Financial Derivatives

FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009

Week 10 – Practical Bond Trading

& Swaps
Practical Bond Trading
 This lecture looks at
 Where are bonds traded?
 How are they quoted?
 How do I buy a bond?
 How much do I pay/receive (exactly)?
 How does the settlement occur?
 When do I earn accrued interest?
 Where are my bonds stored/registered?

 These answers to these practical questions will

give you an insight and a better understanding of
bond and (by extension) other markets.
Practical Bond Trading
 We shall examine an Irish Government Bond
traded through EuroClear
 And an American T-Bond

 Primary and Secondary Bond Markets

 A Primary Market is the market in which investors have
the first opportunity to purchase an asset
 A Secondary Market is the market where an investor
purchases an asset from another investor directly or
through an intermediatory
Practical Bond Trading
 We shall examine an Irish Benchmark
Government Bond traded through EuroClear
 And an American Benchmark 10-year Treasury
Note
 A benchmark bond is a bond that provides a standard
against which the performance of other bonds can be
measured.

 Primary and Secondary Bond Markets

 A Primary Market is the market in which investors have
the first opportunity to purchase an asset
 A Secondary Market is the market where an investor
purchases an asset from another investor directly or
through an intermediatory
Practical Bond Trading
 US Bills, Notes and Bonds are issued in the
primary markey by the US Treasury department
through an auction process

 In 2003, the US Treasury issued $3.42 trillion

new debt issues
 $2.83T was used to redeem existing debt
 Therefore $353B was new debt
 This debt is capped by the US Congress

 All US Treasury debt is traded OTC in the

secondary market
Practical Bond Trading
 Irish Government Bonds are issused through the
National Treasury Management Agency (NTMA)
 A new bond may be issued by either tap, auction
or switching
 Auctions are held on the 3rd Thursday of each
month
 When securities are sold on tap, issuance takes
place on an ongoing basis over the selected
period of sale.
 Switching involved changing maturities
Quoted Prices
 When an investor buys a bond between coupon
payments, the investor must compensate the
seller of the bond for the coupon interest earned
from the time of the last coupon payment to the
settlement date of the bond. This amount is
called accrued interest

 Prices are quoted Clean or Dirty

 Clean Price => quote excludes accrued interest
 Dirty Price => quote includes accrued interest

 Typically, prices are quoted Clean

 Quoted Prices
 Let’s look at an example;
 You buy 5,000 bonds with the following features:
 5% coupon paid semiannually
 Maturity in 9 months
 Current Price = 98
 The bond has a face value of €1,000
 The price quoted is the clean price

t
en
m
on 25 ttle on 5 y
u p . Se t e u p 2 u rit 5
Co -0
= Da 0 Co 0 . t
Ma 0 .
7
T = = =
T T T
Quoted Prices
 The seller is due the price of the bond PLUS the
accrued interest due
 In this simple example, the seller is due
 0.05x½x0.5 = 1.25% addittional

 So you (the investor) paid

(98.0%+1.25%)x1,000x5,000
= €4,962,500.00
Daycount Conventions
 Our previous simple example showed the accrued
interest on exactly half a coupon
 But the market conventions must be more
stringent
 Daycount conventions are expressed as X/Y
 The interest earned between two days is
No of Days Between Dates
X Interest Earned in Ref. Period
No of days in Ref. period

 In finance, a day count convention is a method

to calculate the fraction of a year between two
dates
Daycount Conventions
 Day count conventions include:
 30/360
 30/360E
 actual/360
 actual/365
 actual/actual and more

ly
Days Between Dates 3-Ju
0

4 5 6 7 8
/0 1/0 1/0 1/0 /0 ep
Ma
r 01 0 0 0 01 -S
- 01
01 Reference Period
Daycount Conventions
 Look at the number of dates between 01/03 and
03/07 Ju
ly
Days Between Dates -
03

/0
4
/0
5
/06 /0
7
/0
8
e p
Ma
r 01 01 01 01 01
1-S
- 0
01 Reference Preiod

 Using ACT/ACT = 124/184

 Using 30/ACT = 122/184
 Using 30/360 = 122/180

 These slight differences amount to enormous

amounts of money when dealing with Billion Euro
Deals
Daycount Conventions
 Irish Government Bonds trade ACT/ACT
 US Treasury Notes and bonds settle ACT/365
 US Corporate Bonds settle 360/30

 There are always exceptions to the rule so be

aware of the DayCount conventions of the
instruments and markets that you trade in
Settlement Instructions
 When a deal is agreed, the details are passed
electronically by the trader to the back office
 The back office send the trade details
electronically to the clearing house
 The counterparty to the trade does likewise
 Assuming all is in order the trade settles some 1
to 3 days after the trade date
 Trade Date = TD
 Settle Date = SD
 SD = T+3
Settlement Instructions
 The SD is more important than the TD as it
decides the date ownership is transferred and
hence, when accrued interest commences
accruing for the buyer
 Irish Government bonds settle (payment in full)
on a t+3 basis but deferred settlement can be
arranged on request.
 US Treasury Notes and bonds settle regular way,
which is one day after the trade date (T+1)
Quote Methods
 32nds
 Irish Government bonds
 US Treasury Notes and bonds
Quote Methods
 See the Irish Gov.
2018 Benchmark bond
 Source ISE
 http://www.ntma.ie
 Quote Methods
 A U.S. Treasury-issued security with a maturity of
between 2 and 10 years. Treasury notes are issued
in denominations of $1,000, $5,000, $10,000,
$100,000, and $1 million. Interest is calculated on an
actual / 365 day-count basis and quoted as a
percentage of par to the nearest 1/32nd.

Price
Issue Maturity Interest Yield
Security Term Type Per CUSIP
Date Date Rate % %
$100

10-YEAR NOTE 07-15-2005 07-15-2015 1.875 1.939 99.420765 912828EA4

Introduction to Swaps
 A swap is an agreement between two parties to
exchange a series of cash flows in the future
 The agreement details the payment dates and the way
the payments are calculated

 A swap contract may be considered to be a series

of forward contracts
 Or indeed a forward contract may be considered to be
the simplest type of swap

 The two most common types of swaps are the

plain-vanilla interest rate swap and the fixed-for-
fixed currency swap
Plain-Vanilla Interest Rate Swaps
 With an interest rate swap one party agrees to
make payment of interest at a predetermined
fixed rate for a number of years
 The interest is calculated on an agreed notional principal

 The other party agrees to make payment of

interest at a floating rate for the same number of
years
 The interest is calculated on the same notional principal

 The reference floating rate is the London

Interbank Offer Rate (LIBOR)
Plain-Vanilla Interest Rate Swaps
 The following discussion will illustrate the
workings of an interest rate swap

 Consider a 3-year swap agreed between Intel and

Microsoft

 Microsoft agree to pay Intel a fixed interest rate

of 5% on a notional principal of $100m

 Intel agree to pay Microsoft 6-month LIBOR on

the same principal of $100m
Plain-Vanilla Interest Rate Swaps
 The following diagram illustrates the interest rate
exchange 5%

INTEL MICROSOFT

LIBOR

 The first exchange of cash flows is to be made six

months from the initiation of the swap
 Payment is to be made continue every six months until
the end of the 3-year swap contract

 The next table gives the cash flows for Microsoft

under assumed values of 6-month LIBOR
Plain-Vanilla Interest Rate Swaps

Date 6-month Floating Cash Fixed Cash Net Cash

LIBOR Flow Flow Paid Flow
(%) Received
($m) ($m) ($m)
t0 4.2

t0.5 4.8 +2.10 -2.50 -0.40

t1 5.3 +2.40 -2.50 -0.10

t1.5 5.5 +2.65 -2.50 +0.15

t2 5.6 +2.75 -2.50 +0.25

t2.5 5.9 +2.80 -2.50 +0.30

t3 6.4 +2.95 -2.50 +0.45

Plain-Vanilla Interest Rate Swaps
 Note that the 6-month floating payment is
calculated using LIBOR as recorded at time t0

 The 1-year floating payment is calculated using

LIBOR as recorded at time t0.5

 Similarly, each remaining floating payment is

calculated using the previous period’s LIBOR

 In reality the two companies do not actually

exchange the entire agreed cash flows
Plain-Vanilla Interest Rate Swaps
 Instead the net cash flow is paid by one party to
the other

 Microsoft make payments to Intel of $0.4m and

$0.1m on the 6-month and 1-year dates
respectively

 Thereafter Microsoft actually receives the net

cash flow positions from Intel
 Due to the fact that 6-month LIBOR rises above the
fixed rate of 5% by the end of year 1
Plain-Vanilla Interest Rate Swaps
 Note that the notional principal is not exchanged
by the parties at the end of the swap period
 Hence the use of the term notional principal
Using a Swap to Transform a Liability
 Swap contracts are commonly used to transform
the nature of company liabilities

 To illustrate, suppose Microsoft has entered into a

floating-rate loan to the value of $100m

 Assume that the interest rate to be paid on the

loan is LIBOR plus 10 basis points
 A basis point in the interest rate market is equal to
0.01%, so 10 basis points is 0.1%
Using a Swap to Transform a Liability
 If Microsoft enters the swap as outlined above
then it is committed to three sets of cash flows
 It pays LIBOR plus 0.1% to its outside lenders
 It receives LIBOR under the terms of the swap
 It pays out 5% under the terms of the swap

 Note that all the cash flows above are calculated

on the same principal amount of $100m

 The following diagram illustrates the interest rate

exchanges 5%
LIBOR+0.1%
INTEL MICROSOFT

LIBOR
Using a Swap to Transform a Liability
 The net effect is that Microsoft are paying out a
fixed rate of 5.1%

 In this way, Microsoft have converted a floating-

rate liability into a fixed-rate one

 A similar viewpoint can be taken with Intel

Using a Swap to Transform an Asset
 Swap contracts can also be used to transform the
nature of company assets

 To illustate, suppose Microsoft has purchased

$100m of bonds that provide an interest rate of
4.7%

 If Microsoft enters the swap as outlined then it is

committed to three sets of cash flows
 It receives 4.7% from the bonds
 It receives LIBOR under the terms of the swap
 It pays out 5% under the terms of the swap
Comparative Advantage
 The motivation for the existence of swap
contracts has not been investigated

 This is addressed with the following argument of

comparative advantage

 Specifically, some companies have a comparative

advantage when borrowing in fixed-rate markets

 Other companies have a comparative advantage

when borrowing in floating-rate markets
 Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
 Chapter 6 & 7

 See also details from the issuing authorities,

listed in this lecture