Chapter 9: Bond and money market

Question 1

Money market instruments can be issued by (4)

Answer 1

• Government (treasury bills)
• Regional government bodies (local authority bills)
• Companies (bills of exchange, commercial paper)
• Banks (different types of deposit)

Question 2

4 Types of bank deposits

Answer 2

• call deposits
• notice deposits
• term deposits
• certificates of deposit

Question 3

Call deposits

Answer 3

Depositor has “instant access” to withdraw funds

Question 4

Notice deposits

Answer 4

Depositor has to give a period of notice before withdrawal

Question 5

Term deposits

Answer 5

Depositor has no access to the capital sum earlier than the maturity of the deposit.

Question 6

Certificates of deposit

Answer 6

• 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 tradeable term deposit

Question 7

10 Investment and risk characteristics of money market instruments

Answer 7

• normally good security as term is very short, depends on the borrower though
• Return is through income
• Level of income has a loose, indirect link with inflation
• Lower expected returns than equities or bonds over the long term
• Stable market values
• Short-term
• Low dealing expenses
• Liquid
• Normally highly marketable
• Returns normally taxed as income

Question 8

5 Participants in money markets

Answer 8

• Clearing banks
• Central banks
• Other financial institutions & non-financial companies
• Companies
• Individuals

Question 9

Clearing banks as a player in the money markets

Answer 9

Use money market instruments to lend excess liquid funds and to borrow when they need short-term funds

Question 10

Central banks as a player in the money markets

Answer 10

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

Question 11

Uses of Money Market Instruments (why do investors hold them?)

Answer 11

P - Protect market value
O - Opportunities may occur, liquid
U - Uncertain outgo/ liability
R - Recently received cashflow
S - Short-term liability

Question 12

When are money market instruments attractive for institutions and investors?

Answer 12

G - general economic uncertainty.

R - start of recession (a fear that equity and bond prices will fall)

I- interest rates rising (might cause other asset values to fall)

D - the domestic currency to weaken (makes overseas cash holdings attractive. And it may be followed by rising interest rates)

Question 13

Circumstances under which money market instruments would be temporarily unattractive

Answer 13

• flip the reasons for grid around
• General economic Certainty
• Expectations of falling interest rates
• The end of a recession / start of a boom
• Expectations of a strengthening domestic currency
• If the investor is not risk averse or not concerned with liquidity

Question 14

Main risks for an institutional investor with all their assets in domestic money market instruments

Answer 14

• Cash instruments are short-term investments and hence there is a mismatch by term with the investor’s liabilities
• Means that the investor’s assets will have to be reinvested many times at currently unknown future interest rates (high level of reinvestment risk)
• Holding all assets in one type of investment results in a lack of diversification. Al the investments will be positively correlated, resulting in a concentration of risk

Question 15

What does the term money markets cover? (2)

Answer 15

• Bank Deposits

- Short Term Securities

Question 16

“bond”

Answer 16

An alternative term for a fixed-interest or index-linked security.

Question 17

Bonds are described by (2)

Answer 17

• type of organisation issuing the security, ex. government, local authority, corporate
• nature of the bond - fixed interest/index-linked

Question 18

“gilts”

Answer 18

UK government bonds

Question 19

Fixed-interest / conventional bond

Answer 19

Gives an income stream and final redemption proceeds that are fixed in monetary terms

Question 20

Index-linked bond

Answer 20

Gives an income stream and final redemption proceeds that are linked to an inflation index.

Question 21

3 Types of bond markets

Answer 21

• government bonds
• corporate bonds
• overseas government and corporate bonds

Question 22

7 Investment and risk characteristics of conventional government bonds.

Answer 22

• very good security (if politically stable)
• yield (GRY) is fixed in nominal terms
• lower expected returns than equities over the long term
• market values can be volatile, especially for longer-term bonds
• mixture of terms’ short, medium, long, undated
• low dealing expenses
• highly marketable

Question 23

3 Types of corporate bonds

Answer 23

• Debentures
• Unsecured loan stock
• Subordinated debt

Question 24

Risk and investment characteristics of corporate bonds

Answer 24

Less:
- secure
- marketable
- liquid
than government bonds.
Consequently, they generally offer a higher yield to investors.

Question 25

4 Theories put forward to explain the shape of the yield curve

Answer 25

L - Liquidity preference theory
I - Inflation risk premium theory
M - Market segmentation theory
E - Expectations theory

Question 26

Expectations theory

Answer 26

Describes the shape of the yield curve is determined by economic factors, which drive the market’s EXPECTATIONS for future short-term interest rates

Question 27

Liquidity preference theory

Answer 27

Investors require an additional yield on less liquid (longer-term) bonds.

Question 28

Inflation risk premium theory

Answer 28

Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.

Question 29

Market segmentation theory

Answer 29

Yields at each term are determined by supply and demand at that term.
Demand comes principally from institutional investors trying to match liabilities.

Question 30

Real yield curve

Answer 30

Plot of real gross redemption yields on index-linked bonds against term to maturity.

Question 31

Approximate market expectation of future inflation

Answer 31

Difference between the conventional yield curve and the real yield curve.