Classes of Financial Assets(fixed income securities)

Dr. Himanshu JoshiFORE School of Management

Major Classes of Financial Assets or Securities

• Money market• Bond market• Equity Securities• Indexes• Derivative markets

The Money Market (International)

• Treasury bills (initial maturities of 28,91, or 182 days.)– Bid and asked price(asked price is the price you would have to pay to buy T-bill from a

dealer, and bid price is slightly lower price you would receive if you want to sell a bill to dealer)

– Bank discount method(Days to maturity 90, bid 4.91, ask=4.90, CHG –0.01)

• Certificates of Deposits (Time deposit with bank usually for 3 months or less)

• Commercial Paper (issued by large well known Co. With upto • 270 days maturity)• Bankers Acceptances (an order to bank by a bank’s customer to pay a

sum of money at a future date, typically within 6 months. )

The Money Market (International) Continued

• Eurodollars :• (euro dollars are dollar denominated deposits at foreign

bank or foreign branches of US banks. Escape regulation of Federal Reserve. Less than 6 month maturity)

• Repurchase Agreements (RPs) and Reverse RPs:• (the dealer sells government securities to an investor on an

overnight basis, with an agreement to buyback next day at slightly higher price.)

• In Reverse repo dealer find an investor holding government securities and buys them, agreeing to sell them at slightly higher price on a future date.

The Money Market (International) Continued

• Brokers’ Calls (individuals who buys stocks on margin borrow part of the funds to pay for

the stock from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately on call if bank requires it. Rate is normally short term T-bill rate + 100 BPS )

• Federal Funds bank’s fund maintained with fed.• LIBOR Market• London inter bank offer rate is the rate at which large banks in London are

willing to lend money among themselves. • LIBOR interest rate may be tied to currencies other than the US dollar.

LIBOR rates are widely quoted for transactions denominated in British pounds, yen, euro, and so on.

Figure 2.1 Rates on Money Market Securities

Figure 2.3 The Spread between 3-month CD and Treasury Bill Rates

The Bond Market

• Treasury Notes and Bonds• Inflation-Protected Treasury Bonds• Federal Agency Debt• International Bonds• Municipal Bonds• Corporate Bonds• Mortgages and Mortgage-Backed Securities

Treasury Notes and Bonds

• Maturities– Notes – maturities up to 10 years– Bonds – maturities in excess of 10 years– 30-year bond

• Par Value - $1,000• Quotes – percentage of par

Figure 2.4 Lisiting of Treasury Issues

Federal Agency Debt

• Major issuers

– Federal Home Loan Bank

– Federal National Mortgage Association

– Government National Mortgage Association

– Federal Home Loan Mortgage Corporation

Municipal Bonds

• Issued by state and local governments

• Types

– General obligation bonds

– Revenue bonds

• Industrial revenue bonds

• Maturities – range up to 30 years

Risk in Fixed Income Securities

Risk of Debt Securities

• Interest Rate Risk: debt securities, which pay fixed coupon rates, suffer a price decline when interest rates go up unexpectedly, because the stated coupon is inadequate to compensate for the prevailing higher level of interest rates.

Fixed Income Security Prices

PrevailingInterest Rate In the Market

Risk of Debt Securities

Likewise reinvestment of fixed contractual coupons becomes risky when market interest rate decline.

Re-investment Risk

PrevailingInterest Rate In the Market

Bond Price

Bond Price

• This bond was issued near par value of 100 in the middle of January 2007. price quoted here is for the year 2009 (January to December).

• Fluctuation in bond price may be due to: (a) An increase in interest rate in the market. (b) An increase in unanticipated inflation rate. (c) A fall in risk premium that causes investors to

prefer riskier securities than treasury securities.

Credit Risk

• Treasury securities do not carry credit risk. However there are corporate bonds that carry significant amount of credit risk: that the issuer may be unable to service all or some of the promised obligations due to financial distress, reorganization, workouts, or bankruptcy.

Liquidity Risk

• Some debt securities may trade in illiquid markets (few dealers, wide bid-offer spreads, low depth, and so on).

• Emerging market debt and some high yield debt fall into this category.

• Liquidity refers to the ease with which a reasonable size of a security can be transacted in the market within a short notice, without adverse price reaction.

Liquidity Risk• The seller or the buyer will face following:1. High Transaction costs such as fees and

commissions,2. Bid-offer spreads3. Market impact costs, which refer to the

possibility that following the placement of a buy (Sell) order the market makers may increase (Decrease) the prices at which they are willing to trade.

Contractual Risk• Debt securities may be callable by the issuer at the issuer’s

option.• Holders of mortgage loans have the right to prepay their old

mortgages if they can refinance them at a cheaper rate.• This implies that prepayment should increase when mortgage

rates in market drop. • The lender will want to charge a higher interest rate to account

for the fact that he or she is giving the borrower a valuable option to call away the loans when interest rate fall in the market.

• This is “call risk” in the mortgages.• Hence mortgages must trade at a yield higher than similar non

callable treasury debt securities.

Inflation Risk• Inflation risk is the risk that money obtained in the future will be worth

less than when it is invested, which is almost always the case.• The real risk is how much this risk will be. On the other hand, it is possible,

in some cases, to take advantage of deflation that occurs when interest rates rise.

• A good example is when interest rates are rising, newly issued fixed-income securities start to pay more, while prices of things that generally require borrowing, such as real estate, start declining.

• Thus, for instance, one could buy 4 week T-bills as a way to save for a house or for a down payment. As the T-bills expire, they can be re-invested at progressively higher rates (while rates are rising).

• In the meantime, real estate prices are falling because it is getting more expensive to borrow the money to pay for it. So the money earned on the T-bills becomes even more valuable than the interest rate itself suggests when used to purchase real estate.

Event Risk

• Some debt securities may be sensitive to events such as hostile reorganizations or leveraged buyouts (LBOs). Such events can lead to a significant price loss.

• In October 1988 RJR Nabisco was taken over through an LBO. The resulting company took on heavy debt to finance the takeover. As a result Moody’s rating for RJR Nabisco’s debt from A1 to B3.

• The prices of RJR Nabisco dropped about 15%, and yield spread went from about 100 BPS above treasury to 350 BPS above treasury.

• In corporate debt market this risk is called event risk.

Event Risk (Protection)

• Investors often require protection against this type of risk by requiring a right from the sellers of bonds that allows investors to sell (Put) the bonds back to the seller at par value.

• Waga and Weltch (1993) examined the bondholder losses for 16 firms experiencing LBO were nearly 7% within 20 day window surrounding the event date.

Tax Risk

• If debt securities were originally issued with certain tax exemption features and subsequently there developed an uncertainty regarding their tax status, it could to lead to a price loss.

Foreign Exchange Risk

• Concept of ‘carry trade’• Depending upon the currencies in which the

investor is domiciled, debt securities may pose FX risk as well.

• Central bank of China and Japan hold significant amount of U.S government debt as investments, and consequently they are subject to the risk that the dollar could depreciate.