FMP-IV

Swaps, Commodities, Foreign Exchange, Central

Counterparties, Corporate Bonds and Mortgage
Backed Securities

© EduPristine – www.edupristine.com
© EduPristine For FMP-IV (2016)
 Agenda

 Introduction
 The Comparative Advantage Argument
 Interest rate swaps
 Valuation of swaps
 Currency swaps
 Credit risk
 Other types of swaps

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 Introduction

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 Introduction

 A swap is an agreement between two parties to swap cash flows in the future
 The arrangement covers swaps on multiple dates
 Futures or forwards can be considered as a simple example of a swap where there is a cash flow
exchange on one particular date
 Most common swaps are Interest Rate Swaps (IRS) and currency swaps
 The legal agreement in which the two parties enter is called a confirmation, which covers the
termination date, calendar used, rates of payment, day count conventions etc.

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 The Comparative Advantage Argument

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 The Comparative Advantage Argument

 Take the example of two firms X and Y where:

• X wants to borrow floating
• Y wants to borrow fixed

Company Fixed Borrowing Floating Borrowing

X 5% LIBOR
Y 7% LIBOR + 100bps

 Table tells us that X can borrow fixed at 5% and Y can borrow fixed at 7%
 Also X can borrow floating at LIBOR and Y can borrow floating at (LIBOR + 100bps)
 This implies that X has absolute advantage in borrowing over Y
 The point to note here is that the difference in fixed borrowing rates for X and Y (is not the same
for the floating borrowing rates)
 Combined benefit to both X and Y by using swap is ( Fixed   Floating )which is 100 bps for X and Y

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 The Comparative Advantage Argument (Cont.)

 To reduce the borrowing rates X and Y enter into a swap shown below through the intermediary
which is usually an Investment Bank (IB)
 Assuming zero transaction charges for IB, X borrows at 5% and lends that money at 5.5% to Y
through an investment banker
 Similarly Y borrows at LIBOR + 100bps and lends to X at LIBOR
 Therefore the net borrowing rate for X becomes (LIBOR – 50bps) which is lower than the original
rate at of LIBOR
 Similarly the net borrowing rate Y becomes 6.5% which is 50bps less than the original rate of 7%

5.50% 5.50%
5%
X IB Y
Libor Libor Libor +
100bps

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 Question – Comparative Advantage

 Following are the rates at which company ABC and XYZ can borrow from the market

Fixed Rate Floating Rate

ABC 11% LIBOR + 1%
XYZ 10% LIBOR + 3%

 How can they benefit from Interest Rate SWAP?

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 Solution – Comparative Advantage

+0.50%
10.00% 10.50%
10%
XYZ IB ABC
LIBOR + LIBOR + Libor +
250bps 100bps 100bps
+150bps

 XYZ and ABC both benefit by 50bps while the IB makes 200bps profit

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 Interest Rate Swaps

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 Interest rate swaps

 In the case of fixed-for-floating interest rate swaps two parties get into an agreement where one
pays interest on a floating rate to the other, while the other pays a fixed rate of interest on the
same amount
 LIBOR is the most common reference rate of floating interest
 Notional principal is exchanged or basically no principal is exchanged

Floating Rate
Party 1 Party 2
Fixed Rate

 IRS can be used for

• Changing a liability
• Transforming a liability

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 Changing a liability

8%
10% LIBOR + 0.3%
Party 1 Party 2
LIBOR

 Party 1 avails a loan of 10% while party 2 avails a floating rate loan at LIBOR +0.3%
 Party 1 is receiving a fixed rate of 8% from party 2
 Party 1 pays floating interest rate
• Party 1’s effective cash flow:
 Net cash outflow is (LIBOR + 2% )
• Party 2’s effective cash flow:
 Net cash outflow is 8.3 %
 Point to note here is that Party 1’s fixed liability is changed to floating liability after the swap.
 Party 2’s liability is changed from a floating liability to a fixed liability of 8.3%

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 Financial intermediaries

 In the practical world most swaps are traded in the OTC market where financial institutions act as
market makers

LIBOR LIBOR
10% Financial
Party 1 Party 2
Institution LIBOR +
9.985% 10.015%
0.3%

 In the diagram above you can see that the financial institution is making a 3 basis point spread on
the fixed payment of the transaction
 In such cases the bank has separate contract with party 1 and party 2
 Party 1 and party 2 might not even know that they are on the other sides of the same swap
 Bank creates a market by creating both bid and offer positions so that it can seek clients on either
side of the swap
 It is exposed to certain credit risks in case it is unable to find a counter party for a swap

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 Swap rates

 The swap rate is the average of:

• The fixed rate a market maker is prepared to pay in exchange for a receiving LIBOR (its bid rate)
• The fixed rate it is willing to receive in return for a payment of a floating rate (its offer rate)
 Like LIBOR swap rates are not risk free rates but close to risk free rates

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 Valuation of Swaps

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 Valuation of swaps

 There are 2 ways to value a swap.

• Considering it as a difference of two bonds
• Considering it as a portfolio of FRAs
 Value using bonds
• Consider an example in which the swap lasts for n years. If the payments are made at the end of each year
then :
• If the principal is exchanged between the 2 parties at the end of the swap, then Party 1’s cash flow suggests
that it’s long a fixed rate bond and short a floating rate bond.
• Party 2 is short a fixed bond and long a floating rate bond.
• We can value the swap by looking at the pay offs of either party.
 Hence the value of the swap can be given as:
• V = Bfix – Bfl
• Where:
 Bfix = PV of payments
 Bfl = (P+AI)e-rt
• Value of a floating bond is equal to the par value at coupon reset dates and equals to the Present Value of
Par values (P) and Accrued Interest (AI)

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 Valuation of swaps

 Value using portfolio of FRAs

 In this case we assume that each payment at a future date is a forward rate agreement.
 For payment at time t, the rate used is the rate for the period between t-1 and t. This rate would
be FRA at t-1

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 Currency Swaps

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 Currency swaps

 Currency swap involves exchanging principal and interest payment in one currency with the
principal and interest payments in other currency
 In this case the principal needs to be specified and it is exchanged in the beginning as well as the
end of the swap
 Consider a currency swap between party 1 and 2. In this case Party 1 is in US and can borrow in
USD and party 2 is in Australia and can borrow competitively in AUDs at 6%. Party 1 borrows
$385,000 at 4% and exchanges the principal with Party 2 for 350,000 AUDs (which it borrows in
Australia). The principal is exchanged back at the end of the life of the swap and the life of the
swap is 5 years

5.1% AUD 5% AUD

4% USD Financial 6% AUD
Party 1 Party 2
Institution
4% USD 4.1% USD

 What is the net payout for party 1 and party 2?

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 Questions

 Which of the following statements is correct when comparing an Interest rate Swap with a
Currency Swap?
A. At maturity there is no exchange of principal between the counterparties in IRS and there is an exchange of
principal in Currency Swaps.
B. At maturity there is no exchange of principal between the counterparties in Currency Swaps and there is an
exchange of principal in IRS.
C. The counterparty in an IRS needs to consider fluctuation in exchange rates, while currency swap
counterparties are only exposed to fluctuations in interest rates.
D. Currency swaps counterparties are exposed to less counterparty credit risk due to offsetting effect of
currency risk and interest rate risk embedded within the transaction.

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 Valuation of currency swaps

 Just like IRS this swap can be valued using bonds approach and FRA approach
 Valuation using bonds
• Party 1 is receiving payments in Rupees while paying in AUDs. Hence we can say that he is long a rupee bond
and short an AUD bond
• The value of the swap will be the difference in the PV of the bonds
 Vswap = BRs – S0BAUD
• Where:
 S0 is the current spot exchange rate between Rs and AUDs
 Valuation as a portfolio of forward contracts
• In this case we determine the forward exchange rate at each point when the swap payments occur
• The foreign currency is converted using the forward exchange rate
• In the example above the 1 year, 2 year, 3 year, 4 year forward rate for USD-AUD exchange is used for
converting AUD cash flows to USD every year
• This is then discounted back to the present value to give the value of the swap

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 Question

The USD interest rate is 4% per annum and the AUD rate is 6% per annum. Assume that the term
structure of interest rates is flat in the US and Australia. Assume current value of AUD to be $0.91.
Company ABC, under the terms of a swap agreement, pays 7% per annum in AUD and receives 3%
per annum in US$. The principal in the US is 10million USD and that in Australia is 11million AUD.
Payments are exchanged each year and the swap will last for 3 more years. Determine the value of
swap assuming continuous compounding in all interest rates.

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 Solution

 Valuation of currency swap in terms of bonds (millions):

Time Cash Flow ($) Present Value Cash Flow (AUD) Present Value
1 0.3 0.2885 0.77 0.7264
2 0.3 0.2774 0.77 0.6853
3 0.3 0.2667 0.77 0.6465
3 10.0 8.8900 11 9.2358
Total 9.7225 Total 11.2940

 Value of swap in million $ = 11.294*0.91 – 9.7225= $0.5448 million

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 Credit Risk

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 Credit risk (Covered in detail in VaR later)

 A financial institution has a credit risk exposure from a swap only when the value of the swap is
greater than zero
 Potential losses from a swap are much less than losses from defaults on a loan with the
same principal
 Potential losses from a currency swap are much higher than losses from an interest
rate swap

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 Other Types of Swaps

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 Other types of swaps

 LIBOR is the most common floating rate in IRS; however there can be other floating rates like,
commercial paper (CP) rates
 In floating for floating swaps: rates of one type (LIBOR) can be swapped with floating rates of
another type (CP)
 In an amortizing swap the principal amount reduces in a predetermined amortization rate
 In a step up swap the principal increases in a predetermined way
 In Credit Default Swaps (CDS) the buyer of the swaps pays premium to the seller of the swap till
the time the underlying does not default. If the underlying defaults then the seller of the swap
makes a payment to the buyer and the CDS is terminated
 In a compounding swap the interest on one or both sides is compounded forward to the end of
the life of the swap and there is only one payment at the end of the contract
 In a fixed for floating currency swap the fixed rate of interest in one currency is swapped for a
floating rate of interest in another currency
 An equity swap is an agreement to exchange the total returns (dividends and capital gains) from
an equity index for a fixed/floating rate of interest
 In a puttable swap one party has the option of terminating the contract early
 Swaptions are options on swaps which provide one party with the right at a future time to enter
into a swap where a predetermined fixed rate is exchanged for floating

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 Question

 Which of the following achievable swap positions could be used to transform a floating-rate asset
into a fixed-rate asset?
A. Receive the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swap
B. Pay the fixed-rate leg and receive the floating-rate leg of a plain vanilla interest-rate swap
C. Pay the floating-rate leg and pay the fixed-rate leg of a plain vanilla interest-rate swap
D. Pay the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swap

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 Answer

 D. Pay the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swap

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 FMP-IV
Swaps, Commodities, Foreign Exchange, Central
Counterparties, Corporate Bonds and Mortgage
Backed Securities

© EduPristine – www.edupristine.com
© EduPristine For FMP-IV (2016)
 Agenda

 Introduction
 Commodity futures and forwards
 The commodity Lease rate
 Storage Costs and Forward Prices
 Pricing with convenience
 Hedging oil costs
 Hedging production costs
 Strip and stack hedges

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 Introduction commodity spot and futures markets

 Bill of lading is a document that mentions the commodity owner and acknowledges that the
goods have been received as cargo and are ready for delivery
 The major risks involved with commodity transactions are:
 Price risk: Risk of downward movement in price. Futures/Forward contracts reduce this risk
 Transportation risk: Consists of two risks:
1. Ordinary: Deterioration, spoilage, accident etc.
2. Extraordinary: wars, riots, strike etc.
 Delivery risk: Parties may withdraw from delivery. This risk has been greatly decreased by robust
practises by clearing houses
 Credit risk: Counter party risk which is mainly an issue in spot market
 Commodity markets also, like financial markets consists Hedgers, Speculators and Arbitrageurs
 Hedgers are generally farmers/ranchers who want to lock in a price

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 Basis risk in commodity futures

 Basis is the difference between spot price and the price of commodity’s future contract at any
given time
 Changes in basis is due to changes in cost of carry of the asset. Basis risk is generally represented
by the volatility / variance of the basis over time

 σ2S(t)-F(t) = σ2S(t) + σ2f(t) - 2σS(t)σf(t) ρs,f

 s2( t ) f ( t )
 Hedge effectiveness = 1
 s2( t )

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 Commodity Forwards

 Commodity forward prices can be described using the same formula as used for financial
forward prices
(r   )T
F0,T  S0 e

 For financial assets,  is the dividend yield

• For commodities,  is the commodity lease rate
• The lease rate is the return that makes an investor willing to buy and lend a commodity
• Some commodities (metals) have an active leasing market
• Lease rates can typically only be estimated by observing forward prices

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 Futures term structure

 The set of prices for different expiration dates for a given commodity is called the forward curve
(or the forward strip) for that date
 If on a given date the forward curve is upward-sloping, then the market is in contango
 If the forward curve is downward sloping, the market is in backwardation
 Note that forward curves can have portions in backwardation and portions in contango

F0,T  S0 e(r  )T
• Since r is always positive, assets with  =0 display upward sloping (contango) futures term structure

• With  >0, term structures could be upward or downward sloping

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 A commodity loan

 If you loan a commodity, you are giving up S0 today, and will get back St
 If loan is fairly priced, its NPV = 0
 NPV = E0(St)e-αT – S0
 Where α is required return on the commodity
 Now, suppose commodity price grows at rate g, E0(ST)= S0egT
 Then, NPV = S0e(g-α)T – S
• If g<α, NPV<0
• this is common for commodities (supply with near-perfect elasticity)
• Therefore, to make loan feasible, you would require lender to pay you the α-g difference
• This would get NPV back to zero
• If 1 unit is loaned, you receive a lease payment of e(α-g)T units, and NPV = 0

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 The Commodity Lease Rate

 The lease rate () is the difference between the commodity discount rate, , and the expected
growth rate of the commodity price, g
 For a commodity owner who lends the commodity, the lease rate is like a dividend
 With the stock, the dividend yield, , is an observable characteristic of the stock
 With a commodity, the lease rate,  l, is income earned only if the commodity is loaned. It is not
directly observable unless there is an active lease market

l    g

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 Commodity loan (cont.)

 With the addition of the lease payment, NPV of loaning the commodity is 0
 The lease payment is like the dividend payment that has to be paid by the person who borrowed
a stock
 Therefore:

F0,T  S0 e(r  )T
Where δ is lease rate

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 Forward Prices and the Lease Rate

 The lease rate has to be consistent with the forward price

 Therefore, when we observe the forward price, we can infer what the lease rate would have to be
if a lease market existed
 The annualized lease rate
 The effective annual lease rate
1
 l  r  In (F0,T / S)
T

(1  r)
l  1/T
1
(F0,T / S)

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 Storage and Carry Markets

 A commodity that may be stored is said to be in a carry market

 Reasons for storage
 There is seasonal variation in either supply or demand (e.g., some agricultural products)
 There is a constant rate of production, but there are seasonal fluctuations in demand (e.g., natural
gas)

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 Storage Costs and Forward Prices

 One will only store a commodity if the PV of selling it at time T is at least as great as that of
selling it today
 Whether a commodity is stored is peculiar to each commodity
 If storage is to occur, the forward price is at least
 Where (0,T) is the future value of storage costs for one unit of the commodity from time 0 to T

F0,T  S0 erT   (0,T )

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 Storage Costs and Forward Prices (cont’d)

 When there are storage costs, the forward price is higher. Why?
 The forward price must compensate a commodity holder for both the financial cost of carry
(interest) and the physical cost of carry (storage)
 With storage costs, the forward term structure can be steeper than the interest term structure
 Convenience Yield
• Some holders of a commodity receive benefits from physical ownership (e.g., a commercial user)
• This benefit is called the commodity’s convenience yield
• The convenience yield creates different returns to ownership for different investors, and may or may not be
reflected in the forward price
 Convenience and leasing
• If someone lends the commodity they save storage costs, but lose the ‘convenience’
 Stated as ( –c)
• Therefore, commodity borrower pays a lease rate that covers the lost convenience less the storage costs:
=c–

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 Pricing with convenience

 So, if:
(r   )T
F0,T  S0 e
 And if,  = c – 

 Then, F0,T = S0e(r+  -c)T

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 No-Arbitrage with Convenience

 From the perspective of an arbitrageur, the price range within which there is no arbitrage is:

(r    c)T (r   )T
S0 e  F0,T  S0 e
 Where c is the continuously compounded convenience yield
 The convenience yield produces a no-arbitrage range rather than a no-arbitrage price. Why?
 There may be no way for an average investor to earn the convenience yield when engaging
in arbitrage

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 Question

 Suppose that the price of corn is $2.20/bushel, the effective annual interest rate is 4.6%, and
effective annual priced storage costs are 10% of the current price/bushel. What is the 6-month
forward price?

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 Solution

 F = 2.2e (0.046 + 0.1) 0.5 = $2.37

 Now suppose the holder of the asset realizes a convenience yield of 2%. What is the price?
 F = 2.2e (0.046 + 0.1 - 0.02) 0.5 = $2.34
 The futures price dropped because the cost of carrying corn dropped

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 Hedging oil costs?

 Suppose we are scheduled to purchase 15,000 bbls of oil in July 2008. The current futures price is
$105/bbl, and each contract covers 1,000 bbls. If we hedge, what is our cost of oil if the spot price
of oil in July 2008 is $70/bbl or $120/bbl?
• Our natural exposure is short, therefore hedge long
• Direct hedge, β = 1. N=15/1*1 = 15 contracts
• Payoff = -15,000ST + 15*1000*(ST – 105)
• Payoff = -$1,575,000, at any future oil ST

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 Hedging production costs

 Suppose oil is a major component of our total production costs which equal $40 million, but it is
not the only component. In general, our production costs rise/fall with sensitivity of 0.72
(beta=0.72) to oil. Each crude oil contract is on 1,000bbls. Suppose S0=108 and F=105.
• Now, how many contracts do we use to hedge?
• Cross hedge, β = 0.72. N = 40m/105,000*0.72 = 274.28 contracts
• Suppose oil goes up by 10% from 108 to 118
 Increase in production costs = 0.072*40 = $2.88 million
 Payoff from forwards = 274.28*1,000 (118-105) = $2.88 million
 Note, we now have basis risk – the basis for our hedge does not match the hedging instrument
perfectly – what if our relation is not 0.72?

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 Strip and Stack Hedges

 In the last example, we bought 450K bbls forward

 This might be one component of a “strip hedge” if we are selling forward in other periods as well
 In a “stack hedge”, we enter near-term contracts sufficient to cover the present value of future
obligations
 We then “roll the hedge” into new contracts as the near-term contracts expire

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 FMP-IV
Swaps, Commodities, Foreign Exchange, Central
Counterparties, Corporate Bonds and Mortgage
Backed Securities

© EduPristine – www.edupristine.com
© EduPristine For FMP-IV (2016)
 Agenda

 Introduction
 Sources of profits and losses
 Unhedged foreign assets and liabilities
 Balance sheet hedging
 Interest rate parity

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 Introduction to Foreign Exchange Risk

 Sources of FE Risk:
Large financial institutions hold significant foreign currency assets and liabilities and also buy/sell
significant amount of foreign currency.

 An institution’s actual exposure to any given currency is its net exposure to the currency.
• For example, a bank’s net Great Britain Pound (GBP) exposure is given by:
• net GBP exposure = (GBP assets – GBP liabilities) + (GBP bought – GBP sold)
• i.e., net GBP exposure = net GBP assets – net GBP bought

 A positive net exposure (net long) is subject to the risk that the foreign currency will fall while a
Negative net exposure (net short) is subject to the risk that the foreign currency will rise.

 Thus if the institution fails to maintain a position where net assets matches net liabilities in the
foreign currency, it’s exposed to the risks due to fluctuations in that currency

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 Sources of profits and losses on foreign exchange trading

 A financial institution derives profits from differences between income and costs of funds.

 In foreign exchange markets, an extra dimension “foreign exchange rate” comes into play
increasing the volatility of net returns of the bank if unhedged

 In foreign exchange markets, hedging is of two types:

• Balance sheet hedging
• Off balance sheet hedging

 Balance sheet hedging is achieved when the financial institution matches maturity and currency in
the foreign asset-liability book

 Off balance sheet hedging is done by taking a position in the forward market

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 Example: Unhedged foreign asset and liabilities

 Consider the balance sheet of a US bank:

Assets Liabilities
 USD 10 million 7% US loans, maturity 1 year  USD 20 million 5% CDs maturity 1 year
 USD 10 million equivalent 12% Euro loans,
1-year maturity

 What is the return for the bank if:

1. Exchange rate is unchanged
2. If exchange rate of euro has fallen from 1.2 dollars/euro to 1.05 dollars/euro
3. If exchange rate of euro has risen from 1.2 dollars/euro to 1.35 dollars/euro

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 Solution

1. Average return on assets = (10(7)+10(12) )/2 = 9.5%.

• Cost of funds = 5%
• Therefore, net return = 4.5%

2. Issued euro loans= 10,000,000/1.2= 8333,333 euros;

• End of maturity at 12% interest, 8,333,333*1.12=9,333,333
• Dollar value=9,333,333*1.05=9,800,000.. i.e 2% loss
• Average return = (-2+7)/2= 2.5%
• Cost of funds = 5 %
• Net return= -2.5% (loss)

3.Euros received at the end of maturity = 9,333,333*1.35 = 12,560,000 i.e. 25.6%

• Average return = (25.6+7)/2 = 16.3%
• Cost of funds = 5%
• Net return = 11.3%

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 Balance sheet hedging

 In the previous example, matching the maturity duration but not the currency composition made
the returns very unpredictable. One way to minimize this risk is through balance sheet hedging.
Consider the modified balance sheet of the previous example after hedging

Assets Liabilities
 USD 10 million 7% US loans, maturity 1 year  USD 10 million 5% CDs, 1 year maturity
 USD 10 million equivalent 12% Euro loans,  USD 10 million 9% euro CDs, 1 year maturity
1-year maturity

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 Balance sheet hedging

 Now even if the euro falls from 1.2 USD/euro to 1.05 USD/euro, the bank can lock in a
positive return
 Steps:
1. The bank borrows USD 10 million equivalent of Euros for a year at 9%. i.e., 10/1.2 = 8,333,333 Euros
2. Pays back the Euro CD holders at the end of maturity i.e., 8,333,333*1.09=9,083,332 Euros. Euro depreciated
to 1.05 USD i.e., 9083,332*1.05 = 9,537,499 dollars. i.e., cost of funds = -4.6%
3. As calculated in previous problem, it receives an USD equivalent of 9,800,000 from the 12% euro loans
granted. i.e., -2%
• Average return on assets = (-2+7)/2 = 2.5%
• Average cost of funds = (-4.6+5)/2 = 0.2%
• Net return = 2.3%

© EduPristine For FMP-IV (2016) 56

 Interest rate parity

 In the previous examples, the Euro loans have better return than US loans and lead to arbitrage
argument
 As more banks move to euro loans, the spot exchange rate for buying euro will rise because of
excess demand of Euro
 In equilibrium, the forward exchange rate falls to completely eliminate the attractiveness of Euro
investments. This is called Interest Rate Parity (IRP)

T
1  rDC 
Forward  Spot  
 1  rFC 

 Where; rDC = Domestic currency rate

rFC = Foreign currency rate

© EduPristine For FMP-IV (2016) 57

 Example

 A japanese investor can invest in Japanese Yen at 4.5% or in GBP at 4.67%. Current spot rate is
0.01 JPY/ GBP. Calculate 1 year forward rate in JPY/GBP.

© EduPristine For FMP-IV (2016) 58

 Solution

 Forward = spot * (1+Rdc)/(1+Rfc) = 0.01 * (1.045/1.0467) = 0.00998 Japanese yen per pound

© EduPristine For FMP-IV (2016) 59

 FMP-IV
Swaps, Commodities, Foreign Exchange, Central
Counterparties, Corporate Bonds and Mortgage
Backed Securities

© EduPristine – www.edupristine.com
© EduPristine For FMP-IV (2016)
 Agenda

 Introduction to Central Counterparties (CCPs)

 Exchanges, OTC Derivatives, Derivative Product Companies (DPCs), Monoline s and Credit
Derivative Product Companies (CDPCs) and SPVs
 Basic Principles of Central Clearing
 Risk caused by CCPs

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 What is a CCP (Central Counterparties)?

CCP is a financial intermediary which helps in trade clearing process. Clearing is a process that occurs
after execution of a trade in which a CCP may step in between counterparties to guarantee
performance.
Main function of CCP: To interpose itself directly or indirectly between counterparties to assume
their rights and obligations by acting as buyer to every seller and vice versa. This means that the
original counterparty to a trade no longer represents a direct risk, as the CCP to all intents and
purposes becomes the new counterparty.
The general role and mechanics of a CCP are:
 Sets standard for its clearing members
 Takes responsibility for closing out all the positions of a defaulting clearing members
 Maintains financial resources to cover losses in the event of a clearing member default in the form
of:
1. Variation Margin: To closely track market movements
2. Initial Margin: To cover the worst case liquidation or close out costs above the variation margin
3. Default Fund: To mutualise (risk sharing) losses in the event of a severe default

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 What is a CCP (Central Counterparties)? Cont…

 Mechanism to withstand extreme situation by way of :

1. Additional calls to the default fund.

2. Variation margin gains haircutting.

3. Selective tear-up of positions.

 Benefits of Central clearing and CCPs

1. Netting: Reduces counterparty risk unlike bilateral market.

2. Margining: Protects against the adverse movements of the market and helps uphold the settlement of the
trade.

3. Loss mutualisation: Risk sharing mechanism helps protect the financial systems from contagion of default
risk originating from a loss of one or more counterparty.

4. Liquidity: Orderly close out of the position by way of proper auctioning mechanism along with netting
reduces price impact of unwinding of a large loss making position and enhances liquidity.

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 Possible Drawbacks of CCPs

 Moral Hazard: As OTC derivatives mandatorily getting cleared by CCPs, their importance in the financial
system increases and they become ‘systematically important institutions’ which , in the event of a
default, are likely to be bailed out by the government to limit the contagion it can create to the entire
financial market and eventually to the real economy. The ‘systematically important’ status of CCP may
make it take undue risk leading to moral hazard problem.
 Imposing cost and potential instability: The margin requirement can significantly add cost of the
participant and initially may impact the profitability of the participant financial institution and eventually
impact the economic growth in general. Also, in the adverse market condition, margin calls can put
further downward pressure on already depressed prices and lead to further volatility in the market and
create instability in the market.
 Problem of loss mutualisation: Risk sharing mechanism of homogenising the credit risk among all the
members may significantly disadvantage the more credit worthy market participant. The most credit
worthy market participant may see less advantage of their stronger credit quality with CCP clearing.
Hence, this kind of system leads to adverse selection problem wherein the firms that trade OTC
derivatives know more about the risk of a particular cleared product than the CCPs. The informationally
advantaged party will over trade the product for which CCP underestimates the risk and under trade the
product where CCP over estimates the risk. Loss mutualisation leads to over trading by the party who
knows that in the event of his default, losses would be shared by all the members of CCP.

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 Possible Drawbacks of CCPs Contd…

 Increase in systematic risk: One of the major advantage of CCP was that it reduces systematic risk and
protects the financial system from contagion effect. However, being the single point counterparty to all
trades, CCP also create risk concentration. And any significant market movement, may lead to failure of
CCP (although rare) which in turn leads to huge amount of systematic risk for the markets.

 Characteristics of bilateral OTC derivatives trading, their role in recent financial crisis and regulatory
changes implemented after the financial crisis:
OTC derivatives are private contracts and often contains exotic features. The underlying asset on the
derivative can be interest rate, currency etc. OTC derivatives have counterparty credit risk that is
typically pronounced during the time of default of the counterparty as unwinding of positions put
downward pressure on the already falling prices. The same may lead increased volatility and illiquidity.
This counterparty risk has been historically managed by bilateral clearing process.

The risk with bilateral clearing process is the default of a counterparty can lead to significant systematic
risk which was evident in the financial crisis of 2007 and failure of AIG which was eventually bailed out
by the government.

© EduPristine For FMP-IV (2016) 65

 Possible Drawbacks of CCPs Contd…

 Regulatory changes implemented after the financial crisis:

The regulator focus on improving transparency, reducing market interconnectedness and greater bank
capital requirement to shift the risk from large global financial institution and bilateral trading to
centrally cleared trading securities. The Dodd Frank Act in USA and EMIR in Europe proposed central
clearing through CCPs of all the standardized derivative contracts. Subsequently, they introduced margin
requirement also for the non-cleared OTC derivatives as well.

© EduPristine For FMP-IV (2016) 66

 Exchanges, OTC Derivatives, DPCs, CDPCs and SPVs

Definition of an exchange: An exchange is a central financial centre where parties can trade
standardized contract at a specified price. An exchange promotes market efficiently and enhances
liquidity by centralizing trading in a single price. Exchanges have evolved from a normal trading
forum to a sophisticated financial centre with settlement and counterparty risk management
function.

An exchange performs a number of a function:

 Product Standardization
 Trading Venue
 Reporting Services

© EduPristine For FMP-IV (2016) 67

 Clearing and Forms of Clearing

Clearing: Clearing is the process of reconciling and matching contracts between counterparties from
the time the commitments are made until settlement.
 Forms of Clearing:
1. Direct Clearing: Means bilateral reconciliation of commitments between the original two counterparties. For
example, if party A is in contract with party B where it is required to make a payment of USD 5000 and in an
another transaction between the same party, party B is require to make a payment of USD 4500 to party A.
Under the direct clearing mechanism, rather than exchanging two cash flows of USD 5000 and USD 4500
each, party A will make a payment of USD 500 as a final settlement for both the transaction.

2. Clearing Ring: Under such mechanism of clearing, counterparty exposure is reduced between three or more
parties. It is a voluntary mechanism but once the member joins it, they have to follow the rules of the
exchange and must accept each other’s contracts. For example, here D owns USD 100 to B and is expected
to receive the same amount from party C. By using clearing ring, party D can be removed and party c and B
can be made counterparty. Also, party A remains unaffected in the process. Clearing ring can mitigate
counterparty risk and simplify the dependencies of a member’s open position and allow them to close out
contracts more easily whereby increasing liquidity.

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 Clearing and Forms of Clearing Contd…

 Complete Clearing: Refers to clearing through CCP. All exchange traded contracts are currently
subject to central clearing. The CCP function can be operated either by exchange or provided to
the exchange by a third party.

CCP assumes all contractual responsibilities as counterparty to all contracts: Here party A owes
USD 125 to Party C and B owes USD 50 to party A. When CCP is introduced, party A will be
required to pay USD 75 to CCP being a central counterparty. It is evident from the below figure
that CCP clearly reduces the counterparty risk and facilitates settlement.

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 OTC Vs Exchange traded Derivatives

 Comparison between exchange traded and OTC derivatives: Exchange traded derivatives are
standardized contracts with greater liquidity and regulation as compared to OTC contracts. OTC are
bilateral customized contracts which increases the hedging utility of the product by reducing basis
risk and risk of term mismatch between what is to be hedged and hedging instrument. Clearing of
OTC derivative is challenging due to its long term nature of contracts and late settlement.
Exchange traded contracts are settled through CCP reducing counterparty risk whereby OTC
contracts are generally settled bilaterally.
Exchange-traded Over-the-counter (OTC)
Terms of contract  Standardised (maturity, size,  Flexible and negotiable
strike, etc.)
Maturity  Standard maturities, typically  Negotiable and non-standard
at most a few months  Often many years
Liquidity  Very good  Limited and sometimes very poor
for non-standard or complex
products
Credit risk  Guaranteed by CCP  Bilateral

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 Classes of OTC Derivatives

There are five classes of OTC derivatives:

1. Interest rate derivatives
2. Foreign Exchange derivatives
3. Equity derivatives
4. Commodity derivatives
5. Credit derivatives
Comparison of total notional o/s and market value of OTC derivative (in $ trillions) as on June’13

Gross notional outstanding Gross market Value* Ratio

Interest Rate 561.3 15.2 2.7%
Foreign exchange 73.1 2.4 3.3%
Credit default swaps 24.3 0.7 3.0%
Equity 6.8 0.7 10.2%
Commodity 2.4 0.4 15.7%

© EduPristine For FMP-IV (2016) 71

 Classes of OTC Derivatives Contd...

Though interest rate derivatives market dominate the majority of the OTC market, counterparty risk
is a major concern for foreign exchange derivative like cross currency swap where principal is
exchanged at the beginning as well as at the end of the contract. Furthermore, volatility and wrong-
way risk is a major concern for credit default swaps.

It is worth noting that only notional value should not be considered to determine dominating
product as many contracts like Fixed for Floating interest rate swap never requires exchange of
principle amount which is considered notional. Hence, gross market value is a more useful indicator
to understand the derivatives market product mix. Hence, a ratio of Gross Market value to Gross
Notional Value is useful and the ratio should be relatively small and close to 3% for interest rate,
foreign exchange and credit default swap.

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 Counterparty risk mitigation in OTC markets

Counterparty risk mitigation technique : Capital requirement, regulation, netting, margining etc.
Other mechanism of controlling counterparty credit risk:
1. SPVs: SPV is a legal entity (e.g. a company or limited partnership) created typically to isolate a
firm from financial risk. SPVs have been used in the OTC derivatives market to protect from
counterparty risk. A company will transfer assets to the SPV for management or use the SPV to
finance a large project without putting the entire firm or a counterparty at risk. Jurisdictions may
require that an SPV is not owned by the entity on whose behalf it is being set up. An SPV
transforms counterparty risk into legal risk. The obvious legal risk is that of consolidation, which
is the power of a bankruptcy court to combine the SPV assets with those of the originator.
2. DPCs: The bilaterally cleared dealer-dominated OTC market were perceived inherently more
vulnerable to counterparty risk than the exchange-traded market. The DPCs evolved as a means
for OTC derivative markets to mitigate counterparty risk. DPCs are generally triple-A rated entities
set up by one or more banks as a bankruptcy-remote subsidiary of a major dealer, which, unlike
an SPV, is separately capitalised to obtain a triple-A credit rating. The DPC structure provides
external counterparties with a degree of protection against counterparty risk by protecting
against the failure of the DPC parent.
Advantage of DPC: Provides some of the benefits of the exchange based system while preserving
the flexibility and decentralisation of the OTC market

© EduPristine For FMP-IV (2016) 73

 Counterparty risk mitigation in OTC markets Contd…

The Triple A (AAA) rating of DPCs typically depends on:

1. Minimizing Market risk: In terms of market risk, DPCs can attempt to be close to market- neutral
via trading offsetting contracts. Ideally, they would be on both sides of every trade as these
‘mirror trades’ lead to an overall matched book.

2. Support from a parent.

3. Credit risk management and operational guidelines: Restrictions are also imposed on
counterparty credit quality and activities (position limits, margin, etc.). The management of
counterparty risk is achieved by having daily mark-to-market and margin posting.

DPCs used defined triggers for their own failure through a ‘pre packaged bankruptcy’ process,
which outlines the bankruptcy process and is simpler alternative to standard bankruptcy process.
Once is it is into bankruptcy, it either continues as a part of another firm or is terminated.

The question on their AAA rated status, their link with their parents (whose credit rating is worse
than itself), and advent of alternative AAA rated entities followed by global financial crisis
reduced the importance of DPCs.

© EduPristine For FMP-IV (2016) 74

 Counterparty risk mitigation in OTC markets Contd…

Monoline: Monoline insurance companies were financial guarantee companies with strong credit
ratings that they utilised to provide ‘credit wraps’.

Monolines are well-capitalized entities with their AAA ratings supported by capitalization
requirement based on possible losses and related to the assets for which they provide guarantee.
They are generally highly leveraged and do not have to post margin. Many monoline companies fell
during financial crisis of 2007.

© EduPristine For FMP-IV (2016) 75

 Lessons for Central Clearing

The history of SPVs, DPCs, Monolines provide the following valuable lessons for CCP:
 Shifting priorities from one party to other will really help the system as a whole? CCPs give priority
to OTC derivatives counterparties but that will make other parties (bond holders) worse off and
may increase risk in other markets.
 Reliance on precise sound legal system exposes it a flow in such a framework. Example of
bankruptcy ruling by court.
 Unlike monoline and CDPCs, CCPs do not take up residual risk as they generally have matched
book for trades. Hence, CCPs do not have one-way market exposure.
 Unlike Monolines and CDCPs, CCPs require initial and variation margin which reduces risk.

© EduPristine For FMP-IV (2016) 76

 Basic Principles of Central Clearing

 What is clearing: Clearing represents the period between execution and settlement of a
transaction. This period is short for Non-OTC derivatives while OTC derivatives can be for a period
of years to decades.
 Functions of CCP: The primary role of CCP is to standardise and simplify operational processes .
CCP can reduce interconnectedness within financial markets which may lessen the impact of the
insolvency of a participant. Also, CCP being at the heart of the clearing increases transparency on
the positions of the members.
 Concept of Novation: A legal process whereby the CCP is positioned between buyers and sellers.
Novation is the replacement of one contract with one or more other contracts. Novation means
that the CCP essentially steps in between parties to a transaction and therefore acts as an insurer
of counterparty risk in both directions. The viability of novation depends on the legal
enforceability of the new contracts and the certainty that the original parties are not legally
obligated to each other once the novation is completed. Assuming this viability, novation means
that the contract between the original parties ceases to exist and they therefore do not have
counterparty risk to one another

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 Basic Principles of Central Clearing Contd...

 Margining: To cover the market risk of the trade they cover, CCPs require margin from its
members. CCPs charge two types of margin: Variation margin covers the net change in market
value of the member’s positions. Initial margin is an additional amount, which is charged at trade
inception, and is designed to cover the worst-case close out costs (due to the need to find
replacement transactions) in the event a member defaults.

CCPs generally set margin levels solely on the risks of the transactions held in each member’s
portfolio. Initial margin does not depend significantly on the credit quality of the institution
posting it: the most creditworthy institution may need to post just as much initial margin as others
more likely to default. Two members clearing the same portfolio may have the same margin
requirements even if their total balance sheet risks are quite different.

 Auctions: CCP absorbs the Domino effect of a counterparty default by acting as a central shock
absorber and swiftly terminates all financial relations with the defaulting counterparty without
suffering any losses. CCP guarantees the performance of the trade of the surviving members by
replacement of the defaulted counterparty with one of the other clearing members for each trade.
This is typically achieved via the CCP auctioning the defaulted members’ positions amongst the
other members.

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 Basic Principles of Central Clearing Contd...

Loss Mutualisation: Under this, losses above the resources contributed by the defaulter are shared
between CCP members. The most obvious way in which this occurs is that CCP members all
contribute into a CCP ‘default fund’ which is typically used after the defaulter’s own resources to
cover losses. Since all members pay into this default fund, they all contribute to absorbing an
extreme default loss.

What can be cleared?

The OTC derivatives markets have wide range of products including standardized, non-standardized
products and exotic derivatives
There are four stages of central clearing history:
1. Long history of central clearing (IRS)
2. Short history of central clearing (Index CDS)
3. May soon be centrally cleared (Interest rate swaptions, CDS)
4. Products that will be never centrally cleared (Exotic Derivatives)

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 Basic Principles of Central Clearing Contd...

Conditions for a transaction to be centrally cleared:

1. Standardization
2. Complexity: Only vanilla (or non-exotic) transactions can be cleared as they need to be relatively
easily and robustly valued on a timely basis to support variation margin calculation.
3. Liquidity: Liquidity of a product is important so that risk assessments can be made to determine
how much initial margin and default fund contribution should be charged. In addition, illiquid
products may be difficult to replace in an auction in the event of the default of a clearing
member. Finally, if a product is not widely traded then it may not be worthwhile for a CCP to
invest in developing the underlying clearing capability because they do not stand to clear enough
trades to make the venture profitable.
Who can Clear?
There are requirements to be a member who in turn can only transact with a CCP.
The requirements fall into the following category:
1. Admission criteria
2. Financial commitment
3. Operational

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 Basic Principles of Central Clearing Contd...

Number of CCPs: A large number of CCPs will maximise competition but could lead to a race to the
bottom in terms of cost, leading to a much more risky CCP landscape while having a small number of
CCPs is beneficial in terms of offsetting benefits and economies of scale. A single global CCP is
optimal but not feasible due to following reason:

1. Regional

2. Product

Should CCPs be utilities or profit making organizations?

Due to a very significant systematic role played by CCPs, they need to be resilient . Hence, a utility
led long term stable business model is preferred over short term profit maximizing goal. However, it
can also be argued that it could also be argued CCPs will need to have the best personnel and
systems to be able to develop the advanced risk management and operational capabilities.
Moreover, competition between CCPs will benefit users and provide choice. Expertise and
competition implies that CCPs should be profit-making organisations.

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 Advantages of CCPs

 Transparency
 Offsetting
 Loss Mutualisation
 Legal and Operational efficiency
 Liquidity
 Default Management

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 Disadvantages of CCPs

 Moral hazard
 Adverse Selection
 Bifurcation: The requirement to clear standard products may create unfortunate bifurcations
between cleared and non-cleared trades. This can result in highly volatile cash-flows for
customers, and mismatches (of margin requirements) for even hedged positions.
 Procyclicality: CCPs may create procyclicality effects by increasing margins (or haircuts) in volatile
markets or crisis periods. The greater frequency and liquidity of margin requirements under a CCP
(compared with less uniform and more flexible margin practices in bilateral OTC markets) could
also aggravate procyclicality.

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 Comparing OTC derivatives market with CCP and exchange-traded
market

OTC CCP Exchange

Trading  Bilateral  Bilateral  Centralised
Counterparty  Original  CCP
Products  All  Must be standard, vanilla, liquid, etc.
Participants  All  Clearing members are usually large
dealers. Other margin posting entities can
clear through clearing members.
Margining  Bilateral, bespoke arrangements  Full margining, including initial margin
dependent on credit quality and enforced by CCP
open to disputes.
Loss buffers  Regulatory capital and margin  Initial margins, default funds and CCP
(where provided) own capital

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 Risk caused by CCPs

 Default Risk

1. Default or distress of other clearing members

2. Failed Auctions

3. Resignations

4. Reputational

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 Risk caused by CCPs (Contd.)

 Non default loss events:

1. Fraud

2. Operational

3. Legal

4. Investment

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 Risk caused by CCPs (Contd.)

 Model Risk: Model risk arises due to valuing complex derivative products to calculate initial and
variable margin requirements

 Liquidity Risk

 Operational and legal risk

 Other risk:

1. Settlement and Payment

2. Forex Risk

3. Custody Risk

4. Concentration Risk

5. Sovereign Risk

6. Wrong-way Risk

© EduPristine For FMP-IV (2016) 87

 Risk caused by CCPs (Contd.)

How to keep CCPs safe?

Being a central clearer, CCP creates huge concentration of risk. CCPs should not become overly
competitive during buoyant market and increase the likelihood of falling during volatile market and
crashes.

CCPs are systematically important and their failure lead to cross border impact due to global nature
of derivatives markets. The failure of CCP can be termed a bigger failure than a bank.

If the failure of a single large participant in the OTC derivatives market is capable of endangering the
entire financial system then so is the failure of a CCP that clears OTC derivatives. Therefore,
governments are likely to have little choice as to whether or not to support a failing OTC CCP. This
realisation is problematic since taxpayers bailing out a CCP is no better than bailing out other
financial institutions such as banks. Indeed, a CCP bailout represents a bank bailout of sorts since it
protects the banks that are CCP members (that may be viewed as having taken an excessively large
exposure to the CCP.

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 FMP-IV
Swaps, Commodities, Foreign Exchange, Corporate
Bonds and Mortgage Backed Securities

© EduPristine – www.edupristine.com
© EduPristine For FMP-IV (2016)
 Agenda

 Introduction to corporate bonds

 Interest payment classification
 Retiring of bonds before maturity
 Credit risk
 Default rates

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 Corporate Bonds

 A corporate bond is a debt instrument that obligates the issuer to pay an indicated percentage of
the bond’s face value on designated dates and repay the bond’s face value at maturity
 In the event that either the interest or principal payments are not paid, the bond is in default
 Bondholders have a higher priority for the issuing company’s income over preferred and common
shareholders
 In the United States, corporate bonds are issued in denominations of $1,000 and multiples thereof
 Indenture is a contract that states the promises of the corporate bond issuer and the rights of the
bond holder
 As the indenture is hard to interpret, a third party called the Trustee is introduced
 The basic functions of a trustee are:
• To authenticate the bonds issued; the trustees keep a record of all the bonds sold and ensure they do not
exceed the principal amount stated in the indenture
• The trustees ensure that the issuing firm adheres to all the covenants of the bond’s indenture

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 Interest Payment Classifications

 There are a variety of bonds based on the interest payment characteristics:

 Straight Coupon Bonds: These are also known as fixed-rate bonds. The interest rate received on
these bonds is called the coupon. Most straight coupon bonds pay interest semiannually. For
example, for a 6% coupon rate bond with a face value of $1000 would pay $30 every six months
 Some bonds, known as participating bonds, receive payments that are greater than the coupon.
These payments depend on the profits of the issuer
 Income bonds pay coupon interest if earnings of the issuing company are sufficient. It is not
mandatory. Failures to pay interest or the principal of these bonds do not indicate a default
 Zero Coupon bonds are bonds without coupon payments. They only have a principal payment at
maturity. These bonds are issued at a discount to par. The difference between the face value and
the issue price of the bond is known as the Original-Issue Discount (OID)
 Deferred Interest Bonds (DIBs), generally issued by non-investment grade companies, don’t need
to pay interest for the first several years and then pay semi-annually till maturity
 Pay In Kind (PIK) Bonds are similar to DIBs but rather than accreting the original discount,
additional pieces of the same security are issued

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 Interest Payment Classifications

 Floating Rate Bonds: The interest payments by these bonds are computed in reference to a
reference rate such as the 6- month LIBOR. The issuer may add a spread to the LIBOR
 Collateralized Corporate Bonds
 Mortgage Bonds: A mortgage bond grants the holder a first-mortgage lien on its property. This
means, if the mortgage payments are not made timely, the bond holder has the right to sell the
property. The underlying real estate property is the collateral for the bond
 Collateral Trust Bonds: In case a company wants to issue bonds but does not have a fixed asset or
property base, it can pledge securities of other companies which it owns
 Equipment Trust Certificates: A Bond issued by railway companies where the collateral is cars and
locomotives is an example of Equipment Trust Certificates (ETCs). This method of financing is
called rolling stock
 Debenture Bonds: Debenture bonds are unsecured bonds. Most corporate bond issues are
debentures. They are traded at higher yields than secured debt
 Debenture bonds however, have a general claim on the assets of the issuer that are not pledged
specifically to secure other debt. Debenture bonds are issued by companies who have strong
credit ratings
 Convertible Debentures give the bondholder the right to convert the debenture into
common stock

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 Retiring of Corporate Bonds before Maturity

 Retiring of Corporate Bonds before Maturity

 Corporate bonds can broadly be retired before maturity in two ways namely those mechanisms
that are included in the bond’s indenture and those that are not included in the bond’s indenture.
The methods included in the bonds indenture are:
• Call and refunding provision
• Sinking Funds
• Maintenance and Replacement Funds
• Redemption through sale of assets
• A method not indicated in the bond’s indenture is the fixed-spread tender offers.
• Call and Refunding Provisions
 The right that the issuer has to buy back the bonds in whole or part before maturity is known as a
call provision. A bondholder would demand a higher yield to buy a callable bond, all else equal.
 Callable Bond Cost = Option Free Bond Cost + Value of Embedded Option

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 Methods for retiring bonds

 Fixed Price Call Provision

 The fixed price a bond can be called at its call price. Normally, a bond’s indenture would contain a
call price schedule that typically starts at a high premium above par and converges to par at
maturity
 Bondholders can be protected from a call in one of two ways:
• Some bonds cannot be callable for the first few years
• Some bonds prohibit the issue to be refunded (at a lower cost) for the first few years – non-refundable bonds
 Make-Whole Call Provision
 The call price is not fixed in this provision. The call price is determined as the present value of cash
flows at a particular discount rate. This discount rate would be the yield on a comparable maturity
Treasury bond with a spread. This spread is known as the make-whole call premium
 There are two ways to arrive at the Treasury bond yield:
• Using the Constant-Maturity Treasury rate, published weekly by the FED, for a maturity closest to that of the
issue or a linear interpolation of these rates. This is a more common method
• The yield of a treasury that has similar maturity as that of the issue. The selection of this bond would be a
primary US Treasury dealer mentioned in the bond indenture

© EduPristine For FMP-IV (2016) 95

 Methods for retiring bonds

 Sinking Fund Provision: Bonds are retired periodically rather than retiring the entire issue at
maturity. The terms for the sinking fund would be mentioned in the indenture
 For example, if $20 Million is the notional principal for a bond with a 20 year maturity, the sinking
fund provision may state to retire $5 Million every 5 years
 From a bondholder’s perspective there are two advantages of a sinking fund provision:
• Reduced default risk
• Bond price increases near retirement dates as a result of excess demand because of the issuer buying bonds
in the open market
 However the sinking fund provision can be a disadvantage to the bondholder if their bond is to be
retired when bonds are selling above par in the market
 An accelerated sinking fund provision is when the issuer is granted the right to retire more bonds
than indicated. This reduces the bondholder’s call protection
 Maintenance and Replacement Fund is mainly used by electric utilities companies. These
companies retire their bonds for the maintenance and repair of the pledged collateral
 The tender offer method of retiring bonds is one that is not specified in the bond’s indenture. In
this method, a firm sends a tender offer and announces its aim of buying back its debt issue. The
firm sends a circular to all the bond holders stating the price at which it is willing to pay for the
security

© EduPristine For FMP-IV (2016) 96

 Credit Risk

 Credit Default Risk : The uncertainty whether the issuer can pay interest and principal payments
in a timely manner
 Credit Spread Risk: A credit spread is the difference between a bond’s yield and the yield of a
comparable maturity benchmark of a Treasury security
• Credit spread risk is the risk of a loss in the value of a bond from changes in the level of credit spreads used in
the marking to market
• Factors affecting credit spread risk:
• Macroeconomic factors
 Level and slope of treasury yield curve
 Business cycle
 Consumer confidence
• Issue-Specific factors
 Corporation’s financial position
 Future prospects of the firm and its industry
• A measure of credit spread risk is spread duration. Spread duration is the change in the value of a bond for
1% change in credit spread, assuming the underlying treasury security’s yield is constant

© EduPristine For FMP-IV (2016) 97

 Default rates

Number of issuers that default

Issuer default rate =
Total number of issuers at the beginning of issue

Cumulative dollar value of all defaulted bonds

Dollar default rate =
Cumulative $ value of all issuance *
Weighted Avg. number of years outstanding

Cumulative dollar value of all defaulted bonds

Cumulative annual default rate =
Cumulative dollar value of issue

© EduPristine For FMP-IV (2016) 98

 FMP-IV
Swaps, Commodities, Foreign Exchange, Corporate
Bonds and Mortgage Backed Securities

© EduPristine – www.edupristine.com
© EduPristine For FMP-IV (2016)
 Agenda

 Residential Mortgage Products and Types

 Mortgage Payments: Fixed rate, Level-Payment

 Securitization: Mortgage Pass-through Securities

 Payment/Pre-payment rates

 Prepayment

 Dollar Role Transaction

 Prepayment Modeling

 Dynamic Valuation: Monte Carlo Stimulation

 Dynamic Valuation: Option Adjusted Spread

© EduPristine For FMP-IV (2016) 100

 Residential Mortgage Loans

Mortgage Loan:

Mortgage is a loan secured by some sort of real estate property as a collateral

Borrower is obliged to make a predetermined series of payments or EMI in future.

Prior to 1970 mortgage were restricted solely to primary market.

MBS (Mortgage-backed security):

Mortgages are polled and packages to investor in Secondary Market through Securitization

Payments follow pass through structure.

© EduPristine For FMP-IV (2016) 101

 Residential Mortgage Loan Types

Residential Mortgage Loan Types can be classifies based on various properties of loans:

Lien Status: Lien status of impacts the lender’s ability to recover the balance owed in the event of
default.

First Lien is senior than other subsequent i.e. In event of default lender of first lien loan will have first
right to receive proceeds.

Original Loan Term: Loan term commonly varies from 10-30 years with 30 year loan being most
common. Medium term loan of 10-20 year maturity recently gaining popularity.

© EduPristine For FMP-IV (2016) 102

 Residential Mortgage Loan Types (Cont.)

Credit Classification:

Prime (A-grade) loans: FICO score 660 or greater, Low loan-to-value ratios (<95%).

Subprime (B-grade) loans: FICO score less than 660, High loan-to-value ratios (>95%)

Alternative-A loans: Between Prime and Subprime, essentially prime loans but certain characteristics
makes then riskier (incomplete documentations, LTV on higher end)

Interest Rate Type:

Fixed-rate mortgages: Both interest and payments are constant.

Adjustable-rate mortgages (ARM): Variable interest payments, mostly linked to market interest rate
(LIBOR, OTC etc)

Prepayments and Prepayment Penalties:

Credit Guarantees:

© EduPristine For FMP-IV (2016) 103

 Mortgage Payments: Fixed rate, Level-Payment

Example: To buy a home an individual borrows from a bank,$100,000 which is secured by that
home. To repay the loan the individual agrees to pay the bank $804.62 per month for 30 years.
Interest =9%
 The payments are called level because the monthly payment is same every month
360
1
$804.62  $100,000
n 1 (1  y 12) n

 Interest rate on a mortgage is defined as the monthly compounded yield-to-maturity of the

mortgage 360

 (1  0.09 12)
1
X n
 $100,000
n 1

Every monthly mortgage payment or EMI is due on the first of each month, and consists of interest
on the outstanding mortgage balance and repayment of portion of outstanding mortgage loan B(n)
 The interest component of the payment on date (n+1) is: B(n)  y
12

y
 The principal component of the payment is the remainder: EMI - B(n) 
12

© EduPristine For FMP-IV (2016) 104

 Mortgage Payments: Fixed rate, Level-Payment (Cont.)

 The portion of EMI towards interest payment decreases over the tenure of a loan, whereas
portion of EMI towards principal component increases over the life of a outstanding mortgage
Interest Principal EMI
loan Months
Payment Interest Payment Principal Payment Ending Balance 900

1 750.00 54.62 99,945.38 750

60 719.74 84.88 95,880.14 600

120 671.72 132.9 89,429.74 450

180 596.54 208.08 79,330.49 300

240 478.83 325.79 63,518.27 150

300 294.54 510.09 38,761.39 0

109
127
145
163
181
199
217
235
253
271
289
307
325
343
19
37
55
73
91
1
360 5.99 798.63 0.00

 Payment Allocation Between Principal and Interest:

• Crossover point is the point where principle and interest allocation is same. Post this point more amount is
allocated to principal.
• Mortgages with shorter amortization period result in less interest paid and more of the payment applied
toward reducing the principal balance sooner.
 Servicing fees is the fees charged by servicer or originators for servicing of mortgage i.e.
administrative work which involves collecting EMIs, initiating foreclosures etc.
Servicing fee forms the part of each payment and reduces over period.

© EduPristine For FMP-IV (2016) 105

 Securitization

 Securitization Process

Mortgage Banks
Borrower Mortgage Backed
Security
Mortgage Pool of Mortgages Banks (Investment/
Borrower (collecting principal Commercial), Mutual
repayments and Funds, Pension House,
Mortgage
interest payments, Institutional/ HNI investors,
Borrower
also prepayments) Insurance Firms, etc
Mortgage
Borrower

 Securitization can be structured in numerous ways to suit the Investor’s requirement

• Mortgage pools can be segregated into Interest-Only (IO) tranche and Principal-Only (PO) tranche
• Mortgage pools can have various classes to adjust prepayments (lowest class to receive highest
prepayment, etc)

© EduPristine For FMP-IV (2016) 106

 Securitization: Mortgage Pass-through Securities

Mortgage 1 Investor 1

Mortgage 2 Investor 2
Pool
… …

Mortgage N Investor N

Passthrough securities backed by

the pool are issues to investors

© EduPristine For FMP-IV (2016) 107

 Securitization: Mortgage Pass-through Securities

 A mortgage pass-through security is an asset-backed security or debt obligation that represents a

claim on the cash flows from the pool of underlying mortgage loans,held by the SPV.
 E.g.. Securitization process: Servicing
25-50 bps
• Mortgages are pooled by FNMA
• Principal and Interest (P&I) from the underlying
assets (mortgages) is the security's cash inflow
$ 100Mn,
• Servicing fee for collecting and dispersing 9% P&I FNMA P&I
Investors
payments is removed (25-50 basis points) 30 year
fixed
• Default fee paid to credit enhancer is removed
• Remaining cash is dispersed to investors.
 Cash flow to a pass-through security investor depends on Default fee

the cash flow from pool of mortgage loans

 Not all mortgage loans carries the same interest rate & same maturity and hence weighted
average coupon rate (WAC) & weighted average maturity (WAM) is calculated
 Ginnie Mae is backed by U.S. federal government and carries the full faith & guarantee of U.S.
Govt.
 Freddie Mac & Fannie Mae are U.S. government sponsored corporate entities and does not carry
full faith & guarantee of government

© EduPristine For FMP-IV (2016) 108

 Payment / Pre-payment Rate Measurement

 Calculate the dollar value of a pass-through security if the security is trading at $92 for a $1mn of
a pass-through with a pool factor of 80%
• Pool factor of 80% indicates that 80% of original mortgage pool is still outstanding
Price  par value  pool factor  0.92  $1,000,000  0.80  736,000
 Single monthly mortality rate (SMM) is the ratio of the prepayment in a month and total
outstanding amount available to prepayment:
Prepayment in month(t)
SMM 
Begining mortgage balance for month(t) - scheduled principal payment in month(t)

 e.g. calculate the prepayment for a month, if a remaining mortgage balance is $250 mn with a
next month SMM of 0.55% and the scheduled principal payment for that month is $5 mn
Prepayment in month t  250,000,000 - 5,000,000 0.0055  $1,347,500
 Conditional Prepayment Rate (CPR) is a annualized SMM rate which assumes that some amount
of prepayment is bound to happen apart from scheduled principal repayment
CPR  1  1  SMM   1  (1  0.0055)12  6.404%
12

• Best predictor of CPR is past prepayment rates

• It's called conditional since it's conditional on the remaining mortgage balance
• Benchmark CPR = 100% PSA (Public Securities Association) is discussed in more detail on the next slide

© EduPristine For FMP-IV (2016) 109

 Prepayment rate: Public Securities Association (PSA)

 PSA prepayment benchmark is the monthly series of CPR

 PSA benchmark assumes that prepayment is low for a new mortgages, but it will speed up until 30
months, remaining constant thereafter.
• 100 PSA assumes CPR of 0.2% for the first month and thereafter increases by 0.2% per month for the next
30 months
• If t< 30 months, CPR = 6% x (month/30)
• If t>30 months, CPR = 6%
 Different prepayment characteristics are quoted as a percentage of PSA (e.g. 165% PSA has a
higher pre-payment rate. CPR is 65% greater than the average CPR)
 The percent PSA increases as the yield decreases, which further increases prepayment risk (low
interest rate) 165 PSA 100 PSA
12

10

0
30
108
117
126
135
144
153
162
171
180
18
27
36
45
54
63
72
81
90
99
0
9

Mortgage Age in months

© EduPristine For FMP-IV (2016) 110

 Prepayment rate: Example

 Compute the prepayment for the 22nd month on a 150 PSA mortgage loans of $250mn and
scheduled repayment of $5mn

CPR  6%  22  30
  4.4% 150 PSA  1.5  4.4%   6.6%

SMM  1  1  6.6%
1
12  0.005674

Prepayment in 22 nd month  250,000,000 - 5,000,000 0.005674  $1,390,130

© EduPristine For FMP-IV (2016) 111

 Prepayment

 Average life of a pass-through security depends on the prepayment assumptions:

T
t  Projectedprincipal received at time(t)
Average Life  
t 1 12  Total Principal

 Types of Mortgage Prepayments:

• Increasing frequency or amount of payments.
• Repaying/refinancing the entire outstanding balance.
 Impact of prepayment on lender:
• Loss on higher interest rate of Mortgage loan.
• Reinvestment has to be generally made on lower market rate.

 Factors influencing Prepayment:

• Seasonality
• Age of Mortgage pool
• Personal
• Housing Prices
• Refinancing burnout

© EduPristine For FMP-IV (2016) 112

 Prepayment (Cont.)
$1,250.00
$1,200.00
$1,150.00
$1,100.00
Prepayment Mortgage
$1,050.00
Security
$1,000.00
$950.00
$900.00
$850.00 Standard Bond
$800.00
$750.00
7.0% 8.0% 9.0% 10.0% 11.0% 12.0%

 Contraction risk refers to consequences resulting from a decline in interest rates for a pass-
through security. It results in faster prepayments leading to shortening of life
• Limited upside potential for a pass-through security
• Reinvestment risk that received cash flow have to be invested at a much lower interest rate
 Extension risk refers to consequences resulting from a increase in interest rates.
• It results in slower prepayments leading to lengthening of average life
• Unlimited downside potential with a limited upside makes pass-through security unattractive

© EduPristine For FMP-IV (2016) 113

 Dollar Roll Transaction

A dollar roll transaction: Buying position for one settlement months and selling those same positions
for another month at the same time.

 Valuing dollar role:

• The process involves calculatingthe income and expenses over the holding period.
• Price drop between the two settlements makes purchase of security of back month more attractive.

 Factors impacting Dollar role valuations:

• Security’s coupon age and WAC
• Holding period
• Assumed prepayment speed
• Funding cost in repo market

 Factors Causing Dollar role to trade special: Decrease in back month price (Due to access sale by
originator) and Increase in front month prices(shortage of securities due to increase in demand of
certain maturity)

© EduPristine For FMP-IV (2016) 114

 Prepayment Modeling

There are four major components of prepayment modeling:

 Refinancing: Using proceeds of new mortgage to pay of f principal for existing mortgage.
 Factors impacting refinancing :
• Interest rate fall. Also known as Media effect as large declines in rate likely gain media attention.
• Cash-out Refinancing: Increase in property value allowing borrowers to get more cash for new mortgage on same
property.
• Refinancing burnout: In cyclic change in interest rate, most of the refinancing occurs on first dip with less people
opting to refinancing on subsequent dips.
• Incentive function: Modeling any dollar gain that borrower will refinance.

 Turnover: Refinancing caused due to sale of property.

 Defaults: Modeling default requires an analysis of LVT and FICO scores and overall analysis of housing
market.
 Curtailments: Prepayment due to curtailment depend on age of mortgage as partial payments tend
to occur mortgage is older and has relatively low balance.

© EduPristine For FMP-IV (2016) 115

 Dynamic Valuation: Monte Carlo Stimulation

 Monte Carlo Simulation: Its more process of steps than a specific model. Using various parameters
we try to determine various possible paths that can be taken by underlying variables and based on
that try to determine probability distribution of MBS values.

 Steps for MCS valuation:

• Stimulate interest rate and refinancing path.
• Project cash-flows for each interest rate path.
• Calculate PV of each cash flow path
• Calculate theoretical value of the mortgage security

© EduPristine For FMP-IV (2016) 116

 Dynamic Valuation: OAS

Option Adjusted Spread: Constant spread K when added to spot rate curve and resultant curve used
to discount all cash-flows give market value.
OAS is determined using Monte Carlo Stimulation to get various possible cash-flow path which are
then discounted using Spot rate + OAS. OAS is thus determined iteratively.

Market Price = PV[path1] + PV[path2] + PV[path3] + PV[path4] + …. + PV[pathN] / N

Where N is number of paths

Option Cost = Z spread – OAS

Here Option Cost represents value of prepayment risk.

 Challenges with OAS

• Modeling Risk
• Adjustment required in interest rate path
• Assumption of constant OAS over time.
• Dependency on underlying prepayment model

© EduPristine For FMP-IV (2016) 117

 Thank You!

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www.edupristine.com

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