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Introduction to Financial Engineering

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Capital Guaranteed Bonds

A capital guaranteed bond is a product that assures an investor to get back at least a portion of his invested capital when the security bought matures (Lhabitant, 2006). In a case where the dollar looses its value, these products will assure the investor of an investment return at the initial dollar value during the time for investment. The guarantee is provided by structuring the product in different ways such as investing through an insurance company. Half of the invested money could also be invested in other forms of capital such as derivatives or options. Though so attractive due to the security provided, capital guaranteed products have limitations too which are as follows (Lhabitant, 2006).

1). Inflation effects: Capital guaranteed products may return the initial investment money but will not adjust for inflation effects. They are products, which are structured, and complex: Unlike savings in a bank or in other financial institutions, capital guaranteed products have different legal and investment structures.

2). Benefits versus Costs: Most of these products are very expensive due to the extra cost incurred to provide guarantee. Thus, when the costs are taken into account, they might even outdo the benefits.

Contract for Differences

This is a contract between two parties, usually the buyer, and the seller, indicating that the seller pays to the buyer the difference between the current value of the asset and its value during contract time. However, it is the buyer who pays the seller in cases where the difference is negative. Through these products, investors take advantage of fluctuations in prices of financial instruments. A daily financing charge is usually imposed on these contacts. Traders dealing with CFDs are also required to hold a certain amount of margin as leverage. This amount is usually very low. In these contracts, three risks are involved namely: market risk, liquidation risk and counterparty risk.

Advantages of trading in CFDs include (Walden, 2003).

1)      Certainty and transparency: they are offered in separate markets with separate books, thus, not dependent on any other instruments. There is also precision regarding the price and time of payment.

2)      Market autonomy: The market is independent of the parties that a customer deals with. It is also an organized market which is fair and just to all parties.

Disadvantages (Walden, 2003).

  1. High expenses: The trade involves many costs such as fees for the broker, administration costs, and fees charged by the clearing house.
  2. Few products: the number of CFDs offered to the market is limited.
  3. Poor pricing: the price of a CFD can be higher than the price of its underlying instrument.

Gilt Strips:

Gilts are debt instruments issued by the government. When someone buys them, it’s like lending to the government which pays back the amount in full on the agreed date, plus the interest, (normally referred to as coupon). Stripping, on the other hand, refers to separating of the principle amount from the interest and trading the two separately. Gilt strips, therefore, refer to gilts in which its interest and principle payments are separately held as zero coupon instruments. Though traded separately, for taxation purposes strips are treated normally and, therefore, taxed just as corporate income (Walden, 2003).

When stripped, each strip confers to the holder rights to payment on the due dates. Amount paid equals to the nominal amount of the strip.

A yield curve is graph presenting several yields with their respective interest rates, across different contract lengths for the same debt contract. It is used to analyze the relationship between the level of interest and the maturity time (Houston & Brigham, 2011). There are three types of yield curves namely:

Normal Yield curve

This is an upward sloping curve is gotten when long-term interest rates are more as compared to the short-term interest rates. This is usually when the investors expect growth in the economy. Consequently, with a growth in the economy, the central bank will contract its monetary policy, thus, a rise in the interest rates (Houston & Brigham, 2011).

Inverted yield curve

This curve has a negative slope and it always occurs when short-term interest rates are more than long-term interest rates. It usually occurs when investors expect the market to be more volatile in the future and thereby the rates expected to fall in the future. This could also happen when a long-term debt contract have a higher demand than short-term debt contracts (Houston & Brigham, 2011).

Flat yield curve: This is a curve with a flat shape and is normally experienced when there is no change in the market interest rates. The case is that long-term interest rates are equal to short term interest rates. At this point, the economy is said to be uncertain since the investors have no certain expectations about the future interest rates.

Advantages of Zero Coupon Bonds

1)      Zero coupon bonds have no re-investment risk since no payment is involved in the bond duration. Payment is only made on maturity of the bond (Walden, 2003).

2)      They have long-term benefits: zero coupon bonds are bought at a lower rate and the money grows over a long period of years, thus, yielding higher earnings.

3)      Predictability: zero coupon bonds provide investors with a foreseeable return payable by within a specific duration.

4)      Zero coupon bonds are also beneficial because they are usually offered at a high discount. This means that the investor will pay less than the bond par value (Walden, 2003).

Disadvantages:

1)      Volatility: zero coupon bonds have a limitation of being exceptionally volatile. Interest rate fluctuations can alter the price either upwards or down wards implying that one is not guaranteed of a profit if he sells the bond before its maturity.

2)     Do not provide a constant flow of income to the investor: since zero coupon bonds do not have periodic payments, investor does not earn from them until maturity date.

3)      Zero coupon bonds are callable: meaning that the issuer may demand them anytime before maturity (Walden, 2003).

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