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us consider what exactly is meant by the words “promise,” and “priority,”




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and when and by what criteria a bond might begin to look more like an
equity and vice versa.




Bonds Equities




PROMISES AND PRIORITIES
At issue here is not so much the sincerity of an issuer wanting to keep a
promise, but rather the business realities affecting an issuer™s ability to make
good on the financial promises it has made. Ability, in turn, involves any
number of factors, including financial fundamentals (as with key financial
ratios), quality of company management, economic standing relative to peer
group (other comparable companies if there are any), and the business cycle
(strength of economy).
Various entities within the marketplace have an interest in monitoring
a given company™s likelihood of success. These entities range from individ-
ual investors who use any number of valuation techniques (inclusive of vis-
iting the issuer to check out its premises and operations) to governmental
bodies (e.g., the Securities and Exchange Commission). Increasingly the
investment banks (firms that assist issuers with bringing their deals to mar-
ket) also are actively practicing due diligence (evaluation of the appropri-
ateness of funding a particular initiative.)
A bond issuer that fails to honor its promise of paying a coupon at the
appointed time generally is seen as suffering very serious financial problems.
In many instances the failure to make good on a coupon payment equates
to an automatic distressed (company is in serious financial difficulty) or
default (company is unable to honor its financial obligations) scenario
whereby bondholders are immediately vested with rights to seize certain
company assets. By contrast, companies often choose to dispense with oth-
erwise regularly scheduled dividend payments and/or raise or lower the div-
idend payment from what it was the previous time one was granted. While
a skipped or lowered dividend may well raise some eyebrows, investors usu-
ally look to the explanation provided by the company™s officers as a guide.
For example, a dividend might be lowered to allow the company to build




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up a larger cash reserve that it can use for making strategic acquisitions, and
shareholders might especially welcome such an event.
When a bankruptcy or distressed or default situation does arise, it is
imperative to know exactly where an investor stands in regard to collecting
all or a portion of what the issuer originally had promised to pay. As stated,
bondholders stand in line ahead of equity holders. However, there are var-
ious classifications of bondholders and shareholders, and there are materi-
ally different priorities as to how these categories are rated and treated.
Chapter 3 delves into the nuances of what these classifications mean. Figure
1.1 presents a continuum of investment products that depicts investor rank-
ings in an event of default.
Table 1.1 summarizes this section on bonds and equities. These char-
acteristics are explored further in later chapters, where it is shown that while
these characteristics may hold true generally as meaningful ways to differ-
entiate a bond from an equity, lines also can become blurred rather quickly.




Currencies




Like equities and bonds, currencies are also investment vehicles, a means to
earn a return in the marketplace. Investors based in country X might choose
to save local currency (U.S. dollar for the United States) holdings in some-
thing like an interest-bearing checking account or a three-month certificate
of deposit (a short-term money market instrument) or they might even stuff
it under a mattress. Alternatively, they might choose to spend local currency


Common Preferred Junior Senior Senior Senior secured
equity equity subordinated subordinated bondholders bondholders
holders holders bondholders bondholders


Low High


FIGURE 1.1 Continuum of product rankings in the event of default (from lowest
credit protection to highest).




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TABLE 1.1 Similarities and Differences of Equities and Bonds
Equities Bonds


Entitles holder to vote
Entitles holder to a preferable

ranking in default

Predetermined life span
√ √
Has a price
√ √
Has a yield

May pay a coupon

May pay a dividend




by purchasing goods or services or other investment vehicles, including equi-
ties, bonds, real estate, precious metals, or even other currencies.
A currency typically is thought of as a unit of implied value. I say
“implied value” because in contrast with times past, today™s coins and paper
money are rarely worth the materials used to make them and they tend not
to be backed by anything other than faith and trust in the government mint-
ing or printing the money. For example, in ancient Rome, the value of a par-
ticular coin was typically its intrinsic value”that is, its value in its natural
form of silver or gold. And over varying periods of time, the United States
and other countries relied on linking national currencies to gold and/or sil-
ver where paper money was sometimes said to be backed by gold or subject
to a gold standard”that is, actual reserves of gold were set aside in support
of outstanding supplies of currency. The use of gold as a centerpiece of cur-
rency valuation pretty much faded from any practical meaning in 1971.
Since the physical manifestation of a currency (in the form of notes or
coins) is typically the responsibility of national governments, the judgment of
how sound a given currency may be generally is regarded as inexorably linked
to how sound the respective government is regarded as being. Rightly or
wrongly, national currencies today typically are backed by not much more than
the confidence and expectation that when a currency (or one of its derivatives,
as with a check or credit card) is presented for payment, it typically will be
accepted. As we will see, while the whole notion of currencies being backed
by precious metals has faded as a way of conveying a sense of discipline or
credibility, some currencies in the world are backed by other currencies, for
reasons not too dissimilar from historical incentives for using gold or silver.
While the value of a stock or bond generally is expressed in units of a
currency (e.g., a share of IBM stock costs $57 or a share of Soci©t© Generale
stock costs 23), a way to value a currency at a particular time is to mea-
sure how much of a good or service it can purchase. For example, 40 years



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ago $1 probably could have been exchanged for 100 pencils. Today, how-
ever, 100 pencils cost more than $1. Accordingly, we could say that the value
of the dollar has depreciated; it buys fewer pencils today than it did 40 years
ago. To express this another way, today we have to spend more than $1 to
obtain the same 100 pencils that people previously spent just $1 to obtain.
Spending more money to purchase the same goods is a classic definition of
inflation, and inflation certainly can contribute to a currency™s depreciation
(weakening relative to another currency). Conversely, deflation is when the
same amount of money buys more of a good than it did previously, and this
can contribute to the appreciation (strengthening relative to another cur-
rency) of a currency. Deflation may occur when there is a technological
advancement with how a good or service is created or provided, or when
there is a surge in the productivity (a measure of efficiency) involved with
the creation of a good or providing of a service.
Another way to value a currency is by how many units of some other
currency it can obtain. An exchange rate is defined simply as being the mea-
sure of one currency™s value relative to another™s. Yet while this simple def-
inition of an exchange rate may be true, it is not very satisfying. Exchange
rates generally tend to vary over time; what influences how one currency will
trade in relation to another? Well, no one really knows precisely, but a cou-
ple of theories have their particular devotees, and they are worth mention-
ing here. Two of the better-known theories applied to exchange rate pricing
include the theory of interest rate parity and purchasing power parity the-
ory.


INTEREST RATE PARITY
Assume that the annual rate of interest in country X is 5 percent and that
the annual rate of interest in country Y is 10 percent. Clearly, all else being
equal, investors in country X would rather have money in country Y since
they are able to earn more basis points, or bps (1% is equal to 100 bps), in
country Y relative to what they are able to earn at home. Specifically, the
interest rate differential (the difference between two yields, expressed in basis
points) is such that investors are picking up an additional 500 basis points
of yield. However, by investing money outside of their home country,
investors are taking on exchange rate risk. To earn the rate of interest being
offered in country Y, investors first have to convert their country X currency
into country Y currency. At the end of the investment horizon (e.g., one year),
international investors may well have earned more money via a rate of inter-
est higher than what was available at home, but those gains might be greatly
affected (perhaps even entirely eliminated) by swings in the value of respec-
tive currencies. The value of currency Y could fall by a large amount rela-




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tive to currency X over one year, and this means that less of currency X is
recovered.
Indeed, the theory of interest rate parity essentially argues that on a fully
hedged basis, any differential that exists between the interest rates of two
countries will be eliminated by the differential in exchange rates between
those two countries. Continuing with the preceding example, if a forward
contract is purchased to exchange currency Y for currency X at the end of
the investment horizon, the pricing embedded in the forward arrangement
will be such that the currency loss on the trade will exactly offset the gain
generated by the interest rate differential. That is, currency Y will be priced
so as to depreciate relative to currency X, and by an equivalent magnitude
of 500 bps. In short, whatever interest rate advantage investors might enjoy
initially will be eliminated by currency depreciation when a strategy is exe-
cuted on a hedged basis.
When currency exposures are left unhedged, countries™ interest rates and
currency values may move in tandem or inversely to other countries™ inter-
est rates and currency values. Given the right timing and scenario, interna-
tional investors could not only benefit from the higher rate of interest
provided by a given market, but at the end of the investment horizon they
might also be able to exchange an appreciated currency for their weaker local
currency. Accordingly, they obtain more of their local currency than they had
at the outset, and this is due to both the higher interest rate and the effect
of having been in a strengthening currency. Nonetheless, many portfolio
managers swear by the offsetting nature of yield spreads and currency moves
and argue that, over time, these variables do manage to catch up to one
another and thus mitigate long-term opportunities of any doubling of ben-
efits in total return when investing in nonlocal currencies. Figure 1.2 illus-
trates this point. As shown, there is a fairly meaningful correlation between
these two series of yield spread and currency values.
In summary, while interest rate differentials may or may not have mean-
ingful correlations with currency moves when currencies are unhedged, on
a fully hedged basis there is no interest rate or currency advantage to be
gained. As is explained in the next chapter, interest rate differentials are a
key dynamic with determining how forward exchange rates (spot exchange
rates priced to a future date) are calculated.


PURCHASING POWER PARITY
Another popular theory to explain exchange rate valuation goes by the name
of purchasing power parity (PPP).
The idea behind PPP is that, over time (and the question of what period
of time is indeed a relevant and oft-debated question), the purchasing ability




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