Disney Case
¥ Debt Support
2 2
€ Debt Support
¥ Debt Support
€ Debt Support
1 1
¥ Principal
€ Principal€ Principal
¥ Principal
Variation on a currency swap
Step 1 is notionalStep 2 is net
Borrow in Europe against income from Tokyo Disney
Dis
ney
IBJ Borrow in
Japan, invest in Europe
Fre
nch
Uti
lity
Currency Swap
German rate x €1,000,000
€ 1,000,000
2 2
U.S. rate x $1,500,000
German rate x €1,000,000
U.S. rate x $1,500,000
1 1
€ 1,000,000
$1,500,000$1,500,000
€ 1,000,000
3 3
$1,500,000
€ 1,000,000
$1,500,000
Illustration of a straight currency swap
Step 1 is notionalSteps 2 & 3 are net
Borrow in US, invest in Europe
Borrow in Europe, invest in US
Problem 40
Two-year bondR = 6.5%P/YR = 1N = 2Let’s say PV = $10,000Then FV = $11,342.25
Rollover StrategyStart with $10,0001st year add 6%
$10,600
2nd year add 7.5%$11,3952-year average return is 6.75%
Expected return is higher with rollover strategy
What risks are involved?
Problem 41
Two-year bondR = 7%P/YR = 1N = 2Let’s say PV = $10,000Then FV = $11,449.00
Rollover StrategyStart with $10,0001st year add 6%
$10,600
2nd year add 7.5%$11,3952-year average return is 6.75%
Expected return is higher with two-year bond
What pressures would result?Given the expectations, equilibrium 2-year rate would be
6.75% (Problem 42)
Problem 43
Start with $10001st year add 5%
$1050
2nd year add 6%$1113
3rd year add 7%$1190.91
Average return:
PV is –1000
FV is 1190.91
P/YR is 1
N is 3
Calculate interest
Result is 6.00 %
Problem 44
Start with $1,000,0001st year add 6%
$1,060,000
2nd year add 6.5%$1,128,900
3rd year add 7%$1,207,923
4th year add 8%$1,304,556.84
Average return:
PV is –1,000,000
FV is 1,304,556.84
P/YR is 1
N is 4
Calculate interest
Result is 6.8724 %
Expectations Theory
• We’ve just had some practice building up the yield curve according to the expectations theory
• Now, let’s do some arbitrage!
Problem 45
• Moving from 0% coupon to 6% couponAdds extra income of $6 per yearAdds $38.28 to price ($75.08 minus $36.80)
• Moving from 6% coupon to 8% couponAdds extra income of $2 per yearAdds $3.92 to price ($79 compared with $75.08)
Therefore an extra $6 per year should cost three times as much, $11.76
• The 0% bond is a bargain!
Problem 45
0 1 2 19 20
Sell $300.32 $12 $12 $412$12
Buy $12$237.00 $12 $312$12
NPV is clearly positive
Net $26.52 0 0 00
Buy 0$36.80 0 $1000
Coupon Stripping
• 6% coupon (2 pmts/yr)
• 10 years to maturity• Price: $76.71
• 8% coupon (2 pmts/yr)
• 10 years to maturity• Price: $89.72
Let’s combine these components into a zero-coupon bond
• Buy four of the 6%• Sell three of the 8%• Net: $100 in 10 years
• Pay $306.84
• Receive $269.16
• Net Payment: $37.68
Implied interest is 10% APR (2 P/YR)
Coupon Stripping
Buy
Sell
0 1 2
$306.84 $12
$12
$12 $412
$269.16 $12
19 20
$312
$12
$12
Implied interest is 10% APR (2 P/YR)
Net $37.68 0 0 $1000
Coupon Stripping
• Stripped zeroes of different maturities can be used to construct the yield curve
• Better than using duration
Problem 46
• Moving from 6% coupon to 8% couponAdds extra income of $2 per year
Adds $9 to price ($76 compared with $67)
• Moving from 8% coupon to 10% couponAlso adds extra income of $2 per year
But, adds $12 to price ($88 compared with $76)
• Therefore, the 10% bond is over-priced (compared with the 8% bond)
Problem 46
0 1 2 19 20
Buy $152.00 $8 $8 $208$8
Sell $3$67.00 $3 $103$3
NPV is clearly positive
Net $3.00 0 0 00
Sell $5$88.00 $5 $105$5
Problem 47
NPV is always positive
0 1 14 161211 13 15
Buy $174.00 $6 $6 $206$6 $6
Sell $90.61 $3 $3 $103
Sell $88.35 $3 $3 $3 $3 $3 $3 $103
Net $4.96 0 0 $100 $3 $203 $3 $103
Problem 48
NPV is always positive
0 1 14 161211 13 15
Sell $178.88 $6 $6 $206$6 $6
Buy $88.44 $3 $3 $103
Buy $86.35 $3 $3 $3 $3 $3 $3 $103
Net $4.09 0 0 $100 $3 $203 $3 $103
Problem 49
NPV is always positive
0 1 14 161211 13 15
Sell $178.88 $6 $6 $206$6 $6
Buy $90.61 $3 $3 $103
Buy $85.70 $3 $3 $3 $3 $3 $3 $103
Net $2.57 0 0 $100 $3 $203 $3 $103
Problem 50
NPV is always positive
0 1 14 161211 13 15
Buy $181.36 $6 $6 $206$6 $6
Sell $90.61 $3 $3 $103
Sell $93.95 $3 $3 $3 $3 $3 $3 $103
Net $3.20 0 0 $100 $3 $203 $3 $103
Problem 51
$170.96 £84.63
$200
Profit = £0.77
NYtoday
$1.00 = £ 0.495
$1.00 = £ 0.50
LONtoday
LONlater
$200 NYlater
What is not balanced?
Price £83.86Face £100
Price $85.48Future $100
£100
£83.86
Problem 52
€8,885 $12,439.00
€10,000
Profit = $899.20
FRAtoday
€1.00 = $1.40
€1.00 = $1.35
NYtoday
NYlater
€10,000 FRAlater
What is not balanced?
Price $85.48Face $100
Price €88.85Future €100
$13,500
$11,539.80
JunkCo Arbitrage
Fixed
If net is positive, underwriter pays party. If net is negative, party pays underwriter.
Illustration of a Floating/Fixed Swap
Party Underwriter CounterpartyVariable
Fixed
Variable
JunkCo Arbitrage
11% Fixed
Net for AAA Corp:•During 1st year, borrows at T-Note rate•During remaining time, net flow is zero•This is better than AAA could do by itself
JunkCo Underwriter AAA CorpT-Bill
11% Fixed
T-Bill
Lender
T + 3%
Lender
11% Fixed
T-Bill
SinkingFund
After 1st year
Net for JunkCo:•Net is 14% fixed•This is better than JunkCo could do by itself
Net for Underwriter:•Net flows are zero•Gains fees, future opportunities, & goodwill
JunkCo Arbitrage
How is this possible?Answer: Quality gap is inconsistent
Maturity
Rat
e
Yield Curves
AAA
JunkQuality Gap
Myron Labs Arbitrage
8% Fixed, £ Principal
1 1
BT, £ Principal
8% Fixed, $ Principal
BT, $ Principal 1st yr£ Principal after 1st yr
After 1st year£1,000,000
$2,000,000
Variation on a currency swap
Myr
on L
abs
Inte
rmed
iary
Ad
van
ced
Dev
ices
Lender
8% Fixed
BT-Bill
SinkingFund, £
After 1st year
Lender
BT + 2%
Dynamic Hedge
Volatility
$2,000,000
£1,000,000
End of last year
BF Goodrich Rabobank
11% Fixed
Net for Rabobank:•During initial time, borrows at LIBOR – x•During remaining time, net flow is x•This is better than Rabo could do by itself
BFG Morgan RabobankLIBOR – x
11% Fixed
LIBOR – x
Lender
LIBOR + .50%
Lender
11% Fixed
LIBOR
SinkingFund
At refinancing
Net for Goodrich:•Net is fixed 11.5% + x•This is better than BFG could do by itself
Net for Underwriter:•Net flows are zero•Gains fees, future opportunities, & goodwill
Caps
PremiumClient UnderwriterToday
*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year
Illustration of a 7% Interest Rate Cap on LIBOR
Max[(LIBOR – 7%), 0]
UnderwriterLater* Client
Floors
PremiumClient UnderwriterToday
*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year
Illustration of a 3% Interest Rate Floor on LIBOR
Max[(3% – LIBOR), 0]
UnderwriterLater* Client
Collars
PremiumClient UnderwriterToday
*Payments are made periodically (say, monthly or quarterly) over the life of the contract, with rates appropriately adjusted for the number of periods per year
Illustration of a 3,7 Collar on LIBOR
Max[(LIBOR – 7%), 0]+ Max[(3% – LIBOR), 0]
UnderwriterLater* Client
Another Approach to Yield Curve
Bond A• No coupon• 6 months to maturity• Price: $98.52
• Yield: 3%
Bond B• 3% coupon (2 pmts/yr)
• 1 year to maturity• Price: $99.52
Let’s use this information to find pure one-year rate implied in the second bond
• 1st payment is $1.50
• 6-month rate is 3%• PV is $1.48
• Final payment: $101.50
• Cost is $99.52 – $1.48 • = $98.04
Implied one-year rate is 3.5% APR (2 P/YR)
Finding the Yield Curve
Simplified:
0 1 2
Start: $99.52 $1.50 $101.50
Net: $98.04 0 101.50
Implied one-year rate is 3.5% APR (2 P/YR)
$1.48 $1.50
Another Approach to Yield Curve
Background data:• 6-month rate: 3%• 1-year rate: 3.5%
Bond C:• 3% coupon• 18 months to maturity• Price: $99.10
Let’s use this information to find pure 18-month rate implied in the second bond
• 1st pmt has PV $1.48
• 2nd pmt has PV $1.45
• Final payment: $101.50
• Cost is $99.10 – $1.48 – $1.45 = $96.17
Implied 18-month rate is 3.63% APR (2 P/YR)
Finding the Yield Curve
Simplified:
Implied 18-month rate is 3.63% APR (2 P/YR)
$1.48 $1.50
0 1 2 3
Start: $99.10 $1.50 $101.50$1.50
Net: $96.17 0 101.500
$1.45 $1.50
Another Approach to Yield Curve
Background data:• 6-month rate: 3%• 1-year rate: 3.5%• 18-month rate: 3.63%
Bond D:• 3% coupon• 2 years to maturity• Price: $98.67
Let’s use this information to find pure two-year rate implied in the second bond
• 1st pmt has PV $1.48
• 2nd pmt has PV $1.45
• 3rd pmt has PV $1.42
• Final payment: $101.50
• Cost is $98.67 – $1.48 – $1.45 – $1.42 = $94.32
Implied 2-year rate is 3.70% APR (2 P/YR)
Finding the Yield Curve
Simplified:
Implied 2-year rate is 3.70% APR (2 P/YR)
$1.48 $1.50
0 1 2 3
$1.45 $1.50
4
Start: $98.67 $1.50 $101.50$1.50 $1.50
Net: $94.32 0 101.500 0
$1.42 $1.50
Deriving Implied Forward Rates
Bond A• No coupon• 6 months to maturity• Price: $98.52
• Yield: 3%
Bond B• 3% coupon• 1 year to maturity• Price: $99.52 • Yield: 3.49%
Deriving Implied Forward Rates
NYtoday
$101.01
$101.50
$99.52
$1.50
Implied forward rate is 4% APR (2 P/YR)
3.00%NY
6 mos
4.00%
3.49%NY
1 year
Netreceipt$99.51
• Sell a one-year bond• Invest $99.52 for 6
months at 3%
Lock in a future loan
Bond A:• 3% coupon• 1 year to maturity• Price: $99.52
Bond B:• 3% coupon• 18 months to maturity• Price: $99.10
Buy a one-year bond and sell an 18-month bond
Net payment $99.52 - $99.10 = $0.42
In 6 months:• Receive: $1.50
• Pay: $1.50
• Net zero
In 1 year:• Receive: $101.50
• Pay: $1.50 • Net $100
Paid $0.42 to contract a $100 loan in 1 year at 3% APR
In 18 months:• Pay: $101.50
Lock in a future loan
Buy $99.52 $1.50 $101.50
0 1 2 3
Net $0.42 0 $100 $101.50
Sell $1.50$99.10 $ 1.50 $ 101.50
Paid $0.42 to contract a $100 loan in 1 year at 3% APR
PENsS
CP
ER
S
BT
Cou
nte
rpar
ty
PE
FC
O
$5 mm
$5mm + Appreciation
1% Coupon Fixed Undisclosed Flow
AppreciationAppreciation
What happens to Tokyo Index?
Nikkei Put Warrants (Bringing innovation to retail)
Gol
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Opt
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Pre
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Cou
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Alternative PlanS
CP
ER
S
BT
PE
FC
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$5mm + App
1% Fixed
App
Flow
App
Gol
dm
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s
PriceFlow
Dep DepKin
gdom
of
Den
mar
k
Pu
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Dynamic Hedge
Volatility
MARKETING
Capital AdequacyCapital Adequacy
Will It Meet Competitive Requirements in a Virtual Space with Tomorrow’s Financial Services Dominators?
INNOVATION HUMANCAPITAL
Credit QualityCredit QualityLiquidityLiquidity
ENTERPRISERISK
MANAGEMENT
Bank of the FutureBank of the Future
Foundations & Structure
VISION(PLANNING
&STRATEGY)
COSTTRACKING& PRICING
Relationships & CapabilitiesRelationships & Capabilities
Market Timing for Bonds
• The basic idea of market timing is to get into the market before it rises and get out before it falls– Translation:
• Long duration in advance of falling interest rates• Short duration in advance of rising interest rates
• Extreme market timing– Very long duration in advance of falling interest rates– Very long negative duration in advance of rising interest rates
Basic Bond Market Timing
• So, if you hold a portfolio of bonds worth $1,000,000 (duration 15 years) and you think you can predict ups and downs of interest rates, do the following:– When you think the rate is about to fall, hold the
portfolio without any position in the bond futures, so duration is 15 years
– When you think the rate is about to rise, continue to hold the portfolio while selling $1,000,000 worth of the bond futures, so duration is near 0
Immunization
• Immunization might be appropriate for a bank with the following – Asset portfolio has average duration of 10 years– Liability portfolio has average duration of 1 year
• Immunization would use the same techniques as market timing strategies in order to– Shorten the duration of the asset portfolio– Adjust the duration of the liability portfolio so they
are both nearly the same