Treasury Finance and Development Banking E-Book

Biagio Mazzi

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 566

Veröffentlichungsjahr: 2013

Beschreibung

Credit and credit risk permeates every corner of the financial world. Previously credit tended to be acknowledged only when dealing with counterparty credit risk, high-yield debt or credit-linked derivatives, now it affects all things, including such fundamental concepts as assessing the present value of a future cash flow. The purpose of this book is to analyze credit from the beginning--the point at which any borrowing entity (sovereign, corporate, etc.) decides to raise capital through its treasury operation. To describe the debt management activity, the book presents examples from the development banking world which not only presents a clearer banking structure but in addition sits at the intersection of many topical issues (multi-lateral agencies, quasi-governmental entities, Emerging Markets, shrinking pool of AAA borrowers, etc.). This book covers: * Curve construction (instruments, collateralization, discounting, bootstrapping) * Credit and fair valuing of loans (modeling, development institutions) * Emerging markets and liquidity (liquidity, credit, capital control, development) * Bond pricing (credit, illiquid bonds, recovery pricing) * Treasury (funding as an asset swap structure, benchmarks for borrowing/investing) * Risk and asset liability management (leverage, hedging, funding risk)

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

List of Figures

List of Tables

Acknowledgments

Introduction

I.1 TREASURY, FUNDING, AND THE REASONS BEHIND THIS BOOK

I.2 FUNDING ISSUES AS CREDIT AND PRICING ISSUES

I.3 TREASURY FINANCE AND DEVELOPMENT BANKING

I.4 THE STRUCTURE OF THE BOOK

Chapter 1: An Introductory View to Banking, Development Banking, and Treasury

1.1 A REPRESENTATION OF THE CAPITAL FLOW IN A FINANCIAL INSTITUTION

1.2 LENDING

1.3 BORROWING

1.4 INVESTING AND ALM

1.5 THE BASIC STRUCTURE OF A TRADITIONAL FINANCIAL INSTITUTION

1.6 DEVELOPMENT BANKING

Chapter 2: Curve Construction

2.1 WHAT DO WE MEAN BY CURVE CONSTRUCTION?

2.2 THE INSTRUMENTS AVAILABLE FOR CURVE CONSTRUCTION

2.3 USING MULTIPLE INSTRUMENTS TO BUILD A CURVE

2.4 COLLATERALIZED CURVE CONSTRUCTION

2.5 NUMERICAL EXAMPLE: BOOTSTRAPPING AN INTEREST RATE CURVE

Chapter 3: Credit and the Fair Valuing of Loans

3.1 CREDIT AS AN ASSET CLASS

3.2 A BRIEF OVERVIEW OF CREDIT MODELING

3.3 FAIR VALUE OF LOANS AND THE SPECIAL CASE OF DEVELOPMENT INSTITUTIONS

3.4 NUMERICAL EXAMPLE: CALCULATING THE FAIR VALUE OF A LOAN

Chapter 4: Emerging Markets and Liquidity

4.1 THE DEFINITION OF EMERGING MARKETS

4.2 THE MAIN ISSUES WITH EMERGING MARKETS

4.3 EMERGING MARKETS AND DEVELOPMENT BANKING

4.4 CASE STUDIES OF DEVELOPMENT PROJECTS

Chapter 5: Bond Pricing

5.1 WHAT IS A BOND?

5.2 A FEW FUNDAMENTAL CONCEPTS OF THE BOND WORLD

5.3 EXPRESSING CREDIT EXPLICITLY WHEN PRICING A BOND

5.4 ILLIQUID BONDS

5.5 NUMERICAL EXAMPLE: ESTIMATING THE COUPON OF AN EMERGING MARKET DEBT INSTRUMENT

Chapter 6: Treasury Revisited

6.1 FUNDING AS AN ASSET SWAP STRUCTURE

6.2 FUNDING LEVEL TARGETS

6.3 THE FUNDAMENTAL DIFFERENCES BETWEEN INVESTMENT BANKING AND DEVELOPMENT BANKING

6.4 BENCHMARKS FOR BORROWING AND INVESTING

Chapter 7: Risk and Asset Liability Management

7.1 THE ISSUE OF LEVERAGE

7.2 HEDGING

7.3 MANAGING RISK RELATED TO FINANCIAL OBSERVABLES

7.4 FUNDING RISK

Chapter 8: Conclusion

8.1 CREDIT IS EVERYWHERE

8.2 THE FUNDAMENTAL STEPS TO BORROWING, LENDING, AND INVESTING: A SUMMARY

Appendix A: Implying Zero Rates from FX Forward Quotes

Appendix B: CDS Spreads and Default Probabilities

Appendix C: Modeling the Credit-Driven Prepayment Option of a Loan

Appendix D: The Relation between Macaulay and Modified Durations

Appendix E: The Impact of Discounting on an Asset Swap Spread

Appendix F: Replication Leading to Risk-Neutral Probabilities

References

About the Web Site

THE IMPLEMENTATION OF THE BOOTSTRAPPING OF AN INTEREST RATE CURVE

THE IMPLEMENTATION OF THE BOOTSTRAPPING OF A HAZARD RATE CURVE

Index

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Copyright © 2013 by Biagio Mazzi. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

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Library of Congress Cataloging-in-Publication Data:

ISBN 978-1-118-72912-0 (Hardcover) ISBN 978-1-118-72942-7 (ebk) ISBN 978-1-118-72936-6 (ebk)

To Eglantine, Edmondo, Albertine, and Leopoldo

List of Figures

1.1A schematic representation of the inflow and outflow of capital to the treasury of a development institution.1.2A schematic representation of the role of a treasury desk in relation to other trading desks. Desk 1 provides the coupon and the other desks receive the proceeds of the issuance. 100/M, 100/N, 100/P (with M, N, P some integers) are fractions of the original principal, 100, of the issuance.1.3A more detailed version of the relation between treasury and any trading desk in need of funds.2.1Quotes for U.S. Treasury notes as of March 1, 2013, with a few discount notes highlighted. Source: Thomson Reuters Eikon.2.2Quotes for Canadian Dollar cash deposits as of February 27, 2013. Source: Thomson Reuters Eikon.2.3A sample of quotes of forward rate agreements for major currencies. Source: Thomson Reuters Eikon.2.4a) Russian Rubles FX forwards quoted in pips; b) Russian Rubles FX forwards quoted outright. Source: Thomson Reuters Eikon.2.5Norwegian Krone interest rate swap quotes. Source: Thomson Reuters Eikon.2.6A few examples of quotes for common USD tenor basis swaps. Source: Thomson Reuters Eikon.2.7A few examples of quotes for common cross currency basis swaps quoted as USD three-month flat versus foreign currency three-month rate plus basis. Source: Thomson Reuters Eikon.2.8A plot highlighting the difference between the overnight rate and the three-month LIBOR over time before, during, and after the peak of the financial crisis.2.9a) The zero rates of the bootstrapped curve; b) the one-year forward rates calculated from the bootstrapped discount factors.3.1A schematic representation of a CDS contract with a) physical exchange of the bond and b) without.3.2The credit default swap rate term structures for the republics of Germany, France, and Korea on January 18, 2012.3.3A quote screen for Germany CDS rate. Source: Thomson Reuters Eikon.3.4a) The term structures of CDS rates for the borrowers used in the example; b) the fair value of the loan as a percentage of the principal (primary axis) and the value, in basis points, of the prepayment option (secondary axis).4.1A comparison between developed and emerging markets bid-offer spreads. a) Developed markets: USD and EUR five-year interest rate swap rates; b) advanced emerging markets: ILS (Israeli Shekel) and CZK (Czech Krone) five-year swap rate as of September 6, 2011. Source: Thomson Reuters Eikon.4.2A comparison between developed and emerging markets bid-offer spreads. a) Mid-development emerging markets: ZAR (South African Rand) and HUF (Hungarian Florin) five-year swap rates; b) low-development emerging markets: TRY (Turkish Lira) and PHP (Philippine Pesos) five-year swap rate as of September 6, 2011. Source: Thomson Reuters Eikon.4.3FX forward rates for a) Turkish Lira (TRY); b) a selection of African currencies as of September 7, 2011. Source: Thomson Reuters Eikon.4.4An example of curve inversion for a) Ukraine; b) Kazakhstan.4.5FX forwards premia for Chinese renmibi (CNY). Source: Thomson Reuters Eikon.4.6SHIBOR fixings as of September 8, 2011. Source: Thomson Reuters Eikon.4.7A schematic representation of the project for rural development in X explaining the provenance of the final 100 units of funds dedicated to an individual project.4.8A representation of the relationship between the different parties involved in the textile export development project.5.1A sample quote for a French government bond with the different benchmarks highlighted. Source: Thomson Reuters Eikon.5.2A schematic representation of a (par) asset swap at inception.5.3A detailed representation of a par asset swap, where P is the bond price.5.4A detailed representation of a market (or proceeds) asset swap, where P is the bond price.5.5A collection of corporate bonds pricing near recovery. Source: Thomson Reuters Eikon.5.6A collection of four Greek government bonds pricing near recovery. Source: Thomson Reuters Eikon.5.7CDS quotes of entities trading at recovery. Source: Thomson Reuters Eikon.5.8A plot in time of the market price of the Greek government bond, the up-front premium to buy five-year protection against the default of Greece, and the sum of the two for a) the 2028, 6.14% bond (EUR) and b) the 2013, 4.625% bond (USD).5.9The cumulative profit and loss resulting from holding bond and protection from August 16, 2010, up to the default of Greece for a) EUR-denominated debt and b) USD-denominated debt.6.1The debt profile in time as of October 19, 2011, for a few selected entities.6.2A graphic representation of the lending and borrowing carried out by a development institution.6.3A plot, on the primary axis, of the LIBOR and funding curves in currencies X and Y and an inverted plot, on the secondary axis, of the currency basis between X and Y and the implied currency basis.7.1A representation of the debt-to-loan balance of a possible portfolio.7.2A representation of the debt-to-loan balance of a possible portfolio after additional debt has been issued to rebalance.7.3The six-month LIBOR curve and the funding curve of our financial institution.7.4The net resetting principal of the loan and the bonds in our example.7.5The absolute value of the 10-day reset differential for USD six-month LIBOR.

List of Tables

2.1Cash flows in a par swap (ATM) and in an out-of-the-money swap (OTM).2.2Shifts in discount factors and zero rate equivalent.2.3Impact of shifts in discount factors on MTM of ATM and OTM swaps.2.4Market inputs used to bootstrap the interest rate curve in our example.2.5The output of the bootstrapping process: the discount factors, the zero rates (annually and continuously compounded), and the one-year forward rates.3.1The detailed output of the fair value of the loan to China.3.2The summary of the fair values of the four loans.4.1Credit spread of selected emerging markets' sovereign shown against a few developed markets sovereign and corporate for comparison, as of March 4, 2013.4.2Principal outstanding of bonds issued in emerging market currencies by selected development institutions as of September 13, 2011 (in millions of local currency).5.1Cash flows of two similar bonds issued by two issuers with different credit standings.5.2Data, on interest rate instruments as of March 1, 2012, relevant in the assessment of the coupon of a two-year Electricity of Vietnam bond.5.3Data, on debt instruments as of March 1, 2012, relevant in the assessment of the coupon of a two-year Electricity of Vietnam bond.6.1Example of USD funding level term structure for the Republic of Italy as of October 17, 2011.6.2Example of EUR funding level term structure for the Republic of Italy as of October 17, 2011. Indicative levels are shown for the currency basis swap as spread to be paid over EURIBOR versus USD LIBOR flat.7.1The hedging of a fixed-coupon bond issued to borrow capital.7.2The hedging of a fixed-rate loan.7.3The hedging of a bond in a foreign currency issued to borrow capital.7.4The hedging of a bond in a nondeliverable currency Z purchased as an investment.7.5The hedging of a fixed- or floating-rate loan in a foreign currency.7.6The hedging of an investment in an ABS with an asset swap.7.7The hedging of an investment in an ABS with a total return swap.7.8The hedging of an equity investment with an equity return swap.7.9Taking a view on interest rates by locking a fixed rate.7.10A summary of the debt and loan portfolio in our example.7.11The income by rate reset period for each instrument in our portfolio.7.12Two scenarios for the yearly net income of our portfolio.7.13The effect of floating rates resetting consistently in a way detrimental to the portfolio income.

Acknowledgments

The topic of this book is treasury finance, but the way it is written tries to reflect a broader view and an approach to finance in general, which I have built throughout my career and for which I am indebted to many people.

Tal Sandhu, whom I worked with at Banca Caboto and Morgan Stanley, took a chance on a green PhD graduate and taught me to look at finance in terms of fundamentals: one should always start from first principles, and often risk neutrality is just plain common sense. He has the same traits as the great experimental physicists I had worked with in my previous career: when one truly understands a subject, no amount of obscure math can get in the way. Stefano Boschian Pest, also a colleague from Banca Caboto and Morgan Stanley, shares the same worldview and many of the issues treated in this book can be traced back to questions and problems we have asked ourselves in the past.

At the Word Bank I need to thank Christopher Vallyeason: some key discussions we have had on the topics of funding and nonprofit banking have helped greatly to shape my understanding. In this book I try to paint a picture (albeit an often simplified one) of how an entire banking operation works: I owe part of the success of this attempt to him (while I reserve the full blame in case of failure). Also at the World Bank I need to thank Carlo Segni and Tenzing Sharchok for some very useful discussions on the dynamics of the search, particularly when option driven, for lower borrowing costs; George Richardson for explaining to me some important points on funding in Emerging Markets and non-deliverable currencies. Finally, I need to thank Dirk Bangert for a few extremely interesting conversations on credit modeling.

I need to thank at John Wiley & Sons the editorial team and, in particular, Susan McDermott, Jennifer MacDonald, and Tiffany Charbonier: their enthusiasm and help were crucial to the publishing of this book.

Finally I would like to thank my wife, Eglantine, for putting up with me during the writing of this book. As Tom W. Körner would say, though, the last six words seem unnecessarily limiting.

Introduction

I.1 TREASURY, FUNDING, AND THE REASONS BEHIND THIS BOOK

Any economic activity, or practically any activity for that matter, needs to be funded somehow. The parallel between these funds, or cash, and the blood in an organism has been abused at great length but it remains a powerful one. While we are used to the idea of corporations or governments raising cash for investments, we are less familiar with the idea of financial institutions doing the same. When we study finance, and in particular the derivatives world, we often assume that the money used for these transactions is basically already there. This of course is not the case since financial institutions need to raise the liquidity they subsequently use to finance derivatives transactions. At the center of the operation of raising funds is the treasury, a specific desk or unit in an investment bank or a separate division in the case of a corporation.

Funding, through the action of borrowing, is intimately connected to the concept of credit and since the financial crisis of 2007 to 2009, credit has been a central topic in any financial discussion. When discussing financial theory at a more or less quantitative level, the cost of funding has never entered as a deciding factor. Now (as it is elegantly described by Piterbarg 70) this can no longer hold true.

There is a fair amount of literature covering treasury operations, but none that addresses the need of understanding at the same time the role of a treasury desk and its impact on the valuation of financial instruments. The works by Bragg 16 or Cooper 28 or Horcher 47 are very specific to the operational aspects of a treasury and deal in great detail with its practical aspects. Of similar practical nature is the work of Jeffrey 54 where the role of treasury is seen through its corporate goals. In these books we see how a treasury can either participate in the corporate growth of an institution or how an institution can deal with specific challenges such as cash and debt management or currency risk. Of the literature that does focus on valuation issues of the risk-neutral type one might encounter on a trading desk, there is work by Kitter 58 with a good analysis, for example, of interest rate curve construction which, because of age, does not include the crucial developments that have taken place during the first decade of the twenty-first century. Banks’ work 7 is another text that, while very similar in spirit to the present one, unfortunately lacks a very topical update on the recent financial crisis. Oricchio’s work 67 is close to our goals but, focusing on highly illiquid credit, his treatment straddles the boundaries of risk neutrality within which we shall always try to remain.

What exactly are our goals? Who is the ideal reader of this book? While, as we said, treasuries are present in all corporations (and sovereign entities), we shall be focusing mainly on treasuries within financial institutions. We are going to show how the role of funding is crucial for these institutions and how it affects the way all activities are seen and transactions priced. Most important we shall highlight how focusing on the cost of funding introduces specific risk management considerations. Moreover we shall offer a special focus on the role of funding when it comes to development banking. The ideal reader of this book is the practitioner with experience in fixed income or another asset class, new to treasury and to concepts such as funding, asset swaps, or loan pricing. Of course, because of the special focus on development banking, the ideal reader might be a practitioner in an institution applying the tools of investment banking toward development goals. A basic knowledge of concepts such as optionality and types of options is assumed; while they will be briefly introduced again, a knowledge of simple fixed income concepts such as accrual or forward rates would be preferable. Except for the fairly brief one on the prepayment options of loans, no discussion will involve stochastic formalism: a solid grasp on financial modeling in the strict sense is not needed, any knowledge of it, however, can only be beneficial. To summarize as only a head hunter could, the ideal reader would be someone that, at some point in his or her career, has read and understood a substantial amount of Hull.1

Particularly since the issue of funding is so crucial to the functioning of any entity and in particular a financial institution, the approach has been to look at problems in terms of fundamentals: the mathematical tone of the book is kept at a minimum precisely because questions and answers have been based on fundamentally practical problems. Formalism has been modified in a way to suit the problems at hand sometimes, particularly when discussing the discounted value of bonds, with a twist that hopefully will add clarity rather than confusion. The same way mathematical physics needs to follow the logical laws of nature, finance, once we allow for the complexity of the instruments on which it is built, needs to follow very sensible rules based on profit, choice, and uncertainty. It is by this type of common sense that we describe the world of debt: as we shall see, all sorts of formulas can be written to value and describe the price of a bond; however, at the end it is just a number that rises and falls according to the investors’ interest.

Next to mathematical simplicity, we have striven for brevity. This book is intended as a tale of credit. We shall discuss how it is a tool for the practitioner to see credit in terms of spread, and how the markets, through different phenomena, affect those spreads. In the belief that once the basic understanding is obtained—there is no better way to learn than through action—the size and scope of this book have been kept within the boundaries of this purpose. We have relied heavily on actual market data literally snapped from brokers’ screens to show how to proceed with individual learning. A goal we hope to have achieved with this book is to show where to look and how to extract knowledge. Once this is achieved, there are few things as valuable as a few hours spent browsing Reuters (or an equivalent market data repository).

I.2 FUNDING ISSUES AS CREDIT AND PRICING ISSUES

As we show in Chapter 6, a treasury desk faces no hedging needs: if it is a desk within a financial institution the risk remains within the firm; if it is the treasury of a development institution or a corporation, the risk is outsourced. In any case it does not remain with the treasury itself. Because of this it has specific risk and valuation issues which it is our intent to prepare the reader for.

Not surprisingly for a book centered around debt, credit will be the paramount issue and we shall strive to show how as an issue it appears almost everywhere. Its first appearance is in the realm of curve construction, the fundamental process by which we generate forward floating rates and calculate their present values. The pricing of financial instruments, swaps in particular, have been subject to profound changes due to the interpretation and perception of the credit risk involved: from the different risk incurred by financial institutions borrowing in different currencies, to the different credit risk inherent in rates of different maturities, to finally the different credit risk linked to the posting or not posting of collateral. The classical theory of swap pricing (see Duffie and Singleton 32) considered the credit risk of a swap to be the same as the interbank credit when in practice, due to collateral posting, it was the same as the overnight rate. These details appear small in a normal environment but assume great proportions in a turbulent market. Moreover, with the increasing disappearance of complex exotic structures and the focusing on vanilla ones, the small details will become even more important. Curve construction and in particular discounting plays an exact role in our discussion because, as we introduced previously, a treasury operation does not carry out hedging. A correct discounting of an instrument is essential to arrive at what constitutes the raison d’être of a treasury operation, the funding level.

In a debt-raising operation the funding level is the measure of everything. After showing how this level is essentially an asset swap spread, we will position it at the center of our discussion. Our goal will be to place in the reader’s hands an imaginary rope representing the funding level of some imaginary entity of which the reader is the treasurer. Once in possession of the rope, the reader will learn what makes this rope move, what in the financial world pulls at its extremities or shifts it. Bond pricing will be seen almost entirely in terms of discounting and, with the risk of confusing the reader, the issue will be stressed to the point of introducing a quantity representing the credit correction to the money market discount factor. This will be to show that this appendix to the risk-free discount factor is what moves, through the prism of the asset swap, the funding level on the other side. To remain with the image of the rope, we shall try to show how, while always representing credit risk, there are many, often parallel, curves that take different meanings. CDS spreads, yields, benchmarks, and the asset swap spread itself can be related to each other or differ by little, but they can also mean and imply different types of credit risks.

The understanding of the difference between the various representations of credit risk can only come from an understanding of credit as a modeling of default; because our focus is always the valuation of financial instruments in the context of trading, our modeling will be risk neutral and centered around the concept of credit default swaps. Although it might seem like a detour, an introduction to the basics of credit modeling is fundamental to understanding the relationship between the market data, the CDS spread, and the concept of survival probability. We have tried to present it in a way that makes the latter appear as a risky discount factor, the appendix to the riskless discount factor we mentioned previously.

Our goal is therefore to make the reader comfortable with the concept of credit risk and the idea of its representation as a spread. Once we do so, we can show what else can be seen to affect this spread from liquidity issues to leverage (Schwarz 75, Adrian and Shin 2, and Acharya and Pedersen 1). It is partly with this intent that we touch upon emerging markets, markets that in their simplicity allow us to identify with ease individual factors. A simple example would be the bid-offer spreads: large or small spreads appear in every market; however, in developed markets many factors can drive their size. In emerging markets one can, most of the time, see a simple correlation between maturity, credit standing of the country and/or region, and bid-offer spread size—the mark of liquidity. We can simply offer an introduction without straying too much from our path: hopefully with it the reader can continue in the discovery of this fascinating topic.

I.3 TREASURY FINANCE AND DEVELOPMENT BANKING

The core of this book has two sides, debt management and development banking. The focus on development is not only for its own sake, but particularly because development banking, as an example of a simple banking activity that nonetheless maintains all the essential characteristics, allows the reader to understand concepts which apply to all banking but are easier to see in a simpler situation. Development banking will be introduced and then presented mainly through specific and yet theoretical financial examples. In the chapter on emerging markets we look at a few case studies in which we relate financial activity to realistic and practical development projects.

The type of development banking we are going to discuss is the one that uses the tools of investment banking—borrowing and lending—with the goal of assisting countries or institutions that would struggle to obtain the same type of assistance in the financial markets. Although the tools are the same, there are many differences that are important to stress. Earlier we mentioned the prism of the asset swap as the nexus between risky discounting and funding level. We will portray development banking as the prism through which to view credit going from the financial markets—open to everyone—to the bespoke lending (developed) markets where only development institutions dare to venture. A development bank, by lending at a level which is essentially (minus costs of operation) the one at which it can borrow, acts as a sort of transformer, enabling risky borrowers to access liquidity at rates they could never otherwise obtain. Throughout the book we stress the technical and formal elements differentiating the two types of banking (with the assumption that, unless stated otherwise, things are identical). At first one might be surprised that both types of institutions, only as far as borrowing is concerned of course, are not very different; however, when differences will appear (for example, in the case of the prepayment option in loans or the passing on of the institution’s borrowing costs to the subsequent borrower) they will be as startling.

The development banking world is particularly interesting because it straddles the separation between a financial institution and a sovereign entity. A development institution borrows, lends, and invests more or less like a traditional bank, yet it has some of the constraints and limitations of a sovereign entity. The instruments used for investments are fairly simple—they do not borrow to fund financial investment, they do not seek exposure to exotic financial risks, and so on. Moreover, a development institution, or at least those that are known as supranational, has constraints that go beyond those of a sovereign entity, exemplified, as we shall see, in the view that a development institution can be seen as a credit cooperative.

In the volatile times following the 2007 to 2009 financial crisis it is particularly difficult to forecast the direction of finance. It is clear that a few issues seem to gain in importance and will likely remain in focus for a long time. Credit will probably never leave the center of any financial consideration; sovereign debt will be treated with more interest going forward; financial transactions will probably move toward plainer structures; the developing world with its mixture of need and growth will play a larger role in the financial world. Development banking, and we shall try to treat it in a way that will make this clearer, sits at the intersection of all these issues in the sense that each one of these can be illustrated and better understood if seen in the context of banking with the goal of development.

I.4 THE STRUCTURE OF THE BOOK

As we said, this book is structured in an attempt to build the foundations of a clear understanding of the role of a treasury within a financial institution, the special functions of a development institution, and the specific risks that are associated with funding and managing debt.

In Chapter 1 we offer an introductory view to banking, development banking, and the role of the treasury within a financial institution. We present the fundamental activities of banking as lending (Section 1.2), borrowing (Section 1.3), and investing (Section 1.4). In Section 1.5 we offer a brief picture of how a financial institution is structured and in particular where the treasury is placed. In Section 1.6 we introduce development banking.

In Chapter 2 we discuss what can be considered the single most important problem in fixed income, curve construction. No attempt to value a financial instrument can be considered serious without a careful construction of its discount and index curves. In Section 2.1 we lay the foundation for the problem and in Section 2.2 we describe the instruments available in the market to construct a curve. In Section 2.3 we discuss the fairly recent development of the simultaneous use of multiple instruments to build a curve. The even more recent use of overnight index swaps to discount cash flows is approached in Section 2.4, where it is inserted in the historical evolution of the perception of credit risk when valuing derivatives. We conclude the chapter with Section 2.5, the first numerical example section, in which we lead the reader through the bootstrapping of an interest rate curve. Like the other numerical sections that will follow, the examples will be limited only to those calculations that the reader could then independently replicate on, say, a spreadsheet or in a simple VBA piece of code, such as the one presented on the web site.

Chapter 3 is dedicated to credit. Given the fact that a treasury’s main activity is raising debt, credit is central to it, and this chapter attempts to understand its fundamental concepts. In Section 3.1 we describe what characterizes credit as an asset class and what its main underlyings are. We end by introducing credit default swaps (CDS) upon whose risk neutral definition of survival we shall base further credit considerations. In Section 3.2 we show the three main approaches to credit modeling and we settle on the preferred choice, for our purpose, of intensity based model. We conclude the section with a useful and rigorous toolkit for obtaining survival probabilities from CDS spreads. In Section 3.3 we discuss the fair value of loans and we dedicate a considerable space to issues specific to development banking. In Section 3.4 we conclude the chapter with the numerical example of pricing the same loan issued by a development institution to four different borrowers.

As introduced earlier, the reasons for the focus on emerging markets in Chapter 4 are twofold. As a text dedicating considerable attention to development banking, it is important to discuss the regions and the markets where this takes place. At the same time, under a financial point of view, emerging markets offer an invaluable example of phenomena such as liquidity and capital control. After attempting a definition of the essentially nebulous concept of emerging markets in Section 4.1, we touch upon the financial characteristics typical of these markets such as liquidity, capital control, and credit risk in Section 4.2. We continue with Section 4.3 where we see the role played by emerging markets in development banking (or vice versa). In Section 4.4 we present two case studies of realistic projects involving the action of a development institution in an emerging market.

Chapter 5 is dedicated to the most important instrument we deal with and the essence of debt: bonds. In Sections 5.1 and 5.2 we introduce the idea of bonds and the essential concepts associated with it, such as par, duration, and—the most fundamental of all—yield. In Section 5.3 we discuss the credit element of bond and we understand how to express it through proxies such as asset swap spread and how to view it in terms of CDS spreads. We continue in Section 5.4 with a look at how to price illiquid and/or distressed debt (using as an example in Section 5.4.2 the default of Greece); on this particular topic in Section 5.5 we try to estimate the numerical value of a coupon of a real emerging market entity.

In Chapter 6, after having built the necessary knowledge, we finally approach the topic of treasury. In Section 6.1 we return to the all-important concept of asset swap and we discuss how funding is essentially seen through it. In Section 6.2 we discuss what it means to search for ever-smaller funding cost, the main role of a treasury desk, and what it entails in terms of risk and valuation. In Section 6.3 we look at how a development institution differs from a normal investment bank. In Section 6.4 we revisit the concept of benchmark in the context of a development bank’s borrowing and investment strategies.

In Chapter 7 we analyze some of the risk and challenges facing treasury operations, irrespective of whether it is within a development institution or a desk within an investment bank. In Section 7.1 we return to the concept of leverage and see it in terms of capital requirements. In Section 7.2 we discuss what replication and hedging means in terms of pricing and what it means to price a financial instrument when no hedging or static hedging is carried out. We continue the chapter with a view on risk management. First, in Section 7.3 we discuss the management of risk associated with financial variables. In Section 7.3.1 we look at interest rate and FX risk and its management through static hedging. In Section 7.3.2 mentions briefly the explicit treatment of credit risk. We continue in Section 7.4 with a look at the different types of funding risk that are typical of the situation where a pool of debt and loans needs to be managed. In Sections 7.4.3 and 7.4.5 we offer two numerical examples of estimating refinancing and reset risk in a loan/debt portfolio.

We finish the book with Chapter 8 where we draw some conclusions from our discussion. We stress how credit is present in any corner of the financial landscape, and finally, as a way of putting everything together, we imagine we are setting up a treasury operation and we recap what the fundamental steps would be.

A few interesting topics, which would have nonetheless disrupted the flow of the main text, have been presented in a series of appendices. Finally, in the chapter, About the Web Site, we direct the reader to a web site where we offer some implementations of numerical techniques presented in the preceding chapters.

1. Meaning, of course, John Hull’s Options, Futures, and Other Derivatives.

CHAPTER 1

An Introductory View to Banking, Development Banking, and Treasury

We have mentioned that our focus is going to be any treasury activity carried out by a traditional financial institution, a development bank, a corporation, or a government. When discussing the issuance of debt we will indeed draw examples from all four types of entities listed; however, when the objective will be a deeper understanding of several concatenated activities, we shall focus on the former two types of institution: investment banks and development banks. Furthermore, our view will narrow toward development banking not only because it is a special concern of ours but also because, in its simpler type of financial activity, it offers an opportunity to isolate clearly the different functions of a bank. A development institution that uses the tools of investment banking (we shall see in Section 1.6.1 that some do not) offers the simplest type of banking activity, a type made up of instruments upon which traditional investment banks have built increasingly more sophisticated ones; the higher level of sophistication, in our situation, does not translate necessarily to a better understanding.

In this chapter we shall introduce the fundamental activities of a financial institution as lending, borrowing, investing, and asset liability management (ALM); we shall try to present them in this order so as to follow the business line that goes from the client’s need for a loan, through the bank’s need to fund the loan, and then invest the income generated and hedge the potential risks. We shall then conclude with a sketch of the structure of a typical financial institution and a definition of the type of development bank we shall be dealing with.

1.1 A REPRESENTATION OF THE CAPITAL FLOW IN A FINANCIAL INSTITUTION

Before offering an introduction to fundamental banking activities, let us focus on a schematic representation of the flow of capital within a financial institution. As we have said before, we shall use a development institution as an example, since it encapsulates at least the fundamental aspects of banking plus a few additional features.

In Figure 1.1 we show the capital inflow and outflow to the treasury of a development institution. In Section 1.6 we describe which type of institutions obtain their funds in which particular way, but here we attempt to describe in a general way how development institutions obtain their funds and what they do with them.

FIGURE 1.1 A schematic representation of the inflow and outflow of capital to the treasury of a development institution.

A development institution, like many institutions, has shareholders who have brought a certain initial amount of equity to the institution and own a share of it. The sum of all these contributions constitutes the majority of the institution’s equity. Additionally, and this is peculiar to development organizations, there are donors’ contributions. These contributions can be made either by the shareholders themselves or by other entities; they can actually be given to the institution or they can be pledged, meaning that they remain with the donor until the institution asks for it. These contributions can be offered or, when coming from the shareholders, they can be requested by the collection of shareholders.

An additional inflow of capital, and the main topic of this book, is debt. In Section 1.3 we introduce how borrowing fits within the general activity of an institution and define the varieties of those instruments. Throughout the rest of the book we describe how debt is priced.

The main outflow, and the reason for being a development institution or a commercial bank, is lending. In Section 1.2 we introduce how lending takes place in relation to clients’ needs. Income generated by loans is used to repay the debt; any additional return flows into the institution’s equity.

The role played by the investment unit of a development institution will be introduced at a general level in Section 1.4 and in more detail in Section 6.4.2. Its main mandate is essentially to prevent depreciation in the institution’s equity and to provide emergency liquidity to its lending unit. Investments’ returns flow back into the institution’s equity.

Finally, the institution’s capital is also used for asset liability management, which will be introduced in Section 1.4 at a general level and then in detail in Chapter 7. Its main mandate is to balance debt and income and to hedge high-level exposures. It is an activity that should be more or less return neutral; however, any positive return would flow into the institution’s equity.

Having sketched the general movement of capital within a development institution, we can now begin introducing its main activities in more detail before—in the subsequent chapters—getting into even greater detail by adopting more analytical tools.

1.2 LENDING

A bank is a firm whose core business is dealing with money itself. A bank exists and profits from making money available to others. To make money available is an intentionally vague expression because the ways banks inject liquidity (a favorite journalese expression meaning helping to increase the circulation of money) into the world are multiple and some are more direct than others. The simplest, and the one we shall focus on, is through lending money to whoever needs it (and, of course, qualifies for it).

A loan is the main instrument of lending and the one we shall discuss at length throughout the book. In Section 3.1.1 we give a rigorous definition of it, in Section 3.3.1 we discuss its valuation, and in Chapter 7 we discuss its relationship to debt. Here we are simply going to introduce a loan in the context of a description of the activity of a bank. If we allow for the statement that, irrespective of the sophistication of a banking activity, the business of a bank is lending, we can simply focus on loans, and for that matter the activity of a development bank is sufficient for our discussion. Any additional activity a traditional financial institution, such as an investment bank, carries out can be seen as built on this.

Who are the clients facing a development bank, the entities needing a loan? A typical client of a development institution is a sovereign or private entity most often associated with the developing world; such client would seek the help of a development bank because to do the same in the capital markets would be too expensive or downright impossible. The need for a loan can be associated with a more or less specific development project that the sovereign or corporate entity envisages to carry out. The term development project is vague but we can imagine it including building schools and hospitals, developing infrastructure and power sources, even developing a basic capital market. We can imagine it excluding unnecessarily the strengthening of armed forces or building infrastructures closely linked to the ruler or the ruling party (e.g., a road to the ruler’s estate).

Not all projects benefit from the same type of loan, and the role of a development institution is to construct the lending instrument around the needs of the client. We now present some of the possible types of loans in the context of the type of project.

Loan versus credit or guarantee: The first choice facing a development institution offering financial help to a borrower is whether this help should take the form of a loan, a credit, or a guarantee. A loan is an instrument where the repayment of the principal is linked to some market-driven variable; we leave this vague but it means that irrespective of whether the interest rate is fixed or floating (see the following), it is driven by some market considerations. A credit on the other hand is an instrument where the repayment is usually made of a nominal (small) rate. Finally, a guarantee is not an offer of funds but a guarantee to honor a promise made by a borrower that an investor will purchase a bond issued by some country with the understanding that, in case the borrowing country defaults, the development institution wil step in to honor the debt. In general, the wealthier the borrower, the more likely it will be offered a loan rather than the other two instruments. Another general rule is that the size of a credit or a guarantee is usually smaller than the size of a loan.Bullet versus amortizing loans: A project that might be more or less capital intensive and it might offer returns in a more or less gradual way. A way for the lending institution to accommodate the needs of the client is to issue a loan with a specific repayment profile.

A loan (we shall see this in more formal detail later) consists of a series of repayments of interest and principal, with the principal, as the name suggests, being the main component of the loan. Should the principal repayment prove to be difficult for the borrower, a solution is made available through a bullet loan in which the borrower throughout the life of the loan repays only the interest1 and the principal is returned only at maturity. Let us imagine that the borrower needs the funds to build up the country’s energy industry; these projects, ranging from dams to oil exploration, usually require a large initial investment, a long time to build, and then must produce a fairly regular source of income. During the build-up period it would be difficult for the borrower to repay the principal, therefore, in this situation, for example, a bullet loan would be ideal.

A lender is, however, hesitant to issue too many bullet loans. This will be treated more formally when dealing with the issue of credit, but it is easy to see how the further into the future we push the repayment of the main part of the loan, the more—particularly when dealing with countries and projects fraught with uncertainty—we place ourselves in a riskier situation. Because of this, the more standard form of loan is an amortizing loan, one where, at each interest paying date, the principal upon which the interest is calculated is partly repaid.

Fixed-versus floating-rate loans: The interest repayments on a loan are a percentage amount that can be either the same at each repayment date (a fixed-rate loan) or variable, linked to some external parameter (a floating-rate loan). The choice of loan on the part of the borrower and the lender will be mainly driven by considerations linked to the financial markets of the currency in which the loan has been issued. The volatility of interest rates and the expected levels of inflation, all compounded by the length of the loan, will be deciding factors in the choice. Similar to the previous situation in which the choice was about which repayment profile, the choice of fixity in the interest repayments will be a balance between the borrower’s needs and the lender’s ability to deal with financial risk.

Development banks are typically very risk averse and will usually try to convert both costs (from their own borrowing, which we shall see later) and income (from loans repayments) into an easy-to-interpret and manage cash stream. Fixed- and floating-rate loans offer the lender different risk profiles with typically a preference for floating-rate loans.2

The currency of the loan: An important issue is the currency in which the loan is offered, important also because the currency will decide which interest rate regime will govern the loan (i.e., if the loan is in currency X, it will be X interest rates that both borrower and lender will examine in their decision for a floating- or fixed-rate loan).

The return on the investment the borrowing entity is hoping to obtain will drive, as it did in the previous cases, the choice of currency of the loan. We mentioned the example of oil extraction as a possible project: should the project be successful, the income generated will be in U.S. Dollars (USD) since oil is a global commodity priced in USD. The borrowing country will then be motivated to take a loan in USD. In the case, for example, of the construction of a dam to provide electricity to local customers (who are expected therefore to pay for consumption in local currency) the income generated will be in local currency and therefore the borrowing country would prefer the loan to be in local currency. We can easily see how from the borrower’s point of view it would be desirable to match, currencywise, the income stream with the debt stream.

A similar and therefore symmetrical wish is on the lender’s part. Development banks are usually financed (as we shall see in the following section) in strong currencies3 and therefore would like to match the income they receive with the costs they face. A development bank would rather issue a USD loan than a local currency loan. Furthermore, a local currency loan is more subject to devaluation and/or inflation. An intuitive rule of thumb would be that anyone would rather receive income in a strong currency and pay debt in a weak one. As a consequence of this, local currency loans usually constitute a small, yet far from negligible portion of a loan portfolio.

The needs of a borrower are assessed at the moment of deciding the type and amount of loan. It is considered that the borrower will face certain costs throughout the life of the project, and the loan should be used to cover those costs. These costs, however, could change dramatically—driven by changes in the foreign exchange—after the issuance of the loan and this is because of a third currency other than the strong and the weak mentioned before (e.g., the borrower needs to purchase equipment in a third country). To manage this type of exposure there are also multi-currency loans that are issued, linked not to a single currency but to a basket of usually strong currency.

Here we have presented very briefly the type of choices facing a borrower and a lender when deciding which type of loan is best suited to the financing of a project. We now take on the point of view of the development institution and observe the different types of debt we can use to finance these loans.

1.3 BORROWING

The type of development institutions we are concerned with are those (we discuss them in more detail later) that use the tools of investment banking toward development, that is, they use their superior credit to borrow in the capital markets and then use the funds raised toward lending.

The debt profile of a development institution is one that should at the same time be in tune with its income profile (by income profile we mean the types of loans issued as discussed in the previous section) and capable of maximizing investors' needs. We shall discuss this at great length in the following chapters but, it is almost obvious, a bank should issue debt that can be considered as attractive as possible in the eyes of investors, otherwise not only will it be difficult to place, it will also be unduly onerous to serve.

In a way similar to the one adopted in the previous section we give a brief and informal description of the type of choices an institution has to make when it comes to funding through debt. The description is informal in that all mathematical and/or rigorous formalism is left for later parts of the book.

Currency of debt: In the previous section we mentioned that any financial player tries to match the currency of its debt with the currency of its income. A development bank issues loans in at least a few strong currencies and, as we have seen, in some cases also in weak currencies. Assuming that for any institution there is only one mother currency, the other currencies, weak or strong, need to be obtained in order to be subsequently disbursed in the form of a loan. This could happen either by converting the institution’s principal currency to the currency needed for the loan or, as in most cases, by issuing debt in that currency.

Issuing debt in a specific currency not only has the advantage of matching the currency of a loan but also, as we shall see more formally in Section 6.2.1, has the advantage of exploiting investors’ appetite for the institution’s debt. Let us consider development bank ABC, which has a certain credit rating and is USD centered, meaning that its main currency of business is USD. Let us assume that in the United States there are other institutions similar to ABC, both in nature and in credit standing, but in Japan there are none. This absence results in a great interest on the part of Japanese investors for debt of ABC’s kind. It would make sense for ABC to issue debt in Japanese Yen (JPY) since, all things considered, it would receive more favorable terms.4 Now, ABC is in possession of a certain amount of JPY, which is not only needed for a loan, but results in an advantageous servicing of debt from its own point of view.

Profile and tenor of debt: The careful balance between a bank’s cost and income shall be treated rigorously in Chapter 7, however, it is quite intuitive to imagine that, the same way we would like to match the currency between debt and income, it would be ideal to try to match the tenor and general structure of our debt and our loans. As we shall see later, this turns out to be rather complicated.

We mentioned in the previous section that bullet loans are extremely rare. It turns out that amortizing debt in the form of bonds with an amortizing principal profile is also rare. This means that there is an initial and fundamental mismatch in the principal profile of the debt issued by the institution and the income it receives in the form of loans. In Section 3.1.1 we shall attribute this difference principally to the fact that bonds tend to be securitized instruments as opposed to the overwhelming over-the-counter nature of loans. A second fundamental difference is driven by credit. It is almost a universal truth that borrowing over the short term is cheaper than borrowing over a longer one. Since, despite being not-for-profit organizations, development banks have some fixed costs and cannot operate at a loss, they are obliged to have a shorter average maturity for debt than for loans. This is what ensures, in principle, a small positive net income. However this also ensures that, as far as maturity and principal amortization are concerned, bonds and loans will never be matched and this can lead to serious risks.

Fixed or floating rate: The choice, on the part of an institution, to issue fixed- or floating-rate debt is driven, like the one of currency, by a balance between the borrower’s need and the investors’ appetite. As in the case of a loan, a fixed-rate bond is one where the investor receives the same percentage amount of principal at regular intervals and a floating-rate bond is one where that amount is variable and is linked to some external parameter. Although, as we said, the tendency on the part of the lender (i.e., the bank) is to prefer the disbursement of floating-rate loans, there could be situations in which, in response to great investors’ interest in a fixed-rate bond, the bank is in the situation in which the fixed-rate nature of the loan matches the one of the bond.Vanilla or exotic: A debt instrument can be anything in terms of complexity. It can be a bond paying a simple coupon (fixed or floating), it can be a coupon offering the payout of a simple option (a call or a put on a familiar5 underlying), or it can be a coupon linked to the payout of an exotic option, that is, an option whose payout is complex and needs a serious computational effort in order to be priced. These payouts can include a combination of caps, floors, values linked to past performances (look-back features), spreads, and so forth. The reason behind the choice of more or less complexity, that is, more vanilla or more exotic, in the type of debt issued is linked to a search for more attractive funding levels. This will be explored in detail in Section 6.2.1.Debt managing tools: We have mentioned quite a few times the concept of matching. Ideally a development bank would try to make sure that the nature (in terms of amortizing profile), currency, and fixity of rate of its debt is similar to the one of its income, that is, its loans. This, we have seen, is not always possible. We have also said that development banks are generally risk averse and prefer to be exposed to the smallest number of financial variables. A development bank would usually choose one currency and one type of rate and take them to be a measure of all things, so to speak. A U.S.-based development bank would, for example, choose USD to be its principal currency and a certain floating rate, for example, the LIBOR rate resetting every six months, to be its principal rate. (We have not defined the LIBOR rate yet, but for the rest of the chapter we shall simply treat it as some generic variable rate.) This means that all income and all debt that does not match the USD six-month LIBOR profile needs to be converted into it. A USD fixed-rate loan would need to be converted into a similar floating-rate loan, then the bank would seek to enter into a contract with some other party in which it pays the fixed rate received from the loan and receives a floating rate in return. A similar, if opposite, situation would be needed to convert a USD fixed-rate bond. The bank would enter into a contract paying a floating rate in USD and receiving the fixed-rate coupon in USD, which goes on to the investor. What applied to fixity also applies to currency. Should the loan be fixed (or floating) in, say, EUR, the bank would seek to enter into a contract in which it would pay another party the fixed (or floating) coupon in EUR it receives from the loan and it would obtain in return a floating payment in USD. A similar, if opposite, contract would be needed to convert a fixed (or floating) rate bond in EUR. These types of subsequent contracts are known as swaps and will be discussed at length later.

1.4 INVESTING AND ALM

The main source of income for a development bank is the revenues from its lending business. There is however usually, as in any normal financial institution, considerable investment activity taking place. In Section 7.1 we shall discuss where a development bank’s funds come from and what percentage they constitute of the loan portfolio. Here we simply state that a bank is in possession of funds of its own that are independent of those raised through debt. We have seen in Section 1.1 that these funds can be made of equity and other assets or in the specific case of development institutions they can be donations or requested capital. We have also seen that these funds are also replenished by the net income (i.e, a profit, should there be one) given by the sum of the inflows from the loans and the outflows of the debt.