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Sub-sovereign Credit Markets

Sub-sovereign Credit Markets. Fixed Income Securities Applications to Municipal Markets Samir El Daher The World Bank May 1999. Fixed Income Securities Main Parameters. Definitions Market Risk Liquidity Risk Credit Risk Risk/Return Analysis Structured Products/Derivatives.

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Sub-sovereign Credit Markets

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  1. Sub-sovereign Credit Markets Fixed Income Securities Applications to Municipal Markets Samir El Daher The World Bank May 1999

  2. Fixed Income SecuritiesMain Parameters • Definitions • Market Risk • Liquidity Risk • Credit Risk • Risk/Return Analysis • Structured Products/Derivatives

  3. Definitions • Bond is a financial asset represented by a schedule of cash flows • Amounts and timing of payments are “fixed” in advance or predictable • Difference with equities, real-estate or industrial investments

  4. Bond Price Formula • P = Ci / (1+r)i • P is a function of the variable r as cashflows Ci are constant numbers • Equation indicates that P is a decreasing function of variable r

  5. Market Risk • Unanticipated change in value of asset • Duration as a measure of risk of fixed income security • Measuring Duration: = - D • Duration D: Price elasticity of interest rate

  6. Duration -- Some Characteristics • Duration: increasing function of maturity • Duration: decreasing function of yield level • Duration: decreasing function of coupon level (ex. zero-coupon) • Duration: increasing function of frequency of coupon payments

  7. Duration Versus Maturity • Maturity relates to the timing of final cash-flow only • Duration includes all cash-flows time-weighted • Duration carries more information, and is more relevant, than maturity

  8. Case of Discount Note:Zero Coupon Bond • Discount note consists of: • one initial outlay (I0) at time zero • one final payment at time n • P = • dP = - n [Cn / (1+r)n] [dr / (1+r)] • dP / P = • D = n ==> Duration = Maturity for zero coupon bond

  9. Example of Zero Coupon Bond • Example: P0 = 100 / (1+ 0.065)30 = 15 • Only in case of bond with single cashflow payment would duration and maturity be the same

  10. Comparison Between Duration and Maturity • Example of 8% coupon rate • Maturity 1y, 3y, 5y, 7y, 10y, 20y, 30y • Duration 1y, 2.5y, 4.2y, 5.6y, 6.8y,10y,12y • 30-Y, zero coupon bond is three times riskier than a 10-Y zero coupon • 30-Y, 8% coupon bond is only 12/6.8 = 1.75 time riskier than 10-Y coupon

  11. Duration of a Portfolio • Portfolio is a group of securities • Portfolio concept essential for investors for whom “munis” are part of diversified basket of investment instruments • Duration of a portfolio of securities is equal to the sum of the market-value-weighted durations of its component securities

  12. “Additivity” of Duration • Securities S1, S2, S3,....Si,....Sn • Weights in portfolio a1, a2, a3,.... ai,....an • with ai = 1 • Durations D1, D2, D3,........Di,.....Dn • Maturities M1, M2, M3,.......Mi,....Mn • Average Portfolio Duration = ai Di • Average Portfolio Maturity = ai Mi

  13. Comparing Portfolios (A) & (B): Portfolio (A) • Portfolio (A) includes 50% 10-Year note and 50% 30-Year note • 10-Year note ===> Duration 7 years • 30-Year note ===> Duration 12 years • Average Duration, Portfolio (A) (50% x 7) + (50% x 12) = 9.5 years • Average Maturity, Portfolio (A) (50% x 10) + (50% x 30) = 20 years

  14. Comparing Portfolios (A) & (B): Portfolio (B) • Portfolio (B) includes 100% 20-Year zero coupon note • 20-Year zero coupon note ===> Duration 20 years • Average Duration, Portfolio (B) = 100% x 20 = 20 years • Average Maturity, Portfolio (B) = 100% x 20 = 20 years

  15. Comparing Duration & Maturity of Portfolios (A) & (B) • Portfolio (A) and (B) have same average maturity and different durations • Average Maturity, Portfolio (A) = Average Maturity, Portfolio (B) = 20 years • Average Duration, Portfolio (B) = 20 years • Average Duration, Portfolio (A) = 9.5 years • Portfolio (B) twice as risky as Portfolio (A) for same average maturity

  16. Implication for Investor -- Portfolio Approach • Question: What is meaning of: “a 20-year municipal bond is “too risky” for an investor” • Answer: Meaning not clear if the 20-year bond is part of a balanced portfolio • Importance of assessing contribution of a security, or asset, within a portfolio approach [ex: fixed income and real estate (inflation hedge)]

  17. Example of “Balanced” Fixed Income Portfolio • One third Cash ===> Duration zero • One third 1-year bill ===> Duration 1 year • One third 20-year municipal bond ===> Duration 10 years • Average duration of portfolio: (1/3 x 0) + (1/3 x 1) + (1/3 x 10) = 3.6 years • Result might well be within risk tolerance of investor

  18. Liquidity Risk • Liquidity Spectrum • More liquid ---------to---------> Less Liquid • Cash, Gov Securities, ........... Fixed Assets,.. • Liquidity risk is associated with existence of “ready market” where assets may be exchanged at a small difference between sale and purchase price

  19. Liquidity Risk • For fixed income securities, liquidity is measured by bid-ask spread in secondary markets • Bid-ask spread constitutes margin of market-makers (small 1/32nd in US) • For cash ==> bid-ask spread = 0 • For real estate ==> bid-ask spread > 6% (agent’s fee)

  20. Credit Risk -- Definition • Loss of value of an asset as a result of a party to a contract (seller, issuer,...) not fulfilling a contractual obligation - • Loss of value due to default: spot loss might overestimate real loss • Loss might affect principal and/or interest • Securities trading: c.o.d - Opportunity loss due to change in market value between trade date and delivery

  21. Credit Risk -- Estimation • Example: Fixed income Security • Years 0----(i) ----(10)------(j)----------(20) • Cashflows -----------(C10)-----(Cj)-------(C20) • Income -------------<---Forgone Income---> • Actual Loss at Year-10 = (In year-10 value) • Potential Loss at time Zero = Actual Loss at Year 10 / (1+r)10 =

  22. Implication for Investor --An Example • Investor must chose 10-Y versus 20-Y • Question: If investor’s risk tolerance for a given credit is 10 years • Would investor not buy a 20-Y instrument from same credit? • Answer: Not necessarily ==> Several scenarios

  23. Implication for Investor -- Scenarios • 1st Scenario ===> Yield Premium (compensating for risk) • 2nd Scenario ===> Guarantee or insurance beyond 10-Y • 3rd Scenario ===> Derivatives, such as put option • 4th Scenario ===> Collateral, such as mortgage-backed security

  24. Guarantee or Insurance • Insurance may be full or partial (say beyond 10 years) • Case 1: Insurance may be necessary for debt acceptance • Case 2: Insurance would reduce price of debt issue and enhance liquidity (USA) • Feasibility: Interest without Insurance > Interest with Insurance + Insurance Fee

  25. Other Enhancement Mechanisms • Structured finance and derivatives (e.g. put option allowing maturity “reduction”) • Other non-maturity related enhancements • Collateral (revenue pledge, MBS,...) • Bank letter of credit • Other features such as convertible debt

  26. Example of Credit Enhancement“Zero Coupon Collateral” • Several recent cases for bullet repayment • Zero coupon “deposited” in segregated account in “highest credit quality (say US treasuries) • Zero coupon to accrue interests so as to become equivalent to face value of principal upon maturity • Definition of real cost of zero-coupon collateralized principal (ex. of calculation)

  27. Risk/Return Analysis -- Definitions • Return = Enhancement in market value of an asset • Risk is measure of uncertainty of outcome • Risk = volatility of returns expressed by Standard Deviation • (Example daily price changes during one year)

  28. Simple Risk/Return Measures • A number of ways to define and measure risk • Information Ratio = Return Standard Deviation • Sharpe Ratio = (Return - Risk-free Return) Standard Deviation

  29. Benchmark for Municipal Debt Security • “Risk -free” Government Securities in relevant maturity range • Ymuni = Ygvn + dYn • dYn = premium that covers, inter-alia, two categories of risks: • credit risk • liquidity risk

  30. Risk/Return: Portfolio Approach • Long-term investors and hedgers need to know the relative risk of securities so that they may construct portfolios that match their preferences for risk and expected return • Optimize risk/return function: • For one unit of risk ===> Highest return (e.g. Foundations,...) • For one unit of return ===> Lowest risk

  31. Defining a Portfolio for Institutional Investors • Definition of Classes of Assets: Fixed income, equities, commodities, real-estate, currencies,... • Analyses of historical returns (over representative period, say 20 years) • Analyses of volatilities • Analyses of correlations

  32. Defining a Portfolio for Institutional Investors • Optimization function (e.g. “Efficient Frontier”) with iterations providing percentages for each “class” of assets ==> Asset allocation process • Example of pension fund: government securities, high yield, MBS, marketable equities, private equities, real-estate, currencies,...

  33. Structured Finance -- Derivatives • Main categories: Futures, Options, Swaps • Derivatives as investment vehicles: leverage • Derivatives as hedge and credit enhancement vehicles • Derivatives transfer investment risks to those (speculators) willing to assume risks • Futures, options and swaps traded over the counter (OTC) or on regulated exchanges

  34. Futures • Futures contract is a commitment to buy or sell a security at a future specified date and specified price • Future neutralizes price uncertainties • Example of farmer hedging crop with futures • Same result may be achieved by put option as both futures and options provide hedge

  35. Swaps • Swaps are arrangements between two parties • Swaps entail exchange of mutual liabilities as these come due • Swaps may involve currencies (US$/DM) • Swaps may involve interest rates (floating/fixed)

  36. Options • Option is a right -- not an obligation -- to buy or sell an asset at a pre-established price within a specified time period (US), or at a specified time (Europe) • Privilege to exercise such a right entails a fee, or option “premium” • Calculation of “premium” is crucial element • Option pricing models for equities and interest rate instruments

  37. Options • Call Option - Market position of an investor/hedger speculating that asset price would increase • Put Option - Market position of an investor/hedger speculating that asset price would decline

  38. Option Value -- Bond Example

  39. Option Parameters • Definition of “underlying” asset • Exercise or strike price • Time to expiration • “In-the-money”, “Out-of-the-money” and “At-the-money” options • Premium = Intrinsic Value + Time Value

  40. Option Parameters • Delta = dP/dF or Hedge Ratio (change in Price P of option to change in price F of underlying security) • Gamma = d/dF = d2P/ (dF)2 • Zeta  = dP / dV (ratio of change of price to change in volatility V) • Theta  = dP/dt (time dimension, time “decay”)

  41. Option Pricing • Call price: Increasing function of price of “underlying” relative to “strike” price • Call price: Increasing function of “time to expiration” • Call option price: Increasing function of riskless rate of return (on treasury) • Call price: Increasing function of volatility

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