Here is what you need to know about TIPS, Eurobonds and credit default swaps or CDS to pass your FINRA Exams
Treasury Inflation Protected Securities or TIPS are direct obligations that are designed to protect investors from the negative impact of inflation.
A conservative investor purchases a TIP with a coupon rate of 4 percent. Prior to taking inflation into consideration the investor will receive 4% X $1,000 or $40 per year paid $20 or 2 percent every 6 months. TIPS pay interest every 6 months based on the adjusted principal amount. If Inflation is running at 6 percent per year over the next 2 years the investor’s principal and interest payments will be as follows:
Year 1 Semi Annual Adjustment number 1, new principal = $1,030 new interest payment = $20.60
Year 1 Semiannual adjustment Number 2, new principal = $1,60.90 new interest payment = $21.22
Year 2 Semi Annual Adjustment number 1, new principal = $1,092.73 new interest payment = $21.85
Year 2 Semi Annual Adjustment number 2 new principal = $1,125.51 new interest payment = $22.51
Because inflation was running at 6 percent per year the principal was increased by 3 percent every 6 months. The adjustment to the principal and interests compounds semiannually and results in the continued increase in the principal amount and payment received. To determine the amount of the payment take half of the coupon rate and multiply it by the adjusted principal. In our example the TIP paid interests at a rate of 2 percent of the adjusted principal every 6 months. If on your test you cannot remember how to calculate compound interest over time you may approximate it by simply taking the inflation rate over a given period and multiply it by the principal. In our case 6 percent per year for two years = 12 percent. 12 percent of $1,000 = $120. The adjusted principal would be approximately $1,120. On the exam round up to the next nearest answer as you can see the approximate method gets you within about $5 of the compounded principal.
A Eurobond is a bond issued in domestic currency of the issuer but sold outside of the issuer’s country. For example if Virgin Plc sold bonds to investors in Japan with the principal and interest payable in British Pounds this would be an example of a Eurobond. A Eurobond carries significant currency risk should the value of the foreign currency fall relative to the domestic currency of the purchaser. If the foreign currency fell the interest and principal payments to be received in the foreign currency would result in the receipt of fewer units of the domestic currency upon conversion. A Eurodollar bond is bond issued by foreign issuer denominated in U.S. dollars and sold to investors outside of the US and outside of the issuer’s country. Eurodollar bonds are issued in barer form by foreign corporations, federal governments and municipalities. Eurobonds trade with accrued interest and interest is paid annually A Yankee bond is similar to a Eurodollar bond except Yankee bonds are dollar denominated bonds issued by a foreign issuer and sold to US investors. If Virgin sold the same bonds to US investors but the bond’s interest and principal were dominated in US dollars rather than in British pounds the bonds would be a Yankee bond. The advantage of a Yankee bond over a Eurobond for US investors is that the Yankee bond does not have any currency risk.
Credit Default Swaps
A credit default swap is a derivative security that is used to transfer the risk of default from the holder of a credit instrument to the seller of the CDS. The buyer of the CDS makes payments to the seller of the contract much like the premium on an insurance policy. The CDS is based on a notational or stated amount of value of a particular reference issue or issues not on an actual bond. The seller of the CDS will be required to make a payment to the buyer if certain stipulated credit events take place such as a default or a credit rating down grade by an NSCO. A CDS can also be used by speculators to bet on the credit worthiness of the reference issues. Credit default swaps have margin requirements that are based on the contract’s term and the interest rate or basis point spread above the London Interbank Offered Rate or LIBOR and based on whether the account holder is long or short the CDS. The contract requirement for an account short a CDS is anywhere from 1 percent to 50 percent of the notional amount. While the margin requirement for buyers of CDS are usually significantly less than that of the seller’s.