Published on April 13, 2008
International Financial Markets& Reserves Management: International Financial Markets & Reserves Management Daranee Saeju, Ph.D. Bank of Thailand 2 July 2005 Outline: Outline Part I: International Financial Markets their roles and functions International Money Market International Bond Market Global Bond Market Structure Interpreting Bond Quotes Risks Associated with holding bonds Asian Bond Market Development Part II: Role of Central Banks in international financial markets Reserves management Foreign exchange policy management Function of Financial Markets: Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency: efficient allocation of capital Functions Performed by the Global Financial System and the Financial Markets: Functions Performed by the Global Financial System and the Financial Markets Savings function. The global system of financial markets and institutions provides a conduit for the public’s savings. Wealth function. The financial instruments sold in the money and capital markets provide an excellent way to store wealth. Liquidity function. Financial markets provide liquidity for savers who hold financial instruments but are in need of money. Credit function. Global financial markets furnish credit to finance consumption and investment spending. Payments function. The global financial system provides a mechanism for making payments for goods and services. Risk protection function. The financial markets around the world offer businesses, consumers, and governments protection against life, health, property, and income risks. Policy function. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation. Classifications of Financial Markets: Classifications of Financial Markets 1. Classification by nature of Claim: Debt market bonds, CDs Equity market Common stocks 2. Classification by maturity of Claim: Money Market Short-term (maturity < 1 year) Capital Market Long-term (maturity > 1 year) 3. Classification by seasoning of Claim: Primary Market New security issues sold to initial buyers Secondary Market Securities previously issued are bought and sold 4. Classification by organizational structure: Exchanges Market Trades conducted in central locations (e.g. stock exchange) Over-the-Counter Market Dealers at different locations buy and sell 5. Classification by immediate delivery or future delivery: Cash or Spot Market assets or financial services are traded for immediate delivery (usually within two business days). Derivative Market Contracts calling for the future delivery of financial instruments are traded in the futures or forward market. Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments. : Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments. Money Market Instruments in the U.S. Capital market instruments are debt and equity instruments with maturities of greater than one year. They have far wider price fluctuations than money market instruments and are considered to be fairly risky investments. : Capital market instruments are debt and equity instruments with maturities of greater than one year. They have far wider price fluctuations than money market instruments and are considered to be fairly risky investments. Capital Market Instruments in the U.S. Internationalization of Financial Markets: Internationalization of Financial Markets Internationalization of financial markets has profound effect on the world economy E.g. the Japanese are not only providing funds to corporations in the United States, but are also helping the federal government. Without these foreign funds, the U.S. economy would have grown far less rapidly in the last twenty years Debt securities (e.g. corporate bonds) play an important role in the international financial markets issuing bonds is an important vehicle for raising funds for both the public and private sectors Sources of External Finance in U.S: Sources of External Finance in U.S Sources of Foreign External Finance: Sources of Foreign External Finance Size of Thai Financial Markets (% of GDP): Size of Thai Financial Markets (% of GDP) International Money Market: International Money Market Outline Characteristics and purpose of Money market Types of Investment Risk Participants in the Money Market Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds, and Bank CDs, Commercial Paper, Federal Agency Securities, Bankers’ Acceptances, and Eurocurrency Deposits Characteristics and Purpose of the Money Market: Characteristics and Purpose of the Money Market The money market is the market for short-term (one year or less) credit. The money market is the mechanism through which holders of temporary cash surpluses meet holders of temporary cash deficits. The money market arises because for most individuals and institutions, cash inflows and outflows are rarely in perfect harmony with each other, and the holding of idle surplus cash is expensive. the money market provides low-cost source of funds to firms, financial institutions, and government Investors purchase money market instruments for: temporary purpose. They have cash to invest for a short period of time, such as a corporate cash manager. Or, they are shifting funds among longer-term assets and have not yet made a permanent allocation. strategic purpose. Based on the different risk/return characteristics of equities, bond and cash, the investor has decided upon an allocation that includes money market securities. Characteristics and Purpose of the Money Market: Characteristics and Purpose of the Money Market The money market is a wholesale market for funds – most trading occurs in multiples of a million dollars. money market securities usually have an active secondary market. this makes them very flexible instruments to use to fill short term financial needs. Governments and central banks around the world play major roles in the money market as the largest borrowers and as regulators. Money market investors seek mainly safety and liquidity, plus the opportunity to earn some interest income. Risk that investors face include: Types of Investment Risk: Types of Investment Risk Market risk – The risk that the market value of an asset will decline, resulting in a capital loss when sold. Also called interest rate risk. Reinvestment risk – The risk that an investor will be forced to place earnings from a security into a lower-yielding investment because interest rates have fallen. Default risk – The probability that a borrower fails to meet one or more promised principal or interest payments on a security. Inflation risk – The risk that increases in the general price level will reduce the purchasing power of earnings from the investment. Currency risk – The risk that adverse movements in the price of a currency will reduce the net rate of return from a foreign investment. Also called exchange rate risk. Political risk – The probability that changes in government laws or regulations will reduce the expected return from an investment. Participants in the Money Market: Participants in the Money Market Governments – the largest borrowers in the market Central banks – buy and sell securities as its primary method of controlling money supply Businesses – for cash management purpose Commercial banks – for investment and liquidity management purposes Investment companies – market makers Finance companies – fund raising Insurance companies – maintain liquidity needed to meet unexpected demands Pension funds – maintain funds in money market instruments in readiness for investment in stocks and bonds Individuals – occasionally buy money market mutual funds Money market mutual funds – allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities Money market instruments: Money market instruments Money market instrument are securities with an original maturity of no more than one year. Money market instruments are issued by government and its agencies, Banking institutions, Non-financial corporate entities, Security dealers The key money market instruments include Treasury bills Repurchase agreements Federal funds Federal agency notes CDs and eurocurrency deposits Commercial paper and bankers’ acceptances Most money market securities do not pay interest. instead, they are issued at a discount from par (their value at maturity). The increase in price provides a return. this is called discounting. Treasury Bills: Treasury Bills Treasury bills (T-bills) are direct obligations of the government that have an original maturity of one year or less. They carry great weight in the financial system due to their zero (or nearly zero) default risk, ready marketability, and high liquidity. T-bills are usually issued routinely every week or month via auctions Competitive auction (Multiple-price auction) Noncompetitive auction Dutch auction (uniform-price auction) T-bills are held mainly by commercial banks, non-financial corporations, state and local governments, and the Federal Reserve banks. Commercial banks and private corporations hold T-bills as a reserve of liquidity. The Federal Reserve banks conduct part of their open market operations in T-bills because of the depth and volume of activity of the market. Calculating the Yield on Bills: Calculating the Yield on Bills T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value. From the standard “time value of money” formula for a single cashflow instrument, the investment yield or rate (IR) on T-bills is = Par value – Purchase price 365 . Purchase price Days to maturity Calculating the Yield on Bills: Calculating the Yield on Bills However, for US money market instruments quoted on a discounted basis, bill yields are determined by the discount method, which does not compound interest rates, uses a 360-day year for simplicity and the rate is per dollar of face, not per dollar invested (i.e. face value is in the denominator) The discount rate on T-bills = Par value – Purchase price 360 . Par value Days to maturity This formula represents the “discount rate” convention. The previous page shows the “money market yield” or “CD equivalent yield” convention. Calculating the Yield on Bills: Calculating the Yield on Bills Example A Treasury bill with 80 days to maturity is priced at 98.6. Its discount rate is d = (100-98.6)/100 * 360/80 = 6.3% Conversely, at a discount rate of 6% its price is P = 100 * (1-d * 80/360) = 98.667 It is necessary to place instruments on the same basis in order make relative value comparison Other US money market instrument quoted on a yield basis. The only change is calculating per price, not face value. Putting this 6% bill on a “CD equivalent” basis i = (100-98.6667)/98.667 * 360/80 = 6.08 6% on a discount basis is worth 6.08% (over 80 days) on a money market, or CD equivalent, basis. A “ bond equivalent yield” basis takes the above result and multiplies by (365/360) bey = 6.08 * (365/360) = 6.16% Federal Funds: Federal Funds Federal funds are any monies available for immediate payment (i.e. same-day money). They are generally transferred from one depository institution to another by simple bookkeeping entries requested via an on-line computer system, by wire, or by telephone. Federal funds are the principal means of making payments in the money market. Total federal funds borrowings by banks in the U.S. exceeded $600 billion as the 21st century began. Most federal funds loans are either overnight transactions or continuing contracts that have no specific maturity and that can be terminated without advance notice by either party. One-day loans carry a fixed rate of interest, but continuing contracts often do not. Beginning 1989, the Federal Reserve has routinely set target levels for the federal funds rate, and raised or lowered those targets depending on whether it wishes to slow down borrowing and spending in the economy or speed them up. Through daily open market operations (buying and selling securities), the Fed is able to push the funds rate in the desired direction. Federal Funds Target Rate: Federal Funds Target Rate Repurchase Agreements (RP, Repo): Repurchase Agreements (RP, Repo) Under a repurchase agreement (RP), the dealer sells securities with a commitment to buy back the securities at a specified future date at a fixed price plus interest. RPs are essentially a short-term collateralized loans Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months,…) while continuing contracts may be terminated by either party on short notice. Most RPs have a very short term, the most common being 1-14 days. Securities dealers use repos to manage their liquidity and to take advantage of anticipated changes in interest rates. Most central banks also uses repos in conducting monetary policy. as repos are usually collateralized with Treasury securities, they are usually low-risk investments and therefore have low interest rates. There is usually a “haircut” or “initial margin” to ensure that the value of collateral is higher than the value of the loan. Periodically, RPs are marked to market. If the price of the pledged securities has dropped, the borrower may have to pledge additional collateral. (Margin Call) Negotiable Certificates of Deposit: Negotiable Certificates of Deposit A certificate of deposit (CD) is an interest-bearing receipt for funds left with a depository institution for a set period of time. True money market CDs are negotiable CDs that may be sold any number of times before maturity and that carry a minimum denomination of $100,000. They were introduced in 1961 to attract lost deposits back into the banking system. The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions. Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market. Commercial Paper : Commercial Paper Commercial paper consists of short-term, unsecured promissory notes issued by well-known and financially strong companies. Commercial paper is traded mainly in the primary market. Opportunities for resale in the secondary market are more limited. Commercial paper is rated prime, desirable, or satisfactory, depending on the credit standing of the issuing company. There are two major types of commercial paper. Direct paper is issued mainly by large finance companies and bank holding companies directly to the investor. Dealer paper, or industrial paper, is issued by security dealers on behalf of their corporate customers (mainly non financial companies and smaller financial companies). Commercial Paper: Commercial Paper Maturities of U.S. commercial paper range from three days (“weekend paper”) to nine months. Most commercial paper is issued at a discount from par, and yields to the investor are calculated by the discount method, just like Treasury bills. The volume of commercial paper has grown rapidly due to its relatively low cost and high quality, as well as the expanding use of credit enhancements. Commercial Paper: Commercial Paper Advantages Relatively low interest rates Flexible interest rates - choice of dealer or direct paper Large amounts may be borrowed conveniently The ability to issue paper gives considerable leverage when negotiating with banks Disadvantages Risk of alienating banks whose loans may be needed when an emergency develops May be difficult to raise funds in the paper market at times Commercial paper must generally remain outstanding until maturity - does not permit early retirement without penalty Bankers’ Acceptances: Bankers’ Acceptances A bankers’ acceptance is a short-term promissory note drawn by a company to pay for goods on which a bank guarantees payment at maturity. Usually used in international trade. Acceptances are used in international trade because most exporters are uncertain of the credit standing of their importers. The issuing bank unconditionally guarantees to pay the face value of the acceptance when it matures, thus shielding exporters and investors in international markets from default risk. Acceptances carry maturities ranging from 30 to 270 days, with 90 days being the most common. Investors in acceptances include banks, industrial corporations, money market mutual funds, local governments, federal agencies, and insurance companies. To many investors, acceptances are a close substitute for Treasury bills, negotiable CDs, or commercial paper in terms of quality, although the acceptance market is far smaller in terms of the volume of trading. Bankers’ Acceptances: Bankers’ Acceptances The Growth and Decline of Acceptance Financing The volume of US$ acceptances outstanding grew rapidly, from less than $400 million in 1950, to slightly more than $7 billion in 1970, and almost $80 billion in 1984. Then the volume declined sharply to $10 billion in 2000, as several leading export nations entered a recession, as economic problems developed in Asia, and as businesses turn to other payment and financing methods. Acceptance Rates Acceptances do not carry a fixed rate of interest, but are sold at a discount in the open market like Treasury bills. The yield on acceptances is usually only slightly higher than the yield on Treasury bills, and close to the negotiable CD rates offered by major banks, because of the high credit quality of the banks that issue the acceptances and CDs. Eurocurrency Deposits: Eurocurrency Deposits The Eurocurrency market has arisen because of the tremendous need worldwide for funds denominated in dollars, Euros, pounds, and other relatively stable currencies. The Eurocurrency market represents the largest of all money markets worldwide, with total funds probably in excess of $4 trillion. They are employed to finance the import and export of goods, to provide working capital for the foreign operations of multinational corporations, and to provide liquid reserves for the largest banks. Most Eurocurrency deposits are short-term deposits ranging from overnight to one year, although a small percentage are long-term time deposits. Eurocurrency deposits are known to be volatile and highly sensitive to fluctuations in interest rates and currency prices. They also carry political risk and default risk. the Eurocurrency market is not limited to U.S. dollar. An account denominated in Japanese yen held in London or New York bank would be termed a Euroyen account. Eurodollar Market: Eurodollar Market Eurodollars are deposits of U.S. dollars in banks located outside the U.S. the Eurodollar market is by far the largest short-term security market in the world. This is due to the international popularity of the U.S. dollar for trade. The large majority of Eurodollar deposits are held in Europe, although Europe’s share of the total is declining. the Eurodollar market has continued to grow rapidly. As multinational banks are not subject to the same regulations restricting U.S. banks, Eurodollars interest rates are more favorable: higher return on deposit and lower cost on loan. Eurodollars are an alternative to fed funds. Some large London banks act as brokers in the interbank Eurodollar market. Banks from around the world buy and sell overnight funds in this market. LIBOR (London Interbank Offered Rate) is the rate paid by banks borrowing funds in this market. the overnight LIBOR and the fed funds rate tend to be very close to each other because they are near-perfect substitutes. Benefits and Costs of the Eurocurrency Markets: Benefits and Costs of the Eurocurrency Markets Benefits Makes possible an efficient mobilization of funds around the globe. Encourages international cooperation among nations. Creates a cash-management source to aid the financial operations of corporations and governments around the globe. Costs The capacity to mobilize massive amounts of funds may contribute to instability in currency values. Monetary and fiscal policies designed to cure domestic economic problems may not achieve their desired impact. International Bond Market : International Bond Market Global Bond Market Structure Issuers Public sector bonds Treasury bonds Federal agency bonds Municipal bonds Private sector bonds or Corporate bonds Eurobonds and Foreign Bonds Investors Securities Market Operations Credit Ratings 1. Issuers: 1. Issuers The bond markets in most countries can be categorized into the following sectors: Domestic or National Bonds 1.1 Government bonds 1.2 Government Agency Bonds 1.3 State and Local Government Bonds 1.4 Corporate Bonds International Bonds 1.5 Foreign Bonds 1.6 Eurobonds 1.1 Domestic Government Bonds: 1.1 Domestic Government Bonds The four largest government bond markets in descending order are U.S. - USTs Japan - JGBs Germany - Bunds U.K. - Gilts government bonds are backed by the the full faith and credit of the government. It has the best credit rating in the country and thus considered risk-free by the residents. government bond yield curves are used as benchmark yields in each country U.S. Treasury Notes and Bonds: U.S. Treasury Notes and Bonds The Treasury issues notes and bonds to finance the national debt. The difference between a note and a bond is the original maturity Treasury note : maturity 1 to 10 years Treasury bond : maturity 10 to 30 years Treasury securities are default-risk free, but this does not mean that they are risk-free. The auction method is the principal means of selling Treasury notes, bonds, and bills today. Today, the marketable public debt is issued in book-entry form only . Treasury STRIPS: Treasury STRIPS STRIPS – Separate Trading of Registered Interest and Principal Securities A STRIP separates the periodic interest payments from the final principal repayment. Each promised interest and principal payment in effect becomes a discount bond. Each interest payment from a stripped bond is called an interest-only security (IO) The principal of a stripped security is called a principal-only security (PO) for example, a five-year bond paying interest every six months could be split into 11 discount bonds: 10 IOs and 1 PO, each can be traded on its own. STRIPS makes it easier for investors to hedge against interest rate risk. 1.2 Government Agency Bonds: 1.2 Government Agency Bonds government agencies securities are obligations issued by agencies of the government These obligations are not direct issues of the government, yet implicitly carry the full faith and credit of the government Agency issues are subject to state and local income tax. government agencies issues account for 25% of the US market 15% of the Japanese market 5% of the German market No agency bonds issued in the UK US government agencies: Government National Mortgage Association (GNMA) Federal National Mortgage Association (FNMA) Student Loan Marketing Association (SLMA) Japanese government Agency: Government Associate Organizations U.S. Government Agencies : U.S. Government Agencies Federal National Mortgage Association – FNMA Government National Mortgage Association – GNMA Federal Home Loan Bank Board (FHLBB) Federal Home Loan Mortgage Corporation (FHLMC) Student Loan Marketing Association (SLMA) Tennessee Valley Authority (TVA) Private Export Funding Corporation (PEFCO) Federal Agency Securities: Federal Agency Securities Beginning in 1916, the U.S. federal government created special agencies to make direct loans or guarantee private loans to certain sectors of the economy. Congress has authorized a number of U.S. agencies to issue bonds to raise funds that are used for purpose that Congress has deemed to be in the national interest. For example, the Government National Mortgage Association (Ginnie Mae) issues bond to raise funds that are used to finance home loans. Similarly, the Student Loan Marketing Association (Sallie Mae) The government does not explicitly guarantee agency bonds, though most investors feel that the government would not allow the agencies to default. The risk on agency bonds is actually very low. they are usually secured by the loans that are made with the funds raised by the bond sales and the agencies may use their lines if credit with the Treasury should they have trouble meeting their obligations. Federal Agency Securities: Federal Agency Securities The agency market has soared in recent years, with the volume of outstanding securities climbing from about $2 billion during the 1950s to almost $2 trillion today. Agency securities are generally short to medium term in maturity (running out to about 10 years). The most active buyers of agency securities include banks, state and local governments, government trust funds, and the Federal Reserve System. The Federal Reserve is authorized to conduct open market operations in agency securities. Major securities dealers who handle U.S. government securities also generally trade in agency issues. 1.3 Municipal Bonds : 1.3 Municipal Bonds Municipal bonds are securities issued by state and local governments. Is large in the U.S. but small elsewhere The proceeds from these bonds are used to finance public interest projects such as transportation systems. There are two main types of municipal bonds. General obligation bonds (GOs) – do not have specific assets pledged as security or a specific source of revenue allocated for their repayment. Revenue bonds – payable only from a specified source of revenue, ie. backed by a particular revenue-generating project. For example, toll bridge project. The selling of municipals is usually carried out through a syndicate of banks and securities dealers. These institutions purchase the securities from the issuing government units and then resell them in the open market at a higher price. Prices paid by the underwriting firms may be determined by competitive bidding or by negotiation. Key Feature of Municipal Bonds: Key Feature of Municipal Bonds Tax exemption: municipal bonds that are issued to pay for essential public projects are exempt from federal taxation. This allows the municipality to borrow at a lower cost because investors will be satisfied with lower interest rate on tax-exempt bonds. The following equation can be used to determine what tax-free rate of interest is equivalent to a taxable rate tax-free rate = taxable rate * (1 – marginal tax rate) Example: suppose the rate on taxable corporate bond is 9% and the marginal tax rate is 30%. what is the tax-free municipal interest rate? tax-free rate = 0.09 * (1 – 0.3) = 0.063 = 6.3% The Municipal Market: The Municipal Market Many observers question the social benefit of the tax-exemption privilege. Although state and local governments can borrow more cheaply, the federal government must tax more heavily to make up for the lost revenue. Many important investor groups (such as pension funds) have little need for tax shelters. The Outlook for State and Local Governments With slower economic growth and less federal support, more states will be under pressure to force cities, counties, and school districts to deal with their own problems and find their own funding sources. At the same time, the need for local government services and the interest of investors are not likely to fade, thus ensuring the future growth of the market for state and local government debt securities. 1.4 Corporate Bonds: 1.4 Corporate Bonds issued by firms and businesses to finance their investment The corporate bond market is very large and important in the US. but are small in UK and very small in Japan and Germany corporate bonds provide the most diverse issues in terms of type and quality (low to high credit risks) Bonds with higher credit rating have lower interest rates than more risky bonds. Corporate Bonds: Corporate Bonds Each corporate bond is accompanied by an indenture – a contract listing the lender’s rights and privileges and the borrower’s obligations. Any collateral offered as security to the bondholders will also be describe in the indenture. Indentures usually contain restrictive covenants designed to protect bondholders against actions by the borrowing firm or its shareholders that might weaken the value of the bonds. They usually limit the amount of dividend the firm can pay, limit additional borrowing, restrict merger agreements, or limit the sale of the borrower’s assets. Typically, the interest rate will be lower the more restrictions are placed on management through restrictive covenants. These and other terms in a bond indenture are enforced by a third party – the trustee (often a bank trust department) – that represents the investors. The degree of risk varies widely among issues because default risk depends on the company’s health. Bonds with higher credit rating have lower interest rates than more risky bonds. Major classes of corporate: Major classes of corporate Secured or Senior Bonds … are backed by legal claims on specific assets, i.e. guaranteed by collateral Unsecured bonds or debentures … are backed only by the promise of the issuer to pay interest and principal on a timely basis. They are general credit obligations. No specific collateral is pledged to repay the debt. Subordinated or junior debentures … possesses a claim on income and assets that is subordinated to other debentures. Income or revenue bonds which pay only if the company has earnings. Characteristics of Corporate Bonds: Characteristics of Corporate Bonds A considerable proportion of corporate bonds that are outstanding today carry call privileges. The issuer has the right to force the holder to sell the bond back at a pre-specified ‘call price’. Investors do not like call provisions as it limits the amount that they can earn from the appreciation of the bond’s price From a firm’s standpoint, a callable bond provides flexibility to the firm’s financing needs and capital structure, or if the restrictive covenants are too restrictive. Some corporate bonds are backed by sinking funds. It is designed to ensure that the issuing company will be able to pay off the bonds when they come due. Periodic payments are made into the fund and a portion of the bonds may be retired from monies accumulated in the fund (Amortizing bonds). This reduces the probability of default. convertible bond. Some bonds can be converted into shares of common stock. This permits bondholders to share in the firm’s good fortunes if the stock price rises. A convertible bond is a bond + a stock option. The price of a convertible bond will be higher than the price of a comparable nonconvertible bonds, reflecting the value of the option The Marketing of Corporate Bonds: The Marketing of Corporate Bonds New corporate bonds may be offered publicly in the open market to all interested buyers through a public sale, or sold privately to a limited number of investors via a private or direct placement. The majority of corporate bond sales are public sales. Private placements are, however, popular among smaller companies and firms with unique financing requirements. In a public sale, an investment banking firm or a syndicate of underwriters may either purchase the securities directly from the issuing company through a bidding process or guarantee the issuer a specific price for the securities. (Firm commitment VS Best effort) In both approaches, the underwriter carries the risk of losses (or gains) when the securities are marked for sale in the open market. Best-efforts agreement is an alternative to underwriting securities. In a best-efforts agreement, the investment banker sells the securities on a commission basis with no guarantee regarding the price the issuing firm will receive. The investment banker has no risk of mispricing the security. 1.5 Foreign Bonds: 1.5 Foreign Bonds are denominated in the local currency and sold in the country’s domestic market but issued by foreigners (non-domestic firms) For example, if German automaker Porsche sells a bond in the U.S. denominated in U.S. dollars, it is classified as a foreign bond. Foreign bonds have been an important instrument in the international capital market for centuries. In fact, a large percentage of U.S. railroads built in the 19th century were financed by sales of foreign bonds in Britain Foreign bonds are usually named after the country they are sold in. For example, Yankee bonds (sold in U.S.), Samurai bonds (sold in Japan), Bulldog bonds (sold in Britain) and Baht bonds (sold in Thailand) Recently, Asian Development Bank (ADB) has issued Baht bonds 4 Bil. Bt. with 5-yr maturiy Bonds issued by Thai Govt. in Foreign Currencies:Yankee and Samurai Bonds: Bonds issued by Thai Govt. in Foreign Currencies: Yankee and Samurai Bonds Spread of KOT over UST: Spread of KOT over UST 1.6 Eurobonds: 1.6 Eurobonds A bond denominated in a currency other than that of a country in which it is sold. For example, a bond denominated in U.S. dollars sold in London. Currently, over 80% of the new issues in the international bond markets are Eurobonds, and the market for these securities have grown very rapidly. As a result, the Eurobond market is now larger than the U.S. corporate bond market Note that the new currency, the euro, can create some confusion about the terms Eurobond (or Eurocurrencies, and Eurodollars). A bond denominated in euros is called a Eurobond if it is sold outside the countries that have adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with the euros, but are instead U.S. dollars deposited in banks outside the U.S. 2. Investors: 2. Investors Individual and institutional investors (e.g. mutual funds, insurance companies, pension funds) with diverse investment objectives participate in the bond market. Institutional investors account for 90%-95% of the trading in the bond markets. Institutions tend to select issues based on two facts: 1. The tax code applicable to the institution. 2. The nature of the institution’s liability structure. 3. Securities Market Operations (1): 3. Securities Market Operations (1) The smooth functioning of securities markets, in which bonds and stocks are traded, involves several financial institutions 3.1 Investment banker assist in the initial sale of securities in the primary market some of the well known U.S. investment banking firms are Goldman Sachs, Lehman Brothers underwriters are investment bankers that guarantee a corporation a price on the securities and then sell them to the public 3. Securities Market Operations (2): 3. Securities Market Operations (2) 3.2 Securities brokers and dealers assist in the trading of securities in the secondary markets, some of which are organized into exchanges Brokers act as agent for investors in the purchase and sale of securities. They match buyers and sellers and get paid brokerage commission Dealers link buyers and sellers by standing ready to buy and sell at given prices. They hold inventories and earn the “spread” between the asked price and the bid price Dealers takes on more risks 4. Bond Ratings (1): 4. Bond Ratings (1) Four major rating agencies: Duff and Phelps Fitch Investors Moody’s Standard & Poor’s (S&P) Grades: Investment – AAA, AA, A and BBB Speculative – BB and B Income bonds – C Default – D 4. Bond Ratings (2): 4. Bond Ratings (2) A firm’s subordinated issues are assigned lower ratings than the firm’s senior issues. Academic studies have found that the rating agencies tend to overestimate the probability of default when assign ratings. Bonds rated BB and below are commonly called junk bonds. 45% of junk bonds are BB, 49% are B, and 6% are CCC and below. Most high yield bonds are currently owned by mutual funds. 4. Bond Ratings (3): 4. Bond Ratings (3) AAA The highest rating. AA There is a strong capacity to pay interest and principal. A There may be some impairment in case of adverse economic changes. BBB Adequate capacity to pay interest and principal, some safeguards are missing. BB Moderate protection to pay interest and principal. B Assurance of long term payment of interest and principal is small. CCC Poor quality and danger of default or in default. CC Highly speculative, may be in default, the issue has serious shortcomings. C Rating for income bonds, i.e. the bonds are not paid interest. D In default, principal or interest is in arrears. Bond Ratings : Bond Ratings Risk Structure of Long-Term Bonds in the United States: Risk Structure of Long-Term Bonds in the United States Interpreting Bond Quotes (1): Interpreting Bond Quotes (1) Bonds can be quoted on the basis of either yield or price. Price quotes are interpreted as a percentage of par. A quote of 98½ is not $98.50 but rather 98.50% of par. A $1,000 par bond would sell for $985 while a $5,000 par value bond would sell for $4,925. Corporates are quoted to the nearest 1/8 of a point. A bid of 98 1/8 is 98.125% of par. Also listed is the bond’s current yield (dollar coupon/market price) and any bond specifics: (zr for zero coupon, cv for convertible, f for trading flat) Interpreting Bond Quotes (2): Interpreting Bond Quotes (2) Quoted bond prices do not include accrued interest. (i.e. clean price) At the time of sale, the buyer pays the seller accrued interest in addition to the quoted price. Flat means you pay the price but not the accrued interest. Treasuries and agencies are bid-ask quotes in 32nds of a price point. A bid of 114:03 is a bid of 114.09375% of par or $1,140.9375 for a $1,000 par value. Agency maturity listing of 2003-2008 means the bonds has deferred call feature until 2003 and final maturity of 2008. Bond Page of the Newspaper: Wall Street Journal: Bond Page of the Newspaper: Wall Street Journal Slide67: Quotes for Thai Government Bonds on Newswire service (Reuters) Some Risks Associated with Holding Bonds: Some Risks Associated with Holding Bonds Interest rate risk (Market risk) Reinvestment risk Liquidity risk (Marketability risk) Default risk (Credit risk) Call risk Inflation risk (Purchasing power risk) Exchange rate risk (Currency risk) Interest Rate Risk: Interest Rate Risk When interest rates change, the price of the underlying bond will move in the opposite direction. When rates fall, bond prices rise. When rates rise, bond prices fall. This is also called price risk. Duration and convexity measure this interest rate risk Floating rate notes or derivatives such as interest rate swap can reduce this risk Floating Rate Notes (FRNs): Floating Rate Notes (FRNs) FRNs are bonds having floating interest rates. the coupon payments are reset periodically according to some reference rate. Typical FRN carries a fixed rate for the first year, after which time interest rates vary based on a predetermined index. Coupon rate = reference rate + quoted margin Floating index : LIBOR FRN quote : LIBOR + spread Spread is fixed and reflects credit risk Reinvestment Risk: Reinvestment Risk One of the key assumptions in bond investing is the reinvestment of the bond’s coupon payments. If you can not reinvest the coupons at the YTM, your actual yield will be less than promised. This is called reinvestment risk. If rates fall, coupon payments received can no longer be reinvested at the old, higher rate. Zero coupon bonds have no reinvestment risk Zero Coupon Bonds (Zeros): Zero Coupon Bonds (Zeros) Zeros promise to pay a stipulate principal amount at the maturity date. Zeros don’t make any interim interest payments. The price of bond is the present value of the principal payment at the maturity date using the required discount rate for the bond. Liquidity Risk: Liquidity Risk Liquidity risk refers to how easy it is to sell an issue close to its value. The primary measure of liquidity risk is the size of the dealer bid and ask price spread. The wider the dealer spread the greater the liquidity risk. Default Risk: Default Risk Default risk refers to the risk that the issuer of a bond may default. Corporate bonds sell at a premium or spread over Treasuries of similar maturity to compensate the investor for this risk. Except for the lowest rated securities (junk bonds with ratings of BB or lower), default risk is associated with the change in yield caused by the perception of changes in the probability of default. Call Risk: Call Risk The ability of the issuer to call a bond creates three problems for investors: The cash flow pattern of callable bonds cannot be known with certainty. The investor is exposed to additional reinvestment rate risk. Why? The bonds will only be called if interest rates fall. If this happens, investors will have to reinvest the received principal prepayment at the lower interest rates. Callable bonds have reduced capital appreciation potential. If rates fall, the bond will not raise above the call price adjusted for the time to first call. Inflation Risk: Inflation Risk Since most bonds have fixed coupon and principal payments, the future purchasing power of these fixed amounts diminishes as inflation increases. Inflation-indexed bonds can protect investors from this TIPS – Treasury Inflation Protected Securities Exchange Risk: Exchange Risk For US investors, non-dollar denominated bonds have unknown US dollar cash flows. The dollar value of the cash flows is dependent on the exchange rate at the time the payments are received. Cross currency swap can eliminate this risk Asian Bond Market Development:The Asian Bond Funds (ABFs): Asian Bond Market Development: The Asian Bond Funds (ABFs) Asian Bond Market Development: Asian Bond Market Development Promote regional Cooperation promote efficiency of financial intermediation in the region broadening and deepening regional bond markets Mobilize regional savings into regional investments Diversify reserves investments beyond the more traditional reserve assets and to enhance their returns Boost demand for regional debt securities (ABF1, ABF2) Spark increased efforts to develop local bond markets to remove impediments Demand and supply sides, market infrastructure such as benchmark yield curve, tax issues, clearing and settlement system, hedging instruments Of the Asians, by the Asians, for the Asians Slide80: Total outstanding value of Domestic Bonds in Thailand Source: Thai BDC Slide81: Source: BoT Holdings of Public Sector bonds as of end 2004 What is Asian Bond Fund (ABF)?: What is Asian Bond Fund (ABF)? ABFs are the first initiatives in which a regional organisation (EMEAP) has contributed financial resources to setting up actual bond funds in Asia. It was the first regional pooling of international reserves in Asia. The first bond fund, ABF1, was launched in June 2003 invest $1 billion of EMEAP international reserves in US dollar-denominated bonds issued by sovereigns and quasi-sovereign borrowers in eight of the 11 EMEAP economies. The second bond fund, ABF2, was launched in May 2005 invest $2 billion of reserves in local currency denominated sovereign and quasi-sovereign issues in the same eight EMEAP markets. The aim was to foster regional bond market development. See “Opening markets through a regional bond fund:lessons from ABF2” by Ma, G. and E.M.Remolona (BIS Quarterly Review, June 2005) for a comprehensive summary and analysis of the ABF intiatives “In creating a regional bond fund, central banks in East Asia and the Pacific worked to reduce impediments in eight local markets. Moreover, they built into the fund’s structure an incentive mechanism for reducing impediments further.” Slide83: Asian Bond Fund 1 (ABF1) Launched July 2003 Investors The 11 EMEAP central banks: Japan, China, Korea, Hong Kong, Singapore, Thailand, Malaysia, Indonesia Philippines, Australia and New Zealand Securities US dollar-denominated bonds issued by sovereigns and quasi-sovereign borrowers in 8 of the EMEAP economies. (excluding Australia, Japan and New Zealand) $1 billion of International reserves of the 11 EMEAP economies Source of funds Fund Manager Bank for International Settlements (BIS) Management style Passive Management against Benchmark Slide84: Asian Bond Fund 2 (ABF2) Phase I: Launched in May 2005 Investors The 11 EMEAP central banks: Japan, China, Korea, Hong Kong, Singapore, Thailand, Malaysia, Indonesia Philippines, Australia and New Zealand Securities local currency-denominated bonds issued by sovereigns and quasi-sovereign borrowers in 8 of the EMEAP economies. (excluding Australia, Japan and New Zealand) $2 billion of International reserves of the 11 EMEAP economies Source of funds Phase II Offer the Funds to other public and private investors Fund Structure 1) PAIF : Pan-Asia Bond Index Fund 2) FOBF : Fund of Bond Funds – comprises 8 single market funds Structure of ABF2: Structure of ABF2 Source: BIS The iBoxx ABF Indices : The iBoxx ABF Indices Weighting based on size, turnover ratio, sovereign credit rating and a market openness factor Transparency, replicability and credibility of these market indices will provide useful benchmarks Source: BIS Part II: Role of Central Banks in International Financial Markets: Part II: Role of Central Banks in International Financial Markets Most central banks are participants in the international financial markets: money, bond and foreign exchange markets They are responsible for managing the country’s international reserves managing the country’s foreign exchange policy Reserve Management: Reserve Management What are official reserves? Importance of international reserves Reasons for holding reserves Framework for reserve management Trends in international reserves Risks measurement and control What are official reserves?: What are official reserves? Reserves consist of official public sector foreign assets readily available to and controlled by the monetary authorities (IMF) two imporatnt characterisitcs Liquid or easily marketable must be in form of convertible foreign currency claims Importance of international reserves and its management: Importance of international reserves and its management International reserves are a major national asset They are used to support economic policies Reserve adequacy or inadequacy can have significant consequences on economy, financial markets and credibility of policy makers Reserves management help ensure reserves are safeguarded and readily available Reasons for Holding Reserves: Reasons for Holding Reserves back domestic currency to implement exchange rate or monetary policy Service foreign currency liabilities and debt obligations maintain market confidence in times of crisis or when access to borrowings is constrained defend against national emergencies or disaster obtain investment returns and create wealth Framework for Reserve Management: Framework for Reserve Management Objectives of reserve management Liquidity: reserves must be available when needed Security: essential as reserves are national assets Returns: subject to liquidity and risk constraints, reasonable returns are expected Three levels of decisions: Policy: Articulating the objectives Strategy: Implementing policy Tactical: Portfolio management and execution Effective management : Segregation of duties: Effective management : Segregation of duties Top level has to set : Objectives and Strategies Size and broad currency split of the reserves Overall interest rate exposure position Credit risks and credit limits policy Second level has to: Interpret and implement the strategy from the top Report back to the higher level on the results Which market Which instrument Position taking Allocation of funds Staff have to Carry out the instructions Provide the day-to-day management of the port within agreed guidelines Reserve Management Policy: Reserve Management Policy Specify objectives: what are the reserves for? How liquid must they be? Derive Risk-return preference: what returns are desired? What is the tolerance for risk? Determine asset allocation: asset types and amount Set benchmark: that is consistent with achieving the objectives Benchmark Construction Process: Benchmark Construction Process Optimized portfolio (foreign currency and asset composition) that best reflects investment objectives and risk tolerance Each benchmark portfolio is constructed to align with its strategic objectives Strategy Formulation: Strategy Formulation Front-office dealers are primarily responsible for the formulation of the investment strategy based on Fundamental analysis Technical analysis Econometric models These tools are employed to forecast interest rates and currency movements Portfolio Construction: Portfolio Construction An optimization model is employed to construct portfolio allocation. Inputs are based on the expected return derived from the formulated strategy Risk allocation among currencies, assets, and duration are prioritized according to the expected risk-adjusted returns Expectation of Market Movements Risk Allocation Tracking Error Duration Deviation Market Deviation Currency Deviation Trends in Reserves Management: Trends in Reserves Management Many central banks have: Distinguished between liquidity and investment needs Widened universe of eligible assets Lengthened duration of securities Paid more attention to risk management US dollar remains the predominant reserve currency for central banks Appropriate currency composition Short term debt coverage Trading partners approach Optimisation/diversification approach Forwards, swaps and options are used to manage currency positions Many central banks continue to maintain gold as a reserve, despite low returns from gold relative to other asset classes try to enhance returns through gold lending, gold swaps and collateralized borrowing Recent Trends: Huge Reserves Accumulation…: Recent Trends: Huge Reserves Accumulation… Source: BIS …mostly by Asian Central Banks : Source: BIS …mostly by Asian Central Banks Thailand’s International Reserves is Increasing: Thailand’s International Reserves is Increasing Source: www.bot.or.th Challenges of Increasing Reserves: Challenges of Increasing Reserves Reserves increasingly seen as wealth of the country Increasing public pressure to account for performance of reserve management Increase in reserves may mean a mismatch between central banks’ domestic liabilities and reserves Foreign exchange risks can be sizeable Many countries’ reserves have doubled in 4 years : Many countries’ reserves have doubled in 4 years Source: S&P’s US Dollar continues to be the main reserve currency: US Dollar continues to be the main reserve currency Source: BIS Majority of reserves are invested in securities: Majority of reserves are invested in securities Source: BIS The Case for Diversification: The Case for Diversification Source: BIS Risk Measurement: Risk Measurement Purpose Monitor and control risk limits (benchmark deviation limits, liquidity, and credit risk) Risk allocation (tracking error, marginal value-at-risk) Evaluate risk-adjusted performance (absolute value-at-risk & tracking error) The outstanding position of the whole portfolio is marked-to-market. Then the risk is measured based on the marked-to-market position Tracking error plays an important role in both risk allocation and performance evaluation. It is the risk relative to benchmark portfolio. Monitoring and Control: Monitoring and Control Risk Limit Setting To maintain foreign exchange reserve exposure within predetermined risk tolerance. Three types of risk limit controls employed: 1. Credit risk-based limit setting 2. Benchmark deviation rules (duration, market, currency deviations / tracking error) 3. Maximum level of yield-enhanced instruments (credit portfolio model) Performance Evaluation: Performance analysis is the tool to evaluate the value added from benchmark deviation The risk-adjusted return is employed to Provide a comparable measure of performance across portfolios Ensure consistency of portfolio strategy with the benchmark Performance Evaluation Return Attribution Relative to Benchmark Structure of Reserves by Portfolio and Account : Structure of Reserves by Portfolio and Account Foreign Reserves General Acct. Investment Currency Reserve Acct. Exchange Equalization Fund Liquidity Port. Liability Port. EEF Port. CR. Acct. SR. Acct. B. Acct. Gold Ext’l FMGR Rep Office ABF Slide111: FMOG (สายตลาดการเงิน) Financial Markets & Reserves Mgmt. Dept. (ฝตง.) Reserves Management Division Mid Office/ Compliance Settlements Treasury Operations and Control (ฝปบ.) Quant. Analysis FX&MM Bonds Risk Mgmt. Office (RMO) สบส. IS Team Top Management Committee (TMC) คบร. Reserves Management Sub-committee (RMSC) องส. Rep. Office NY & LDN II. Reserves Management Organization Structure FX policy management in Thailand: FX policy management in Thailand Foreign exchange regime Basket peg until June 1997 Managed float after that Why do we need to manage the float? to prevent excessive volatilities in the markets, while fundamental trends are accommodated In other words, movements in the exchange rates which are in line with the changes in economic fundamental and financial development would only be smoothened and not resisted. How do we manage exchange rates? By using both intervention and anti-speculation measures For details, see paper on “Foreign Exchange Policy and Intervention in Thailand” in the BIS Paper #24. Movements of Exchange Rates After the Float: Movements of Exchange Rates After the Float As foreign exchange regulations were imposed, the proportion of NR trading was gradually declining. : As foreign exchange regulations were imposed, the proportion of NR trading was gradually declining.