Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 7 (Conti ) Global Bond Investing

Copyright © 2009 Pearson Prentice Hall. All rights reserved Floating Rate Notes (FRNs)  FRNs are a major segment of the international bond market.  FRNs represent a quarter of all Eurobonds, with issues in euros and dollars playing a dominant role.  Major issuers are financial institutions.  FRNs have coupons that adjust to interest rates, so coupons react to interest rate movements rather than the bond price.  FRNs are generally indexed to LIBOR.  The coupon on Eurobond FRNs is generally reset every semester or every quarter.

Copyright © 2009 Pearson Prentice Hall. All rights reserved FRNs (Conti.)  The coupon to be paid the next period is set equal to the index rate plus a spread that has been fixed at the time of issue  For example, : the coupon will be paid at time t : the LIBOR rate at time t-1 : the fixed spread  The motivation for an investor to buy FRNs is to avoid interest rate risk that could lead to a capital loss in case of a rise in interest rates.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Valuing FRNs on Reset Date  No default risk, i.e. And the FRNs price must be equal to 100 at each reset date.  With default risk, i.e. The FRNs price will depend on the market required spread which is likely to be different from that at time of issuance,.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exhibit 7.9: FRNs: The Stability of Reset Date Prices Midland Bank, May 1987

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exhibit 7.10: The Impact of a Change in Market-required Spread Perpetual Midland Bank FRN, LIBOR Plus 0.25 Percent

Copyright © 2009 Pearson Prentice Hall. All rights reserved FRN – example 7.11  A perpetual bond is issued by a corporation rated A with an annual coupon set at yearly LIBOR plus a spread of 0.25 percent. Some time later, LIBOR is equal to 5 percent, and the market requires a spread of 0.5 percent for such an A corporation. Give an estimate of the bond value on the rest date using the “freezing” method.

Copyright © 2009 Pearson Prentice Hall. All rights reserved FRN – example 7.11(Ans.) With the “freezing” method, the coupon is supposed to be fixed at: C = 5% % = 5.25% The market-required yield is supposed to be fixed at r = 5% + 0.5% = 5.5% An approximation of the value of this perpetual FRN is:

Copyright © 2009 Pearson Prentice Hall. All rights reserved Floating Rate Notes (Extension)  FRNs exhibit great price stability when compared with straight bonds.  Bull FRNs strongly benefit investors if interest rates drop.  Bear FRNs benefit investors if interest rates rise.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Bull FRNs (example)  Consider a five-year dollar FRN with a annual coupon set at 14% minus LIBOR.  The coupon cannot be negative, so it has a minimum (floor) of 0%.  The bull bond could be seen as the sum of three plain-vanilla securities: 1. two straight bonds with a 7% coupon 2. a short position in a plain-vanilla FRN at LIBOR flat 3. a 14% cap option on LIBOR

Copyright © 2009 Pearson Prentice Hall. All rights reserved Bear FRNs (example)  Consider a five-year dollar FRN with a annual coupon set at twice LIBOR minus 7%.  The coupon cannot be negative, so it has a minimum (floor) of 0%.  The bear bond could be seen as the sum of three plain-vanilla securities: 1. two plain-vanilla FRN at LIBOR flat 2. a short position in a straight bond with a 7% coupon 3. two 3.5% floor options on LIBOR

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exhibit 7.11: Characteristics of Bonds, Assuming a Drop in Market Interest Rates

Copyright © 2009 Pearson Prentice Hall. All rights reserved Dual Currency Bond  A bond is issued with coupons in one currency and principal redemption in another.  The NKK bond described in Exhibit 7.3 is an example for dual currency bond.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Dual Currency Bond (example 7.12)  Let’s consider the NKK bond described in Exhibit 7.3. It promises annual coupon of 8% on 20 billion yen and is redeemed in 10 years for $ million. The current spot rate is ¥ per dollar. The yen yield curve is flat at 4%, and the dollar yield curve is flat at 12%. 1. What is the theoretical value of this dual currency bond? 2. If the coupon on the bond was set at fair market conditions, what should be its exact value?

Copyright © 2009 Pearson Prentice Hall. All rights reserved Dual Currency Bond (example 7.12 Ans.) Let the coupon rate be x%

Copyright © 2009 Pearson Prentice Hall. All rights reserved Currency Option Bond  A bond is issued with coupons and/or the principle can be paid in two or more currencies, as chosen by the bondholder.  A currency option bond benefits the investor, who can always select the stronger currency.  The value of the currency option bond can be broken down into 2 elements: 1. a straight bond 2. an option to swap the currency

Copyright © 2009 Pearson Prentice Hall. All rights reserved Currency Option Bond (example 7.13)  A company issue a one-year currency option bond with a coupon rate of 3%. It is issued for £100, pays a coupon of either £3 or €4.8, and is redeemed for either £100 or €160, at the option of the bondholder. The current spot rate is €1.6 per pound, and the one-year interest rates are 6% in € and 5% in £. A one-year put pound, with a strike price of €1.6 per pound, is quoted at £ What is the fair market value of this currency option bond ? 2. What should have been the fair coupon rate set on this currency option bond according to market conditions?

Copyright © 2009 Pearson Prentice Hall. All rights reserved Currency Option Bond (example 7.13 Ans.) 1. (£) 2. Let the coupon rate be x%

Copyright © 2009 Pearson Prentice Hall. All rights reserved Collateralized debt obligation (CDO)  A special type of structured note that allows structuring the credit risk assumed on a portfolio of bonds.  A bank bundle together a set of bonds and sell the portfolio of bonds to a special purpose vehicle (SPV).  In turn the SPV securitizes the portfolio and issues a set of structured notes called “tranches” or “slices”.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exhibit 7.12: Example of a CDO