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Actuarial Risk Management (A311) 2021 > Chapter 9 - Bond and Money Markets > Flashcards

Chapter 9 - Bond and Money Markets Flashcards

1
Q

Money market instruments can be issued by (4)

A
  • Government (treasury bills)
  • Regional government bodies (local authority bills)
  • Companies (bills of exchange, commercial paper)
  • Banks (different types of deposit)
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2
Q

4 Types of bank deposits

A
  • call deposits
  • notice deposits
  • term deposits
  • certificates of deposit
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3
Q

Call deposits

A

Depositor has “instant access” to withdraw funds

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4
Q

Notice deposits

A

Depositor has to give a period of notice before withdrawal

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5
Q

Term deposits

A

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

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6
Q

Certificates of deposit

A
  • 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
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7
Q

10 Investment and risk characteristics of money market instruments

A
  • 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)

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8
Q

5 Participants in money markets

A
  • Clearing banks
  • Central banks
  • Other financial institutions & non-financial companies
  • Companies
  • Individuals
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9
Q

Clearing banks as a player in the money markets

A

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

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10
Q

Central banks as a player in the money markets

A
  • 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
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11
Q

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

A

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

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12
Q

When are money market instruments attractive for institutions and investors?

A

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).

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13
Q

Circumstances under which money market instruments would be temporarily unattractive

A

!! 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
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14
Q

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

A
  • 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
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15
Q

What does the term money markets cover? (2)

A
  • Bank Deposits

- Short Term Securities

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16
Q

SYSTEM T

A 
Security (default risk)
Yield (real or nominal; expected return)
Spread (volatility of market values)
Term 
Expenses & Exchange Rate
Marketability & Liquidity
Tax
17
Q

Tools/Roles of Central Banks (in implementation of objectives)

A
  • 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)
18
Q

Policy Objectives of Central Banks

A
  • Inflation (Types: Demand-pull / Cost-push)
  • Economic growth
  • Exchange rate; implement foreign exchange laws
  • Stability of the financial sector
19
Q

“bond”

A

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

20
Q

Bonds are described by (2)

A
  • type of organisation issuing the security, ex. government, local authority, corporate
  • nature of the bond - fixed interest/index-linked
21
Q

“gilts”

A

UK government bonds

22
Q

Fixed-interest / conventional bond

A

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

23
Q

Index-linked bond

A

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

24
Q

3 Types of bond markets

A
  • government bonds
  • corporate bonds
  • overseas government and corporate bonds
25
Q

7 Investment and risk characteristics of conventional government bonds.

A
  • 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)

26
Q

3 Types of corporate bonds

A
  • Debentures
  • Unsecured loan stock
  • Subordinated debt
27
Q

Risk and investment characteristics of corporate bonds

A 
Less:
- secure
- marketable
- liquid
than government bonds.
Consequently, they generally offer a higher yield to investors.
28
Q

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

A

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

29
Q

Approximate market expectation of future inflation

A

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

30
Q

Gross Redemption Yield (in terms of governments bonds)

A

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

31
Q 
Nominal Yield ("risky bond")
Real vs Nominal Yield Relationship
A

Nominal 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

32
Q

Assessing Credit Risk for a Bond

A
  • 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)

Actuarial Risk Management (A311) 2021 (26 decks)

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