CH 9: Bond and money market Flashcards
Determine Characteristics of investment
- Security: Default risk
- Yield: Real vs Nominal / Expected return vs other assets
- Spread: Volatility of market values
- Term:ST/MT/LT
- Expenses/Exchange
- Marketability
- Tax
SYSTEM T
Money Market Characteristics
- Security: Good due to ST nature. Depend on issuer.
- Yield: Real vs Nominal: approx ST rate earned (Nom) with positive real return
- Exp ret vs other assets: Lower exp return than riskier assets. approx risk free
- Spread: Volatility of market values: Nominal values fixed = no volatility(low ST varies)
- Term:ST
- Expenses: Low
- Exchange: Currency risk if international deposit
- Marketability: High marketability, traded on mony market
- Tax: Income tax
SYSTEM T
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)
Types of bank deposits
4
- Call deposits: Instant access to funds
- Notice deposits: period of notice before access
- Term deposits: no access till maturity
- Certificates of deposit:
Participants in money markets
5
- Clearing banks: Lend/borrow short term @ benchmark interbank rate.
- Central banks: Lender of last resort. Est level of ST rates via sale/purchase of Tbills
: Sell Tbill receive cash, create shortage in mkt. Incr ST rate - Other financial institutions & non-financial companies
- Individuals
Attractions of money market Instruments
5,4,1
Institutions mainly hold money market instruments for liquidity reasons:
- Protect monetary value: risk averse hold large cash
- Opportunities (take advantage when arise)
- Uncertain liabilities: uncertain outgo cover
- Recently received cashflows
- Short term liabilities: known outgo
Institutions may also hold cash due to economic circumstances:
- General economic uncertainty: cash more attractive
- Recession expected: Equities volatile/bonds supply inc prices fall
- Increase in interest rates expected: decr bond prices/equity mkts.
- Depreciation of domestic currency expected: Central bank raise ST rate incr demand for currency.
Institutions may also hold money market instruments for diversification.
POURS + GRID + Diversification
Circumstances under which money market instruments would be temporarily unattractive
4
- 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
Flip the GRID
Fixed-interest / Conventional bonds
1,3,3
- Issued by Gov or corporates to fund shortfall/raise equity.
Cashflows are known with timing :
* Price= - CF < nominal value
* Regular coupon paymets= +CF
* Redemption payment= +CF
Gross redemption yield:
* Return investor expect on bond held to maturity,reinvest coupon @ same rate.
* Yield that makes discounted CF = Price of bond
* P= CF/GRY
Characteristics of Fixed-interest/Conventional Gov bonds
- S: No risk of default on Gov bond.
- Y: Bond held to maturity = nominal yield. Actual return depend on when sell it. Real return depend on exp vs act inflation.
- Y: Exp approx risk free rate, lower than risky assets.
- S: Mkt values fluctuate via change supply/demand
- T: Short, medium or long
- E: Low
- E: Currency risk if internation Gov bond
- M: High
- T: Income tax + CGT
SYSTEM T
Corporate bonds
Main differnces from Gov bond:
* S: Carry more risk of default
* Y: GRY higher to compensate for risk and lower marketability
* S: Mkt values more volatile
* M: Less marketable
GRY margin:
* Excess yield on corporate bond over Gov
* Vary over time with econ conditions
Index-linked bond
- Coupon and redemption payments are linked to an index and provide real returns.
Cashflows:
* Known in real terms, lag to actual index.
* Payment of price -CF , coupon and redemption +CF
GRY:
* Actual inflation is req to calc.
* Price of bond linked to real rate not nominal
Outline three situations when index linked bonds will appear relatively more attractive to an investor than conventional bonds
- When the investor needs to match real liabilities and hence requires inflation prediction
- When the investor expects the future inflation to be higher than that currently predicted in the market
- When the investor expects the inflation risk premium to be higher than that currently predicted in the market
Relationship between Nominal and Real Yields
Nominal Yield = Risk-free real yield + Expected future inflation + Inflation risk premium
- Inflation risk premium: Yield req by investors with real liabilities for taking risk of uncertain future inflation.
- Est of mkt expectation of inflation is Real - Nom
Main risks for an institutional investor with all their assets in domestic money market instruments
- Cash instruments are short-term investments and hence there is a mismatch by term with the investor’s liabilities
- Means that the investor’s assets will have to be reinvested many times at currently unknown future interest rates (high level of reinvestment risk)
- Holding all assets in one type of investment results in a lack of diversification. Al the investments will be positively correlated, resulting in a concentration of risk
Why do institutional investors not normally invest a large proportion of funds in money market instruments?
I. Money market instruments give a lower expected return than other, riskier assets
II. Money market instruments are not a good match for long-term liabilities.
III. There is reinvestment risk – Proceeds will have to be reinvested on unknown terms
IV. Short term interest rates will move broadly in line with price inflation. However, money market instruments are not a good match is the investor has real liabilities linked to some other index
V. Too large a proportion would result in a lack of diversification
VI. There may be a limited supply of money market instruments available
