CH:9 Bond and money markets

Question 1

Outline three situations when index linked bonds will appear relatively more attractive to an investor than conventional bonds

Answer 1

• 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

Question 2

What does the size of the inflation risk premium reflect?

Answer 2

The inflation risk premium reflects the additional yield required by investors with real liabilities for taking on the risk of uncertain future inflation.

The size of the inflation risk premium is determined by:

• The degree of uncertainty about future inflation
• The balance between the number of investors who require a fixed return and investors who require a real return

Question 3

Q
Write down an equation stating the link between nominal yields and real yields.

Answer 3

Nominal Yield = Risk-free real yield + Expected future inflation + Inflation risk premium

Question 4

Why do institutional investors hold money market instruments?

Answer 4

Institutions mainly hold money market instruments for liquidity reasons:
* Protect monetary value
* Opportunities (to size them)
* Uncertain liabilities
* Recently received cashflows
* Short term liabilities

Institutions may also hold cash because they feel that other assets are going to perform poorly:
* General economic uncertainty
* Recession expected
* Increase in interest rates expected
* Depreciation of domestic currency expected

Institutions may also hold money market instruments for diversification.

Question 5

List the money market investments

Answer 5

• Treasury bills
• Local authority bills
• Bills of exchange
• Certificates of deposit (CDs)
• Commercial paper
• Term deposits
• Call deposits