Enterprise Risk Analytics for Capital Markets: Proactive and Real-Time Risk Management

ENTERPRISE RISK ANALYTICS FOR CA PITAL MARKETS

PROACTIVE AND REA L-TIME RISK MANAGEMENT

Copyright © 2014 Raghurami Reddy Etukuru.

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ISBN: 978-1-4917-4491-8 (e)

ISBN: 978-1-4917-4492-5 (sc)

Library of Congress Control Number: 2014916842

iUniverse rev. date: 10/9/2014

Contents

1   About the Book

2   Financial Products Explained

2.1   Bonds

2.1.1   Zero-Coupon Bonds

2.1.2   Step-Up Bonds

2.1.3   Step-Down Bonds

2.1.4   Callable Bonds

2.1.5   Puttable Bonds

2.1.6   Step-Up Bonds with Call Option

2.1.7   Step-Down Bonds with Put Option

2.1.8   Convertible Bonds

2.1.9   Treasuries

2.1.10   Index-Linked Bonds

2.1.11   Floating-Rate Notes

2.1.12   Inverse Floating-Rate Notes

2.1.13   Indexed Amortizing Notes

2.1.14   Interest-Differential Notes

2.2   Derivatives

2.2.1   Options

2.2.2   Forwards

2.2.3   Futures

2.2.4   Swaps

2.2.5   Combinations

2.3   Equity Derivatives

2.3.1   Equity Options

2.3.2   Exotic Options

2.4   Option Strategies

2.4.1   Covered Call

2.4.2   Protective Put

2.4.3   Simple Math on Option Combos

2.4.4   Straddles

2.4.5   Strangles

2.4.6   Condors

2.4.7   Vertical Spreads

2.4.8   Butterfly Spreads

2.4.9   Equity Swaps

2.5   Interest-Rate Derivatives

2.5.1   Interest-Rate Options

2.5.2   Interest-Rate Swaps

2.5.3   Interest-Rate Swaptions

2.5.4   Forward Rate Agreements

2.5.5   Interest-Rate Futures

2.6   Foreign Exchange Derivatives

2.6.1   Fx Forward

2.6.2   Fx Futures

2.6.3   Fx Options

2.6.4   Cross Hedging with Forwards

2.6.5   Cross-Currency Swaps

2.7   Credit Derivatives

2.7.1   Asset Swaps

2.7.2   Credit Default Swaps

2.7.3   Nth-to-Default Baskets

2.7.4   Contingent Credit Default Swaps

2.7.5   Total Return Swaps

2.7.6   Credit Linked Notes

2.7.7   Credit Spread Options

2.8   Repo-Style Transactions

2.8.1   Repos

2.8.2   Reverse Repos

2.8.3   Tri-Party Repos

2.8.4   Security Finance Transactions

2.9   Commodities

2.9.1   Structure of the Commodity Market

2.9.2   Pricing of Commodity Futures

2.9.3   Market Conditions

2.10   Securitized Products

2.10.1   Securitization Process

2.10.2   Mortgage-Backed Securities

2.10.3   Asset-Backed Securities

2.10.4   Collateralized Debt Obligations

2.10.5   Asset-Backed Commercial Paper

2.11   Other Derivatives

2.11.1   Property Derivatives

2.11.2   Operational Risk Derivatives

2.11.3   Weather Derivatives

2.12   Financial Markets and Data Explained

2.12.1   Trade Life Cycle

2.12.2   Financial and Risk Data

3   Fundamentals of Quantitative Finance

3.1   Statistical Measures

3.1.1   Mean, Median, and Mode

3.1.2   Standard Deviation

3.1.3   Skewness

3.1.4   Kurtosis

3.1.5   Covariance

3.1.6   Correlation Coefficient

3.1.7   Beta

3.1.8   Alpha

3.1.9   Treynor Ratio

3.1.10   Sharpe Ratio

3.1.11   Sortino Ratio

3.1.12   D-Statistic

3.1.13   Omega

3.1.14   Limitations of Statistical Measures

3.2   Probability Distributions

3.2.1   Normal Distribution

3.2.2   Lognormal Distribution

3.2.3   Poisson Distribution

3.2.4   Student’s T-Distribution

3.2.5   Chi-Square Distribution

3.3   Equity Option Quantitative Models

3.3.1   Black-Scholes Model

3.3.2   Greeks Explained

3.4   Quantitative Concepts of Bonds

3.4.1   Duration

3.4.2   Convexity

3.5   Interest Rate Models

3.5.1   Rate Curves

3.5.2   Vasicek Model

3.5.3   Cox-Ingersoll-Ross Model

3.5.4   Heath-Jarrow-Morton Model

3.5.5   Brace-Gatarek-Musiela Model

3.5.6   Markov Process

3.6   Hedging Principles

3.7   Quantitative Strategies

3.7.1   Long/Short Equity

3.7.2   Relative-Value Arbitrage

3.7.3   Convertible Arbitrage

3.7.4   Bond Strategies

3.7.5   Volatility Arbitrage Strategy

4   Market Risk Analytics

4.1   VaR Measurement Methodologies

4.1.1   Parametric Approaches

4.1.2   Historical Simulation Approaches

4.1.3   Monte Carlo Simulation

4.2   Application of VaR Models to Various Portfolios

4.2.1   Marginal VaR

4.2.2   Incremental VaR

4.2.3   Component VaR

4.2.4   Annualizing the VaR

4.3   Advantages and Shortcomings of Value-at-Risk

4.3.1   Coherent Risk Measures

4.3.2   Disadvantages and Alternatives

4.4   Alternatives to Value-at-Risk Models

4.4.1   Conditional VaR (ETL and ES)

4.4.2   Extreme Value Theory

4.4.3   VaR with Cornish-Fisher Formula

4.4.4   VaR for Leptokurtic Distribution

4.5   Scenario Analysis and Stress Testing

4.6   Regime-Switching Analysis

4.6.1   Regime-Switching Models

4.7   Valuation Models

4.8   Correlation Risk

4.8.1   Correlation Breakdown in Commodities

4.9   Sources of Market Risk: Macroeconomic Factors

4.10   Contagion Risk and Interconnectedness

4.10.1   1992 European Currency Crash

4.10.2   1997 Asian Currency Crisis

4.11   Model Risk Management

4.11.1   Controlling Model Risk

4.12   Market Risk Measurement Under Basel III

4.12.1   VaR-Based Capital Requirement

4.12.2   Stressed VaR-Based Measure

4.12.3   Specific Risk

4.12.4   Incremental Risk

4.12.5   Comprehensive Risk

4.12.6   Standardized Measurement Method for Specific Risk

5   Counterparty Credit Risk Analytics

5.1   Basic Metrics of Counterparty Credit Risk

5.1.1   Mark-to-Market Value

5.1.2   Exposure at Default

5.1.3   Potential Future Exposure

5.1.4   Maximum PFE

5.1.5   Expected Exposure

5.1.6   Effective Expected Exposure

5.1.7   Expected Positive Exposure

5.1.8   Effective Expected Positive Exposure

5.1.9   Effective Maturity

5.1.10   Probability of Default

5.1.11   Recovery Rate or Loss Given Default

5.1.12   Collateral

5.1.13   Rehypothecation

5.1.14   Haircut

5.2   Advanced Concepts of Counterparty Credit Risk

5.2.1   Wrong-Way Risk

5.2.2   Credit Value Adjustment

5.2.3   Debt Value Adjustment

5.2.4   Funding Value Adjustment

5.2.5   Cross Gamma

5.3   Managing Counterparty Credit Risk

5.3.1   ISDA Master Agreement

5.3.2   Single Agreement

5.3.3   Netting of Payments

5.3.4   Cross-Product Netting

5.3.5   Close-Out Netting

5.3.6   Terminations

5.3.7   Walkaway Features

5.3.8   Multilateral Netting

5.3.9   Deliverables

5.3.10   Collateral Management

5.3.11   Credit Support Annex

5.3.12   Margin Calls

5.3.13   Collateral Threshold

5.3.14   Collateral Disputes

5.3.15   Credit Limits

5.3.16   Concentrations

5.3.17   Stress Testing

5.3.18   Central Counterparties

5.3.19   CVA Desk

5.3.20   CVA VaR

5.3.21   Significant Changes Under Basel III

6   Liquidity Risk Management

6.1   Understanding Liquidity Risk

6.2   Characteristics of Liquidity Risk

6.3   Historical Scenarios of Liquidity Risk

6.3.1   LTCM and Liquidity Risk

6.3.2   MGM and Liquidity Risk

6.3.3   Year 2007 and Liquidity Risk

6.4   How Hedge Funds Manage Liquidity Risk

6.5   Modeling Liquidity Risk

6.6   Sources of Liquidity Risk

6.6.1   Firm-Specific Sources

6.6.2   Customer-Driven Transactions

6.6.3   Systemic Risk

6.7   Effective Liquidity Risk Management for Banking

6.7.1   Corporate Governance

6.7.2   Cash-Flow Projections

6.7.3   Maturity Gap Analysis

6.7.4   Monitoring the Quality of Products

6.7.5   Monitoring Collateral and Margins

6.7.6   Monitoring Wrong-Way Risk

6.7.7   Liquidity Across Currencies, Legal Entities, and Business Lines

6.7.8   Intraday Liquidity Position Management

6.7.9   Imposing Limits

6.7.10   Liquidity Cushion

6.7.11   Early-Warning Indicator System

6.7.12   Funding-Source Diversification

6.7.13   Contingency Funding Plan

6.7.14   Stress Test

6.8   Liquidity Risk Under Basel III

6.8.1   Liquidity Coverage Ratio

6.8.2   Net Stable Funding Ratio

6.8.3   Monitoring Tools and Metrics

7   Risk Data Aggregation and Reporting

7.1   BCBS Principles for Effective Risk Data Aggregation

7.2   Analysis of BCBS Principle on Data Governance

7.3   Analysis of BCBS Principle on Data Architectures

7.4   Analysis of BCBS Risk Data Aggregation Principles

7.5   Analysis of BCBS Principles on Risk Reporting Practices

7.6   Analysis of BCBS Supervisory Review, Tools, and Cooperation

8   Information and Risk Architectures

8.1   Governance Program

8.1.1   Chief Data Officer

8.1.2   Data Steward

8.1.3   Data Custodian

8.1.4   Data Architect

8.1.5   Metadata Manager

8.1.6   Data Quality Manager

8.1.7   Data Privacy Officer

8.1.8   Internal Data Auditor

8.2   Information Architectures

8.2.1   Enterprise Data Architecture

8.2.2   Effective ETL with Big Data Technologies

8.3   In-Memory Analytics and Real-Time Risk Calculations

8.4   Market Risk Analytics

8.5   Managing Counterparty Risk with Big Data

8.5.1   The CVA Desk

8.5.2   How Does the CVA Desk Work?

8.5.3   Counterparty Credit Risk Management

8.6   Liquidity Risk Analytics with Big Data

8.6.1   Enterprise Data Management

8.6.2   Interaction Between Collateral Management and Liquidity Risk

8.7   Sovereign and Country Risk

8.7.1   Internal Evaluation Models

8.7.2   External Evaluation Models

8.7.3   Implied Sovereign Risk Model

8.7.4   Implied Country Risk in Market Prices

8.8   Operational Risk

8.8.1   Measuring Operational Risk

9   Glossary

1   About the Book

Traditionally, risk management has been about looking for negative information after a decision has been made and reacting to negative events. Now risk management is maturing, and financial institutions are realizing that risk management must be integrated with business strategy. Traditional risk management relied heavily on quantitative models. While it is true that quantitative models are helpful for analyzing data quickly and detecting patterns, the effectiveness of the model depends on how and where it is used.

Quantitative models have been in use for several centuries. In physics, chemistry, engineering, and other fields, they have proven to be stable. When it comes to financial engineering, however, what drives the stability of the quantitative model is the needs of people. For example, a quantitative model developed to forecast the price of real estate in one place might not work in another place, as there are macroeconomic factors involved that are driven by human behavior.

The aftereffect of the wrong model is critical in the financial world. If the weather forecast says that there will be snowfall in the next two days and it doesn’t snow, there will be no significant impact. If a forecast goes wrong in financial engineering, however, the impact will be heavy, causing other problems that can spiral out of control.

One of the main factors fueling such a crisis is the way data is maintained and analyzed. Though in the past it was possible to analyze data proactively and predict a crisis, it was not done. The quantitative models implemented by financial institutions have their own firewalls that restrict thinking to the broadest terms. Silo-based risk management failed to examine the connectedness among various investment strategies, departments, organizations, and countries. Quantitative financial models must be designed to use qualitative data and plug in the relationships among various instruments.

Risk management should become more proactive and real-time to influence investment decision making. Such changes require not only aggregated data but also faster processing. Managing risk, discovering prices, preventing fraud, following industry trends, processing derivatives, dealing with increased regulation, and providing granular reporting to regulators all demand new ways of storing and analyzing data.

Portfolios are sensitive to variations in interest rates, currencies, econometrics, catastrophic events, consumer confidence, and commodity prices, among other factors. Calculating the profit or loss of the portfolio for the past few days and making the assumption that we will probably see those levels in the coming few days is not enough anymore. It is necessary to simulate portfolio valuations across thousands of scenarios based on thousands of risk factors and to aggregate the results across all scenarios for each risk factor. This requires a huge volume of market data, qualitative data, and historical performance of various positions. This in turn requires an infrastructure that can read and process such data efficiently and generate the required analytics. The existing data warehouse infrastructures for external market data and internal data will have to go through several phases of change.

Market data, historical performance of positions, and contract terms and conditions belong to the category of structured data. This data is not enough to base decisions on. Much of the information about current market conditions, associated countries, counterparties, currencies, and opinions expressed in social media are only available in an unstructured format. Such information must be processed and structured into analytics engines to deliver pre-deal risk-reward metrics—such as CVA (Credit Valuation Adjustment), funding costs, and capital charges—that capture a variety of products, risk relationships, and scenarios.

The next big challenge after gathering this huge volume of data is processing that data quickly. Well-integrated hardware and software approaches are needed to meet end-user demands for analytics to deliver the required risk insights within the appropriate time frame of seconds, minutes, or hours. The level of demand for higher-quality information depends on the nature of the data. The trader may want to analyze the entire set of data and derive a conclusion before the trade is entered into the system, in which case the allowed time range expands from nanoseconds to microseconds.

Another example is rank-ordering trades with an individual counterparty by their standalone exposure or their CVA before placing a trade with a counterparty; the aggregated data for a regulatory report would need to be collected, processed, and stored in less than an hour, on a daily basis. Huge artifacts of data stored on disks and read/write hardware are the bottlenecks in this process, but that can be overcome to some extent by in-memory analytics.

Regulations like Basel III and Dodd-Frank require banks to track a trade’s history and lineage and all events around it. This adds another dimension of governance risk and compliance in capital markets. Regulators are also becoming more stringent on what practices are acceptable, and reporting must prove that banks are following regulatory guidelines. For example, a big issue in capital markets is the shrinking liquidity of the CDS (credit default swap) market, which makes it more challenging to price credit risk into trades via measures like CVA. It is becoming more difficult to get regulators to accept hedges on the CVA capital charge, since the hedge must be 1:1 and cannot be from a proxy name. 

Risk management practices must evolve from the current state to enterprise risk management. ERM does not mean simply pulling all the data into aggregated stores and generating various reports. It must be capable of analyzing the interconnectedness of various risk factors across asset classes and regions. Traditional risk management was capable of providing post-trading negative information that in turn could help avoiding the risk. However, risk management is not about avoiding risk. Avoiding risk will lead to loss of business opportunities. Risk management must be transformed into something that really manages risk instead of avoiding it.

ERM must be capable of redefining the value proposition of risk management by elevating its focus from the tactical to the strategic. It must be able to add value to the business strategy. ERM is about designing and implementing capabilities for managing the risks that matter. In my opinion, the following components are essential to ERM’s effectiveness:

• risk knowledge

• risk quantification

• risk data management

• risk data aggregation

• risk architectures

• risk analytics and reporting

• risk regulation

• risk culture

This book is designed to bring these eight components (scattered across various chapters) to the attention of the professional who has just started in risk management or wants to enter the field.

2   Financial Products Explained

A financial instrument is an electronic or physical document that represents monetary value. It is the written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. Financial instruments are designed to deliver value to both buyer and seller. They play a key role in the flow of capital among institutions and investors.

A customer buying a CD (certificate of deposit) from a bank, for example, receives a certificate. The certificate carries value to the buyer for its lifetime. The bank typically agrees to pay the money back to the customer after a predetermined time and also pay interest on the principal. Upon maturity, the customer receives the principal and interest. A CD is therefore classified as an instrument.

Other examples of financial instruments are stocks, bonds, and ETFs (exchange-traded funds). Financial instruments are intangible assets. For example, a gold coin is tangible, so it is not listed as a financial instrument, but the gold ETF is a financial instrument.

2.1   Bonds

Corporate structure is comprised of two things: equity and debt. Both the equity and the debt are sliced into smaller pieces to improve the liquidity of funding. Equity slices are called stocks and debt slices are called bonds. Bonds are issued for a few months to a few years. The issuer pays a specified rate of interest during the life of the bond and repays the face value of the bond at maturity. The buyer of the bond is nothing but a lender or investor.

For example, let’s say that XYZ Inc. is planning to expand its business by raising $100 million in capital by issuing bonds. It plans to return the loaned capital in ten years. In this case, it issues one million bonds for $100 each. It pays interest of 5 percent (for example) annually. Every six months, it pays a coupon of $2.50, and at the end of the tenth year, it pays $102.50 ($100 principal plus the last coupon).

The issuing value of $100—called face value or par value or principal—is the amount of money the bondholder will get back at the end of the maturity period. The face value may differ from the amount the bond buyer pays to buy the bond. If the buyer is buying the bond from the issuer at the time of issuance, the purchase value may be the same as the face value. But the bond price may go up or down after issuance because of fluctuations in interest rates or the credit quality of the issuer.

Assume that the buyer purchased a bond at the time of issuance at face value and is receiving a 6 percent annual coupon. Let’s assume the interest rates go down to 3 percent after a year. Newly issued bonds will typically pay around 3 percent, but an investor who purchases previously issued bonds, which are paying 6 percent, will continue to receive 6 percent interest even if market interest has fallen. However, the holder of a 6 percent bond will demand more than face value for the bond. For simplicity, assume that the investor pays $102. In this case, $102 is called the bond price. Similarly, if interest rates go up after issuance, the bond price goes down. Bond prices are inversely related to interest rates—if the credit quality of the issuer improves after the issuance, the bond price will go up, and vice versa.

Bonds can be customized based on certain features to fulfill the needs of investors and issuers. For example, an investor may think that interest rates will rise over time and so prefer to receive a coupon proportionate to market interest rates; or an issuer may want to withdraw the bond in the middle of the life of the bond. A variety of types are available in the bond market, and each has advantages and disadvantages to both the investors and issuers.

2.1.1   Zero-Coupon Bonds

A zero-coupon bond, also called a discount bond or zero bond, does not pay regular interest payments. Instead, the investor buys the bond at a steep discount price—that is, at a price lower than face value. At the time of maturity, bondholders will receive the face value of the bond. For example, a bond with a face value of $100 may be issued at $90 for the duration of two years. At the end of the two years, bondholders will get $100, implying an interest income of $10 per two years or $5 per year. The implied interest rate is (10/90)/2 = 5.5 percent.

Larger investors or dealers who have bought bonds may be receiving bulk coupons periodically. Such an investor may choose to separate coupons from the principal of the bond, which is known as the residue, so that he can sell them to different investors as zero-coupon bonds. Or a particular entity may need cash for the short term—say, six months—and therefore issue zero coupons.

2.1.2   Step-Up Bonds

Step-up bonds have coupon payments that increase (step up) over the life of the security according to a predetermined schedule. In the case of one-step bonds, the coupon will reset once during the life of the bond; with multistep bonds, the coupon will reset multiple times. The initial coupon paid on a step-up is usually lower than comparable market rates, and the step-up may eventually increase its future coupon payments and even yield higher than prevailing market rates. The step-up bondholder chooses to forgo some interest income in the near term in exchange for a potential higher yield over the life of the investment.

2.1.3   Step-Down Bonds

Step-down bonds have coupon payments that decrease (step down) over the life of the security according to a predetermined schedule. In the case of one-step bonds, the coupon will reset once during the life of the bond; with multistep bonds, the coupon will reset multiple times. The initial coupon paid on a step-down is usually higher than comparable market rates, and the step-down may eventually decrease its future coupon payments and yield less than prevailing market rates.

2.1.4   Callable Bonds

Bonds are usually issued with a specific maturity, but callable bonds have the provision that they can be redeemed by the issuer prior to maturity. A callable option gives the issuer the flexibility of withdrawing the bond prior to maturity, but it usually comes with a premium paid to the bond owner, either when the bond is called or in terms of interest rate.

Let’s take the simple example of a home loan. When you take out a fixed-rate mortgage to buy a house, you usually have the option of prepaying the mortgage either by refinancing or paying down fully. You might refinance the mortgage because interest rates have gone down and you want a cheaper loan. All US mortgage loans come with embedded prepayment options, and no additional premium is required. Bond issuers, however, don’t have such a provision by default. They must issue bonds with an embedded call option.

Investors who purchase callable bonds take a chance that an issuer may redeem them prior to the stated maturity date, typically when interest rates are low. If the bonds are called, investors may have to reinvest the proceeds at lower coupon rates. To compensate investors for the reinvestment risk and unknown final term, callable bonds generally offer higher yields than noncallable alternatives.

The three most common callable features are American, callable on any date, usually with thirty days notice; European, callable only at one specific future date; and Bermudan, callable only on interest-payment dates.

2.1.5   Puttable Bonds

Just as the issuer of a callable bond has the flexibility of withdrawing the bond from market when interest rates go down, the bondholder may also want to put the bond back to the issuer when interest rates go up or when the issuer’s credit quality is trending down. Puttable bonds are considered investor-friendly. The same concept of premium applies to puttable bonds as to callable bonds, but in this case bondholders pay a premium, in lower coupon rates or at the point of putting it back.

2.1.6   Step-Up Bonds with Call Option

As discussed in 2.1.2, step-up bonds pay gradually increasing coupons. The risk to the issuer is that the coupon rate may rise above comparable rates over time. To mitigate such a risk, the issuer sometimes embeds a call option. The risk to the bondholder is that the bond is more likely to be called back by the issuer before the maturity date. As a result, the bondholder will not be able to enjoy the higher coupon payments.

Step-up securities are typically structured so that they are callable by the issuer at any interest payment date on or after the first step-up date. Some step-up securities have been issued so that they are continuously callable after the first step-up date, meaning they can be called at any time, not just on the payment dates.

2.1.7   Step-Down Bonds with Put Option

Since the bondholder has the risk of receiving lower interest rates in the future, buyers of step-down bonds prefer to have a put option so that they can put the bond back to the issuer if they start receiving coupons lower than prevailing market rates.

2.1.8   Convertible Bonds

Firms issue bonds to raise capital. But certain firms—such as early-stage companies, companies with a high potential for growth but poor credit, or established companies with weak financial health—may not be able to raise the capital in the bond market or will have to offer higher coupons to do so. At the same time, those companies may not want to issue additional stocks, as it would dilute the earnings of existing stakeholders. Such companies often issue convertible bonds, which give the investor the right to convert the bonds into common stock in the future. The right to convert the bond into common stock can be interpreted as the issuer implicitly selling the call option to the investor to purchase the issuer’s stock. This option reduces the coupon payment on the convertible bond.

Convertible bonds have two components: a bond and an equity option. The option also acts as a long put on the bond, as the investor can put the bond back to the issuer with an exchange of stock. In this case, stock price acts as exercise price.

The convertible-bond market is considered to be high-risk, as firms with noninvestment credit ratings or emerging firms issue most of the convertible bonds. Since many institutional investors have constraints against investing in these issuers, the liquidity of the convertible bond market is not so attractive. As a result, convertible bonds are undervalued.

2.1.9   Treasuries

Treasury securities, or simply Treasuries, are backed by the full faith and credit of the US government, and thus by its ability to raise tax revenues and print currency. Treasuries are generally considered to be the safest of all investments. They are viewed in the market as having virtually no credit risk, meaning it is highly probable that the interest and principal will be paid fully and on time. Treasures are divide into three types—bills, notes, and bonds—depending on term.

Bills

Treasury bills are short-term instruments with maturities of no more than one year. They can be used to hold investors’ money so that they will be able to access it quickly as needed. The Treasury bill market is considered to be highly liquid, as investors can quickly convert bills to cash through a broker or bank.

Like zero-coupon bonds, Treasury bills do not pay periodic interest payments. Investors buy bills at a discount from the par or face value and then receive the full amount when the bill matures. The difference between the amount paid and amount received is the interest earned. Treasury bills play a key role in liquidity risk management that will be covered in forthcoming sections.

Notes

Treasury notes are intermediate- to long-term investments, typically issued in maturities of two, three, five, seven, and ten years. These are typically purchased for specific future expenses, such as college tuition, or used to generate cash flow during retirement. Interest is paid semiannually.

Bonds

Treasury bonds cover terms of longer than ten years and are currently being issued in maturities of thirty years. Interest is paid semiannually. Although Treasury bonds are considered to have very low credit risk, other types of risk—mainly interest-rate risk and inflation risk—do affect them.

Investors are effectively guaranteed to receive interest and principal payments as promised, but the underlying value of the bond itself may change depending on the direction of interest rates. As with all fixed-income securities, if interest rates in general increase after a US Treasury security is issued, the value of the security will fall, since bonds paying higher rates will come into the market. Similarly, if interest rates fall, the value of the older, higher-paying bond will increase in comparison with new issues.

Newly or most recently issued bonds are called on-the-run and old ones are called off-the-run. Because on-the-run issues are traded most frequently, they provide the most liquidity and therefore typically trade at a slight premium. Some trading strategies successfully exploit this price differential through an arbitrage strategy that involves selling or shorting on-the-run Treasuries and buying off-the-run Treasuries.

2.1.10   Index-Linked Bonds

Inflation risk is a potential problem for many investors. If the inflation rate is higher than the coupon rate being received on a bond, it diminishes the purchasing power of the consumer. Inflation makes a dollar today worth more than a dollar tomorrow, even after ignoring the opportunity cost. Some investors—especially those who are managing inflation-related funds—or individuals who defer the purchase of certain products to the future prefer coupon or principal or both to be linked to the inflation index.

Inflation, however, is just one index. Bond payments can be linked to numerous indexes, including GDP (gross domestic product), consumer price index (CPI), earning measures, and foreign exchange rates. The need for index linkage depends on the type of business with which the investor is involved.

Treasury inflation-protected securities (TIPS) protect investors from inflation risk. The US Treasury created these inflation-indexed notes just for this purpose. The value of the principal is adjusted to reflect the effects of inflation with the CPI as a guide, in addition to a fixed rate of interest. At maturity, if inflation has increased the value of the principal, the investor receives the higher, adjusted value back. If deflation has decreased the value, the investor nevertheless receives the original face amount of the security.

2.1.11   Floating-Rate Notes

Bond investors purchase bonds to earn interest that matches the market interest rates. However, prevailing market interest rates can vary from time to time. Floating-rate notes (FRNs) protect investors from fluctuations in interest rates. The coupon is linked to a specific index, such as the London Interbank Offered Rate (LIBOR). The interest is set for a certain period, typically three months, at the end of which it is reset.

Additional terms can also be added to the note, including when, where, and at what interest the rate can be reset. For example, a floor specifies the minimum level below which the coupon cannot fall; a cap specifies the maximum rate above which the rate cannot be reset; and dates specify possible redemption dates.

2.1.12   Inverse Floating-Rate Notes

Inverse floating-rate notes are just the opposite of FRNs. While FRNs are good when interest rates are trending upward, they are not favorable in declining periods. An inverse floater pays a coupon that increases as prevailing market rates decline. Inverse floaters can be linked to any reference index.

Let’s say the borrower agreed to pay 15 percent minus (2 × LIBOR). Each time the LIBOR resets, the new coupon is calculated using the above formula. If the LIBOR is 3 percent at the inception, then the investor gets 9 percent per annum at the end of the first quarter of the life of the bond. If LIBOR is 2 percent at the end of the quarter, the investor gets 11 percent at the end of the second quarter.

Like FRNs, inverse floaters have additional features, such as caps and floors. For example, if the calculated coupon falls below 6 percent of the floor, the investor will continue receiving 6 percent.

2.1.13   Indexed Amortizing Notes

In regular bonds, the full principal is paid at the end of maturity, while the coupon can be either fixed or floating for a certain period. Indexed amortizing notes pay the specified coupon for a certain period called a lockout period and gradually pay down the principal from there on. For example, a $100 million bond on which it is agreed to pay a 5 percent coupon for three years will start paying down a certain portion of the principal every six months after the end of three-year lockout time. During the period of principal paying-down, the borrower pays the interest that is linked to a certain index, such as LIBOR.

These are called indexed amortizing notes because the principal pay-down is amortized based on a certain index. There are two flavors of maturities: one is a lockout period during which the principal is stable, and the other is actual maturity, before which the final schedule of principal is paid. For example, a $100, three-year lockout, twenty-five-year maturity bond pays a coupon on $100 for the first three years and $25 plus accrued interest for every six months after three years.

2.1.14   Interest-Differential Notes

IDNs are designed to pay the difference between interest rates in two countries or currencies. Investors use these bonds to take advantage of higher rates in other countries without actually investing in that country, thus avoiding the exchange-rate risk.

For example, let’s assume interest rates in Country A and Country B are 4 percent and 5 percent respectively. That means a bond issued in Country B yields 25 percent higher than a bond issued in Country A. If an investor from Country A invests in Country B, he will have to convert the currency into Country B’s currency and again convert back to home currency at the maturity. If at the end of one year—the time of repatriation—the currency of Country A depreciates by 25 percent of the original value, the investor will gain no net benefit.

In order to avoid currency risk, investors can buy IDNs, which will pay the difference in interest rates, such as 1 percent.

2.2   Derivatives

A derivative is a financial contract the value of which is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, and equity prices. While most derivative transactions do not involve the exchange of underlying assets, certain derivative contracts dealing with currencies do involve such an exchange. Derivative transactions include options, forwards, futures, swaps, caps, floors, collars, and various combinations thereof.

Derivatives are meant for hedging and risk-transfer purposes. However, there are situation where investors can make a profit with little investment by applying derivatives or derivative strategies.

2.2.1   Options

An option is a derivative that represents a contract sold by one party to another party. The contract offers the buyer the right, but not the obligation, to buy or sell an asset at an agreed-upon price called the strike price during a certain period of time or on a specific date called an exercise date. Here the seller is called an option writer and the buyer is called an option holder.

Depending on whether the privilege is to buy or sell an asset, there can be options: a call option, which gives the holder the option to buy an asset at a certain price on or before a certain date, and a put option, which gives the holder the option to sell an asset at a certain price on or before a certain date.

The underlying asset in an option can be any allowed financial asset, such as a stock or interest rate. To buy an option, the buyer pays the premium. The buyer gets the benefit only if the contract value rises beyond the premium. If the value of the asset in the contract is reached, the strike price is called an at-the-money option to the buyer. If the value rises above the strike, then it is called an in-the-money option. If the value is below the strike price, it is called an out-of-money option.

2.2.2   Forwards

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. In a forward contract, the seller is obligated to sell the asset and the buyer is obligated to buy it as per the agreement, whereas in an option contract, the holder of the option has the option to buy or sell but is not obligated to do so. The following are the main features of the forward contract:

• There is an agreement to buy or sell the underlying asset.

• The transaction takes place on a predetermined future date.

• The price at which the transaction will take place is predetermined.

For example, suppose a food company is foreseeing that the demand for its products will be high in next six months. At the same time, it also foresees that the price of the raw material (wheat, for example) will also go up. The company thinks that it is not economical to buy and store the wheat because of the incurred storage costs. It will enter a forward agreement with farmers to buy X quantity of wheat at price Y on date Z. On that day, the farmer is obligated to sell X quantity of wheat at price Y. At the same time, the food company is obligated to buy as per the terms.

Even if market rates are low, the buyer is obligated to buy at an agreed-upon price. Similarly, even if market rates are higher, the seller is obligated to sell at an agreed upon price. There are various contract terms, such as quality of material, delivery location, and delivery mode.

Let’s consider another example. Suppose the farmer is expecting the crop in the next four months, and he foresees that the prices may go down by the time the crop is ready. He will enter a forward contract with the buyer to sell X amount of crop at Y price on Z date. On date Z, the farmer is obligated to sell as per the agreement, whereas the other party is obligated to buy the same.

2.2.3   Futures

Future contracts are similar to forward contracts. The difference is that forward contracts are bilateral, meaning buyer and seller can design the contract terms. Future contracts are executed on future exchanges, and both the buyer and seller need to obey the terms and conditions set by the exchange. Value to the buyer or seller is calculated on a daily basis, and the difference must be deposited with the exchange.

For example, let’s say that a farmer enters a future contract to sell 1,000 pounds of wheat at $1 per pound on a certain date in future—say, in three months. On the next day, the price of wheat goes up to $1.10/pound. If for some reason the crop gets damaged and the farmer is unable to deliver the wheat, the buyer will end up buying the wheat in market at the higher price of $1.10/pound. In order to protect the future buyer, the exchange demands $1,000 × 0.10 = $100 to be deposited in the buyer’s account that is held with the exchange.

If wheat prices go down to $0.90/pound the next week, and if the buyer declines to buy the wheat as he thinks that he can get it in the market at a cheaper price, the farmer will lose the money. Therefore, the exchange will ask the buyer to deposit $1,000 × ($1.10 – 0.90) = $200 in the seller’s account. The revaluation and reimagining continues until the delivery date is reached.

Because of the requirement of margin deposits, future contracts are considered as not exposed to counterparty risk and are also much more liquid. However, the most recent regulations require the Futures to be given certain risk weight.

2.2.4   Swaps

Swaps involve returns on one type of product being exchanged with the returns on some other type of product. There may be a situation where investors are holding certain products and think those products are no longer suitable to their portfolios; selling those products and buying a different type of product may involve transaction costs and tax payments. Or it may be that certain parties are not qualified for the product they want but are qualified for similar products.

In such cases, the parties exchange the returns with the returns of the desired products, which are held by other parties. The whole mechanism of exchange of returns are created as products and called assets. There are several types of asset, depending on underlying assets. Interest rate swaps, equity swaps, and total return swaps are a few examples.

2.2.5   Combinations

Using multiple types of derivatives allows for customization of derivative products. For example, swaps provide the facility to exchange the returns of two products for their owners. However, a contract can be signed that gives an option to enter into such a swap agreement at a certain date in the future. If, on that date, the option holder thinks that the product he has is the right one for him, then he doesn’t need to enter into a swap agreement. On the other hand, if he thinks that he would benefit from the swap agreement, he can enter into an agreement as per the terms set in the option contract. Such a product is called a swaption, as it combines swap and option. There are several such combo products.

2.3   Equity Derivatives

Equity derivatives are derivative contracts whose value is derived from the performance of the underlying stock. Equity-derivative transactions do not involve paying or receiving notional amounts. For example, buying an option on Apple stock does not require Apple stock to be bought or sold. Instead, options allow for transacting the fluctuations in stock price.

2.3.1   Equity Options

An option is a contract that allows the holder to buy or sell an underlying security at a given price, called the strike price. The two most common types of options contracts are put and call. A call option gives the holder the right to buy the underlying asset at the strike price if the price of the underlying asset crosses above the strike. Similarly, the put option allows the holder to sell the underlying asset at the strike price if the price of the underlying asset falls below the strike.

The three types of call or put options vary by