Chapter 9: Bond and money markets Flashcards
1) How can cash be placed on deposit?
- Instant cash or call deposit => the depositor has an “instant access” to withdraw the capital deposited
- Notice deposit => a depositor has to give a period of notice before the withdrawal
- Fixed term or term deposit => The depositor cannot access the capital until the end of the fixed term
2) Who are the key players in the money market?
1> Clearing Banks
> Lend and borrow money via short term deposits to control their liquidity levels
2> Central Banks
o The lender of last resort
o Stands by to provide liquidity to the banking system
o Sets short term rates via the sale and purchase of Treasury and other eligible bills
——-Sell Treasury bills -> Makes cash scarce and drives the interest rates up (vice versa)
3> Other financial and non-financial institutions also lend and borrow short-term funds
3) SYSYEEM T of money market investments
1> Security (default risk)
> Depends on the issuer
> Due to short term nature – default is very rare
2> Yield – real or nominal
> Tend to give a positive real return (net of inflation)
> Because short-term interest – higher when inflation is higher
3> Yield – expected return relative to other assets
> E[R] lower than most classes
> Close to being risk-free
4>Spread – volatility of capital values
> Stable market values due to short term
5> Term
> Short term (less than 1 year)(overnight)
6> Expenses
> Very low dealing expenses
7> Exchange rate – currency risk
> Possible fluctuations in exchange rates on overseas deposits
8> Marketability
> Highly marketable except for call and term deposits (illiquid and zero/low returns)
> Unquoted – traded through inter-bank
9> Tax
> Total return is normally treated as income
4) Why do institutional investors hold money market instruments?
a. Held for liquidity reasons: (POURS)
i. Preservation of nominal value of capital and risk aversion
ii. Opportunities (take advantage of)
iii. Uncertain liabilities(outgo)(e.g. General insurers)
iv. Recently received cashflow
v. Short term commitments known
b. Held if prospect of other assets is poor: (GRID)
i. General economic uncertainty
ii. Recession expected (start of an economic recession) (no risk of capital loss)
iii. Interest rates expected to rise (depress economic activity and reduce companies’ profits)
iv. Depreciation of domestic currency expected (short term rates raised, cash investment in a stronger currency attractive)
c. HELD FOR DIVERSIFICATION
5) Why do institutional investors not normally invest large proportions of funds in money market instruments?
a. Low return than other riskier asset classes
b. NOT GOOD MATCH for long term liabilities
i. Reinvestment risk
c. Short term interest rates -> Move broadly in line with inflation
i. However, may not be a good match for real liabilities linked to another index
ii. TOO LARGE PROPORTIONS -> No diversification
d. Limited supply of money market instruments available
6) What are the three types of bonds markets?
a.> Government bonds - > listed in their country of origins
b.>Corporate bonds -> listed in the country of origin
c.>Overseas Government and Corporate bonds -> listed in any county other than home country
7) SYSTEEM T for conventional government bonds
1> Security (default risk)
> Virtually no risk of default in developed countries (reputable government)
> Governments can increases taxes or print more money
2> Yield – real or nominal
> Nominal returns known from outset
> Real return are uncertain (unknown reinvestment term, sell price not known, higher inflation)
3> Yield – expected return relative to other assets
> long term E[R] lower than equities and property
4> Spread – volatility of capital values
> Volatility of capital values higher for long term than short term bonds
> Falling values problem for (GI and selling early)
5>Term
> Shorts(<5yrs)
Medium dated(5-15)
Long dated(>15 years)
Undated/irredeemable
6> Expenses
> Very low dealing costs => narrow than corporate
7> Exchange rate – currency risk
> Currency risk – bonds and liabilities in difference currencies
8> Marketability
> Excellent marketability – developed country
9> Tax
> Depends on the territory, SA (tax income and capital gains). Pension funds may be exempt
8) What are the cashflows on a conventional government bond from the investor’s perspective?
a.> Bond purchase -> initial lump sum (negative cashflow) = Price paid + dealing costs
b.> Coupon payments -> regular series of positive nominal cashflows (usually semi-annually). Term is known unless callable. (Credit risk)
c.>Redemption payment => A lump sum positive cashflow on the redemption date.
Timing and amount of cashflows is known in monetary terms
9) What are the cashflows on an index linked government bond from the perspective of the investor?
a.> Bond purchase => Initial lump sum => initial lump sum = Price of the bond + dealing costs (negative cashflows)
b.> Coupon payments => A regular series of positive cashflows. Timing is known. Amounts are in real terms. Total payment term is known
c.> Redemption payment => A lump sum positive cashflow on the redemption date. Timing is known. Amount is in real terms
d.> NB LAG: Index used to calculate payments based on an earlier period so the amount on payment date can be known in advance
10) What is the relationship between nominal yields and real yields?
a.> Nominal yield = risk-free yield + expected future inflation + inflation risk premium
o The inflation risk premium represents the extra return that investors with real liabilities demand to compensate for the uncertainty of future inflation (may be higher than expected)
11) What does the size of the inflation risk premium represents?
a.> Additional yield required by investors with real liabilities bearing the risk of uncertain future inflation
b.>The risk is determined by:
i. Degree of uncertainty over future inflation
ii. Balance between the number of investors requiring a fixed return and those requiring a real return
