UE 4 - Financing and Risk Management PDF

The famous Black-Scholes (or Black-Scholes-Merton) formula applies to European options on Non-dividend paying stocks. The essence of the option to delay is that it allows the firm to avoid the “bad” outcome. You should therefore delay deciding until you know what the state of the world is: You...

The famous Black-Scholes (or Black-Scholes-Merton) formula applies to European options on Non-dividend paying stocks. The essence of the option to delay is that it allows the firm to avoid the “bad” outcome. You should therefore delay deciding until you know what the state of the world is: You lose some sales on delay If the market turns out to be bad, you do not invest and do not take the loss Does the avoided loss make the foregone sales worthwhile? Compare NPV now and NPV of delaying Bond Issuance and Debt Capital Markets Part 1: bond issuance - a key element to get funding Many ways to finance a corporation, but they largely fell into one of two categories: Debt & Equity Both are financial assets, but they are some key differences from the perspective of both the issuer and the investor: Debt has a promise to pay: o Bond: legal commitment to meet some payment schedule in a timely manner and failure to meet a payment could lead to bankruptcy o Repayment of principal Equity: o Payment under equity is discretionary o Management decides if they desire to pay dividend or not Equity holders and bond holders take on different risks: A fixed interest holder has lent the company money, and is expecting interest payments Equity holders are taking a stake in a company and the value of this stake will dependent upon the profits that the company makes. If the company is perceived to be making more profit, then the share price will tend to rise “Hybrid bond”: some bond contain an option (call/put). For example, with a callable bond, the issuer of the debt has the right to call the bond under prescribed terms coupons are paid based on fixed amounts and principal Bullet bond is repaid at par at maturity a bond that gives the issuer the option to repay the bond in advance à on a specified future date (the call dates) ahead of scheduled final maturity The possibility of earlier redemption is a potential benefit to the issuer: if interest rates fall in the future, the issuer has the ability to repay the bond earlier and Callable bond refinance more cheaply. à callable bonds typically pay higher coupons than Price of callable bond = equivalent straight bonds. Price of straight bond – à this higher coupon is a compensation for the pre- Price of call option payment risk : in case of early payment, the investor will have to reinvest his capital, at possibly lower rates à price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer à yield on a callable bond is higher than the yield on a straight bond a bond that gives the investor the right to demand bond repayment in advance à on a specified future date (the put dates) Advantages for the investor : If market rate rises, the investor can force early repayment and reinvest the proceeds elsewhere Putable bond (at a higher rate) It also a valuable insurance if the Price of putable bond = creditworthiness of the issuer come into doubt. Price of straight bond + Putable bonds are relatively uncommon and tend to be Price of put option offered by companies with weaker credit ratings as a way of reducing the issue’s credit risk: cost effective funding strategy, but if rate rises, the issuer faces the risk of being forced to refinance at a higher rate. à price of a putable bond is always higher than the price of a straight bond because the put option adds value to an investor  à Yield on a putable bond is lower than the yield on a straight bond a convertible bond gives its holder the right to exchange the principal of the security and any remaining unpaid coupons for a specified amount of alternative securities from the same issuer (for example equity) Convertible bond Then, it combines features of pure debt and pure equity Like straight bond, they pay a fixed coupon and have a stated maturity date Like equity, they allow investors to participate in the prosperity of the issuing company by switching into equity if the shares perform well Benefits to the issuer: Allow them to reduce its cost of finance (lower coupon) Allow them to sell common stock at a premium price to its current market price Benefits to the investor: It combines the certainty of a fixed income security (coupons and repayment date) with the potential for significant capital gains if the underlying stock performs well 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 𝑝𝑎𝑟𝑖𝑡𝑦 (%) = ∗ 100 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 Parity: the option’s intrinsic value à 100 – parity = in/out the money Premium: indicates how much more expensive it is to buy the underlying shares indirectly, by purchasing the convertible and exercising the conversion right, rather than going directly to the equity secondary market 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 − 𝑝𝑎𝑟𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 (%) = ∗ 100 𝑝𝑎𝑟𝑖𝑡𝑦 clean price basis: formula up dirty price basis: ((bond price + X days of accrued interest – parity)/ parity) * 100 An inflation linked bond pays: like a conventional bond interest at fixed intervals returns the principal at maturity Tend to have lower coupon rates than nominal bonds ; later coupons will be bigger than initial ones Quotation always in real yield (not nominal): net of inflation (therefore no fear of loss of purchasing power) In addition, interests and maturity value are adjusted by the rate of inflation over the life of the bond: The cash flows of an inflation-linked bond are depending on the evolution of its linking price index Linkers pay coupons on a variable principal which increases or decreases with the price index over the life of the bond The principal repayment at maturity is also adjusted for the change in the price index 𝑇𝐼𝑃𝑆 = (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙) ∗ 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟 𝑡𝑖𝑚𝑒 𝑑𝑖𝑟𝑡𝑦 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑇𝐼𝑃𝑆 = (𝑐𝑙𝑒𝑎𝑛 𝑝𝑟𝑖𝑐𝑒 + 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) ∗ 𝑖𝑛𝑑𝑒𝑥 𝑟𝑎𝑡𝑖𝑜 (𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛) Why do governments issue inflation-linked bonds? To reduce its cost of financing o Recall: Bond yield (nominal yield) = yield to compensate the risk that you take + extra yield to compensate inflation o To directly reduce its cost of financing: in the Inflation Linked Bond, the investors know that they will receive the inflation, so they do not ask for an extra premium in the yield (so, lower yield, so it is less expensive for the issuer) o Indirectly: if governments issue part of their debt in the form of inflation- linked bonds, they have less to earn from inflation, and therefore a low inflation policy becomes more credible To generate social welfare o ILB are the only asset to provide a true and perfect hedge against the risk of unanticipated inflation o Investors need to become accustomed to the properties of the new asset class and the government can lead o The introduction of one financial innovation may in turn facilitate other innovations which would help to complete financial markets Why do investors buy inflation-linked bonds? Provide the only true hedge against the risk of inflation From a standard portfolio diversification point of view, there are benefits from holding part of their assets in the form of ILB if inflation is uncertain  𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 (𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑖𝑜𝑛) = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 − 𝑟𝑒𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 = 𝑟𝑒𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑠 𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑡𝑖𝑜𝑛𝑠 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑇𝐼𝑃𝑆 𝑦𝑖𝑒𝑙𝑑 = 𝑟𝑒𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 When inflation risk premium increases, inflation breakeven increases When liquidity risk premium increases, inflation breakeven decreases Part 2: using bonds to get some funding - repo operations A repo (sale and repurchase agreement): is a contract under which the seller: Commits to sell the securities to the buyer for an agreed amount and value date Simultaneously commits to repurchase the same (or similar) securities from the buyer at a later date (the maturity date), repaying the original sum of money, plus a return or the use of that money over the term of the repo (interest) The repo is a vehicle for funding “long position” or covering “short position” à Fund manager: they wish to earn additional income by lending securities they hold à The repo interest they pay on the cash proceeds may be very low, compared with rates available in other money market instruments (for example depo) à Investors: they have surplus cash to place in money markets, and because repo is secured, it is particularly attractive mostly because it carries lower credit risk than unsecured lending à Securities trader: they need to fund long or short position in securities. Legal status: the collateral in repo is not pledged but sold to the buyer, so that legal ownership of the collateral passes from the seller to the buyer, during the time of the repo à The risk and return on the collateral remain with the seller à Coupon: since the seller retains all the risks on the collateral, he is also entitled to keep the return. If a coupon is paid during the term of the repo, it will be paid to the buyer (legal owner of the bond during the term of the repo). However, the buyer is required to make an equivalent cash payment to the seller Advantage for the buyer: If the seller defaults, he can liquidate the collateral immediately and without difficulties (does not have to wait the insolvency proceedings) He can use the collateral to cover a short position in securities (he only have the obligation to return “the same or similar securities” at maturity) Repo offer a double protection against credit risk: If the issuer of the collateral fails, the seller has an obligation to provide a new collateral If a repo counterparty fails, the non-defaulting buyer would sell the collateral and the non defaulting seller would use the cash to buy new collateral The collateral in a repo is intended to protect the buyer against default by the seller The buyer must have enough collateral The collateral is valued at its current market price at the start of the repo: o If illiquid: the valuation might be inaccurate o The price of the collateral may fall very quickly when he begins to sell (specially if illiquid bond) o The price of the asset may be very volatile Initial margin or haircut: the buyer may insist on buying the collateral at discount price to its current market value (the repo will be overcollateralised) Haircut rate: usually 2% for Government bond, 5% for equity and as much as 50% for emerging market debt rolled over at the same rate until one Open repo / Demand repo counterparty decides to terminate the transaction Short dated repo less than one month Term repo fixed term longer than 1 month Activity in the repo market is segmented into: General collateral (GC): the buyer is willing to accept as collateral any of the several securities satisfying certain predetermined criteria (AAA…). The collateral is only seen as protection against default. GC repo: secured form of borrowing and lending money Specials: the essential purpose of repo in this context is the borrowing and lending of specific securities (not the borrowing of cash) Competition between buyer will force them to offer cheap cash in exchange of the bond (repo rate can be 0% and even negative). Seller may be reluctant to use certain securities as collateral in longer-term repo, in case they need the securities for another purpose before the maturity of the repo. Right of substitution of the seller: the seller has the right to recall collateral during a repo and substitute alternative collateral of equivalent value and quality Valuable for the seller, but may be inconvenient for the buyer: Substitution can be limited to certain dates The seller may substitute a limited number of time The buyer can expect a higher repo rate on his cash in exchange of granting rights of substitution Delivery repo: the buyer takes custody of the collateral from the seller This is safest for the buyer (he has the collateral under his control), however, because collateral is transferred across settlement systems, it is also the most expensive alternative Hold in custody (HIC) repo: the seller retains custody of the collateral on behalf of the buyer. à Cheapest option à Disadvantages: Greatest credit risk if the seller defaults (difficulties in recovering collateral) An unscrupulous seller could use the same piece of collateral several time in parallel with HIC repo 𝑟𝑒𝑝𝑜 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 = 𝑠𝑡𝑎𝑟𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑 ∗ 𝑟𝑒𝑝𝑜 𝑟𝑎𝑡𝑒 ∗ 𝑡𝑒𝑟𝑚 𝑏𝑎𝑠𝑖𝑠 (360 𝑜𝑟 365) 𝑑𝑖𝑟𝑡𝑦 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑠𝑡𝑎𝑟𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 ∗ (100 + % ℎ𝑎𝑖𝑟𝑐𝑢𝑡) The haircut is included in the dirty price of the bond 𝑛𝑒𝑡 𝑔𝑎𝑖𝑛 = 𝑔𝑎𝑖𝑛 𝑜𝑛 𝑡ℎ𝑒 𝑓𝑖𝑥𝑒𝑑 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 − 𝑟𝑒𝑝𝑜 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 Part 3: over-the-counter (OTC) derivatives - useful market instruments for corporate firms It is an over-the-counter contract between parties that determines the rate of interest to be paid on a principal amount beginning at a future start date Market quotation: Forward Rate Agreement FRA (3*6) = 3 months rate in 3 months FRA (3*9) = 6 months rate in 3 months FRA (6*9) = 3 months rate in 6 months à To speculate à To cover your rate exposure (hedging purposes): protection against an increase/decrease in rates (if buy or sell)  Buyer Seller Thinks that the rate will rise Thinks that the rate will fell Will borrow some money and Will lend some money and wants a wants a guarantee against a protection against a fall in rate potential rise in rate How to calculate the amount that will be exchanged (on the value date): 𝑛° 𝑑𝑎𝑦 (𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 𝑟𝑎𝑡𝑒 − 𝑔𝑢𝑎𝑟𝑎𝑛𝑡𝑒𝑒𝑑 𝑟𝑎𝑡𝑒) ∗ 360 ∗ 𝑎𝑚𝑜𝑢𝑛𝑡 𝑛° 𝑑𝑎𝑦 1 + (𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 𝑟𝑎𝑡𝑒 ∗ ) 360 What will be the 3month rate in 3 months? We are looking for “x%” 90 90 180 J1 + K0,02 ∗ OP ∗ J1 + K𝑋 ∗ OP = J1 + K0,035 ∗ OP 360 360 360 2 different swaps: Interest swap rate (IRS) Currency swap In a fixed-for-floating swap (also called vanilla swap): § One party pays fixed rate of interest § The other party pays a variable rate (LIBOR or EURIBOR) § The notional amount is constant A swap seller A swap buyer Pay variable Pay fix Receive fix Receive variable Thinks that rates will fall Thinks that rates will rise à Speculation à Hedging: swaps are perfect instruments to hedge bank’s global interest rate risk Assets Liabilities Fixed rate investment Fixed rate loans Variable rate investment Variable rate loans à Main risk: a fall in rate You will have a fall in your revenue (because the variable rate investment will generate lower revenue) and it might not be enough to cover the fixed rate interest (that you have to pay from fixed rate loan) The currency swap is contractually similar to an IRS. The main differences are: Each interest rate is in a different currency The notional amount is now replaced by two principal amounts (one in each currency) These principal amounts are exchanged at the start of the swap and then re- exchanged at maturity A Swiss bank requires 5Y USD floating rate loan to fund its growing US business It has 2 alternatives: Fund in the US interbank market at LIBOR flat Issue a 5Y CHF Bond with a coupon of 5.85% and swap with a currency swap (receive 5.96% fix leg in CHF and pay USD LIBOR flat) Net cash flow: - CHF 5.85% + (CHF 5.96% - USD LIBOR Net cash flow: - USD LIBOR + CHF 0.11% Through the swap, the bond issuer can fund at LIBOR – 0,11% Part 4: covered bond - an attractive instrument for credit institutions Covered bond: a debt instrument, issued by a credit institution. à It differs from a corporate bond in that, in the event of the issuer’s insolvency, bondholders have preferential recourse to specified collateral (the “cover pool” or “asset pool”) which is ring-fenced from the claims of the issuer’s general creditors Covered bonds are characterized by the following common essential features: (Europe) The bond is issued by a credit institution which is subject to public supervision and regulation o Full recourse right: creates an unrestricted unconditional obligation on the credit institution to repay a debt o Key difference between securitisation and covered bonds: credit institution which originated the assets typically does not guarantee the performance of the securitization (no claim) Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution o Most common cover assets are mortgage loans secured on residential or commercial property, mortgage loans secured on ships and loans to public sector entities o Cover pool: the assets in the cover pool will be used to repay the covered bondholders before they are made available for the benefit of the credit institution’s unsecured creditors  The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times o Sufficient assets: the value of the cover pool assets meeting the minimum quality criteria must be at least equal to the value of the covered bonds. In most jurisdictions, the value of the cover pool is required to exceed the value of the covered bonds by a prescribed amount, known as overcollateralization o Ongoing obligation: the credit institution has the obligation to ensure that the value of cover pool assets is equal to or higher than the value of the covered bonds at all times The obligations of the credit institution in respect of the cover pool are supervised by public or other independent bodies In securitization, by contrast, the credit institution is generally not compelled to replace assets which enter into default after they have been transferred into the securitization portfolio. UCITS compliant covered bond: are considered as particular safe investments, which justify the easing of prudential investment limits Covered bonds are attractive instruments for credit institutions to issue for several reasons: They are a source of long-term funding which can be used to finance a credit institution’s long-term activities It can also reduce its refinancing risk compared with shorter-maturity funding options There is also a large investor base in Europe for UCITS-compliant covered bonds Liquidity Coverage requirement à Under Basel III, banks will be required to hold a stock of high quality liquid assets to cover the total assumed volume of net cash outflows over a 30 day period in a stressed scenario à Under Basel rules, high quality liquid assets are split into Level 1 Assets (cash, Governement bond, BIS, IMF bonds…) and Level 2 Assets. Covered bonds, if they are rated at least AA-, can be included in the Level 2 Asset (with a haircut of 15%) Solvency II Solvency II aims to provide a regulatory framework for insurance companies. UCITS compliant Covered bonds are eligible for preferential treatment under Solvency II The ECB Covered bonds receive a preferential treatment over unsecured bank bonds and ABS within the collateral framework of the ECB (lower haircut) Category I Government bonds Jumbo covered bonds Category II Local and regional government debt Agency and supranational debt Traditional covered bonds (non Jumbo) Structured covered bonds Spanish multi- Category III Cédulas Corporate bonds Category IV Unsecured bank Category V ABS Difference between covered bond and ABS (Asset Backed Securities): No banking supervision All type credits If case of default, the investor will be forced to accept the loss Maturity of the underlying asset Part 5: the Quantitative Easing (QE) - what kind of impact on bonds? New solution after the subprimes crisis: already existing in US and Britain Central bank creates money by buying securities such as government bonds or corporate bonds, since July 2016, from commercial banks The aim is to stimulate the economy by encouraging banks to issue more loans: the banks take the money and then buy assets to replace the ones they have sold to the central bank It should: Raise stock prices Lower interest rates (boosts investment) Help inflation to go higher (fear of deflation) Push lower the EUR/USD (boosts European net exportation): 1.40 vs 1 à Fear of liquidity, lower rates and higher risks Transmission mechanism of monetary policy: process through which monetary policy decisions affect the economy in general and the price level in particular à Long, variable and uncertain time lags à Difficult to predict the precise effect of monetary policy actions on the economy and price level