Chapter9-Bond and money markets

Question 1

Framework

Answer 1

1 Types of cash on deposit
2 Providers of money markets instruments
3 Investment and risk characteristics of money market instruments
4 Reasons for holding money market instruments (POURS GRID)
5 Reasons for not holding a large proportion of funds in money market instruments
6 Types of bond market
7 Investment and risk characteristics of conventional government bonds
8 Cash Flows of a conventional government bond
9 Cash flows of an index-linked government bond
10 Nominal vs real yields
11 Inflation risk premium
12 Relative attractiveness of index-linked over conventional bonds
* Gross redemption yield

Question 2

Investment and risk characteristics of money market instruments (9)

Answer 2

1. Liquid
2. Generally very low default risk due to short term (although depends on issuer)
3. Expected return lower than on most other asset classes
4. Return expected to move broadly in line with inflation
5. Stable market values due to short term
6. Term: short
7. Very low dealing expenses
8. Marketable (with the exception of call and term deposits)
9. Usually taxed as income

Question 3

Reasons for holding money market instruments (POURS GRID)

Answer 3

Institutions hold money market instruments for liquidity reasons:

Protect monetary values 
Opportunities (to take advantage of) 
Uncertain liabilities
Recently received cashflow 
Short-term liabilities 

Institutions also hold cash if they expect prospects for other assets to be poor:

General economic uncertainty
Recession expected
Interest rates expected to rise
Depreciation of domestic currency expected (where invested in overseas money market instruments)

Institutions may also hold money market instruments for diversification.

Question 4

Investment and risk characteristics of conventional government bonds (10)

Answer 4

1. Income = coupons (usually semi-annual) fixed in nominal terms.
2. Capital = redemption payment (usually at par) fixed in nominal terms.
3. Usually negligible default risk if a developed country.
4. Lower long-term expected return than equities and property.
5. Provides a fixed nominal return. Real return eroded by actual inflation.
6. Volatility of capital values higher for long-term than short-term bonds.
7. Term: short, medium, long, irredeemable.
8. Very low dealing costs if a developed country.
9. Very marketable if a developed country.
10. Tax treatment depends on the territory

Question 5

Gross Redemption Yield

Answer 5

Return that you would expect to get on a bond if you hold it until redemption, assuming you could reinvest the coupons at the same rate.

I.e. the yield that equates the price of the bond with the discounted value of the interest and capital proceeds on the bond.