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Credit derivatives

Credit derivative are contracts where the payoff depends on the creditworthiness of one or more commercial or sovereign entities , credit derivative allow companies to manage their credit risk actively.

According to the definition, the use of the derivative security determines whether the derivative is a credit derivative or not. A simple derivative contract like a forward contract on a defaultable bond may be credit derivative to one counter party risk.(because he intends to use it to manage credit risk) and not a credit derivative to another.

Credit derivative bilateral contract between debtor and creditor.It allows the creditor to transfer the risk of the debtor default to a third party.

What are derivatives?
As the name suggests derivatives are based on or derived from an underlying  asset and the way to evaluate derivatives is to value an equivalent structure of assets (or liabilities)
All derivatives are redundant because they can be replicated with a bundle of straight forward basic operations.Derivative have one decisive advantage over the underlyining bundle of assets and that is transaction costs.
It is not an uninteresting perspective to look at stocks and bonds as primitive options.

How credit derivative works
A credit derivative can remove the risk of default. Lender and borrower both can use it. By use of credit derivative banks has the right to transfer the risk of default to the third party.

Type of credit derivative
Credit default swap(CDS)
Total return swap
Credit spread option

Credit default swap->A credit default swap (CDS) is a contract that provides insurance against the risk of default by a particular company.The company is known as the reference entity and default by the company is known as the reference entity and default by the company is known as a credit event.The buyer of the insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event occurs. The bond is known as the reference obligation and the total par value of the bond that can be sold is known as the swap’s notional principal.
The buyer of CDS makes periodic payments to the seller until the end of the life.If the CDS or until a credit event occurs.

Credit derivative allow companies to manage their credit risk actively.

a)Binary credit default swaps-> Binary credit default swap can be quite sensitive to the expected recovery rate estimate. This is structured similarly to a regular credit default swap. Except that the pay of is a fixed dollar amount. In this case, the expected recovery rate affects the probability of default but not the payoff. As a result, the credit defaults spread is quite sensitive to the recovery rate.

b)Basket credit default swaps-> In a basket credit default swap there are a number of reference entities.An add-up basket credit default swaps.One an each reference entity.A first to default swap provides a payoff only when the first reference entity defaults.

2)Total return swaps->A total return swap is an agreement to exchange the total return a bond or other reference assets for LIBOR plus a spread. The total return includes coupons interest and the gain or loss on the assets over the life of the swap.A total return swap always used as a financing tool.

The payer retains ownership of the bond swap and has much less exposure to the risk of the receiver defaulting than it would have if it had lent money to the receiver to finance the purchase of the bond. The total return swap is similar to repos. They are structured to minimize credit risk when money is borrowed.
There are number of variation on the change  in value of the bond.there physical settlement where the payer exchange the underlying asset  for the notional principal at the end of the life of the swap.Sometimes the change in value payments are made periodically rather than all at the end.

3)Credit spread options->Credit spread option are options where the pay off depends on either  a practical credit spread or the price of a credit-sensitive asset. Typically the options are structured so that they ease to exist if the underlying assets default. If a trader wants protection against both an increase in a spread and a underuritylying asset defaults then both credit spread option and another instrument such as credit default swap are required one type of credit spread option is defined so that it has a payoff of.
D_{max}(K-S_{r},0)
D_{max}(S_{T}-K,0)
where S_{T} is a particular credit spread at option maturity
K=Stike spread

Another type of credit spread option is a European call or put option on a credit sensitive asset such as a floating rate note.
max(S_{T}-k,0)
max(K-S_{T},0)

 

 

 

 

 

 

 

 

 

Financial services

Financial services is an intermediary activity involved in security the saving of the public fund and facilitating them to be available to the needy for investment.The presence of well organized financial system is highly imperative for the development of any country.Financial system is the nerve point which are accelerate the economic growth.

Role of financial services
Saving culture
Investment opportunity
Neutralizing the risk
Enhancing the return
Economic development

Type of financial service
Saving oriented service
Investment related service
Facilitating service
Income related service

Classification of financial services
Financial services offered not only lending and deposit money but also serve many more thing like easy banking,investment.This era of digitalization.Technology made services more easy and advanced like mobile banking and e-wallets.

Classifying services
Fund based activities
Dealing with security market services
Underwriting of share debenture and bond
Participating in new issue market new issue market
Dealing in foreign exchange market

Non-fund based activities
Financial institution provide services on fee basis that is called non-fund based activity.Financial product are taken by clients only when they are suitably supported with the services.Capital market consist of term lending institution and investing institution which mainly provide long term fund.Money market consist of commercial bank,co-operative bank.Financial services industry include all kind of organization which facilitate services for both individuals and corporate customer.

 

 

 

 

 

 

 

 

Bonds

Investment media includes bonds and debentures. This form of investment needs of a risk avertor who is primarily interested in steady returns. Coupled with the safety of the principal sum.
Definition of bond
A debenture is a legal document containing an acknowledgment of indebtness by a company. It contains a promise to pay a stated rate of interest for a defined period. Repay the principal at a given date of maturity.
Bond is a formal legal evidence of a debt and are termed as the senior securities of a company.

                           Why issuing bonds

The government has no choice but he borrows when they are unable to meet their express from the current revenue corporation. On the other hand, have a wider choice in the matter of financing their operation. Retained earnings, new equity issues, etc. They still prefer to go in for borrowing for the following reason.

1) To reduce the cost of capital ->Bonds are the cheapest source of financing. A corporation is willing to incur the risk of borrowing in order to reduce the cost of capital. Financing a portion of its assets with securities bearing a fixed rate of return of increasing the ultimate return to the equity holder.

2)To gain the benefit of leverage->Presence of debt and preference share in the company’s financial leverage. When financial leverage is used changes in earnings before interest and tax(EBIT) translate into the larger changes in earning per share. If EBIT falls and financial leverage is used the equity holders endure negative changes in EPS that are larger than the negative decline in EBIT.

3)To effect tax-saving-> The interest on bonds is deductible in figuring up corporate income for tax purposes, Hence the Eps increase. If the financing is through bonds rather than with preference or equity share.

4) To wider, the source of a funds->The corporation can attract fund from individual investor and especially from those investing institutions which are reluctant or not permitted to purchase equity share.

5)To preserve control->An increases in debt does not diminish the voting power of present owners since bonds ordinarily carry no voting right.

                                  Types of Bonds

1) Sinking fund bonds->Sinking fund bonds arise when the company decides to retire its bond issue systematically by setting aside a certain amount each year for the purpose.This person the users the money to call the bonds annually at some call premium or to purchase then or the open market if they are selling at discount.

2)Mortgage or secured bonds ->The term mortgage generally refers to a lien on real property or buildings mortgage bonds may be an open-end close end and limited open-end. An open-end mortgage means that a  corporation under the mortgage may issue additional bonds.
In close end mortagage the company agrees to issue at one time a stated amount of bonds.
In a limited open-end mortagage.The indenture provides that corporation may issue a stated amount of bonds over a period of years in series.

3)A convertible and non-convertible bonds->A convertible bond is a cross between a bond and a stock.The holder can at his option convert the bonds into a predetermined number of shares of common stock at a predetermined price. In all convertible bonds, the indenture contract specifies the term of conversion and the period during which the conversion privilege can be exercised.

4)Serial bonds->Serial bonds are appropriate for companies that wish to divide their issues into a series each point of the series maturing at a different time ordinarily the bonds are not callable and the company pay each part of the series as it matures.|

5)Collateral trust bonds->Collateral trust issues are secured by a pledge of intangibles usually in the form of stocks and bonds of a corporation collateral trust issue are thus secured by
a)Shares, representing ownership incorporation.
b)Bonds, representing the indirect pledge of assets or a combination of both, usually, the pledged securities are those of other corporations. The shares pledged frequently represent a contract of a subsidiary corporation and such control often materially adds to or detracts from the intrinsic value of collateral issues secured thereby.

6)Convertible and Non-convertible bonds-Convertible bonds can be one of the finest holdings for the investor looking for both appreciations of investment and income of bonds. A convertible bond is a cross between a bond and a stock. Convert the bond into a predetermined number of shares of common stock at a predetermined price.

7)Income bonds->Income bonds on which the payment of interest is mandatory only to the extent of current earnings.If earnings are sufficient to pay only a portion of the interest that portion usually required to be paid. Income bonds are not offered for sale as new financing but are often issued in reorganization or recapitalization to replace other securities.

8)Adjustment Bonds->Adjustment issued in the reorganization of companies in financial difficulties. In practically all cases, interest is payable only if earning permits. They are the leading type of income bond.

9)Assumed bonds->Assumed bonds issued in the reorganization of companies in financial difficulties. In practically all cases, interest is payable only if earning permits. They are a leader type of income bond.

10)Adjustment bonds->Adjustment bonds issued in the reorganization of companies in financial difficulties. In practically all cases interest is payable only if earning permit. They are lading types of income bonds.

11)Joint bonds->Joint bonds are loan certificates that is jointly secured by two or more companies,two companies that use a common facility, and have raised money to finance. It through the sale of debt would provide a good example of a situation where the bonds might jointly secure.

12)Guaranteed bonds->Bonds may be guaranteed by a firm other than the debtors. Some guarantors assure payment of both principal and interest only. A guaranty or lease contract will add assurance to a bond if the guarantor or lessee is financially strong.

13)Redeemable and irredeemable bonds->A redeemable debenture is a bond which issued for a certain period on the expiry of which its holder will be repaid the amount thereof with or without premium. A bond without the redemption period is termed as an irredeemable debenture.

14)Participating bond->Companies with poor credit position issue participating bonds. They have a guaranteed rate of interest but may also participate in earning up to an additional specified percentage.

 

 

Active equity management

The security analyst always faced with the problem of buy hold or sell decision.He/she must evaluate the past performance of the security for forecasting the future performance.

Valuation of preference share and bond is straight forward because return generally constant and certain.Equity valuation is different because return on equity is uncertain and it can change time to time.therefore analysis and forecasting of equity is crucial.Stock market is not totally efficient.

Active Equity investment style:
Active equity management has two styles top-down and bottom-up.In top-down equity management style begins with overall  economic environment forecasting near term outlook and make a general asset allocation decision.Top-down managers analyses the stock market is an attempt to identify economic sector after identifying attractive and unattractive sectors and industries top-down managers finally select a portfolio of individual stock.

Bottom-up equity management style:
In bottom-up styles managers focuses analysis of individual security instead economic and environmental analysis using financial analyst or computer screening bottom-up managers analyses company performance ratio analysis,price earning ratio other financial ratio,management efficiency.

Financial Leverage

Financial leverage refers to debt a firm’s capital structure. Firms with debt in the capital structure is called levered firms. The inter firm’s irrespective of the firm’s earnings. Hence, interest charges are fixed costs of debt financing. The fixed financial costs result in financial leverage and cause profit after tax to vary with change in EBIT.

Hence, the degree of financial leverage defined as the change in the company’s profit after tax due to change in the EBIT. Since financial leverage increases the firm’s (financial) risk. It will increase the equity beta of the firm.

            USE OF FIXED CHARGE FUND

The use of the source of the fixed charge funds.Such as debt and preference capital along with the owners’ equity in the capital structure financial leverage or gearing or trading on equity. The use of term trading on equity derived from the fact that is the owner’s equity that is used as a basis to raise debt.

Every time firm makes an investment decision. It is at the same time making a financial decision also. A decision to build a new plant or to buy a new machine implies a specific way of financing that project. A company finances its investment by debt and equity. The rate of return an asset.The company has a legal binding to pay interest on the debt.

The use of the fixed charges source of funds such as debt and preference share capital with the owner’s equity in the capital structure. Describe as financial leverage employed by a company intended to earn more return on the fixed charge funds than their cost.
Financial leverage at once provides the potential of increasing the shareholder earning as well as creating the risk of loss to them.

IMPACT OF FINANCIAL LEVERAGE ON SHAREHOLDER RETURN

Financial leverage is managing the shareholder return fixed charge funds (loan from financial market institutional bank and debenture can be obtained at a cost lower than the firm’s rate of return on net assets (RONA &ROI).

Based on assumption EPS or return on equity (ROE) increases EPS ROE  will fall. The company obtains the fixed charge fund at a cost higher than the rate of return.

                MEASURES OF FINANCIAL LEVERAGE

The most commonly used measures of financial leverage.
1) Debt Ratio:-The ratio of debt to total capital.
L_{1}=\frac{D}{D+E}=\frac{D}{V}
Where
D=debt
E=value of share holder’s equity
V=Value of capital

2)The debt-equity ratio-The ratio of debt to equity.
L_{2}= \frac{D}{E}

3)Interest coverage ratio= The ratio of net operating income(or EBIT) to interest charges.
L_{3}= \frac{EBIT}{Interest}

The firm two measures of financial leverage expressed either in terms of book value reflects. The current attitude of an investor.

                       Role of financial leverage

->The financial leverage or trading on equity is derived from the fact that it is the owner’s equity that is used as a basis to raise debt.
->The supplier of debt has limited participation in the company’s profit and therefore.it will insist on protection in earnings and protection in values represented by ownership equity.
->The surplus or deficit will increase for a decrease in the return on the owners’ equity is levered above or below the rate of return in total assets for example if a company borrows Rs.100 at 8 percent interest.(that is rs.8  per annum).

The balance of 4 percent (rs.4 per annum ) after payment of interest will belong to the shareholder. It constitutes the profit from financial leverage. On the other hand, if the company could earn only a return of 6 percent on Rs.100(rs.6 per annum). The loss to the shareholders would be rs. 2 per annum.
Thus financial leverage at once provides the potentials of increasing the shareholder’s earning as well as creating the risk of loss of to them.

 

 

 

Derivative and risk management

A company faces several kind of risk.Unanticipated change in selling price,cost taxes,demand,interest rate technology fluctuated profitability of a firm.Sometime managers are not able to reduce risk.They try many strategies.All financial difficulties and risk can reduce their risk entering into financial contracts.

Risk hedging by derivatives 

The topic will explain what is derivatives and how to hedge risk by it.Derivatives mans those items that do not have their own independent value it is a financial instrument derived from some other asset which is called underlying asset. In the firm risk always remain firm can avoid cash flow fluctuation by reducing the risk.Itwill increase value of their asset or investment.Firm always seeking the way to reduce risk derivative are tools to reduce a firm’s risk exposure.

Firm risk can hedge by four derivatives these are future,forward,option and swap.

Hedging by option

Option is one of  the most complex financial instrument.Firm can use option to minimize risk.Option has two type call option and put option.If a firm purchase new product in large quantity most of firm’s capital invested.In this type of deal always risk remain,to reduce risk firm can buy option in stock market only premium have to pay if strike price more than spot price firm will make profit but unfortunately if price opposite each other firm will loose option premium amount.

Hedging by forward

Forward contract is non-standardized contract between two parties.In this contract assets buy or sell in future at predetermined price.Forward contracts are similar to option in hedging but there is a difference both buyer and seller are bounded by the contract both must have exercise the contract at the agreed price on the specified due date forward contracts are flexible suits the need of buyer and seller.We can enter into a forward contract for any good commodities and asset.We can choose any delivery date and quantity of goods. 

Hedging by future 

Future contract are same as a forward contract.Future contracts are not different from forward contracts.The difference is in terms of standardisation and method of operation.Future contracts have standardised contract size and they trade only the organised exchanges.In future contract both parties should agreed as same price,duedate and time.In future contracts like in the forward contracts one party will loose and other will gain.

Hedging by swap

Swap are same as future and forward contracts.It is also providing hedge against risk.Swap also a agreement between two parties called counter parties most popular swap are currency swap and interest rate swap.This two swap can be combined when interest on loan can be swapped between two currency.

1)Currency swap :- In currency swap exchange of cash payment done between two currency most of companies want overseas investment but they find difficulties entering in new market currency swap is an alternative to overcome this problem.

2)Interest rate swap:-The interest rate swap allows a company to borrow capital at fixed and exchange its interest payment at floating rate or fixed rate LIBOR is the market determined interest rate for banks to borrow from each other in the euro dollar market.

 

Beta Estimation

The security ‘s beta, which measures the sensitivity of the security ‘s return to those of the market because beta captures the market risk of security as opposed to its diversifiable risk, it is the appropriate measure of risk or a wealth diversified investor.
                 Using historical returns
We would like to know a stock’s beta in the future that is how sensitive will its features returns to market risk. In practice, We estimate beta based on the stock’s historical sensitivity. This approach makes sense if a stock is a beta that remains relatively stable over time, which appears to be the case for most firms.
               Many data sources provide estimates of beta based on historical data. Typically those data sources estimate. Correlation and volatilities from two or five years of weekly or monthly returns.
Beta estimation has two method.           
                                          

                                                      Direct method


Beta is the measures of systematic risk and it is a ratio of covariance between market return variance.
\beta _{j} =\frac{Covarj,m}{\sigma ^{2}m}

=\frac{\sigma _{j}\sigma _{m}corj,m}{\sigma _{m}\times \sigma _{m}}=\frac{\sigma _{j}}{\sigma _{m}}\times cor_{j,m}

Let’s consider an example suppose that percent return on the market. Represented by the BSE Sensex(sensitivity index) and the share of ABC Infotech limited for recent five years.
                                Return on Sensex and ABC Infotech

Year Market return(%) ABC infotech(%)
1 18.60 28.46
2 -16.50 -36.15
3 63.85 52.64
4 -20.65 -7.29
5 -17.80 -12.95

Beta estimation for ABC infotech limited

year r_{m} r_{j} (r_{m}-\bar{r}_{m}) (r_{j}-\bar{r}_{j}) (r_{m-}\bar{r}_{m} )\times(r_{j}-\bar{r}_{j}) (r_{m}-\bar{r}_{m})^{2}
1 18.60 23.46 13.11 19.51 255.91 171.98
2 -16.50 -36.13 -21.98 -40.08 880.83 483.08
3 63.83 52.64 58.35 48.69 2841.35 3404.85
4 -20.65 -7.29 -26.13 -11.24 293.64 682.96
5 -17.87 -12.95 -23.35 -16.90 394.57 545.35
  \bar{r}_{m}=5.48 \bar{r}_{j}=3.95     sum=4666.30 sum=5288.23

i)Average return on market
cov_{m.j}=\frac{4666.30}{5}=933.26

ii) Square deviations of market return
\sigma ^{2}=\frac{5228.23}{5}=1057.65

iii) Divide the covariance of market and ABC infotech by the market variance to get beta.
\beta _{j}=\frac{cov_{j,m}}{\sigma ^{2}m}=\frac{933.26}{1057.65}=0.88

The intercept term is given by the following formula
\alpha _{j}=\bar{r}_{j}-\beta _{j}\times\bar{r}_{_{m}}
3.95-0.88\times 5.48=-0.89
   The characteristic line of ABC Infotech p=0.89+0.88

                           

The market model or Index model


Another procedure of calculating beta is the use of market model.In the market model, we regress return on a security against returns of the market index.The market model is given by the following regression equation.
                                       R_{j}=\alpha+\beta _{j}R_{m}+e_{j}
where
R_{j}=expected market return
\alpha= intercept
e_{j}=error term
\beta _{j}=regression measures the variability of the security’s beta

Beta is the ratio of the covariance between the security returns and the market returns and it is the covariance between the security returns and the market returns to the variance of the market return.\alpha indicates the return on a security when the market return is zero. It could be interpreted as the return on security on account of unsystematic risk. Over a along given the randomness of unsystematic risk .
                            The observed return on market and ABC share and a regression line. The regression line of the market model is called the characteristics line.
The characteristics line
The value of \alpha is 0.89 and the value of \beta is 0.88.
The value of \beta and \alpha in the regression equation are given by the following equations.

\beta = \frac{N\Sigma XY-(\Sigma X)(\Sigma Y)}{N\Sigma X^{2}-(\Sigma X^{})^{2}}

\beta _{j}=\frac{(5)4,774.49)-(27.42)(19.73)}{(5)(5,438.58)-(27.42)^{2}}

      =\frac{23,872.45-541.00}{27,192.90-751.86}
    
      =\frac{23,331.45}{26,441.04}   =0.88


Alpha=\alpha=\bar{Y}-\beta \bar{X}
Alpha=\alpha _{j}=3.95-(0.88)(5.48)= -0.89

 Estimation for the regression equation

Year X_{m}(X) r_{m}(Y)  XY X^{2} Y^{2}
1 18.60 23.46 436.30 345.88 550.37
2 -16.50 -36.13 595.99 272.10 1305.38
3 63.83 52.64 3360.26 4074.86 2770.97
4 -20.65 -7.29 150.54 426.42 53.14
5 -17.87 12.95 231.41 319.31 167.70
Sum \Sigma X=27.42 \Sigma Y=19.73 \Sigma XY=4774.49 \Sigma X^{2^{}}=5438.58 \Sigma Y^{2}=4847.56
Average \bar{X}=5.48 \bar{Y}=3.95      

Beta estimation in practice
In practice, the market portfolio is approximate by a well-diversified share price index. Portfolio should include all risky assets shares, bonds,gold, silver real estate art objects, etc.
                   In computing beta by regression .We need data on return market index and the security for which beta is estimating over a period of time.There are no theoretical determined time intervals for calculating beta. The time period and the time interval may vary. The returns may be measured on daily,weekly, or monthly basis.
              The return on a share and market index may be calculated as a total return that is, divided yield plus capital gain.

 Rate of return=Current dividend+(share price in th beginningshare price at the endshare price in the beginning

                               r=\frac{D_{t}+(P_{t-1})}{P_{t-1}}=\frac{D_{t}}{P_{t-1}}+[\frac{P_{t}}{P_{t-1}}-1]

In practice, one may use capital gain/loss or price return that is  p_{t}/p_{t-1}-1 rather total return to estimate beta of the company’s share. A further modification may be made in calculating the return.