Chapter 9: Bonds and Money Markets Flashcards
Cash on Deposit
Call Deposit (the depositor has instant access to withdraw the capital deposited)
Issuer: Banks
Typical Term: n/a
Tradable: No
Term Deposit (cash deposited for a fixed term with no access to the capital sum earlier than maturity)
Issuer: Banks
Typical term: 1 week to 1 year
Tradable: No
Notice deposit (depositor has to give a period of notice before withdrawal)
Issuer: Banks
Typical term: n/a
Tradable: No
The rate of interest paid by the borrower can be:
- fixed for the term of the deposit
- fixed for an initial period
- variable from day to day
The borrower (lender?) may have to give notice of any change in interest rates
Money Market Instruments
Treasury Bill:
Issuer: Central Government
Typical Term: 91 or 182 days
Tradable: Yes
Local Authority Bill:
Issuer: Local Government
Typical Term: 91 or 182 days
Tradable: Yes
Bill of Exchange:
Issuer: Companies
Typical Term: Up to 1 year
Tradable: Yes
Commercial Paper:
Issuer: Large, listed companies
Typical Term: Up to one year
Tradable: Yes
Certificate of Deposit:
Issuer: Banks
Typical Term: 28 days to 6 months
Tradable: Yes
Key Players in Money Markets
Clearing Banks:
- The money markets are dominated by the clearing banks, which use them to lend excess liquid funds and to borrow when they need short-term funds.
- These loans and deposits are usually very short term, often overnight
Central Banks:
- Act as lenders of last resort, standing ready to provide liquidity to the banking sector when required
- Use their operations in the money markets to establish the level of short-term interest rates
- Central bank money market operations involve the sale or purchase of Treasury and other eligible bills
- When it sells Treasury bills a central bank will receive cash from the money market. This makes cash scarcer and tends to drive up interest rates. Similarly, when it buys back treasury bills and other bills they are eligible to be sold to the central bank, the central bank will pay out cash. This tends to reduce interest rates, since interest rates represent the price of using money
Other institutions (financial institutions & companies) - Other financial and non-financial companies also lend and borrow short-term funds in the money market
Policy objectives of Central Banks
Inflation
- Demand-pull inflation is the increase in aggregate demand which pull prices upward
- Cost-push inflation is the decrease in the aggregate supply of goods and services stemming from an increase in the cost of production.
Economic growth
Exchange rate
- Implement foreign exchange laws
Stability of financial sector
Monetary policy / Money market operations of the central bank to manage liquidity and inflation rates (ie the money supply)
- 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
Quantity Theory of Money
MV=PY
Where M=quantity of money, V=velocity of money, P=price level, Y=no. of transactions
(i.e. money supply matches the value of transactions or GDP)
In the short term, V and Y are constant.
Hence an increase in M leads to an increase in P
Investment and Risk Characteristics of Cash on Deposit and Money Market Instruments
Security: Depends on the Issuer
Yield: Real, but not high compared to other assets
Spread/Capital volatility: Low (short term)
Term: Short
Expenses: Minimal
Exchange rate (Currency RIsk): Varied
Marketability: Good, except call/term deposits
Tax: Return taxed as income
Why do institutional investors not normally invest a large proportion of funds in money market instruments?
I. Money market instruments give a lower expected return than other, riskier assets
II. Money market instruments are not a good match for long-term liabilities.
III. There is reinvestment risk – Proceeds will have to be reinvested on unknown terms
IV. Short term interest rates will move broadly in line with price inflation. However, money market instruments are not a good match if the investor has real liabilities linked to some other index
V. Too large a proportion would result in a lack of diversification
VI. There may be a limited supply of money market instruments available
Bonds
An alternative term for a fixed-interest or index-linked security
Nominal GRY (required return)
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
Investment and Risk Characteristics of Government Bonds
Security: usually very good
Returns: Expect returns lower than shares but better than cash
=GRY at time of invest (and assuming held to maturity etc..)
Does not protect against unexpected inflation
Capital volatility: depends on term
(problem if have to report market values and/or sell prior to maturity)
Term: greater than 1 year; can be up to 30 or 40 years
Expenses: low dealing expenses
Exchange rate: varied
Marketability: good
Tax: income and capital gains may be taxed differently
Investment and Risk Characteristics of Corporate Bonds
Similar to government fixed interest securities except that they are:
- Less Secure
- less marketable (depends on size of issue)
- Less liquid
- Higher expected return
- Higher expenses
than government bonds
Outline three 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 prediction
- When the investor expects the future inflation to be higher than that currently predicted in the market
- When the investor expects the inflation risk premium to be higher than that currently predicted in the market
Describe the cashflows of a conventional government bond from the perspective of the investor
I. Bond purchase:
- An initial negative lump sum cashflow equal to the price paid for the bond plus dealing expenses
II. Coupon payments:
- A regular series of positive cashflows. The timing of the cashflows are known and the amount is known in monetary terms. The term of the payments is known in advance, except if the bond is callable (The borrower can repay the bond at any time)
III. Redemption payment:
- A single positive cashflow that is received at redemption. The timing is known, and the amount is known in monetary terms
Describe the cashflows of an index-linked government bond from the perspective of the investor
I. Bond Purchase:
- A single negative lump sum payment that is equal to the price paid for the bond plus dealing expenses
II. Coupon Payments:
- A series of regular positive cashflows. The timing is known in advance and the amount is known in real terms. The term of payment is known, except if the bond is callable.
III. Redemption Payment:
- A single lump sum positive cashflow received at redemption. The timing is known in advance and the amount is known in real terms.
