Our Lady of the Pillar College-San Manuel, Inc.

District 3, San Manuel, Isabela

CAPITAL MARKET

FINAL MODULE

CHAPTER 1

Introduction to Swaps, Caps, and Floors Markets

LEARNING OBJECTIVES

After reading this chapter you will understand:

 what a swap is
 what is meant by the notional amount.
 the various types of swaps, including interest rate swap, interest rate-equity swap, equity swap,
and currency swap.
 the relationship between a swap and a forward contract.
 how swaps can be used for asset/liability management.
 how swaps can be used to create securities.
 what a credit default swap is what a cap and a floor are.
 the relationship between a cap and a floor and an option.
 how a cap can be used by a depository institution.

Swaps, caps, and floors are derivative instruments that can be used to control risks faced by borrowers
and investors. Moreover, particularly in the case of swaps, these instrument give investment bankers
the ability to create a wide range of securities to meet the objectives of investors. These derivative
contracts are traded in the over-the-counter market and therefore they expose the parties to
counterparty risk.

In this chapter, we provide an overview of these contracts and some basic applications, we shall
take a closer look at these contracts and their mechanics. Our motivation for introducing them at this
early stage is to emphasize the key role they play in the development of a global financial market and
the development of new financial instruments and strategies.

SWAPS

A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic
payments. The dollar amount of the payments exchanged is based on some predetermined dollar
principal, called the notional amount or notional principal. The dollar amount each counterparty pays
to the other is the agreed-upon periodic rate times the notional amount. The only dollars exchanged
between the parties are the agreed-upon payments, not the notional amount.

To illustrate a swap and give you a flavor for the wide range of swaps, consider the following four swap
agreements in which the payments are exchanged once a year for the next 5 years.

1. The counterparties to the swap are the First Renwick Bank and the General Manufacturing
Corporation. The notional amount of this swap is $100 million. Every year for the next 5 years,
First Renwick Bank agrees to pay General Manufacturing 8% per year, while General
Manufacturing agrees to pay First Renwick the rate on a 1-year Treasury security. Therefore,
every year First Renwick will pay $8 million (8% times $100 million) to General Manufacturing.
The amount that General Manufacturing pays the bank depends on the rate on a 1-year
 Treasury security. For example, if this rate is 5%, General Manufacturing pays the bank $5
million (5% times $100 million).

2. The counterparties to this swap agreement are the Brotherhood of Basket Weavers (a
pension sponsor) and the Reliable Investment Management Corporation (a money management
firm). The notional amount is $50 million. Every year for the next 5 years the Brotherhood
agrees to pay Reliable the return realized on the Standard & Poor's 500 stock index for the year
minus 200 basis points. (This index will be described in Chapter 13.) In turn, Reliable agrees to
pay the pension sponsor 10%. So, for example, if over the past year the return on the S&P 500
stock index is 14%, then the pension sponsor pays Reliable 12% (14% minus 2%) of $50 million,
or $6 million, and the money management firm agrees to pay the pension sponsor $5 million
(10% times $50 million).

3. The counterparties to this swap agreement are the Beneficial Pension Fund (a pension fund
sponsor) and Investment Management Associates (a German money management firm). The
notional amount is $80 million. Every year for the next 5 years Beneficial Pension agrees to pay
Investment Management the return realized on the S&P 500 stock index for the year. In turn,
Investment Management agrees to pay the pension fund sponsor the return realized on the
German stock index (called the DAX index) for the year. So, for example, if over the past year the
return on the S&P 500 stock index and the German stock index are 14% and 10%, respectively,
then the pension fund sponsor pays Investment Management $11.2 million (14% times $80
million), and the German money man agreement firm agrees to pay Beneficial Pension $8
million (10% times $80 million).

4. The two counterparties to this swap agreement are the Regency Electronics Corporation (a
U.S. manufacturing firm) and the All-Swiss Watches Corporation (a Swiss manufacturing firm).
The notional amount is $100 million and its Swiss franc equivalent at the time the contract was
entered into was SF 127 million. Every year for the next 5 years the U.S. manufacturing firm
agrees to pay All Swiss Watches Swiss francs equal to 5% of the Swiss franc notional amount, or
SF 6.35 million. In turn, the Swiss manufacturing firm agrees to pay Regency Electronics 7% of
the U.S. notional amount of $100 million, or $7 million.

Types of Swaps

Swaps are classified based on the characteristics of the swap payments. The five types of swaps are
interest rate swaps, interest rate-equity swaps, equity swaps, currency swaps, and credit default swaps.
In an interest rate swap, the counterparties swap payments in the same currency based on an interest
rate. For example, one of the counterparties can pay a fixed interest rate and the other party a floating
interest rate. The floating interest rate is commonly referred to as the reference rate. The swap between
First Renwick Bank and General Manufacturing Corporation described in the first swap agreement is an
example of an interest rate swap. The payments made by both parties can be based on different
reference rates. For example, one of the counterparties can pay an interest rate based on the 1-year
Treasury security rate and the other party can pay an interest rate based on the federal funds rate.
 In an interest rate-equity swap, one party is exchanging a payment based on an interest rate
and the other party based on the return of some equity index. The payments are made in the same
currency. Our second swap agreement is an interest rate equity swap. In this agreement one of the
counterparties paid a fixed interest rate, but other interest rate-equity swaps include agreements
whereby one of the parties pays a floating interest rate.

In an equity swap, both parties exchange payments in the same currency based on some equity
index. The third swap agreement provides an example of an equity swap. Finally, in a currency swap,
two parties agree to swap payments based on different currencies as in the fourth swap agreement.

A relatively new member of the swaps family is a credit default swap (CDS). A CDS is a
derivative instrument that can be used to buy or sell protection against particular types of events that
can adversely affect the credit quality of a debt obligation such as the default of the borrower.
Derivative instruments to buy or sell such credit risk are referred to as credit derivatives. The market for
credit derivatives since the turn of the century has developed into one of the largest derivative markets.
The largest type of credit derivative is the CDS. We briefly discuss the CDS here not only because of its
importance but because although it is referred to as a "swap," it does not follow the general
characteristics of a swap described earlier.

The two parties to a CDS are referred to as the protection buyer and protection seller. Over the
life of the CDS, the protection buyer agrees to pay the protection seller a payment at specified dates to
insure against the impairment of the debt of a reference entity due to a credit-related event. The
reference entity is a specific issuer, say, Ford Motor Company. The specific credit-related events are
identified in the contract and are referred to as credit events. If a credit event does occur, the
protection buyer only makes a payment up to the credit event date and makes no further payment. At
this time, the protection buyer is obligated to perform. The contract will call for the protection seller to
compensate for the loss in the value of the debt obligation. The specific method for compensating the
protection buyer is not important at this time.

For now, it is just important to realize that (1) a CDS allows parties to buy and sell credit risk, and
(2) the mechanism is not like the standard swap described earlier where two parties exchange payments
periodically.

Interpretation of a Swap

If we look carefully at a swap, we can see that it is not a new derivative instrument. Rather, it can be
decomposed into a package of derivative instruments that we have already discussed. Consider our first
illustrative swap. Every year for the next 5 years Renwick Bank agrees to pay General Manufacturing
Corp. 8% per year, while General Manufacturing agrees to pay First Renwick the rate on a 1-year
Treasury security. Because the notional amount is $100 million, General Manufacturing agrees to pay $8
million. Alternatively, we can rephrase this transaction as follows: Every year for the next 5 years,
General Manufacturing agrees to deliver to First Renwick lion. Look at it in this way: The two parties
enter into multiple forward contracts. party agrees to deliver something at some time in the future, and
the other party agrees to accept delivery. The reason for saying that there are multiple forward
contracts is because the agreement calls for making the exchange each year for the next 5 years.

Even though a swap may be nothing more than a package of forward contracts, it is not a
redundant contract for several reasons. First, in many markets with forward and futures contracts, the
longest maturity does not extend out as far as that of a typical swap. Second, a swap is a more
transactionally efficient instrument, which means that in one transaction an entity can effectively
establish a payoff equivalent to a package of forward contracts. The forward contracts would each have
to be negotiated separately. Third, the liquidity of the swap market continues to grow since its beginning
in 1981; it is now more liquid than many forward contracts, particularly long-dated (i.e., long-term)
forward contracts.

Applications

Now that you know what a swap is and how it can be viewed as a package of forward contracts, the next
question is how can a market participant use a swap to accomplish a financial objective? We provide
more detailed applications in later chapters, but for our purposes here, we provide two simple ones. The
first application demonstrates how a swap, more specifically an interest rate swap. can be used by a
depository institution for asset/liability management. In our second application, we show how we can
create a new financial instrument by using an interest rate-equity swap.

Application to Asset/Liability Management

Suppose that the Buckingham Bank raises $100 million for 3 years at a fixed interest rate of 8% and then
lends that money to All American Airlines for 3 years. The loan calls for an interest rate that changes
every year. The interest rate that the airline company agrees to pay is the London interbank offered rate
(LIBOR) plus 250 basis points. Suppose LIBOR is 7.5% when the loan is initiated. Therefore, in the first
year the airline company will pay 10% (LIBOR of 7.5 % plus 2.5%). The bank locks in a spread of 2% for
the first year.

The interest rate risk exposure for this bank occurs if LIBOR declines. Should LIBOR fall below
5.5%, the interest rate for the loan for that 1-year period would be less than Buckingham Bank must pay
on the money it borrowed at 8%. Thus, the bank would realize a negative spread for that period.

Suppose that Buckingham Bank could find another party, say Deutsche Bank, that would be
willing to enter into an interest rate swap on the following terms: (1) the term of the swap is 5 years
with a notional amount of $100 million: (2) every year Deutsche Bank pays Buckingham Bank 7.5% of
$100 million; and (3) at the same time Buckingham Bank pays Deutsche Bank LIBOR plus 100 basis points
of $100 million. Each year the outcome of this interest rate swap, coupled with the fixed interest rate
that Buckingham Bank must pay on the money it borrowed, and the interest income it receives on the
loan it made to the airline company, is as follows.

1. It earns LIBOR plus 250 basis points on the $100 million loan.
2. It pays 8% on the $100 million it borrowed.
3. As part of the swap, it receives 7.5% of $100 million from Deutsche Bank.
4. As part of the swap, it pays LIBOR plus 100 basis points of $100 million to Deutsche Bank.
Buckingham Bank therefore earns LIBOR plus 250 basis points (from the loan) and pays LIBOR
plus 100 basis points (as per the swap), resulting in a net inflow of 150 basis points. In addition, it pays
8% (to borrow funds) and receives 7.5% (as per the swap), resulting in a net outflow of 50 basis points.
As the net result, then, it locked in a spread of 1% (150 basis points minus 50 basis points) on the $100
million, regardless of how LIBOR changes.

This simple illustration demonstrates how an interest rate swap can be employed for
asset/liability management. You might wonder: Who would be willing to take the other side of the swap
(i.e., who would be the counterparty)? How does one find a counterparty? How are the terms of the
swap determined? Why couldn't this depository institution just issue a floating-rate note rather than
issue a fixed-rate note? These questions are addressed in Chapter 30 when we discuss interest rate
swaps more fully.

Application to Creation of a Security

Swaps can be used by investment bankers to create a security. To see how, suppose the following
scenario: The Universal Information Technology Company (UIT) seeks to raise $100 million for the next 5
years on a fixed-rate basis. UIT's investment banker, the Credit Suisse, indicates that if bonds with a
maturity of 5 years are issued, the interest rate on the issue would have to be 8%. At the same time,
institutional investors are seeking to purchase bonds but are interested in making a play on the stock
market. These investors are willing to purchase a bond whose annual interest rate is based on the actual
performance of the S&P 500 stock market index.

Credit Suisse recommends to UIT's management that it consider issuing a 5-year bond whose
annual interest rate is based on the actual performance of the S&P 500. The risk with issuing such a
bond is that UIT's annual interest cost is uncertain because it depends on the performance of the S&P
500. However, suppose that the following two transactions are entered:

1. On January 1, UIT agrees to issue, using Credit Suisse as the underwriter, a $100 million 5-year bond
issue whose annual interest rate is the actual performance of the S&P 500 that year minus 300 basis
points. The minimum interest rate, however, is set at zero. The annual interest payments are made on
December 31.

2. UIT enters into a 5-year, $100 million notional amount interest rate-equity swap with Credit Suisse in
which each year for the next 5 years UIT agrees to pay 7.9% to Credit Suisse, and Credit Suisse agrees to
pay the actual performance of the S&P 500 that year minus 300 basis points. The terms of the swap call
for the payments to be made on December 31 of each year. Thus, the swap payments coincide with the
payments that must be made on the bond issue. Also as part of the swap agreement, if the S&P 500
minus 300 basis points results in a negative value, Credit Suisse pays nothing to UIT.
Consider the accomplishment of these two transactions from the perspective of UIT. Specifically, focus
on the payments that must be made by UIT on the bond issue and the swap and the payments it will
receive from the swap. These results are summarized here:

Interest payments on bond issue: S&P 500 return - 300 basis points
Swap payment from Credit Suisse: S&P 500 return - 300 basis points
Swap payment to Credit Suisse: 7.9% .
Net interest cost: 7.9%

Thus, the net interest cost is a fixed rate despite the bond issue paying an interest rate tied to the S&P
500, which was accomplished with the interest rate-equity swap.

Several questions in this scenario need to be addressed. First, what was the advantage to UIT in
entering into this transaction? Recall that if UIT issued a bond, Credit Suisse estimated that UIT would
have to pay 8% annually. Thus, UIT saved 10 basis points (8% minus 7.9%) per year. Second, why would
investors purchase this bond issue? As explained in earlier chapters, regulations impose certain
restrictions on institutional investors as to types of investment. For example, a U.S. depository
institution is not entitled to purchase common stock, however it may be permitted to purchase a bond
of an issuer such as UIT despite the fact that the interest rate is tied to the performance of common
stocks. Third, is Credit Suisse exposed to the risk of the performance of the S&P 500? Although is it
difficult to demonstrate at this point, Credit Suisse can protect itself in a number of different ways.

This example may seem like a far-fetched application, but it is not. In fact, it is quite common
and one of the reasons for discussing swaps so early in this book. Debt instruments created by using
swaps are commonly referred to as structured notes (dis cussed in Section VI of this book).

CAP AND FLOOR AGREEMENTS

Agreements are available in the financial market in which one party, for a fee (premium), agrees to
compensate the other if a designated reference is different from a predetermined level. The party that
receives payment if the designated reference differs from a predetermined level and pays a premium to
enter into the agreement is called the buyer. The party that agrees to make the payment if the
designated reference differs from a predetermined level is called the seller.

When the seller agrees to pay the buyer if the designated reference exceeds a predetermined
level, the agreement is referred to as a cap. The agreement is referred to as a floor when the seller
agrees to pay the buyer if a designated reference falls below a predetermined level.

The designated reference could be a specific interest rate such as LIBOR or the prime rate, the
rate of return on some domestic or foreign stock market index such as the S&P 500 or the DAX, or an
exchange rate such as the exchange rate between the U.S. dollar and the Japanese yen. The
predetermined level is called the strike. As with a swap, a cap and a floor are based on a notional
amount.
 In general, the payment made by the seller of the cap to the buyer on specific date is
determined by the relationship between the designated reference and the strike. If the former is greater
than the latter, then the seller pays the buyer the following:

Notional amount x (Actual value of designated reference Strike)

If the designated reference is less than or equal to the strike, then the seller pays the buyer nothing.

For a floor, the payment made by the seller to the buyer on a specific date is also determined by
the relationship between the strike and the designated reference. If the designated reference is less
than the strike, then the seller pays the buyer the following:

Notional principal amount x (Strike - Actual value of designated reference)

If the designated reference is greater than or equal to the strike, then the seller pays the buyer nothing.

The following two examples show how these agreements work.

Example 1. The Peterson Shipping Company enters into a 5-year cap agreement with Citibank with a
notional amount of $50 million. The terms of the cap specify that if LIBOR exceeds 8% on December 31
each year for the next 5 years, Citibank (the seller of the cap) will pay Peterson Shipping Company the
difference between 8% (the strike) and LIBOR (the designated reference). The fee or premium Peterson
Shipping agrees to pay Citibank each year is $200,000.

The payment made by Citibank to Peterson Shipping on December 31 for the next 5 years based
on LIBOR on that date will be as follows. If LIBOR >8%, then Citibank pays $50 million X (Actual value of
LIBOR-8%). If LIBOR 8%, then Citibank pays nothing. So, for example, if LIBOR on December 31 of the
first year of the cap is 10%, Citibank pays Peterson Shipping Company $1 million.

$50 million x (10%-8%) = $1 million

Example 2. The R&R Company, a money management firm, enters into a 3-year floor agreement with
Merrill Lynch with a notional amount of $100 million. The terms of the floor specify that if the S&P 500 is
less than 3% on December 31 each year for the next 3 years Merrill Lynch (the seller of the floor) pays
R&R Company the difference between 3% (the strike) and the return realized on the S&P 500 (the
designated reference). The premium R&R Company agrees to pay Merrill Lynch each year is $600,000.
The payment made by Merrill Lynch to R&R Company on December 31 for the next 3 years based on the
performance of the S&P 500 for that year will be as follows. If the actual return on S&P 500 < 3%, then
Merrill Lynch pays: $100 million x 3% - (Actual return on S&P 500). If the actual return on S&P 500 2 3%.
then Merrill Lynch pays nothing. For example, if the actual return on the S&P 500 in the first year of the
floor is 1%, Merrill Lynch pays R&R Company $2 million.

$100 million x (3% -1%) = $2 million

Interpretation of a Cap and Floor

In a cap or floor, the buyer pays a fee that represents the maximum amount the buyer can lose and the
maximum amount the seller of the agreement can gain. The only party required to perform is the seller.
The buyer of a cap benefits if the designated reference rises above the strike because the seller must
compensate the buyer. The buyer of a floor benefits if the designated reference falls below the strike
because the seller must compensate the buyer.

In essence the payoff of these contracts is the same as in an option. A call option buyer pays a fee and
benefits if the value of the option's underlying asset (or equivalently, designated reference) is higher
than the strike price at the expiration date. A cap has a similar payoff. A put option buyer pays a fee and
benefits if the value of the option's underlying asset (or equivalently, designated reference) is less than
the strike price at the expiration date. A floor has a similar payoff. An option seller is only entitled to the
option price. The seller of a cap or floor is only entitled to the fee.

Thus, a cap and a floor can be viewed as simply a package of options. As with a swap, a complex contract
consists of basic contracts (forward contracts in the case of swaps and options in the case of caps and
floors) packaged together.

Application to Asset/Liability Management

To see how a cap can be used for asset/liability management, consider the problem faced by
Buckingham Bank in our earlier illustration. Recall that as its objective the bank wishes to lock in an
interest rate spread over its cost of funds. Yet because it borrows short term, its cost of funds is
uncertain. The Buckingham Bank may be able to purchase a cap such that the cap rate plus the cost of
purchasing the cap is less than the rate it earns on its fixed-rate commercial loans. If short-term rates
decline. Buckingham Bank does not benefit from the cap, but its costs of funds declines. The cap
therefore allows the bank to impose a ceiling on its cost of funds while retaining the opportunity to
benefit from a decline in rates.

SUMMARY

In this chapter we covered three types of derivative contracts: swaps, caps, and floors. In a swap the
counterparties agree to exchange periodic payments. The dollar amount of the payments ex changed is
based on the notional amount. The five types of swaps are interest rate swaps, interest rate-equity
swaps, equity swaps, currency swaps, and credit default swaps. A credit default swap is a credit
derivative that allows a party to buy and sell credit risk. The mechanics of this type of swap differ from
that of a standard swap. A swap offers the risk/return profile of a package of forward contracts. Swaps
can be used for asset/liability management and the creation of securities.
A cap is an agreement whereby the seller agrees to pay the buyer when a designated reference exceeds
a predetermined level (the strike). A floor is an agreement whereby the seller agrees to pay the buyer
when a designated reference is less than a predetermined level (the strike). The designated reference
could be a specific interest rate, the rate of return on some stock market index, or an exchange rate. A
cap and a floor are equivalent to a package of options.

CHAPTER 2

Money Markets
LEARNING OBJECTIVES

After reading this chapter you will understand:

 what the money market is.

 what a Treasury bill is what commercial paper is and why it is issued.
 the types of issuers and major buyers of commercial paper.
 the difference between directly placed and dealer- placed commercial paper.
 what a bankers acceptance is and how it is created.
 what a certificate of deposit is and the different types of certificates of deposit.
 what a repurchase agreement is and how it can be used to finance a security position.
 the factors that influence the interest rate on repurchase agreements.

In this section of the book we turn our attention to debt securities-instruments that obligate the debtor
to make a contractually fixed series of payments, generally in nominal dollars, up to some terminal
maturity date. This chapter focuses on debt instruments that at the time of issuance have a maturity of
1 year or less. These instruments are referred to as money market instruments, and the market they
trade in is called the money market. It is in this market where (1) governments, government agencies,
corporations, and municipal governments borrow money on a short-term basis, and (2) investors with
funds to invest for a short term can invest.

The assets traded in the money market include Treasury bills, commercial paper. medium-term
notes, bankers acceptances, short-term federal agency securities short-term municipal obligations,
certificates of deposit, repurchase agreements, and federal funds. The U.S. Department of the Treasury
borrows short term by issuing Treasury bills. Both financial and nonfinancial corporations issue
commercial paper. Obligations of one type of financial corporation, depository institutions (banks and
savings and loan associations), include certificates of deposit, bankers acceptances, and federal funds
borrowing. Repurchase agreements provide the most common mechanism for entities to borrow funds
using securities as collateral.
 In this chapter we discuss Treasury bills, commercial paper, bankers acceptances, certificates of
deposit, repurchase agreements, and federal funds.

TREASURY BILLS

Treasury securities are issued by the U.S. Department of the Treasury and backed by the full
faith and credit of the U.S. government. As a result, market participants perceive Treasury securities to
carry no risk of default.

The U.S. Treasury issues three types of securities: bills, notes, and bonds. At issuance, bills
mature in 1 year or less, notes more than 2 years but no more than 10 years, and bonds more than 10
years. In the next chapter we cover Treasury securities in greater detail, but here we limit our discussion
of Treasury securities to bills because they fall into the category of money market instruments, that is,
instruments with 1 year or less to maturity. These securities are called Treasury bills and are issued on a
regular basis with initial maturities of 4 weeks, 13 weeks, and 26 weeks. The latter two bills are more
popularly referred to as the 3-month and 6-month Treasury bills, respectively

A Treasury bill is a discount security. Such securities do not make periodic interest payments.
The security holder receives interest instead at the maturity date, when the amount received is the face
value (maturity value or par value), which is larger than the purchase price. For example, suppose an
investor purchases a 6-month. Treasury bill with a face value of $100,000 for $96,000. By holding the bill
until the maturity date, the investor receives $100,000; the difference of $4,000 between the proceeds
received at maturity and the amount paid to purchase the bill represents the interest. Treasury bills are
only one example of a number of money market instruments that are discount securities. The market for
Treasury bills is the most liquid market in the world. Interest on Treasury bills is exempt from state and
local income taxes.

COMMERCIAL PAPER

Commercial paper is a short-term unsecured promissory note issued in the open market that represents
the obligation of the issuing corporation. The issuance of commercial paper is an alternative to bank
borrowing for large corporations (nonfinancial and financial) with strong credit ratings.

The original purpose of commercial paper was to provide short-term funds for seasonal and
working capital needs, but companies use this instrument for other purposes. It is used quite often for
bridge financing. For example, suppose that a corporation needs long-term funds to build a plant or
acquire equipment. Rather than raising long term funds immediately, the corporation may elect to
postpone the offering until more favorable capital market conditions prevail. The funds raised by issuing
commercial paper are used until longer-term securities are sold. Interestingly, commercial paper
sometimes acts as bridge financing to finance corporate takeovers.

In the United States, the maturity of commercial paper is typically less than 270 days, with the
most maturing in less than 90 days. Several reasons explain this pattern of maturities. First, the
Securities Act of 1933 requires that securities be registered with the SEC. Special provisions in the 1933
Act exempt commercial paper from registration as long as the maturity does not exceed 270 days.
Hence, to avoid the costs associated with registering issues with the SEC, firms rarely issue commercial
paper with maturities exceeding 270 days, Another consideration in determining the maturity is
whether the commercial paper would be eligible collateral for a bank borrowing from the Federal
Reserve Bank's discount window. In order to be eligible, the maturity of the paper may not exceed 90
days. Because eligible paper trades at a lower cost than paper that is not eligible, firms prefer to issue
paper whose maturity does not exceed 90 days.

To pay off holders of maturing paper, issuers generally use the proceeds obtained by selling new
commercial paper. This process is often described as rolling over short term paper. The risk that the
investor in commercial paper faces is that the issuer will be unable to sell new paper at maturity. As a
safeguard against this rollover risk, commercial paper is typically backed by unused bank credit lines.
The commitment fee the bank charges for providing a credit line increases the effective cost of issuing
commercial paper.

Investors in commercial paper are institutional investors Money market mutual funds purchase
roughly one-third of all the commercial paper issued. Pension funds, commercial bank trust
departments, state and local governments, and nonfinancial corporations seeking short-term
investments purchase the balance.

Little secondary trading of commercial paper takes place. Typically, an investor in commercial
paper is an entity that plans to hold it until maturity, which is understand able because an investor can
purchase commercial paper in a direct transaction with the issuer, who sells paper with the specific
maturity the investor desires.

Issuers of Commercial Paper

Corporate issuers of commercial paper can be divided into financial companies and non financial
companies. Financial companies are the major issuers of commercial paper.

Three types of financial companies include captive finance companies, bank related finance
companies, and independent finance companies. Captive finance companies are subsidiaries of
equipment manufacturing companies. Their primary purpose is to secure financing for the customers of
the parent company. For example, the three major U.S. automobile manufacturers have captive finance
companies: General Motors Acceptance Corporation (GMAC), Ford Credit, and Daimler Chrysler
Financial. GMAC is by far the largest issuer of commercial paper in the United States. Furthermore, a
bank holding company may have a subsidiary finance company that provides loans to enable individuals
and businesses to acquire a wide range of products. Independent finance companies are not subsidiaries
of equipment manufacturing firms or bank holding companies.

The issuers of commercial paper typically have high credit ratings. Smaller and less well-known
companies with lower credit ratings have been able to issue paper, how ever, by means of credit
support from a firm with a high credit rating (such paper is called credit-supported commercial paper) or
by collateralizing the issue with high quality assets (such paper is called asset-backed commercial paper).
An example of credit-supported commercial paper is one supported by a letter of credit. The terms of a
letter of credit specify that the bank issuing the letter guarantees that the bank will pay off the paper
when it comes due, if the issuer fails to do so. The bank will charge a fee for the letter of credit. From
the issuer's perspective, the fee enables it to enter the commercial paper market and thereby obtain
funding at a lower cost than that of bank borrowing. Commercial paper issued with this credit
enhancement is referred to as LOC paper. The credit enhancement may also take the form of a surety
bond from an insurance company.

Both domestic and foreign corporations issue commercial paper in the United States.
Commercial paper issued by foreign entities is called Yankee commercial paper.

Directly Placed versus Dealer-Placed Paper

Commercial paper is classified as either direct paper or dealer-placed paper. Directly placed paper is
sold by the issuing firm directly to investors without the help of an agent or an intermediary. (An issuer
may set up its own dealer firm to handle sales.) A majority of the issuers of direct paper are financial
companies. These entities require continuous funds in order to provide loans to customers. As a result,
they find it cost effective to establish a salesforce to sell their commercial paper directly to investors. An
institutional investor can obtain information about the rates posted for issuers on Bloomberg Financial
Markets, Telerate/Bridge, Reuters, and the Internet.

Dealer-placed commercial paper requires the services of an agent to sell an issuer's paper. The
agent distributes the paper on a best efforts underwriting basis by investment banking firms.

BANKER ACCEPTANCES

Simply put, a bankers acceptance is a vehicle created to facilitate commercial trade transactions. The
instrument is called a bankers acceptance because a bank accepts the ultimate responsibility to repay a
loan to its holder. The use of bankers acceptances to finance a commercial transaction is referred to as
acceptance financing.

The transactions in which bankers acceptances are created include (1) the importing of goods
into the United States; (2) the exporting of goods from the United States to foreign entities; (3) the
storing and shipping of goods between two foreign countries where neither the importer nor the
exporter is a U.S. firm; and (4) the storing and shipping of goods between two entities in the United
States. As demonstrated in the following illustration, maturities are typically arranged to cover the time
required to ship and dispose of the goods being financed.

Bankers acceptances are sold on a discounted basis just as Treasury bills and commercial paper.
To calculate the rate to be charged the customer for issuing a bankers acceptance, a bank determines
the rate for which it can sell its bankers acceptance the open market. To this rate it adds a commission.

Illustration of the Creation of a Bankers Acceptance

The best way to explain the creation of a bankers acceptance is by an illustration. Several entities are
involved in our transaction:

• Car Imports Corporation of American (Car Imports), a firm in New Jersey that sells
automobiles
• Germany Fast Autos Inc. (GFA), a manufacturer of automobiles in Germany
• First Hoboken Bank (Hoboken Bank), a commercial bank in Hoboken, New Jersey
• West Berlin National Bank (Berlin Bank), a bank in Germany
• High-Caliber Money Market Fund, a mutual fund in the United States that invests in money
market instruments

Car Imports and GFA are considering a commercial transaction. Car Imports wants to import 15 cars
manufactured by GFA. GFA is concerned with the ability of Car Imports to make payment on the 15 cars
when they are received.

Acceptance financing is suggested as a means for facilitating the transaction. Car Imports offers
$300,000 for the 15 cars. The terms of the sale stipulate payment to be made to GFA 60 days after it
ships the 15 cars to Car Imports. GFA determines whether it is willing to accept the $300,000. In
considering the offering price, GFA must calculate the present value of the $300,000, because it will not
be receiving payment until 60 days after shipment. Suppose that GFA agrees to these terms.

Car Imports arranges with its bank, Hoboken Bank, to issue a letter of credit. The letter of credit
indicates that Hoboken Bank will make good on the payment of $300,000 that Car Imports must make to
GFA 60 days after shipment. The letter of credit, or time draft, will be sent by Hoboken Bank to GFA's
bank, Berlin Bank. Upon receipt of the letter of credit, Berlin Bank will notify GFA, which will then ship
the 15 cars. After the cars are shipped, GFA presents the shipping documents to Berlin Bank and
receives the present value of $300,000. GFA is now out of the picture.

Berlin Bank presents the time draft and the shipping documents to Hoboken Bank. The latter will
then stamp "accepted" on the time draft. By doing so, Hoboken Bank creates a bankers acceptance and
agrees to pay the holder of the bankers acceptance $300,000 at the maturity date. Car Imports receives
the shipping documents so that it can procure the 15 cars once it signs a note or some other type of
financing arrangement with Hoboken Bank.

At this point, the holder of the bankers acceptance is the Berlin Bank. It has two choices. It can
continue to hold the bankers acceptance as an investment in its loan portfolio, or it can request that
Hoboken Bank make a payment of the present value of $300,000. Let's assume that Berlin Bank requests
payment of the present value of $300,000.

Now the holder of the bankers acceptance is Hoboken Bank. It has two choices retain the
bankers acceptance as an investment as part of its loan portfolio, or sell it to an investor. Suppose that
Hoboken Bank chooses the latter, and that High-Caliber Money Market Fund is seeking a high-quality
investment with the same maturity as that of the bankers acceptance. Hoboken Bank sells the bankers
acceptance to the money market fund at the present value of $300,000. Rather than sell the instrument
directly to an investor, Hoboken Bank could sell it to a dealer, who would then resell it to an investor
such as a money market fund. In either case, at the maturity date, the money market fund presents the
bankers acceptance to Hoboken Bank, receiving $300,000, which the bank in turn recovers from Car
Imports.

REPURCHASE AGREEMENTS

A repurchase agreement is the sale of a security with a commitment by the seller to buy the security
back from the purchaser at a specified price at a designated future date. Basically, a repurchase
agreement is a collaterized loan, where the collateral is a security. The collateral in a repo can be money
market instruments, Treasury securities, federal agency securities, mortgage-backed securities, or asset-
backed securities.

The agreement is best explained with an illustration. Suppose a securities dealer purchases $10
million of a particular bond. Where does the dealer obtain the funds to finance that position? Of course,
the dealer can finance the position with its own funds or by borrowing from a bank. Typically, however,
the dealer uses the repurchase agreement or repo market to obtain financing. In the repo market the
dealer can use the $10 million of the bond as collateral for a loan. The term of the loan and the interest
rate that the dealer agrees to pay (the "repo rate") are specified. When the term of the loan is 1 day, it is
called an "overnight repo"; a loan for more than 1 day is called a "term repo."

The transaction is referred to as a repurchase agreement because it calls for the sale of the
security and its repurchase at a future date. Both the sale price and the purchase price are specified in
the agreement. The difference between the purchase (repurchase) price and the sale price is the dollar
interest cost of the loan.

In our illustration the dealer needs to finance $10 million par value of the bond that it purchased
and plans to hold overnight. Suppose that a customer of the dealer has excess funds of $10 million. The
dealer would agree to deliver ("sell") $10 million of the bond to the customer for an amount determined
by the repo rate and buy ("repurchase") the same bond from the customer for $10 million the next day.
Suppose that the overnight repo rate is 6.5%. Then (as explained below), the dealer would agree to
deliver the bond for $9,998,195 and repurchase the same bond for $10 million the next day. The $1,805
difference between the sale price of $9.998,195 and the repurchase price of $10 million is the dollar
interest on the financing. From the customer's perspective, the agreement is called a "reverse repo."

The following formula is used to calculate the dollar interest on a repo transaction:

Dollar interest = Dollar principal x Repo rate x Repo term

360
Notice that the interest is computed on a 360-day basis. In our example, at a repo rate of 6.5% and a
repo term of 1 day (overnight), the dollar interest is $1,805:

$9,998,195 x 0.065 x 1/360 = $1,805

 The advantage to the dealer of using the repo market for borrowing on a short term basis is that
the rate is less than the cost of bank financing. We explain why later in this section. From the customer's
perspective, the repo market offers an attractive yield on a short-term secured transaction that is highly
liquid.

The example illustrates financing a dealer's long position in the repo market , but dealers can
also use the market to cover a short position. For example, suppose a government dealer sold $10
million of Treasury securities 2 weeks ago and must now cover the position that is, deliver the securities.
The dealer can do a reverse repo (agree to buy the securities and sell them back). Of course, the dealer
eventually would have to buy the Treasury security in the market in order to cover its short position.

A good deal of Wall Street jargon describes repo transactions. To understand it remember that
one party is lending money and accepting security as collateral for the loan; the other party is borrowing
money and giving collateral to borrow money. someone lends securities in order to receive cash (i.e.,
borrows money), that party is said to be "reversing out" securities. A party that lends money with the
security as col lateral is said to be "reversing in" securities. The expressions "to repo securities" and "to
do repo" are also used. The former means that someone is going to finance securities using the security
as collateral; the latter means that the party is going to invest in a repo. Finally, the expressions "selling
collateral" and "buying collateral" are used to describe a party financing a security with a repo on the
one hand, and lending on the basis of collateral on the other.