9. Bond and money markets Flashcards
Investment and risk characteristics
SYSTEEM T
- Security (default risk)
- Yield (real or nominal, expected return)
- Spread (volatility of market values)
- Term (short, medium or long)
- Expenses or Exchange rate
- Marketability
- Tax
Three ways in which cash can be placed on deposit
- Instant access (or call deposit) – depositor can withdraw capital eanytime
- Notice deposit – notice required before withdrawal
- Fixed term (or term deposit) – depositor cannot access the capital until the end of the fixed term
Money markets instruments
4
- Bills of exchange
- Certificates of deposit
- Commercial paper
- Treasury bills
Main players in the money markets
3
- Clearing banks – lend and borrow short-term (usually overnight) deposits to control liquidity levels
- Central bank – lender of last resort to clearing banks. Central bank also sets short-term interest rates by selling and buying bills
- Other financial and non-financial institutions can lend and borrow short-term funds
Why do institutional investors hold money market instruments
POURS GRID
Liquidity reasons:
- Protect monetary values and risk aversion
- Opportunities (take advantage if become available)
- Uncertain liabilities
- Recently received cashflows
- Short-term liabilities (known)
Expected poor prospects for other assets:
- General economic uncertainty
- Recession expected
- Interest rates expected to rise – depress both bond and equity markets
- Depreciation of domestic currency expected
- Held for diversification
What are the reasons why institutions do not hold large portion of funds in money market
6
- Lower expected return than other riskier asset classes
- Not good match for long-term liabilities
- Reinvestment risk – reinvestment at unknown terms
- Short-term interest rates move broadly in line with inflation
- However, may not be a good match for real liabilities linked to another index
- Too large proportion => No diversification
- Limited supply of money market instruments available
What is Gross Redemption Yield (GRY)
The yield that equates the price of the bond with the discounted value of interest and capital proceeds from the bond
What cause an increase in values of:
Index-linked bonds
4
Uncertainty with prospects for future inflation
Causes:
* Less government commitment to a low inflation environment
* Loose monetary policy
* Devaluation of the domestic currency
* Rapid economic growth
Investment and risk characteristics of MMI
Security (default risk) – depends on issuer (government vs company). Short-term nature => generally low default risk
Yield (real, nominal, expected return) – positive real return (return above inflation). E(R) < most other asset classes. Return expected to move in line with inflation
Spread (volatility of market value) – stable market value due to short term nature. No volatility in call deposits
Term – short
Expenses – very low dealing expenses
Exchange rate – could be high risk due to exchange rate volatility
Marketability – marketable with the exception of call and term deposits. Unquoted and traded through interbank
Marketable (except for call and term deposits)
Tax – total return is usually taxed as income
Very liquid
What are bonds and three types
Fixed-interest or index-linked security
* Government bonds
* Corporate
* Overseas government and corporate bonds
Investment and risk characteristics of conventional government bonds
- Security (default risk) - Depends on reputation of issuing government
- Yield (real, nominal, expected return) - Expected nominal returns are known from the outset. Real return (return in excess of inflation) is uncertain. Long term E(R) < Equity + property
- Spead (volatility of market value) - Volatility of capital values higher for long-term than short-term.
- Term (short, med, long) - Short, medium, long and undated/irredeemable
- Expenses - Very low dealing expenses – developed country
- Exchange rate - Only to investors with liabilities in different currency
- Marketability - Very marketable – developed country
- Tax - Depends on territory and income and capital gains may be taxed differently
What are the cashflows of conventional government bonds from the investor’s perspective
- Negative bond purchase
- Positive coupon payments – term is known unless callable bond
- Redemption payment (positive) – known in monetary values
What are the cashflows of index-linked government bond from the perspective of the investor
- Bond purchase = bond price + dealing costs
- Coupon payments – a regular series of positive cashflows. Timing is known. Amounts are in real terms. Total payment term is known
- Redemption payment – timing and amount known in real terms
- LAG – index used to calculate payments based on an earlier period so the amount on payment date can be known in advance.
- Because of this LAG – there is effectively no inflation protection and investor is exposed to erosion of real value if inflation is higher than expected (before?)
Describe the difference in investment and risk characteristics between government and corporate bonds
Security – CB are generally less secure. Level of security depends on type of debt security, the issuing company and term of the bond
Marketability – CB are less marketable because size of issue is small
Liquidity – market values of CB are more volatile/less predictable than GB less liquid
Yields – the GRY on CB is higher than similar GB. To compensate for lower marketability and liquidity and perceived additional default risk
What is the relationship between nominal yields and reals yields
- Nominal yield = risk-free yield + expected future inflation + inflation risk premium
- For index-linked bonds, it is fall in real yields (not nominal yields) that increases prices. V =1/(1+i)
What does the size of inflation risk premium represent
- Additional yield required by investors with real liabilities bearing the risk of uncertain future inflation
- The risk premium is determined by:
1. Degree of uncertainty over future inflation
2. Balance between the number of investors requiring a fixed-return and those requiring a real return
What are the information and assumptions required to value index-linked bond (links to data and modelling chapters)
- Assumed future inflation rate
- Nominal values of coupon and redemption payments
- Outstanding term
- Value of price index to calculate next coupon payment
- Time to the next coupon
- Yield at which to discount future cashflows
What is the reason for increases in fixed-interest bonds
- Conventional bonds yields will fall if investor’s expectations for future inflation fall or if size of inflation risk premium fall.
- Investor who expects lower inflation than the difference between nominal and real yields will find conventional bonds more attractive than index linked
What is the reason for increases in index-linked bonds
- Value increases as markets become more uncertain about future inflation
- Demand pushes index-linked bonds prices up
What are the reasons for uncertain future inflation
- Less government commitment to low inflation environment
- Loose monetary policy
- Devaluation of the domestic currency
- Rapid economic growth
What situations will make an index-linked bond appear more attractive than a conventional bond
- Investor has real liabilities – requires inflation protection
- Investor believes future inflation to be greater than the currently predicted by the market
- Investor believes the inflation risk premium to be higher than currently predicted by the market
