1w FinEcon 2024fall v3

Summary

The transcript discusses financial transactions and their impact on a company's balance sheet, focusing on repo markets and bond markets. It explains how a company's funding sources, such as short-term borrowing and bond issuance, can alter its financial standing. The concept of negative carry is introduced, highlighting the challenges faced when market interest rates fall below the fixed coupon rates on bonds. Strategies to mitigate this, including bond buybacks and interest rate swaps, are explored. The summary emphasizes the importance of financial risk management in dealing with market volatility and the potential consequences of not managing such risks effectively.

Takeaways

• 📈 Repo and repurchase agreements are integral to the financial market, interacting with bond and stock markets.
• 💼 The balance sheet of an entity like Caleb can change due to different funding sources, such as repo funding versus short-term borrowing.
• 💵 Caleb's balance sheet example illustrates a shift from short-term borrowing to repo funding, affecting the liability side without altering total cash.
• 📉 The concept of negative carry arises when an entity is locked into paying a higher interest rate than the current market rate, leading to a loss.
• 🔄 A bond buyback strategy can be a solution to eliminate negative carry by repurchasing and reissuing bonds at a lower market rate.
• 🚫 Investor willingness plays a crucial role in a bond buyback, as they may reject offers that reduce their current returns.
• 🔄 Interest rate swaps are financial instruments that can be used to manage negative carry by exchanging fixed for floating rates.
• ⏳ The floating rate in a swap is typically based on a three-month term, reflecting market expectations and volatility.
• 📉 Market rate fluctuations pose risks; if rates rise contrary to expectations, the negative carry issue can re-emerge.
• 🛡 Financial risk management is essential for navigating market volatility and protecting against potential business losses.

Q & A

What does 'repo sell' and 'repo buy' represent in the context of the financial market?

In the financial market, 'repo sell' refers to a transaction where a party sells securities with an agreement to repurchase them at a later date, effectively a form of collateralized borrowing. 'Repo buy' is the opposite transaction where a party buys securities with the agreement to sell them back at a later date, which is a form of lending.

How are the repo market and bond market interconnected?

The repo market and bond market are interconnected as they both involve the use of financial instruments for borrowing and lending. The collateral provided in repo transactions can be bonds, which means changes in the bond market can affect the repo market and vice versa.

What is the impact of short-term borrowing on a company's balance sheet?

Short-term borrowing increases a company's cash and cash equivalents on the asset side of the balance sheet. On the liability side, it increases the short-term debt or payables, reflecting the new source of funding.

What is meant by 'negative carry' in the context of bond issuance?

Negative carry refers to a situation where the cost of borrowing exceeds the return on investment. In the context of bond issuance, if the market interest rates fall below the coupon rate of the bond, the issuer is locked into paying a higher interest rate than what is currently available in the market, resulting in a loss.

How can a company address the issue of negative carry on its bonds?

A company can address negative carry by either buying back the bonds from investors at a premium or engaging in an interest rate swap to exchange fixed-rate payments for floating-rate payments, thereby aligning the bond's interest payments with current market rates.

What is an interest rate swap and how can it be used to manage financial risk?

An interest rate swap is a financial derivative in which two parties exchange interest rate payments based on a notional principal amount. It can be used to manage financial risk by allowing a company to convert fixed-rate payments into floating-rate payments or vice versa, thus hedging against interest rate movements.

What are the potential risks associated with entering into an interest rate swap?

The potential risks of an interest rate swap include the possibility that market interest rates may move in an unfavorable direction, leading to losses. For example, if a company swaps to a floating rate and rates rise, it could end up paying more in interest than it would have under a fixed-rate agreement.

How does the concept of 'floating rate' work in the context of interest rate swaps?

In the context of interest rate swaps, a floating rate is a variable interest rate that changes over time, often based on a benchmark rate such as LIBOR. It is used to calculate the periodic interest payments that one party will make to the other in the swap agreement.

What is the role of financial risk management in a company's operations?

Financial risk management plays a crucial role in a company's operations by identifying, assessing, and mitigating potential financial risks. It helps protect the company from adverse effects of market volatility and ensures the stability and sustainability of its financial position.

Why is it important for students to understand financial economics and financial products?

Understanding financial economics and financial products is important for students as it equips them with the knowledge to make informed financial decisions, manage risks, and navigate the complexities of financial markets, which are essential skills in various business and economic fields.

Outlines

00:00

📈 Financial Market Interactions and Repo Transactions

This paragraph discusses the interconnectedness of the repo market and the bond market, emphasizing how short-term borrowing, bond issuance, stock issuance, and other financial products are traded in the financial markets. It explains the impact of repo transactions on a company's balance sheet, specifically how cash funding sources can change without altering the total cash amount. The example provided illustrates a scenario where a company shifts from short-term borrowing to repo funding, altering the composition of its liabilities.

05:02

📉 Negative Carry and Bond Buyback Strategies

The second paragraph delves into the concept of negative carry, which occurs when a company is locked into paying a higher interest rate than the current market rate on its bonds. It explores the idea of a bond buyback as a strategy to mitigate this negative carry. The summary explains the potential challenges of implementing a buyback, such as investor reluctance to sell back bonds that offer a higher coupon rate than what is available in the market. It sets the stage for considering alternative solutions to address the issue of negative carry.

10:02

🔄 Interest Rate Swaps to Manage Negative Carry

This paragraph introduces interest rate swaps as a financial instrument to manage negative carry. It describes a swap transaction where a company exchanges fixed interest payments for floating rate payments with a counterparty, such as a bank. The summary explains how this can help the company if market interest rates decline, as the floating rate payments would decrease, offsetting the fixed coupon payments to investors. However, it also points out the risk of rates rising, which could reverse the negative carry into a positive one, highlighting the importance of financial risk management.

15:03

⚠️ Risks of Financial Transactions and Market Volatility

The fourth paragraph highlights the risks associated with financial transactions, particularly the unpredictability of market rates. It discusses how a company might face negative carry again if market rates rise contrary to expectations. The summary underscores the importance of financial risk management in dealing with market volatility and the potential consequences of not managing these risks effectively, such as significant financial losses or even business failure.

20:04

🏫 Recap of Financial Economics and Course Details

The final paragraph summarizes the key financial concepts covered in the video, such as funding through CP borrowing, bond issuance, FX markets, repo transactions, and interest rate swaps. It emphasizes the importance of understanding these financial products and the need for risk management in the face of market volatility. The summary also provides information about the course, including evaluation methods like midterm exams, final assignments, attendance, and participation, and encourages students to review the lecture plan and reach out with any questions.

Keywords

💡Repo Sell and Buy

Repo Sell and Buy refers to the sale and repurchase agreements in finance, which are transactions where securities are sold with an agreement to repurchase them at a predetermined price. In the script, it is mentioned that the repo market and bond market are interconnected, indicating that repo transactions can influence the broader financial market dynamics.

💡Collateral

Collateral in finance is an asset that a borrower pledges as security for a loan. It ensures that the lender has some form of protection if the borrower defaults on the loan. In the script, it is mentioned that the collateral provided is 'HB', which signifies the importance of collateral in repo transactions.

💡Short-term Borrowing

Short-term borrowing refers to the act of borrowing money for a short period, typically less than one year. It is a common practice in finance to meet immediate cash flow needs. The script discusses how short-term borrowing can be replaced by repo funding, showcasing the flexibility in financing options.

💡Bond Issuance

Bond issuance is the process of a company or government selling bonds to investors to raise capital. It is a form of debt financing. The script mentions bond issuance as one of the financial products in the market, highlighting its role in corporate finance.

💡Negative Carry

Negative carry in finance occurs when the cost of holding an investment exceeds the income generated by it. In the script, it is discussed in the context of a bond issuer who has to pay a higher coupon rate than the current market rates, resulting in a loss.

💡Buyback Strategy

A buyback strategy in finance is when a company repurchases its own outstanding shares or bonds from the market. The script suggests this as a potential solution for a company facing negative carry by buying back high-coupon bonds and reissuing them at a lower rate.

💡Interest Rate Swap (IRS)

An Interest Rate Swap (IRS) is a financial derivative in which two parties exchange interest rate payments based on a notional principal amount. In the script, an IRS is proposed as a solution to manage negative carry by exchanging fixed-rate payments for floating-rate payments, thereby aligning the company's cost with market conditions.

💡Floating Rate

A floating rate is an interest rate that changes over time in response to market conditions, such as changes in a central bank's benchmark rate. The script discusses how a company might use a floating rate in an IRS to manage the risk of changing interest rates and negative carry.

💡Financial Risk Management

Financial Risk Management involves the identification, evaluation, and mitigation of financial risks. The script emphasizes the importance of managing financial risks, such as interest rate volatility, to prevent significant losses and ensure the stability of financial institutions.

💡Volatility

Volatility in finance refers to the degree of variation in the price of a security or market. The script mentions that volatility is inherent in financial markets and that it poses risks that need to be managed through strategies like interest rate swaps.

💡Financial Economics

Financial Economics is the study of the mechanisms through which financial markets function and the roles of financial institutions, instruments, and markets. The script ties the discussion of various financial products and strategies back to the broader field of financial economics, emphasizing the importance of understanding these concepts for making informed financial decisions.

Highlights

Repo market and bond market are interactive and connected.

Financial products like short-term borrowing, bond issuance, and stock issuance have an impact on financial markets.

The balance sheet of an entity can change through different funding sources like repo funding.

Negative carry occurs when the market rate is lower than the coupon rate on a bond.

A bond buyback strategy can be used to address negative carry issues.

Investors may not be willing to sell back high-coupon bonds to the issuer if market rates are lower.

Interest rate swaps can be used as a financial product to fix negative carry.

Swap transactions involve exchanging fixed-rate payments for floating-rate payments.

Market participants anticipate future interest rates when entering into swap agreements.

Financial risk management is crucial for dealing with market volatility.

Volatility in financial markets can lead to significant gains or losses for businesses.

Understanding financial products is essential for making informed financial decisions.

The lecture covered various financial instruments like repo, bonds, and interest rate swaps.

The importance of risk management in financial transactions was emphasized.

The session aimed to connect economic theories with practical financial decision-making.

The lecture plan will be uploaded for students to evaluate their performance in the course.

Students are encouraged to ask questions and engage with the course material.

The course aims to provide a comprehensive understanding of financial economics.

Transcripts

hold second let me

erase uh one more point I like to uh you

discuss with you

now repo sell and

by it doesn't stand alone reple sell

and

is uh working uh with

PL here

collateral that c provided is

HB which means uh repo market and bond

market they are are interactive they are

connected so here shortterm borrowing

Bond

issuance stock issuance F spot effect

forward Bond rapper these are Financial

products uh in the in the uh Trad it in

the financial uh Market such as funding

market and the bond market and stock

market a Foreign Exchange Market and

this is bond market in the secondary and

this is rep Market yeah this is all

about uh you know financial transaction

traded through financial Market

okay

now uh let's see uh how uh you know

Cabas has been uh changing from the

prior one H has paid back shortterm

borrowing because he gained uh borrowing

from repo sell and buy repo sell now

what would be C balance sheet please

forget about the effect spot and F for

the

thing left hand side still uh you know

CB has 10 million 10 billion KW asset 5

billion Cash 5 billion H

KTV and the that and Equity part right

hand side he has

KW 5

billion but not through short-term

borrowing but through rep funding prior

one prior one

short-term

borrowing but this time he gained five

billion

from rep barrowing so component I mean

the cash amount is same but the source

funding source is different another one

uh still uh 4 billion uh B Bond uh

issuance doesn't change 1 billion Equity

issuance doesn't change yeah this is uh

you know one uh simple

example uh for cop uh balance sheet to

be changed through uh funding uh

different funding uh

sources Yeah final one uh yeah this is

relatively uh you know not easy to

understand but uh I try to make it uh

concise as much as

possible let's

suppose tab had issued 10year Bond with

the fixed rate

here cop issued Bond 4 billion

KW but the bond ter

is 10 year

bond

coupon

5% coupon payment free frequency three

months so every 3

[Music]

months calab has to pay

5% for 10

[Music]

years however uh one uh one uh one

information arrives Market

participants expect believe leave it to

go down for a long fight like this

now it

round a

person it may go down 4 person it may go

down 3% it may go down 2% and stay

worldwide

if this happen then you still P still

pay how much uh how much percentage

5% now in the market rate is 2% but KB

has to pay

5% then this is also this is also part

of negative carry how much 3% loss day

by day

it's negative

carry you are in care of a situation how

what's the idea how to fix this uh you

know uh negative car how to sort out

negative K in know

problem what your what's your idea

please think about

it first option uh maybe uh in a cab uh

off four

buyback buy

back

strategy which

means it which means a cab issu Bond and

uh it's owned by investor already so

Caleb uh will ask investor please please

sell it back to me sell it back to

me that's uh if uh you know if investor

they are willing to sell it back to uh

CB I think this is really perfect

solution to uh effects because once he

uh buybacks all the outstanding uh you

know Bond issues and then uh reissue

reissue bond in the market again then

probably

probably

newbor

newborn issued at

2% so negative carry uh gone away this

is H absolute goal cab has to uh make it

happen but

from

from a investor point of view if you are

if you are investor of Kaleb bond which

gives you a 5% coupon but in the market

the rate is 2% go 2%

coupon if you know

Caleb asked you to sell it back are you

willing to

accept or are are you willing to accept

or are you willing to reject definitely

uh you know you need to reject so no

reason to sell it back because you can

bit you generate 5% coupon you otherwise

you may lose like 3% additional uh you

know positive carry that's why uh you

know buyback uh strategy buyback option

is not a

workable then what is uh you know uh

what is uh next option

other than a buy

back uh in that

case think uh swap is one of financial

product have car up to fix out his

negative

carry how he going to do

that here instrument product a interest

rate

swap which

means H

up and or

bank kup and R Bank between cop

Bank uh there is exchange of coupon

payment hello

uh

pay proin rates T

receive

5% that this is swap transaction this is

very typical swap

transaction

now now K uh based on uh his bond

isurance he need to pay you need to

pay

by% to the

investor because investor they are

bought

KW 5

billion

Bond now what is cash flow what is cash

flow

this part is

Bond Bond cash flow this

part uh swap related cash

flow this is

a this is B now let's uh in know

sum A and B

means a is minus 5 perc which means you

pay out b means plus

5% which means you gain uh 5% from uh re

bank

now you don't know you don't know yet uh

floting

rate the REM what's the remaining uh

cash flow from a plus

b uh this is offset

remaining part

is floting

rate floting rate usually set by in a

three months form then in that case let

me give you the concept of for rate now

t

z t 3 months T 6 months T 9 months

from

today uh sorry hold a second hold a

second yeah from uh today uh Market

already uh Market already tells you what

is uh in know three months rate this is

fixed already three

months

is fixed let's say

5% but from uh 3

months to uh six months another three

months

rate is not fixed it's a floating it's

unknown from uh 6 months to 9 months

another 3 months the

rate it's not decided it's uncertain so

now here rates going

down further and

further which means floting rates going

down further and

further now Market uh participant uh in

a uh exp anticipate it uh may go down

for long

file through uh So based on that

information kab made the cab added the

swap transaction to uh fix negative car

so final remaining cash flow is floating

rate payout so if uh you know rates

going down and then protein rate going

down

further

fixed cost I mean the coupon uh amount

will be less and

less this is good to uh you know Caleb

he um has sorted out his negative

carry that's one uh you know a good uh

Financial trans transaction to have cop

address his

uh in a homework but what the catch over

here what the

catch there is some uh you know there is

some uh the potential uh you know point

you need to think about before you know

swap a

transaction what could it

be what if uh

rates going

up

opposed to your expectation opposed to

Market expect Market expectation such

as

5%

10% even like

15% keep going

up and from your transaction add it to

to uh you know negative carry from a

plus b your remaining uh Cash Out

is protein rate pay out so if rates

going up and going up and going up then

your floting rate is going up going up

going up further then now you turn to

you turn to negative carry

again you you turn to negative carry

again because you are losing uh you are

losing uh between uh floating

rate and you uh

fixed uh fixed amount day by day day by

day

so cop uh may think well I shouldn't

have I shouldn't have uh you know traded

swap transaction for fixing my my

negative

carry but this is the market no one

really is sure uh you know bond rate

going down and bond rate going up it's

purely uncertain area soall a

volatility so in the financial Market uh

rates uh change every day price change

every day so we we this is part of like

volatility volatility gives you the risk

so Financial Risk Management is against

like uh

volatility if you not uh rate to uh risk

manage

volatility then you may uh you know uh

you may uh face like a bigger loss

probably you need to shut down your

business uh that's why uh Financial Risk

Management is uh uh is really important

factor for you know most of Finance form

to uh operate their business and then

even like a manufacturing company to

operate their uh business as well yeah

this is part of uh you know uh swap

transaction

okay uh I think uh you know uh I uh went

through uh in most of

concept uh most of you know coverage uh

today uh through uh financial

transaction uh let's make a you know

small WRA we talked

about

economics and we talked about financial

decision

right

financial decision

combine those to

[Music]

financial

economics so yeah this topic is about

the financial

economics uh through uh today's session

we uh

reviewed

Financial

products such

as

funding

funding say uh in a CP borrowing and uh

arrival

uh

borrowing

funding uh instrument we uh talked about

and bond issuance we talked

about

issuance and what else yeah we talked

about FX Market here

spot and

forward okay spot means uh you uh

transact today

transaction uh happened today and sett

uh done uh today or within uh T

plus2 this

is uh spot forward you transaction uh

done today a statement will not be done

today will not be done within t plus2

uh you know like uh our

cases uh settlements are done in three

months it's part of

forward what else we talked about

repo reple by means what

lending because you receive a collateral

for your

lending and rep po sell means what

borrowing you provide it collateral you

gain uh equalent money as a

borrowing and uh what else we uh talked

about as

last

swap

interest rate

so to risk manage kop negative

car uh through this uh you know uh

through

this

IRS you touch it you experience what the

volatility out there and why you need to

uh risk manage some volatility otherwise

you may lose full amount of money and

you go on bankrupt you're not able to uh

run your business anymore that's why uh

that's why you are studying uh Financial

economics and that's why you need to get

some understanding of financial uh

product okay let's uh in a let's call

let's close uh this uh section uh this

session today and uh I mentioned already

uh if you have any question and ques

please uh send me uh to my email or

mobile I will uh get back to you and I

will upload uh also lecture plan in the

kaca talk uh Kaka talk uh room uh later

on uh please take a look of take a look

at you know a lecture plan uh uh you can

see uh how to uh evaluate your uh

performance through uh you know this

course uh I already mentioned uh you

know how to evaluate in the lecture plan

uh which is which

comprised midterm uh exam and the final

assignment and also attendance and the

others such as participation

and teamwork and your question Etc

please have a look and let me know any

question I I will answer back right away

okay thank you so much this is not uh

you know easy for you but uh let's make

a good journey uh through this semester

uh with uh with me okay thank you so

much