Cash bond is a deposit that helps to stop the running of interest in situation when the amount of underpayment equal to the deposit which does not earn itself interest (Congress Joint Committee on Taxation 2005, 406).
Cash bond's owner is entitled to having its available funds cap risk. If the ABS security is not repaid by the expected maturity of the cash bond, it means the owner of a cash bond receive the coupon step-up (L.Goodman 2008, 141).
Cash bonds keep to be main recipients of global liquidity. At the same time availability of derivatives influence the investors' willingness to hold cash bonds (D. Yalkovlev, M.Lu 2018, 38).
There was an active market in corporate bonds on the NYSE but only until 1946. In the 1930s, the trading volume on bonds was around one fifth to one third of the trading volume in stocks. In earlier years, there was also a market of municipal and governments bonds. First organized exchange was established by a group of “under the buttonwood tree” brokers to trade bonds of U.S. government. It was an event that modern NYSE its descent ( B. Biais, R. C. Green 2007, 1).
Bond itself is a certificate to show evidence of debt. The par value is the bond's face amount payable at maturity. The rate of the coupon is the amount of the yearly payments that are going to be divided by the principal amount. Physical coupons helps holders to engage in income tax evasion. Firms tend to issue not coupon bonds but registered bonds. The firm or it's agent register track of the registered bonds(C. Stickney 2009, 844).
Bonds are also referred as „fixed income” investments. Investor knows exactly how much he is going to earn from a bought bond at its maturity date. Stocks does not assure buyer about the investment rate (S. Jovanovic 2014,245).
Bonds can be purchased individually or as a package of funds. When bonds are purchased individually buyer can decide of specific characteristic of them. Buying bonds in a package in a variety of forms helps to diverse risk (H. Richelson, S. Richelson 2011, 301).
Some types of bonds:
- Convertible bonds – are corporate types on debt securities that allows the older to forgo future coupon or/and principal payments. In such case bond holder can receive specified number of shares. Convertible bond is a hybrid of straight bond and a call on the underlying equity (K. Tsiveriotis, C. Fernandes 1998, 95).
- Zero coupon bond (discount bond) – they are sold at a discount and do not make interest payments every month like the regular bond does (S. Jovanovic 2014, 245).
- Bond premium - parrarel of bond discount, issue price exceed par value (C. Stickney 2009, 844).
OTC market consists only two parties during selling and buying process (M. A. Wong, R. High 1991, 46).
In the most of the cases bonds are traded through over-the –counter markets which are decentralized. OTC markets allows only a little of pre-trade transparency. It means that dealers do not post accessible firm quotes publicly. Additionally, only dealers are able to provide quotes ( B. Biais, R. C. Green 2007, 1). Listed bonds traditionally have been traded OTC and on the Exchange as well. Bond dealers manage inventories in the securities ( B. Biais, R. C. Green 2007, 9).
Key difference between the OTC and the NYSE is the difference in their transparency. The OTC market does not record prices and dealers does not have any obligation to disclose them. On the Exchange transactions prices and orders are recorded and available to the public ( B. Biais, R. C. Green 2007, 10).
Hedging using fututres
Future is a contract that is legally binding to make or take a delivery of a given commodity (quantity and quality) at the previously decided price on a specific date. The buyer (long position) is entitled to purchase the underlying commodity and the seller (short position) is entitled to sell it (M. Scheidler 2007, 3).
Equation: risk free position = cash bond position - futures option states that the investor who is short in futures contract and long the cash market bond should anticipate to earn "the rate of return ona risk-free security with the same maturity as the futures delivery date" (F.J. Fabozzi 2001, 602).
Equation for a long bond position: cash bond position = risk-free position + futures position. it means that a cash bond position is equal to "short-term risk-free security position plus a long bond futures position" (F.J. Fabozzi 2001, 602).
Bond futures can be used in many ways depending on purpose. Significant part of one day's trading in futures might change and be speculative. Another use of futures is to keep bond position. In theory hedging bonds and futures results in minimalizing loss from one position that is going to be offset by gain from another position providing cash and price of futures move together (M. Choudhry 2010, 299).
- Biais B., Green R.C (2007), The Microstructure of the Bond Market in the 20th Century, 1-10
- Choudhry M. (2010), An Introduction to Bond Markets, John Wiley & Sons, 299
- Congress (U S ) Joint Committee on Taxation (2005), General Explanation of Tax Legislation Enacted in the 108th Congress, Government Printing Office, 408
- Fabozzi F.J. (2001), Bond Portfolio Management, John Wiley & Sons, 602
- Goodman L. and others (2008), Subprime Mortgage Credit Derivatives, John Wiley and Sons, 141
- Jovanovic S. (2014), Hedging Commodities: A practical guide to hedging strategies with futures and options, Harriman House Limited, 245
- Richelson H., S. (2011), Bonds: The Unbeaten Path to Secure Investment Growth, John Wiley & Sons, 301
- Scheidler M. (2007), Hedging a Portfolio with Futures, GRIN Verlag, 3
- Stickney C.P and others (2009), Financial Accounting: An Introduction to Concepts, Methods and Uses, Cengage Learning, 844
- Tsiveriotis K., Fernandes C. (1998), Valuing convertible bonds with credit risk , “The Journal of Fixed Income; New York” no. 2, 95
- Wong M.A., High R. (1991), Trading and Investing in Bond Options: Risk Management, Arbitrage, and Value Investing, John Wiley & Sons, 46
- Yalkolev D., Lu M. (2018), Instruments, Investor Base, and Recent Developments ..., International Monetary Fund, 38
Author: Jola Jańczy