Ch9: Bond and money markets Flashcards
3 Cash deposits
- Call deposit - Depositor has intsant access to withdraw the capital deposited
- Notice deposit - Depositor needs to give a period of notice before withdrawal
- Fixed-term deposit - No access to the capital sum earlier than the maturity of the deposit
Clearing banks description
- Use money markets to lend excess liquid funds and to borrow when they need sjort-term funds
- Interbank rates are usually taken as the benchmark for short-term interest rates
SYSTEM T: Money markets
Security
* Depends on the issuer
* In most cases, ecurity will be very good due to the short-term nature of the investments, and default is very rare
Yield
* Income from cash on deposit and money market investments will approximately equal prevailing short-term interest rate set out by the monetary authorities - can vary considerably over time
* In general cash deposits and money market investments yend to give a positive real return - expect short-term interest rates to be a few % higher than inflation, otherwise no incentive to save
* Very low risk - very low expected returns (not necessarily lower actual returns)
Spread
* Nominal values are fixed in cash terms and are short-term - very little volatility in market value
Term
* Short-term - generally less than 1 year
Expenses
* Expenses dealing in and managing money market instruments are minimal
Exchange rate - currency risk
* Available in a wide range of currencies - consider possible fluctuations in exchange rates
Marketability
* Most highly marketable - except call and term deposits
Tax
* Total return normally treated as income for tax purposes
Money market - type of instruments (4)
- Treasury bills (issued by government; max 1 year)
- Local authority bills (issued by regional government)
- Bills of exchange and commercial paper (issued by companies)
- Certificate of deposit (issued by banks - tradable)
Central bank objectives (4)
- Maintain and achieve price stability
- Sustainable economic growth
- Control exchange rate - implement foreign exchange laws
- Stability of financial sector
Central bank tools (5)
- Manage money supply
* Set repo rate
* Sale and purchase of treasury bills
* Commercial bank reserve requirement
* Printing money (issues banknotes and coinage) and quantitative easing (buy long-term securities) - Lender of last resort to maintain well-functioning banking system
- General oversight of financial sector (solvency etc.)
- Management of currency stability and custodian of foreign reserves
- Manage GDP and unemployment through monetary policy
Holding cash and money market instruments for liquidity (5)
- Known short-term commitments
- Uncertain outgo
- Opportunities
- Recent cashflow
- Preservation of nominal value of capital and risk aversion
Economic circumstances in which cash and money market instruments are attractive (4)
- Generally rising interest rates
* Gross redemption yields on bonds will likely increase and prices will fall
* Equity market might also suffer a fall in market values due to an increase in interest rates, as higher interest rates will generally depress economic activity and reduce companies’ profits
* An investor who correctly anticipates an increase in interest rates (when others have not) would therefore hold cash rather than suffer a capital loss
* Higher nominal income from higher interest rates may also be attractive - Start of an economic recession
* Domestic stock market likely to perfrom badly - share prices unlikely to increase if companies are struggling to maintain profitability
* Government borrowing might increase - more bonds which would lead to the reduction of bond prices
* Cash investments may be more atrractive than bonds and equities at the start of a recession - cash provides regular income stream with no risk of capital loss. - Depreciation of domestic currency
* Short-term interest rates may be raised by the government in an attempt to defend the domestic currency - might make cash more attractive since value of other assets might be expected to fall in value
* Cash investment in a stronger currency could prove attractive, even if the interest rates abroad were lower. As domestic currency depreciated, value in the domestic currency of overseas cash would increase - General economic uncertainty
* Stability of cash values will make cash investments attractive to risk-averse investors - enhanced in times of economic uncertainty
SYSTEM T: Bonds
Security
* Virtualy no risk of default - if issued by reputable government
Yield
* If conventional bonds is held to maturity monetary amounts of income and capital are known and fixed - expected return known at outset
* Actual returns might be uncertain:
* Coupon payments would have to be reinvested on terms not known at outset
* If planning to sell before redemption - price not known at outset
* Real return is uncertain - inflation could be higher than expected
* Low risk - low expected return
Spread
* Market values will shift from day to day if changes in supply or demand
* Risk of falling market values may be a problem for:
* Investors who need to prove financial strength by reference to market value of assets held
* Investors who have to sell at lower market prices
Term
* Short to long term bonds available
Expenses
* Dealing costs usually very low
Exchange rate - currency risk
* Bonds available denominated in various currencies.
* Currency risk for investors investing in bonds denominated in one currency with liabilities denominated in another currency
Marketability
* Excellent - can deal in large quantities with little to no impact on price
Tax
* Taxation on income and capital gains will depend on relevant tax regime
* Institutional investors pay uniform rate of tax on total return (income + capital gains)
* Certain institutions (e.g. pension funds) may be exempt from tax on bonds
Economic conditions that cause greater uncertainty over future expected inflation are: (4)
- Less government commitment to a low inflation rate
- Loose monetary policy
- Devaluation of domestic currency
- Rapid economic growth
