Introduction

Features of Debt Securities

 Decision Sequence
Think of investment management
Allocation of funds
Choose asset class
Only equities and fixed income securities
Others: real estate, private equity, hedge funds,
commodities.......Alternative Investments

FIS (fixed
We will stick to

income securities)
 Cont.
Can you invest in equities of small
company and retire early? Damn
Daring
Multitude of possible structures with
decent recent in
FIS.........Really?.........overshadowed
by the media prominence of equity
market
But VVI for portfolios of HNIs, FIIs,
DIIs
 Can we introduce FIS?
Financial obligation of an entity that
promises to pay a specified sum of
money at specified features dates.
( fixed everything)
Most issued by Govt., municipalities,
Multilateral organizations ( World
Bank)......Issuer
Two general categories (1) debt
obligations (2) preferred stock
 Cont.
In case of debt obligations,
Issuer is called ............borrower
Investors (purchaser)......lender or
creditor
Promised payments by the issuer till
maturity........interest and principal
Examples: Bonds, Mortgage Backed
securities, Asset Backed Securities
and Bank loans
 Cont.
In case of preferred stock (FIS)
Represents ownership interest in a corporation
Dividends payments made to preferred stockholder
Normally fixed dividend payment unlike common investors
Priority for dividend payments in comparison to common
equity holders
In bankruptcy, they are given preference over common
stockholders
It is in the form of equity having characteristics of bonds

But obligations are fixed thus

fixed income security.
 Cont.
Thus simple investment product
Maturity is common
Coupon and principal well known
Let bygones, be bygones, proceed in future
Now it is convoluted
Now we dont know when the amount will be
paid.
How long interest will be received?.....no idea
Hold to maturity investors are replaced by FII
and DII
 Time changed (delta is
continuous) ..........
FIS and Bonds interchangeable
parley
Term bonds .....for ABS, MBS and
Bank Loans
US FIS market is the largest market
Growth Entities
facilitator:
shifting from bank finance
to issuance of FIS.
 How to start
First ice breaking with various
features of FIS

Then we will see the interaction of

risks and investment in FIS
 Indentures and Covenants
Promise of issuer and rights of bond holders
are set forth in bonds indenture
Trustee will entrusted with the responsibility
of keeping bond or debt contract intact.
Trustee ....representative of interests of
bondholders
Indenture have two types of covenants: (1)
Affirmative covenants (2) Negative
Covenants (
 Cont.
Affirmative covenants ( activities that the borrower
promises to do)
To pay interest and principal on timely basis
To pay all taxes and other claims when due
To maintain all properties in borrower business in
good condition
To submit periodic reports to trustee for
compliance
Negative Covenants are limitations and restrictions
on the borrowers activities ( to incur additional
debt unless certain tests are sacrificed.
 Maturity
Time of final redemption
Time till which it is outstanding
Time after which it ceases to exist.
Issuer should redeem fully the outstanding balance.
Loose parley...........term..........term to
maturity.............maturity
This is changed if provisions are mentioned in the
indenture for issuer or bond holders
Types
1. Short Term (less than 5 years)
2. Medium Term ( 5-12 YEARS)
3. Longer Term ( MORE THAN 12 YEARS)
 Cont.
Term to maturity is important
Maximum time by which all the interest and
principal amounts are redeemed
Yield = f ( maturity)..........Yield curve well
depicts the relationship of yield of bond vs
maturity.
Price of bond will fluctuate till maturity......this
volatility= f (maturity)............longer the
maturity of the bond, greater the price volatility
resulting from a change in interest rates.
 Cont.
Select the best time to maturity

T
T
 Par Value
Amount the issuer agrees to repay the bondholder at
or by the maturity date.
Finance parley also call it
1. Principal value
2. Face Value
3. Redemption value
4. Maturity value
Bonds can have any par value but the price is quoted as
a percentage of par value. While computing the price
it is usually converted into price per unit. Finally
multiply by par value and get the price of the bond.
This is practice.
 Cont.
May be
1. Traded at par
2. Traded at discount
3. Traded at a premium

No free lunch ...............provisions are

priced well
 Coupon Rate
Called nominal rate also
Interest rate paid by the issuer
May be semi-annually or
annually.......sometimes months as well
= par value * coupon rate
High Coupon ..............low sensitivity with
interest rates
Low coupon ...............more sensitivity with
interest rates
Choice is yours
 Cont.
Zero Coupon Bonds
No intermittent payments
Realize the return from trading in
discount
Step Up Notes
Coupon rate gradually increases over
time
Can be single step or multiple step
 Cont.
Deferred Coupon Bonds
Coupon deferred for specific number of years
After this period, coupon rate may be higher
to compensate the previous loss
Floating Rate Securities
Coupon rates are reset periodically as per
some reference rates.
Coupon rate = reference rate +or - quoted
margin
Called as variable rate securities
 Cont.
Floater may have restrictions on max
coupon rates ...........called as Cap ( un-liked
feature by investors)
Floater can have restrictions on min
coupon rate.............called as Floor ( Most
liked feature by the investors)
Reference can be inflation index as well.
US issued TIPS in 1997 as inflation adjusted
securities. ( TIPS= Treasury Inflation
Protection securities)
 Cont.
In TIPS..........reference rate is Consumer Price Index
Thus in floaters, coupon rate is directly proportional
to reference rate.
In contrast, in inverse floaters or reverse floaters,
coupon rates are inversely proportional to
reference rates. .........few people with different
school of thought
Issuers specifically address this issue by hedging
instruments or derivatives or by offbeat coupon
formula with caps and floors placed in the
indenture.
(1)Yield Spread

Let us practice
Prof Santosh Kumar
 Are you aware
Interest rate models ( five factor model)
Central bank interventions
i. Open market operations
ii. Bank rate
iii. Reserve requirement
. Change in interest rate and money
supply
. Inflation and interest rates
. Status of economy
 Cont.
Treasury yield curve ( bills, notes, bonds)
On the run and off the run issues
Yield curve ( upward, flat, downward)
Benchmark yield
Absolute, relative and ratio yield
Inter-market and intra-market spread
Treasury vs non treasury
Issue size, liquidity, embedded features,
credit risk
 Cont.
Credit spread ( treasury and non
treasury) or quality spread
Expansion or contraction of economy
Cyclic nature of industry
Taxability

May be many more factors

 Problem 1
The yield on a 10 year non-callable
corporate bond is 8.36% and the also
the yield for on the run treasury is
7.03%. Compute the following.
i. The absolute yield spread
ii. The relative yield spread
iii. The yield ratio
 Problem 2
What is the after tax yield for an
investor in the 30% tax bracket if the
taxable yield is 6%?
What is the taxable equivalent yield
for an investor in the 30% tax
bracket if the tax exempt yield on an
investment is 4.2%?
 Problem 3
Suppose that an institutional investor
has entered into an interest rate
swap, as the fixed rate payer with
the following
Term of Swapterms;3 years
Frequency of Quarterly
payments
Notional amount Rs 1 million
Reference rate 3-month MIBOR
Swap spread 125 bp
 Cont.
At the time of the swap, the treasury
yield curve is as follows
3 month rate 4.5%
6 month rate 4.9%
1 year rate 5.4%
2 year rate 6.3%
3 year rate 7.0%
4 year rate 7.6%
5 year rate 8.3%
 Cont.
i. What is swap rate?
ii. What is the rupee amount of the
quarterly payment that will be
made by the fixed rate payer?
iii. Complete the following table
showing the quarterly payment that
the fixed rate payer will receive,
based on 3 month MIBOR
 Cont.
3 Month MIBOR (%) Annual Rupee Quarterly Payment
Amount

5.5
6
6.5
7
7.5
8
8.5
9
 Cont.
Complete the following table showing
the quarterly net payment that the
fixed rate
3 Month MIBOR
payer must
Floating Rate
make based
Net Payment by
on
3
(%)month MIBOR Received Fixed Rate Payer
5.5
6
6.5
7
7.5
8
8.5
 Problem 4
An investor has purchased a floating
rate security with a 6 month
maturity. The coupon formula for the
floater is 6 month MIBOR plus 150
basis points and the interest
payments are made semi-annually.
The floater is callable. At the time of
purchase the 6 month MIBOR is 8%.
The investor borrowed the funds to
purchase the floater by issuing a 6
 Cont.
Ignoring credit risk, what is the risk that the
investor faces.
Explain why an interest rate swap can be
used to offset this risk.
Suppose that the investor can enter into a 6
year interest rate swap in which the investor
pays MIBOR ( investor is fixed rate receiver).
If the swap rate is 8.4% and the frequency of
the payments is semi-annual, at what annual
income spread can the investors lock in?
 Solution 1
Absolute YS = 8.36%-
7.03%=1.33%=133bp

Relative YS= (8.36-7.03)/(7.03)%=

0.189%=18.9bp

Yield ratio = 8.36/7.03= 1.189

 Solution 2
After tax yield = 0.06 (1-0.30)=
0.06*0.7= 0.042= 4.2%

Taxable equivalent yield is =

0.042/0.7= 0.06=6%
 Solution 3
From the treasury yield curve, the relevant
rate is 3 year rate because the swap has a
3 year term. The swap rate is 7%+ 125
bp= 8.25%.
The annual payment made by the fixed
rate payer of a Rs 1 million notional
amount interest rate swap with a swap rate
is : Rs 1000000*0.0825= Rs 82500. Since
the swap specifies quarterly payments, the
quarterly payment is Rs 20,625.
 Cont.
3 month Annual amount Quarterly Amount
MIBOR (%)
5.5 55000 13750

6 60000 15000

6.5 65000 16250

7 70000 17500

7.5 75000 18750

8 80000 20000

8.5 85000 21250

9 90000 22500
 Cont.
3 month MIBOR (%) FLOATING RATE Net payment by
RECEIVED fixed rate payer
5.5 13750 -6875

6 15000 -5625

6.5 16250 -4375

7 17500 -3125

7.5 18750 -1875

8 20000 -625

8.5 21250 625

9 22500 1875
 Solution 4
The risk that the investor faces if 6
month MIBOR falls below 6.5% is that
the return from the floater for the 6
month period (on an annual basis)
would be less than the 7.5%
borrowing cost ( fixed rate coupon is
7.5%). Thus the investor is exposed
to the risk of a decline in 6 month
MIBOR. In general terms, the investor
faces a mismatch with assets and
 Cont.
When there is a mismatch of the
assets and liabilities as this investor
faces, an interest rate swap can be
used to convert a floating rate asset
into a fixed rate asset or fixed rate
liability into a floating rate liability.
 Cont.
Inflows
i. Floater: 6 month MIBOR+ 150 bp
ii. Swap: 8.4%
iii. Total: 9.9%+6month MIBOR
. Outflows
i. Note: 7.5%
ii. Swap: 6 month MIBOR
iii. Total: 7.5+ 6 month MIBOR
Total annual income spread: 2.4%= 240 bp
Immunization and Duration
Let us practice
 Problem 1
Mr. Finance estimates that there will be annual
cash outflows of Rs 40000 for four years from the
end of three years from now. Mr. Anurag wants to
immunize the payments by investing in the
following two bonds.
Bond A: A zero coupon bond of face value Rs 1000
maturing after 6 years and currently trading at Rs
455.60
Bond B: A 12% coupon bearing bond of face value
of Rs 1000, maturing after 5 years, redeemable at
par value and currently trading at Rs 930.00
 Cont.
Duration of Bond A= maturity of zero
coupon bond = 6
Duration of Bond B
 Cont.
Interest rate is 14% fixed.
Calculate the following particulars
a. The proportion of funds to be
invested in bonds A and B such that
Mr finance payments are immunized
b. Whether Mr finance will still be
immunized after 2 years from now.
 a. Solution
Duration of outflows
Year Cash PVIF@1 PV Proporti T*propo
outflows 4% on of PV rtion
3 40000 0.675 27000 0.301 0.903

4 40000 0.592 23680 0.264 1.056

5 40000 0.519 20760 0.232 1.16

6 40000 0.456 18240 0.203 1.218

89680 4.337=
duration
 Cont.
Duration of
Bond B 0.14

Year CF PV

1 120 105.2632 105.2632

2 120 92.3361 184.6722

3 120 80.99658 242.9897

4 120 71.04963 284.1985

5 1120 581.6929 2908.465

931.3384 3725.588 4.000252

 Cont.
Duration of bond A = maturity of
zero coupon bond =6
To immunize the payments
Duration of investments=duration of
liabilities
Let the proportion of funds to be
invested in Bond A be x
Then duration of investment = 6x +
(1-x)4=4.337
Answer: Bond A= 17% and Bond B
 b. Cont.
Duration of liabilities after 2 years
Year Cash PVIF@1 PV Proporti T*propo
Outflow 4% on of PV rtions
s
1 40000 0.877 35080 0.301 0.301

2 40000 0.769 30760 0.264 0.528

3 40000 0.675 27000 0.232 0.696

4 40000 0.592 23680 0.203 0.812

116520
 Cont.
Duration of Bond A = 4 years
Duration of Bond B:
Market price at the end of two years
= 120 PVIFA (14%, 3) + 1000 PVIF
(14%, 3)=953.64
 Cont.

0.14
Year CF PV
105.263 105.263
1 120 2 2
184.672
2 120 92.3361 2
755.968 2267.90
3 1120 1 4

953.567
4 2557.84 2.68239
 Cont.
Weighted duration of the portfolio
= 0.17*4 + 0.83*2.683 = 2.907

As the duration of liabilities is not

equal to duration of assets, the
portfolio is not perfectly immunized
and has to be changed.
 Cont.
1 40000 35087.72 0.301056 0.301056
8 81
2 40000 30778.7 0.264084 0.528169
9 84
3 40000 26998.86 0.231653 0.694960
4 31
4 40000 23683.21 0.203204 0.812819
8 08
116548.5 2.337006
04
Duration of liability = 2.33
 Cont.
We need to churn our portfolio.
Rebalancing of portfolio is desired.
 Problem 2
Mr finance is required to make the
following payments at the end of
each year for the next 6 years.
Year Payments
1 25.5
2 19.25
3 18.25
4 17.50
5 19.50
6 17.50
 Cont.
He is planning to immunize his liability by
investing in the following two bonds.
Bond X: A 11% coupon bond of face value Rs
1000 maturing after 5 years, redeemable
at 5% premium and currently trading at Rs
966.38.
Bond Y: A 13% coupon bond of face value Rs
1000 maturing after 3 years, redeemable
at 5% discount and currently trading at Rs
988.66
 Cont.
You may calculate the following.
a. If the interest rate is 12%, calculate the
proportion of funds to be invested in
bonds X and Y, so that Mr. Finance
payments are immunized.
b. After one year, if the interest rate changes
to 14%, determine the adjustment to be
made so that Mr. Sharmas portfolio will
remain immunized.
 a. Solution
Duration of liability: 2.98
Duration of Bond X: 4.087
Duration of Bond Y: 2.66
X= 22%
Y= 77%
 b. Solution
Duration of liability: 2.71
Bond X duration: 3.43
Bond Y duration: 1.88
X= 53%
Y=46%

It seems that portfolio is rebalanced.

 Duration based hedging
strategies
Illustration:
It is August 2 and a fund manager with Rs 10
million invested in Govt. Bonds is concerned
that interest rates are expected to be highly
volatile over the next 3 months. The fund
manager decides to use the December T bond
futures contract to hedge the value of the
portfolio. The current future price is 93-02, or
93.0625. Because each contract is for delivery
of Rs 100000 face value of bonds, the future
contract price is Rs 93062.50.
 Cont.
Suppose that the duration of the
bond portfolio in 3 months will be
6.80 years. The cheapest to deliver
bond in the T bond contract is
expected to be a 20 year , 12% per
annum coupon bond. The yield on
this bond is currently 8.80% per
annum, and the duration will be 9.20
years at maturity of the futures
contract.
 Cont.
The fund manager requires a short position
in T bond futures to hedge the bond
portfolio. If interest rate goes up, a gain will
be made on the short futures position, but
a loss will be made on the bond portfolio. If
interest rate decreases, a loss will be made
on the short position, but there will be a
gain on the bond portfolio. The number of
bond futures contracts that should be
shorted can be calculated as below
 Cont.
No of futures contracts

= (10000000 * 6.8)/ ( 93062.50*9.2) = 79.42

= P*Dp/(Vf*Df)
Where P is the forward value of the portfolio being
hedged ( value of portfolio)
Dp is the duration of the portfolio
Vf is the contract price for one interest rate futures
contract
Df is the duration of the asset underlying the futures
contract at the maturity of the futures contract
 Cont.
Delta P = -P* Dp*delta y
Delta Vf = -Vf*Df*delta y
To neutralize, n contracts are
required.
 Let us learn new chapter
The term structure and the volatility
of interest rates
 Agenda
We will learn economic theories of
term structure of interest rates.
 Shape of the Yield Curve
Historically three types of yield curves
have been seen
1. Normal or positively sloped yield curve:
Investor is rewarded with a higher yield
for holding longer maturity treasuries
2. Flat yield curve: Yield does not vary
with maturity
3. Inverted or negative sloped yield curve:
Longer the maturity, lower the yield.
 Yield Curve Shift
The relative change in the yield for
each treasury maturity is known as a
shift in the yield curve.
When the changes in the yield for all
maturity is same, then there is a
parallel shift in the yield curve
When the changes in the yield for all
maturity is not same, then there is a
non-parallel shift in the yield curve
 Cont.
Two types of non-parallel yield curve shifts:
1. Twist in the slope of yield curve refers to the flattening
and steepening of the yield curve. If slope
decreases..............flattening
If slope increases...............steepening
2. The other type is a change in the humpedness or
curvature in the yield curve. These shifts involve the
relative movements of yield at the long and short
maturity sectors of the yield curve relative to
intermediate maturity sector of the yield curve. These
changes are called as butterfly shift. Intermediate sector
is known as body of the butterfly. Short and long
maturity sectors are known as wings of the butterfly.
Treasury returns resulting from yield
curve
Robert Litterman and Jose Scheinkman studied
first how changes in the shapes of the yield
curve affect the total return on the treasury
securities.
Historical returns = f( changes in the level of
interest rates, slope of yield curve, changes in
the curvature of the yield curve)
Changes in the level of interest rates....90% (can
be measured by duration)
Slope of the yield curve.........................9%
Curvature of the yield curve..................1%
 Theories of the Term Structure
(shapes of the yield curve)

Expectation Theory Market

Segmentation
Theory
Pure Biased
Expectation Expectation
Theory Theory
(1) Broadest (1) Liquidity
Interpretation theory
(2) Local (2) Preference
Interpretations Habitat Theory
 Pure Expectation Theory
Forward rates represent expected future spot
rates
Thus, term structure reflects market
expectations of future short term rates.
Rising term structure reflects an expectation that
the future short term rates would rise
Flat term structure indicates an expectation that
future short term rates would mostly be constant
Falling term structure reflects an expectation
that future short term rates would decline.
 Cont.
Drawback of this theory is that it
does not consider the risks inherent
in investing in bonds. The
uncertainty in the future interest
rates and the future prices of the
bonds makes investment in such
instruments risky as the return over
some investment horizons is
unknown.
 Cont.
The uncertainty about the return over
some investment horizons is mainly due
to the risk about the price of the bond at
the end of investment horizon and the
risk of reinvestment. Reinvestment risk
can be defined as the uncertainty about
the rate at which the proceeds from the
bond that mature prior to the end of the
investment horizon can be reinvested
until the maturity date.
Biased Expectations Theory
The Liquidity theory
The Preferred habitat theory
 The Liquidity Theory
This theory believes that an investor will
hold a long term bond up to maturity if he
is compensated with long term rates
higher than the average of expected
future rates. The risk premium is
positively related to the term of maturity.
In other words, the forward rates should
reflect both interest rate expectations and
liquidity premium. This premium should
be higher for longer maturities.
 Cont.
This theory states that forward rates are a biased
estimate of the market expectations of future
interest rates. This is because they represent
liquidity premium. Therefore, an upward slopping
yield curve may reflect an expectation in
investors that there will be rise in the future rates
nor it may remain unchanged or even fall. When
the liquidity premium increases with the maturity,
it produces an upward sloping yield curve. This
theory helps in explaining the yield curve as well
as the term structure of the interest rates.
 The Preferred Habitat
Theory
Opines that the term structure reflects both the
risk premium and the expectation of the future
path of interest rates.
But doesnt subscribe to the thought that the
risk premium must rise uniformly with maturity.
Advocates of this theory say that this is true if all
borrowers want to borrow long and the investors
want to liquidate their investment at the shortest
possible time. ( Limitations: Normally institutions
dictate their holding period as per the
requirement of the maturity of liabilities.
 Cont.
This theory states that when there is imbalance
between supply and demand for funds within a
given maturity range, investors can be induced
by a yield premium to shift from their preferred
sectors. This premium compensates the
additional risk that is associated with shifting
funds out of their preferred maturity sectors.
Similarly, borrowers would prefer to raise funds
out of their preferred sectors only when they
see a cost saving that would compensate the
resultant funding risk.
 Cont.
According to this theory, the yield
curve can be either an upward
sloping, a downward sloping or a flat
curve. The curve shape depends not
only on the future interest rates
expectation but also on the future
interest rates expectations but also
on risk premium paid to induce the
market participants to shift from their
preferred habitat.
 Market Segmentation
Theory
Participants in one segment would be
indifferent to supply demand forces in
adjacent maturity segments. In other
words, the investors and borrowers would
be reluctant to move from one maturity
sector to other to take advantage of any
imbalance present. This theory asserts
that the shape of the yield curve is
determined by the supply of and demand
for securities within each maturity sector.
 Measuring Yield Curve Risk
Duration is well know for that
Every point on the spot rate curve will
have its own duration. Thus, in stead of
duration, we can use vector of durations
representing each maturity on the spot
rate curve.
If all rates change by similar basis points,
then total change in the value will give us
the duration of a security or portfolio to a
parallel shift in rates.
 Cont.
Of late, we have the convention of
computing 11 key maturities of spot
rate curve. They are called as key
rate durations. It is for 3 month, 1
year, 2 year, 3 year, 5 year, 7 year,
10 year, 15 year, 20 year, 25 year,
and 30 year maturities on the spot
rate curves. The changes between
any two key rates are calculated
using a linear approximation.
 Can we say
Portfolio value depends on duration
Duration depends on change in level
of interest rates
Is it short term or long term
Is it small or large
Is it volatile or smooth
So many questions
Measure historical volatility of yield

SD or variance is most commonly used for

volatility
Or 100 * Ln ( Yt/Yt-1) is used for % change
in yields........then take moving average
Then annualize by ( annual SD = daily SD
* ( no of days)^0.5
The number of trading days is the
jurisdiction of decision maker
( 360/250/258)
 Interpretation
SD for 15 year zero coupon bond is
14% . Current yield is 8%.
Annual standard deviations will be
8*14= 112 basis points
 Implied Volatility
Backward calculations of volatility
from observed market values.
 Weight based volatility
SD gives equal weight for all the
days under consideration
But recent observations should be
given higher weights and distant
observation should be given lower
weights.
 Let us solve few problems
Compute the 10 day daily standard
deviations of the percentage in yield
assuming continuous compounding
and assuming the following daily
yields.
 Cont.
t Yt
0 7.439
1 7.427
2 7.351
3 7.291
4 7.299
5 7.337
6 7.377
7 7.292
8 7.331
9 7.366
 solution
t Yt Xt= 100 * (Xt Xbar)^2
ln(Yt/Yt-1)
0 7.439
1 7.427 -0.16278 0.00045

2 7.351 -1.02716 0.78447

3 7.291 -0.82638 0.46911

4 7.299 0.10556 0.06102

5 7.337 0.52611 0.44565

6 7.377 0.53827 0.46203

7 7.292 -1.15485 1.02696

8 7.331 0.52659 0.44629

9 7.366 0.47904 0.38502

 Cont.
Sample mean = =1.41464/10 =
-0.141464%
Variance = 4.15805331/(10-1)=
0.4620059
SD = (0.4620059)^0.5= 0.679710%
 Can we calculate volatility for the
year
SD annual = (360)^0.5 * 0.679710%
SD annual = (365)^0.5 * 0.679710%
SD annual = (258)^0.5 * 0.679710%
SD annual = (366)^0.5 * 0.679710%
Let us change the topic to

Asset
Backed
Securities
 Asset Backed Securities
We can pool financial assets and bonds and offer it to
investors whose income is linked with these underlying
assets.
These underlying assets are called as ABS
1. Credit card receivables
2. Auto loans and car loans
3. Housing loans
Normally the companies involved with these business
will issue ABS. They do it through securitization and
offer it to different investors.
May shortly be available on stock exchange (Budget
announcement this year)
 Few facts
Relatively new in the market
First issued in 1985
Market potential has reached around
$120 billion.
 What is unique about ABS
Better yield.............than MBS and
bonds of similar maturity and quality
Better credit
quality..........collateral
supported.........so less default
risk.....thus more credit worthiness
Diversity and internal
diversification..........pooled of three
four types of assets.............less risk
 Cont.
Predictability of cash flows.........pool of
assets understood better...........thus
modelling of cash flows and prepayments
understood better.
Reduced event risk..in case of share and
bond, risk is prevalent in terms of future
downgraded rating of their investments due
to unforeseen events. It may be due to
corporate restructuring............but ABS is
much more dependent on underlying assets.
 Most popular types of ABS
CAR (Certificate for Automobile
Receivables)
CARD( Certificates for Amortizing
Revolving Debts)
HELS ( Home Equity Loan Securities)
 Features of ABS
Amortizing /Non-amortizing assets
Fixed rate versus floating rates
Credit enhancements (external and
internal)
Pass through and pay through
structures
Call provisions
 Amortizing/Non Amortizing
Assets
Collateral asset can be amortizing or
non amortizing
In amortizing case, loan payment is
distributed over the life of the
loan.....with amortizing
schedule.....but if excess payment is
made...it is called as termed
prepayment. It could be partially or
completely.
e.g. Housing loan
 Cont.
In amortizing case, no fixed pattern
of principal and interest
payment. .....but minimum periodic
payment is mandatory......if paid less
than minimum one.........outstanding
loan balance increases...........if
excess paid.........the outstanding
loan balance is reduced.
e.g: credit card receivables
 Cont.
What triggers prepayment?
Market interest rate lower than loan
rate
100 % not guaranteed due to this
Projection of cash flows
Default probability
Recovery rate
 Cont.
Prepayments analysis in two ways
1. Pool level analysis: all loans
comprising the collateral are
assumed to be identical
2. Loan level analysis: each loan is
amortized individually
 Fixed rate vs. floating rate
floating rate.......credit card
receivables, student loans, trade
receivables, home equity loans
Fixed rate....underlying assets have
fixed but security is divided into
floating tranche
 Credit enhancement
Requires existence of support for one
or more of the bond holders in the
structure
It also depends on credit rating
Two types
1. Internal
2. External
 Cont.
External credit enhancement
Third party guarantee protecting from
loss up to a particular level
Corporate guarantee or letter of credit
from bank or bond insurance
Called first loss protection
Or primary protection
Sponsors will be not be liable for any loss
more than this amount ( e.g 10%)
Internal credit enhancement
Reserve funds
Overcollateralization
Senior or subordinate tranches
 Cont.
Reserve funds:
Cash reserve funds: cash deposits from
issue proceeds. Portion of these
underwriting profits are from the deal and
they are normally used for investing in
money market instruments forming a
separate fund.
Excess servicing spread: Any excess amount
left paying the net coupon, service charge,
and all other expenses on a monthly basis
 Cont.
Interest rate of borrowers: 6.5%
Servicing and other associated costs:
0.5%
Interest rate paid to the tranches:
5.5%
Excess servicing spread: 6.5-5.5-0.5
= 0.5%

Kept in a reserve account, which will

gradually increase and will be used
 Cont.
Overcollateralization
Total liabilities: value of all tranches
Total assets: value of the collateral
Total assets total liabilities =
Overcollateralization
e.g. total liability Rs 100 crore, total
collateral: 110 crore.........thus loss
up to Rs 10 crore can be met by
collaterals reserve.
 Cont.
Senior /subordinate tranches....helps in
credit enhancement
Let us have the structure like
90% senior tranche
10% subordinate tranche
Thus first 10% loss will be met by the funds
from subordinate tranches. We can have any
number of subordinate tranches. They are
also called as non-senior tranches. They
provide additional credit protection.
 Cont.
But they may face the problem of
prepayment so interest shifting
mechanism can resolve this issue to
a certain extent ( allocate more
prepayment in the initial years for
senior tranche and as we
mature......subordinate can also be
included).....THUS WE REDUCE
CREDIT RISK BUT INCREASE
PREPAYMENT RISK
 Pass through and pay
through
Pass through: pro-rata distribution of
receivables within the tranche
Pay through: senior tranche can be
split into many tranche. But
subordinate split is not possible
 Let us do
Few numerical on
1. Servicing spread
2. Overcollaterization
3. Prepayment interest shifting
mechanism
4. First loss and next loss sharing
 Let us learn

Mortgaged
Backed
Securities