Chapter 9: Bonds and money markets

Question 1

Name the types of cash deposits

Answer 1

• Call
• Notice
• Term

Question 2

Name the types of interest rate structure

in terms of period

Answer 2

• Fixed for the term
• Fixed only for an initial period, then variable
• Variable

Question 3

Key players in money markets

Answer 3

• Clearing banks
• Central banks

Question 4

Set out the investment and risk charecteristics of cash on deposit and money market instruments

Answer 4

Security
Depends on the issuer. Governemnt issued securities are usually relatively risk free

Yield - Nominal vs real
* Nominal profit can be made if the security is bought at a discount
* Real return is positve since short-term interest rates are usually higher than nominal interest rates

Yied - compared to other assets
* There is usually low risk of default, thus the expected returns are lower than other assets which are usually higher risk.

Spread - volatility of capital values
* Money market instruments and cash on deposit are usually fixed in nominal terms.
* Due to their short-term nature, this makes for little volatility in market value

Term
* Usually short-term

Expenses
* Expenses are usually minimal

Exchange rate - currency risk
* Movements in exchange rates are usually compensated by different interest rates.
* However, movements in exchange rates are usually hard to predict

Marketibility
Usually highly marketible but unquoted

Tax
Return is usually treated as income for tax purposes

Question 5

Why are money market instruments and cash on deposit usually inappropriate for life insurance companies

Answer 5

• Usually give a lower expected return than other asset classes
• May not match liabilities

Question 6

Why would a long-term investing institution hold money market instruments or cash on deposit

Answer 6

• As liquidity to meet outgoings
• Temporarily, when taking a view that other asset classes might fall

Question 7

Why would an institution hold cash for liquidity purposes

Answer 7

• Known short-term commitments
• Uncertain outgo
• Opportunities
• Recent cashflow
• Preservation of nominal value of capital and risk aversion

Question 8

Economic conditions in which cash is attractive

Answer 8

• Rising interest rates
• Start of an economic recession
• Depreciation of domestic currency
• General economic uncertainty

Question 9

Explain why cash is attractive in the following economic conditions:

• Rising interest rates
• Start of an economic recession
• Depreciation of domestic currency
• General economic uncertainty

Answer 9

Rising interest rates
* Gross redemption yield will increase
* Causing a decrease in the price for bonds
* Increasing interest rates will also depress economic activity, decreasing the value of equities
* An investor who anticipates the rising interest rates can sell equities and bonds before the rise.
* And hold cash as the others fall in value

Start of an economic recession
* Share prices are likely to peform badly if there is little economic activity.
* There might be an increase in government borrowing leading to a larger supply of fixed-interest governement bondas.
* The increase in supply will decrease the price of bonds
* However, recessions are followed by decreases in short-term interest rates, which will increase the prices of bonds
* So cash investments are attractive at the start of a recession.

Depreciation of domestic currency
* Short-term interest rates may be raised.
* A cash investment in a stronger currency might be attractive, even if its interest rates might be lower, as an appreciation would be anticipated.

General economic uncertainty
* The stability of capital values of cash investors might be attractive to risk-averse jnvestors.
* However, over the long-term, they give low expected returns

Question 10

Investment and risk characteristics of government bonds

Answer 10

Security
* Bonds issued by a reputable governemnt have almost no risk of default.

**Yield - Nominal vs real **
* If held until redemption, monetary amounts are known and fixed.
* A nominal profit can be made if bought at a dicount or redeemable at a premium.
* Actual return might differ if:
1. Coupun payments may have to be reinvested at terms not known at the outset.
2. Investor plans to sell before redemption, price not known at the outset.
3. The real return is uncertain as it depends on inflation, which is unknown at the outset.

Yield - expected return relative to other assets
* Usually low risk low return compared to other assets.

Spread - volatility of capital values
* Investors can deal in large quantities without impact on price.
* The day-to-day market values may change due to supply and demand forces.
* Changes are much more volatile for long term bonds

Question 11

Why would risk of falling market values be a problem

Answer 11

• Investors who need to show financial strength usong the market values of instruments.
• Investors who have to sell at low prices

Question 12

Nominal yield calculation

Answer 12

risk-free real yield + exopected future inflation + inflation risk premium

Question 13

Index linked vs fixed interest bonds for investors who require a real return

Answer 13

• There will be an inflation risk premium on fixed-interest bonds.
• Will require a high return from fixed interest bonds to compensate them for inflation being higher than expected, eroding the real return.

Question 14

Index linked vs fixed interest bonds for investors who require a certain nominal return

Answer 14

• Investors will require a monetary risk premium on index linked bonds.
• They will require a high return from index linked bonds
• To compenate them for the risk of inflation being lower than expected, and the required nominal return not being achieved.