Treasury Finance and Development Banking

Contents

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

1.5.1 Private and Public Sides

1.5.2 Sales and Trading Desks

1.5.3 The Treasury Desk

1.6 Development Banking

1.6.1 The Different Types of Development Institutions

1.6.2 The Structure of a Development Bank

CHAPTER 2 Curve Construction

2.1 What Do We Mean by Curve Construction?

2.2 The Instruments Available for Curve Construction

2.2.1 Discount Bonds and Cash Deposits

2.2.2 Interest Rate Futures and Forward Rate Agreements

2.2.3 FX Forwards

2.2.4 Interest Rate Swaps

2.2.5 Basis Swaps

2.2.5.1 Tenor Basis Swaps

2.2.5.2 Cross Currency Basis Swaps

2.3 Using Multiple Instruments to Build a Curve

2.4 Collateralized Curve Construction

2.4.1 The Evolution of the Perception of Counterparty Credit Risk

2.4.1.1 Overnight Index Swaps

2.4.2 Discounting in the Presence of Collateral

2.4.2.1 Collateral in a Foreign Currency

2.4.3 Clearing, the Evolution of a Price, and the Impact of Discounting

2.4.4 The Special Case of AAA-Rated Institutions

2.5 Numerical Example: Bootstrapping an Interest Rate Curve

2.5.1 The Short End of the Curve: Deposits and FRAs

2.5.2 The Long End of the Curve: Interest Rate Swaps

2.5.3 Interpolation and Extrapolation

CHAPTER 3 Credit and the Fair Valuing of Loans

3.1 Credit as an Asset Class

3.1.1 The Underlyings

3.1.2 Credit Default Swaps

3.2 A Brief Overview of Credit Modeling

3.2.1 Hazard Rates and a Spread-Based Modeling of Credit

3.2.2 The Bootstrapping of a Hazard Rate Curve

3.2.3 Different Quotations and Different Currencies

3.3 Fair Value of Loans and the Special Case of Development Institutions

3.3.1 The Argument around the Fair Valuing of Loans

3.3.2 Prepayment Option and the 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

4.2.1 Liquidity

4.2.2 Maturity

4.2.3 Credit

4.2.4 Capital Control

4.3 Emerging Markets and Development Banking

4.3.1 Borrowing

4.3.2 Lending

4.4 Case Studies of Development Projects

4.4.1 Rural Development in X

4.4.2 Development of Textile Exports in Y

CHAPTER 5 Bond Pricing

5.1 What Is a Bond?

5.2 A Few Fundamental Concepts of the Bond World

5.2.1 Par

5.2.2 Yield

5.2.3 Duration

5.3 Expressing Credit Explicitly When Pricing a Bond

5.3.1 Benchmarks and Z-Spreads

5.3.2 Asset Swaps

5.3.3 Constructing a CDS-Implied Credit Framework for Bond Pricing

5.4 Illiquid Bonds

5.4.1 Pricing at Recovery

5.4.2 Case Study: The Default of Greece

5.4.3 Building Proxies

5.4.3.1 The Case of Missing Maturities

5.4.3.2 The Case of Quasi Government Entities

5.4.3.3 Similar Countries

5.4.3.4 Similar Companies

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

6.1.1 Asset Swaps Revisited

6.1.2 The Impact of Discounting on Asset Swap Levels

6.2 Funding Level Targets

6.2.1 The Objective of Ever-Smaller Funding Levels

6.2.2 Different Funding Levels for Different Types of Debt

6.3 The Fundamental Differences between Investment Banking and Development Banking

6.4 Benchmarks for Borrowing and Investing

6.4.1 Borrowing

6.4.2 Investing

6.4.3 Case Study: A Note on the LIBOR Scandal

CHAPTER 7 Risk and Asset Liability Management

7.1 The Issue of Leverage

7.2 Hedging

7.2.1 Risk Neutrality and the Meaning of Hedging

7.2.2 Static and Dynamic Hedging

7.2.3 Valuation in the Absence of Dynamic Hedging

7.3 Managing Risk Related to Financial Observables

7.3.1 Interest Rate and FX Risk

7.3.1.1 Hedging a Fixed or Structured Bond

7.3.1.2 The Unhedgeable Nature of the Discount Spread _

7.3.1.3 Hedging a Fixed-Rate Loan

7.3.1.4 Hedging a Foreign Currency Bond or Loan

7.3.1.5 Hedging a Credit-Linked Instrument Such as an Asset-Backed Security

7.3.1.6 Hedging an Equity Position

7.3.1.7 Locking an Interest Rate Position

7.3.2 Credit Risk

7.4 Funding Risk

7.4.1 Funding Gap Risk

7.4.2 Refinancing Risk

7.4.2.1 The Case of Constant Funding Level

7.4.2.2 The Case of Funding Level Lower Than Expected

7.4.2.3 The Case of Funding Level Higher Than Expected

7.4.3 Numerical Example: Estimating Refinancing Risk

7.4.4 Reset Risk

7.4.5 Numerical Example: Estimating Reset 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

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