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CHAPTER 9: INTERMEDIARY DEBT SECURITIES,

INVESTMENT FUNDS, AND MARKETS

PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. Define the following:


a. Prime CDs
b. Nonprime banks
c. Yankee CDs
d. Eurodollar CDs

a. Prime CDs are the CDs of larger banks.


b. Nonprime CDs are the CDs of smaller banks.
c. Yankee CDs are the dollar-denominated CDs issued by foreign banks often through
their U.S. branches.
d. Eurodollar CDs are dollar-denominated CDs often issued out of London by foreign
branches of banks from the U.S., Europe, and Japan that are incorporated in countries
with favorable banking laws.

2. Describe the primary market for CDs. Who are the some of the major investors in
CDs?

Today, dealers and brokers form the core of the primary and secondary markets for CDs,
selling new CDs and trading and maintaining inventories in existing ones. Money-market
funds, banks, bank trust departments, state and local governments, foreign governments
and central banks, and corporations are the major investors in CDs.

3. Explain the history of the secondary CD market. In your explanation bring out the
significance of a positively sloped yield curve that is not expected to change.

In 1961, First Bank of New York issued a negotiable CD that was accompanied by an
announcement by First Boston Corporation and Salomon Brothers that they would stand
ready to buy and sell the CDs, thus creating a secondary market for CDs. The secondary
market provided a way for banks to circumvent Regulation Q and offer investors rates
competitive with other money market securities. Specifically, with Federal Reserve
Regulation Q setting the maximum rates on longer term CDs (e.g., 6 months), and with
those rates set relatively higher than shorter term CDs (e.g., 3 months), the existence of a
secondary market meant that an investor could earn a rate higher than either a short or
longer term CD, by buying a longer term CD and selling it later in the secondary market
at a higher price associated with the short-term maturity.

4. What are bank notes? How do they differ from medium-term notes issued by
corporations?

Bank notes are similar to medium-term notes. They are sold as a program consisting of a
number of notes with different maturities typically ranging from one to five years and

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offered either continuously or intermittently. They differ from corporate MTNs in that
they are not registered with the SEC, unless it is the banks holding company, and not the
individual bank, issuing the MTN.

5. Define a bankers acceptance, acceptance financing, and accepting banks.

Bankers Acceptances (BAs) are time drafts (postdated checks) guaranteed by a bank
guaranteed postdated checks. The guarantee of the bank improves the credit quality of
the draft, making it marketable. BAs are used to finance the purchase of goods that have
to be transferred from a seller to the buyer. They are often created in international
business transactions where finished goods or commodities have to be shipped. The use
of BAs to finance transactions is known as acceptance financing and banks that create
BAs are referred to as accepting banks.

6. Define the Eurocurrency market. What is the fundamental factor contributing to


the growth of this market?

The Eurocurrency market is a market in which funds are intermediated (deposited or loaned)
outside the country of the currency in which the funds are denominated. For example, a
certificate of deposit denominated in dollars offered by a subsidiary of a U.S. bank
incorporated in the Bahamas is a Eurodollar CD. Similarly, a loan made in yens from a
bank located in the U.S. would be an American-yen loan.

The Eurocurrency market is one of the largest financial markets. The underlying reason
for this is that Eurocurrency loan and deposit rates are often better than the rates on
similar domestic loans and deposits because of the differences that exist in banking and
security laws among countries. Foreign lending or borrowing, regardless of what
currency it is denominated in and what country the lender or borrower is from, is subject
to the rules, laws, and customs of the foreign country where the deposits or loans are
made. Accordingly, if a country's banking laws are less restrictive, then it is possible for
a foreign bank or a foreign subsidiary of a bank to offer more favorable rates on its loans
and deposits than it could in its own country by simply intermediating the deposits and
loans in that country.

7. What is the interbank Eurocurrency market?

The interbank Eurocurrency market is a market where Eurocurrency deposits are bought
and sold. For example, a bank holding a $10 million Eurocurrency deposit might sell the
deposit at a discount to a London Eurobank who might be arranging a $100 million loan
by buying Eurocurrency deposits.

8. Define the London Interbank bid rate (LIBID) and London interbank offer rate
(LIBOR).

London interbank bid rate (LIBID) is the rate paid on funds purchased by large London
eurobanks in the interbank market.

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London interbank offer rate (LIBOR) is the rate on funds offered for sale by London
Eurobanks in the London interbank market. This rate is commonly used to set the rate on
bank loans, deposits, and floating-rate notes and loans.

9. Define and explain the distinguishing features of the following funds:


a. Open-End Fund
b. Closed-End Fund
c. Real Estate Investment Trust

a. Open-End Fund: An open-end fund or mutual fund stands ready to buy back shares
of the fund at any time the fund's shareholders want to sell, and they stand ready to
sell new shares at any time that an investor wants to buy into the fund. With an open-
end fund the number of shares can change frequently. The price an investor pays for
a share of an open-end fund is equal to the fund's net asset values (NAV).

b. Closed-End Fund: A Closed-end fund has a fixed number of non-redeemable shares


sold at its initial offering. Unlike an open-end fund, the closed-end fund does not stand
ready to buy existing shares or sell new shares. The number of shares of a closed-end
fund is therefore fixed.

c. Real Estate Investment Trust (REIT) is a fund that specializes in investing in real
estate or real estate mortgages. The trust acts as an intermediary, selling stocks and
issuing debt instruments, then using the funds to invest in commercial and residential
mortgage loans and other real estate securities.

10. Define a unit-investment trust. Explain how a financial institution would set up a
unit-investment trust with 10-year T-bonds with $100 million par value selling at
par as the underlying securities and with 100,000 certificates created.

A unit investment trust has a specified number of fixed-income securities that are rarely
changed, and the fund usually has a fixed life. A unit investment trust is formed by a
sponsor who buys a specified number of securities, deposits them with a trustee and then
sells claims on the security, known as redeemable trust certificates, at their net asset value
plus a commission fee.

The financial institution would purchase $100 million worth of 10-year Treasury bonds,
place them in a trust, and then issue 100,000 redeemable trust certificates at net asset value
of $1,000 plus commission: NAV = ($100,000,000/100,000) = $1,000. The financial
institutions sale of trust certificates provides the proceeds to purchase the $100 million of T-
bonds.

11. Explain how hedge funds are structured.

Hedge funds are structured so that they can be largely unregulated. To achieve this, they
are often set up as limited partnerships. By federal law, as limited partnerships, hedge

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funds are limited to no more than 99 limited partners each with annual incomes of at least
$200,000 or a net worth of at least $1 million (excluding home), or to no more than 499
limited partners each with a net worth of at least $5 million. Many funds or partners are
also domiciled offshore to circumvent regulations. Hedge funds acquire funds from many
different individual and institutional sources; the investments range from $100,000 to $20
million, with the average investment being $1 million.

12. Explain how an ETF is constructed. Include in your explanation the tracking
methods, creation basket, authorized participants, and the issuance of ETF shares.

Most ETFs originate with a sponsor, who defines the investment objective of the ETF and
the method for tracking the performance. The sponsor of an index-based ETF, for
example, would define the index (e.g., large U.S. Bank Sector), and the method of
tracking it (e.g. a total replication-index method that holds every security in the target
index or a sample index-based method that holds a representative sample of securities in
the index). Given the fund objective and tracking method, a creation basket is identified
that specifies the names and quantities of securities and other assets designed to track the
performance of the index portfolio. ETF shares are created after an authorized participant
(typically an institutional investor) deposits the creation basket and/or cash into the fund
the ETF. In return for the creation basket and/or cash, the authorized participant
received the block of ETF shares, referred to as a creation unit. The authorized participant
can then either keep the ETF shares that make up the creation unit or sell all or part of
them on a stock exchange.

13. Explain why the price of an ETF should trade close to the underlying NAV.

The price of an ETF is based on market supply and demand conditions. However,
because of the disclosure requirements that specify that the composition of the ETFs
basket be made public, arbitrageurs are in a position to ensure that the price of an ETF
trades close the underlying net asset value of the securities held in the index basket.

ETFs contract with third parties to calculate a real-time estimate of an ETFs current
value, often called the Intraday Indicative Value (IIV). The IIVs are disseminated at
regular intervals during the trading day. Investors, in turn, can observe any discrepancies
between the ETFs share price and its IIV during the trading day. When a gap exists
between the ETF share price and its IIV, investors may decide to trade in either the ETF
share or the underlying securities that the ETF holds in its portfolio in order to attempt to
capture a profit. This trading helps to narrow discrepancy between the price of the ETF
share and IIV.

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14. What types of investments do hedge funds make?

Hedge Funds use their funds to invest or set up investment strategies reflecting pricing
aberrations. Many of these strategies involve bond positions. One of the most famous is
that of Long-Term Capital who set up positions in T-bonds and long-term corporate
bonds to profit from an expected narrowing of the default spread that instead widened.

15. Define a mortgage-backed security and explain how they are constructed. What is
the primary risk that investors in MBS are subject to?

Definition: Mortgage-backed securities (MBS) are instruments that are backed by a pool
of mortgage loans. They represent claims on the cash flows from the mortgage portfolio.

Construction: (1) Financial institution, agency, or mortgage banker buys a pool of


mortgages of a certain type from mortgage originators. (2) A MBS is created and sold,
with the funds from the MBS sale used to finance the mortgage portfolio purchase. (3)
The mortgage originators usually agree to continue to service the loans, passing the
payments on to the mortgage-backed security holders. (4) A MBS investor has a claim on
the cash flows from the mortgage portfolio. This includes interest on the mortgages,
scheduled payment of principal, and prepaid principal.

Risk: Since most mortgages can be prepaid early, the cash flows from a portfolio of
mortgages, and therefore the return on the MBS, are uncertain. For MBS that are not
backed by a federal agency, there is also default risk in which some of the mortgages in
the pool may default.

16. Define a guaranteed investment contract, GIC. List some of its features of the
generic GIC.

A guaranteed investment contract (GIC) is an obligation of an insurance company to pay


a guaranteed principal and rate on an invested premium.

Features: (1) Lump-sum premium, (2) specified rate and compounding frequency, (3)
lump-sum payment at maturity, and (4) maturities can range from one year to 20 years.

17. What would an investor/policyholder receive from investing $1 million in a six-year


guaranteed investment contract, GIC, paying 6% interest compounded
semiannually?

For a premium of $1 million, the holder a six-year GIC paying 6% interest compounded
semiannually would receive $1,425,761 (= $1,000,000(1.03)12) in six years.