Fixed Income Securities
Essay 1
For a Hong Kong retail investor, he may be exposed to a number of risks in buying the China Mobile Bond. The major risks for this bond are inflation risk and exchange rate risk, where some minor risks also exists in the purchasing of this bond.
Firstly, inflation risk arises as the future value of the future cash flow will decrease because of the inflation. This risk in this bond is significantly high due to the fact that China’s booming economy will certainly increase rapidly in the near future. For exchange rate risks, it means that the future value of the cash flow of the bond will subject to the exchange rate at those particular moments. As the China Mobile Bond is paying coupons in RMB, it is uncertain for the value in terms of HKD for a HK based investor. However it is likely the RMB will appreciate over the future, which means that the Hong Kong investor will benefit from the appreciation.
There are also some common and minor risks for this bond. When the interest rate changes during the bond holding period, interest rate risk and reinvestment risk exist. Immunization can be used to offset them. Liquidity risk is the risk that one may not sell the bond at or near the value of it during the holding period. Moreover, risk risk may also exist for buying this bond if the investor does not know what the risks of this security are. With detailed analysis certain risk can be significantly low. Finally it is the credit risk that China Mobile will fail to satisfy the terms of the obligations of the bond, but China Mobile is certainly enjoying good credit rating with its successful operations in mainland China now, thus the risk can be neglected.
Essay 2
The case is a typical credit default swap (CDS) transactions that are introduced in the early 1990s, as this case happened in 1997, this type of transaction is still relatively new to many investors or even the issuers. CDS is a credit derivative that allows the issuer to have extra capital to generate profits, while the investor can earn a return that is sufficiently high on a return-on-equity basis. Therefore during the 1990s the CDS developed rapidly over the market, as investors are willing to engage in the contract in view of higher returns from the bonds.
The CDS is a swap contract in which the protection buyer makes a series of payments to the protection seller, and in exchange receive a payoff if a credit event happens for the particular credit instrument, as defined in the contract. The events are usually failure to pay coupons, restructuring or bankruptcy.
In this case, the protection buyer is ABC Bank and the protection seller is the major financial corporation. ABC bank will first pay a fee to the financial corporation in return to receive a payment conditional upon the occurrence of a specific credit event. If the bond fulfill its obligations and does not default, ABC bank will be obliged to pay a premium to the investor every year until the maturity of the XYZ bond. However the bank will not need to pay if the bond defaults in its obligations, instead the financial corporation will pay the notional amount of the XYZ bond and receive the bond from the bank. Thus as long as everything goes well, the bank may transfer the default risk of the bond to the financial corporation by paying a premium.
This transaction may make ABC Bank exposed to certain risks. First of all, as mentioned above CDS was still relatively new in the market when the case took place. There is high demand and supply for the contracts as they might look attractive to many investors. Therefore the financial corporation in this case may also swap this particular credit transaction to other investors, and so on the protection seller may not be known by the corporation. With the protection buyers not knowing the credit rating of the protection seller in the secondary market, engaging in the CDS contracts may become more risky. Thus it is possible that when the bond defaults the investors will not be able to pay the notional amount to the financial corporation, and when it suffers it may also not be paying the amount to the bank, thus the bank may suffer by this chain effect of the CDS.
The financial corporation is enjoying as an A-rated creditor, and the XYZ bond in the transaction is also rated at AA. Therefore it may imply that the bond is still in high quality and the corporation has great chance to pay the notional amount to the bank if the bond defaults. However certain level of default risks still exist for them even they are highly rated. If the corporation defaults, ABC will not be able to get the notional amount, implying that it will suffer greatly when XYZ default. In this case this may not be likely to happen since all of the involved companies are having high rating for their creditability.
The bank should carefully analyze the bond and the reliability of the credit rating of the involved companies before making the decision. They should not use CDS as a major profit generator of the company, but only as a kind of hedging derivatives for risk management. Speculation in the CDS is very risky and may put the bank itself at the edge of bankruptcy, so the management should make the decision carefully.
Reference:
http://en.wikipedia.org/wiki/Credit_default_swap
Fabozzi, F., Bond Markets, Analysis, and Strategies, 7th edition, Prentice Hall.