FIN2001 - FINANCIAL MARKETS

AND INSTITUTIONS

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 Chapter 3
DEBT MARKET

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 Content
n Debt securities market preview.
n Debt market Instruments: Treasury Bills, Commercial papers,
(Negotiable Certificates of Deposit – NCDs, Repurchase
Agreements, Banker’s Acceptance, Euro dollars...
n Bond market
n Treasury Bonds market.

n Municipal Bonds market.

n Corporation Bonds market.

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 Readings
① Chapter 6,7,8 - Financial Markets and Institutions;
Jeff Madura; South-Western Cengage Learning
(2010).
② Chapter 6,7,8 Financial Markets and Institutions-
Federic S. Mishkin, Stanley G. Eakins; Pearson
(2012).

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 3.1. Debt security overview
n Debt security markets create profitable environment.
n Debt security markets help institutions adjusting their
payable balances.
n Central Bank makes trading of open market
instruments.

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 3.1. Debt security overview
n Debt securities transactions are made by:
n Central bank
n Financial Institutions:
n Commercial banks

n Savings and Loans Associations

n Financial companies

n Mutual funds

n Brokerage firms

n Insurance companies

n Pension funds

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 3.2. Money market securities
3.2.1. Money market securities characters
n Money market securities are debt securities with a
maturity of one year or less.
n Low default risk
n High liquidity
n Issued by the Treasury, corporations, and financial
intermediaries that wish to obtain short-term financing.
n Popular money market securities: T-bills, commercial
paper, negotiable certificates of deposit, repurchase
agreements, banker’s acceptances.
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 3.2. Money market securities
3.2.2. Treasury bills (T-bills)
n Short-term securities, issued by the Treasury.
n T-bills can be issued with 4-week, 13-week, 26-
week, or one-year maturities.
n Virtually free of credit (default) risk
n Highly liquid
n T-bills are issued at a discount from their face
value (par value).

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 3.2. Money market securities
3.2.2. Treasury bills (T-bills)

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 3.2. Money market securities
3.2.2. Treasury bills (T-bills)

n Pricing Treasury Bills

• Example: If investors require a 7% annualized return

on a one-year T-bill with a $10,000 par value, the

price that they are willing to pay is:
P = $10,000/1.07 = $9.345.79

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 3.2. Money market securities
3.2.2. Treasury bills (T-bills)
n Treasury Bill auction
• Primary T-bill market is an auction.
• At the auction, investors have the option of bidding
competitively or noncompetitively.
• After accounting for non-competitive bids, the
Treasury accepts the highest competitive bids first
and works it way down until it has generated the
amount of funds from competitive bids that it needs.
• The Treasury applies the lowest accepted bid price
to all competitive and non-competitive bids.
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 3.2. Money market securities
3.2.2. Treasury bills (T-bills)
n Estimating the Yield
• The yield is influenced by the difference between the selling
price and the purchase price.
SP − PP 365
γT = x
PP n
• If the investors hold the T-bills until maturity, the selling
price is par value. If not, the selling price is determined in the
secondary market.
• Example: Assume an investor purchased a six-month T-bill
with a $10,000 par value for $9000 and sold it 90 days later
for $9,100. What is the yield?
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 3.2. Money market securities
3.2.2. Treasury bills (T-bills)
n Estimating the T-bill discount
• Some business periodical quote the T-bill discount along with
the T-bill yield. The T-bill discount represents the percent
discount of the purchase price from par value for newly
issued T-bills and is computed as
Par − PP 360
T − bill discount = x
Par n
• Example: newly issued three-month T-bills with a par value
of $10,000 sold for $9,700. Compute the T-bill discount?

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 3.2. Money market securities
3.2.3 Commercial paper (CP)
n CP is a short-term debt instrument issued only by well-known,
creditworthy firms to finance a firm’s investment in inventory and
accounts receivable.
n CP is typically unsecured and is subject to credit risk.
n Can be backed by assets or obtaining credit guarantees from a
sponsoring institution.
n The denominations of commercial paper offerings are substantial,
usually $100,000 or more.
n Maturities are normally between 20 and 45 days but can be as
short as one day or as long as 270 days.
n Direct placement or through dealers 14
 3.2. Money market securities
3.2.3 Commercial paper (CP)
n An active secondary market for CP is vey limited. However, it is
sometimes possible to sell the paper back to the deals who initially
helped to place it.
n CP does not pay interest and is priced at a discount from par value.
n The nominal return to investors who retain the paper until maturity
is difference between the price paid for CP and its par value.
n Estimating the Yield:
Par − PP 360
γ CP = x
PP n
n At a given point time, the yield on CP is slightly higher than the
yield on T-bill with the same maturity. Why?
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 3.2. Money market securities
3.2.4 Negotiable Certificates of deposit (NCDs)
n NCDs are certificates issued by large commercial banks as a
short-term source of funds.
n Maturities on NCDs normally range from 2 weeks to one
year.
n Placement: directly; using a correspondent institution that
specializes in placing NCDs; or through securities dealers.
n A secondary market for NCDs exists.
n NCDs are guaranteed by banks, cannot be redeemed before
their maturation date, and can usually be sold in highly liquid
secondary markets.
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 3.2. Money market securities
3.2.4 Negotiable Certificates of deposit (NCDs)

n NCDs provide a return in the form of interest along with the

difference between the price at which the NCD is redeemed
(or sold in the secondary market) and purchase price.
SP − PP + interest 360
γ NCD = x
PP n
n Example: Investors purchased an NCD a year ago in the
secondary market for $990,000. He redeems it today upon
maturity and receives $1,000,000. He also receives interest
of $40,000. His annualised yield on this investment?
n At a given point time, the yield on NCDs is higher than the
yield on T-bill with the same maturity. Why? 17
 3.2. Money market securities
3.2.5 Repurchase Agreement (Repo)
n With a Repo, one party sells securities to another with an
agreement to repurchase the securities at a specified date
and price.
n A reverse repo refers to the purchase of securities by one
party from another with an agreement to sell them.
n The Repo transaction represents a loan backed by the
securities.
n Most Repo transaction use government securities, although
some involve other securities such as CP or NCDs.
n If the borrower defaults on the loan, the lender has claim to
the securities. 18
 3.2. Money market securities
3.2.5 Repurchase Agreement (Repo)
n The repo rate is determined by the difference between the
initial selling price of the securities and the agree-on repurchase
price, annualized with a 360-days year.
SP − PP 360
Repo rate = x
PP n
n Example: An investor initially purchased securities at a price of
$992,000 while agreeing to sell them back at a price of
$1,000,000 at the end of a 60-day period. What is the repo rate?

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 3.2. Money market securities
3.2.6 Banker’s acceptance (BA)

n A banker’s acceptance indicate that a bank accepts

responsibility for a future payment.
n The use of BAs is most common in international trade
transactions.
n An exporter that is selling goods to an importer whose
credit rating is not known will often prefer that a bank act
as a guarantor. The bank therefore facilitates the
transaction by stamping ACCEPTED on a draft, which
obligates payment at a specified point in time.
n Maturities on BA often range from 30 to 270 days.
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 3.2. Money market securities
3.2.6 Banker’s acceptance (BA)
n Exporter can hold a banker’s acceptance until the date at which
payment is made, but they frequently sell BA before then at a
discount to obtain cash immediately.
n An active secondary market exists.
n The investor who purchase BA the receives the payment
guaranteed by the bank in the future.
n The investor’s return is derived from the difference between the
discounted price paid for BA and the amount to be received in
the future.
n BA’s return is above T-bill yield because the bank can default
on payment.
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 3.3. Bond market
3.3.1 Background on bond
n Bonds are long-term debt securities that are issued by
government agencies or corporations.
n The issuer of a bond is obligated to pay interest (or coupon)
payments periodically and the par value (principal) at maturity.
n Bonds are often classified according to the type of issuer:
Treasury bonds, federal agency bonds, municipal bonds,
corporation bonds.
n Bonds are classified by ownership structure as either bearer
bonds or registered bonds.
n Most bonds have maturities of between 10 and 30 years.

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 3.3. Bond market
3.3.1 Background on bond
n Bond yields depend on whether it is viewed from the perspective
of issuer of the bond or from the perspective of the investors.
n Yield from the Issuer’s Perspective: The issuer’s cost of
financing with bonds is commonly measured by the yield to
maturity, which reflects the annualized yield that is paid by the
issuer over the life of the bond.
n Yield from the Investor’s Perspective: Many investors do not
hold the bond a maturity and therefore focus on their holding
period returns.

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 3.3. Bond market
3.3.1 Background on bond
Most bonds share some common basic characteristics
including:
n Face value (Par value, maturity value):

• Face value is the money amount the bond will be

worth at maturity.
• Face value is also the reference amount the bond
issuer uses when calculating interest payments.

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 3.3. Bond market
3.3.1 Background on bond
Most bonds share some common basic characteristics
including:
n Maturity date:

• Maturity date is the date on which the bond will

mature and the bond issuer will pay the bondholder
the face value of the bond.
• Bonds that have longer maturity date also usually
pay a higher interest rate because the bondholder is
more exposed to risks for an extended period.
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 3.3. Bond market
3.3.1 Background on bond
Most bonds share some common basic characteristics
including:
n Coupon date:

• Coupon dates are the dates on which the bond issuer

will make interest payments.
• Payments can be made in any interval, but the
standard is semiannual payments.

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 3.3. Bond market
3.3.1 Background on bond
Most bonds share some common basic characteristics
including:
n Coupon payment and coupon rate:

• Coupon payment is the amount of interest which a

bond issuer pays to a bondholder at each payment
date (coupon date).
• Coupon rate is the rate of interest the bond issuer
will pay on the face value of the bond, expressed as
a percentage.
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 3.3. Bond market
3.3.1 Background on bond
Most bonds share some common basic characteristics
including:
n Collateral:

• Many bonds come with collateral attached to them.

The collateral provides compensation to the lender
should the borrower fail in their financial obligation.

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 3.3. Bond market
3.3.2 Government bond market
n A government bond is a debt security issued by a
government to support government expenditures.
• Treasury bonds: issued by Treasury
• Municipal bonds: issued by state & local government.
n U.S Treasury commonly issues Treasury Notes and
Treasury Bonds. Note maturities are less than 10 years,
whereas bond maturities are 10 years or more.

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 3.3. Bond market
3.3.2 Government bond market
n A government bond is a debt security issued by a
government to support government expenditures.
• Treasury bonds: issued by Treasury
• Municipal bonds: issued by state & local government.
n U.S Treasury commonly issues Treasury Notes and
Treasury Bonds. Note maturities are less than 10 years,
whereas bond maturities are 10 years or more.
n Types of Treasury bonds:
• Coupon bonds
• Perpetual bonds
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• Zero coupon bond
 3.3. Bond market
3.3.2 Government bond market

n Treasury bond auctions

• Bond offerings are conducted through periodic auctions.
• Financial institutions submit bids (either competitive or non-
competitive bids)
• Treasury ranks the competitive bids in descending order. All
competitive bids are accepted until the desired amount of
funding is achieved.
• Treasury has used the lowest accepted bid price as the price
applied to all accepted competitive bids and all
noncompetitive bids.
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 3.3. Bond market
3.3.2 Government bond market

§ Secondary market
• Treasury bonds: An active OTC secondary market
• Municipal bonds: Their secondary market exists, but it is less
active than the one of Treasury bonds.

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 3.3. Bond market
3.3.3 Corporate bond market
n Corporate bonds are long-term debt securities issued by
corporations.
n Their maturity is typically between 10 and 30 years or even
100 years (Disney, AT&T and the Coca–Cola)
n Interest paid by company is tax-deductible to corporation,
which reduces the cost of financing with bonds.
n The interest income earned on corporate bonds represents
ordinary income and is therefore subject to taxes.

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 3.3. Bond market
3.3.3 Corporate bond market
n Corporate bonds can be described according to a
variety of characteristics
n The bond indenture is a legal document specifying the
rights and obligations of both the issuing firm and the
bondholders.
n Bond are not as standardized as stocks with many
different maturities and payment terms.

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 3.3. Bond market
3.3.3 Corporate bond market
a. Corporate bond’s characteristics
n Sinking-Fund provision: A requirement that the firm
retire a certain amount of the bond issue each year.
n This provision is considered to be an advantage to the
remaining bondholders because it reduces the payments
necessary at maturity.
n Example: A bond with 20 years until maturity could
have a provision to retire 5% of the bond issue each
year.

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 3.3. Bond market
3.3.3 Corporate bond market
a. Corporate bond’s characteristics

n Protective Covenants: restrictions on the issuing firm

that are designed to protect bondholders from being
exposed to increasing risk during the investment period.
n Frequently limit the amount of dividends and corporate
officers’ salaries the firm can pay and also restrict the
amount of additional debt the firm can issue.

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 3.3. Bond market
3.3.3 Corporate bond market
a. Corporate bond’s characteristics
n Call provision normally requires the firm to pay a
price above par value when it calls its bonds (call
premium). Call provisions have TWO principal uses.
• First, the firm might end up paying a high rate of interest by
selling a new issue of bonds when market interest rates
decline.
• Second, a call provision may be used to retire bonds as a
required by a sinking-fund provision.

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 3.3. Bond market
3.3.3 Corporate bond market
a. Corporate bond’s characteristics
n Bond collateral: Bonds can be classified according to
whether they are secured by collateral and by the nature
of that collateral. Usually, the collateral is a mortgage
on real property (land & building).

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 3.3. Bond market
3.3.3 Corporate bond market
b. Types of Corporate bonds
n Low-and Zero-Coupon bonds:
• The low-coupon and zero-coupon bonds are issued at a deep
discount from par value. These bonds are purchased mainly
for tax-exempt investment account such as pension funds &
individual retirement accounts.
• To issuing firm, these bonds have the advantage of requiring
low or no cash out flow during their life.
• The firm is permitted to deduct the amortized discount as
interest expense for federal income tax purpose, even though
it does not pay interest.

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 3.3. Bond market
3.3.3 Corporate bond market
b. Types of Corporate bonds
n Variable-Rate bonds (Floating-rate bonds):
• These bonds affect the investors and borrowers as follows:
(1) They allow investors to benefit from rising market
interest rates over time.
(2) They allow issuers of bonds to benefit from declining
rate over time.
• Most issuers tie their coupon rate to the LIBOR (the rate at
which banks lend funds to each other on an international
basis) and adjust every three months.

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 3.3. Bond market
3.3.3 Corporate bond market
b. Types of Corporate bonds
n Convertible bonds:
• Convertible bonds allow investors to exchange the bond for a
state number of shares of the firm’s common stock (offering
a high return if stock’s price rise).
• This conversion feature offers investors the potential for high
returns if the price of the firm’s common stock rises.
• Investors are willing to accept a lower rate of interest on
these bonds, which allows the firm to obtain financing at a
lower cost.

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 3.3. Bond market
3.3.3 Corporate bond market
c. Bond risks
n Default risk (credit risk)
• Down grade risk
n Interest rate risk
n Re – Investment risk
n Inflation risk
n Liquidity risk

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 3.3. Bond market
3.3.3 Corporate bond market
c. Bond risks
n Default risk (credit risk): the possibility of a loss
resulting from a borrower's failure to repay a loan or
meet contractual obligations.
• Down grade risk: a negative change in the rating of a security
n Interest rate risk: the potential for investment losses
that result from a change in interest rates. If interest
rates rise, for instance, the value of a bond or other
fixed-income investment will decline.

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 3.3. Bond market
3.3.3 Corporate bond market
c. Bond risks
n Re – Investment risk: refers to the possibility that an
investor will be unable to reinvest cash flows (e.g.,
coupon payments) at a rate comparable to their current
rate of return. Zero-coupon bonds are the only fixed-
income security to have no investment risk since they
issue no coupon payments.

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 3.3. Bond market
3.3.3 Corporate bond market
c. Bond risks
n Inflation risk: the risk that inflation will undermine an
investment's returns through a decline in purchasing
power. It is the probability that the value of assets and
investments will be negatively affected by changes in
inflation.
n Liquidity risk: is the risk that the investor may have to
sell the bond at a price lower than the expected price.

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3.4. Vietnamese debt securities markets
Students research themselves

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