Bond & Derivative Markets

Department of Accounting & Finance

Instructor: S. Spyrou

sspyrou@aueb.gr

210-8203169

Libor

• Libor (London InterBank Offer Rate)

• The rate at which the big banks in London borrow each other money

• It is used as a base rate for many financial instruments

• For example, the fixing of US Dollar Libor is determined by

• Bank of America, Bank of Tokyo, Barclays Bank, BNP Paribas, Citibank, Credit Agricole, Credit Suisse, Deutsche Bank, HSBC, JP Morgan Chase, Lloyds Bank, Royal Bank of Scotland, among others

Libor• Libor rates are calculated for 10 different currencies

→ US $, Yen, Euro, SFr, BP Pound, Swedish Krn, Danish Krn, New Zealand $, Australian $, Kanadian $,

• For 15 different time periods

→ overnight, 1 week, 2 weeks, 1 to 12 months

• Published daily 11:30 am. (London Time) by Thomson Reuters

• Derivative products worth over 350 trillion US$ have prices connected to Libor.

BOND MARKETS

• The bond market (credit market, or fixed income market) is a market where participants can issue new debt (Primary market) or buy and sell debt securities (Secondary market)

• The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures.

• Size : As of 2009, the size of the worldwide bond market is an estimated $82.2 trillion (outstanding U.S. bond market debt was $31.2 trillion) according to Bank of International Settlements (BIS)

• Average daily trading volume in the U.S: $822 billion (mainly between broker-dealers and large institutions, OTC market).

• References to the "bond market" usually refer to the government bond market, because of its size, liquidity, relative lack of credit risk and, therefore, sensitivity to interest rates.

Capitalization (US $, billion)

.00

500000.00

1000000.00

1500000.00

2000000.00

2500000.00

3000000.00

3500000.00

4000000.00

4500000.00

London Stock Exchange

Capitalization (US $, billion)

.00

50000.00

100000.00

150000.00

200000.00

250000.00

300000.00

End 2001 End 2002 End 2003 End 2004 End 2005 End 2006 End 2007 End 2008

Αthens Exchange

Datast ream Indices

Recent Values:

Latest Value

High over 12 M thsLow over 12 M thsAvg over 12 M ths

Perform ance:

Actual Value% Change

-1M -3M -12M

Clean Price IndexG ross Price IndexT otal Return Index

M arket Value(000's)

Average LifeAverage CouponAverage Durat ionAverage Int .Y ieldAverage Red.Y ieldAverage Red.Y ield(A nnualised)

S tart DateCurrencyDatatype

22/12/05 11.15

US LO NG BO ND - P RICE INDEX

01/01/1985U$PI

110.6400 -0.37

U$

110.2300

118.4800 106.4100 111.9065

113.7300 -3.08

USLG BND

PRICE INDEX

21/12/05

27/06/0529/12/04

108.5200 1.58

110.23

4.68

PRICE INDEX

95 96 97 98 99 00 01 02 03 04 0580

90

100

110

120

USLG BND

Source: DAT AST REAM

Bonds• Debt security where the issuer owes the holders a debt and,

depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity.

• A bond is a formal contract to repay borrowed money with interest at fixed intervals.

• Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

• Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders).

Bond Markets• Domestic Bond: A company issues a bond in the country of origin (e.g.

IBM issues a bond in the USA); the bond is denominated in the home currency, and is subject to the home country regulatory, legal, tax, environment

• International Bond: A company issues a bond in another country (e.g. IBM issues a bond in Japan); the bond is denominated in the foreign currency, and is subject to the foreign country regulatory, legal, tax, environment

• Eurobond: A company issues and sells a bond to investors in many different countries simultaneously; the issue is organized by a syndication of banks with one bank a the lead manager. The bond is a “bearer bond”, can be denominated in any currency, the market is self-regulated, and the issuing period is fast. The market is wholesale (World Bank, European Investment Bank, UK government, large international banks and organizations) and, usually, for medium-term bonds.

Bond Definitions• Par Value, Face Value, Nominal, Principal: the amount that has to

be repaid at the end of the life of a bond.

• Issue price: the price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount.

• Maturity date: the date on which the issuer has to pay back the holders the nominal amount.

• The coupon rate: the interest rate that the issuer pays to the bond holders. Coupon payments are calculated on the Par Value.

• Coupon Frequency: how often the coupon payments take place (once a year, twice a year, monthly, etc).

Bond Definitions• Fixed coupon bonds: they pay a fixed coupon at every coupon

payment date (e.g. 10%)

• Floating rate coupon bonds: they pay a floating coupon based on some reference rate (e.g. Libor+2%)

• Zero coupon bonds: they pay no coupon, but the issue price is very low (e.g. 5-year zero with an issue price of $200 and a Par of $1000)

• Mortgage Bonds: the issuer uses assets (buildings, land, etc) as collateral

• Guaranteed Bonds: bonds that are secured by other organisations or firms

Bond Definitions• Debentures: Bonds that have no guarantee or collateral and the bond

holders are treated as general creditors of the firm, in case of bankruptcy

• Subordinated debentures: the bond holders are satisfied AFTER the general creditors of the firm, in case of bankruptcy

• Market price: the bond price in the secondary market, which may be at a premium or a discount compared to the nominal price (e.g. with a Par of $100 a bond may trade at $95 (discount) or at $105 (premium))

• Putable Bonds: the bondholder has the right to ask for a payment of the Par value from the issuer at specified prices and specified dates, BEFORE the actual maturity

• Callable bonds: the issuer has the right to ask to pay the Par value to the bondholders at specified prices and specified dates, BEFORE the actual maturity

Bond Definitions: Example of Callable Bond «Bond with a Par Value of $100 and a coupon rate of 6%, that matures on the

10th of January 2020, and that is callable in every coupon payment date between 2005 and 2015 according to the following schedule:»

Call year Call Price

2005 $103,94

2006 $103,55

2007 $103,15

2008 $102

2009 $102

2010 $101,97

2011 $101,78

2012 $101,18

2013 $100,79

2014 $100,39

2015 $100

Bond Definitions

• Conversion Feature: the bond holder has the right but not the obligation to convert the bond to stocks at the maturity of the bond according to a pre-specified conversion ratio, instead of receiving the Par Value

• Asset-Backed Securities: bonds that are guaranteed by other loans, or personal property

• Bonds with a Sinking Fund Provision: the issuers retires gradually the bond from the market before maturity

Example: Bond with a face value of $100,000,000 Ευρώ, coupon rate 6%, maturity in 15 years, and a sinking fund of 20% between years 11-15. In each of the last 5 years the issuer will retire $20,000,000 Ευρώ (20% of 100,000,000)

Price Quotation

• In practice traders quote each other the bond market prices as a percentage (%) of their par value

• For example, a market price of 95.5 means that the bond trades at 95.5% of its Par value

(1)

Quotation Price

(2)

Decimal

(3)

Face Value

(4)

Price

(2)x(3)

95 0,9500000 $1.000 $950

95 (1/2) 0,9550000 $100.000 $95.500

98(1/4) 0,9825000 $5.000 $4.912,5

100 1,0000000 $10.000 $10.000

106(3/4) 1,0675000 $500.000 $533.750

111(11/32) 1,1134375 $100.000 $111.343,75

Accrued Interest

• Traders also quote the clean (flat) bond prices, i.e. prices without accrued interest

• When clearing takes place, however, accrued interest is estimated and added to the final price

• clean price = dirty price - accrued interest

• dirty price = clean price + accrued interest

Estimation of Accrued Interest

• Accrued Interest (AI) is estimated as:

AI = C (Ζ/Ν)

• Z = Days since last coupon payment to the deal

• Ν = Days of interest period

• C = Coupon payment

Estimation of Accrued InterestExample

• You buy a Bond with a coupon rate of 8% and a Par value of 100 Euro, that pays interest semi-annually.

• The last coupon payment was 38 days ago (year = 360).

• The market price was 98

• How much will you pay at the end of the day?

• Ν = 180, C = 4 Euro, Z = 38

• AI = 4 (38/180) = 0,8444 Euro

• You will pay 98,8444 Euro

Securitization• Securitization is the issue of securities (bonds) that are based on

future cash flows from assets (usually loans) that are pulled together

• It is basically the sale of existing loans from banks and other organizations

• Consider a bank that has 20,000 mortgage loans to customers: the bank can pull together these loans to one portfolio (the “reference portfolio”) and sell it to another company (the “special purpose vehicle”, SPV).

• The SPV then issues and sells to investors a bond that is secured (in terms of coupon payments and the repayment of the principal) by the mortgages of the reference portfolio.

• Important point: the bank not only receives cash but also transfers the credit risk involved in the loans.

Securitization• The originator initially owns the assets engaged in the deal. Usually this

firm can raise new capital by (i) loans, (ii) bonds, (iii) stocks. However, stocks dilute the ownership, while loans and bonds may be expensive and subject to interest rate risk.

• Consider a bank that “pools” together a large portfolio of loans and then transfers this portfolio to the a Special Purpose Vehicle (SPV), i.e. a tax-exempt company or trust formed for the specific purpose of funding the assets.

• When the portfolio is transferred the SPV, the “issuer” issues tradable securities to fund the purchase.

• The issuer is "bankruptcy remote," , i.e. if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator.

• Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.

Securitization• Credit rating agencies rate the securities which are issued to provide an

external perspective on the liabilities being created and help the investor make a more informed decision.

• Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.

• The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system.

• Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills.

• Floating rate securities may be backed by both amortizing and non-amortising assets in the floating market. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR).

SecuritizationMain Advantages to Issuer

• Reduce funding costs: For example, a company with a low credit rating but with highly creditworthy cash flows via securitization is able to borrow at lower rates.

• Locking in profits: When future cash flows are securitized, the level of profits has now been locked in for that company.

• Transfer risks: via securitization a firm is able to transfer risks to investors that want to bear it

• Admissibility: Securitization turns an admissible future surplus flow into an admissible immediate cash asset.

• Liquidity: When a future cash flow is securitized, it is available for immediate spending or investment.

SecuritizationMain Disadvantages to Issuer

• Reduced portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.

• Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees , administration, etc.

• Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

Securitization

• In 2008 there was an estimated outstanding value of $10.24 trillion in the United States and $2.25 trillion in Europe.

• In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe.

Catastrophe bonds (cat bonds)

• Insurance firms need to share some of the huge risks they face from major catastrophes, thus, they may (and do) issue bonds that the payment depends on specific physical events.

• Consider for instance, an insurance company that issues and sells bonds to investors (through an investment bank or through securitization).

• These bonds pay a high coupon rate to investors (Libor + 3 to 20%) and the face value IF a specific catastrophic event DOES NOT occur.

• If a specific catastrophic event DOES occur the principal would be

forgiven and the insurance company would use this money to pay their claim-holders.

Catastrophe bonds (cat bonds)

• Investors include hedge funds, catastrophe-oriented funds, and asset managers.

• They are often structured as floating rate bonds whose principal is lost if specified trigger conditions are met. The triggers are linked to major natural catastrophes.

• Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.

Catastrophe bonds (cat bonds)

• Consider a hypothetical Insurance firm I that has a large portfolio of insurable risks from earthquakes in Japan.

• Firm I could create a Special Purpose Vehicle with an investment bank to issue a 5-year Cat Bond

• Investors buying this bond would receive a floating coupon rate, say Libor + 15%.

• If an earthquake does not occur within the next 5 years, investors will enjoy a good returns

• If an earthquake occurs within the next 5 years, firm I will keep the principal to pay insurance claims

Catastrophe bonds (cat bonds)

• Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings.

• A catastrophe bond is rated based on its probability of default due to a qualifying catastrophe triggering loss of principal.

• This probability is determined with the use of catastrophe models.

• Most catastrophe bonds are rated below investment grade (BB and B category ratings)

• The various rating agencies have recently moved toward a view that securities must require multiple events before occurrence of a loss in order to be rated investment grade.

Catastrophe bonds (cat bonds)

• The idea of securitizing these type of risks developed after Hurricane Andrew in the US and the large insurance claims that prevailed (early 1990s)

• Between 1998 and 2001 this market was growing at a rate of 2 billion $ a year; however after 2001 this rate more than doubled.

• Since they have very low correlation with economic activity and any other investment asset they are often used by investors looking for portfolio diversification

• It is a wholesale market; major players are Mutual Funds, Hedge Funds, professional maney managers, insurance organizations, large pension funds, investment banks (e.g. BNP Paribas, Goldman Sachs, Lehman Brothers, Swiss Re Capital Markets, etc).

Financial crisis in the US (2007) • Low interest rates → ↑ demand for loans to buy houses

• Rising house prices

• Extremely high lending in the USA & financing engineering

• Banks first lend aggressively and then used securitization to transfer credit risk; they used accounting valuation methods such as “mark – to – market” which led to valuation at the (inflated) market prices

• Banks created Credit Default Swaps (CDS) which allowed the transfer of risks, on top of securitization

• Evaluation of credit and default risks with methodologies such as Value at Risk, VaR, tends to push loans on a parallel direction to the economics cycles

Financial crisis in the US (2007)

• Massive loans and securitization

• Rising house prices thought enough to “secure” the loans

• However, consider a bank that gives a loan knowing that the loan will be transferred to an SPV soon

• The bank has NO MOTIVE to evaluate prudently the credit risk

• Subprime loans or subprime mortgages led to the subprime crisis (mortgages to high risk clients with the house as a collateral)

Financial crisis in the US (2007)• ΤIn 2004 Fed started to increase the central interest rate a move

that affected all rates (in 2007 interest rates stood at 5.25%; from just 1% in 2004)

• The US economy stopped growing as fast as before

• Unemployment rose

• Difficulties to service loans (especially subprimes)

• The subprime market rose from 9% of total loans in 2003, to 24% of total loans in 2007 (competition drove banks to provide these loans; they could also transfer these to SPVs).

• Banks provided loans with an attractive rate during the first 3 years which turned to a not-so-attractive rate thereafter

Financial crisis in the US (2007)• House prices started to correct

• Many borrowers could not repay loans

• Repossessions

• Securitized bonds could not pay investors

• Insurance companies received claims

• Banks simply did not have enough money to service losses from non-performing loans

• In May 2008 Bear Stearns is sold to J.P. Morgan; In Sept 2008 Lehman Brothers defaults (with assets worth of $700 billions)

• Bank stock prices fell• ……………………………(the rest is history)………………………………

Credit Default Swap (CDS)• A credit default swap (CDS) is similar to a traditional insurance

policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default.

• In the event of default the buyer of the CDS receives money (usually the face value of the loan), and the seller of the CDS receives the defaulted loan (and with it the right to recover the loan at some later time).

• Note that anyone can purchase a CDS; a buyer does not need to hold the loan instrument and may have no direct insurable interest in the loan.

• The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

Credit Default Swap (CDS)

• In some cases (not often) the “credit event” may even be the loan restructuring or the downgrade of the credit rating of a company

• In case of a “credit event” (e.g. a loan default) the buyer may:

(i) Deliver to the seller the bond and receive the face value of the bond (physical settlement),

Or

(ii) Receive from the seller the difference between the face value of the bond and the current market price of the bond, which may be very low (cash settlement).

Credit Default Swap (CDS)• The price that the buyer pays is referred as a (spread) and is the

annual periodic payment to the seller

• For example, Investor A buys from Bank B a 3-year CDS contract on the bond of Company C (BONDC).

• A owns BONDC of $1,000,000

• Assume that the current CDS spread on BONDC is 0.4% (i.e. 40 basis points; 1 bp = 0.01%)

• Thus, A will pay to B $4,000 annually (i.e. 0.4% of $1,000,000)

• The payments will continue for 3 years (until the contract matures) or until Company C defaults (in which case A will receive $1,000,000).

Credit Default Swap (CDS)

• Generally, the level of the spread is considered as an indication of the probability of default; spreads are traded continuously in the market and reflect the changing conditions and market beliefs.

• For example, consider BONDC above.

• If negative news arrive in the market about company C the spread may rise to, say, 0.8%.

• In that case a new buyer of a 3-year CDS on BONDC will be required to pay $8,000 as an insurance.

• Of course, Investor A now owns a more valuable contract and he/she may sell it back to the market and receive the difference.

Credit Default Swap (CDS)• Note that, historically, only about 0.2% of firms with a credit rating

above ΒΒΒ eventually default; thus, in the vast majority of CDS there is never a payment of the face value.

• Consider Hedge Fund F that believes that Company X will default.

• F buys a 3-year CDS on bonds of X from Bank B at 570 bp (5,7%) for $10,000,000.

• If X defaults in one year F will have paid to B $570,000 but will get back $10,000,000.

• The Bank will loose $9,430,000 (unless she has hedged this risk)

• If X does not default F will have paid $1,710,000 to the Bank

• In that case the Bank has a profit of $1,710,000.

Credit Default Swap (CDS)• Credit default swaps have existed since the early 1990s, designed by

various investment banks (e.g. JPMorgan Chase) • By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling

to $26.3 trillion by mid-year 2010.

• Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs.

• CDSs have many variations.

• In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS).

• In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.

Credit Default Swap (CDS)• CDSs are not traded on an exchange and there is no required

reporting of transactions to a government agency.

• During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systemic risk to the economy.

• The International Swaps and Derivatives Association (ISDA) administered two key changes (among others) in the trading of CDSs:

(i) The introduction of central clearing houses (one for the US and one for Europe) to act as the central counterparty to both sides, thereby reducing the counterparty risk that both buyer and seller face.

(ii) The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases.

Credit Default Swap (CDS)• A CDS contract is documented under a confirmation referencing the

credit derivatives definitions as published by the ISDA and specifies:

• The reference entity (a corporation or sovereign that generally, although not always, has debt outstanding)

• The reference obligation (usually a corporate or government bond)

• The contract effective date and scheduled termination date)

• The calculation agent (responsible for making determinations and for performing various calculation and administrative functions in connection with the transaction; the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent)

Credit Default Swap (CDS)

• The credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. (e.g. bankruptcy failure to pay, restructuring, etc.)

• The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling on March 20, June 20, September 20, and December 20.

Structured Bonds

• Through financial engineering, it is possible to adjust asset structures in order to address the needs of specific investors and at the same time capture market trends.

• Structured bonds are hybrid securities, are based on derivatives, and combine two elements :

(i) that of a fixed income security (maturity coupon payable periodically or at maturity)

(ii) that of an investment asset whose return varies with market trends or other financial variables (equity market indexes, exchange rates, interest rates, commodities, options, futures, debt, etc).

Structured Bonds• There is a large variety of such assets, thus, there is no single

definition; most compine some form of a “"principal guarantee" if held to maturity.

• Structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets.

• Consider the following structured bond (Hellenic Republic):

Par Value: €100,000,000.00 Issue date: 1/7/2007 Maturity date: 1/7/2017 Coupon rate: At 1/7/2008 and 1/7/2009 it will pay 8%

For the remaining eight years it will pay 5% if the equity index FTSE/ASE 20 has a negative return on that year and 1% in any other case.

Structured Bonds• The issuance of such products is standard in international markets not only

for governments (e.g. Italy, Austria, Germany, France, etc.) but also for international organizations (European investment Bank) in order to raise long term funds.

• Issuing takes place as in other bonds (underwriting).Any bank that has a license for underwriting can offer this service.

• These bonds trade in secondary markets and prices change according to supply and demand conditions in the markets

• The bondholders face the credit/default risk of the issuer (just like any other bond) and the market risk i.e. changes in discount rates will affect their price (just like any other bond)

Structured Bonds• Another example (Hellenic Republic):

Issue price: 100%

Maturity: 12 years (Issue date: Feb 2007)

Coupon rate: For the first two years 6,25% For the remaining ten years→ if the difference between the 10-year interbank

Euroswap rate and the 2-year interbank Euroswap rate is below 1% it will pay the product of this difference times five

→ If the difference between the 10-year interbank Euroswap rate and the 2-year interbank

Euroswap rate is above 1% it will pay the 3-month Euribor+1.5%

Structured Bonds

• Assume that 10-year interbank Euroswap rate = 3%

2-year interbank Euroswap rate = 2.5%

Difference: 0.5%

Coupon = 0.5% times 5 = 2.5%

• Assume that 10-year interbank Euroswap rate = 3%

2-year interbank Euroswap rate = 1.5%

Difference: 1.5%

Coupon = 3-month Euribor + 1.50 %

Structured Bonds• See what happened in 2009:

• Interest for the first two years 6.25% (tax-free) (plus 1.6% annually from re-investment of the coupon (12 year average))

• In Feb 200910-year interbank Euroswap rate = 3.55%2-year interbank Euroswap rate = 2.15%Difference: 1.4% Coupon = 3-month Euribor + 1.50 %

• In Feb 2009 the 3-month Euribor was approximately 2%

• Thus, the coupon was: 3.5% (2%+1.5%)

Credit Rating

• How can investors evaluate the probability of default of an issuer?

• The evaluation requires resources (time, know how, access to data, etc) and is difficult for investors

• Investors can turn to independent international credit rating agencies who help lenders deal with asymmetric information issues

• Standard & Poor’s, Moody’s, Fitch, International Bank Credit Rating Agency, Japan Credit Rating Agency, etc.

• Standard & Poor’s use letters: ΑΑΑ, ΑΑ, Α, ΒΒΒ, ΒΒ, Β, CCC, CC, C, C1, D. Often they use signs (+) or (-) to distinguish between ratings(e.g. ΑΑ+, CCC-). Moody’s is using Aaa, Aa, Α, Baa, Ba, B, …….….D, and letters (e.g. Αα1, Αα2).

Credit Rating

• Credit rating agencies evaluate the creditworthiness of issuers and estimate the likelihood of default. The rating represents the agency’s evaluation of qualitative and quantitative information for a company or government;

• Credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government.

• The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.

• They evaluate bonds irrespective whether this is asked by issuer (if asked for the issuer shares info but must pay an ad hoc charge)

• Indicative charges for Moody’s and S&P: 3.25 basis points for issues up to $500,000,000 with a minimum charge of $25,000 and maximum $125,000 (S&P) or $130,000 (Moody’s). For issues higher than $500,000,000 they charge 2 basis points more; both negotiate charges for frequent issuers.

• Fitch evaluates issues only after a request by the issuer.

Rating Outlook

• Outlooks are used by the agencies in order to provide a possible direction for their long-term evaluation within the following 6 months; they report on expected economic changing conditions and expected changes on issuers

• An Outlook does not necessarily means a future change of the Rating or a Credit Watch

• An Outlook is usually accompanied by the following signs:(+): when a rating upgrade is expected (-): when a rating downgrade is expected Stable: when no rating changes are expected Developing: when it is considered possible that the rating will

change but the direction is unknown

Credit Watch

• A Credit Watch is announced in order to underline their point relative to the possible future direction of a long/short term Rating

• It focuses on very specific events and short term trends

• A Credit Watch may be positive (suggesting a possible upgrade) or negative (suggesting a possible downgrade)

• It may also be accompanied by the term “Developing”

Critisism

• During the 2000-2002 period Enron and WorldCom defaulted despite the investment-grade evaluation by credit rating agencies

• Same with Leeman

• Same with the securitized (toxic as it turned out) bonds that were based on US home loans

Studies (indicative)

• Hand, Holthausen and Leftwich (1992) examine 1100 ratings by Moody’s and S&P and 256 Credit Watches of S&P (period: 1977-1982) and find that there is a significant impact on stock and bond prices ONLY after downgrades and negative watches

• Goh and Ederington (1993) examine daily abnormal stock returnsfor a window [-30, +30] days after the announcement of a Moody’s rating (period: 1984-1986) and their results indicate that there is a significant negative market reaction only in downgrades due to financial deterioration

• Wansley, Glascock and Clauretie (1992) examine weekly bond returns for 351 bonds (period: 1982-1984) and find statistically negative returns during the week the downgrade was announced; no reaction to upgrades

Studies (indicative)

• Dichev and Piotroski (2001) examine 4727 rating changes by Moody’s and find a significant negative reaction of investors during the month the downgrade was announced; no reaction to upgrades

• Hull, Predescu and White (2003) examine the change in the spreads of Credit Default Swaps (Period: 1998-2002) for in changes in rating/reviews/outlooks by Moody’s. Spreads seem to rise significantly before negative ratings are announced.

• Steiner and Heinke (2001) examine 182 watches and 546 rating changes by S&P and Moody’s (period: 1985-1996) and find statistically significant negative bond returns for up to 90 days before downgrades and negative watches.

Greece (Moody’s) * warning for downgrade

• 2011: CC• 16-12-2010: Ba1*• 14-11-2010: Ba1• 22-4-2010: A3• 22-12-2009: A2• 29-1-2009: A1*• 4-11-2002: Α1 • 19-7-1999: Α2 • 23-12-1996: Βαα1 • 24-5-1994: Βαα3 (initial rating)

The agencies on the Greek issue

• Moody’s (2002): • The economy was growing above 3% per annum since 1995; • Public deficits reduced between 1993-2003; • Government debt was expected to reduce to 105,3% of GDP from

108,7% in 1995; • Was skeptical for the result of a possible recession on public

finances and for the growth policies after the Olympic Games in 2004

• In September 2004 Standard & Poor’s downgrades to “negative” from “stable” the outlook of Greece (due to expected public finance difficulties) and issued the FIRST WARNING for the credit worthiness of the country, stressing that public spending is growing, public income is shrinking, the public deficit will grow to 5.4% of GDP

Fitch Ratings on Greece (21-10-2003)

• Public debt higher than 100% of GDP

• Debt to foreigners equal to 384% of the income from foreigners (2002)

• High unemployment

• Deficit

• Problems in the pension system (unsustainable)

• The report stresses that the debt is very high for a country with a rating of A and that the rating would have benn lower if the country was not in the Eurozone

Introduction

• During the spring of 2010 Greece admitted it was facing a major fiscal crisis and requested a major bailout package by the European Union and the International Monetary Fund (EU/IMF).

• The package (110 billion euro loan) was provided within the year.

• This, however, and despite a series of austerity measures that were imposed throughout European countries with fiscal problems, did not calm financial markets which were in turmoil.

• A few months later an aid package for Ireland (85 billion euro) was agreed and by the early summer of 2011 Portugal followed (78 billion euro).

10-Year Government Bond Yields (2001-2013)

Introduction

• At the same time the major CRAs were downgrading the creditworthiness of the aforementioned countries

• Many observers and EU officials suggested that downgrades only added to speculation in the market and suggested that CRAs have an anti-Europe bias*

* See the press conference of the President of the European Commission José Barroso on the

downgrade of Portugal in 2011

Introduction• Note that this is not the first time it has been suggested that CRAs play a

part in the deepening of a crisis.

• Ferri, Liu, and Stiglitz (1999) argue that CRAs behave pro-cyclically and aggravated the 1997-1998 East Asian crisis; first by failing to predict it and then by being excessively conservative by downgrading countries more than what the economic fundamentals could justify.

• Cantor and Packer (1994) suggest that investors and financial market regulators have come to rely significantly on the opinions of the CRAs.

• For example, before the subprime crisis investors relied on CRAs to rate instruments such as mortgage bonds and asset back commercial paper (ABCP) issued by entities such as the structured investment vehicles (SIVs) or monolines which insure municipal bonds and structured credit products such as tranches of CDOs (Crouhy, Jarrow, and Turnbull, 2008).

Introduction

• The empirical literature on the spillover effects of credit rating changes is sparse (Arezki, Candelon, Sy, 2011).

• Kaminsky and Schmukler (2002) is the first study to examine whether changes in a country’s credit rating impacts on the financial stability of another country. They find that rating changes affect not only the rated country but also that there is cross-country contagion (more pronounced during crisis periods).

• Alsakka and Gwilym (2013) examine the reaction of the foreign exchange market to credit changes for the period between 2000 and 2010, and find strong spillover effects to neighboring countries exchange rates; these effects are more pronounced during financial crises.

Introduction• We examine how CRA announcements affect yield and volatility in five

European markets with fiscal imbalances during the recent financial crisis.

• Do country rating changes convey new information to market participants? If announcements convey new information we should observe a positive (negative) and statistically significant market reaction around or at the announcement day of an upgrade (downgrade).

• Do country rating changes convey information not only for the rated country but for other markets as well? Is there a spill-over effect of a rating announcement to the other markets?

• Do country rating changes affect not only yield volatility for the rated country but for other markets as well? Previous studies on the issue tend to concentrate on bond or stock prices and ignore volatility.

Data• Daily Bond Yields (vs Germany); Benchmark 10-year bonds

• Credit Rating Announcements

• Greece, Portugal, Ireland, Spain, and Italy

• All data are collected for Datastream

• Period 2001 – 2011

• Sub-periods: • before-crisis period (2001-2008) • crisis period (2009-2011)

Dummy variables take the value of

• (1) in the case of an upgrade• (-1) in the case of a downgrade• zero otherwise

• on the three days surrounding the CRA for • Greece (GR), Portugal (POR), Ireland (IR), Italy (IT), Spain (SP)

• If upgrades and downgrades in country X affect bond prices in country Y, then the dummy variable regression coefficient of country X should be statistically significant when the dependent variable is the yield change of country Y.

• Note that we estimated similar regressions in a pair-wise specification and we obtained similar results

Conclusion • We find that bond and stock market investors in the sample markets

seem to react efficiently to credit rating changes, at both at the announcement day and the week following this date.

• We argue that this is due to the fact that during the crisis the sample markets attracted increased attention not only by market participants but also by the international press and as a result, information was incorporated swiftly in prices.

• As a result, the downgrade of a country by a CRA had little to add to publically available information and was hardly a surprise (in a statistically significant manner).

• Also, during the financial crisis in Europe (2008–2013) we find that credit rating announcements for Portugal tend to have a statistically significant (at the 5% level) impact on bond yield changes for all other countries.

Conclusion

• For stock markets we find a similar trend although rating changes for Ireland and Spain seem to also have a (weaker) effect on stock markets.

• One could argue that this is inconsistent with the fact that during the crisis Greece attracted global media attention in an unprecedented scale, and as a result, one would expect credit rating announcements for Greece to have an impact on bond yield changes for other markets.

• However, our findings indicate that Greece was perhaps considered as a special case by market participants; Portugal was considered as a more representative case for the European economies in crisis.

Bond Returns

• There are three main ways to calculate the return of a bond

• Current Yield

• Yield to Maturity

• Yield to Call

Current Yield, CY)

• It relates the annual coupon (C) to the current market price (P0)

CY = C / P0

• Examples:

• 18-year bond, coupon rate, 6%, current price $700,89

CY = $60 / $700,89 = 0.0856 or 8.56%

• 2-year bond, coupon rate 11%, current price $1,233.64

CY = $110 / $1,233.64 = 0.0892 or 8.92%

Yield-to-Maturity, YtM

• The “required return” of a bond; the Internal Rate of Return (IRR) of a bond

• Example: 5-y bond with a coupon rate of 9%, pays coupons annually, Par = $1,000, Current Price = $962.10.

Approximate YtM

Yield to Call

Bond Valuation

Bond Valuation

Bond Valuation

Bond Valuation

Bond Valuation

• Conclusion

• (i) if the coupon rate > YtM → bond trades at a premium • (ii) if the coupon rate < YtM → bond trades at a discount • (iii) if the coupon rate = YtM → bond trades at Par

• and visa versa

Bond Valuation

Bond Valuation

Bond Valuation• What happens if we do not assume a constant discount rate?

• Consider the following problem: find the price of a 3-year Government bond (Par = $100, coupon rate = 7%, annual payment) when we expect that the discount rate will change over time.

P0 = [ 7 / (1+S01) ] + [ 7 / (1+S02)2 ] + [ (7 + 100) / (1+S03)3 ]

• S01: proper discount rate for period 0 (today) to period 1 (in one year)

• S02: proper discount rate for period 0 (today) to period 2 (in two years)

• S03: proper discount rate for period 0 (today) to period 3 (in three years)

Bond Valuation

• Assume that in the market currently we can find zero coupon Government bonds (i.e. same issuer) that mature in 1, 2, 3 years from today with current prices $92, $87, $85 respectively

• Par Value = $100/

• We know that P0 = P / (1+r)n

• Thus, the YtM of a zero coupon is YtM = [P / P0]1/n -1

Bond Valuation Thus the YtM for the zeros are:

• YtM01= (P/P0)1/1 -1 = (100/92) -1 = 0.0869

• YtM02= (P/P0)1/2 -1 = (100/87)0.5 – 1 = 0.0721

• YtM03= (P/P0)1/3 -1 = (100/85)0.33 -1 = 0.0556

• Since we want to price a Gov Bond with 3 cash flows

• Since there are 1-y, 2-y, 3-y Gov zeros with YtM 8.69%, 7.21%, 5.56%, respectively

• Then, according to the Law of one price these are the proper discount rates

Άρα η τιμή θα είναι:

• Thus, the price should be:

• P0 = [ 7 / (1+0,0869) ]

+ [ 7 / (1+0,0721)2]

+ [ (7 + 100) / (1+0,0556)3]

= 103,50 Ευρώ

Spot Rates – Forward Rates

• The discount rate we used for the valuation is called the Spot rate, S• The spot rates are YtM (required returns) from zero coupon bonds

για ομολογίες zero• We can also use them to obtain Forward rates, i.e. rates where the

deal date and the transaction date is different• Example: we agree with a bank today (period 0) to take a loan of

$925 in one period from now (period 1) and repay the Par value of $1000 in two periods from the transaction date (i.e. three periods from today):

• 925 = 1000 / (1 + f13)2

• ↔ f13 = (1000 / 925)1/2 – 1

• ↔ f13 = 3,975%

Spot Rates – Forward Rates

• Example: we agree with a bank today (period 0) to take a loan of $845 in two periods from now (period 2) and repay the Par value of $1000 in four periods from the transaction date (i.e. six periods from today):

• 845 = 1000 (1 + f26)4

• ↔ f26 = (1000 / 845)1/4 – 1

• ↔ f26 = 4,3%

Spot Rates – Forward Rates• Assume there is an investor with an investment horizon of 2 years

and has $1 available for investment and two ways to invest it: $ετών ο οποίος έχει 1 Ευρώ και 2 τρόπους επένδυσης:

• (i) buy a 2-year zero; in that case the returns will be: $1 (1 + S02)2

• (ii) buy a 1-year zero for the first period and agree today with a bank

to invest the amount available at the end of the first year; in this case the return will be: (1 + S01) (1 + f12)

• If markets are efficient and there is equilibrium then:

• 1 (1 + S02)2 = 1 (1 + S01) (1 + f12) ↔ (1 + f12) = (1 + S02)2 / (1 + S01)

• For 3 periods: (1 + f23) = (1 + S03)3 / (1 + S02)2, etc

Yield curves

The graphical representation of the spot rates

Yield curves

Yield curves

Yield Spreads

• The difference in YtM between two bonds

• Usually, we employ government bonds and employ one country as the “base” against which we measure the spread

• In Eurozone = German bonds

• It shows the difference in lending rates between two countries, e.g. if the YtM of German 10-year bonds is 2% and the YtM of Greek 10-year bonds is 6%, this means that Greece will have to pay aprox. 4% more than Germany for 10-year lending.

• In other words, investors demand higher compensation due to higher risk

Yield Spreads

• Recall that in order to obtain the YtM we use the current price of a bond, thus, yields change on a daily basis and reflect all available information about the bond and the issuer

• As a results, when, say, negative info arrives in the market, investors sell, bond prices fall, yields rise, and spreads (relative to the base market) also rise

Yield Spreads• Graph: Greek 10-year Government bond Price 2000-2012

• During most of the 00’s the market price of the Greek bond was near the Par value, but when the size of the fiscal problems became apparent (Nov 2009) investors started to sell and the price fell (in 2012 it fell to 18%)

• As a result, the YtM rose, an dthe spread (relative to German 10-year bonds) also rose

10-year Greek Bond (Price, 2000-2012)

YtM of German and Greek 10-year bond (2000-2011)

Yield Spreads relative to German bonds (2000 – 2014)

Spreads 10 of 10-y bonds (3/10/2014)

Country Yield Spread vs Bund Spread vs T-bond

Austria 1,14% +0,21 -1,30

Australia 3,46% +2,54 +1,02

Belgium 1,20% +0,27 -1,24

France 1,27% +0,35 -1,17

Germany 0,92% - -1,52

Denmark 1,19% +0,26 -1,25

Switzerland 0,48% -0,45 -1,96

Greece 6,43% +5,51 +3,99

USA 2,44% +1,52 -

Japan 0,52% -0,40 -1,92

Ireland 1,67% +0,75 -0,77

Spain 2,12% +1,19 -0,32

Italy 2,33% +1,41 -0,11

Canada 2,10% +1,18 -0,34

UK 2,36% +1,43 -0,08

New Zealand 4,14% +3,21 +1,70

Netherland 1,07% +0,15 -1,37

Portugal 3,06% +2,13 +0,62

Sweden 1,47% +0,54 -0,97

Finland 1,04% +0,12 -1,40

What determines the spread; • Previous empirical work suggests that yield spreads reflect mainly

three different types of risk:

• (i) general market risk (Codogno et al., 2003; Haugh et al., 2009; among others),

• (ii) default risk, i.e. the possibility that a debtor will not fulfil the bond obligations, and

• (iii) liquidity risk, i.e. the possibility that investors will not be able to liquidate their investments without significantly affecting prices in secondary markets.

What determines the spread;

• For example, Hund and Lesmond (2008) suggest that liquidity risk is an important determinant of bond spreads even after controlling for macroeconomic influences, while other studies find that liquidity is an important explanatory variable along with default risks (see Gomez-Puig, 2006; Schwartz, 2009; Ferrucci, 2003; among others).

• Barbosa and Costa (2010) find that euro area sovereign spreads are affected by a common factor (risk premium in international financial markets) and factors that are related to local bond market credit and liquidity risk, although since the collapse of Lehman Brothers local risk factors have gained importance.

Factors that determine spreadsAn empirical example

Factors that determine spreadsAn empirical example

• An important issue in empirical testing is to choose the right variable in order to proxy for the theoretical factors.

• For example, default risk may be proxied with the Debt-to-Reserves ratio (see Martell, 2008). Debt is measured as the Government Consolidated Gross Debt and Reserves are the Official Reserve Assets, except for Ireland where the Official External Reserves are used due to unavailability of data (source: Eurostat, Datastream)

• Alternatively, one could use other variables in order to gain further insight on the macroeconomic conditions in the local market; one such example is industrial production as a proxy for economic growth (source: Datastream)

Factors that determine spreadsAn empirical example

• To capture the effect of general market conditions (general market risk) one could use: the Eurozone Consumer Price Index or the difference between the European Central Bank (ECB) Reference Rate and the three month Euribor (Ebner, 2009).

• Why? For example, higher consumer prices may suggest worsening economic conditions and thus a larger spread

• To capture the effect of market liquidity one could use the bid-ask spread

• Alternatively, one may use the yield volatility of the 10 year Benchmark Bond, for each country (e.g. from a GARCH(1,1) model). The rationale for using yield volatility as a proxy for illiquidity is as follows: as Houweling, et al. (2005) argue, higher yield volatility suggests higher yield uncertainty which leads to larger bid–ask spreads, and thus to lower liquidity.

Factors that determine spreadsAn empirical example

• For example, take the monthly spread of Greece, Spain, Italy, Ireland, Portugal (vs Germany)

• The following Table the results indicate that most coefficients are statistically significant

• E.g. the coefficient on Industrial Production for Greece is -4.14, indicating that it plays an important role for the spread level

• Sign: negative, indicating that a fall in Industrial Production leads to a rise in spreads

• Adjusted R-squared: especially high for some markets (for Greece: 0.8725)

• Source: Spyrou, S. (2013) “Investor sentiment and yield spread determinants: Evidence from European markets”, Journal of Economic Studies, Vol. 40, N. 6, 739-762

Other Empirical Results • Bernoth & Erdogan (2010) examine government spreads for 10

EMU countries (1999-2010) with a semi-parametric model that allows time-varying parameters and find that while in the early 00’s public lending and risk aversion was important for spreads, towards the end of the decade the situation is changed

• Overall, they argue, the spread determinants vary over time

• Bernoth, Κ., Erdogan, Β., (2010) “Sovereign bond yield spreads: A time-varying coefficient approach”, DIW Berlin, German Institute for Economic Research, Discussion Paper 1078.

Other Empirical Results

• Abmann & Boysen-Hogrefe (2009) find that default risk (estimated with the debt-to-GDP ratio) can explain the larger part of spread variation in the Euro area between 2003 and the beginning of the financial crisis

• During the crisis, however, liquidity risk became more significant

• Abmann, C., Boysen-Hogrefe, J., (2009) “Determinants of government bond spreads in the Euro area, in good times as in bad” Kiel Institute for the World Economy, Working Paper 1548.

Other Empirical Results

• Sgherri & Zoli (2009) find that government yield spreads in the Euro area co-vary significantly over-time and, apparently, they seem to have a common factor that determines them (at least until 2008)

• After 2008, the financial sector in each country gained importance over the common factor as spread determinants, however, liquidity risk remained as an important factor

• Sgherri, S., Zoli, E., (2009) “Euro Area Sovereign Risk During the Crisis”, European Department, IMF Working Paper, WP/09/222.

Other Empirical Results

• Sgherri & Zoli use as variables inflation, interbank rates, German equity volatility (DAX implied Volatility), currency volatility (G7 currency implied volatility), and an error correction model

• The following Table shows that in the long term government spreads are related to inflation and interbank rates

• In the short term, however, only 13% of daily spread variation can be explained

Sgherri, S., Zoli, E., (2009) “Euro Area Sovereign Risk During the Crisis”, European Department, IMF Working Paper, WP/09/222.

Other Empirical Results

• Nickel, Rother, & Rulke (2009) examine the effect of fiscal variables on spreads (vs US bonds) for the Czech Rep., Hungurry, Poland, Russia, and Turkey, between 1998 and 2007.

• Their variables are the fiscal deficit to GDP), GDP growth, expected inflation, whether a country is a EU member or not, reserves to imports, debt to exports, etc.

• When they examine all markets together (panel data) they find that many variables are important

• When they examine each country on its own they find that different variables are important in each country

Nickel, C., Rother, P., Rulke, J. (2009) “Fiscal Variables and Bond Spreads: Evidence from Eastern European Countries and Turkey”,

European Central Bank, Working Paper Series, No 1101.

Nickel, C., Rother, P., Rulke, J. (2009) “Fiscal Variables and Bond Spreads: Evidence from Eastern European Countries and Turkey”,

European Central Bank, Working Paper Series, No 1101.

Martell, R. (2007) “Understanding common factors in domestic and international bond spreads” Emerging Markets Research, Barclays

Global Investors, Working Paper.

Duration

• What is the major source of risk for bond holders?

• Interest rate volatility (since it affects prices)

• Thus, in order to estimate bond risk or uncertainty we could use the sensitivity of the bond price to interest rate changes

• Macaulay (1938) suggested to measure this uncertainty with DURATION (D), i.e. the weighted average of the term structure of the bond’s cash flows

• With this term we know that for every 1% change in interest rate the price of the bond with D* = Χ, will change by Χ%

Definition

• CFt = Cash flow at time t

• PV(CFt) = Present Value of CFt

• PV(TCF) = Present Value of total Cash Flows (i.e. the current market price in efficient

markets)

• D = Duration

D (in periods)

D (in years)

Example

• Estimate Duration:

• Maturity : 5-year Bond

• Coupon rate : 8%

• Coupon payments : Semi-annual

• Discount rate : 8%

Example

• D (periods) = (843,5332) / (100)

= 8,435352

• D (years) = 8,435332 / 2

= 4,21

Derivation of Duration

Derivation of Duration

Derivation of Duration

Duration of a zero coupon bond

• The Duration of a zero coupon bond is equal to the years left to maturity

Portfolio Duration

• The duration of a portfolio of bonds is equal to the weighted average of the Duration of each bond in the portfolio

W1 = (4.000.000) / (9.609.961) = 0,416W2 = (4.231.375) / (9.609.961) = 0,440W3 = (1.378.586) / (9.609.961) = 0,144

D*p = (0,416) (3,861) + (0,440) (8,047) + (0,144) (9,168) = 6,47

Errors with D

Same D but different Convexity

Convexity (in periods)

Convexity (in years)

Example

• Find the convexity

• 5-year bond

• Coupon rate = 8%

• Paid semi-annually

• Par Value 100 Euro

• YtM= 8%

C (periods) = (8,734.388) / (1+0.04)2(100) = 80.75

C (years) = 80.75 / 22 = 20.18

Convexity and interest rate changes

• It can be shown that the approximate change in the price of a bond for a given change in the rates (Δr) due to convexity will be equal to:

• ΔΡ = (0,5) C (Δr)2

Example

• If C = 20.18 and we expect rates to grow from 8% to 11% (i.e. 3%)

• ΔΡ ≈ (0,5)(20,18) (0,03)2 = 0,009054

• If rates increase by 3% the bond price due to convexity will rise by 0,9054%.

Duration and Convexity

ΔΡ = -D* (Δr) + (0,5) C (Δr)2