CH8 - Bond and money markets

Question 1

Cash on deposit instruments include (3)

Answer 1

1. Call deposits, where the depositor has ‘instant access’ to withdraw funds
2. Notice deposits, where the depositor has to give a period of notice before withdrawal
3. Term deposits, where the depositor has no access to the capital sum earlier than the maturity of the deposit.

Interest rates on bank deposits may be fixed or variable over the term of investment

Question 2

Money market instruments can be issued by (3)

Answer 2

1. Treasury bills (issued by governments)
2. Local authority bills (issued by regional government bodies)
3. Bills of exchange and commercial paper (issued by companies)

Question 3

Main players in the money markets (3)

Answer 3

The main players are:

1. The clearing banks, who use money market instruments to lend excess liquid funds and to borrow when they need short-term funds
2. central banks, who act as lenders 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
3. 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 (10)

Answer 4

1. normally good security as term very short, but will depend on the borrower
2. all return is through income (or capital gain that can be considered as income)
3. level of income has a loose, indirect link with inflation
4. lower expected returns than equities or bonds over the long term
5. stable market values
6. short-term
7. low dealing expenses
8. liquid
9. normally highly marketable
10. return normally taxed as income

Question 5

Reasons for holding cash on deposit and money market instruments (5)POURS + (4)GRID

Answer 5

Institutions may hold a portion of their funds in deposits and money market instruments for the following reasons

1. to meet short-term commitments
2. because outgo is uncertain
3. to be ready to take advantage of other investment opportunities
4. because the institution has received funds which are awaiting investment in some other asset category
5. because the institution needs to protect the monetary value of assets

Institutions may also hold money market instruments temporarily if they are pessimistic about the outlook of other assets, e.g. if they expect:

1. rising interest rates (which might cause other asset values to fall)
2. economic recession (with a fear that equity and possibly bond prices will fall)
3. the domestic currency to weaken (which makes overseas cash holdings attractive)
4. general economic uncertainty

Question 6

Bonds and types of bond markets (3)

Answer 6

A bond is a fixed-interest or index-linked security that is traded on a bond market

The most important distinct types of bond market are:

• the markets in government bonds, listed in their country of origin
• the markets in corporate bonds, listed in their country of origin
• the markets in overseas government and corporate bonds, listed in other than the ‘home’ country.

Question 7

Investment and risk characteristics of fixed-interest bonds (7)

Answer 7

A fixed-interest or conventional bond gives an income stream and final redemption proceeds that are fixed in monetary terms.

Investment and risk characteristics of fixed-interest government bonds include:

1. very good security (in politically stable countries)
2. yield (gross redemption yield) is fixed in nominal terms
3. lower expected returns than equities over the long term
4. market values can be volatile especially for longer-term bonds
5. mixture of terms: short, medium, long, undated
6. low dealing expected
7. highly marketable

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

Question 8

Index-linked bonds

Answer 8

An index-linked bond gives an income stream and final redemption proceeds that are linked to an inflation index.

Question 9

Nominal yield formula on a fixed-interest government bond

Answer 9

nominal yield = risk-free real yield + expected future inflation + inflation risk premium

Question 10

Relative attractiveness of fixed-interest and index-linked bonds

Answer 10

An investor whose expectation for future inflation is lower than that implied by the difference between nominal and real yields in the market will find fixed-interest bonds more attractive than index-linked bonds and vice versa.