Bonds

What is a Credit Default Swap (CDS)?

A credit default swap (CDS) is a credit derivative product which allows the holder of a fixed income security to transfer the credit risk portion associated of that security on to a counterparty for a fee.  A credit default swap is basically an insurance premium that a security holder pays to guarantee themselves against negative credit events such as bankrupcy or credit rating downgrades. The party buying insurance is known as the buyer, the party providing the insurance is the seller, and the security that is being insured in the transaction is known as the reference entity. 

In the case of a default or other negative credit event, the seller will either assume the reference entity and pay the buyer par value or pay the buyer the spread between the par value and the recovery amount, which is nothing more than the current cash value of the bond.

The currency carry trade is created by simply borrowing funds at a low rate and investing these funds into higher yielding assets.  A very relevant example can be seen in the famous "yen carry" trade in which Japanese Yen are borrowed at an interest rate which is next to nothing and invested into higher yielding US treasury bonds.  The interest rate differential between the two is a bit over 300 basis points.  As you can see, investors using leverage stand to make quite a bit of money.

What is an Inverted Yield Curve?

An inverted yield curve refers to a phenomena in the bond markets where bond securities with shorter maturities actually have higher yields than bonds with longer term maturities with similar credit qualities.

Interest Rate Swap - Overview

An interest rate swap is a contractual agreement to exchange periodic interest payments. In most cases one of the rates is fixed and the other is a variable rate whose performance is matched against the prime rate. Interest rate swaps are normally longer in their terms, generally for a period of one year or more.

What is Inflation?

The measure of price increases within a set of goods and services over a period of time is known as inflation.

What is the GDP?

The gross domestic product, or GDP, is the total value of a nations goods and services produced within a preset period of time.  Usually, GDP is measured on a calendar year basis.  More precisely, GDP can be calculated by adding up the following components:  consumption, investment, government spending, and net exports, or the spread between imports and exports. 

Consumption includes personal items such as food, utilities, rent, clothing, fuel, and financial services received by individuals.  It is important to note that housing purchase costs are NOT included in this category.  This is by far the largest component of GDP.

What is the Federal Reserve Bank?

The Federal Reserve acts as the central bank of the United States.  The "Fed" was instantiated by congress and was put in place to stabilize and formalize the banking system within the country.  The primary role of the federal reserve bank is to implement monetary policy to keep a balance between steady economic growth and high levels of inflation. 

How is the Federal Reserve Organized?

The federbal reserve is organized in tiers; there is a board of governors which oversees the entire federal reserve system.  Then, there are 12 district federal reserve banks, and each district has a group of 9 directors. 

Overview of the Federal Fund Rate

What are Federal Funds?

All commercial and thrift banks are required to keep a certain percentage of deposits, as cash, at their district Federal Reserve Bank. This reserve is known as federal funds and is a safety measure put in place to keep stability in the banking system in the case of a financial crisis where there is a run at the banks. Federal funds are non-interest bearing and usually average 10% of the banks deposits over the past 14 days. Banks, usually smaller thrifts, who are not able to meet the reserve requirements look to other institutions which have excess reserves for a loan at a negotiated interest rate.

What is an Economic Recession?

In economics, the term recession is generally used to describe a situation in which a country's GDP, or gross domestic product, sustains a negative growth factor for at least 2 consecutive quarters.  I say generally because recession can be defined differently by different economists.  Just as there is an agency to define the measure of inflation; the official agency in charge of declaring that the economy is in a state of recession is the National Bureau of Economic Research (NBER).  NBER's definition of recession is a bit more vague than the standard one that was described above; they define recession as a "significant decline in economic activity lasting more than a few months".  For this reason, the official designation of recession may not come until after we are in a recession for six mon

What is LIBOR?

The London Interbank Offered Rate, or LIBOR, is the European version of the federal funds rate in the United States and represents the interest rate at which London banks charge each other on funds borrowed.  This is not to be confused with the BBA LIBOR rate, which is a filtered average of inter-bank loans maturing within 1 year.  BBA LIBOR is published once per day by the British Bankers Association at around 11 AM London standard time.  The BBA is advised by a group of senior banking experts from at least 8 contributor banks and uses their lending activity to derive the BBA LIBOR rate. 

How is it used?

LIBOR represents a benchmark for short term borrowing worldwide and is used to settle interest rate contracts in many of the world's futures and options exchange