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Economics 434
Financial Markets
Professor Burton
University of Virginia
Fall 2015
October 27, 2015
Present Value is the most Crucial
Concept in Finance
• Value of future stream of
payments
• As valued today
• Emphasis on
“discounting” future
revenue streams
• Common practice to use
higher rates to reflect
higher uncertainty of
receipt of future
payments
Yield curve
Junk bonds
Rates
Maturities
Corp Bonds
Treasuries
Yield curve
Junk bonds
Rates
Maturities
Corp Bonds
Treasuries
ABS (Asset-Backed Securities)
• Includes a wide variety of securities: CLOs, CDOs, CMBS, and
on and on (in 2007, amounted to 20 % of all non-government
lending in the United States…now much less)
• Simple Principle
– Create a “pool” of cash flows
– Then create new securities that assigned some part of the
pool’s cash flows
• Why? To credit different “credit” and “duration” securities
October 30, 2014
A Simple One Period ABS
(Asset Backed Security) with default risk
The Pool:
Bond A
Pays $ 100,000 at end of period
with 90 % probability
Bond B
Pays $ 100,000at end of period
with 90 % probabiilty
The New Securities to Be Created From The Pool:
Security 1 Pays $ 100,000 if either bond fails to default
Security 2 Pays $ 100,000 if both bonds fail to default
Securities 1 and 2 are examples of ABS
The riskiness of the newly created
securites: 1, 2
Imagine that each bond, A and B, separately have a 10 percent chance
of default.
What is the probability that Security 1 defaults (that both A and B will default)?
What is the probability that Security 2 defaults (that either A or B will default
or both)?
If bonds A and B are
“independent”
• 1/10 times 1/10 = 1/100, meaning that the probability that
both default is 1/100 or a one percent chance of simultaneous
default
– Not very likely
– Get a AA rating for the first tranche (Security 1)
• That neither one will default: 90/100 times 81/100 or 81
percent of the time.
– Pretty often (slightly more than 1/5 of the time)
– Get a C rating for the second tranche (Security 2)
October 30, 2014
But, what if the bonds are not
“independent”
• What if their correlation is one? (Which means that either
both pay off or both default, not one or the other)
• Then each of Security 1 and Security 2 have a 90 percent
chance of paying off
• Both get a B- rating
• Compared to independence pricing
– “Independence” assumption overprice Security One
– “Independence” assumption underprice Security Two
October 30, 2014
What is a CDO?
• Collateralized Debt Obligation
• Could be a pool of any group of fixed income
securities or bank loans
• CLO is a special case of CDO: CLO is
Collateralized Loan Obligation (bank loans
normally, but could be car loans, etc.)
October 30, 2014
CMBS
• Collateralized Mortgage-Backed Securites
• Commercial real estate (mostly office
buildings are financed by CMBS)
• Typical office mortgage financing is 5 – 7 year
maturites (unlike residential mortgages)
October 30, 2014
What is financed by CMBS?
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Residential mortgages
Commercial mortgages
Car loans
Credit card receivables
Home equity loans
Student loans
Defaulted loans (auto, credit card, etc.)
Almost anything
October 30, 2014
What Else
• “Credit Enhancements”
– Main enhancement is a CDS (credit default swap)
– CDS is basically an insurance contract
• Normally on a debt instrument (note or bond)
• An act of default (not paying interest or principal)
triggers the payment of CDS, insurer takes the
defaulted note or bond and gives the insured the cash
value as if no default)
October 30, 2014
History of US ABS Issuance
October 30, 2014
ABS Issuance in Europe
October 30, 2014
October 27, 2015