18.2: Short-Term Debt and the Money Market

Question 1

What are the key features of short-term debt?

Answer 1

The maturity of the debt and whether the debt is marketable and can be traded in a secondary market.

Question 2

What is a promissory note?

Answer 2

A written promise to pay back a loan.

Question 3

What are Treasury Bills (T-bills)?

Answer 3

Treasury bills (T-bills) are promissory notes issued by a government treasury department.

Question 4

How are T-bills typically sold?

Answer 4

T-bills are sold at a discount to their par value, and the interest is earned by the investor being paid the full par value at maturity.

Question 5

What is commercial paper (CP)?

Answer 5

Short-term debt instruments, usually unsecured, issued by companies.

Question 6

What is the default or credit yield spread?

Answer 6

The difference between the yield on a default-risky debt instrument and the yield on an equivalent-maturity Government of Canada instrument.

Question 7

What are promised yields?

Answer 7

The quoted interest rates received if the issuer does not default and the investor is paid off on time, as promised.

Question 8

How is the value of a 30-day CP issue calculated?

Answer 8

V = (PAR(1 + R)P + RECOVER(1 - P)) / (1 + k)

Question 9

What is liquidity support?

Answer 9

Money available to pay off a debt, often in the form of a dedicated backup line of credit from a bank, which ensures that companies have money to pay off the CP if the firms cannot roll it over by selling to new investors.

Question 10

What is the distribution of CP by DBRS rating category?

Answer 10

• R-1 (high): 26.1%
• R-1 (mid): 15.4%
• R-1 (low): 49.7%
• R-2 (high): 8.8%

Question 11

What are the three basic rating categories for CP by DBRS?

Answer 11

1. Prime credit quality (R-1)
2. Adequate credit quality (R-2)
3. Speculative (R-3)

Question 12

Why is the yield spread between three-month T-bills and “prime” CP important?

Answer 12

It indicates the default risk attached to prime CP in Canada, with a spread of 0.57 percent as of December 31, 2018.

Question 13

What is the role of credit rating agencies in the CP market?

Answer 13

Credit rating agencies provide default or credit ratings to investors, thereby relieving investors of the need to do individual analyses and helping to assess default risk.

Question 14

How does the Bank of Canada influence the T-bill market?

Answer 14

The Bank of Canada acts as the Government of Canada’s fiscal agent in selling T-bills, maintaining an orderly auction market, and setting the maximum amount of T-bills each dealer can buy to avoid market manipulation.

Question 15

What is the formula for the promised yield necessary for the CP to be issued at PAR?

Answer 15

R = (1 + k_TB) / P - 1

Question 16

What is the formula for the required yield for investing in T-bills?

Answer 16

1,000 = 990.099(1 + k)
k = 1%

Question 17

What is the formula for calculating the annual interest rate from the 91-day period?

Answer 17

Annual interest rate = 1% × (365/91) = 4.011%

Question 18

What are Bankers’ Acceptances (BAs)?

Answer 18

Short-term paper sold by an issuer to a bank, which guarantees or accepts it, obligating the bank to pay off the debt instrument at maturity if the issuer defaults.

Question 19

How are BAs typically created and used in international trade?

Answer 19

An exporter receives a “bill of exchange” from the foreign importer, guaranteed by the importer’s local bank. The exporter sells the note to its own bank for cash, creating BAs.

Question 20

How do yields on BAs compare to CP and T-bills?

Answer 20

Yields on BAs are usually marginally lower than prime commercial paper (CP) but higher than T-bills.

Question 21

What are the typical costs associated with issuing BAs?

Answer 21

The total cost includes the yield on the BA plus the bank’s stamping or acceptance fee, typically ranging from 0.5 to 0.75 percent, plus any incidental fees.

Question 22

What were the yields on 1-month and 3-month T-bills, BAs, and CP as of December 31, 2018?

Answer 22

1-Month:
- T-bills: 1.63%
- BAs: 2.25%
- CP: 2.22%

3-Month:
- T-bills: 1.64%
- BAs: 2.24%
- CP: 2.21%

Question 23

What event caused the default spreads on CP and BAs to spike in August 2007?

Answer 23

Coventree’s announcement that its asset-backed commercial paper (ABCP) was backed by U.S. sub-prime mortgages, leading to a freeze in the ABCP market.

Question 24

What happened during the financial crisis of 2007-2008 that affected the CP and BAs market?

Answer 24

Bear Stearns and Lehman Brothers collapsed, causing a panic in the market, leading to increased default spreads and a temporary freeze in the money market.

Question 25

What is asset-backed commercial paper (ABCP)?

Answer 25

Commercial paper issued by a special-purpose vehicle (SPV) with the proceeds used to pay off underlying assets such as car loans or mortgages.

It is typically rated highly due to credit enhancement techniques.

Question 26

Concept Review Question - Explain how interest is received on most money market instruments.

Answer 26

Interest on money market instruments is typically received by buying the instrument at a discount to its par value and receiving the full par value at maturity.

Question 27

Concept Review Question - Contrast treasury bills, commercial paper, and BAs in terms of who issues them, their basic structure and default risk, and the yields they provide.

Answer 27

• Treasury bills: Issued by government, short-term, low default risk, lower yields.
• Commercial paper: Issued by corporations, usually unsecured, higher default risk, higher yields.
• Bankers’ acceptances: Issued by banks on behalf of corporations, guaranteed by banks, moderate default risk, yields slightly higher than T-bills.

Question 28

Concept Review Question - Define yield spreads and explain how they arise.

Answer 28

Yield spreads are the differences in yield between different debt instruments, which arise due to differences in credit risk, maturity, and liquidity.