FUNDAMENtAL5OF FINANCIAL MARKET

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 FUNDAMENTALS OF FINANCIAL WAKE

Debt Securities Market

Financial market is a forum or market that enables suppliers and demanders of

funds to make transactions. This can be money market or capital market in the form of
debt or equity/stock transactions. Debt can be short term or long term that is why it can be
within money market definition if short term, while in capital market if long term. Equity or
stock is normally long term.
Debt market or Debt Securities Market is the financial market where the debt
instruments or securities are transacted by suppliers and demanders of funds. This
chapter shall focus on this type of financial market.

Debt Instrument

A debt instrument is a paper or electronic obligation that enables the issuing Party
to raise funds by promising to repay a lender in accordance with terms of a contract. Types
of debt instruments include notes, bonds, debentures, certificates, mortgages, leases or
other agreements between a lender and a borrower. These instruments provide a Way for
market participants to easily transfer the ownership of debt obligations from one party to
another.

A debt instrument is legally enforceable evidence of a financial debt and the

promise of timely repayment of the principal, plus any interest. The importance of a debt
instrument is twofold. First, it makes the repayment of debt legally enforceable. Second, it
increases the transferability of the obligation, giving it increased liquidity and giving
creditors a means of trading these obligations on the market. Without debt instruments
acting as a means o■ facilitating trading, debt would only be an obligation from one party
to another. However, when a debt instrument is used as a trading means, debt obligations
can be moved from one party to another quickly and efficiently.

Types of Debt instruments

Debt instruments can be either long-term obligations or short-term obligations.

Shortterm debt instruments, both personal and corporate, come in the form of obligations
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expected to be repaid within one calendar year. Long-term debt instruments are
obligations due in one year or more, normally repaid through periodic installment
payments.

■ Short-Term Debt Instruments

From a personal finance perspective, short-term debt instruments come in the

form of credit card bills, payday loans, car title loans and other consumer loans that
have repayment terms of less than 12 months. If a person incurs a credit card bill of
Php 1,000, the debt instrument is the agreement that outlines the obligated payment
terms between the borrower and the lender.

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 FUNDAMENTALS OF FINANCIAL MARKET

In corporate finance, short-term debt usually comes in the form of revolving

lines of credit, loans that cover networking capital needs and Treasury bills. if for
example, a corporation looks to cover six months of rent with a loan while it tries to
raise venture funding, the loan is considered a short-term debt instrument.

• Long Term Debt Instruments

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Long-term debt instruments in personal finance are usually mortgage

payments or car loans. For example, if an individual consumer takes out a 30-year
mortgage for Flip 500,000, the mortgage agreement between the borrower and the
mortgage bank is the long-term debt instrument.

Debt Security

Debt security refers to a debt instrument, such as a government bond, corporate

bond, certificate of deposit (CD), municipal bond or preferred stock, that can be bought or
sold between two parties and has basic terms defined, such as notional amount (amount
borrowed), interest rate, and maturity and renewal date. It also includes collateralized
securities, such as collateralized debt obligations (CDOs), collateralized mortgage
obligations (CMOs), mortgage-backed securities issued by the Government National
Mortgage Association (GNMAs) and zero-coupon securities.
The interest rate on a debt security is largely determined by the perceived
repayment ability of the borrower; higher risks of payment default almost always lead to
higher interest rates to borrow capital. Also known as fixed-income securities, most debt
securities are traded over the counter. The total dollar value of debt security trades
conducted daily is much larger than that of stocks, as debt securities are held by many
large institutional investors as well as governments and nonprofit organizations.

Types of Debt Securities

Debt securities, sometimes referred to as fixed-income securities, include
money market securities and capital market debt securities such as notes, bonds,
and mortgage backed securities. Like Debt instruments, debt security can be
classified into short term/money market debt securities or long termicapital market
securities.

Money market debt securities

Money market securities are debt securities with maturities of less

than one year. Money market securities of most interest to individual
investors are treasury bills (T-bills) and certificates of deposit (CDs).

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FUNDAMENTALS OF FINANCIAL. MARKET

• Capital market debt securities

Capital market debt securities are debt securities with maturities of

longer than one year. Examples are notes, bonds, and mortgage-backed
securities.

Debt Security vs. Debt Instrument

Usually Financial Instruments and Financial Securities are interchangeably used ,

however technically these two are different. Not all financial instruments are securities.
security is a fungible, negotiable financial instrument that holds some type of monetary
value. It represents an ownership position in a publicly-traded corporation (via stock), a
11- creditor relationship with a governmental body or a corporation (represented by owning
that entity's bond), or rights to ownership as represented by an option.

Financial Instruments are called securities since securities carry some value on
them_ When they are exchanged in the market, the realization will be in the form of cash
and a benefit for the holder of the securities.

Alternately we can call financial instruments are called Securities, since they are
backed by Corporations or Government. Take for example Government Bonds, Money
market Instruments. Equities or Shares though have no formal backing, sti!I they carry
value on them and when they are exchanged in the secondary market, the shareholder
will still be able to receive cash

With the above, debt securities therefore are negotiable and tradable debt
instruments which carry value on them. A credit card bills and payday loans for example
are just debt instrument but not debt securities. On the other hand, Government bonds
are debt instrument and also debt securities since they carry value that is negotiable and
tradable in the financial market and that holder will still be able to receive cash.

Safety of Debt Securities

Debt securities have an implicit level of safety simply because they ensure that the
principal amount that is returned to the lender at the maturity date or upon the sale of the
security. They are typically classified by their level of default risk, the type of issuer and
income payment cycles. The riskier the bond, the higher its interest rate or return yield.

For example, Treasury bonds, issued by the U.S. Treasury Department, have
lower interest rates than bonds issued by corporations. Corporate and government bonds,
however, are both rated by agencies such as Standard & Door's and Moody's Investors
Service. These agencies assign a rating, similar to the credit scores assigned to
individuals, and bonds with high ratings tend to have lower interest rates than bonds with
low ratings. For example, historically, corporate AAA bonds have lower yields than
corporate BBB bonds.

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 FUNDAMENTALS OF FINANCIAL MARKET

The Bond Market \V)

Debt market or Debt securities market Is also known as bond market is a financial
market i
n which the participants are provided with the issuance and trading of debt
securities. The bond market primarily includes government-issued securities and
corporate debt securities, facilitating the transfer of capital from savers to the issuers or
organizations requiring capital for government projects, business expansions and ongoing
operations. In the bond market, participants can issue new debt in the market called the
primary market or trade debt securities in the market called the secondary market. These
products are typically in the form of bonds, but they may also come in the form of bills and
notes. The goal of the bond market is to provide long-term financial aid and funding for
public and private projects and expenditures.
The participants of the bond market are nearly the same as the
participants in other
financial markets. In bond markets, the participants are either buyers a funds (that is, debt
issuers) or sellers of funds (institutions). Participants include institutional investors,
traders, governments and individuals who purchase products provided by large
institutions. These projects may be in the form of pension funds, mutual funds and life
insurance, among many other product types.

Types of Bond Markets

The general bond market can be classified into corporate bonds, government
and agency bonds, municipal bonds, mortgage-backed bonds, asset-backed bonds, and
collateralized debt obligations,

Corporate Bond
Corporations provide corporate bonds to raise money for different
reasons, such as financing ongoing operations or expanding businesses. The
term "corporate bond" is usually used for longer-term debt instruments that
provide a maturity of at least one year.
Government Bonds
National governments issue government bonds and entice buyers by
.:, `; providing the face value on the agreed maturity date with periodic interest
.
t

payments. This characteristic makes government bonds attractive fu

conservative investors,

Municipal Bonds
Local governments and their agencies, states, cities, special-purpose
districts, public utility districts, school districts, publicly owned airports and
seaports, and other government-owned entities issue municipal bonds to fund
their projects.

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„..1" Mortgage Bonds

Pooled mortgages on real estate properties provide mortgage bonds.
,
N- 1 Mortgage bonds are locked in by the pledge of particular assets. They pay
c)k
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L monthly, quarterly or semi-annual interest.

.,V
Assetbacked bonds
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Also known as asset-backed security (ABS) is a financial security

collateralized by a pool of assets such as loans, leases, credit card debt,
royalties or receivables. For investors, asset-backed securities are an alternative
to investing in corporate debt. An ABS is similar to a mortgage-backed security,
except that the underlying securities are not mortgage-based.

Collateralized Debt Obligation (COO)

COO is a structured financial product that pools together cash flow-

generating assets and repackages this asset pool into discrete tranches that can
be sold to investors. A collateralized debt obligation is named for the pooled
assets — such as mortgages, bonds and loans — that are essentially debt
obligations that serve as collateral for the CDO. The tranches in a COO vary
substantially in their risk profiles. The senior tranches are generally safer
because they have first priority on payback from the collateral in the event of
default. As a result, the senior tranches of a CDO generally have a higher credit
rating and offer lower coupon rates than the junior trenches, which offer higher
coupon rates to compensate for their higher default risk.

Characteristics of Bonds

A bond is a debt instrument that provides a steady income stream to the investor
in the form of coupon payments. At maturity date, the full face value of the bond is repaid
to the bondholder. The characteristics of a regular bond include:

• Coupon rate

Some bonds have an interest rate, also known as the coupon rate, which is
paid to bondholders semi-annually,The coupon rate is the fixed return that an
investor earns periodically until it matures.

• Maturity date

All bonds have maturity dates, some short-term, others long-term. When the
bond matures, the bond issuer repays the investor the full face value of the
bond. For corporate bonds, the face value of a bond is usually Php 1,000 and
for government bonds, face value is Rip 10,000. The face value is not
necessarily the invested principal or purchase price of the bond

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• Current or Market Price

Depending on the level of interest rate in the environment, the investor may
purchase a bond at par, below par, or above par. For example, if interest rates
increase, the value of a bond will decrease since the coupon
rate will be lower
than the interest rate in the economy. When this occurs, the bond will trade
at a discount, that is, below par. However, the bondholder will be paid the
full face value of the bond at maturity even though he purchased it for less
than
the par value.

Bond Valuation

Bond valuation is a technique for determining the theoretical fair value of a

particular bond. Bond valuation includes calculating the present value of the bond's future
interest payments, also known as its cash flow, and the bond's value upon maturity, also
known as its face value or par value. Because a bond's par value and interest payments
are fixed, an investor uses bond valuation to determine what rate of return is required for
a bond investment to be worthwhile. Eq 5.1 describe the formula to value a bond.
x
Eq 5.1 B0 i-771)j
(14-rd)t L
Bo -7 present value of the bond
= annual interest paid in dollars
n = number of years to maturity
M = par value in dollars
rd = required return

To illustrate, suppose a 10-year 10% bond with a par value of Php1,000 is traded
in the market. The similar debt instrument is expecting 9% returns in the market. Now
much is the value of the bonds?
Using Eq 5.1 the bond is valued at Rip 1,064. The value is higher than par and
issued on a premium because the market offers a lower return as compared the
guaranteed returns of 10%. 10

[ _____ 1 j
Bo = Php1,000 x 10% x t=i 0 ÷ 9000 + Php1,0.00 x [(I + 9%) i.ol
B0 = Php100 x 6.4177 + Php1,000 x 0,4244
B, = Php641.77 + 422.41

Bo = Php1,064,18

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FUNDAMENTALSOFFINANCIALMARKET

This principle simply states that the bonds can be resold at Phpl,064 since this is
perceived by the market to be better off that what is available to everyone else.

Since bonds are an essential part of the capital markets, investors and analyst
seek to understand how the different features of a bond interact in order to determine
intrinsic value. Like a stock, the value of a bond determines whether it is a suitable
investment for a portfolio and hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the present value of a bond's expected

future coupon payments. The theoretical fair value of a bond is calculated by discounting
the present value of its coupon payrrTents by an appropriate discount rate. The discount
rate used is the yield to maturity, which is the rate of return that an investor will get if s/he
reinvested every coupon payment from the bond at a fixed interest rate until the bond
matures. It considers the price of a bond, par value, coupon rate, and time to maturity.

A zero-coupon bond makes no annual or semi-annual coupon payments for the

duration of the bond. Instead, it is sold at a deep discount to par when issued. The
difference between the purchase price and par value is the investor's interest earned on
the bond. To calculate the value of a zero-coupon, we only need to find the present value
of the face value.

Following our example above, if the bond paid no coupons to investors, its value
will simply be the present value of the face value of the bonds i.e. Php422.41 Under both
calculations, a coupon paying bond is more valuable than a zerocoupon bond.
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Valuation for a Non-Treasury bond (Adding Risk Premium)

The above valuation assumes a default free rate and thus fora non-Treasury bond,
a risk premium has to be added to the base interest rate (the Treasury rate). The risk
premium is the same regardless of when a cash flow is to be received. This risk premium
is also called constant credit spread. So, for the above, assuming the appropriate risk
premium credit spread is 100 bps equivalent to 1%, the discount rate to be used should
be 6% i.e. 5% the risk free interest rate (the Treasury rate) + 1% risk premium.

In practice, the spot rate used to discount the cash flow of a non-Treasury security
is the Treasury spot rate plus a constant credit spread. The drawback of this approach is
that there is no reason to expect the credit spread to be the same regardless of when the
cash flow is expected to be received. Instead, it might be expected that the credit spread
increases with the maturity of the bond. That is, there is a term structure for credit spreads.
Dealer firms typically construct a term structure for credit spreads for a particular rating
based on the input of traders. The term structure of interest rates is the relationship
between interest rates or bond yields and different terms or maturities. When graphed, the
term structure of interest rates is known as a yield curve discussed in the earlier chapter,
and it plays a central role in an economy. The term structure reflects expectations of
market participants about future changes in interest rates and their assessment of

monetary policy conditions.

Generally, the credit spread increases with maturity. This is a typical shape for the
term structure of credit spreads. In addition, the shape of the term structure is not the

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same for all credit ratings. The lower the credit rating, the steeper the term structure. when
the credit zero spreads for a given issuer are added to the Treasury rates,the
i

resulting term structure is used to value bonds of issuers of the same credit quality. ty. This
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term structure is referred to as the benchmark spot rate curve or benchmark zero
coupon rate curve. spot rat

Approaches in Valuation

The above formula can be adjusted based on the approaches in valuation. There
are at least 2 approaches in valuation of bonds. Below are approaches which assumed
option-free bonds.

• Traditional approach

The traditional approach to valuation has been to discount every cash

flow of a bond by the same interest rate (or discount rate). The cash flows are
viewed as default free I risk free, the traditional practice is to use the same
discount rate to calculate the present value of securities and use the same
discount rate for the cash flow for each period. So, suppose that the yield on a
10-year Treasury trading at par value is 5%. Then, the practice is to discount
each cash flow using a discount rate of 5%. In case of non-treasury securities,
the risk premium has to be added.

• Arbitrage Free Valuation approach

The fundamental flaw of the traditional approach is that it views each
security as the same package of cash flows. For example, consider a 10-year
Philippine Treasury bond with an 8% coupon rate. The cash flows per Php 100
of par value would be 19 payments of Php 4 every 6 months and Php 104 for
20 six month periods from now. The traditional practice is to discount every
cash flow using the same interest rate. The proper way to view the 10-year 8%
coupon bond is as a package of zero coupon bonds. Each cash flow should
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be considered a zero-coupon bond whose maturity value is the amount of the

cash flow and whose maturity date is the date that the cash flow is to be
received. Thus, the 10-year 8% coupon bond should be viewel as 20 zero-
coupon bonds. The reason this is the proper way to value a bond is that it does
not allow a market participant to realize an arbitrage profit by taking apart or
"stripping" a security and selling off the stripped securities at a higher
aggregate value than it would cost to purchase the security in the market. This
approach to valuation is referred to as the arbitrage-free approach,

The arbitrage-free approach values a bond as a package of cash

flows, with each cash flow viewed as a zero-coupon bond and each cash

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flow discounted at its own unique discount rate. For better appreciation
the difference of the traditional valuation approach and arbitrage fret
valuation approach, traditional uses interest. rate one time for 10 year
tenor of the securities while in arbitrage free, it uses different interest rate
published every period or near term since the securities are viewed as
it
separate zero coupon bonds. With this, to implement the arbitrage..fre4
approach, it is necessary to determine the theoretical rate that the Li
Treasury would have to pay to issue a zero-coupon Treasury bond for each
maturity. Another name used for the zero-coupon Treasury rate is the
Treasury spot rate. Spot rates are available from vendors of financial
information such as Bloomberg and Reuters. The spot rate for a Treasury
security of some maturity is the base interest rate that should be used to
discount a default-free cash flow with the same maturity.

Valuation of Bonds with Embedded Options

The two approaches to valuation presented above have dealt with the valuation of
option-free bonds, Thus, a Treasury security and an option-free non-Treasury security can
be valued using the procedures described above. More general valuation models handle
bonds with embedded options. Practitioners commonly use two models in such cases:
The lattice model and Monte Carlo simulation model

• The lattice model is used to value callable bonds and putable bonds.
• The Monte Carlo simulation model is used to value mortgage-backed securities
and certain types of asset-backed securities.

This chapter will not to go into the details of these two models. What is critical to
understand is that these valuation models use the principles of valuation described earlier
in this chapter. Basically, these models look at possible paths that interest rates can take
in the future and what the bond's value would be on a given interest rate path. A bond's
value is then an average of these possible interest rate path values.
There are four features common to the binomial and Monte Carlo valuation
models.
1. Each model begins with the yield on Treasury securities and generates the
Treasury spot rates.
2. Each model assumes about the expected volatility of short-term interest rates. This
is a critical assumption in both models since it can significantly affect the bond's
estimated value.
3. Based on the volatility assumption, different paths that the short-term interest rate
can take are generated.
4. The model is calibrated to the Treasury market. This means that if Treasury issue
is valued using the model, the model will produce the observed market price.

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SUMMARY

• Debt Securities Market is the type of financial market in the form of debt
transactions between demanders and suppliers of funds.

• Debt instrument is legally enforceable evidence of a financial debt and the promise
of timely repayment of principal, plus any interest.

• Debt security is a debt instrument however not all debt instruments are debt
securities.

• Debt securities are different from equity securities as equity securities represent
claims on earnings and assets of a corporation, while debt securities are
investment into debt instruments.

• The characteristics of a regular bond are coupon rate, maturity date and current
price.

• Bond Valuation in Practice essentially is calculating the present value of a bond's

expected future coupon payments.

• The theoretical fair value of a bond is calculated by discounting the present value
of its coupon payments by an appropriate discount rate

• The discount rate used is the yield to maturity, which is the rate of return that an
investor will get if s/he reinvested every coupon payment from the bond at a fixed
interest rate until the bond matures. It takes into account the price of a bond, par
value, coupon rate, and time to maturity,

• Discount rate used normally is the risk free or default free rate plus the risk
premium, if applicable.

• There are 2 approaches in Bond Valuation for option-free bonds: traditional

approach and arbitrage free valuation approach.

• There are 2 approaches in Bond Valuation for bonds with embedded options:
lattice model and Monte Carlo Simulation

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