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Bonds and Derivatives: Types, Risks, and Swaps, Apuntes de Negocios Internacionales

Universitat Pompeu Fabra (UPF)Negocios Internacionales

An overview of bonds, including types such as pure discount and coupon bonds, and discusses the risks associated with them, including default, inflation, and liquidity risk. Additionally, it introduces derivatives as financial instruments whose payoff depends on the value of another financial variable, and explains the concept of futures and forwards, options, and swaps.

Tipo: Apuntes

2014/2015

Subido el 30/09/2015

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Financial'Economics'
PART'1:'ASSET'PRICING'UNDER'UNCERTAINTY'
CHAPTER'1:'INSTRUMENTS'AND'MARKETS'
1.'Introduction'and'Basic'Concepts''
Defining' our' topic' of' study:'“F inancial( Economics( is( the( study( of( how( best( to( allocate( and(
deploy( resources( (by( individuals( or( firms)( across( time( in( an( uncertain( environment( (across(
states(of(nature)(and(the(role(of(economic(organizations(in(facilitating(these(allocations”((
(
Key( topics:' allocation' of' resources,' intert emporal' and' uncertain' environments,' instruments'
and'financial'institutions'and'markets''
'
Key(elements:''
• Agents:'households,'firms,'financial'intermediaries''
• Capital'markets'
'
Financial' economics:' Studies' how' funds' are' transferred' across' time' and' across' possible'
scenarios'
> Financial'assets'and'financial'instruments'à'if'traded'='financial'securities'
'
WHY'this'desire'to'move'resources'around?''
CONSUMERS'à'Shift'purchasing'power'(consumption)'across'time'and'future'states'of'nature.''
! Student:'no'resources'today,'a'lot'in'the'future:'borrow!''
! Worker:'a'lot'of'resources'today,'no'resources'when'old:'save!''
! Bad'future'state:'house'fire.'Avoid'it' by' purchasing' insurance'(move' resources' from'
non>fire'states,'to'fire'states)''
'
FIRMS'à'Moving'capital'from'those'who'have'it'to'those'who'can'use'it'productively.'
• No'resources'today,'but'great'investment'opportunities:'borrow!''
• I'export'to'US,'want'to'protect'myself'against'dollar'depreciation'vs.'€,'buy'€'forward!'
(Transfer'resources'from'high'to'low'dollar'value'states).'
The'interplay' between'allocating' resources'through' time' and'across'states'of'the' economy' is'
the'key'issue'of'financial'economics.'
Agents' implement' their' planned' shifts'of' resources' (saving,' hedging,' etc…)' with' the' use' of'
securities.''To'do'so,' investors'need'to'know' the'value' of' these'securities'they'trade' in'order'
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PART 1: ASSET PRICING UNDER UNCERTAINTY

CHAPTER 1: INSTRUMENTS AND MARKETS

1. Introduction and Basic Concepts Defining our topic of study: “Financial Economics is the study of how best to allocate and deploy resources (by individuals or firms) across time in an uncertain environment (across states of nature) and the role of economic organizations in facilitating these allocations” Key topics : allocation of resources, intertemporal and uncertain environments, instruments and financial institutions and markets Key elements :

  • Agents: households, firms, financial intermediaries
  • Capital markets Financial economics : Studies how funds are transferred across time and across possible scenarios -­‐ Financial assets and financial instruments à if traded = financial securities WHY this desire to move resources around? CONSUMERS à Shift purchasing power (consumption) across time and future states of nature. -­‐ Student: no resources today, a lot in the future: borrow! -­‐ Worker: a lot of resources today, no resources when old: save! -­‐ Bad future state: house fire. Avoid it by purchasing insurance (move resources from non-­‐fire states, to fire states) FIRMS à Moving capital from those who have it to those who can use it productively.
  • No resources today, but great investment opportunities: borrow!
  • I export to US, want to protect myself against dollar depreciation vs. €, buy € forward! (Transfer resources from high to low dollar value states). The interplay between allocating resources through time and across states of the economy is the key issue of financial economics. Agents implement their planned shifts of resources (saving, hedging, etc…) with the use of securities. To do so, investors need to know the value of these securities they trade in order

to satisfy their desired patterns of consumption through time and across states à ASSET PRICING -­‐ Deficit units: agents that need resources -­‐ Surplus units: agents that have more funds than the ones they need -­‐ The bank is liable with all of his assets What’s the most important source of funding in Europe for companies? -­‐ Banks à are more important than markets. -­‐ Example: Spain bailout banks à in order to avoid bank runs so to avoid defaults! -­‐ Small and medium size companies have problems on barrowing in financial markets because nobody knows them.

2. Financial Securities A security (= financial asset = financial instrument ) is a document that confers upon its owner a financial claim.

-­‐ In fact, a coupon bond is equivalent to a collection, or a basket, of pure discount bonds with nominal values equal to the coupons

  • Bonds issued by a corporation or Government are called debt
  • If the price at which the bond is sold is exactly the same as the nominal value, we say that the bond sells at par ; if it is higher the bond sells above par ; if it is lower the bond sells below par (zero-­‐coupon bonds always sell below par) -­‐ Above par: are sold at a price above the discount -­‐ Below par: are sold at a price below the discount Do bonds really guarantee a fixed payment? No! Risk of trading bonds àyou cannot be sure that the debtor will meet its obligations.
  • The debtor might fail to meet the payment obligation embedded in the bond ( credit or default risk ) à In principle, bonds issued by Governments represent the paradigm of risk-­‐free securities (there is a guaranteed payoff at maturity, known in advance)
  • Even if the amount to be paid in the future is fixed, it is in general impossible to predict the amount of goods which that sum will be able to buy ( inflation risk ); there are bonds that guarantee a payment that depends on the inflation level (inflation-­‐index bonds) The final risk arises when the creditor needs money before maturity ( liquidity risk ) and tries to sell the bond -­‐ Apart from the risk of default, the creditor knows with certainty that the nominal value will be paid at maturity. -­‐ However, there is no price guarantee before maturity: The creditor can in general sell the bond, but the price that the bond will reach before maturity depends on factors (interest rates) that cannot be predicted. -­‐ Bond prices change as consequence of movements in interest rates; therefore, if we want to sell our bond before maturity, the bond will be trading at a price which may represent a gain or a loss to the investor. -­‐ Bond prices fluctuate as the price of any other security: However, the degree of fluctuation of bond prices (volatility) tends to be lower than other risky assets like stocks. “One can lose money investing in Bonds” Sometimes there is a collateral, which guarantees you the payment, but it is not always the case.

You can never compute real interest rate ex-­‐ante, as you don’t know how inflation will be in the future à Inflation risk There are 3 types of risk: -­‐ Default risk -­‐ Inflation risk -­‐ Liquidity risk Examples of bonds -­‐ Bank deposit -­‐ Mortgage loan -­‐ US treasury bills: issued by the government. They are usually short-­‐term, sell at the discount and don’t pay periodic interests. -­‐ Corporate debt 2.2 Stocks Stock à Security that gives its owner the right to a fraction of any profits that might be distributed (rather than reinvested) by the firm that issues the stock and to the corresponding part of the firm in case it decides to close down and liquidate. These distributions are called dividends and are in general random; they will depend on the firm’s profit, as well as on the firm’s policy. In principle (if it does not go out of business), the stock will not expire. The potential risky gains (losses) of the stock include capital gains (losses) and the dividend yield (relation between the dividend and the price of the stock).

  • Capital gains (losses) are random, depend on the company’s ability to make profits Overall stocks will be more risky than bonds (generally), although with respect to inflation uncertainty, stocks can behave better than bonds à general price increases mean than corporations are charging more for their sales and might be able to increase their revenues and profits (it does not apply to bonds).
  • As a bondholder your returns are limited
  • Shareholders = stockholders = equityholders à no limited returns
  • Stakeholder: anyone who has a stake on the firm, everybody who has an interest in the company: workers, suppliers…

The exchange price the parties agree upon is such that today’s value of the contract is zero: there is a price to be paid at maturity, but there is no exchange of money today. The price to be paid at maturity (but agreed upon today!) is called the future price or the forward price. The regular market price of the underlying at which you buy the underlying at the present time is called the spot price. The side that accepts the obligation to buy takes a long position, while the side that accepts the obligation to sell takes a short position “Our investor is pretty sure that the value of the US dollar will go down relative to euro. However, right now he does not have funds to buy Euros. Instead, he agrees to buy one million Euros six months from now at the exchange rate of $0.95 for one euro” -­‐ Price of 0,95€ à by doing this I fix the price 2.3.2 Options Option à A security that gives its owner the right (not the obligation) to buy ( call ) or sell ( put ) another, underlying security, at ( European ) or before ( American ) a future predetermined date ( maturity or expiration date ) for a predetermined price ( exercise or strike price ). -­‐ It gives the right but not the obligation to the owner to buy that asset (or sell) for a given price and on a given day In an option contract there are two parties: the holder has a right, and the writer has an obligation. In order to accept the obligation, the writer will request a payment; this is called the premium , although usually we will call it the option price. When a person accepts the option obligation in exchange for the premium, we say that the person is writing the option and he has a short position in the option. The owner of the option , then, is said to be long in the option. It’s different from a forward contract à you can say NO!! Because it is a right not an obligation, so you can say no as a buyer to pay 0,95€ when the market price is 0,87€. -­‐ Option to buy = CALL -­‐ Option to sell = PUT When you buy an option, you always pay a price for it as whoever sells that right wants something in exchange. One of the party has the rights and the other the obligations à in a forward contract there is no premium.

Reasons for trading options:

  • They are widely used for hedging risk à A portfolio with a stock and a put option is equivalent to a portfolio in the stock with a limit on a possible loss in the stock value ( portfolio insurance ): If the stock drops in price below the exercise price, the put is exercised (the owner has the right to sell at the exercise) and the stock/option holder keeps the exercise price amount (in this case, the premium for this insurance is the price of the put option to be paid by the investor making the hedge)
  • In addition, options can be attractive from an investment point of view because of the implicit leverage, that is, as a tool for borrowing money à buying options is similar to borrowing money for investing in the stocks. Example: Option to buy (CALL) 100 shares XYZ @€10/share on December 21, 2015 Case 1: price of XYZ shares is 9€ on Dec 21, 2015 Case 2: price of XYZ shares is 12€ on Dec 21, 2015 In case 1, you don’t exercise your right. In case 2, you simply exercise your right and pay 10€ instead of 12€, and you have a profit of (12-­‐10)*100 = 200. The seller of the option in this case will lose money. 2.3.3 Swaps Swap à Contract by which two parties agree to exchange two cash flows with different features. Example: An investor has to pay a variable interest rate on his house mortgage loan, issued by bank A. However, he would rather be paying a fixed rate, because he does not like the fact that he cannot know what the variable rate will be each month He could go to bank B, which trades swaps, and request a swap contract by which he would be paying bank B a fixed amount of interest each month, while in return bank B would be paying the variable interest to bank A. A swap can be thought of as exchanging interest rates on two different types of bonds. Usually, only the interest rate payments are exchanged, and not the principal since it is the same for both parties ( notional principal ). It is only a reference amount used to compute the coupon payments.

Reasons for trading swaps: An investor might want to buy or sell a swap for speculation purposes as a way to make money based on a change in interest rates à If the investor thinks that interest rates will go up, he will buy a swap (will receive the floating rate), locking in the fixed rate he will have to pay in exchange for the variable interest payments that, if the prediction is correct, will go up. As a hedging instrument, swaps are typically used by investors who have to pay a floating rate and receive a fixed rate Example: a bank might have many clients to whom it pays a floating rate on certain accounts. Suppose that the bank is also providing a lot of mortgage loans, the majority of which pay a fixed rate: this is a risky situation for the bank because, if the interest rates go up, it might face losses, since it will not be able to pass a higher interest rate to its mortgage customers à One possibly way to avoid that risk is to buy a swap :

  • The bank will be paying the fixed interest rate, the cost of which can be covered by the funds received through the mortgages, and it will be receiving a floating rate that will allow it to pay the floating interest on the floating-­‐rate accounts Swaps are also zero-­‐sum games (one side’s profit is the other side’s loss) 2.4. Short-­‐selling Two investors might have different expectations (based on their own judgment of the available information) about future dividends and prices. An optimistic investor might decide to buy the stock ( long position ). A pessimistic might prefer to sell; however, suppose that this investor does not own the stock. This investor still can bet on his beliefs by short-­‐selling the stock. It consists in borrowing the stock from someone who owns it and selling it The short-­‐seller hopes that the price of the stock will drop; when that happens, he will buy the stock at that lower price and return it to the original owner. The investor has a short position in the stock. The act of buying back the stock and returning it to the original owner is called covering the short position. Successful Short-­‐Selling: An investor thinks the stock of Downhill, Inc. is overvalued. It sells at 45€. The investor goes on-­‐line, signs into his Internet brokerage account, and places an order to sell short 1,000 shares of Downhill. By doing so he receives 45,000€. After patiently waiting four months, he sees that the stock price has indeed plunged to 22€. He buys 1,000 shares at a cost of 22,000€ to cover his short position. He thereby makes a profit of 23,000€. Here we ignore transaction fees, required margin amounts, and inflation/interest rate issues. Short selling is not restricted to stocks; investors can also short-­‐sell bonds, for example. But short-­‐selling a bond, for economic purposes, is equivalent to issuing the bond: the person who has a short position in a bond is a debtor, and the value of the debt is the price of the bond (borrowing). Short-­‐selling position is like having a “negative” position in the corresponding security.

Example: PRICE CASH FLOWS Borrow shares (100)

  1. 000 Sell shares 20 The company pays a dividend (1€) -­‐ 100 At some day in the future you buy the shares in the market and give them back

TOTAL 700

-­‐ Interests and fees are assumed to be 0 -­‐ For the lender of the share there is no risk -­‐ Who gets the dividend in this case is the owner of the share not me, because I have sold the shares to someone else. Appendix (Chap. 2, MR) Simple interest loan : interest is paid on a periodic basis Compound interest loan : No interest is paid until the end of the loan. Accrued interest is added to capital and generates interest. Consider a loan with a principal C0, rate r, and n years. Interest payment: there is an interest I have to pay but I don’t pay anything = 0