Download Intro to Banking 4

Guy Hargreaves
ACE-102
Recap of yesterday
 The concepts of market liquidity and product
fungibility
 The major instruments traded in global financial
markets
 Broad trends that have led to today’s financial
instruments
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Today’s goals
 Describe the term structure of interest rates
 Understand risk based pricing theory
 Understand generic bond and discount instrument
valuation models
 Understand FX and forward rate pricing
 Understand the concepts of market efficiency and
arbitrage
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Interest rates
 Interest rates are a fundamental input into conditions
in any given economy
 The level of interest rates provide an incentive in the
decision on whether to consume or save
 For each currency we find a “term structure” of interest
rates – the “yield curve”
 To develop yield curves, markets take “risk free”
interest rates and add appropriate “risk premia”
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The risk free yield curve
 Many theories on the drivers behind risk free yield
curve level and shape
 Firstly the issuer must be risk free!
 Major components of risk from Money Market and
Fixed Income instruments:





Interest rate risk
Default risk
Liquidity risk
Duration / convexity risk
Tax / other event risk
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The risk free yield curve
Issuer
Government
Agency
Corporate IG
Corporate HY
Interest rate risk
Similar
Similar
Similar
Similar
Default risk
“zero”
Near zero
Moderate
High
Liquidity risk
Low
Low
Moderate
High
Duration risk
Similar
Similar
Similar
Similar
Tax/event risk
Low
Low
Lowish
Lowish +
=> Clearly the best “risk free” yield curve it the government
curve – noting that nothing is really risk free!
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US Treasury yield curve
Long end
Short end
• Short end rates formed from announced setting of Fed Funds overnight
cash rate and expectations on its 1-2 year path
• Long end rates formed from Inflation Expectations, inflation linked
bond yields (real rates) and the expected path of inflation expectations
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Measuring inflation expectations
TIPS rates
• Treasury Inflation Protected Securities (TIPS) - real rate yield
curve showing long term inflation expectations of ~ 1.5-2%
• Inflation expectations ~ (Nominal Rates – Real Rates)
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Fed watching and the CPI
 Setting the risk free rate in an economy is critical


Too tight (high rates) and economic activity might contract
Too loose (low rates) and the economy might overheat
 Fed watching is a national sport!

Janet Yellen, current Fed chief, is very influential in setting the
path of Fed Funds cash rates => short rates
 The Consumer Price Index (CPI), amongst other
indicators, is critical to setting longer term inflation
expectations

Real rates are quite stable – changing inflation expectations
can play havoc with bond prices
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Now we have a risk free yield curve
 All other interest rate based financial instruments can
priced as a margin to risk free



Risky bonds
Derivatives and other contracts
Any cash flow imaginable!
Issuer
Government
Agency
Corporate IG
Corporate HY
Interest rate risk
Similar
Similar
Similar
Similar
Default risk
“zero”
Near zero
Moderate
High
Liquidity risk
Low
Low
Moderate
High
Duration risk
Similar
Similar
Similar
Similar
Tax/event risk
Low
Low
Lowish
Lowish +
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Current USD yield curves
4.50
4.00
3.50
3.00
US Treasury Bonds Yield
2.50
Corporate Bonds AAA
2.00
Corporate Bonds AA
Corporate Bonds A
1.50
1.00
0.50
0.00
3 Month
6 Month
2 Year
3 Year
5 Year
10 Year
30 Year
• How does the market conclude “A” rated corporate bonds should yield ~
2.0% more than risk free UST in 5-years?
• “A” rating default probability => compensation for expected loss + some
compensation for unexpected losses
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Recall our ratings table
Standard & Poor’s
Moody’s
Fitch
Default Risk profile
AAA
Aaa
AAA
Investment Grade: extremely strong
AA+ | AA | AA-
Aa1 | Aa2 | Aa3
AA+ | AA | AA-
Investment Grade: very strong
A+ | A | A-
A1 | A2 | A3
A+ | A | A-
Investment Grade: strong
BBB+ | BBB | BBB-
Baa1 | Baa2 | Baa3
BBB+ | BBB | BBB-
Investment Grade: adequate
BB+ | BB | BB-
Ba1 | Ba2 | Ba3
BB+ | BB | BB-
High Yield : less vulnerable
B+ | B | B-
B1 | B2 | B3
B+ | B | B-
High Yield : more vulnerable
CCC
Caa1 | Caa2 | Caa3
CCC
High Yield : vulnerable
CC
Ca
CC
High Yield : highly vulnerable
C
C
C
High Yield : highly vulnerable +
SD
Selective default
D
D
Default
NR
NR
Not rated
 Credit ratings are a critical component of the efficient
operation of the fixed income market
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Credit spread pricing
 Some science, plenty of art!
 Assuming our A rated corporates had a probability of
defaulting over 5 years of 2% and if they defaulted we
would lose 60% 0f our investment (40% recovery)


This could account for 1.2% of the 2.0% credit margin
The balance 0.8% could account for liquidity and event risk
pricing
Rating
Probability of default
(PD) over 5-years
Loss Given Default
(LGD)
Expected Loss (PD * LGD)
A
~ 2%
60%
1.20%
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Pricing in the Money Market
 We now have a “Yield to Maturity” (YTM) curve for an
issuer – what do we do with that?
 Money market instruments are mostly “discount”
securities



Say a corporate issues Commercial Paper (CP) which repays
$100 in 90 days
Investors will lend the issuer (buy the CP) $X today to receive
$100 in 90 days
How do we calculate X?
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Discount valuation
 Simple interest formula
$PV =
$FV
(1 + YTM * t)
Where:




$PV is the purchase price of the discount instrument
$FV is the repayment amount of the discount instrument
YTM is the yield an investor requires for investing
t is the term of the instrument in years (watch the daycount)
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Discount valuation
 So in this case let’s assume



$FV is $100
YTM is 0.25% based on a 365 day daycount
t is 90 days
$PV =
$100
(1 + 0.25% * 90 / 365)
= $99.938
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What happens if yields rise?
 Say investors now demand a higher YTM to account
for higher short term interest rate expectations



$FV is still $100
YTM is 0.50% based on a 365 day daycount
t is 90 days
$PV =
$100
(1 + 0.50% * 90 / 365)
= $99.877 (versus $99.938
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Yield versus price
 Discount instrument prices fall when yields rise
 Does this make sense?
If investors demand higher yields this implies they need to be
compensated for higher expected and unexpected risks
 Issuers of discount instruments can not change repayment
 Investors need to buy those instruments at lower prices to
generate their higher required returns

 What are the implications for “traders” of these
instruments?
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Pricing in the Bond Market
 Bond pricing is a much more complicated process than
discount pricing



Bonds can pay quarterly, semi annual or annual coupons
To calculate a price today multiple coupons need to be
discounted using an appropriate YTM
Many assumptions go into bond pricing models but
ultimately the markets tend to simplify models and apply
agreed conventions
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Typical bond cashflows
 Apple issues a 3-year fixed rate bond to investors paying 1.0%
semi annual coupon
 Bond principal is $100m with a “bullet repayment”
 Cashflows are:
Apple pays $0.5m
coupons every 6 months
Apple repays
$100m + $0.5m
coupon on
maturity date
Apple receives
$100m on issue
date
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Theoretical bond pricing model
 Where:





C = coupons payable
i = YTM
N = number of annual coupons
M = principal repayment
P = market price
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Foreign exchange pricing
 “Spot” FX markets need no special pricing models



Pricing of cash is simply the principal or notional amount of
cash one holds
An FX transaction is just the exchange of cash in one currency
for cash in another
Settlement periods are normally very short T, T+1 or T+2
 Market pricing in FX markets is function of pure
supply and demand
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Foreign exchange pricing
 Many factors influence supply and demand in FX
markets including:




Relative interest rates in each currency
Expectations of the direction of interest rates in each currency
Trade and capital flows into and out of each currency/country
International commodity prices
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Foreign exchange pricing
 For example the Canadian economy is a significant
exporter of crude oil
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Foreign exchange pricing
 The Australian economy is large exporter of iron ore
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Forward FX pricing
 The forward FX market is very deep and liquid
 Importers and exporters enter into FX transactions
where settlement is not spot but some time in the
future eg 3 months
 Used to hedge known or expected future FX flows
 Pricing is straight forward – use discount methodology
pricing each currency leg against interest rates in each
currency
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Forward FX pricing
 Assume an Australian iron ore exporter expects to receive
US$10m in 90 days from the sale of iron ore



Spot AUD/USD rate = 0.80
90 day AUD interest rate = 3.00% (365 daycount)
90 day USD interest rate = 0.30% (360 daycount)
Discount USD10m for 90 days
2. Convert discounted USD amount to AUD at spot FX
3. “Future Value” the resulting AUD amount for 90 days
4. Calculate forward FX rate
1.
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Forward FX pricing
 Discount USD10m for 90 days
US$ =
US$10,000,000
(1 + 0.30% * 90 / 360)
= US$9,992,505.62
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Forward FX pricing
 Convert discounted USD amount to AUD at spot FX
AU$ =
US$9,992,505.62
0.80
= AU$12,490,632.03
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Forward FX pricing
 “Future Value” the resulting AUD amount for 90 days
FV(AU$) = AU$12,490,632.03 * (1 + 3.00% * 90 / 365)
= AU$12,583,028.48
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Forward FX pricing
 Calculate forward FX rate
90 day AUD/USD Forward FX rate
= US10,000,000.00
AU$12,583,028.48
= 0.7947
 Quoted as 53 “Forward points”
 “Arbitrage free” pricing
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Financial Arbitrage
 Arbitrage is the act of profiting by taking two equal
but opposing positions in the “same product” at the
same time
 Find a buyer at $10 at the same time find a seller at $9
 Buy at $9 and sell at $10 to realise $1 profit
 Assume no market risk in doing so
 Financial instruments are priced in markets to be
“arbitrage free”
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Financial Arbitrage
 Many activities in markets today are called arbitrage
but are not in fact arbitrage



eg “Merger Arbitrage” – in a M&A transaction usually the
share price of the acquirer falls whereas the share price of the
target rises
Buy the target, sell the acquirer
Not risk free
 Most arbitrage requires asymmetric information to
exist => potential abuse eg 2007-9 GFC
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Market efficiency
 Global market pricing is much more efficient than it
was say three decades ago
 Professional arbitrageurs act to remove pricing
discrepancies on a 24/7/365 basis
 Players consistently on the wrong side of arbitrage lose
money and leave the business
 “Algo” traders and “HFTs” troll the markets
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Market efficiency
 While arbitrage in markets is now low, market prices
move daily in reaction to updated information that
impacts on risk premia
 Efficient markets hypothesis: the application of
rational expectations to financial markets so that the
equilibrium price of a security is always equal to its
fundamental value


Most applicable to corporate securities – bonds/shares
Many players believe share prices are driven more by “Random
Walk”
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