Chapter 8-Bond and money markets Flashcards
- Describe the three different ways in which cash can be placed on deposit.
Cash can be placed on deposit with the depositor either having ‘instant access’ to withdraw the capital deposited, or with the depositor having to give a period of notice before withdrawal, or for a fixed term with no access to the capital sum earlier than the maturity of the deposit.
- Describe the three different types of interest that may be paid on cash deposits.
The rate of interest paid by the borrower can similarly be fixed for the term of the deposit, fixed for an initial period, or variable from day to day. The borrower may have to give notice of any change in interest rates.
- Describe the cashflows associated with cash on deposit.
At one extreme, a fixed-term deposit at a fixed interest rate throughout the term, all the cashflows are certain and known in advance. At the other extreme, an instant access or ‘call’account with variable interest, the amounts and timing of cashflows will be completely unknown.
- Discuss the main borrowers and lenders involved in the money markets.
The money markets are dominated by the clearing banks who use them to lend excess liquid funds and to borrow when they need short-term funds. These loans and deposits are usually very short term, often overnight. Interbank rates are usually taken as the benchmark for short-term interest rates.
Central banks, as lenders of last resort, stand ready to provide liquidity to the banking system when required and also use their operations in the money markets to establish the level of short-term interest rates.
Central bank money market operations involve the sale or purchase of Treasury and other eligible bills.
Other financial institutions and non-financial companies also lend and borrow short-term funds in the money market.
Long-term institutional investors such as life insurance companies and pension funds generally hold cash only as liquidity to meet expected outgoings or, temporarily, when taking a view that values of other assets are likely to fall.
- Describe the economic conditions that might make cash investments attractive to long-term institutional investors.
Economic conditions which might make cash temporarily attractive to long-term institutional investors, or to other investors seeking to maximise returns include:
• generally rising interest rates which will depress both bond and equity markets
• the start of a recession if it is thought that equity markets will suffer from lower growth and bonds might suffer from an increase in the government’s deficit
• weakness of the national currency making cash investments in other currencies attractive.
The stability of capital values will make cash investment attractive to risk-averse investors - this effect is enhanced in times of economic uncertainty.
- What is the main reason why institutions do not normally hold a large proportion of funds in cash?
Over the long term cash would be expected to give a lower return than more risky or less liquid investments.
- Explain fully what is meant by the term ‘bond’.
‘Bond’ is an alternative term for a fixed-interest or index-linked security. Bonds are described by the type of organisation issuing the security, for example government bonds, local authority bonds, corporate bonds etc. UK government bonds are commonly referred to as ‘gilt-edged securities’ or ‘gilts’.
- List the three most important distinct types of 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 any country other than the ‘home’ country.
- List three bodies who may raise money by issuing fixed-interest securities such as bonds.
A body such as an industrial company, a public body, or the government of a country may raise money by issuing a fixed-interest security, normally in bonds of a stated nominal amount.
- Describe the characteristic features of these loans and the cashflows involved.
The characteristics of such a security are that the holder of a bond receives a lump sum of specified amount at some specified future time together with a series of regular level interest payments until the payment of the lump sum. The fixed lump sum payment is called the redemption of the bond; it is paid on the redemption date and is
normally of the original nominal amount, ie ‘at par’.
The investor has an initial negative cashflow to buy the bond, a single known positive cashflow on the redemption date, and a series of smaller known positive cashflows on the interest payment dates.
Although the amounts and timing of these positive cashflows are known, there is still uncertainty associated with them due to credit risk.
- Outline the main features of an index-linked security and the reason to issue it.
This is a security where the cash amount of the interest payment and the financial capital repayment are linked to an index which reflects the effects of inflation.
Three reasons why a government may issue index-linked securities rather than fixed-interest securities:
* to offer a range of different types of securities
* it believes that inflation will fall
* it wants to convince the private sector that it will reduce inflation
- Explain in detail the cashflows involved with an index-linked security.
Here the initial negative cashflow is followed by a series of unknown positive cashflows and a single larger unknown positive cashflow, all on specified dates. However, it is known that the amounts of the future cashflows relate to the inflation index. Hence these cashflows are known in ‘real’ terms.
In practice the operation of an index-linked security will be such that the cashflows do not relate to the inflation index at the time of payment, due to delays in calculating the index. It is also possible that the borrower (or perhaps the investors) may need to know the amounts of the payments in advance. This may lead to the use of an index from an earlier period so that the amount to be paid is known in advance of the payment date.
- What is the relationship between real and nominal yields?
The nominal yield on conventional government bonds can be expressed as:
nominal yield = risk-free real yield + expected future inflation + inflation risk premium
The inflation risk premium reflects the additional yield required by investors with real liabilities for bearing the risk of uncertain future inflation. The size of the premium is therefore determined by the degree of uncertainty as well as the balance between the numbers of investors requiring a fixed return and those requiring a real return. If the inflation risk premium is ignored, the difference between nominal and real yields gives an estimate of the market’s expectations for inflation.
- Describe the relationship between the yields on government bonds and other debt securities.
Security and marketability
Government securities generally provide the most secure and marketable fixed-interest investment in a particular currency. Therefore investors will require a higher yield on other forms of debt. The size of this yield margin depends on both the security and the marketability of the debt. Relatively low security and marketability will mean a large margin whereas a large secure issue will trade at a small yield margin to the closest equivalent government bond.
Volatility
The yield on a fixed-interest bond is a function of price, which will be determined by supply and demand, and will hence be affected by investor sentiment.
Tax
If government bonds have preferential tax treatment, then a higher yield might be required on corporate bonds to compen, sate investors for holding them.
- What factors influence investors’ expectations for the relative performance of different asset classes?
In general, investors’ expectations for the relative performance of different asset classes will depend on their views of all the factors that affect supply and demand.
