Chapter 9 - Bond and Money Markets Flashcards
Money market instruments can be issued by (4)
- Government (treasury bills)
- Regional government bodies (local authority bills)
- Companies (bills of exchange, commercial paper)
- Banks (different types of deposit)
4 Types of bank deposits
- call deposits
- notice deposits
- term deposits
- certificates of deposit
Call deposits
Depositor has “instant access” to withdraw funds
Notice deposits
Depositor has to give a period of notice before withdrawal
Term deposits
Depositor has no access to the capital 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 a specified term and rate of interest.
- Interest payable on maturity
- Kind of like a tradeable term deposit
10 Investment and risk characteristics of money market instruments
- 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
(Apply SYSTEM T)
5 Participants in money markets
- 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 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
Uses of Money Market Instruments (why do investors hold them?)
P - Protect market value
O - Opportunities may occur (strong liquid base needed to partake in inc opportunities).
U - Uncertain outgo/ liability (GI companies)
R - Recently received cashflow
R - Risk aversion and preservation of nominal capital value
S - Short-term liability
When are money market instruments attractive for institutions and investors?
G - general economic uncertainty. (stability of capital values are attractive to risk-averse investors)
R - start of recession (a fear that equity and bond prices [due to increased gvmt borrowing to finance deficits] will fall)
I- interest rates rising (might cause other asset values to fall - less economic activity and reduced company profits)
D - the domestic currency to weaken (makes overseas cash holdings attractive - hedges against local currency weakness. Gvmt may raise short-term interest rates to defend domestic currency).
Circumstances under which money market instruments would be temporarily unattractive
!! 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
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 (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
What does the term money markets cover? (2)
- Bank Deposits
- Short Term Securities
SYSTEM T
Security (default risk) Yield (real or nominal; expected return) Spread (volatility of market values) Term Expenses & Exchange Rate Marketability & Liquidity Tax
Tools/Roles of Central Banks (in implementation of objectives)
- Manage liquidity and interest rates (i.e. money supply). Monetary Policies/”MM Operations”:
> Set (overnight) repo rate and use repo and reverse repo arrangements
> Sale and purchase of treasury bills (and possibly other instruments)
> Commercial bank reserve requirements (‘reserve ratio’)
> Printing money and quantitative easing - Lender of last resort to maintain well-functioning banking system
- General oversight of financial sector (solvency etc)
- Management of currency stability and custodian of foreign reserves
- Manage GDP/unemployment (through monetary policy)
Policy Objectives of Central Banks
- Inflation (Types: Demand-pull / Cost-push)
- Economic growth
- Exchange rate; implement foreign exchange laws
- Stability of the financial sector
“bond”
An alternative term for a fixed-interest or index-linked security.
Bonds are described by (2)
- type of organisation issuing the security, ex. government, local authority, corporate
- nature of the bond - fixed interest/index-linked
“gilts”
UK government bonds
Fixed-interest / 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
7 Investment and risk characteristics of conventional government bonds.
- very good security (if politically stable)
- yield (GRY) is fixed in nominal terms
- lower expected returns than equities over the long term, but is expected to be more than money market instruments (if reinvested at GRY)
- market values can be volatile, especially for longer-term bonds - due to demand/supply. Volatility might be problematic if liability needs to be met or solvency adequacy needs to be met).
- mixture of terms: short, medium, long, undated (greater than 1 year; can be up to 30 or 40 years)
- low dealing expenses & overseas bonds can be used to match foreign currency liabilities.
- highly marketable
- Individuals taxed on income and on capital returns. Institutional Investor pay uniform rate on total return (income + capital gains).
(SYSTEM T)
3 Types of corporate bonds
- Debentures
- Unsecured loan stock
- Subordinated debt
Risk and investment characteristics of corporate bonds
Less: - secure - marketable - liquid than government bonds. Consequently, they generally offer a higher yield to investors.
4 Theories put forward to explain the shape of the yield curve
L - Liquidity preference theory
I - Inflation risk premium theory
M - Market segmentation theory
E - Expectations theory
Approximate market expectation of future inflation
Difference between the conventional yield curve and the real yield curve.
Gross Redemption Yield (in terms of governments bonds)
GRY is the IRR that is earned given the price paid and cashflows received…
…but need to consider: reinvestment rates, defaults, whether held to maturity.
GRY is in practice the starting point for determining price (=PV of expected CFs)…
…GRY needs to be the return required by investors holding the bond to maturity…
…GRY = risk free real rate + expected inflation + inflation risk premium
Nominal Yield ("risky bond")
Real vs Nominal Yield RelationshipNominal GRY (required return)
= Risk-free real yield
+ expected future inflation
+ bond risk premium
Where bond risk premium
= inflation risk premium
+ default / credit risk premium
+ marketability / illiquidity premium
The size of this yield margin depends on both the security and marketability of the debt.
Low security and marketability will lead to a large margin, whereas a large secure issue will trade at a small yield margin to the closest equivalent government bond
Assessing Credit Risk for a Bond
- Income Cover - Operational Profit (bf interest, tax) / interest of loan and prior ranking loans
- Capital Cover - Assets (excl intangibles and less current liabilities) / amount of loan and prior ranking loans
- Ratings (which reflect some probability of default)
- Bond terms (incl seniority, covenants, term to maturity)
