CH 9 Bond and money markets Flashcards
Types of cash on deposit
Call deposit: instant access to withdraw capital
Notice deposit: give notice period before withdrawal
Term deposit/fixed term deposit: no access for fixed term
Types of MM instruments
Treasury bills
Certificates of deposit
Commercial papers
Bills of exchange
Key players in MM
Clearing banks
- use MM instruments to lend excess liquid funds
- borrow when need ST funds
- interbank rates taken as benchmark ST rates
Central banks
- act as lender of last resort
- provide liquidity to banking system
- operations include sale/purchase of treasury bills/other bills
Characteristics of MM Instruments and COD
Security
- depends on issuer, govt more secure.
- very short nature, low risk of default
Yield: real vs nominal
- provide known nominal return
- income approx = st interest rates set by monetary authorities
- Positive real yield as STIR>Infl usually (else no incentive to save)
Yield: compared to other assets
- close to risk free - lower yield than other assets
Spread: volatility of capital values
- nominal values fixed in cash terms. Have little volatility as ST.
- Call deposits no volatility
Term
- very short (less than a year. can be week or day)
Exchange rates: currency risk
- available in wide range of companies
- movements in exchange rates expected to compensate for differences in interest rates between companies over term
Marketability
- Call and term deposits not marketabe/tradeable
- other instruments highly marketable
- but unquoted and traded through interbank money market rather than stock exchange
Tax
- total return usually treated as income
Economic conditions making C + MM attractive:
RUDI
RISING INTEREST RATES
- increase interest rates - incr GRY on FIB - FIB prices fall - less attractive/stable
- increase interest rates - higher cost of borrowing - reduce company profits - fall in market value
- increase interest rates - reduced consumer spending - lower profitabiliyu
START OF ECONOMIC RECESSION
- Attractiveness of equity: Companies less profitable - domestic equity stock market perform poorly
- Attractiveness of bonds: Fears of increased Gvt Borrowing - Incr supply of FIGB - decr price of FIGB
(but recession usually followed by decr STIR - lower GRY and higher bond prices)
DEPRECIATION OF DOMESTIC CURRENCY
- ST interest rates raised by gbt to defend currency. Other investments less attractive
- Cash investment in stronger currency attractive since investment will increase in value
GENERAL ECONOMIC UNCERTAINTY
- stable capital values make cash attractive to risk averse investors
- over LT cash gives less return than less liquid investments
Reasons for holding C MM assets: Liquidity
POURS
- Preservation of money/nominal capital values and risk aversion
- Opportunities:
take advantage of investment opportunities as they arise - Uncertain outgo -
maintain min level of liquidity to meet immediate liabilities. Allows companies not to have to sell assets at depressed prices if have to meet unanticipated outgoes (like general insurers) - Recent cash inflow - may take time to invest the cash so hold C MM in sT
- Known short term liabilities: match
CH 12: Factors affecting ST int rates (MM returns)
EIE
ST rates controlled by govts through CB intervention in MM.
Reasons for altering ST interest rates:
- Cont Econ Growth
- low real int rates -> encourage investment spending (cheap credit) -> increase consumer spending -> increase demand for goods -> incr ST economic growth - Cont Inflation
a. QUANTITY THEORY:
- direct relationship btwn quant of money in economy and price levels
- increase money supply - higher inflation
- reduction in ST int rates - cheaper credit to country - incr money supply - incr demand (consumer expenditure) - increase prices - inflationDEMAND PULL INFLATION: excess demand increases prices - inflation - CONTROLLING EXCHANGE RATE
Low interest rates -> deceased exchange rate
- int rate in dom curr low compared to foreign
- international investors not want invest in country
- decr demand for domestic curr
- decr exchange rates
VICE VERSAProblem: COST PUSH INFLATION by decr ST int rates:- low int rates -> weak exchange rate
- high import costs
- firms increase prices
Types of bond markets
- Gvt bonds in origin country
- Corp bonds listed in origin company
- Overseas gov and corporate bonds
Why issue FIB?
- Govt raise money to fund shortfalls
- Local authorities to raise finance for projects
- Companies to raise non-equity based capital
Definition of GRY
Return investor expects to get on bond if they hold it to redemption assuming they could reinvest coupons at the same rate.
Ignores tax and default risk
Equivalently - yield equating bond price to PV of interest and capital proceeds
FIB: Investment and risk characteristics
- Security
GB: virtually no default risk
CB: more risky - Yield: real vs nominal
GB + CB:
Nominal returns known at outset, CFS fixed and known
Real/actual return uncertain:- Coupons reinvested at different/unknown at outset rates
- If investor sells before redemption, price they will get not known
- Inflation may be higher than expected (priced for in nominal yield)
Yield: compared to other assets:
Low for GB, higher for CB (compensate for higher risk).
SPREAD: volatility of capital values
- market fluctuates due to supply/demand
- CB more volatile
TERM: Short < 5 y Med 5-15y LT >15 y undated
Expenses
Low dealing costs.
Margin between buy and sell narrower for GB than GB
Exchange rate risk:
- Investor who has invested in Overseas gvt bonds to meet liabilities in domestic currency has risk
Marketability
- very good. can deal in large quantities with little impact on price
Tax
Depends on companies tax regime
Companies: tax on capital gains and income
Institutions: tax on total return
Relationship between real and nominal yields,
If investors require certain real return
If investors require certain nominal return
Nom yield = risk free real yield + expected inflation + inflation risk premium
- inflation risk premium: additional yield required by investors with real liabilities for bearing inflation risk
- size of premium determined: degree of uncertainty, balance between number of investors requiring fixed nominal returns and requiring real returns
If they require certain real return:
- usually have real liabilities
- require higher return for FIB than ILB to compensate for risk of inflation being higher than expected and erroding real return on FIB
- INFLAT RISK PREMIUM on FIB
If require certain nominal return:
- have fixed liabilities
- require higher return for ILB than FIB to compensate for risk inflation lower than expected
- and required nominal yield not being achieved
- > MONETARY RISK PREMIUM on ILB
CFS of ILB
- initial negative CF
- series of unknown positive CFS and single unknown positive CF on specified dates
- amounts of cfs linked to some index, usually inflation
LAGGING
- CFs dont relate to index at time of payment, delays in calculating index
- If borrower/lender must know amounts to be paid in advance - use index from earlier period
- lag in indexation
- no inflation protection in last few months of bond (# months = length of time lag)
- investor exposed to erosion of real investment value in those last months
ILB vs FIGB
- ILB: Interest and Capital pmts linked to index reflecting effects of inflation. Provide real returns - inflation protection
- ILB usually smaller issues and less marketable than Gov FIB
- Issue of ILB by gvt infrequent
Increasing value of FIB
Market vals of FIB incr when nom yields decr Nom yield = rf rate + EI + IRP Will fall if - expect lower inflation - IRP lower (both have no effect on ILB bond prices)
FIB > ILB for investor if they think inflation will be lower than what priced for by IRP. Must act quickly, buy and hold bond while market changes view about future interest rates and inflation. Prices will adjust (and be higher if true)
