1w FinEcon 2024fall v3
Summary
TLDRThe 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
📈 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.
📉 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.
🔄 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.
⚠️ 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.
🏫 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.
Mindmap
Keywords
💡Repo Sell and Buy
💡Collateral
💡Short-term Borrowing
💡Bond Issuance
💡Negative Carry
💡Buyback Strategy
💡Interest Rate Swap (IRS)
💡Floating Rate
💡Financial Risk Management
💡Volatility
💡Financial Economics
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
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