Chapter 9: Bond and money markets Flashcards
Money market instruments can be issued by:
- Government (treasury bills)
- Regional government bodies (local authority bills)
- Companies (bills of exchange, commercial paper)
- Banks (different types of deposit)
Money market instruments are highly liquid and short term.
4 types of bank deposits
- call deposits
- notice deposits
- term deposits
- certificates of deposit
Call deposit
Depositor has “instant access” to withdraw funds.
Notice deposits
Depositor has to give a period of notice before withdrawel
Term deposit
Depositor has no access to the capiral sum earlier than the maturity of the deposit
Certificates of deposit
- Tradable notes
- Short term security issued by banks showing a stated amount of money has been deposited for specified term and rate of interest.
- Interest payable on maturity
- Kind of like a tradeable term deposit
Characteristics of investments
SYSTEM T
* Security (default risk)
* Yield (real or nomianal, expected return)
* Spread (volatility of market values)
* Term (short, medium or long)
* Expenses or Exchange rate
* Marketability
* Tax
10 investment and risk characteristics of money market instruments
- Security: good as term is very short, depends on the borrower though
- Yield (real vs nominal): return is through income, level of income has a loose, indirect link with inflation. Positive real return
- Yield (expected return relative to other assets): Lower expected returns than equities or bonds over the long term (lower risk of default)
- Spread: stable market values (short term)
- Term: short-term
- Expenses: low dealing expenses
- Exchange rate: currency risk, currency movements very difficult to predict.
- Marketability: normally highly marketable but unquoted. Traded through an interbank
- Tax: Returns usually taxed as income
- Liquid
5 Participants in the money market
- Clearing banks
- Central banks
- Other financial institutions & non-financial companies
- Companies
- Individuals
Clearing banks as a player in the money markets
Use money market instruments to lend excess liquid funds and to borrow when they need short-term funds
Central banks as a player in the money markets
Act as lender 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.
Uses of Money Market Instruments (why do investors hold them?)
POURS
* Protect market value
* Opportunities may occur, liquid
* Uncertain outgo / liability
* Recently received cashflow
* Short-term liability
When are money market instruments attractive for institutions and investors?
GRID
* General economic uncertainty (risk-averse investors)
* Recession (a fear that equity and bond prices will fall).
* Interest rates rising will depress bond, equity markets
* Domestic currency to weaken (makes overseas cash holdings attractive and it may be followed by rising interest rates)
Circumstances under which money market instruments would be temporarily unattractive
Flip the reasons for grid around
* General economic certainty
* End of a recession / start of a boom
* Expectations of falling interest rates
* Expectations of a strengthening domestic currency
* If the investor is not risk averse or concerend with liquidity
Main risks for an institutional investor with all their assets in domestic money market instruments
- 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 (reinvestment risk)
- Holding all assets in one type of investment results in a lack of diversification. All the investments will be positively correlated, resulting in a concentration of risk
What does the term money markets cover?
- Bank deposits
- Short term securities
Bond
An alternative term for a fixed-interest or index-linked security
Bonds are described by
- type of organisation issuing the seccurity, e.g. government, local authority, corporate
- nature of the bond- fixed interest / index-linked
Fixed-interst / conventional bond
Gives an income stream and final redemption proceeds that are fixed in monetary terms
Index-linked bond
Gives an income stream and final redemption proceeds that are linked to an inflation index.
3 Types of bond markets
- government bonds
- corporate bonds
- overseas government and corporate bonds
Investment and risk characteristics of conventional government bonds
- Security: very good (if politically stable)
- Yield (real vs nominal): fixed in nominal terms, uncertain in real terms (inflation)
- Yield (expected return relative to other assets): lower expected returns than equities over the long term. (Hold when GRY is falling, buy when high)
- Spread: Market values can be volatile, especially for longer-term bonds
- Term: mixture of terms, short, medium, long, undated
- Expenses: low dealing costs
- Exchange rate: currency risk. Risk for investor who is investing in bonds denominated in one currency but who has liabilities denominated in another.
- Marketability: High, Investors can deal in large quantities with little impact on price
- Tax: Income and capital gains. Pension funds may be exempt from tax on bonds
3 Types of corporate bonds
- Depentures
- Unsecured loan stock
- Subordinated debt
Risk and investment characteristics of corporate bonds
Less:
* secure (depends on type of debt security considered, issuing company, term)
* marketable (size of issue is smaller)
* liquid (more volatile)
than government bonds
Consequently, they generally offer a higher yield to investors.
4 Theories put forward to explain the shape of the yield curve
LIME
* Liquidity preference theory
* Inflation risk premium theory
* Market segmentation theory
* Expectations theory
Expectations theory
Describes the shape of the yield curve is determined by economic factors, which drive the market’s EXPECTATIONS for future short-term interest rates
Liquidity preference theory
Investors require an additional yield on less liquid (long-term) bonds
Inflation risk premium theory
Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.
Market segmentation theory
Yields at each term are determined by supply and demand at that term.
Demand comes pricipally from investors trying to mach liabilities.
Real yield curve
Plot of real gross redemption yields on index-linked bonds against term to maturity.
Approximate market expectation of future inflation
Difference between the conventional yield curve and the real yield curve
Outline 3 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 protection
- When the investor expects the future inflation to be higher than that currently predicted in the market
- When the investor expects the inflation risk premum 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
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
