Ch 9: Bonds and money markets Flashcards
Outline 3 situations when index-linked bonds will appear relatively more attractive to an investor than conventional bonds
1) When the investor needs to match real liabilities and hence requires inflation protection.
2) When the investor expects the future inflation to be higher than that currently predicted by the market.
3) When the investor expects the inflation risk premium to be higher than that currently predicted in the market.
List 10 investment and risk characteristics of conventional government bonds.
1) Income = Coupon that is fixed in nominal terms
2) Capital = Redemption amount that is fixed in nominal terms
3) The yield is fixed in nominal terms. The real yield is eroded by actual inflation.
4) The expected yield is lower than for equities and property.
5) Variability in capital values is lower for short term bonds than for long term bonds.
6) Tax treatment depends on territory.
7) Very marketable if in a developed country.
8) Very low default risk if issued by a developed country. Almost non-existent.
9) Term: Short, medium, long, irredeemable
10) Very low dealing costs if developed country.
List 9 investment and risk characteristics of money market instruments.
1) Liquid
2) Short term
3) Generally, very low default risk due to short term (although depends on issuer)
4) Low expected yield compared to other assets.
5) Return expected to be more broadly in line with inflation.
6) Stable market values due to short term.
7) Very low dealing expenses.
8) Usually taxed as income.
9) Marketable (except for call and term deposits).
What does the size of the inflation risk premium reflect?
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.
Outline the main players in the money market.
1) The money market is dominated by the clearing banks who lend and borrow via short term deposits to control their liquidity needs.
2) The central bank acts as a lender of last resort, standing by to help with the clearing banks’ liquidity issues. The central bank sets short-term interest by buying and selling bills.
3) Other financial and non-financial organizations also operate in the money market by lending and borrowing short term funds.
Why do institutional investors not normally invest a large proportion of their funds in money market instruments.
1) Money market instruments give a lower expected return than other, riskier assets.
2) Money market instruments are not a good match for long-term liabilities.
3) There is reinvestment risk - proceeds will have to be reinvested on unknown terms.
4) Short term interest rates will move broadly in line with price inflation. However, money market instruments are not a good match if the investor has real liabilities linked to some other index.
5) Too large a proportion would result in a lack of diversification.
6) There may be a limited supply of money market instruments available.
Write down an equation stating the link between nominal yields and real yields.
Nominal Yield =
Risk-free real yield
+ Expected future inflation
+ Inflation risk premium
Why do institutional investors hold money market instruments?
Institutions mainly hold money market instruments for liquidity reasons:
- Protects 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 rated expected
- Depreciation of domestic currency expected
Institutions may also hold money market instruments for diversification.
List 3 distinct types of bond markets
1) Markets in government bonds listed in their country of origin.
2) Markets in commercial bonds listed in their country off origin.
3) Markets inn foreign commercial and government bonds listed in other than the home country.
Describe the cashflows of a conventional government bond from the perspective of the investor.
1) Bond purchase:
An initial negative lump sum cashflow equal to the price paid for the bond plus dealing expenses.
2) Coupon payments
A regular series of positive cashflows. The timing and amount (in monetary terms) of which are known. The term of payments is known in advance, except if the bond is callable (the borrower can repay the bond at any time)
3) Redemption payment
A single positive cashflow that is received at redemption. The timing is known, and the amount is known in monetary terms.
Describe the cashflows of an index-linked government bond from the perspective of the investor.
1) Bond purchase:
A single negative lump sum payment that is equal tot he price paid for the bond plus dealing expenses.
2) Coupon payments:
A series of regular positive cashflows. The timing is known in advance and the amount is known in real terms. The term of payment is known, except if the bond is callable.
3) Redemption payment:
A single lump sum positive cashflow received at redemption. The timing is known in advance and the amount is known in real terms.
Outline 3 ways in which cash can be placed on deposit.
1) Call deposits
The depositor can withdraw the funds at any time.
2) Notice deposits:
The depositor must give a period of notice before withdrawal.
3) Term deposits:
The depositor cannot access the capital until the end of a fixed term.
Certificates of deposit
- Tradable notes.
- Short term security issued by banks showing a stated amount of money has been deposited for a specified term and rate of interest.
- Interest payable on maturity
- Kind of like a tradable term deposit
Uses of Money Market Instruments (why do investors hold them?)
POURS
P - protect market value
O - opportunities may occur, liquid
U - uncertain outgo/liability
R - recently received cashflow
S - short-term liability
When are money market instruments attractive for institutions and investors?
- General economic uncertainty
- Start of recession (or a fear that equity and bond prices will fall)
- Interest rates rising (may cause other asset values to fall)
- Weakening domestic currency (makes overseas cash holdings attractive. And it may be followed by rising interest rates)
