Foundational Theories and Techniques for Risk Management, A Guide for Professional Risk Managers in Financial Services - Part II - Financial Instruments

Part II - Financial Instruments

This part of the textbook contains material aligned with the second major domain of the PRM Designation syllabus. The syllabus section is listed here for your reference.

Visit the PRM Resources and Case Studies page at www.prmia.org/PRM for a current list of reading materials aligned to the PRM Desigation program.

II. FINANCIAL INSTRUMENTS

A. Bonds

1. Understand the characteristics of bonds, using concepts of duration, convexity, and yield.

2. Price different types of bonds (e.g., zero coupon, fixed/floating, investment/ non-investment grade, etc.)

B. Forward and Futures Contracts

1. Understand the relationship between spot and forward prices.

2. Value a forward contract using concepts of interest differential and delivery cost.

3. Understand the standardized characteristics of futures contract, for bonds, stocks, currencies, and commodities.

C. Swaps

1. Understand the key components of a swap agreement and value a vanilla interest rate swap.

2. Understand features of various types of swaps on instruments (e.g., currencies, bonds, equities, commodities, assets, etc.)

D. Options

1. Identify and understand the components of option valuation.

2. Verify an option price using a given methodology (e.g., binomial models, Black-Scholes-Merton, etc.)

3. Identify different option trading strategies.

E. Credit Derivatives

1. Apply the concepts of default probability and loss given default in determining a credit default swap premium.

2. Understand different types of credit derivatives and securitized products.

F. Hedging Strategies

1. Understand hedging strategies for specific risk exposures within a portfolio.

2. Calculate hedge ratios using cash instruments or derivatives (e.g., forwards, futures, swaps, and options.)

Chapter 7: General Characteristics of Bonds

Authors: Lionel Martellini and Philippe Priaulet

*Reproduced with permission from John Wiley & Sons, Ltd from Fixed-Income Securities: Valuation, Risk Management and Portfolio Strategies, 2003.

Fixed-income markets are populated with a range of instruments. This section provides a typology of the simplest types of these instruments—bonds and money-market instruments—and describes their general characteristics.

Definition of a Bullet Bond

A bond, or debt security, is a financial claim by which the issuer (i.e., borrower) is committed to repaying the bondholder (i.e., lender) cash borrowed (i.e., principal) plus periodic interest calculated on this amount during a given period. A bond can have either a bullet or a non-bullet structure. A bullet bond is a fixed-coupon bond, without any embedded option, delivering its coupons on periodic dates and the principal on the maturity date.

As an example, a U.S. Treasury bond with a coupon of 1.375%, a maturity date of 30 November 2018, and a nominal issued amount of $30.3 billion pays semi-annual interest of $208.3 million ($30.3 billion times 1.375%/2) every six months until 30 November 2018, inclusive, and $30.3 billion on the maturity date. Another example is a French Treasury bond with a coupon of 2.50%, a maturity date of 25 October 2020, and a nominal issued amount of €33 billion, which pays annual interest of €825 million (€33 billion times 2.50%) every year until 25 October 2020, inclusive, and €33 billion on the maturity date.

The purpose of a bond issuer (e.g., the Treasury Department, a government entity, or corporation) is to finance its budget or investment projects (e.g., construction of roads, schools, development of new products, and new plants) at an interest rate that is expected to be lower than the rate of return on the investment (at least for the private sector). Through the issuance of bonds, it has direct access to the market and avoids borrowing from banks at higher interest rates. This process of financial disintermediation has gathered momentum in recent times. One important point to underscore is that the bondholder has the status of a creditor and not an equity holder (i.e., someone who has the status of an owner of the issuing corporation), which is the reason a bond is generally less risky than an equity.

Terminology and Convention

A bond issue is characterized by many components, including:

The issuer’s name. For example, Bundesrepublik Deutschland for a Treasury bond issued in Germany.

The issuer’s type. Primarily the sector to which it belongs. For example, the oil sector if Total Fina Elf is the bond issuer.

The market in which the bond is issued. This can be the U.S. domestic market, the Eurozone domestic market, the domestic market of any country, the Eurodollar market, which corresponds to bonds denominated in U.S. dollars and issued in European countries, or any other market.

The issuer’s country of origin.

The bond’s currency denomination. For example, U.S. dollars for a U.S. Treasury bond.

The type of collateral. The type of asset pledged against possible default. The collateral type can be a mortgage on property, an automobile loan, a government guarantee, etc.

The maturity date. The date on which the principal amount is due.

The maturity type. Some issues are callable prior to term at predetermined prices and times. That is, the issuer can elect to buy back the debt issue.

The coupon type. Fixed, floating, or multi-coupon (i.e., a mix of fixed and floating or different fixed). For example, a step-up coupon bond is a kind of multi-coupon bond with a coupon that increases at predetermined intervals.

The coupon rate. Expressed as a percentage of the principal amount when the coupon is fixed.

The coupon frequency. The coupon frequency for Treasury bonds is semi-annual in the United States, the United Kingdom, and Japan, and annual in the Eurozone, except for Italy where it is semi-annual.

The interest rate type. Interest rates can be nominal or real. When interest rates are nominal rather than real, the effects of inflation have not been removed. For example, a nominal rate of return of 8%, with a 3% rate of inflation, implies a real rate of return of 5%.

The day count type. The most common types are actual/actual, actual/365, actual/360 and 30/360. Actual/actual (i.e., actual/365, actual/360) means that the accrued interest between two dates is calculated using the exact number of calendar days between the two dates divided by the exact number of calendar days of the relevant year (365, 360). 30/360 means the number of calendar days between the two dates is computed assuming each month counts as 30 days. For example, using the 30/360 day count basis, there are 84 days (2 × 30 + 24) from 1 January 2001 to 25 March 2001, and 335 days (11 × 30 + 5) from 1 January 2001 to 6 December 2001. Using the actual/actual or actual/365 day count basis, there are 83 days from 1 January 2001 to 25 March 2001, and 339 days from 1 January 2001 to 6 December 2001. Using the actual/actual day count basis, the period converted in years from 1 August 1999 to 3 September 2001 is (152/365) + 1 + (246/365) = 2.0904. Using the actual/365 day count basis, the period converted in years from 1 August 1999 to 3 September 2001 is 764/365 = 2.0931. Using the actual/360 day count basis, the period converted in years from 1 August 1999 to 3 September 2001 is 764/360 = 2.1222. Using the 30/360 day count basis, the period converted in years from 1 August 1999 to 3 September 2001 is 752/360 = 2.0888.

The method used for the calculation of the bond yield. There are several ways of calculating the yield to maturity, depending on the day count convention and style of compounding. In the example below, the Bloomberg Yield Analysis screen displays a variety of yield calculations. The most common—i.e., the street convention—uses simple interest during the first period and compounded interest, thereafter. It also uses the actual/actual day count.

The method used for the calculation of the bond price. In most (but not all) markets, the bond price is quoted as a clean price; it excludes accrued interest. When a bond is bought/sold, however, the invoice price should include accrued interest.

The announcement date. The date on which a bond is announced and offered to the public.

The interest accrual date. The date when interest begins to accrue.

The settlement date. The date on which payment is due in exchange for the bond. It is generally equal to the trade date plus a number of working days. For example, in Japan, the settlement date for Treasury bonds and T-bills is equal to the trade date plus three working days. In the United States, the settlement date for Treasury bonds and T-bills is equal to the trade date plus one working day. In the United Kingdom, the settlement date for Treasury bonds and T-bills is equal to the trade date plus one and two working days, respectively. In the Eurozone, the settlement date for Treasury bonds is equal to the trade date plus three working days, and for T-bills one, two, or three working days, depending on the country.

The first coupon date. The date of the first interest payment.

The issuance price. The price paid at issuance, expressed as a percentage of par value.

The spread at issuance. The difference between the yield on the bond and the yield on a benchmark Treasury bond, expressed in basis points.

The identifying code. The most popular ones include the ISIN (International Securities Identification Number) and CUSIP (Committee on Uniform Securities Identification Procedures) numbers.

The rating. The purpose of rating agencies is to assess the default probability of corporations through what is known as rating. A rating is a ranking of a bond’s quality, based on criteria such as the issuer’s reputation, management, balance sheet, and record in paying interest and principal. The two major ones are Moody’s and Standard and Poor’s (S&P). Their rating scales are listed in Table II.22. We refer the reader to Martellini et al. (2003) for more details.

Table II.22. Moody’s and S&P’s Rating Scales

The total issued amount. Given in thousands of the issuance currency on Bloomberg.

The outstanding amount. The amount of the issue outstanding, which appears in thousands of the issuance currency on Bloomberg.

The minimum amount and minimum increment that can be purchased. The minimum increment is the smallest additional amount of a security that can be bought above the minimum amount.

The par amount or nominal amount or principal amount. The face value of the bond. The nominal amount is used to calculate the coupon bond. For example, consider a bond with a fixed 5% coupon rate and a $1000 nominal amount. The coupon is equal to 5% × $1000 = $50.

The redemption value. Expressed as a percentage of the nominal amount, the price at which a bond is redeemed on the maturity date. In most cases, the redemption value is equal to 100% of the bond nominal amount.

The figures and examples below offer examples of a Bloomberg bond description screen (DES function) for Treasury and corporate bonds.

Figure II.47. Bloomberg Screen for US Treasury Bond

Example: T-Bond

The T-bond, with coupon rate 1.375% and maturity date 30 November 2018 (see Figure II.47), bears a semi-annual coupon with an actual/actual day count basis. The issued amount was equal to $30.3 billion, and the outstanding amount is $30.3 billion. The minimum amount that can be purchased is equal to $100. The T-bond was issued on 30 November 2011 in the U.S. market, and interest began to accrue from this date. The issue price was 99.7343. The first coupon date was 31 May 2012, 6 months after the interest accrual date (semi-annual coupon). For bullet bonds (our case here), the workout date is always the maturity date. In the case of callable bond and for yields to worst call, the workout date is the call date with the lowest yield. The risk factor, better known as Modified Duration, is 4.906. SOMA holdings are 54.569%. SOMA (System Open Market Account) is an account managed by the Federal Reserve, containing assets acquired through operations in the open market. These assets serve as a store of liquidity to be used during an emergency and as collateral for the liabilities on the Federal Reserve’s balance sheet. This bond has an AAA rating.

Example: Bouygues Bond

In comparison to the previous bond, the Bouygues Telecom bond has an A3 Moody’s rating (see Figure II.48) and it belongs to the industrial sector. The issued amount was €0.8 billion, and the minimum purchasable amount is €100,000. The issue price was 99.66. It delivers an annual fixed 4.5% coupon rate, and its maturity is 9 February 2022. Its spread at issuance amounted to 217 basis points over the interpolated mid-swap level.

Figure II.48. Bloomberg Screen for Bouygues Bond

Market Quotes

Bond securities are usually quoted in terms of price (i.e., percentage price of the nominal amount), yield, or spread over an underlying benchmark bond.

Bond Quoted Price

The quoted price (i.e., market price) of a bond is usually its clean price, which is its gross price minus the accrued interest. These two prices are usually given as percentages of the nominal amount.¹ When an investor purchases a bond, he/she is entitled to receive all future cash flows of the bond until he/she no longer owns it. If he/she buys the bond between two coupon payment dates, he/she logically must buy it at a price reflecting the fraction of the next coupon the seller of the bond is entitled to receive for having held it until the sale. This price is called the gross price (or dirty price or full price), computed as the sum of the clean price and the portion of the coupon due to the seller of the bond. This portion is called the accrued interest. Accrued interest is computed from the last coupon date to the settlement date. The settlement date is equal to the transaction date plus n working days, and n depends on the bond market type. For example, n is equal to 1 for U.S. Treasury bonds.

Example: Clean Price of Bonds

On 11 October 2013, an investor buys a given amount of a U.S. Treasury bond, with a coupon of 1.375% and maturity on 30 November 2018. The current clean price is 99.53125. Hence, the market value of $1 million face value of this bond is equal to 99.53125% × $1 million = $995,312.50. The accrued interest period is 137 days, the number of calendar days between the settlement date (12 October 2013) and the last coupon payment date (30 May 2013). Hence, accrued interest is equal to the last coupon payment (0.6875 because the coupon frequency is semi-annual) times 137 divided by the number of calendar days between the next coupon payment date (30 November 2013) and the last coupon payment date (30 May 2013). In this case, accrued interest is 0.6875% × 137/183 = 0.51469%. The gross price is then 100.04594. An investor will pay $1,000,459.40 (100.04594% × $1 million) to buy this bond.

The clean price of a bond is equal to the gross price on each coupon payment date, and U.S. bond prices are commonly quoted in multiples of 1/32. For example, a bond quoting a price of 98 – 28 has a price of 98 + 28/32 = 98.875. In most other markets, decimal quotes are the norm.

Bond Quoted Yield

The quoted yield of a bond is the discount yield that equates to its gross price times its nominal amount to the sum of its discounted cash flows.

Example: Bond Yield Quotes on Bloomberg

In the previous example, the cash-flow schedule of the bond with $1 million face value is shown in Table II.23.

Table II.23. Cash Flow Schedule of Bond with $1M

The Bloomberg Yield Analysis screen (YA function) associated with this bond is shown in Figure II.49. Its quoted yield is 1.47% using the standard street convention. The yields calculated using the Treasury convention and true yield are similar; the latter adjusts for non-business days by moving the coupon date to the next valid business date. The equivalent one-year compound yield of this bond is 1.476%. This method is similar to the street convention, but converts the yield from semi-annual to annual compounding. The Japanese yield is a simple yield calculation, whereby the annualized cash flow is expressed as a percentage of the original clean price. The current yield is the annual rate of return based on the price obtained by: coupon par amount/price = 1.375% 100/99.53125 = 1.381%. Standard risk measures (e.g., duration, modified duration, and convexity).

Figure II.49. Bloomberg Yield Analysis Screen

Bond Quoted Spread

Corporate bonds are usually quoted in price or in spread over a benchmark bond, rather than in yield. To recover the corresponding yield, one must add the spread to the yield of the underlying benchmark bond.

Example: Bond Quoted Spread

The Bloomberg screen in Figure II.50 shows an example of a bond yield and spread analysis. Ford Motor issued the bond, and it bears a spread of 141 basis points (see ISPRD function) over the interpolated U.S. dollar swap yield (the reference for the Interbank curve), whereas it bears a spread of 155.9 basis points over the interpolated U.S. Treasury benchmark bond yield (see GSPRD function). It is spread over the U.S. Treasury benchmark bond, with the nearest maturity amounting to 163.1 basis points (SPRD function). The Z-SPRD of 143.1 basis points is the bond’s constant spread over the benchmark zero-coupon swap curve.

Figure II.50. Bloomberg Screen for Yield and Spread Analysis

This last method of quoting spreads relative to government bonds is common in bond markets. In this case, the underlying government bond is identified clearly. ; Uusing interpolation on the government bond curve might lead to other results, depending on the two bonds and the type of interpolation.

Liquidity Spreads

Investors prefer to invest in more liquid securities that offer opportunities for trading in larger volumes with lower bid-offer spreads. A liquid Treasury note/bond is known as an on-the-run issue, whereas less-liquid counterparts are off-the-run issues. The liquidity of an issue is a function of time since issue, with seasoned issues tending to be less liquid. More recent issues are more liquid because dealers have more information about who owns the securities and in what amounts. Consequently, trading volumes in these on-the-run securities are higher, and bid-offer spreads can be as little as 1/32. Yields of off-the-run bonds exceed those of on-the-run bonds even though their duration and credit rating might be identical. This additional yield is a risk premium to compensate an investor for liquidity risk. During a liquidity crisis, such as that which occurred in 1998, liquid securities are even more highly prized, and the liquidity spread widens.

The Bid-Ask Spread

Every traded bond has a quoted bid and an ask price. The bid price is the price at which an investor can sell a bond, and the ask price is the price at which he/she can buy it. The ask price is, of course, higher than the bid price, which means that the ask yield is lower than the bid yield. The disparity between the two yields is the bid-ask spread, which can be considered a type of transaction cost. It is very small for liquid bonds such as U.S. or Euro Treasury bonds, and is large for illiquid bonds. The bond’s mid-price is the average of its bid and ask prices. The same holds for the mid-yield.

Non-Bullet Bonds

Strips

Strips (i.e., separate trading of registered interest and principal) are zero-coupon bonds issued primarily by governments of the G7 countries. The strips program was created in 1985 by the U.S. Treasury Department in response to a common practice of investment banks in the early 1980s, where the banks were buying long-term Treasury bonds and issuing their own zero-coupon bonds to the public, collateralized by payments on the underlying Treasury bonds. These so-called trademark zeros were a success, but the higher liquidity of strips soon came to dominate them. The only cash flow distributed by strips is the principal on the maturity date.

There are two types of strips: coupon and principal. Coupon and principal strips are built by stripping coupons and the principal of a coupon-bearing bond, respectively. Candidates for stripping are government bonds (i.e., Treasury bonds and government agency bonds). Strips are not as liquid as coupon-bearing bonds, and their bid-ask spreads are usually higher.

Example: Strips

An investor buys a Treasury strip bond for $20,000, with maturity on 15 May 2030 and nominal amount $100,000. As a bondholder, he/she is entitled to receive $100,000 on 15 May 2030, if he/she has not sold the bond.

A bond that yields no coupon interest over the investment period might appear peculiar and unattractive; it effectively bears interest on maturity since it is bought at a price lower than its maturity price. Investors who buy these bonds are usually long-term investors such as pension funds and insurance companies, and have at least one main purpose: secure a return over their long-term investment horizon. To understand this point, consider an