Module 4 – Debt securities and markets

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Module 4 – Debt securities and markets Self-assessment question 4.1 Revision questions 1, 3, 4, 8, 9, 10 & 11 from Valentine et al., chapter 2.

Revision questions 1. What type of investor would be interested in Australian TIBs? Answer: These bonds could be attractive to: ●

retirees who want to maintain the real value of their retirement income

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superannuation funds which are obliged to pay indexed pensions.

However, a problem with these indexed bonds is that the nominal rather than the real rate of return is subject to tax. This can result in a negative after-tax real return. As a result, investors are often attracted to such investments as shares and property which are regarded as inflation hedges (i.e. their prices increase with the general price level). 3. What are the advantages/disadvantages of securitisation? How does it affect the original mortgage borrower? Answer: The advantages of securitisation are: ●

the housing mortgages of lenders such as banks have become liquid assets. They can be used in the process of asset/liability management

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fund managers have access to a new asset class (home mortgages) allowing a greater diversification of their portfolios

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securitisation increases the volume of bonds traded in the market

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securitisation potentially increases the availability of funds available to borrowers in particular segments such as the housing market. This increased competition also places downward pressure on the cost of borrowing.

The major danger with the securitisation process arises from the credit enhancement necessary to make it work. If defaults exceed the expected level, the organisation guaranteeing the asset-backed bonds can get into difficulties. For example, such a development could undermine the viability of mortgage insurers. Securitisation of a mortgage has no direct impact on the borrower. However, many borrowers would be disconcerted to discover that they no longer have a relationship with the original lender, the lender of their choice. During the GFC many non-banks found it very difficult to issue new, and roll-over existing, bonds. The result can be substantially higher interest rates for those borrows with a variable mortgage relative to the top-tier banks that rely less on securitisation as a source of funds. © University of Southern Queensland

FIN8202 – Financial markets and instruments

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4. Discuss the differences in the functions of the AOFM and the RBA. Answer: The AOFM manages the Government’s debt obligations. It also manages the Government’s surplus cash balances and invests surplus funds in financial assets. The RBA manages the entire monetary system by maintaining exchange settlement accounts, issuing currency notes, and actively participating in the short-term money market to set the official interbank cash rate. 8. What type of investor would be interested in a zero-coupon bond? Answer: Zero-coupon bonds are attractive to investors who do not need regular cash flows but who want to lock in a return over a long period of time. 9. How has the recent GFC affected the demand and supply of government bonds in financial markets? Answer: Commonwealth Government deficits, resulting from the impacts of the GFC, have increased the supply of Treasury bonds dramatically and reversed a decade long retreat away from debt finance. Conversely, the GFC has also prompted investors to re-evaluate the concept of risk and riskless assets such as Treasury bonds. This risk aversion has seen an increase in the demand for Treasury bonds by investors in order to reduce risk and to replenish underweight portfolios. 10. What are the potential investment risks involved with interest rate securities? Answer: Interest rate securities can be traded on the ASX, e.g. floating rate notes, convertible notes, and hybrid debt securities. This type of security is a form of bond which pays a coupon payment, either fixed or floating, plus it pays the face value upon maturity. The main risk associated with these securities is that the coupon payment (cash flow) is fixed for the life of the security unless it is a floating rate security. The investment risks associated with longer term interest rate securities are greater due to the variability of interest rates over time. 11. What factors determine a company’s credit rating? Answer: Ratings agencies attempt to make informed conclusions based upon information from a range of sources, but importantly from the company itself. There are three major credit rating agencies globally, and each of these agencies applies different criteria to calculate company credit ratings. However, the ratings of each company can be compared with each other. For example, Moody’s investment grade ‘good – A3’ is equated with Standard and Poor’s investment grade ‘good – BBB+’. The main factors influencing company ratings include key financial and accounting ratios such as: ●

Cash flow ratios © University of Southern Queensland

Module 4 – Debt securities and markets

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Earnings data

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Cover ratios

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Capital structure

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As well as these financial ratios, ratings agencies consider some ‘macro’ factors such as the economic performance and direction of the country’s economy, and how changes to national and international accounting practices would impact upon the particular company.

Self-assessment questions 4.2 Questions 3, 5, 6, 7, 14 & 15; Quantitative problems 2, 5, 6, 8, & 9 from Mishkin & Eakins, chapter 11.

Answers to end-of-chapter questions Mishkin & Eakins, chapter 11 3. Banks have higher costs than the money market owing to the need to maintain reserve requirements. The lower cost structure of the money markets, coupled with the economies of scale resulting from high volume and large-denomination securities, allows for higher interest rates. 5. Following the Great Depression, regulators were primarily concerned with stopping banks from failing. By removing interest-rate competition, bank risk was substantially reduced. The problem with these regulations was that when market interest rates rose above the established interest-rate ceiling, investors withdrew their funds from banks. 6. The U.S. government sells large numbers of securities in the money markets to support government spending. Over the past several decades, the government has spent more each year than it has received in tax revenues. It makes up the difference by borrowing. Part of what it borrows comes from the money markets. 7. Businesses both invest and borrow in the money markets. They borrow to meet short-term cash flow needs, often by issuing commercial paper. They invest in all types of money market securities as an alternative to holding idle cash balances. 14. Large businesses with very good credit standings sell commercial paper to raise shortterm funds. The most common use of these funds it to extend short-term loans to customers for the purchase of the firm’s products. 15. Banker’s acceptances substitute the creditworthiness of a bank for that of a business. When a company sells a product to a company it is unfamiliar with, it often prefers to have the promise of a bank that payment will be made.

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FIN8202 – Financial markets and instruments

Quantitative problems Mishkin & Eakins, chapter 11 2. What is the annualized discount rate % and your annualized investment rate % on a Treasury bill that you purchase for $9,940 that will mature in 91 days for $10,000? Solution:

$ 1 0 , 0 0 0  $ 9 , 9 4 0 3 6 0 D i s c o u n t r a t e   0 . 0 2 3 7 4  2 . 3 7 4 % $ 1 0 , 0 0 0 9 1 $ 1 0 , 0 0 0  $ 9 , 9 4 0 3 6 5 I n v e s t m e n t r a t e   0 . 0 2 4 2 1  2 . 4 2 1 % $ 9 , 9 4 0 9 1

5. The price of 182-day commercial paper is $7,840. If the annualized investment rate is 4.093%, what will the paper pay at maturity? Solution: Let B = what will be paid at maturity [ (B  $ 7 ,8 4 0 )/( $ 7 ,8 4 0 ) ] ( 3 6 5 /1 8 2 ) 0 .0 4 0 9 3 [ (B  $ 7 ,8 4 0 )/( $ 7 ,8 4 0 ) ] 2 .0 0 5 5  0 .0 4 0 9 3 (B  $ 7 ,8 4 0 ) 2 .0 0 5 5  3 2 0 .8 9 B  $ 7 ,8 4 01 6 0 B  $ 8 ,0 0 0

6. How much would you pay for a Treasury bill that matures in 182 days and pays $10,000 if you require a 1.8% discount rate? Solution: Let C = what you would pay [ ( $ 1 0 , 0 0 0  C ) / ( $ 1 0 , 0 0 0 ) ](  3 6 0 / 1 8 2 )  0 . 0 1 8 [ ( $ 1 0 , 0 0 0  C ) / ( $ 1 0 , 0 0 0 ) ]1  . 9 7 8  0 . 0 1 8 [ ( $ 1 0 , 0 0 0  C ) ]0  . 0 1 8  $ 1 0 , 0 0 0  1 . 9 7 8 $ 1 0 , 0 0 0  C  9 1 C  $ 9 , 9 0 9

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Module 4 – Debt securities and markets

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8. How much would you pay for a Treasury bill that matures in one year and pays $10,000 if you require a 3% discount rate? Solution: Let C = what you would pay [ $ 1 0 , 0 0 0)  C / ( $ 1 0 , 0 0 0 ) ]  ( 3 6 0 / 1 8 2 )0  . 0 3 [ ( $ 1 0 , 0 0 0)  C / ( $ 1 0 , 0 0 0 ) ]0  . 0 3  ( 1 8 2 / 3 6 0 ) $ 1 0 , 0 0 0  C  1 5 1 . 6 7 C  $ 9 , 8 4 8 . 3 3

9. The annualized discount rate on a particular money market instrument is 3.75%. The face value is $200,000 and it matures in 51 days. What is its price? What would be the price if it had 71 days to maturity? Solution: Let B = the price with 51 days to maturity [ ( $ 2 0 0 ,0 0 0  B )/( $ 2 0 0 ,0 0 0 ) ]  ( 3 6 0 /5 1 ) 0 .0 3 7 5 [ ( $ 2 0 0 ,0 0 0  B ) ( 3 6 0 /5 1 ) 0 .0 3 7 5$ 2 0 0 ,0 0 0 ( $ 2 0 0 ,0 0 0  B ) ( 3 6 0 /5 1 ) $ 7 ,5 0 0 ( $ 2 0 0 ,0 0 0  B ) $ 7 ,5 0 0(  5 1 /3 6 0 ) $ 2 0 0 ,0 0 0  B$ 1 ,0 6 2 .5 0 B  $ 1 9 8 ,9 3 7 .5 0

If 71 days to maturity, then B = $198,520.83.

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