Structured financial instruments represent a broad sector of financial instruments including asset-backed securities and collateralized debt obligations. A common characteristic of these instruments is that they repackage and redistribute risks. In this section, we focus on the following four categories of instruments:
Capital protected instruments offer different levels of capital protection, and are only as good as the issuer of the instrument. One example of a capital protected instrument is a guarantee certificate that offers full capital protection. This is achieved by combining a bond and a call option.
For example, consider an investor who has $100,000 to invest. The investor buys zero-coupon bonds that will pay off $100,000 after one year. The investor pays $99,000 for the bond and invests the remaining $1,000 from the purchase of the bond to buy a call option on some asset that expires one year from now. Now, let us see what happens one year from now when the bond matures. If the price of the underlying asset on the call option increases, the call expires in the money. The investor gets $100,000 when the bond matures and profits from the call option. If the price of the underlying asset on the call option falls, the call expires worthless. The investor’s capital is still protected as he gets $100,000 when the bond matures and loses the premium paid for the call option. The downside is limited to the $1,000 premium paid for the call option.
Yield enhancement refers to higher risk exposure and possibly a higher expected return. A credit-linked note is an example of a yield enhancement instrument.
The characteristics of a CLN are as follows:
A participation instrument is a type of instrument that allows investors to participate in the return of an underlying instrument. They give investors indirect exposure to a particular index or asset price. A floating-rate bond is an example of a participation instrument whose coupon rate adjusts periodically to a pre-defined formula.
Unlike capital-protected instruments that offer equity exposure, participation instruments do not offer capital protection.
Leveraged instruments are structured financial instruments that offer higher returns for small investments. An example of a leveraged instrument is an inverse floater. Unlike a traditional floater, the cash flows are inversely related to changes in the reference rate. When the reference rate decreases, the coupon payment of an inverse floater increases.
Inverse floater coupon rate = C – (L * R)
C = the maximum coupon rate reached if the reference rate is equal to zero
L = the coupon leverage. This indicates the multiple the couple rate will change for a 100 basis points change in the reference rate
R = the reference rate on the reset date
Inverse floaters with a coupon leverage rate greater than 0 but lower than 1 are known as deleveraged inverse floaters. Inverse floaters with a coupon leverage rate greater than 1 are known as leveraged inverse floaters.
This section looks at where banks get their funds from in the short-term.
One of the primary sources of funds for a bank is the money deposited by retail (like you and me) and commercial investors in their accounts. It is the lowest possible source of funding for a bank. The three types of retail accounts and characteristics of each of these accounts are discussed below:
Demand deposits or checking accounts
Money market accounts
Central Bank Funds
Certificates of Deposit
A repurchase agreement or repo is a sale and repurchase agreement. It is an agreement between two parties where the seller sells a security with a commitment to buy the same security back from the purchaser at an agreed-upon price at a future date. It is similar to borrowing funds against collateral. Assume there are two parties: banks A and B. A has a 90-day T-bill that it sells to B for $99.50. It agrees to buy the same T-bill the next day for $99.51. This was a means of borrowing $99.50 overnight for A. The 1¢ can be considered as the interest for the borrowed amount.
Structure of Repurchase and Reverse Repurchase Agreements: We will look at some terms related to repo with the help of the A and B example we saw earlier.
The factors that affect the repo rate include:
Credit Risk Associated with Repurchase Agreements
Both the parties in a repo agreement face the risk of default from the counterparty. There is credit risk even if the collateral is a highly rated sovereign bond. Let us analyze what happens when each party defaults.
If the dealer defaults and cannot repurchase the collateral:
If the investor defaults and cannot deliver the collateral: