Fixed Income Securities Individual Essay
Essay 1
Firstly, there is liquidity risk buying this bond. However, China Mobile is a large company and attracts a lot of investors. There are actually many investors trading bond of China Mobile in the bond market. The liquidity risk is therefore reduced.
Secondly, there is exchange rate risk. The investor is receiving RMB coupons, and also RMB principle if he holds the bond to maturity. He has to convert the RMB into HKD in which exchange rate risk arises. However, the risk is not high as RMB was appreciating against HKD over recent years due to the rapid expansion of China market.
Thirdly, there is interest rate risk if the investor has to sell the bond prior to the maturity date. If the RMB interest rate increases, the price of bond would decline and thus lead to a loss on selling. This risk is particular higher for the bond in this case as the bond has long maturity, which would increase the chance of selling the bond before maturity.
Fourthly, there is reinvestment risk. It is the risk of reinvesting the coupon at an investment rate that is variable due to the changes in interest rate. The investor would receive coupon in RMB, he can choose to reinvest the coupon directly in RMB or convert it into HKD for reinvestment. The former would create an offsetting effect to the interest rate risk. If the RMB interest rate increases, the reinvestment rate increases and offset the lost due to bond price decline. The latter would create a relatively lower level of offsetting effect as the reinvestment rate is linked to Hong Kong, but not RMB interest rate. However, the exchange rate risk would be diversified in the latter case as each RMB coupon is converted in HKD in different time.
Essay 2
The buyer of CDS protection, i.e. ABC bank bears most of the risk of the swap, as the main risk of CDS is that the seller of protection is unable to pay in the case of a credit event that is covered by the CDS contract. In other words, while a CDS is supposed to protect the buyer of the CDS from credit risk of the reference entity, it does not protect against the credit risk of the CDS seller, i.e. the investor. Furthermore, if the investor defaults, then ABC bank suffers losses from both the referenced credit event of the XYZ bank and from the loss of premiums paid to the investor.
Although the A-rated financial corporation appeared to be having a low credit risk, its hidden interconnections between other financial institutions created buy the CDS market was actually increasing its credit risk. In other words, the A-rated corporation may enter into different CDS with other financial institutions, the failure of one institution can substantially raise CDS spreads on other institutions. These multiple, hidden interconnections between financial institutions increase the uncertainty of the CDS contract, i.e. increasing the risk risk.
A typical example would be the bankruptcy of AIG. Originally, AIG was AAA-rated, which gives their counterparties confidence that the credit risk of AIG was very low. However, it was not the case in reality. Although AIG had a small department that sold only CDS protection, the traders in this department considered the premiums to be virtually free money, since they did not hedge their own risk, and they sold a lot more protection than what they could actually cover. Worse still, most of the protection was for the mortgage-backed securities based on subprime mortgages that started defaulting in significant numbers in 2008, causing the credit rating agencies to downgrade the credit rating of AIG, which, by force of contract, required AIG to post more collateral for its credit default swaps. Afterwards, it become acutely obviously that AIG didn’t really have the capital to cover all of its CDS buyers and thus enter into bankruptcy.
The above problem is particularly serious in 1997 when CDS was very new. Unlike nowadays, there was no supervision over over-the-counter derivatives like CDS. For example, there was no clearinghouse, which act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Without such supervision, the credit risk, as well as the in case of a real default would increase.
In addition, a transparent platform for trading CDS did not exist as the market was new in 1997, which would increase the liquidity facing by ABC bank. ABC bank would be locked in paying premiums yearly once the CDS contract is confirmed since the bank cannot easily find another party to sell the contract without a transparent platform for trading CDS.
The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. However, ABC bank is unable to enjoy such benefits from a transparent marketplace.