With the exception of some government bonds , debt is traded on OTC markets rather than on exchanges .
This is the case even when, as is usual in Europe, bonds are listed on an exchange .
Issuers find it worthwhile to have a listing, demonstrating that they have satisfied certain exchange rules about accounting and other disclosure standards , even when trading itself still takes place outside of the exchange .
Liquidity risk is also linked with perceived credit risk on individual securities .
Compare markets for otherwise similar securities with different degrees of credit risk, for example BBB corporate bonds and AA corporate bonds.
Credit risk is difficult to assess and so securities with lower credit risk are seen as more homogeneous and can be bought and sold more easily and in larger quantities without a substantial price impact .
This is apparent, for example, in the much greater depth and liquidity of the interest-rate swap market compared to government bond markets .
Taking a position in interest-rate swaps involves no exchange of principal and, hence, no funding beyond any initial margin . Taking an equivalent position in the cash markets would require a large amount of capital funding.
Liquidity can also be created through the removal of credit (counterparty) risk, most notably in money markets through the use of the ‘sale and repurchase agreement’ or repo.
The repo is short-term contract in which one party agrees to sell a security (most often a high-quality bond such as a government bond or AAA corporate bond) to another party (the lender) and then repurchase subsequently at a higher price.
Any coupon or dividend payments are still paid to the original owner , not the temporary purchaser of the security .
The reduction of counterparty risk and consequently lower interest-rate required on these transactions makes repos the preferred approach for corporate borrowers .
Only if they are unable to pledge high-quality securities for repo borrowing will they undertake other forms of borrowing such as issuing commercial paper, drawing down bank lines of credit or (in the case of financial institutions) interbank borrowing .
In order for a company to list on a security exchange such as the New York Stock Exchange, the London Stock Exchange, or the Deutsche Börse, it must satisfy additional requirements over and above those of general company law .
Accounts must be prepared according to specified standards and released at specified frequency (for larger companies quarterly statements are now usually required).
Companies are also required to make public any significant information affecting the prices of their securities.
All this gives greater confidence to the purchaser of a listed equity that the characteristics of the share are well understood and that there will be a ready market should there be a need to sell the share.
Exchange rules also govern the market for corporate acquisitions , imposing rules for the announcement of bids and the conduct of a contested acquisition.
This is well illustrated in forward foreign exchange where there are sufficient high credit quality participants that the OTC market has no difficulty providing the same control of counterparty risk and much greater liquidity than the competing exchange-traded contracts.
As a result, the volume of trades in OTC currency forwards dwarfs the liquidity of exchange-traded currency futures .
These master contracts allow for greater flexibility than anything traded on a derivatives exchange ;
buyers and sellers are free to alter specific aspects of the contract to meet their own requirements .
ISDA master agreements also support bilateral netting arrangements that act to reduce counterparty exposures.
International Swaps and Derivatives Association
The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. It is headquartered in New York, and has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions.
The ISDA Master Agreement is a bilateral framework agreement.
Following the trade, buyer and seller exchange messages confirming both their agreement to trade and all the details of the trade (security or contract, quantity, price, arrangements for settlement, etc.)
Senior debt, is debt that takes priority over other unsecured debt owed by the issuer. Senior debt has greater seniority in the issuer's capital structure than subordinated debt. In the event the issuer goes bankrupt, senior debt theoretically must be repaid before other creditors receive any payment.
Senior debt is often secured by collateral on which the lender has put in place a first lien. It is the debt that has priority for repayment in a liquidation.
Tranching is an important concept in structured finance because it is the system used to create different investment classes for the securities that are created in the structured finance world. Tranching allows the cash flow from the underlying asset to be diverted to the various investor groups.
Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDOs tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority.
Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets.
Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."
Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs are assigned different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.
CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of Asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:
The SPE issues bonds (CDOs) in different tranches and the proceeds are used to purchase the portfolio of underlying assets. The senior CDOs are paid from the cash flows from the underlying assets before the junior securities and equity securities. Losses are first borne by the equity securities, next by the junior securities, and finally by the senior securities.
Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches.
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers.
Securitization is the method which participants of structured finance utilize to create the pools of assets that are used in the creation of the end product financial instruments.
BORROWER BANK INVESTOR SECURITISATION MODEL LOAN TRANSACTION SALE OF LOAN BACKED SECURITIES BANK ORIGINATES AND ADMINISTERS THE LOAN. BANK SELLS LOAN TO SECURITISATION VEHICLE WHICH ISSUES LOAN ASSET BACKED SECURTIES. FUNDING AND CREDIT RISK OF BORROWER IS BORNE BY INVESTOR. SECURITISATION VEHICLE SALE OF LOAN TO SECURITISATION VEHICLE
The principal is the amount that the borrower agrees to repay to the lender on the maturity date .
The principal has many synonyms in the interest-rate market, including face value, par value, and deposit or loan – although technically the last two terms describe a type of instrument, rather than the amount lent.
Treasury bills (also known as T-bills) are short-term securities issued by governments , normally national governments, often using auction mechanisms , as part of their liquidity management operations.
Credit risk is very low or effectively non-existent , depending on the credit standing of the issuing government.
It is now more common for Eurobonds to be referred to as international bonds, to avoid confusion with ‘euro bonds’, which are bonds denominated in euros , the currency of most countries of the European Union (EU).
As an issue of international bonds is
not restricted in terms of currency or country ,
the borrower is not restricted as to its nationality either.
The details of stock that are listed on the various stock markets are generally available via daily official lists from the market controlle r (e.g. the London Stock Exchange or New York Stock Exchange)
which are often reproduced in whole or part in newspapers such as the Financial Times or Wall Street Journal .
By their nature OTC markets are diffuse and non-centralised
and are therefore ideal for electronic information and trading platforms.
It also makes OTC markets potentially more difficult to monitor and regulate and they may not provide true price discovery (i.e. making sure that all potential participants have the opportunity to quote),
which is a feature of a centralised market such as the exchange.
A long hedge is executed by someone who anticipates buying the underlying asset at some point in the future.
In order to protect against rising prices between the present and the time when the asset is needed , the hedger can take a long position in a futures contract on the underlying asset which matures approximately at the time of the anticipated purchase of the asset.
By taking this action in the futures market the hedger has fixed the purchase price , even though delivery does not need to be accepted until some point in the future.
These factors are very well defined in energy markets and as a result they are the most volatile commodity markets ever created , and therefore risk management has become a core competency and fiduciary responsibility for many energy companies.