8 - Bond and Money Markets Flashcards
What does the term money markets cover? (2)
- Bank Deposits
- Short Term Securities
Money market instruments can be issued by (4)
- Government (treasury bills)
- Regional government bodies (local authority bills)
- Companies (bills of exchange, commercial paper)
- Banks (different types of deposit)
4 Types of bank deposits
- call deposits
- notice deposits
- term deposits
- certificates of deposit
Call deposits
Depositor has “instant access” to withdraw funds
Notice deposits
Depositor has to give a period of notice before withdrawal
Term deposit
Depositor has no access to the capital sum earlier than the maturity of the deposit.
Certificates of deposit characteristics
- Tradable notes.
- Short term security issued by banks showing a stated amount of money has been deposited for a specified term and rate of interest.
- Interest payable on maturity
- Kind of like a tradeable term deposit
10 Investment and risk characteristics of money market instruments
- Normally good security as term is very short, depends on the borrower though
- Return is through income
- Level of income has a loose, indirect link with inflation
- Lower expected returns than equities or bonds over the long term
- Stable market values
- Short-term
- Low dealing expenses
- Liquid
- Normally highly marketable
- Returns normally taxed as income
Who are the participants in the money market?
- Clearing banks
- Central banks
- Companies
- Individuals
- Other financial institutions & non-financial companies
Clearing banks as players in the money market
Use money market instruments to lend excess liquid funds and to borrow when they need short-term funds
Central banks as players in the money market
- Act as lenders of last resort
- Stand ready to provide liquidity to the banking system when required
- Buy and sell bills to establish the level of short-term interest rates
Uses of Money Market Instruments (why do investors hold them?)
P - Protect market value O - Opportunities may occur, liquid U - Uncertain outgo/ liability R - Recently received cashflow S - Short-term liability
When are money market instruments attractive for institutions and investors?
G - general economic uncertainty.
R - start of recession (a fear that equity and bond prices will fall)
I- interest rates rising (might cause other asset values to fall)
D - the domestic currency to weaken (makes overseas cash holdings attractive. And it may be followed by rising interest rates)
Circumstances under which money market instruments would be temporarily unattractive
- flip the reasons for grid around
- General economic Certainty
- Expectations of falling interest rates
- The end of a recession / start of a boom
- Expectations of a strengthening domestic currency
- If the investor is not risk averse or not concerned with liquidity
Main risks for an institutional investor with all their assets in domestic money market instruments
- Cash instruments are short-term investments => there is a mismatch by term with the investor’s liabilities
- Investor’s assets will have to be reinvested many times at currently unknown future interest rates (high level of reinvestment risk)
- Lower expected return than other assets
- Holding all assets in one type of investment results in a lack of diversification. All the investments will be positively correlated, resulting in a concentration of risk
‘Bond’ is an alternative term for:
Fixed-interest or index-linked security
How are bonds described?
- Organisation issuing the security (govt, corporate, local authority)
- Nature of the bond (fixed-interest or index-linked)
- Overseas or domestic (think currency risk)
Gross redemption yield (GRY) definition
The return the investor would expect to get on a bond if they held it until redemption
What are the investment and risk characteristics to consider?
S - Security Y - Yield S - Spread (volatility in value) T - Term E - Expenses (dealing) M - Marketability A - Asset specific (index-linked?) T - Tax I - Intricacy (redeemable for diff. asset? floating rates?) C - Currency
Fixed-interest government bond characteristics?
S - Highly secure if govt. is stable
Y - Expected long-term yield of equity is higher
S - Long-term bonds can be highly volatile
T - Terms can be of a wide range
E - Low dealing expenses (equities have greater dealing exp.)
M - Highly Marketable (majority of market)
A -
T - Tax charged on coupons as income tax + capital gains tax
I -
C - Usually issued in domestic currency but not always
Difference between index-linked government bonds and fixed-interest government bonds characteristics?
- IL bonds are less volatile than fixed-interest bonds as they are protected against inflation
- Issues are small so not a wide variety of terms
- IL bonds are less marketable (smaller issues of IL bonds)
Corporate bond characteristics
S - Security depends on rating of the company
Y - Yield is fixed or floating, GRY is rating dependent
S - Can be volatile depending on company rating
T - Term can be of wide ranges (typically shorter than govt bonds)
E - Expenses are low
M - Marketability depends on size of issue
A - Sometimes bonds can have callable options
T - Tax charged on income & capital gains
I - Intricacy (redeemable for equity? floating rates?)
C - Currency is usually domestic
What are the different types of corporate bonds?
- Secured loan stock (debentures, mortgages)
- Unsecured loan stock
- Subordinated debt (lowest ranking debt)
- Convertible bonds (convert to equity shares in a company)
Nominal yield on conventional govt. bonds can be expressed as:
Nominal yield = risk-free yield + expected future inflation + inflation risk premium
What does the size of inflation risk premium depend on?
- Inflation uncertainty
- Balance between investors who require real returns and those that require fixed returns (demand)
Monetary risk premium
Risk premium added onto the yield of index-linked bonds for risk of inflation being lower than expected and required nominal return not being achieved
How to estimate the market’s expectations for inflation?
- The difference b/w nominal and real yields (ignoring inflation risk premium)
What will cause the value of fixed interest bonds to increase?
- If Investors expectations for future inflation fall
- Inflation risk premium falls
What are economic circumstances under which inflation becomes more uncertain?
- Less government commitment to a low inflation environment
- Loose monetary policy
- Devaluation of the domestic currency
- Rapid economic growth
