bm fi6051 wk10 lecture

8/14/2019 Bm Fi6051 Wk10 Lecture

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Financial DerivativesFI6051

Finbarr MurphyDept. Accounting & FinanceUniversity of LimerickAutumn 2009

Week 10 Practical Bond Trading& Swaps


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This lecture looks atWhere are bonds traded?How are they quoted?

How do I buy a bond?How much do I pay/receive (exactly)?How does the settlement occur?When do I earn accrued interest?

Where are my bonds stored/registered?

These answers to these practical questions willgive you an insight and a better understanding of bond and (by extension) other markets.

Practical Bond Trading


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We shall examine an Irish Government Bondtraded through EuroClearAnd an American T-Bond

Primary and Secondary Bond MarketsA Primary Market is the market in which investors havethe first opportunity to purchase an asset

A Secondary Market is the market where an investorpurchases an asset from another investor directly orthrough an intermediatory



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We shall examine an Irish BenchmarkGovernment Bond traded through EuroClearAnd an American Benchmark 10-year TreasuryNote

A benchmark bond is a bond that provides a standardagainst which the performance of other bonds can bemeasured.

Primary and Secondary Bond MarketsA Primary Market is the market in which investors havethe first opportunity to purchase an assetA Secondary Market is the market where an investor

purchases an asset from another investor directly orthrough an intermediatory



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US Bills, Notes and Bonds are issued in theprimary markey by the US Treasury departmentthrough an auction process

In 2003, the US Treasury issued $3.42 trillionnew debt issues

$2.83T was used to redeem existing debt

Therefore $353B was new debtThis debt is capped by the US Congress

All US Treasury debt is traded OTC in thesecondary market



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Irish Government Bonds are issused through theNational Treasury Management Agency (NTMA)A new bond may be issued by either tap, auctionor switching

Auctions are held on the 3 rd Thursday of eachmonthWhen securities are sold on tap, issuance takesplace on an ongoing basis over the selectedperiod of sale.Switching involved changing maturities



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When an investor buys a bond between couponpayments, the investor must compensate theseller of the bond for the coupon interest earned

from the time of the last coupon payment to thesettlement date of the bond. This amount iscalled accrued interest

Prices are quoted Clean or DirtyClean Price => quote excludes accrued interestDirty Price => quote includes accrued interest

Typically, prices are quoted Clean

Quoted Prices


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Lets look at an example;You buy 5,000 bonds with the following features:

5% coupon paid semiannually

Maturity in 9 monthsCurrent Price = 98The bond has a face value of 1,000The price quoted is the clean price

Quoted Prices

M a t u r

i t y

T = 0. 7

5 C o u p o n

T = 0. 2

5 S e t t l e m

e n t

D a t e

T = 0 C

o u p o n

T = - 0

. 2 5


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The seller is due the price of the bond PLUS theaccrued interest dueIn this simple example, the seller is due

0.05xx0.5 = 1.25% addittional

So you (the investor) paid(98.0%+1.25%)x1,000x5,000

= 4,962,500.00

Quoted Prices


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Our previous simple example showed the accruedinterest on exactly half a couponBut the market conventions must be morestringentDaycount conventions are expressed as X/YThe interest earned between two days is

In finance, a day count convention is a methodto calculate the fraction of a year between twodates

Daycount Conventions

No of Days Between DatesNo of days in Ref. period X Interest Earned in Ref. Period


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Day count conventions include:30/36030/360E

actual/360actual/365actual/actual and more


0 3 - J u l y

0 1 - M a

r 0 1 -

S e p 0 1 / 0 4

0 1 / 0 8

0 1 / 0 7

0 1 / 0 6

0 1 / 0 5

Reference Period

Days Between Dates


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Look at the number of dates between 01/03 and03/07

Using ACT/ACT = 124/184Using 30/ACT = 122/184Using 30/360 = 122/180

These slight differences amount to enormous

amounts of money when dealing with Billion EuroDeals


0 3 - J u l y

0 1 - M a

r 0 1 -

S e p 0 1 / 0 4 0 1 / 0 8 0 1 / 0 7 0 1 / 0 6 0 1 / 0 5

Reference Preiod

Days Between Dates


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Irish Government Bonds trade ACT/ACTUS Treasury Notes and bonds settle ACT/365US Corporate Bonds settle 360/30

There are always exceptions to the rule so beaware of the DayCount conventions of theinstruments and markets that you trade in



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When a deal is agreed, the details are passedelectronically by the trader to the back officeThe back office send the trade details

electronically to the clearing houseThe counterparty to the trade does likewiseAssuming all is in order the trade settles some 1to 3 days after the trade date

Trade Date = TDSettle Date = SDSD = T+3

Settlement Instructions


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The SD is more important than the TD as itdecides the date ownership is transferred andhence, when accrued interest commences

accruing for the buyerIrish Government bonds settle (payment in full)on a t+3 basis but deferred settlement can bearranged on request.

US Treasury Notes and bonds settle regular way,which is one day after the trade date (T+1)

Settlement Instructions


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32ndsIrish Government bondsUS Treasury Notes and bonds

Quote Methods


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Quote Methods

See the Irish Gov.2018 Benchmark bondSource ISE

http://www.ntma.ie


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Quote Methods

A U.S. Treasury-issued security with a maturity of between 2 and 10 years. Treasury notes are issuedin denominations of $1,000, $5,000, $10,000,

$100,000, and $1 million. Interest is calculated on anactual / 365 day-count basis and quoted as apercentage of par to the nearest 1/32nd.

Security Term TypeIssueDate

MaturityDate

InterestRate %

Yield%

Price

Per $100 CUSIP

10-YEAR NOTE 07-15-2005 07-15-2015 1.875 1.939 99.420765 912828EA4


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A swap is an agreement between two parties toexchange a series of cash flows in the future

The agreement details the payment dates and the way

the payments are calculated

A swap contract may be considered to be a seriesof forward contracts

Or indeed a forward contract may be considered to bethe simplest type of swap

The two most common types of swaps are the plain-vanilla interest rate swap and the fixed-for-fixed currency swap

Introduction to Swaps


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With an interest rate swap one party agrees tomake payment of interest at a predeterminedfixed rate for a number of years

The interest is calculated on an agreed notional principal

The other party agrees to make payment of interest at a floating rate for the same number of

yearsThe interest is calculated on the same notional principal

The reference floating rate is the London

Interbank Offer Rate (LIBOR)

Plain-Vanilla Interest Rate Swaps


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The following discussion will illustrate theworkings of an interest rate swap

Consider a 3-year swap agreed between Intel andMicrosoft

Microsoft agree to pay Intel a fixed interest rateof 5% on a notional principal of $100m

Intel agree to pay Microsoft 6-month LIBOR onthe same principal of $100m



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The following diagram illustrates the interest rateexchange

The first exchange of cash flows is to be made sixmonths from the initiation of the swap

Payment is to be made continue every six months untilthe end of the 3-year swap contract

The next table gives the cash flows for Microsoftunder assumed values of 6-month LIBOR


INTEL MICROSOFT

LIBOR

5%


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Date 6-monthLIBOR

(%)

Floating CashFlow

Received($m)

Fixed CashFlow Paid

($m)

Net CashFlow

($m)

t 0 4.2

t 0.5 4.8 +2.10 -2.50 -0.40

t 1 5.3 +2.40 -2.50 -0.10

t 1.5 5.5 +2.65 -2.50 +0.15t 2 5.6 +2.75 -2.50 +0.25

t 2.5 5.9 +2.80 -2.50 +0.30

t 3 6.4 +2.95 -2.50 +0.45


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Note that the 6-month floating payment iscalculated using LIBOR as recorded at time t 0

The 1-year floating payment is calculated usingLIBOR as recorded at time t 0.5

Similarly, each remaining floating payment iscalculated using the previous periods LIBOR

In reality the two companies do not actuallyexchange the entire agreed cash flows



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Instead the net cash flow is paid by one party tothe other

Microsoft make payments to Intel of $0.4m and$0.1m on the 6-month and 1-year datesrespectively

Thereafter Microsoft actually receives the netcash flow positions from Intel

Due to the fact that 6-month LIBOR rises above thefixed rate of 5% by the end of year 1



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Note that the notional principal is not exchangedby the parties at the end of the swap period

Hence the use of the term notional principal



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Swap contracts are commonly used to transformthe nature of company liabilities

To illustrate, suppose Microsoft has entered into afloating-rate loan to the value of $100m

Assume that the interest rate to be paid on theloan is LIBOR plus 10 basis points

A basis point in the interest rate market is equal to0.01%, so 10 basis points is 0.1%

Using a Swap to Transform a Liability


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The net effect is that Microsoft are paying out afixed rate of 5.1%

In this way, Microsoft have converted a floating-rate liability into a fixed-rate one

A similar viewpoint can be taken with Intel

Using a Swap to Transform a Liability


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Using a Swap to Transform an Asset

Swap contracts can also be used to transform thenature of company assets

To illustate, suppose Microsoft has purchased$100m of bonds that provide an interest rate of 4.7%

If Microsoft enters the swap as outlined then it iscommitted to three sets of cash flows

It receives 4.7% from the bondsIt receives LIBOR under the terms of the swap

It pays out 5% under the terms of the swap


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Hull, J.C, Options, Futures & Other Derivatives,2009, 7 th Ed.

Chapter 6 & 7

See also details from the issuing authorities,listed in this lecture

Further reading

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