Chapter 7 (Conti. 98.10.23)

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 7(Conti. 98.10.23)

Global Bond Investing

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 7 - 2

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.


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.

01 miC tt

tC1ti

0m


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, .

1 tt iC

01 miC tt

0m


Exhibit 7.9: FRNs: The Stability of Reset Date Prices Midland Bank, May 1987


Exhibit 7.10: The Impact of a Change in Market-required Spread Perpetual Midland Bank FRN, LIBOR Plus 0.25 Percent


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.


FRN – example 7.11(Ans.)

With the “freezing” method, the coupon is supposed to be fixed at:

C = 5% + 0.25% = 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:%4545.95

5.525.5

P


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.


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


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


Exhibit 7.11: Characteristics of Bonds, Assuming a Drop in Market Interest Rates


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.


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 $110.48 million. The current spot rate is ¥181.02824 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?


Dual Currency Bond (example 7.12 Ans.)

1.

2. Let the coupon rate be x%

4169.1948.11012.102824.181

04.16.1

04.16.1

04.16.1

10102 V

%0845.97204169.19

P

10102 12.120

04.120%

04.120%

04.120%20

xxx

%3591.8% x


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


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 £0.015.

1. 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?


Currency Option Bond (example 7.13 Ans.)

1. (£)

2. Let the coupon rate be x%

64.99015.010305.1

103V

015.0100%)1(05.1

100%)1(100

xx

%37.3% x


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”.


Exhibit 7.12: Example of a CDO

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Chapter 7 (Conti. 98.10.23)

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