Study On Debt Bonds And Interest Rates Finance Essay - Free Essay Example

Bonds is a debt security, in which the issuer owes the holders a debt and is obliged to repay the interest (coupon payment) periodically and the principal at a later date, termed maturity. Investing in bonds is not riskless and the value of bonds can be affected by different risks. However, treasurers and financial managers must manage the relation risk-return while mitigating such risks. Interest rate risk (IR) Is the most important risk for bonds, because the IR changes continually and there is an opposite relationship between the price of bonds and IR which is set at the time of issuance. If IR increases the price of the bond will decreases, investors will be unwilling to purchase the bonds in the secondary market at the earlier rate also known as market risk, it happen when the bonds is sold before maturity in the secondary market. The price of the bond will decrease so that the capital appreciation will make up for the difference in interest rates which rises the risk of buying long-term bonds during periods of low interest rates Managing the current risk by anticipating cash flow exposure of the firm. Hedging by derivative instruments such as forward rate agreement, interest rate future, swaps, and options ( put options or an interest-only mortgage-backed securities). Also, we should ensure that the shareholders want to hedge interest rate risk or prefer to diversify t he risk away by diversifying their own portfolio We hold a bond for $1,000 that pays IR=8% which we want to sell at the time the market is offering for the same risk 10%.To do so, we have to sell it at $800 ($80=80010%) to keep the same IR coupon ($80=10008%) so we lost $200 ($1000-800) If the bond is kept till maturity, FV= $1,000 and the price paid for it first time is more, the bond is sold at less (discount). If it will be sold at higher then what we pay first time (premium) Call Risk Callable bond gives the right and not the obligation to the issuer to redeem the bond before maturity as specified in detail in the indenture of the bond so that the issuer can issue new bonds at a lower interest rate. This forces you to reinvest the principal sooner than expected, usually at a lower interest rate It has both a market risk and a reinvestment risk. The market risk arises as even a bond increases in value as interest rates drop, a callable bond will not rise above its call price because the issuer will probably redeem the bond at its call price before maturity. The reinvestment risk exists because a bond is more likely to be called when interest rates are declining, and, thus, the investor will have to settle for a lower rate of interest. Credit Risk Also called roll-over risk, rises when the firm which issue bonds cannot pay (e.g. bankrupcy) the interest or principal to bondholders. If this is the case, the remaining value of your investment can be lost or reduced. The yield on corporate bonds is higher than that of municipal bonds, which is higher than that of treasury bonds because of higher risk. credit spread risk is about how the spread of an issue over the treasury curve will react. For example, Google 3-year bonds may trade at 4% with 50 basis points above the current 3-year T- bonds which is trading at 3.5%.  If this spread widens out compared to other bond issues means that the companys bonds are not performing compared to the market.  It the spreads widens, it will poorly perform the economy. downgrade risk consist of downgrading a company grade reflecting the possibility of default (which decrease its value) by some rating agencies like Moodys, SP and Fitch. The companies can drop from grade AAA (Best) to BBB (Worst) where the bonds become junk bonds and worth nothing. In such case of rating the company, will have difficulties to get credits or to rise debt.  Some agency of rating companies and government can help prevent the risk of each class of bond entails by focussing more on default rates which is the percentage of bonds expected to default, the recovery rate which indicates estimation of how much expected to be refunded in case of default. We can also mitigate the credit risk by using derivatives of credit risk Inflation Risk With few exceptions, the interest rate on your bond is set when it is issued, as is the principal that will be returned at maturity. If there is significant inflation over the time and you held the bond, the real value of initial investment will be less.(e.g.$1000 today worth more than 10 years in the future) Yield-curve maturity, risk, useful in hedging positions where the portfolio of bonds is hedged with bonds of different maturities, and the interest rates of these bonds is assumed to change by a certain amount for a given change in prevailing rates. Yield-curve risk results when bonds prices of different maturities deviates from this assumption when prevailing rates change. Prepayment risk Is the risk that bondholders will prepay their mortgage, when interest rates decline, or when they sell their home. Prepayment risk is also called Reinvestment risk is based on the assumption that cash flows from a fixed-income security are reinvested, so that interest can be earned on interest, and, thus, the risk is that the reinvested money will not earn the same rate of return as the original investment. This risk is contrary to interest rate risk, because when interest rates rise, market risk increases, but reinvestment risk declines. It helps to neutralize market risk with strategies based on these opposing risks called immunization. Liquidity risk which is the spread between the bid and ask prices for a security being offered in the secondary market. If there is not much interest in the security, then the bid-ask spread may be wide, which means that the price that the security can be sold may be significantly less than another similar recent transaction even when there is no change in any other significant factor. For individual investors, this risk exists only if the investor wants to sell the security before maturity. Institutional investors, such as mutual funds, who need to mark their securities to the market, for reports, or to determine the NAV, for instance, will have to calculate a lower effective price for those securities that have little liquidity. Event risk It can be due to some events that can downgrade the credit rating of the issuer such as natural catastrophe disaster, corporate restructuring, regulatory or political change (quotas or trade barriers), takeover by another company or buyout, where the companys debt is increased significantly to finance the buyout, thereby lowering the credit rating of the company, usually below investment grade status. Change of control covenant to bond indentures which limit the ratio of debt (In case of leverage buyouts LBOs) or add a put option to its bonds so the bondholders can sell it back to the company at par value before maturity. Expedia  [1]  recently sold 12-year bonds with a put option that allowed bondholders to turn in the bond after 7 years for par value. Sovereign risk ( country risk, political risk) Possibility that borrowers in country will not be able or will not to service or repay their debts to foreign lenders in a timely manner. It rises when political consideration lead foreign countries to adopt Political stability may include the frequency of changes of government, the level of violence in the country or Conflicts with other states. Countries that default will lose access the national and international financial markets. Analyst can focus largely on ability to repay rather than willingness to repay by assessing factors that affect the ability of that country to generate sufficient dollars to repay due payment. (large budget deficit, inflation, over valuated currency), political factors (stability) related to country risk ( frequency of changes of government, the level of violence and conflict) Foreign exchange risk (Fx) It will happen when the local currency appreciate against the foreign currency. Currency exchange rates are changing all of the time, so if the bond currency depreciates against the investors domestic currency during the term of the bond, then the investor will either lose money or not make as much profit and if the foreign currency appreciates, the investor make big profits. We can mitigate such risk by using derivatives of Fx risk Volatility Risk Bonds issued from emerging countries are more volatile than most other bonds, since these countries are viewed as being less stable and less predictable. Thus, there is a greater price reaction to news about the issuer or about economic conditions in the issuers country. QUESTION 2 Put Option The bond investor has the right but not the obligation to sell the bond back at a given price (strike or exercise price) before its maturity to the issuing firm which instead have the obligation in this case to buy it. It is a hedge of investment in bonds against a drop of value of their investments. Such case can happen if the value of bond go down because of rise in interest rate or to the issuer is facing bankruptcy. It is a good safe exit strategy for the investor. He should buy it at premium compared to bond without option because it is an advantage for the holder. The bondholder can exercise his right if that will be advantage such as the market price is less than the strike he can sell at. The effect will be an increasing of the value of the bond so he will return the bond at the high price which is initially in the indenture which is more than the price in the market and reinvest that money in new bonds for less and get more interest than before. Call Option The bond issuer have the right but not the obligation to redeem or buy the bond back at a given price (strike or exercise price) before maturity as specified in the indenture of the bond from the bondholders who instead have the obligation in this case to sell. In case of an increasing of the value of the bond in the market because of low interest rate, the issuing firm can exercise its right in order to issue new bonds at a lower interest rate which means reduce its cost of capital or to retire bond debt and contract new debt for cheaper. From the side of investor, in case he do not want to keep cash and want to reinvest it in the same market, he will face the risk of reinvestment because he will reinvest the principal in new bonds with less interest than before. It is a good safe exit strategy for the investor however the investor will buy it at discount compared to bond without option because it is an advantage for the issuer and disadvantage to holder. Examples. A bond settling on 4/3/2011 with a par value of 1,000.00, a maturity date of 4/3/2015, a coupon rate of 8%, and a market yield of 10% will be priced at $935.37. (This is with a redemption value of $1,000.00, which is typically the same as par value.) We suppose in our examples that there is no premium or discount on bonds with call option or option and the redeem before the maturity will be at face value to simplify the calculation YTM = 10% With a coupon rate of 8% and a YTM of 10.00%, a bond that has a $1,000.00 par value and a term to maturity of 4 years will be worth exactly $935.37 at maturity YTC=6% YTC of 6.00%, a bond that has a $1,000.00 par value and a term to maturity of 4 years will be worth exactly $1037.17 after just 2 years which is more than the initial issuing value With the call option, the issuer will pay to holdbond $1000 and reissue new bonds at $1037 and pay less interest than 8% the investor will receive only $1000 and if he wants, reinvest it at $1037 at less interest than 8% the issuer is the winner from the deal YTP=12% With a coupon rate of 8% and a YTM of 12.00%, a bond that has a $1,000.00 par value and a term to maturity of 2 years will be worth exactly $930.70 at maturity which is less than the initial issuing value With the put option, the issuer will pay to hold bonds $1000 and reissue new bonds at $$930.70 and pay more interest than 8% the investor will receive $1000 and if he wants, reinvest it at less $930.70 at more interest than 8% the investor is the winner from the deal QUESTION 3 To: Director of ABC currency trading firm From : xyz, consultant Object: Exchange rate arrangement and their implication for international financial market Date: April, 7 2010 The world economy is slowly recovering from the global financial meltdown, the foreign exchange broking industry is under pressure but the outlook is good. In our report, we address some issues: Hard peg and a soft peg  [2] Hard pegs: Regimes where the irrevocable peg is supported by strict institutional and policy commitments (formal dollarization, currency unions, and Currency boards). Soft pegs: Regimes where authorities aim to defend a predetermined value or path of the exchange rate without an institutional commitment to fully devote monetary policy to the unique objective of maintaining the peg (fixed pegs vis-à  -vis a single currency or a basket, horizontal bands, crawling pegs, and crawling bands). It encourages price stability by imposing a significant degree of discipline on the monetary authorities We classify exchange rate regimes (ERRs), as Hard Peg, Soft Peg, Crawling Pegs and Bands and Floats . Up to 1995  [3]  developing countries abandon soft pegs for floating. The disadvantages are less significant for countries which with low capital flows, also, have significant compensating advantages over managed floats which need to be taken into account. Seychelles, since it d efaulted on its debt in 2008, has moved to a managed float. Iceland, which for a period had a managed float, has reverted to a more fixed form of exchange rate since the 2008 crisis and is currently contemplating what system to adopt next. Pegs and a fixed exchange rate regime Are the rate set and maintain by the Central bank of the country as the official exchange rate to another countrys currency ( USD, Euro,..) or to the price of gold. With currency pegs, we know the exact exchange rate expected for trading transactions which make it very simple and help maintaining stability. It lowers inflation which increase the value of money, but can decrease the revenue from money creation (inflation tax), which involve an adjustment to fiscal policy to maintain sustainability. Also, it reduces currency and maturity risks. It is more useful in unsophisticated capital market and not strong regulating because it helps create stability in such environment. Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the long run as example  [4]  , the Mexico (1995),  Asia (1997) and Russia (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the curren cies eventually becoming overvalued. The governments werent able to meet the demands of converting their local currency into the foreign currency at the pegged rate Dollarization, currency board and a fixed exchange rate regime Fixed exchange rate  [5] A countrys exchange rate regime under which  the government  or  central bank ties the official exchange rate to another countrys currency (or  the price of gold). The purpose of a fixed exchange rate system is to maintain a countrys currency value  within a very narrow band.   Known as pegged exchange rate provide greater certainty for exporters and importers. This also  helps the government maintain low inflation, which in the long run should keep interest rates down and stimulate increased trade and investment Dollarization When a country abandon its local currency and adopt the U.S dollar as a new official currency instead. Devaluation as a result of inflation can be a major cause. loss of confidence in the local currency after a period of poor macroeconomic management and economic instability, people have confidence because it is more credible and USA is a strong economy Currency Board (CBAs) A  [6]  monetary authority that makes decisions about the valuation of a nations currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of which is held in reserves (rates which are strictly fixed, not just by policy but by law). The currency board then allows for the unlimited exchange of the local, pegged currency for the foreign currency. A currency board can only earn the interest that is gained on the foreign reserves themselves, so those rates tend to mimic the prevailing rates in the foreign currency. CBAs  [7]  where domestic money (notes and coins) can only be issued when it is fully backed by foreign currency reserves, to guarantee that they can be converted into the reserve currency (usually more than 100 percent of the monetary base, to maintain a margin of protection in case the reserve currency the CBA holds loses value).They are not associated with any greater financial crisis removing monetary policy discretion from the government and the central bank (e.g. in Bosnia, Bulgaria, Estonia, also in Argentina from April 1991). They are credible exchange rate system after dollarization Peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country that issues the anchor currency. It reinforces the result as the domestic money supply is pegged to the initial rise in foreign exchange reserves. Fixed exchange regimes are associated with slower rates of monetary and velocity growth Dollarization can eliminate the ability to monetize debt and enhances budgetary discipline through financing deficits by higher taxes, lower expenditures or more debt rather than by printing money. Compared to CBAs and hard pegs, these arguments are less applicable because the risk of exiting from a CBA is high and for hard pegs even higher, thereby requiring a premium (currency risk will never be eliminated because there is always a chance of devaluation). Compared to CBAs, Hard pegs needs less than 100 for fixed exchange rate pegs while dollarized country does not need any. The institutional costs of carrying out central bank activity are lowest for dollarized countries and highest for hard pegs and CBAs are simpler to run than central bank which needs small, not highly trained staff. A fixed exchange rate arrangement requires a central bank with highly skilled staff and a statistical system to collect data, which is a cost issue and to eliminate currency risk (volatility), They all, satisfy the useful of money as a medium of exchange, store of value and a unit of account Though the difference between dollarized, CBAs and fixed exchange rate are not likely to be high. Some countries have adopted dollarization or abandoned the use of dollarization  [8] Panama has adopted Dollarization more than 100 year before. Ecuador adopt it because of inflation rising and financial panics which drives all depositors to withdraw all their money from banks in the same time. By adopting dollarization, the country eliminate the currency volatility and eventually any crises. A big integration with USA economy and all dollars-zone which may be more advantage. However, some arguments may exist against dollarization as loss of sovereignty over monetary policy, loss of power of Central banks seigniorage  [9]  ( money made by issuing currency and printing their own currency which is equal to the difference between the face value of a coin or bank note and the cost of producing and distributing it) and loss of its role of lending provide liquidity to save financial institutions during financial crisis. Through dedollarization, the authorities may aim to recover seigniorage, adapt the currency in circulation to domestic needs and make it more a ttractive to residents than foreign currency in economic transactions, introduce a more flexible exchange rate regime ultimately, or mitigate risks to financial stability through governments control of monetary policy. As example, Dedollarization in Insrael  [10]  which was very successful and lead to a big macroeconomy stabilization by decreasing inflation, decreasing foreign currency denominator of its public debt by using hedging instruments to manage the risks associated, and extending the length of the public debt . Discussion of how the above may affect the future role and position of foreign exchange brokers? As reviewed in Reisen[1998], pegs in developing countries have repeatedly induced hot money inflows in view of structural interest rate differentials that were exploited by carry traders and local banks QUESTION 4. Many countries have pursued more open and competitive markets based on the theory of comparative advantage. The forces that are reshaping the industry are the globalization of finance, advances in information and computer technologies and regulatory reform. But the past decade has seen the growth of a new limits to financial globalization in the influence and self enrichment of organizational insider. It is a huge risks and challenges that these developments are creating for any firm. How financial globalization is affected by: Deregulation The greater openness is the result of financial system reform and modernization. Many countries have lowered barriers to international trade, eliminated quota and cross-border flows in goods and services have increased significantly. World exports and import of goods and services increased. These changes have stimulated demand for cross-border finance and fostered the creation of an internationally mobile pool of capital and liquidity. II. Capital mobility Loan with a lower interest rate and borrow in foreign currency if foreign-currency loans offer more attractive terms than domestic-currency loans (uncovered interest rate parity UIRP); it can issue stocks or bonds in either domestic or international capital markets; and it can choose from a variety of financial products designed to hedge risks. National financial markets have become increasingly integrated into a single global financial system. Sovereign borrowers at various stages of economic and financial development can access capital in international markets. Multinational companies can tap a range of national and international capital markets to finance their activities and fund cross-border mergers and acquisitions,. The introduction of common currencies Such as introduction of euro in the European Community, IV. The formation of economic communities and trading blocs The globalization of national economies has advanced significantly as real economic activity-production, consumption, and physical investment-has been dispersed over different countries or regions. Today, the components of a radio set may be manufactured in Asia and assembled in Turkey and the final product sold to consumers around the world. New multinational companies have been created, each producing and distributing its goods and services through networks that span the globe, or by merging or acquiring foreign companies. Some others make communities and trading blocs such as NAFTA (North American Accord Free Trading Alliance) b. How the Internet, and technological advances in computing power and communications affects: The liberalization of national financial and capital markets, coupled with the rapid improvements in information technology and the globalization of national economies, has catalyzed financial innovation and spurred the growth of cross-border capital movements, thanks to improvements in information technology that have made their financial risks easier to monitor, analyze and manage. The provision of domestic and global banking products and services Internet with many advances in telecommunications have significantly changed domestic and global financial markets. It has made it easy for market participants and country authorities to collect and process the information they need to mange financial risk; to price and trade new financial instruments that have been developed later. and to manage many transactions spread across international financial centers in the world. The globalization of financial intermediation is partly a response to the demand for mechanisms to intermediate cross-border flows and partly a response to declining barriers to trade in financial services and liberalized rules governing the entry of foreign financial institutions into domestic capital markets. The degree of competition in the worlds financial markets Competition among the providers of intermediary services has increased because of technological advances and financial liberalization. The regulatory authorities in many countries have altered rules governing financial intermediation to allow a broader range of institutions to provide financial services, and new classes of nonbank financial institutions, including institutional investors, have emerged. Investment banks, securities firms, asset managers, mutual funds, insurance companies, specialty and trade finance companies, hedge funds, and even telecommunications, software, and food companies are starting to provide services similar to those traditionally provided by banks. The nonbank financial institutions are competing-sometimes aggressively-with banks for household savings and corporate finance mandates in national and international markets, driving down the prices of financial instruments Domestic and global financial system reform In response both to regulatory incentives such as capital requirements and to internal incentives to improve risk-adjusted returns on capital for shareholders and to be more competitive, banking systems in the major countries have gone through a process of disintermediation, through tradable securities (rather than bank loans and deposits). Both financial and nonfinancial entities, as well as savers and investors, have played key roles in, and benefited from, this transformation. Banks have increasingly moved financial risks (as credit risks) off their balance sheets and into securities markets by pooling and converting assets into tradable securities and entering into interest rate swaps and other derivatives transactions. Corporations and governments have also come to rely more heavily on national and international capital markets to finance their activities. Banks have been forced to find additional sources of revenue, including new ways of intermediating funds and fee-based bus inesses, as growing competition from nonbank financial intermediaries has reduced profit margins from banks traditional business to extremely low levels How regulatory reforms may be seen as:. An important element in reshaping the financial services landscape The regulatory authorities in many countries have changed rules governing financial intermediation to allow a broader range of institutions to provide financial services, and new classes of nonbank financial institutions, including institutional investors, have emerged. Governing regulatory bodies  [11]  can shape domestic and international financial markets by choosing and accommodating a variety of strategies. For example Australia and Canada, have pursued a middle road approach, by considering the trade-off between the benefits of open competition and the long-run costs of greater consolidation A reaction to the other forces of change affecting financial markets Many crises ( including 2008) urged the need for prudent public debt management, properly sequenced capital account liberalization, and well-regulated and resilient domestic financial systems, to ensure national and international financial stability. Private financial institutions and market participants can contribute to financial stability by well managing their businesses and financial risks, by implementing governance mechanisms (maximizing shareholder value and maintaining appropriate counterparty relationships in markets), In fact, the first lines of defence against financial problems and systemic risks are financial institutions, efficient financial markets, and effective market discipline. IMF can play an important by launching numbers of initiatives to maintain financial stability as identifying and monitoring weaknesses area in international financial markets; developing early warning systems and rigorous internal control for imbalances; conducting research to detec t the nature and origins of international financial crises and seeking ways to contain and resolve crises quickly and efficiently, for example, by involving the private sector. As a global public concern, national supervisors and regulators must also play a role by coordinating and sharing information across countries and functional areas (banking, insurance, securities) to identify financial problems and prevent financial systemic risk. Q1_Rà ©fà ©rences https://www.investorguide.com/igu-article-579-benefits-and-risks-associated-with-bonds.html https://thismatter.com/money/bonds/risks.htm https://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/credit-risk.asp David K. Eiteman, Arthur I.Stonehill and Michael H.Moffett, 2010. Multinational Business Finance Global Edition, 12th edition, pages 61-63 Michael Bleaney Manuela Francisco, 2005. Exchange rate regimes and inflation: only hard pegs make a difference, Canadian Journal of Econom ics, Canadian Economics Association, vol. 38(4), pages 1453-1471, November. 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