Bond And Money Markets

Question 1

Cash on deposit instruments

Answer 1

Call deposits - depositor has “instant access” to funds

Notice deposits - depositor needs to give a period of notice to access funds

Term deposits - no access to the capital sum earlier than maturity of the deposit

Question 2

Types of money market instruments

Answer 2

Treasury bills (issued by governments)

Local authority bills (issued by regional government bodies)

Bills of exchange and commercial paper (issued by companies)

Question 3

Main players of money markets

Answer 3

Clearing banks - use money market instruments to lend excess liquid funds and to borrow when they need short-term funds

Central banks - acts as lender of last resort, stand ready to provide liquidity to the banking system when required, and who buy and sell bills to establish the level of short-term interest rates

Other financial institutions and non-financial companies, who lend and borrow short-term funds

Question 4

Investment and risk characteristics of cash on deposit and money market instruments

Answer 4

Normally good security as term is very short, but will depend on the borrower

All return is through income (or capital gain that can be considered as 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

Return normally taxed as income

Question 5

Reasons for holding cash on deposit and money market instruments

Answer 5

To meet short-term commitments

Because outgo is uncertain

To be ready to take advantage of other investment opportunities

Because the institution has received funds which are awaiting investment in some other asset category

Because the institution needs to protect the monetary value of assets

Question 6

Examples of why institutions can be pessimistic about the outlook of other assets. What their expectations are. I.e reasons of holding cash on deposits and money market instruments

Answer 6

Rising interest rates (which might cause other asset values to fall)

Economic recession (which a fear that equity and possibly bond prices will fall)

The domestic currency to weaken (which makes overseas cash holdings attractive)

General economic uncertainty

Question 7

Investment and risk characteristics of fixed-interest government bonds

Answer 7

Very good security (in politically stable countries)

Yield (gross redemption yield) is fixed in nominal terms

Lower expected returns than equities over the long term

Market values can be volatile especially for longer-term bonds

Mixture of terms: short (<5 years), medium (5 to 15 years), long (>15 years), undated

Low dealing expenses

High marketable

Corporate bonds are generally less secure, less marketable and less liquid than government bonds - consequently, investors will generally require a higher yield in order to hold them

Question 8

Nominal yield in a fixed-interest government bond

Answer 8

Risk-free real yield + expected future inflation + inflation risk premium

Question 9

Relative attractiveness of fixed-interest and index-linked bonds

Answer 9

Expectation for future inflation < (>) nominal yield - real yield
=> market will find fixed-interest (index-linked) bonds more attractive (expected higher than implied real yield)