. 3
( 10)


amount of paper in default mushroomed to $315 million by the end of
the next month. Fortunately, the Mercury default in¬‚icted minimal dam-
age on the commercial paper market.
The commercial paper market is divided into tiers according to credit
risk ratings. The “top top tier” consists of paper rated A1+/P1/F1+. “Top
tier” is paper rated A1/ P1, F1. Next, “split tier” issues are rated either
A1/P2 or A2/P1. The “second tier” issues are rated A2/P2/F2. Finally,
“third tier” issues are rated A3/P3/F3. Exhibit 5.3 presents a Bloomberg
MMR screen that presents rates for dealer paper by tier for maturities
ranging from 1 day to 270 days. Exhibit 5.4 presents rates for direct
issues of commercial paper in the same fashion.

Yields on Commercial Paper
Like Treasury bills, commercial paper is a discount instrument. In other
words, it is sold at a price less than its maturity value. The difference
between the maturity value and the price paid is the interest earned by the
investor, although some commercial paper is issued as an interest-bearing

EXHIBIT 5.2 Ratings of Commercial Paper

Fitch Moody™s S&P

Superior F1+/F1 P1 A1+/A1
Satisfactory F2 P2 A2
Adequate F3 P3 A3
Speculative F4 NP B, C
Defaulted F5 NP D

Dusan Stojanovic and Mark D. Vaughan, “Who™s Minding the Shop?” The Re-
gional Economist, The Federal Reserve Bank of St. Louis, April 1998, pp. 1-8.

EXHIBIT 5.3 Bloomberg Screen of Dealer Placed Commercial Paper Rates

Source: Bloomberg Financial Markets

EXHIBIT 5.4 Bloomberg Screen of Direct Issue Commercial Paper Rates

Source: Bloomberg Financial Markets
Medium-Term Notes

EXHIBIT 5.5 Bloomberg Direct Issuer Program Description Screen for
GE Capital Commercial Paper

Source: Bloomberg Financial Markets

As an example, consider some commercial paper issued by GE Capi-
tal. Exhibit 5.5 presents Bloomberg™s Direct Issuer Program Description
Issuer screen for GE Capital commercial paper. Note at the bottom of the
screen are the rates at which GE Capital is willing to issue commercial
paper at various maturities. From Bloomberg™s Yield Analysis (YA) screen
in Exhibit 5.6, we see this commercial paper was issued on October 25,
2001 and matured on December 9, 2001. Moreover, on the left-hand side
of the screen, we ¬nd that the discount yield is 2.27%. The day count
convention in the United States and most European commercial paper
markets is Actual/360 with the notable exception being the UK which
uses Actual/365. Given the yield on a bank discount basis, the price is
found the same way as the price of a Treasury bill in Chapter 3 by ¬rst
solving for the dollar discount (D) as follows:

D = Yd — F — (t/360)

Yd = discount yield
F = face value
t = number of days until maturity

EXHIBIT 5.6 Bloomberg Yield Analysis Screen for GE Capital Commercial Paper

Source: Bloomberg Financial Markets

The price is then

price = F ’ D

With a settlement day of October 25, 2001, the GE Capital commer-
cial paper has 45 days to maturity. Assuming a face value of $100 and a
yield on a bank discount basis of 2.27%, D is equal to

D = 0.0227 — $100 — 45/360 = $0.28375


price = $100 ’ $0.28375 = $99.71625

This calculation agrees with the price displayed in the box on the upper
left-hand side of the screen in Exhibit 5.6.
The yield on commercial paper is higher than that on Treasury bill
yields. Exhibit 5.7 presents a Bloomberg MMCV (money market curves)
screen that plots two money market yield curves on May 31, 2001”
dealer commercial paper (top top tier) and U.S. Treasury bill yields. There
are three reasons for this relationship. First, the investor in commercial
paper is exposed to credit risk. Second, interest earned from investing in
Medium-Term Notes

Treasury bills is exempt from state and local income taxes. As a result,
commercial paper has to offer a higher yield to offset this tax advantage
offered by Treasury bills. Finally, commercial paper is far less liquid than
Treasury bills. The liquidity premium demanded is probably small, how-
ever, because commercial paper investors typically follow a buy-and-hold
strategy and therefore they are less concerned with liquidity.
The yields offered on commercial paper track those of other money
market instruments. Exhibit 5.8 is a time series plot of weekly observations
(Fridays) of three-month commercial paper yields and three-month U.S.
Treasury bills for the period of January 1, 1987 to December 31, 2000. The
average spread between the two yields over this period was 54.5 basis
points with a minimum of 12 basis points and a maximum of 221 basis
points. The yield spread between commercial paper rates and Treasury bill
rates widens considerably in times of ¬nancial crises when the market™s risk
aversion is piqued. For example, in August 1998 when the Russian govern-
ment defaulted on its debt and devalued the rouble, the “paper-bill” spread
for highly-rated non-¬nancial companies widened from 45 basis points at
the beginning of July (pre-crisis) to more than 140 basis points in October.2

EXHIBIT 5.7 Bloomberg MMCV Screen of Two Money Market Yield Curves

Source: Bloomberg Financial Markets

Marc R. Saidenberg and Philip E. Strahan, “Are Banks Still Important for Financing
Large Businesses?” Current Issues in Economics and Finance, Federal Reserve Bank
of New York, August 1999, pp. 1-6.

EXHIBIT 5.8 3-Month CP versus 3-Month T-Bills

Asset-backed commercial paper (hereafter, ABC paper) is commercial
paper issued by either corporations or large ¬nancial institutions
through a bankruptcy-remote special purpose corporation. Moody™s
reports that the amount of ABC paper outstanding surpassed half a tril-
lion dollars during the ¬rst quarter of 2000.3 Exhibit 5.9 presents a
Bloomberg MMR screen that presents rates for ABC paper by tier for
maturities ranging from 1 day to 270 days.
ABC paper is usually issued to ¬nance the purchase of receivables
and other similar assets. Some examples of assets underlying these secu-
rities include trade receivables (i.e., business-to-business receivables),
credit card receivables, equipment loans, automobile loans, health care
receivables, tax liens, consumer loans, and manufacturing-housing
loans. Historically, trade receivables have been securitized most often.4
The reason being is that trade receivables have maturities approximat-
ing that of the commercial paper. Recently, the list of assets has
expanded to include rated asset-backed, mortgage-backed, and corpo-

Maureen R. Coen, Wanda Lee, and Bernard Maas, “ABCP Market Overview:
ABCP Enters the New Millennium,” Moody™s Investors Service, 2000.
“Understanding Asset-Backed Commercial Paper,” Fitch, February 1, 1999.
Medium-Term Notes

rate debt securities as ABC paper issuers have attempted to take advan-
tage of arbitrage opportunities in bond markets.5
The issuance of ABC paper may be desirable for one or more of the
following reasons: (1) it offers lower-cost funding compared with tradi-
tional bank loan or bond ¬nancing; (2) it is a mechanism by which assets
such as loans can be removed from the balance sheet; and (3) it increases
a borrower™s funding options.
According to Moody™s, an investor in ABC paper is exposed to three
major risks.6 First, the investor is exposed to credit risk because some por-
tion of the receivables being ¬nanced through the issue of ABC paper will
default, resulting in losses. Obviously, there will always be defaults so the
risk faced by investors is that the losses will be in excess of the credit
enhancement. Second, liquidity risk which is the risk that collections on the
receivables will not occur quickly enough to make principal and interest
payments to investors. Finally, there is structural risk that involves the pos-
sibility that the ABC paper conduit may become embroiled in a bankruptcy
proceeding, which disrupts payments on maturing commercial paper.

EXHIBIT 5.9 Bloomberg Screen of Asset-Backed Commercial Paper Rates

Source: Bloomberg Financial Markets

There are three types of securities arbitrage programs in existence at the time of this
writing: limited purpose investment companies, market value ABC paper programs,
and credit arbitrage ABC paper programs. For a discussion of this process, see Mary
D. Dierdorff, “ABCP Market Overview: Spotlight on Changes in Program Credit En-
hancement and Growth and Evolution of Securities Arbitrage Programs,” Moody™s
Investors Service, 1999.
Mark H. Adelson, “Asset-Backed Commercial Paper: Understanding the Risks,”
Moody™s Investor Services, April 1993.

Legal Structure
An ABC paper issue starts with one seller or multiple sellers™ portfolio of
receivables generated by a number of obligors (e.g., credit card borrow-
ers). A corporation using structured ¬nancing seeks a rating on the com-
mercial paper it issues that is higher than its own corporate rating. This is
accomplished by using the underlying loans or receivables as collateral
for the commercial paper rather than the issuer™s general credit standing.
Typically, the corporation (i.e., the seller of the collateral) retains some
interest in the collateral. Because the corporate entity retains an interest,
the NRSROs want to be assured that a bankruptcy of that corporate
entity will not allow the issuer™s creditors access to the collateral. Speci¬-
cally, there is a concern that a bankruptcy court could redirect the collat-
eral™s cash ¬‚ows or the collateral itself from the ABC paper investors to
the creditors of the corporate entity if it became bankrupt.
To allay these concerns, a bankruptcy-remote special purpose corpo-
ration (SPC) is formed. The issuer of the ABC paper is then the SPC.
Legal opinion is needed stating that in the event of the bankruptcy of the
seller of the collateral, counsel does not believe that a bankruptcy court
will consolidate the collateral sold with the seller™s assets.
The SPC is set up as a wholly-owned subsidiary of the seller of the
collateral. Despite this fact, it is established in such a way that it is treated
as a third-party entity relative to the seller of the collateral. The collateral
is sold to the SPC which it turn resells the collateral to a conduit (i.e.,
trust). The conduit holds the collateral on the investors™ behalf. It is the
SPC that holds the interest retained by the seller of the collateral.
The other key party in this process is the conduit™s administrative
agent. The administrative agent is usually a large commercial bank that
oversees all the operations of the conduit. The SPC usually grants the
administrative agent power of attorney to take all actions on their behalf
with regard to the ABC paper issuance. The administrative agent receives
fees for the performance of these duties.

Basic Types of ABC Paper Conduits
ABC paper conduits are categorized on two critical dimensions. One
dimension involves their level of program-wide credit support either fully
or partially supported. The other dimension is as either a single-seller or a
multi-seller program. In this section, we will discuss each type.

Fully versus Partially Supported
In a fully supported program, all of the credit and liquidity risk of an
ABC paper conduit is assumed by a third-party guarantor usually in the
form of a letter of credit from a highly rated commercial bank. The ABC
Medium-Term Notes

paper investor™s risk depends on the ¬nancial strength of the third-party
guarantor rather than the performance of the underlying assets in the
conduit. Thus, investors can expect to receive payment for maturing com-
mercial paper regardless of the level of defaults the conduit experiences.
Accordingly, in determining a credit rating, the NRSROs will focus exclu-
sively on the ¬nancial strength of the third-party guarantor.
Partially supported programs exposes the ABC paper investors directly
to credit and liquidity risk to the extent that losses in the conduit exceed
program-wide and pool-speci¬c credit enhancements. The conduit has two
supporting facilities. The program-wide credit enhancement facility covers
losses attributable to the default of the underlying assets up to a speci¬ed
amount. Correspondingly, the program-wide liquidity facility provides funds
to the conduit to ensure the timely payment of maturing paper for reasons
other than defaults (e.g., market disruptions). Since investors are exposed to
defaults of the underlying assets, the NRSROs make their expected perfor-
mance under various scenarios a central focus of the ratings process.

Single-Seller versus Multi-Seller Programs
The other key dimension used to categorize ABC paper conduits is as
either single-seller or multiseller. Single-seller conduits securitize assets
purchased from a single seller (e.g., a single originator). Conversely, mul-
tiseller conduits pool assets purchased from several disparate sellers and
the ABC paper issued is backed by the portfolio of these assets.

Credit and Liquidity Enhancement
In a multiseller partially supported ABC paper conduit, there are two lev-
els of credit enhancement. The ¬rst line of defense is pool-speci¬c credit
enhancement that provides protection from the defaults on assets from a
particular seller. Pool-speci¬c credit enhancement may include overcollat-
eralization, third-party credit support, or excess spread. The second line
of defense is program-wide credit enhancement that provides protection
after the pool-speci¬c credit enhancement is depleted. Program-wide
credit enhancement is usually supplied by a third-party in the form of an
irrevocable loan facility, letter of credit, surety bond from a monoline
insurance company, or cash invested in permitted securities.7
Liquidity enhancement is also structured in two levels”pool-speci¬c
or program-wide. Liquidity enhancement usually takes the one of two
forms. One form of liquidity support is a loan agreement in which the
liquidity facility agrees to extend loans to the conduit if maturing paper
cannot be rolled over due to say, a disruption in the commercial paper
market due to a ¬nancial crisis. Note that the liquidity facility is not

“Understanding Asset-Backed Commercial Paper.”

responsible for interjecting needed funds into the conduit due to defaults
in the asset portfolio. The other form of liquidity support is an asset pur-
chase agreement in which the liquidity facility agrees to purchase non-
defaulted assets if funds are needed.
Exhibit 5.10 presents a ¬‚ow chart illustrating the basic structure of a
partially supported, multiseller ABC paper program. Note the administra-
tive agent invests no cash into the deal but instead provides a ¬‚ow of ser-
vices, as a result, the administrative agent™s connection to the conduit is
represented with a dashed line.

The ABC Paper Market Outside the United States
There are also well-developed ABC paper markets in Europe and Austra-
lia. Moody™s reports that in the ¬rst half of 2000 that the amount of ABC
paper issued in Europe amounted to $61.4 billion.8 The assets underlying
these European ABC programs are similar to those in the United States,
namely, trade receivables, consumer loans, credit card receivables, equip-
ment leases, etc. Moreover, there are an increasing number of programs
designed to engage in arbitrage in the ¬xed-income market by ¬nancing
the purchase of asset-backed and mortgage-backed securities with ABC
paper. Another expanding area is using structured ¬nance to ¬nance
cross-border trade receivables for multinational corporations.

EXHIBIT 5.10 Basic Structure of a Partially Supported,
Multiseller ABC Paper Program

Jean Dornhofer and Annick Poulain, “Mid-Year Review European ABCP Market:
A Pause in the Race,” Moody™s Investors Service, 2000.
Medium-Term Notes

The ABC paper market in Australia is well-developed but consider-
ably smaller than the market in either Europe or the U.S. Moody™s reports
that as of October 1999, the amount of ABC paper outstanding exceeded
A$10 billion.9 The key difference in the Australian market is that the
majority of ABC paper outstanding is used for arbitrage in the ¬xed-
income market primarily mortgage-backed and asset-backed securities as
well as term corporate loans.

Foreign Currency Denominated Commercial Paper
Synthetic foreign currency denominated commercial paper allows inves-
tors to earn non-U.S. interest rates without exposure to non-U.S. counter-
parties or political risk. Two examples are Goldman Sach™s Universal
Commercial Paper or Merrill Lynch™s Multicurrency Commercial Paper.
The process works as follows. First, a U.S. borrower issues commercial
paper in a currency other than U.S. dollars, say German marks, while
simultaneously entering into a currency swap with a dealer. The commer-
cial paper issuer faces no foreign exchange risk because the currency swap
effectively allows the issuer to borrow U.S. dollars at German interest
rates. Investors can then invest in commercial paper issued by a U.S.
counterparty denominated in German marks.

A medium-term note (MTN) is a corporate debt instrument with a char-
acteristic akin to commercial paper in that notes are offered continuously
to investors by an agent of the issuer. Investors can select from several
maturity ranges: 9 months to 1 year, more than 1 year to 18 months,
more than 18 months to 2 years, and so on up to any number of years.
Medium-term notes issued in the United States are registered with the
Securities and Exchange Commission under Rule 415 (i.e., the shelf regis-
tration rule) which gives a corporation the maximum ¬‚exibility for issu-
ing securities on a continuous basis. MTNs are also issued by non-U.S.
corporations, federal agencies, supranational institutions, and sovereign
governments. The MTN market is primarily institutional with individual
investors being of little import.
The label “medium-term note” is a misnomer. Traditionally, the term
“note” or “medium-term” was used to refer to debt issues with a matu-
rity greater than 1 year but less than 15 years. Certainly this is not

Ian Makovec, “1999 Year in Review and 2000 Outlook: Up, Up and Away”
AUSSIE ABCP Programs are Here to Stay,” Moody™s Investors Services, 1999.

descriptive of MTNs since they have been issued with maturities from 9
months to 30 years, and even longer. The focus in this section is on short-
term MTNs with maturities of one year or less.
Borrowers have ¬‚exibility in designing MTNs to satisfy their own
needs. They can issue ¬xed- or ¬‚oating-rate debt. As an illustration, con-
sider a ¬‚oating-rate MTN issued by Bear Stearns on January 18, 2001
and matures on January 18, 2002. Exhibit 5.11 presents the Bloomberg
Security Description screen for this security. The coupon formula is the
prime rate minus 286 basis points and the security delivers cash ¬‚ows
quarterly. Note in the “ISSUE SIZE” box in the center of the screen, the
minimum piece is $100,000 with $1,000 increments thereafter.
The coupon payments for MTNs can be denominated in U.S. dollars or
in another currency. As an example, GE Capital Corporation issued a 1-
year ¬‚oating-rate MTN in December 2000 whose cash ¬‚ows are denomi-
nated in British pounds. Exhibit 5.12 presents the Bloomberg Security
Description screen for this security. The coupon formula is 3-month ster-
ling LIBOR ¬‚at (i.e., without a spread) with the payments made quarterly.
Note on the left-hand side of the screen that the day count convention is
Actual/365 which is the day count basis for the UK money market.

EXHIBIT 5.11 Bloomberg Security Description Screen of a
Bear Stearns Medium-Term Note

Source: Bloomberg Financial Markets
Medium-Term Notes

EXHIBIT 5.12Bloomberg Security Description Screen of a
GE Capital Medium-Term Note

Source: Bloomberg Financial Markets

A corporation that desires an MTN program will ¬le a shelf registra-
tion with the SEC for the offering of securities. While the SEC registration
for MTN offerings are between $100 million and $1 billion, once the
total is sold, the issuer can ¬le another shelf registration. The registration
will include a list of the investment banking ¬rms, usually two to four,
that the corporation has arranged to act as agents to distribute the
MTNs. The large New York-based investment banking ¬rms dominate
the distribution market for MTNs. As an illustration, Exhibit 5.13 pre-
sents a Bloomberg Money Market Program Description screen for Amgen
Inc. MTN program. There are three things to note. First, across the bot-
tom of the screen, it indicates this a $400 million program. Second, as
listed on the left-hand side of the screen, the MTNs issued under this pro-
gram are denominated in multiple currencies. Third, as can be seen at the
bottom of the “PROGRAM INFORMATION” box, two investment
banking ¬rms”Bear Stearns (BEAR) and Goldman Sachs (GS)”will dis-
tribute the issue. Not all MTNs are sold on an agency basis; some have
been underwritten.
An issuer with an active MTN program will post rates for the matu-
rity ranges it wishes to sell. Fixed rate interest payments are typically

semiannual basis with the same interest payment dates applicable to all of
the notes of a particular series of an issuer. Of course, the ¬nal interest
payment is made at maturity. Floating-rate MTNs may have more fre-
quent coupon payments. If interest rates are volatile, posted rates may
change, sometimes more than once per day. The notes are priced at par
which appeals to many investors because they do not have to be con-
cerned with either amortizing premiums and accreting discounts. Any
change in new rates will not affect the rates on previously issued notes.
The purchaser may usually set the maturity as any business day with
the offered maturity range, subject to the borrower™s approval. This is a
very important bene¬t of MTNs as it enables a lender to match maturities
with its very own speci¬c requirements. As they are continuously offered,
an investor can enter the market when portfolio needs require and will
usually ¬nd suitable investment opportunities. With underwritten issues,
the available supply”both in the new issue and secondary markets”
might be unsatisfactory for the portfolio™s needs. A particular series of
MTNs may have many different maturities but all will be issued under the
same indenture. The bulk of the notes sold have maturities of less than
¬ve years.

Bloomberg Money Market Program Description Screen for an
Amgen Medium-Term Note Program

Source: Bloomberg Financial Markets

Debt Obligations of
Financial Institutions

he largest players in the global money markets are ¬nancial institu-
T tions”namely depository institutions (i.e., commercial banks, thrifts,
and credit unions), insurance companies, and investment banks. These
institutions are simultaneously among the biggest buyers and issuers of
money markets instruments. Moreover, there are certain short-term debt
instruments peculiar to ¬nancial institutions such as certi¬cates of depos-
its, federal funds, bankers acceptances, and funding agreements. These
instruments are the focus of this chapter.

A certi¬cate of deposit (CD) is a ¬nancial asset issued by a depository insti-
tution that indicates a speci¬ed sum of money that has been deposited with
them. Depository institutions issue CDs to raise funds for ¬nancing their
business activities. A CD bears a maturity date and a speci¬ed interest rate
or ¬‚oating-rate formula. While CDs can be issued in any denomination,
only CDs in amounts of $100,000 or less are insured by the Federal
Deposit Insurance Corporation. There is no limit on the maximum matu-
rity but Federal Reserve regulations stipulate that CDs cannot have a
maturity of less than seven days.
A CD may be either nonnegotiable or negotiable. If nonnegotiable, the
initial depositor must wait until the CD™s maturity date for the return of
their deposits plus interest. An early withdrawal penalty is imposed if the
depositor chooses to withdraw the funds prior to the maturity date. In con-
trast, a negotiable CD allows the initial depositor (or any subsequent owner
of the CD) to sell the CD in the open market prior to the maturity date.

Negotiable CDs were introduced in the United States in the early
1960s. At that time the interest rates banks could pay on various types of
deposits were subject to ceilings administered by the Federal Reserve
(except for demand deposits de¬ned as deposits of less than one month
that could pay no interest). For complex historical reasons and misguided
political ones, these ceiling rates started very low, rose with maturity, and
remained at below market rates up to some fairly long maturity. Before
the introduction of the negotiable CD, those with money to invest for,
say, one month had no incentive to deposit it with a bank, for they would
earn a below-market rate unless they were prepared to tie up their capital
for an extended period of time. With the advent of the negotiable CD,
bank customers could buy a three-month or longer negotiable CD yield-
ing a market interest rate and recoup all or more than their investment
(depending on market conditions) by selling it in the market.
This innovation was critical in helping depository institutions increase
the amount of funds raised in the money market. It also ushered in a new
era of competition among depository institutions. There are two types of
negotiable CDs. The ¬rst is the large-denomination CD, usually issued in
denominations of $1 million or more. The second type is the small-denomi-
nation CDs (less than $100,000) which is a retail-oriented product. Our
focus here is on the large-denomination negotiable CD with maturities of
one year or less and we refer to them as simply CDs throughout the chapter.
The largest group of CD investors is investment companies, with money
market mutual funds purchasing the lion™s share. Coming in a distant sec-
ond are banks/bank trust departments followed by municipal entities and
corporations. One indicator of the size of the market available to these
investors is the Federal Reserve Board data series of large time deposits.
Exhibit 6.1 presents a time series plot of the amount of large time deposits
outstanding (in billions of dollars) each year for the period 1980“2000.

CD Issuers
CDs whose cash ¬‚ows are denominated in U.S. dollars can be classi¬ed
into four types according to the issuing institution. First are the CDs issued
by domestic banks. Second are CDs that are denominated in U.S. dollars
but are issued outside the United States. These CDs are called Eurodollar
CDs or Euro CDs. A third type of CD is called a Yankee CD which is a CD
denominated in U.S. dollars and issued by a non-U.S. bank with a branch
in the United States. Finally, thrift CDs are those issued by savings and
loans and savings banks.
Money center banks and large regional banks are the primary issuers of
domestic CDs. Most CDs are issued with a maturity of less than one year.
Those issued with a maturity greater than one year are called term CDs.
Debt Obligations of Financial Institutions

EXHIBIT 6.1 Large Time Deposits Outstanding

Source: The Bond Market Association

Unlike the discount instruments discussed in this book (e.g., Treasury
bills, commercial paper, and bankers acceptances), yields on domestic
CDs are quoted on an interest-bearing basis. CDs with a maturity of one
year or less pay interest at maturity (i.e., simple interest). The day count
convention is Actual/360. Domestic CDs issued in the United Kingdom
denominated in pounds are quoted the same way except the day count
convention is Actual/365.
Eurodollar CDs are U.S. dollar-denominated CDs issued primarily in
London by U.S., Canadian, European, and Japanese banks. The CDs earn
a ¬xed rate of interest related to dollar LIBOR. The term LIBOR comes
from the London Interbank Offered Rate and is the interest rate at which
one London bank offers funds to another London bank of acceptable
credit quality in the form of a cash deposit. The rate is “¬xed” by the
British Bankers Association every business morning (in practice the ¬x is
usually about 20 minutes later) by the average of the rates supplied by
member banks. The LIBID is the market™s bid rate”the rate at which
banks pay for funds in the London market. The quote spread for a
selected maturity is therefore the difference between LIBOR and LIBID.

CD Yields
The yield quoted on a CD is a function of the credit quality of the issuing
bank, its expected liquidity level in the market, and of course the CD™s
maturity as this will be considered relative to the money market yield
curve. As CDs are issued by depository institutions as part of their short-

term funding and liquidity requirement, issue volumes are driven by the
demand for loans and availability of alternative sources for potential bor-
rowers. However, the credit quality of the issuing bank is the primary con-
sideration. In the U.S. market, “prime” CDs”issued by highly rated
domestic banks”trade at a lower yield than “non-prime” CDs. Similarly,
in the UK market, the lowest yield is paid by “clearer” CDs which are
issued by the clearing banks (e.g., RBS NatWest plc, HSBC and Barclays
plc). In both markets, CDs issued by foreign ¬nancial institutions such as
French or Japanese banks will trade at higher yields.
CDs yields are higher than yields on Treasury securities of like matu-
rity. The spread is due primarily to the credit risk that a CD investor is
exposed to and the fact that CDs offer less liquidity. The spread due to
credit risk will vary with both economic conditions in general and con¬-
dence in the banking system in particular, increasing in times when the mar-
ket™s risk aversion is high or when there is a crisis in the banking system.
Eurodollar CDs offer a higher yield than U.S. domestic CDs on aver-
age for three reasons. First, there are reserve requirements imposed by the
Federal Reserve on CDs issued by U.S. banks in the United States that do
not apply to issuers of Eurodollar CDs. The reserve requirement effec-
tively raises the cost of funds to the issuing bank because it cannot invest
all the proceeds it receives from the issuance of the CD and the amount
that must be kept as reserves will not earn a return for the bank. Because
it will earn less on funds raised by selling domestic CDs, the domestic
issuing bank will pay less on its domestic CD than a Euro CD. Second,
the bank issuing the CD must pay an insurance premium to the FDIC,
which again raises the cost of funds. Finally, Euro CDs are dollar obliga-
tions that are payable by an entity operating under a foreign jurisdiction,
exposing the holders to a risk (called sovereign risk) that their claim may
not be enforced by the foreign jurisdiction. As a result, a portion of the
spread between the yield offered on Euro CDs and domestic CDs re¬‚ects
what can be thought of as a sovereign risk premium. This premium varies
with the degree of con¬dence in the international banking system. Exhibit
6.2 presents a Bloomberg screen of rates for domestic and Eurodollar
CDs for various maturities out to one year on November 6, 2001. Note
that the yield offered on Eurodollar CDs is higher than the yield on the
domestic CD for each maturity.
Since the late 1980s, the liquidity of the Eurodollar CD has increased
signi¬cantly and the perception of higher risk had diminished. Exhibit 6.3
presents a time series plot of the spread (in basis points) between 3-month
LIBOR and 3-month CDs for the period January 1991 to October 2001.1

Source: Federal Reserve Statistical Release H.15. The CD rates are an average of
dealer offering rates on nationally traded CDs.
Debt Obligations of Financial Institutions

EXHIBIT 6.2 Bloomberg Screen of CD and Eurodollar CD Rates

Source: Bloomberg Financial Markets

Time Series Plot of the Spread between 3-Month LIBOR and
3-Month CD Rates

The rates are sampled every Friday. The patterns evident from the
graph are consistent with Eurodollar CDs and domestic CDs being viewed
as close substitutes. The mean spread over this time period is 11.09 basis
points. The large negative spike (’33 basis points) on the right-hand of the
graph is from September 14, 2001 which was the ¬rst Friday observation
after the terrorist attacks of September 11, 2001. Given the extraordinary
circumstances of this week, this observation can be viewed as an outlier.

Depository institutions are required to hold reserves to meet their reserve
requirements. The level of the reserves that a depository institution must
maintain is based on its average daily deposits over the previous 14 days.
To meet these requirements, depository institutions hold reserves at their
district Federal Reserve Bank. These reserves are called federal funds.
Because no interest is earned on federal funds, a depository institu-
tion that maintains federal funds in excess of the amount required incurs
an opportunity cost of the interest forgone on the excess reserves. Corre-
spondingly, there are also depository institutions whose federal funds are
short of the amount required. The federal funds market is where deposi-
tory institutions buy and sell federal funds to address this imbalance. Typ-
ically, smaller depository institutions (e.g., smaller commercial banks,
some thrifts, and credit unions) almost always have excess reserves while
money center banks usually ¬nd themselves short of reserves and must
make up the de¬cit. The supply of federal funds is controlled by the Fed-
eral Reserve through its daily open market operations.
Most transactions involving federal funds last for only one night; that
is, a depository institution with insuf¬cient reserves that borrows excess
reserves from another ¬nancial institution will typically do so for the
period of one full day. Because these reserves are loaned for only a short
time, federal funds are often referred to as “overnight money.”
One way that depository institutions with a required reserves de¬cit
can bring reserves to the required level is to enter into a repurchase agree-
ment (as described in Chapter 8) with a counterparty other than a ¬nan-
cial institution. The repurchase agreement (which consists of the sale of a
security and an agreement by say a bank to repurchase it later) will pro-
vide funds for a short period of time, after which the bank buys back the
security as previously agreed. Of course, an alternative to the repo is for
the bank to borrow federal funds from a depository institution that holds
excess reserves.
Thus, depository institutions view the repo market and the federal
funds market as close substitutes.
Debt Obligations of Financial Institutions

Federal Funds Rate
The interest rate at which federal funds are bought (borrowed) by deposi-
tory institutions that need these funds and sold (lent) by depository institu-
tions that have excess federal funds is called the federal funds rate. The
federal funds is a benchmark short-term interest. Indeed, other short-term
interest rates (e.,g, Treasury bills) often move in tandem with movements
in the federal funds rate. The rate most often cited for the federal funds
market is known as the effective federal funds rate.
The daily effective federal funds rate is volume-weighted average of
rates for federal fund trades arranged through the major New York bro-
kers. To illustrate how this averaging is accomplished, suppose only two
transactions took place on October 1, one for $50 million at a rate of
2.75% and another for $200 million at rate of 2.875%. The simple arith-
metic average would be 2.8125% which is calculated as follows:
(2.75 + 2.875)/2
By contrast, the transaction-weighted average for that day would be
2.85% which is calculated as follows:
(50/250)(2.75) + (200/250)(02274.275257875\5557\0)\560
The weighted average exceeds the arithmetic average because the
larger transaction occurred at the higher rate.
Exhibit 6.4 presents a Bloomberg screen that plots the daily effective
federal funds rate over the 1-year period beginning October 31, 2000 and
ending October 31, 2001.
When the Federal Reserve formulates and executes monetary policy,
the federal funds rate is frequently a signi¬cant operating target. The Fed-
eral Open Market Committee (FOMC) sets a target level for the federal
funds rate. Announcements of changes in monetary policy specify the
changes in the FOMC™s target for this rate. For example, due to the slug-
gish U.S. economy in 2000-2001 and the terrorist attacks on September
11, 2001, the FOMC launched a dramatic easing of monetary policy by
lowering the target federal funds ten times through November 8, 2001.
Exhibit 6.5 presents a Bloomberg screen of a time series plot of the target
federal funds rate for the period December 31, 2000 through November
8, 2001. During that period of time, the target federal funds rate dropped
from 6.5% to 2.0%. For this reason, the federal funds rate often exhibits
a high level of volatility over short periods of time. To see this, Exhibit
6.6 presents a Bloomberg screen of the daily effective federal funds rate
for the period August 14, 2001 through October 31, 2001. The screen
also shows the daily range of rates at which federal funds were traded.
The volatility is especially pronounced at the end of a quarter as ¬nancial
institution engage in balance sheet “window dressing.”

EXHIBIT 6.4 Bloomberg Screen of a 1-Year Time Series Plot of the Federal Funds Rate

Source: Bloomberg Financial Markets

EXHIBIT 6.5 Bloomberg Screen of a Time Series Plot of the Target Federal Funds Rate

Source: Bloomberg Financial Markets
Debt Obligations of Financial Institutions

EXHIBIT 6.6 Bloomberg Screen of the Daily Effective Federal Funds Rate

Source: Bloomberg Financial Markets

Market for Federal Funds
Although the term of most federal funds transactions is overnight, there
are longer-term transactions that range from one week to one year. As an
illustration, Exhibit 6.7 presents a Bloomberg screen the overnight and
term federal funds rates on October 31, 2001. Trading typically takes place
directly between buyer and seller usually between a large bank and one of
its correspondent banks. Some federal funds transactions require the use of
a broker. The broker stays in constant touch with prospective buyers/sell-
ers and arranging deals between for a commission. Brokers provide
another service to this market in (normally) unsecured loans because they
often can give lenders credit analyses of borrowers if the lenders have not
done business with them previously.
Although the federal funds market is known to be very large, no pre-
cise trading volume numbers are available. One indicator of the level of
trading in this market is the Federal Reserve data series for domestically
chartered banks in the United States. That series records monthly aver-
ages of bank borrowing from other banks in the United States. In the Fed-
eral Reserve Bulletin of September 2001, this ¬gure is $362.3 billion as of
June 2001. A high percentage of that amount is due to federal funds. The
magnitude of this number provides one reason why this market and this
borrowing arrangement are so important.

EXHIBIT 6.7 Bloomberg Screen of Overnight and Term Federal Funds Rates

Source: Bloomberg Financial Markets

A bankers acceptance is a written promise issued by a borrower to a bank
to repay borrowed funds. The lending bank lends funds and in return
accepts the ultimate responsibility to repay the loan to its holder, hence the
name”bankers acceptance. The acceptance is negotiable and can be sold
in the secondary market. The investor who buys the acceptance can collect
the loan on the day repayment is due. If the borrower defaults, the investor
has legal recourse to the bank that made the ¬rst acceptance. Bankers
acceptances are also know as bills of exchange, bank bills, trade bills, or
commercial bills.
Essentially bankers acceptances are instruments created to facilitate
commercial trade transactions. The use of bankers acceptances to ¬nance
commercial transactions is known as acceptance ¬nancing. The transac-
tions in which acceptances are created for include the import and export of
goods, the storage and shipping of goods between two overseas countries
where neither the importer nor the exporter is based in the home country,2
and the storage and shipping of goods between two entities based at home.

A bankers acceptance created to finance such a transaction is known as a third-par-
ty acceptance.
Debt Obligations of Financial Institutions

EXHIBIT 6.8 Bankers Acceptances Outstanding

Source: The Bond Market Association

Bankers acceptances are sold on a discounted basis just like Treasury
bills and commercial paper. The rate that a bank charges a customer for
issuing a bankers acceptance is a function of the rate at which the bank
believes it will be able to sell it in the secondary market. A commission is
added to this rate. The major investors in bankers acceptances are money
market mutual funds and municipal entities.
Bankers acceptances have declined in importance in recent years in
favor of other forms of ¬nancing. Exhibit 6.8 presents the total amount
of bankers acceptances outstanding in billions of dollars each year for
the period 1980-2000. There are several reasons that account for this
decline. First, the rise in ¬nancial disintermediation has reduced corpora-
tions™ dependence on bank ¬nancing in that they now have access to
wider range of funding options (e.g., commercial paper). Second, the
vicious circle of low liquidity leads to less issuance and so on. Third, in
July 1984, the Federal Reserve discontinued the use of bankers acceptan-
ces as collateral for repurchase agreements when conducting open mar-
ket operations.3

The Creation of a Bankers Acceptance
The most ef¬cient way to explain the creation of a bankers acceptance is by
an illustration. The following ¬ctitious parties are involved in this process:

In the UK markets, a similar confluence of forces has diminished the bank bills mar-
ket there.

– PCs For Less plc, a ¬rm in London that sells a wide variety of informa-
tion appliances;
– Kameto Ltd., a manufacturer of personal computers based in Japan
– ABC Bank plc, a clearing bank based in London
– Samurai Bank, a bank based in Japan
– Palmerston Bank plc, another bank based in London
– Adam Smith Investors plc, a money market fund based in Edinburgh

PCs For Less and Kameto Ltd. are preparing to enter into a deal in
which PCs For Less will import a consignment of personal computers
(PCs) with a transaction value of £1 million. However, Kameto Ltd. is
concerned about the ability of PCs For Less to make payment on the PCs
when they are delivered. To get around this uncertainty, both parties
decided to fund the transaction using acceptance ¬nancing. The terms of
the transaction are that payment must be made by PCs For Less within 60
days after the PCs have been shipped to the United Kingdom. In deter-
mining whether it is willing to accept the £1 million, Kameto Ltd. must
calculate the present value of the amount because it will not be receiving
this sum until 60 days after shipment. Therefore, both parties agree to the
following terms:

– PCs For Less arranges with its bankers, ABC Bank plc to issue a letter
of credit (LOC, also known as a time draft). The LOC states that ABC
Bank plc will guarantee the payment of £1 million that PCs For Less
must make to Kameto 60 days from shipment. The LOC is sent by
ABC Bank to Kameto™s bankers who are Samurai Bank. On the receipt
of the LOC, Samurai Bank noti¬es Kameto, who will then ship the
PCs. After the PCs are shipped, Kameto presents the shipping docu-
ments to Samurai and receives the present value of £1 million. This
completes the transaction for Kameto Ltd.
– Samurai Bank presents the LOC and the shipping documents to ABC
Bank plc. The latter will stamp the LOC as “accepted,” thus creating a
bankers acceptance. This means that ABC Bank plc agrees to pay the
holder of the bankers acceptance the sum of £1 million on the accep-
tance™s maturity date. PCs For Less will receive the shipping documents
so that it can then take delivery of the PCs once it signs a note or some
other ¬nancing arrangement with ABC Bank plc.

At this point, the holder of the bankers acceptance is Samurai Bank
and it has the following two choices available: (1) the bank may retain the
bankers acceptance in its loan portfolio or (2) it may request that Bank
ABC plc make a payment of the present value of £1 million. Let™s assume
that Samurai Bank elects to request payment of the present value of £1
Debt Obligations of Financial Institutions

million. Now the holder of the bankers acceptance is ABC Bank plc. It
also has two choices that it can make: (1) it may retain the bankers accep-
tance as an investment or (2) it may sell it another investor. Once again,
assume it chooses the latter, and one its clients, Adam Smith Investors, is
interested in a high-quality security with same maturity as the bankers
acceptance. Accordingly, ABC Bank plc sells the acceptance to Adam
Smith Investors at the present value of £1 million calculated using the rel-
evant discount rate for paper of that maturity and credit quality. Alterna-
tively, it may have sold the acceptance to another bank, such as
Palmerston Bank plc that also creates bankers acceptances. In either case,
on the maturity of the bankers acceptance, its holder presents it to ABC
Bank plc and receives the maturity value of £1 million, which the bank in
turn recovers from PCs For Less plc.
The holder of the bankers acceptance is exposed to credit risk on two
fronts: the risk that the original borrower is unable to pay the face value
of the acceptance and the risk that the accepting bank will not be able to
redeem the paper. For this reason, the rate paid on a bankers acceptance
will trade at a spread over the comparable maturity risk-free benchmark
security (e.g., U.S. Treasury bills). Investors in acceptances will need to
know the identity and credit risk of the original borrower as well as the
accepting bank.

Eligible Bankers Acceptances
An accepting bank that chooses to retain a bankers acceptance in its port-
folio may be able to use it as collateral for a loan obtained from the central
bank during open market operations, for example, the Federal Reserve in
the United States and the Bank of England in the United Kingdom. Not all
acceptances are eligible to be used as collateral in this manner, as the
acceptances must meet certain criteria as speci¬ed by the central bank. The
main requirements for eligibility are that the acceptance™s maturity must
not exceed a certain maturity (a maximum of six months in the United
States and three months in the United Kingdom) and that it must have
been created to ¬nance a self-liquidating commercial transaction. In the
United States, eligibility is also important because the Federal Reserve
imposes a reserve requirement on funds raised via bankers acceptances that
are ineligible. Bankers acceptances sold by an accepting bank are potential
liabilities of the bank but reserve requirements impose a limit on the
amount of eligible bankers acceptances that a bank may issue. Acceptances
eligible for deposit at a central bank offer a lower discount rate than ineli-
gible ones and also act as a benchmark for prices in the secondary market.

Funding agreements (FAs) are short-term debt instruments issued by insur-
ance companies. Speci¬cally, a funding agreement is a contract issued by
an insurance company that provides the policyholder the right to receive
the coupon payments as scheduled and the principal on the maturity date.
These contracts are guaranteed by the insurer™s general account or a sepa-
rate account. FAs are not publicly traded and therefore are less liquid than
other money market instruments such as commercial paper. In recent
years, medium-term notes (U.S. MTNs and Global MTNs) have become
increasingly popular. These are securitizations whose cash ¬‚ows are
backed by a portfolio of FAs. Moody™s estimates in 2000 the amount of
securities outstanding backed by FAs was approximately $20 billion.4
Coupon rates may be either ¬xed or ¬‚oating. Reference rates have
included U.S, Treasury rates, LIBOR, commercial paper rates, the federal
funds rate, and the prime rate. The unique feature of FAs is that the holder
of this security has an embedded put option with a 7, 30, 90, 180 day or
year expiration. Therefore, FAs are putable back to the issuer at par. Yields
offered on FAs depend on the credit quality of the issuing insurer, the
structure of the embedded put option, and the term to maturity.
Like many ¬nancial instruments, FAs have had setbacks. Speci¬cally,
there is credit risk and a major default increases the concerns of investors
about the product. In August 1999, General American Life Insurance Co.
failed to meet its required interest and principal redemption when investors
put back the FAs the company issued. The option was putable in seven
days. The exercise of the put option by investors followed the downgrading
of the insurance company by several rating agencies. Investors eventually
received their payments when Metropolitan Life Insurance Company Co.
acquired General American Life Insurance Co. and satis¬ed the obligation.
Since this incident, life insurance companies issuing FAs have made every
effort to address the concerns investors have had with these contracts. Spe-
ci¬cally, prior to 1999, most FAs were putable in seven days. The contracts
now tend to have longer-dated puts. In addition, there is increased use of
FAs backing medium-term notes that are typically sold without puts.
The major investors in FAs are money market mutual funds”both
institutional-oriented funds and retail-oriented.5 Short-dated putable FAs
are structured to qualify as 2a-7 eligible money market mutual fund
investments because they are illiquid investments since as we noted earlier

Moody™s Special Comment “Institutional Investment Products: The Evolution of a
Popular Product,” April 2000, Moody™s Investor Services. New York.
Information in this paragraph was obtain from “Update on Short-Term Putable
Funding Agreements,” Moody™s Investors Service, October 2001.
Debt Obligations of Financial Institutions

they are not publicly traded. Seven of the largest institutional money mar-
ket funds held FAs as of mid 2001. The top four issuers of FAs sold to
institutional money market funds are Transamerica Occidental Life,
Monumental Life, New York Life, Allstate Life, and Jackson National
Life. The major issuers of FAs sold to retail-oriented money market funds
are Monumental Life, Travelers, Metropolitan, GE Life and Annuity
Assurance Co., and Paci¬c Life. Five of the top ten retail-oriented money
market funds invest in FAs as of mid 2001.
A study by Moody™s in October 2001 investigated the reasons why
money market mutual funds invest in FAs.6 The following reasons were

1. FAs are attractive short-term investments.
2. FAs are highly rated and are “stable value”“type products
3. Investors like FAs as an established product.

“Update on Short-Term Putable Funding Agreements,” p. 9.

Floating-Rate Securities

ash managers invest in not only short-term ¬xed-rate securities but
C also ¬‚oating-rate securities that exhibit little price volatility when
interest rates change. In this chapter, we will discuss the general features
of ¬‚oating-rate securities (or simply “¬‚oaters”), their price volatility
characteristics, and “spread” measures used by market participants.
There are ¬‚oaters in the agency debenture and corporate bond markets.
There are also ¬‚oating-rate products created in the mortgage-backed
and asset-backed securities markets. These securities will be discussed in
Chapters 9 and 10, along with short-term ¬xed-rate products created in
these markets.

A ¬‚oater is a debt obligation whose coupon rate is reset at designated
dates based on the value of some designated reference rate. The coupon
formula for a pure ¬‚oater (i.e., a ¬‚oater with no embedded options) can
be expressed as follows:

coupon rate = reference rate ± quoted margin

The quoted margin is the adjustment (in basis points) that the issuer
agrees to make to the reference rate. For example, consider a ¬‚oating-
rate note issued by Enron Corp. that matured on March 30, 2000.1 This
¬‚oater made quarterly cash ¬‚ows and had a coupon formula equal to 3-
month LIBOR plus 45 basis points.
This illustration will remind the investor that one must always keep credit risk in


Under the rubric of ¬‚oating-rate securities, there are several different
types of securities with the feature that the coupon rate varies over the
instrument™s life. A ¬‚oater™s coupon rate can be reset semiannually, quar-
terly, monthly or weekly. The term “adjustable-rate” or “variable-rate”
typically refers to those securities with coupon rates reset not more than
annually or based on a longer-term interest rate. We will refer to both
¬‚oating-rate securities and adjustable-rate securities as ¬‚oaters.
As noted, the reference rate is the interest rate or index that appears
in a ¬‚oater™s coupon formula and it is used to determine the coupon
payment on each reset date within the boundaries designated by embed-
ded caps and/or ¬‚oors. Common reference rates are LIBOR (with differ-
ent maturities), Treasury bills yields, the prime rate, the federal funds
rate, and domestic CD rates. There are other reference rates utilized in
more specialized taxable ¬xed-income markets such as the mortgage-
backed securities and asset-backed securities markets. For example, the
most common reference rates for adjustable-rate mortgages (ARMs) or
collateralized mortgage obligation (CMO) ¬‚oaters include: (1) the 1-
year Constant Maturity Treasury rate (i.e., 1-year CMT); (2) the Elev-
enth District Cost of Funds (COFI); (3) 6-month LIBOR; and (4) the
National Monthly Median Cost of Funds Index.

Restrictions on the Coupon Rate
A ¬‚oater often imposes limits on how much the coupon rate can ¬‚oat.
Speci¬cally, a ¬‚oater may have a restriction on the maximum coupon
rate that will be paid on any reset date. This is called a cap. Consider a
hypothetical ¬‚oater whose coupon formula is 3-month LIBOR plus 50
basis points with a cap of 7.5%. If 3-month LIBOR at a coupon reset
date is 8%, then the coupon formula would suggest the new coupon
rate is 8.5%. However, the cap restricts the maximum coupon rate to
7.5%. Needless to say, a cap is an unattractive feature from the inves-
tor™s perspective.
In contrast, a ¬‚oater may also specify a minimum coupon rate called
a ¬‚oor. For example, First Chicago (now 1st Chicago NBD Corp.) issued
a ¬‚oored ¬‚oating rate note in July 1993 that matures in July 2003. This
issue delivers quarterly coupon payments with a coupon formula of 3-
month LIBOR plus 12.5 basis points with a ¬‚oor of 4.25%. So if 3-
month LIBOR ever fell below 4.125% the coupon rate would remain at
4.25%. A ¬‚oor is an attractive feature from the investor™s perspective.
When a ¬‚oater possesses both a cap and a ¬‚oor, this feature is
referred to as a collar. Thus, a collared ¬‚oater™s coupon rate has a maxi-
mum and a minimum value. For example, the Economic Development
Corporation issued a collared ¬‚oater in February 1993 that makes semi-
Floating-Rate Securities

annual coupon payments and matures in 2003. The coupon formula is
6-month LIBOR ¬‚at with a ¬‚oor of 5% and a cap of 8%.2

Inverse Floaters
While a ¬‚oater™s coupon rate typically moves in the same direction as
the reference rate, there are ¬‚oaters whose coupon rate moves in the
opposite direction to the change in the reference rate. These securities
are called inverse ¬‚oaters or reverse ¬‚oaters. The general coupon for-
mula for an inverse ¬‚oater is:

K ’ L — (Reference rate).

From the formula, it is easy to see that as the reference rate goes up
(down), the coupon rate goes down (up).
As an example, consider an inverse ¬‚oater issued by one of the Fed-
eral Home Loan Banks in April 1999 due in April 2002. This issue
delivers quarterly coupon payments according to the formula:

18% ’ 2.5 — (3-month LIBOR)

In addition, this inverse ¬‚oater has a ¬‚oor of 3% and a cap of 15.5%.
Note that for this ¬‚oater the value for L (called the coupon leverage) in
the coupon reset formula is 2.5. Assuming neither the cap rate nor the
¬‚oor rate are binding, this means that for every one basis point change
in 3-month LIBOR the coupon rate changes by 2.5 basis points in the
opposite direction. When L is greater than 1, the security is referred to
as a leveraged inverse ¬‚oater.
Unfortunately, some money market investors have purchased inverse
¬‚oaters based on the belief that these ¬‚oating-rate products provide a
hedge against a decline in interest rates. While the coupon rate does
increase when the reference rate decreases, inverse ¬‚oaters have the unfa-
vorable property that their durations are typically very high. That is, they
typically have high effective durations, a characteristic not understood by
managers who still view “duration” in temporal terms (i.e., in terms of
years). Certainly, these two features of an inverse ¬‚oater”higher coupon
rate when rates decline and substantial price appreciation due to a high
effective duration”are appealing to a manager who wants to bet on a
downward movement of rates. But clearly, this is not the approach that
should be pursued by a manager who seeks to maintain a stable value for
a portfolio when rates change.

Here, the term flat means without a quoted margin or a quoted margin of zero.

Other Types of Floaters
There is a wide variety of ¬‚oaters that have special features that may
appeal to certain types of investors. For example, some issues provide
for a change in the quoted margin (i.e., the spread added to or sub-
tracted from the reference in the coupon reset formula) at certain inter-
vals over a ¬‚oater™s life. These issues are called stepped spread ¬‚oaters
because the quoted margin can either step to a higher or lower level over
time. Consider Standard Chartered Bank™s ¬‚oater due in December
2006. From its issuance in December 1996 until December 2001, the
coupon formula is 3-month LIBOR plus 40 basis points. However, from
December 2001 until maturity, the quoted margin “steps up” to 90
basis points.
A range note is a ¬‚oater where the coupon payment depends upon
the number of days that the speci¬ed reference rate stays within a prees-
tablished collar. For instance, Sallie Mae issued a range note in August
1996 (due in August 2003) that makes coupon payments quarterly. For
every day during the quarter that 3-month LIBOR is between 3% and
9%, the investor earns 3-month LIBOR plus 155 basis points. Interest
will accrue at 0% for each day that 3-month LIBOR is outside this collar.
There are also ¬‚oaters whose coupon formula contains more than
one reference rate. A dual-indexed ¬‚oater is one such example. The cou-
pon rate formula is typically a ¬xed percentage plus the difference
between two reference rates. For example, the Federal Home Loan Bank
System issued a ¬‚oater in July 1993 (due in July 1996) whose coupon
rate was the difference between the 10-year Constant Maturity Treasury
rate and 3-month LIBOR plus 160 basis points.
Although the reference rate for most ¬‚oaters is an interest rate or an
interest rate index, numerous kinds of reference rates appear in coupon
formulas. This is especially true for structured notes. Potential reference
rates include movements in foreign exchange rates, the price of a com-
modity (e.g., gold), movements in an equity index (e.g., the Standard &
Poor™s 500 Index), or an in¬‚ation index (e.g., CPI). Financial engineers
are capable of structuring ¬‚oaters with almost any reference rate. For
example, Merrill Lynch issued in April 1983 Stock Market Reset Term
Notes which matured in December 1999. These notes delivered semian-
nual coupon payments using a formula of 0.65 multiplied by the annual
return of the Standard & Poor™s MidCap 400 during the calendar year.
These notes have a cap rate of 10% and a ¬‚oor rate of 3%.
Of course, with these non-traditional (i.e., non-interest rate refer-
ence rates) ¬‚oaters expose portfolios to different types of risks. More-
over, some of them are not simple to value”an undesirable feature for a
cash portfolio.
Floating-Rate Securities

Call and Prepayment Provisions
Just like ¬xed-rate issues, a ¬‚oater may be callable. The call option gives
the issuer the right to buy back the issue prior to the stated maturity
date. The call option may have value to the issuer some time in the
future for two reasons. First, market interest rates may fall so that the
issuer can exercise the option to retire the ¬‚oater and replace it with a
¬xed-rate issue. Second, the required margin decreases so that the issuer
can call the issue and replace it with a ¬‚oater with a lower quoted mar-
gin.3 The issuer™s call option is a disadvantage to the investor since the
proceeds received must be reinvested either at a lower interest rate or a
lower margin. Consequently, an issuer who wants to include a call fea-
ture when issuing a ¬‚oater must compensate investors by offering a
higher quoted margin.
For amortizing securities (e.g., mortgage-backed and some asset-
backed securities) that are backed by loans that have a schedule of prin-
cipal repayments, individual borrowers typically have the option to pay
off all or part of their loan prior to the scheduled date. Any principal
repayment in excess of the scheduled amount is called a prepayment.
The right of borrowers to prepay is called the prepayment option. Basi-
cally, the prepayment option is analogous to a call option. However,
unlike a call option, there is not a call price that depends on when the
borrower pays off the issue. Typically, the price at which a loan is pre-
paid is its par value.

Put Provisions
Floaters may also include a put provision which gives the security
holder the option to sell the security back to the issuer at a speci¬ed
price on designated dates. The speci¬ed price is called the put price. The
put™s structure can vary across issues. Some issues permit the holder to
require the issuer to redeem the issue on any coupon payment date. Oth-
ers allow the put to be exercised only when the coupon is adjusted.
The advantage of the put provision to the holder of the ¬‚oater is
that if after the issue date the margin required by the market for a
¬‚oater to trade at par rises above the issue™s quoted margin, absent the
put option the price of the ¬‚oater will decline. However, with the put
option, the investor can force the issuer to redeem the ¬‚oater at the put
price and then reinvest the proceeds in a ¬‚oater with the higher quoted

The required margin is the spread (either positive or negative) the market requires
as compensation for the risks embedded in the issue. If the required margin equals
the quoted margin, a floater™s price will be at par on coupon reset dates.

The change in the price of a ¬xed-rate security when market rates
change is due to the fact that the security™s coupon rate differs from the
prevailing market rate. So, an investor in a 10-year 7% coupon bond
purchased at par, for example, will ¬nd that the price of this bond will
decline below par value if the market requires a yield greater than 7%.
By contrast, for a ¬‚oater, the coupon is reset periodically, reducing a
¬‚oater™s price sensitivity to changes in rates. For this reason, ¬‚oaters are
said to more “defensive” securities. However, this does not mean that a
¬‚oater™s price will not change.

Factors that Affect the Price of a Floater
A ¬‚oater™s price will change depending on the following factors:

1. time remaining to the next coupon reset date
2. whether or not the market™s required margin changes
3. whether or not the cap or ¬‚oor is reached

Below we discuss the impact of each of these factors.

Time Remaining to the Next Coupon Reset Date
The longer the time to the next coupon reset date, the greater a ¬‚oater™s
potential price ¬‚uctuation. Conversely, the less time to the next coupon
reset date, the smaller the ¬‚oater™s potential price ¬‚uctuation.
To understand why, consider a ¬‚oater with ¬ve years remaining to
maturity whose coupon formula is the 1-year Treasury bill rate plus 50
basis points and the coupon is reset today when the 1-year Treasury bill
rate is 5.5%. The coupon rate will then be set at 6% for the year. One
month from now, the investor in this ¬‚oater would effectively own an
11-month instrument with a 6% coupon. Suppose that at that time, the
market wants a 6.2% yield on comparable issues with 11 months
remaining to maturity. Then, our ¬‚oater would be offering a below mar-
ket rate (6% versus 6.2%). The ¬‚oater™s price must decline below par to
compensate for the sub-market yield. Similarly, if the yield that the mar-
ket requires on a comparable instrument with a maturity of 11 months
is less than 6%, the price of a ¬‚oater will trade above par. For a ¬‚oater
in which the cap is not reached and for which the market does not
demand a margin different from the quoted margin, a ¬‚oater that resets
daily will trade at par value.
Floating-Rate Securities

Whether or Not the Market™s Required Margin Changes
At the initial offering of a ¬‚oater, the issuer will set the quoted margin
based on market conditions so that the security will trade near par. If
after the initial offering the market requires a higher margin, the
¬‚oater™s price will decline to re¬‚ect the higher spread. We shall refer to
the margin that is demanded by the market as the required margin. So,
for example, consider a ¬‚oater whose coupon formula is 1-month
LIBOR plus 40 basis points. If market conditions change such that the
required margin increases to 50 basis points, this ¬‚oater would be offer-
ing a below market quoted margin. As a result, the ¬‚oater™s price will
decline below par value. The price can trade above par value if the
required margin is less than the quoted margin”less than 40 basis
points in our example.
The required margin for a speci¬c issue depends on: (1) the margin
available in competitive funding markets, (2) the credit quality of the
issue, (3) the presence of the embedded call or put options, and (4) the
liquidity of the issue. In the case of ¬‚oaters, an alternative funding
source is a syndicated loan. Consequently, the required margin will be
affected by margins available in the syndicated loan market.
The portion of the required margin attributable to credit quality is
referred to as the credit spread. The risk that there will be an increase in
the credit spread required by the market is called credit spread risk. The
concern for credit spread risk applies not only to an individual issue,
but to a sector and the economy as a whole. For example, the credit
spread of an individual issuer may change not due to that issuer but to
the sector or the economy as a whole.
A portion of the required margin will re¬‚ect the call risk associated
with the ¬‚oater. Because the call feature is a disadvantage to the inves-
tor, the greater the call risk, the higher the quoted margin at issuance.
After issuance, depending on how rates and margins change in the mar-
ket, the perceived call risk and the margin attributable to this risk will
change accordingly. In contrast to call risk due to the presence of the
call provision, a put provision is an advantage to the investor. If a
¬‚oater is putable at par, all other factors constant, its price should trade
at par near the put date.
Finally, a portion of the quoted margin at issuance will re¬‚ect the
perceived liquidity of the issue. The risk that the required margin attrib-
utable to liquidity will increase due to market participants™ perception
of a deterioration in the issue™s liquidity is called liquidity risk. Investors
in non-traditional ¬‚oater products are particularly concerned with
liquidity risk.

Whether or Not the Cap or Floor Is Reached
For a ¬‚oater with a cap, once the coupon rate as speci¬ed by the coupon
formula rises above the cap, the ¬‚oater then offers a below market cou-
pon rate, and its price will decline below par. The ¬‚oater will trade more
and more like a ¬xed-rate security the further the capped rate is below
the prevailing market rate. This risk that the value of the ¬‚oater will
decline because the cap is reached is referred to as cap risk.
On the other side of the coin, if the ¬‚oater has a ¬‚oor, once the ¬‚oor
is reached, all other factors constant, the ¬‚oater will trade at par value
or at a premium to par if the coupon rate is above the prevailing rate for
comparable issues.

Duration of Floaters
We have just described how a ¬‚oater™s price will react to a change in the
required margin, holding all other factors constant. Duration is the
measure used by managers to quantify the sensitivity of the price of any
security or a portfolio to changes in interest rates. Basically, the dura-
tion of a security is the approximate percentage change in a bond™s price
or a portfolio™s value for a 100 basis point change in rates.
Two measures have been developed to estimate the sensitivity of a
¬‚oater to each component of the coupon formula. Index duration is a
measure of the price sensitivity of a ¬‚oater to changes in the reference
rate holding the quoted margin constant. Spread duration measures a
¬‚oater™s price sensitivity to a change in the “spread” or “quoted mar-
gin” assuming that the reference rate is unchanged.


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