Chapter 9 - Bond and money markets Flashcards
Outline three situations when index linked bonds will appear relatively more attractive to an investor than conventional bonds
- When the investor needs to match real liabilities and hence requires inflation prediction
- When the investor expects the future inflation to be higher than that currently predicted in the market
- When the investor expects the inflation risk premium to be higher than that currently predicted in the market
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
I. The money market is dominated by the clearing banks who lend and borrow via short term deposits to control their liquidity levels
II. 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 rates by buying and selling bills
III. Other financial and non-financial organizations also operate in the money market by lending and borrowing short term funds
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:
POURS
- Protect monetary value
- Opportunities (to size them)
- Uncertain liabilities
- Recently received cashflows
- Short term liabilities
Institutions may also hold money market instruments for diversification.
Outline three ways in which cash can be placed on deposit
I. Call deposit – The depositor can withdraw the funds at any time
II. Notice deposit – The depositor must give a period of notice before withdrawal
III. Term deposit – The depositor cannot access the capital until the end of the 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 tradeable term deposit
Circumstances under which money market instruments would be temporarily unattractive
- 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
3 Types of corporate bonds
- Debentures
- Unsecured loan stock
- Subordinated debt
List nine investment and risk characteristics of money market instruments
- Liquid
- Short term
- Generally, very low default risk due to the short term (although depends on the issuer)
- Low expected yield compared to other assets
- Return expected to more broadly in line with inflation
- Stable market values due to short term
- Very low dealing expenses
- Usually taxed as income
- Marketable (except for call and term deposits)
List ten investment and risk characteristics of conventional government bonds
- Income = Coupon that is fixed in nominal terms
- Capital = Redemption amount that is fixed in nominal terms
- The yield is fixed in nominal terms. The real yield is eroded by actual inflation.
- The expected yield is lower than for equities and property
- Variability in capital values is lower for short term bonds than for long term bonds
- Tax treatment depends on the territory
- Very marketable if in a developed country
- Very low default risk if issued by a developed country. Almost non-existent
- Term: Short, medium, long, irredeemable
- Very low dealing costs if a developed country
For index linked bonds, it is the fall in what yield that will increase prices?
Real yield, not nominal
What are the economic conditions that cause great uncertainty over future expected inflation?
- Less government commitment to a low inflation environment
- Loose monetary policy
- Devaluation of the domestic currency
- Rapid economic growth
Economic circumstances that make cash and MMI attractive
Institutions may also hold cash because they feel that other assets are going to perform poorly:
GRID
- General economic uncertainty
- Recession expected
- Increase in interest rates expected
- Depreciation of domestic currency expected
