Question

1. Explain in words the difference between a MBS and a CDO.

2. Give one example of a use of a FRA. (Why would anybody be interested in this derivative?)

Answer 1

1. They are distinct but overlapping categories.

Mortgage-backed Securities (MBS): any kind of asset-backed security where the underlying assets are mortgages. May have one class (tranche), as in the case of pass-through securities, or many classes.

Collateralized Debt Obligations (CDO): the underlying assets can be any kind of debt (bonds, mortgages, even other ABS). Always has multiple tranches with different priority of payments.

An MBS with a CDO-like structure is called a CMO (collateralized morgage obligation). There is a big difference in the typical purpose of CMOs vs other CDOs though:

• CDOs are mainly about apportioning  -- the low-priority tranches buffer the high-priority tranches from the risk that some underlying credits will default.  

• CMOs, on the other hand, are largely about apportioning prepayment risk. Unlike most other kinds of debt, mortgages usually give the borrower the right to repay early. Early repayment is usually a bad thing from the point of view of the mortgage note holder. In CMOs, the lower tranches get repaid first.

  
  Also note that while it's technically correct to say that CMOs are a type of CDOs, it's not very common. Saying something like "the bank trades CMOs and other CDOs" is a bit like saying "I saw my sister and several other animals at the zoo yesterday" – technically not wrong, but a bit weird.

2. A forward rate agreement (FRA) is an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash settled with the payment based on the net difference between the interest rate and the reference rate in the contract

Typically, for agreements dealing with interest rates, the two parties exchange a fixed rate for a variable one. The party paying the fixed rate is usually referred to as the borrower, while the party receiving the variable rate is referred to as the lender.

As a basic example, assume Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 5% for one year on a principal of $1 million in one year. In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on the principal amount. The agreement will be settled in cash in a payment made at the beginning of the forward period, discounted by an amount calculated using the contract rate and the contract period.

Advantages of FRAs for buyers

There are a number of advantages for the treasurer who uses FRAs.

• They are flexible. Because they are ‘over the counter’ instruments, they are flexible. They can be arranged for any notional amount (although this can be subject to a minimum of, say, £500,000).They can be in many different currencies, start on any future date and be for varying contract periods (although not usually for any longer than three years).

• They provide certainty for financial planning, by allowing the interest rate risk manager to know the company’s net interest payments for the contract period.

• FRAs do not have to be arranged from the provider of the original loan.

• Unlike some instruments, the FRA does not involve any premium.

• If conditions change, the FRA can be ‘closed out’ by arranging a reverse agreement, again for which a payment will be made or received.

Why does a seller provide FRAs?

There are also a number of advantages for the seller of the FRAs:

• Because they are based on notional principal amounts, a bank that sells an FRA does not have to comply with the strict capital adequacy requirements for a loan liability. Some cover is required for an FRA, but it is significantly less than that for a loan.

• In addition, the exposure to the seller is only for the settlement amount, rather than for the whole principal.

• Banks build in margins when setting the FRA rate, which is based on the forward rates in the market.

• Even if interest rates move against the seller, such agreements can be ‘closed out’ by entering into a reverse agreement with another market maker.