenders, and sells instruments backed by those loans.

• Farmer Mac is a federally chartered, private corporation responsible for

guaranteeing the timely repayment of principal and interest to investors in a new
agricultural secondary market.

• The secondary market allows a lending institution to sell a qualified farm real
estate loan to an agricultural mortgage marketing facility, or pooler, which
packages these loans, and sells to investors securities that are backed by, or
represent interests in, the pooled loans.

• Farmer Mac guarantees the timely repayment of principal and interest on these
securities and, can also serve as a loan pooler.
 Ginnie Mae
• The Government National Mortgage Association (GNMA), or Ginnie Mae, was
established in the United States in 1968 to promote home ownership.

• As a wholly owned government corporation within the Department of Housing

and Urban Development (HUD), Ginnie Mae’s mission is to expand affordable
housing in the U.S. by channeling global capital into the nation’s housing finance
markets.

• The Ginnie Mae guarantee allows mortgage lenders to obtain a better price for
their loans in the capital markets. Lenders then can use the proceeds to make new
mortgage loans available to consumers.

• This also helps to lower financing costs and create opportunities for sustainable,
affordable housing for families seeking home ownership.

• Ginnie Mae guarantees the timely payment of principal and interest payments on
residential mortgage-backed securities (MBS) to institutional investors worldwide.
 Ginnie Mae cont…
• These securities, or “pools” of mortgage loans, are used as collateral for the
issuance of securities on Wall Street. MBS are commonly referred to as "pass-
through" certificates because the principal and interest of the underlying loans is
"passed through" to investors.

• Ginnie Mae guarantees only securities backed by single-family and multifamily

loans insured by government agencies.

• Ginnie Mae neither originates nor purchases mortgage loans. It does not purchase,
sell, or issue securities. Accordingly, Ginnie Mae does not use derivatives to hedge
and it does not carry long-term debt (or related outstanding securities liabilities)
on its balance sheet.

• Instead, private lending institutions approved by Ginnie Mae originate eligible

loans, pool them into securities, and issue the Ginnie Mae MBS. These institutions
include geographically diverse mortgage companies, commercial banks, as well as
state housing finance agencies.
 Government-sponsored v/s
Government-owned
• Ginnie Mae is a wholly owned government corporation.

• Fannie Mae and Freddie Mac, on the other hand, are "government-sponsored
enterprises" (GSEs), which are federally chartered corporations, but still privately
owned by shareholders.

• In September 2008, the GSEs were placed under government conservatorship,

effectively wiping out shareholders.

• Ginnie Mae neither originates nor purchases mortgage loans, nor does it buy, sell
or issue securities in the U.S. capital markets.

• The credit risk on the mortgage collateral underlying its MBS securities primarily
resides with other insuring government agencies.

• Rather, Ginnie Mae is the guarantor of MBS issued by government-approved

securities issuers who participate in Ginnie Mae’s program.
 Implicit Guarantee / Government
Support
• Originally, Fannie had an 'explicit guarantee' from the government; if it got in trouble, the
government promised to bail it out. This changed in 1968. Ginnie Mae was split off from
Fannie.

• Ginnie retained the explicit guarantee. Fannie, however, became a private corporation, with
only an 'implied guarantee’. There was no written documentation, no contract, and no
official promise that the government would bail it out.

• This unwritten, undocumented guarantee was what enabled Fannie and Freddie to be taken
off the balance sheet of the government; this made the National Debt to falsely appear lower
than it actually was.

• Fannie Mae received no direct government funding or backing; Fannie Mae securities carried
no actual explicit government guarantee of being repaid. Neither the certificates nor
payments of principal and interest on the certificates were explicitly guaranteed by the
United States government. The certificates did not officially constitute a debt or obligation of
the United States or any of its agencies other than Fannie Mae.
Implicit Guarantee / Government Support
cont…
• The implied guarantee allowed Fannie Mae and Freddie Mac to save
billions in borrowing costs, as their credit rating was very good.

• Fannie Mae and Freddie Mac were allowed to hold less capital than
normal financial institutions: e.g., they were allowed to sell mortgage-
backed securities with only half as much capital backing them up as would
be required of other financial institutions.

• Lastly, Money market funds have diversification requirements, so that not

more than 5% of assets may be from the same issuer. That is, a worst-case
default would drop a fund not more than five cents. However, these rules
do not apply to Fannie and Freddie. It would not be unusual to find a fund
that had the vast majority of its assets in Fannie and Freddie debt.
 ABS
• An asset-backed security is a security whose value and income payments
are derived from and collateralized (or "backed") by a specified pool of
underlying assets.

• The pool of assets is typically a group of small and illiquid assets that are
unable to be sold individually.

• Pooling the assets into financial instruments allows them to be sold to

general investors, a process called securitization, and allows the risk of
investing in the underlying assets to be diversified because each security
will represent a fraction of the total value of the diverse pool of underlying
assets.

• The pools of underlying assets can include common payments from credit
cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft
leases, royalty payments and movie revenues.
 ABS cont…
• Often a separate institution, called a special purpose vehicle, is created to handle
the securitization of asset backed securities. The special purpose vehicle, which
creates and sells the securities, uses the proceeds of the sale to pay back the bank
that created, or originated, the underlying assets.

• The special purpose vehicle is responsible for "bundling" the underlying assets into
a specified pool that will fit the risk preferences and other needs of investors who
might want to buy the securities, for managing credit risk—often by transferring it
to an insurance company after paying a premium—and for distributing payments
from the securities.

• As long as the credit risk of the underlying assets is transferred to another

institution, the originating bank removes the value of the underlying assets from
its balance sheet and receives cash in return as the asset backed securities are
sold, a transaction which can improve its credit rating and reduce the amount of
capital that it needs.
 ABS cont…
• In this case, a credit rating of the asset backed securities would be based
only on the assets and liabilities of the special purpose vehicle, and this
rating could be higher than if the originating bank issued the securities
because the risk of the asset backed securities would no longer be
associated with other risks that the originating bank might bear.

• A higher credit rating could allow the special purpose vehicle and, by
extension, the originating institution to pay a lower interest rate (that is,
charge a higher price) on the asset-backed securities than if the
originating institution borrowed funds or issued bonds.

• Thus, one incentive for banks to create securitized assets is to remove

risky assets from their balance sheet by having another institution assume
the credit risk, so that they (the banks) receive cash in return. This allows
banks to invest more of their capital in new loans or other assets and
possibly have a lower capital requirement.
 ABS cont…
• The process for issuing asset-backed securities in the primary market is similar to
that of issuing other securities, such as corporate bonds.

• The Process of trading asset-backed securities in the secondary market is similar to

that of trading corporate bonds, and also to some extent, mortgage-backed
securities.

• Most of the trading is done in over-the-counter markets, with telephone quotes on

a security basis.

• There appear to be no publicly available measures of trading volume, or of

number of dealers trading in these securities.”

• Many asset-backed securities are not liquid, and their prices are not transparent.
This is partly because asset-backed securities are not as standardized as Treasury
securities, or even mortgage-backed securities, and investors have to evaluate the
different structures, maturity profiles, credit enhancements, and other features of
an asset-backed security before trading it.
 ABS – Types
• Home equity loans
• Auto loans
• Credit card receivables
• Student loans
• Others
– Equipment leases and loans,
– Aircraft leases,
– Trade receivables,
– Dealer floor plan loans, and
– Royalties
 MBS
• A mortgage-backed security (MBS) is an asset-backed security that
represents a claim on the cash flows from mortgage loans through a
process known as securitization.

• Securitization
1. Mortgage loans (mortgage notes) are purchased from banks and other
lenders and assigned to a trust
2. These loans are assembled into collections, or “pools”
3. These trusts securitize the pool and issue mortgage-backed securities, with
documentation that identifies the underlying loans

• Residential mortgage-backed security (RMBS) is secured by single-family

or two to four family real estate, a commercial mortgage-backed security
(CMBS) is secured by commercial and multifamily properties, such as
apartment buildings, retail or office properties, hotels, schools, industrial
properties and other commercial sites.
 MBS cont…
• These securitization trusts include government-sponsored enterprises and private
entities which may offer credit enhancement features to mitigate the risk of
prepayment and default associated with these mortgages.

• Since residential mortgages in the United States have the option to pay more than
the required monthly payment (curtailment) or to pay off the loan in its entirety
(prepayment), the monthly cash flow of an MBS is not known in advance, and
therefore presents risk to MBS investors.

• In the United States, the most common securitization trusts are Fannie Mae and
Freddie Mac, U.S. government-sponsored enterprises. Ginnie Mae, a U.S.
government-sponsored enterprise backed by the full faith and credit of the U.S.
government, guarantees its investors receive timely payments, but buys limited
numbers of mortgage notes. Some private institutions, such as Investment Banks,
Real Estate Mortgage Investment Conduits (REMICs) and the Real Estate
Investment Trusts (REITs), also securitize mortgages, known as "private-label"
mortgage securities. Issuances of private-label mortgage-backed securities
increased dramatically from 2001 to 2007, and then ended abruptly in 2008 when
real estate markets began to falter.
 MBS – Types
Mortgage-backed security sub-types include:

1. A Pass-through mortgage-backed security is the simplest MBS, as described

above. Essentially, it is a securitization of the mortgage payments to the
mortgage originators. These can be subdivided into:
– Residential mortgage-backed security (RMBS) is a pass-through MBS backed by
mortgages on residential property.
– Commercial mortgage-backed security (CMBS) is a pass-through MBS backed by
mortgages on commercial property.

2. A Collateralized mortgage obligation (CMO) is a more complex MBS in which the

mortgages are ordered into tranches by some quality (such as repayment time),
with each tranche sold as a separate security.

3. A Stripped mortgage-backed security (SMBS) where each mortgage payment is

partly used to pay down the loan's principal and partly used to pay the interest
on it. These two components can be separated to create SMBS's, of which there
are two subtypes:
 MBS – Types cont…
– Interest-only stripped mortgage-backed security (IO) is a bond with cash flows
backed by the interest component of property owner's mortgage payments.
– Principal-only stripped mortgage-backed security (PO) is a bond with cash flows
backed by the principal repayment component of property owner's mortgage
payments.

• There are several underlying mortgage classifications in the pool:

1. Prime mortgages are conforming mortgages with prime borrowers, full

documentation (such as verification of income and assets), strong credit scores, etc.
2. Alt-A mortgages are an ill-defined category, generally prime borrowers but non-
conforming in some way, often lower documentation (or in some other way: vacation
home, etc.)
3. Subprime mortgages have weaker credit scores, no verification of income or assets,
etc.
4. Jumbo mortgages when the size of the loan is bigger than the "conforming loan
amount" as set by Fannie Mae.
MBS cont…
MBS cont…
 MBS - Uses
There are many reasons for mortgage originators to finance their activities by
issuing mortgage-backed securities. Mortgage-backed securities:

1. Transform relatively illiquid, individual financial assets into liquid and

tradable capital market instruments.
2. Allow mortgage originators to replenish their funds, which can then be
used for additional origination activities.
3. Are frequently a more efficient and lower cost source of financing in
comparison with other bank and capital markets financing alternatives.
4. Allow issuers to diversify their financing sources, by offering alternatives
to more traditional forms of debt and equity financing.
5. Allow issuers to remove assets from their balance sheet, which can help
to improve various financial ratios, utilize capital more efficiently and
achieve compliance with risk-based capital standards.
 MBS - Risks
Interest rate risk and prepayment risk:
• Mortgage prepayments are most often made because a home is sold or because
the homeowner is refinancing to a new mortgage, presumably with a lower rate or
shorter term.

• Prepayment is classified as a risk for the MBS investor despite the fact that they
receive the money, because it tends to occur when floating rates drop and the
fixed income of the bond would be more valuable.

• There are other drivers of the prepayment function (or prepayment risk),
independent of the interest rate, for instance:
– Economic growth, which is correlated with increased turnover in the housing market
– Home prices inflation
– Unemployment
 MBS - Risks
– Regulatory risk; if borrowing requirements or tax laws in a country change this can
change the market profoundly
– Demographic trends, and a shifting risk aversion profile, which can make fixed rate
mortgages relatively more or less attractive.

Credit risk:
•The credit risk of mortgage-backed securities depends on the likelihood of the
borrower paying the promised cash flows (principal and interest) on time. The credit
rating of MBS is fairly high because:
– Most mortgage originations include research on the mortgage borrower's ability to
repay, and will try to lend only to the credit-worthy. An important exception to this
would be "no-doc" or "low-doc" loans.
– Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against
homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the full
faith and credit of the US Federal government. This is not the case with Fannie Mae or
Freddie Mac, but these two entities have lines of credit with the US
 MBS - Risks
Federal government; however, these lines of credit are extremely small when compared
with the average amount of money circulated through Fannie Mae or Freddie Mac in one
day's business. Additionally, Fannie Mae and Freddie Mac generally require private mortgage
insurance on loans in which the borrower provides a down payment that is less than 20% of
the property value.
– Pooling many mortgages with uncorrelated default probabilities creates a bond with a much
lower probability of total default, in which no homeowners are able to make their
payments.
– If the property owner should default, the property remains as collateral. Although real
estate prices can move below the value of the original loan, this increases the solidity of the
payment guarantees and deters borrower default.
 CMOs
• CMO is a special purpose entity that is wholly separate from the institution(s) that
create it. The entity is the legal owner of a set of mortgages, called a pool.
Investors in a CMO buy bonds issued by the CMO, and they receive payments
according to a defined set of rules.

• With regard to terminology, the mortgages themselves are termed collateral, the
bonds are tranches (also called classes), while the structure is the set of rules that
dictates how money received from the collateral will be distributed. The legal
entity, collateral, and structure are collectively referred to as the deal.

• Investors in CMOs include banks, hedge funds, insurance companies, pension

funds, mutual funds, government agencies, and most recently central banks.

• The term collateralized mortgage obligation refers to a specific type of legal entity,
but investors also frequently refer to deals issued using other types of entities such
as REMICs as CMOs.
 CMOs – Credit Tranching
• The most common form of credit protection is called Credit Tranching.

• In the simplest case, credit tranching means that any credit losses will be
absorbed by the most junior class of bondholders until the principal value
of their investment reaches zero.

• If this occurs, the next class of bonds absorb credit losses, and so forth,
until finally the senior bonds begin to experience losses.

• More frequently, a deal is embedded with certain "triggers" related to

quantities of defaults in the loans backing the mortgage pool.

• If a balance of default loans reaches a certain threshold, interest and

principal that would be used to pay junior bondholders is instead directed
to pay off the principal balance of senior bondholders, shortening the life
of the senior bonds.
 CMOs – Overcollateralization
• In CMOs backed by loans of lower credit quality, such as
subprime mortgage loans, the issuer will sell a quantity of
bonds whose principal value is less than the value of the
underlying pool of mortgages.

• Because of the excess collateral, investors in the CMO will

not experience losses until defaults on the underlying loans
reach a certain level.

• If the "overcollateralization" turns into

"undercollateralization" (the assumptions of the default
rate were inadequate), then the CMO defaults. CMOs have
contributed to the subprime mortgage crisis.
 CMOs – Excess Spread
• Another way to enhance credit protection is to issue bonds that pay a
lower interest rate than the underlying mortgages.

For example, if the weighted average interest rate of the mortgage pool is 7%, the
CMO issuer could choose to issue bonds that pay a 5% coupon.

The additional interest, referred to as "excess spread", is placed into a "spread

account" until some or all of the bonds in the deal mature.

If some of the mortgage loans go delinquent or default, funds from the excess
spread account can be used to pay the bondholders.

Excess spread is a very effective mechanism for protecting bondholders from

defaults that occur late in the life of the deal because by that time the funds in
the excess spread account will be sufficient to cover almost any losses.
 CDOs
• Collateralized debt obligations (CDOs) are a type of structured asset-
backed security (ABS) with multiple tranches that are issued by special
purpose entities and collateralized by debt obligations including bonds
and loans.

• Each tranche offers a varying degree of risk and return so as to meet

investor demand.

• CDOs' value and payments are derived from a portfolio of fixed-income

underlying assets.

• CDOs securities are split into different risk classes, or tranches, whereby
"senior" tranches are considered the safest securities. Interest and
principal payments are made in order of seniority, so that junior tranches
offer higher coupon payments (and interest rates) or lower prices to
compensate for additional default risk.
CDOs cont…
 Commercial Paper (CP)
• Commercial paper is an unsecured promissory note with a fixed maturity of 1 to
270 days.

• Commercial Paper is a money-market security issued (sold) by large banks and

corporations to get money to meet short term debt obligations (for example,
payroll), and is only backed by an issuing bank or corporation's promise to pay the
face amount on the maturity date specified on the note.

• Since it is not backed by collateral, only firms with excellent credit ratings from a
recognized rating agency will be able to sell their commercial paper at a
reasonable price.

• Commercial paper is usually sold at a discount from face value, and carries higher
interest repayment rates than bonds. Typically, the longer the maturity on a note,
the higher the interest rate the issuing institution must pay. Interest rates fluctuate
with market conditions, but are typically lower than banks' rates.
 CP – Advantages / Disadvantages
Advantage of commercial paper:
• High credit ratings fetch a lower cost of capital
• Wide range of maturity provide more flexibility
• Tradability of Commercial Paper provides
investors with exit options

Disadvantages of commercial paper:

• Its usage is limited to only blue chip companies
• Issuances of Commercial Paper bring down the
bank credit limits
 Bankers’ Acceptance
• A banker's acceptance, or BA, is a promised future payment, or time draft,
which is accepted and guaranteed by a bank and drawn on a deposit at
the bank.

• The banker's acceptance specifies the amount of money, the date, and the
person to which the payment is due.

• After acceptance, the draft becomes an unconditional liability of the bank.

But the holder of the draft can sell (exchange) it for cash at a discount to a
buyer who is willing to wait until the maturity date for the funds in the
deposit.

• A banker's acceptance starts as a time draft drawn on a bank deposit by a

bank's customer to pay money at a future date, typically within six
months, analogous to a post-dated check. The bank accepts (guarantees)
payment to the holder of the draft.
 Bankers’ Acceptance cont…
• Banker's acceptances make a transaction between two parties who do not
know each other more safe because they allow the parties to substitute
the bank's credit worthiness for that who owes the payment.

• BAs are used widely in international trade for payments that are due for a
future shipment of goods and services. For example, an importer may
draft a banker's acceptance when it does not have a close relationship
with and cannot obtain credit from an exporter. Once the importer and
bank have completed an acceptance agreement, whereby the bank
accepts liabilities of the importer and the importer deposits funds at the
bank (enough for the future payment plus fees), the importer can issue a
time draft to the exporter for a future payment with the bank's guarantee.

• Banker's acceptances are typically sold in multiples of US $100,000.

Banker's acceptances smaller than this amount as referred to as odd-lots.
 Certificate of deposit (CD)
• A certificate of Deposit (CD) is a time deposit, a financial product
commonly offered to consumers in the United States by banks.

• CDs are similar to savings accounts in that they are insured and thus
virtually risk-free; they are "money in the bank" (CDs are insured by
the Federal Deposit Insurance Corporation (FDIC) for banks or by
the National Credit Union Administration (NCUA) for credit unions).

• They are different from savings accounts in that the CD has a

specific, fixed term (often three months, six months, or one to five
years), and, usually, a fixed interest rate. It is intended that the CD
be held until maturity, at which time the money may be withdrawn
together with the accrued interest.
 Certificate of deposit (CD) cont…
• In exchange for keeping the money on deposit for the agreed-on term, institutions
usually grant higher interest rates than they do on accounts from which money
may be withdrawn on demand.

• Fixed rates are common, but some institutions offer CDs with various forms of
variable rates. For example, in mid-2004, interest rates were expected to rise,
many banks and credit unions began to offer CDs with a "bump-up" feature. These
allow for a single readjustment of the interest rate, at a time of the consumer's
choosing, during the term of the CD.

• A few general guidelines for interest rates are:

– A larger principal should receive a higher interest rate, but may not.
– A longer term will usually receive a higher interest rate
– Smaller institutions tend to offer higher interest rates than larger ones.
– Personal CD accounts generally receive higher interest rates than business CD accounts.
– Banks and credit unions that are not insured by the FDIC or NCUA generally offer higher
interest rates.