Debt securities market

2

Central Bank Target

• Main target – price stabilisation• Additional target – supporting government

economic’s policy• The target of Federal Bank Reserves is

another one. For 70 years was unchanged („ to promote effectively the goals of maximum employment, stable prices and moderate long term interest rates”)

3

Price stabilization.

• To get price stabilization the commodities supply should be equal to the money supply

• This equation should regard– on the commodity side: necessary storage changes– on the money side: changes of the money turnover

velocity (first of all – change of saving inclination)

• Leak of the equilibrium results:- inflation (to much money)- payment congestions (to less money)

4

Central bank operations

• Central bank cooperates with the commercial banks only

• Central bank is lending and borrowing money from them

• If amounts of central bank’s credits is higher then deposits that additional money enlarges commercial banks credits for enterprises, households and public units

5

Interest rate – basic instrument of the central bank

• Falling central bank interest rate causes bigger demand for in credits by commercial banks.

• Thanks these cheaper credits commercial banks can offer their own credits by the lower interest rate, which usually is interested form more clients than previously

• Larger credits issue provides to more money supply and enlarges purchasing power of the economic units

• Raising interest rate of the of central bank provides in final result to shrinking the purchasing power

6

Other central banks instruments then interest rate

• Determination of the obligatory deposits in the central banks

• .... capital adequacy coefficient

• ......obligatory reserves

• Currency operations

7

Credits of the central bank

• Refinacial – direct credits for commercial banks

• Rediscount – given to support the discount of the bills of trade

• Lombard – given to maintain the liquidity of the banking sector. It is collateralised by the very firmly securities (T-bonds)

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• Out right – sale or buying securities without any special conditionsCash bill – the bill with the life time of one week sold by central bank to commercial banks

• Conditionally - upon the condition to resale or repurchaseREPO – central bank is buying securities (T-bonds) from the commercial banks and later sell them backRREPO – central bank is selling securities (T-bonds) from the commercial banks and later buy them back

• Such operation are used on the interbank market as well. They are called: „buy-sell-back” and „sell-by-back”

Open market operation

9

Debt securities types

Money market• Cash bills (issued by the central bank)• Treasure bills (issued by the central

government)• Commercial papers (issued by other units

then government and central bank)Capital Market• Bonds

10

Debt security features

• Securities are issued in series. The series contains identical securities

• Issuer of the debt securities series is oblige determine (at least):- maturity- coupon amount and coupon payment data- name and other information about the issuer- other features (if they exist)

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Debt security price

• Nominal price – is taken as 100• Some times there is no possible to buy such sole

pieces, the larger package only(Polish T-bill – 10 000 PLN)

• Bare price – price without rightful part of the coupon• Price with interest - price with rightful part to the

coupon• Price with interest = bare price + coupon(days from

the last payment)/365

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• Zero coupon bonds

• Bonds with fixed coupon

• Bonds with floated coupon

- indexed on LIBOR (WIBOR etc.)

- indexed on inflation

- another form of indexing

Securities coupon types

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Yield

• YTM (Yield To Maturity) – the average annual return rate of debt security upon the condition to keep it to the maturity.

• There is follow relation between price (bare) and YTM:

Ttn

n

kkTt RR

i

TtR

TtiP

/1

/ )1(

100

)1(/1

/

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YTM versus Price

YTM

Price

15

YTM versus Maturity

years 2,5 10 15 20 25

YTM

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Reversed Yield Curve

years 2,5 10 15 20 25

YTM

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Duration

• Easy definition – period of time to the moment, when investment in debt securities is returned

• Full definition – weighted amount of all incomes from security kept to its maturity

18

Duration algorithm

• Lets take y – yield, I - coupon, number of succeeding year to maturity – i, number of years rightful to full coupon, t – time to first coupon payment. Duration (D) is:

n

i

nn

n

i

nnt

yyI

ynyiIyID

1

1

)1(100)1(

)1(100)1()1(

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Duration - calculation

• Lets take yield y= 5%, coupon I= 6, time to maturity – 4 years. Duration is as follow

• D=3,69• This result means: return on invested money

in the four years bond with coupon 6 and YTM 5% takes place after 3,69 years

1 2 3 4 4

1 2 3 4 4

6 (1 5%) 2 6 (1 5%) 3 6 (1 5%) 4 6 (1 5%) 4 100 (1 5%)

6 (1 5%) 6 (1 5%) 6 (1 5%) 6 (1 5%) 100 (1 5%)D

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• Time to maturity. The longer – the higher duration

• Yield – raised yield shorten duration

• Coupon – the higher coupon, the shorter duration

• Frequency of coupon payment – the often payment, the shorter duration

What depends duration on

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How duration depends on coupon

duration 1

coupon payments

paym

ent of princip

al 7year

duration 2

1 year 2 year 3 year 4 year 5 year 6 year1 year 2 year 3 year 4 year 5 year 6 year

Coupon 7% Coupon 5%

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Simplification of price –yield relation

• However the relation between price and yield has a shape of convex curve, for small changes this curve is closed to the line

• Some times the speed of action is more important than exact calculation. Than such equation (however mathematically not fully correct) is used:

price change (%)= yield change(%) durationor more exact

price change (%)= yield change(%) duration/(1+yield)

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Risks connected to debt securities

• Interest rate risk – possibility to loose on bond’s price as result of interest rate raise

• Credit risk – possible of refusing to pay coupon or principal by the issuer in the sake of money shortage

• Liquidity risk – danger of difficulties to sell securities by reasonable price in the sake of insufficient demand

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Bonds types

• According the issuer type

• According the coupon type

Treasure Municipal Mortgage Banks Enterprises

lliquidity

yield

Fixed coupon Floating coupon Zero coupon

LIBOR Indexed Inflation indexed

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Bond types cont.

• According kind of currency

• Specific

In the local currency Eurobond

Convertible Junk bond Sinking bonds Certificate of DepositOld type collateral.