Type: Process Essays
Sample donated: Kelvin Mills
Last updated: December 26, 2019
CreditDefault Swap – CDSCredit default swap is a particulartype of swap between two or more parties where they can transfer the credit riskof municipalbonds, emergingmarket bonds, mortgage-backedsecurities, or corporatedebt. This contract also known as credit derivative contract. This type of credit derivative isthe most widely used and have a powerful force in world markets. JP Morgan firstintroduced the credit default swap contract in 1997. Byusing CDS contract, the buyer can reduce all their debt securities andinvestments risk by switching it all or a portion of the risks to the CDSseller or company in exchange for a periodic fee.
The CDS buyer obtain creditprotection in where the CDS seller guarantees the creditworthiness of the buyer debt securities. If the issuer defaults onthe payments, the CDS buyerare entitled to the par value of the contract because of the credit protection. However,the CDS buyer will lose some money if the debt issuer does not default andmakes all the payments up till maturity date.
Eventhough the CDS buyer willfaces risk of losing some money if it’s all goes well, they will faces largerrisk as losing much greater proportion of their investment if the issuerdefaults and they didn’t have CDS. T BILLSTreasurybills, or T-bills, are a short-term debt instruments that have plenty types ofmaturitiy. T-bills are issued by the US government at a discountfrom par value. Usually time for maturity for T-bills are in term of one yearof less. T-bills can be considered as the world’ssafest debt because the investors will receives an IOU from the US governmentwhich means they didn’t receive regular interest payments as with a coupon bond, but a T-Bill that include interest, which are reflected in the amount it pays when it matures.In other words, T-bills are safe because it is backed by the fullfaith and credit of the US government. Investor will receive the full facevalue payment at the end of the maturity date.
Although T-bills does not providinginterest payments such as other instruments, the difference between the discounted purchase price and thefull-face value equates to the interest rate earned by the investor. NewT-bills can be purchase at the government auctions. Investors who wants topurchase the previously issued T-bills can purchase it in the secondary market.Investors will have to go through a bidding process in order to purchaseT-bills. Commercial PaperCommercialpaper is a short-term unsecured promissory notes issued bycompanies.
It can be used for financing of accountsreceivable, inventories and meeting short-term liabilities. Time tomaturity range for commercial usually up to 270 days, not longer than that.Average maturity of commercial paper are between one and two months usually. It is issued at a discountedface value and reflects prevailing market interest rates. Investors return arecalculated by the differences between that price and the face value at maturity.Commercial paper is considered as very safe because only companies with high credit ratingsand credit-worthiness only will issue commercial paper. On the buyer sides,commercial paper buyer mostly coming from other corporations, financialinstitutions, wealthy individuals and money market funds.
Small investors canonly invest in commercial paper indirectly through money market funds becausecommercial paper are issued in denominations of $100,000 or more. Negotiable Certificate Of Deposit (NCD)A negotiable certificate of deposit(NCD) is a bank guaranteed certificate of deposit with a minimum face value of$100,000. This certificate are sold in a highly liquid secondary market, but itcannot be cashed in before maturity. Same as commercial paper which have largedenominations, NCD are mostly bought by large institutional investors which use the certificate as a wayto invest in a low-risk, low-interest security. NCD was first introduced byFirst National City Bank of New York, which is now Citibank in 1961. Bank canraise funds that would be used for lending to customer by using this instrument. Repurchase Agreement Repurchase agreement (repo)is a form of an agreement where government securities are borrowed in a shortterm basis by a dealer. Government securities that have been sold by the dealertoday will be bought back by the dealer on the following day.
This agreementusually happen on an overnight basis. In other words, repurchase agreement iswhen a party selling a security and agrees to buy it back in the future.Reverse repurchase agreement happens when the party at the end of the transactionpurchase the security and agreeing to sell it in the future. Repurchaseagreement are used in the market for the purpose of raising short term capital.Repurchase agreement is classified as a money market instrument. In thismarket, buyers will be the lender while seller will be the borrower and thecollateral is the securities that being traded. Long-term capital management(LTCM) Long-term capital management(LTCM) is a type of fund which is a large hedge fund. Salomon Brothers bondtrader, John Meriwether created the fund in 1993.
The fund is led by NobelPrize-winning economistsand renowned Wall Streettraders that nearly collapsed the global financialsystem in 1998 because of high-risk arbitragetrading strategies. Focused on bond trading, Long-term capital management startedwith initial assets worth just over $1 billion. This fund trading strategy worksby making convergence trades. This trades takes advantage of arbitrage betweensecurities which are wrongly priced relative to each other. In order to makemoney with the small spread in arbitrage opportunities, the fund had toleverage itself highly.
Leveraged Buyout Aleveraged buyout (LBO) is the acquisition of another company where thesignificant amount of borrowed money are used to meet the cost of theacquisition. The acquired assets of the company are usually used for the loansas a collateral together with the acquiring company assets. Without committingto a lot of capital, companies can make large acquisitionsby using the leverage buyout.
Bond issued in buyout known as junk bonds becauseof its high debt/equity ratio. Sentimentin Stock MarketMarketsentiment or also called “investor sentiment” is very important for day tradersand technicalanalysts who are using technicalindicators for them to calculate and gain benefits from the changesin short term price which caused by attitude of the investors towards asecurity. For contrarian traders, this stock market sentiment is also importantfor them where they would act in opposite direction of the prevailingsentiment. For example, contrarian would sell if everyone in the market ispurchasing. In stock market sentiment, trader takes advantage by making moneyfrom the stocks that are overvalued or undervalued based on market sentiment.Various types of indicators used by traders and investors to calculate stockmarket sentiment in order to choose the best stocks to trade.
Example of theindicators are CBOE Volatility Index (VIX), 52 week High/Low Sentiment Ratio,Bullish Percentage, 50-day moving average and 200-day moving average. Stock Market IntegrationStock Market integration is an indicator that shows howmuch different stock markets are related to each other. Stock marketintegration happens when prices between different locations or relatedstock follow same patterns for a long period of time. Stockmarket is said to be integrated when a group of stock price often moverelatively to each other and the relation is very clear between different stocksmarkets. MarketEfficiency in Bond Market Bondmarket can be considered as efficient because massive growth in communicationtechnology enables investors to access and react to market information faster.Here is a few factors why bond market are efficient. First, bond pays loweryields and are less volatile. Second, bond valuation is fairly straightforwardas the bondholders are promised with a fixed return and have specific maturitydates.
It makes the bond valuation generally easier and more precise. Last butnot least, bonds are not traded in centralized exchange or trading systems. Soin bond market, investors will only face minor challenges relating to issues oftransparency, subjectivity and liquidity.