IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

# Part 4

## 7.  Structured Financial Instruments

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:

### 7.1. Capital Protected 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. ### 7.2. Yield Enhancement Instruments 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: • It pays regular coupons but its redemption value depends on a well-defined credit event such as a ratings downgrade of an underlying reference asset. • If the event does not occur, then the investor will receive par value at maturity. However, if the event occurs, then the investor receives the par value of the CLN minus the nominal value of the underlying reference asset. • A CLN therefore allows the issuer to transfer the credit risk to investors. Investors are willing to buy CLNs because they offer higher coupons as compared to otherwise similar bonds. ### 7.3. Participation Instruments 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. ### 7.4. Leveraged Instruments 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) where: 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. ## 8. Short-Term Funding Alternatives Available to Banks This section looks at where banks get their funds from in the short-term. ### 8.1. Retail Deposits 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 • Depositors have access to funds anytime. • The funds may be used to pay for transactions. • Little or no interest is paid. Savings accounts • Depositors have access to funds. • Unlike checking account, savings accounts pay an interest. But they do not offer the same transactional convenience. Money market accounts • Funds are available at short or no notice. • Offer money market rates of return. ### 8.2. Short-Term Wholesale Funds Central Bank Funds • When a bank receives deposits from customers, a certain percentage of this money must be kept as a reserve with the national central bank. The amount a bank keeps as reserves varies based on its financial position: some have a deficit and some have a surplus. • The funds stashed in the central bank by all banks are collectively known as the central bank funds market. • Assume a bank is running low on cash and a customer wants to withdraw money from this bank. The bank has two choices. It may withdraw cash from its reserve account in the central bank to pay the customer, if it has sufficient funds. Or it may borrow money from banks that have a surplus in their accounts at the central bank. The funds, known as central bank funds, may be borrowed for a period up to one year at rates known as central bank funds rates. • If the borrowing is for one day, it is called overnight funds. If it is for more than one day, then it is called term funds. Interbank Funds • Banks lend to and borrow from each other in the interbank market. • It is an unsecured system of lending. • The term may vary from overnight to one year. • The reference rate at which they borrow is called the interbank offered rate. Or, they may borrow at a fixed interest rate. • Often large banks publish two rates: one at which they borrow and one at which they lend. Certificates of Deposit • A certificate of deposit is a savings instrument with a maturity date, a fixed interest rate, and can be issued in any denomination. The investor or bearer of the certificate receives an interest at the end of the deposit period. CDs can be issued to individuals, companies, trusts, funds, etc. • There are two forms of CD: negotiable and non-negotiable CD. • In a non-negotiable CD, the interest and deposit are paid at maturity. There is a penalty if the depositor withdraws funds before maturity. • In a negotiable CD, depositors are allowed to sell the deposits before maturity. • There are two types of negotiable CDs: • Large-denomination CDs: CDs of denomination of$1 million or more; often traded among institutional investors.
• Small-denomination CDs: of lower denominations and meant for retail investors.

### 8.3.     Repurchase and Reverse Repurchase Agreements

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.

• Reverse repo: It was a repo arrangement from bank A’s (seller of security) perspective. But from bank B’s perspective (purchaser of security), it is a reverse repo.
• Repurchase price: The price at which A will buy back the security from B the next day is called the repurchase price. The price at which the dealer repurchases the security is called the repurchase price.
• Repurchase date: The date on which the dealer (A) repurchases the security (from B) is called the repurchase date. In our example, it was the next day.
• Overnight repo: If the repurchase happens the next day, i.e., if the agreement is for one day, it is called overnight repo.
• Term repo: If the repurchase happens after more than a day, it is called term repo.
• Repo to maturity: If the agreement is honored until maturity, then it is called repo to maturity.
• Repo rate: The interest rate negotiated between both the parties is called the repo rate. In our example, 1¢ was the interest paid.

The factors that affect the repo rate include:

• The risk of the collateral: Highly rated collateral such as sovereign bonds exhibit low risk and lower repo rates.
• Term of the repurchase agreement: The longer the term, the higher the rates.
• Delivery requirement: If the collateral is delivered to the lender, the rates are lower. If the underlying collateral is not delivered to the counterparty, then the risk is higher and so is the repo rate.
• Supply and demand: Collateral in high demand has lower repo rate. If the collateral is scarce/low supply, the repo rate is lower.
• Interest rates of alternative financing.

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:

• The investor keeps the collateral and retains any income from the same.
• The investor is at a disadvantage if the price of the collateral falls below the repurchase price (owed by the dealer).

If the investor defaults and cannot deliver the collateral:

• The dealer keeps the cash.
• The dealer is at a disadvantage if the price of the collateral rises above the price quoted in the repurchase agreement. The dealer now holds less cash than the collateral’s current value.
• The lender of funds carries a greater credit risk than the dealer. In order to protect the investor, usually the amount lent is lower than the market value of the collateral.
• Haircut or repo margin = market value of security (collateral) – amount lent to dealer
• The amount of difference or repo margin depends on:
• Length of the repo. The longer the duration of the repo, the higher the risk and greater the margin.
• Quality of the security used as collateral: The higher the quality, the lower the margin.
• Creditworthiness of the dealer: The higher the creditworthiness, the lower the margin.
• Supply and demand: If the collateral is in high demand / low supply then the repo margin is lower.