Finals Flashcards
The role of the money market (four components)
- Provides an alternative flow-of-funds process (to ADIs) for surplus and deficit units = wholesale amounts = short-term debt securities = low risk and return
- it provides the banking system with a low-risk market for their liquid reserves = funding through issuing NCDS + banks can sell bills they accept to investors
- it performs price discovery by identifying short-term reference rates = BBSW (bank-bill swap rate = the rate at which banks will lend to eachother)
- it enables the RBA to implement monetary policy and so influence the economy = effect interest rates to influence spending decisions of households and businesses = money market contribution to banking system liquidity helps the RBA meet its responsibilities for financial system stability
Define “money market security”
secured or unsecured?
level of credit risk?
Two types of money market securities?
Securities with a term less than a year that make a single payment (their face value) at maturity
- issued and trade at a discount to their face value
- mostly unsecured
- very low credit risk
Type 1: BABS = both borrower and acceptor promise to redeem security
Type 2: Promissory notes: promise by borrower to redeem security at maturity date = NCDs, Treasury notes, Commercial paper.
BAB and NCD = most prevalent
Treasury notes?
Commercial paper?
Treasury notes = issued by commonwealth government through a competetive tender (large auction to institutional investors to purchase newly issued government debt) = risk free (trades below BBSW) and makes up 10% of money markets securities
Commercial paper = issued by low-risk borrowers through a dealer panel (borrower permits a dealer to solicit (obtain/ask for) bids on a best efforts basis to finance a project) = state governments, public enterprises, large companies, SPVs
Repurchase agreements?
how long?
Predominant type of securities used for repos?
who uses repos?
An arrangement to sell securities on the basis that they
are repurchased at a later date at an agreed price = short term finance for seller from buyer for period of agreement
Periods vary from intra day to a number of months
Predominantly commonwealth government bonds
Used extensively by the RBA and others including fund managers and bond dealers
Explain the trading and settlement arrangements relative to the money market
Maturity buckets?
OTS, wholesale maret where dealers quote their bid and offer yields when called by another dealer as a simple interest yield (to two decimal places)
main dealers = majors, foreign owned banks, SPVs and merchant banks = they trade from their own dealing rooms mostly by phone
Austraclear = clearinghouse and arranges RTGS on a same day (T+0) basis
Maturity buckets = to promote liquidity, NCDs and BABs are divided into two maturity buckets = early bucket mature between 1st and 15th and the rest go into late bucket
Money market dealers: Define yield? How dealers operate? why do dealers sell when the yield drops? Hit and shade?
Yield = return on investment = if you hold a security till maturity then the yield you recieve will be equal to the interest earned expressed as a percentage Dealers = hold inventory of securities and earn interest and trading income
Dealers attract trades (being ‘hit’) by setting competitive quotes and ‘shade’ quotes to stay competitive. They do not provide buy and sell prices when trading securities. They quote bid and offer yields and prices are calculated with the agreed yield
because price and yield are inversely related. Price will go up if yield drops as per the simple interest formula we use to calculate the value of money market securities.
Quotes are private and valid for that call only
Money market securities:
Price risk?
Holding period yield? + how to calculate it?
Capital gain or loss? + how to calculate?
Interest + how to calculate?
price risk = the risk of a capital loss from selling a security before maturity = arise from changes in the market yield = if security is sold at a lower yield (than the purchase yield) a capital gain is achieved, and vice versa for a loss
Holding period yield = the actual yield (return) achieved = to calculate simply rearrange the formula for calculating price of money market security to equal to r and replace the days till maturity with days matured and ensure numerator equals current selling price (not face value) and denominator equals purchase price)
Capital gain or loss = actual sale price at new yield less the sale price is yields remained the original value
interest = change in the value of the security if yields had remained at original value (simple subtraction)
Define bond?
Bond = a long-term security that makes regular interest payments, known as coupons, and pays its face value at maturity
Role of the bond market: Flow of funds? Price discovery? default free interest rates? Credit risk premiums + credit spreads?
- the bond market contributes to the flow of funds by enabling wholesale borrowers to raise large sums for long terms + providing wholesale investors with access to a defensive asset class (more risky than cash but less risky than shares) (market risk arise from changes in yields)
- contributions to price discovery = bonds trading reveals long-term interest rates that inform borrowers of the cost, and investors of the return, of long-term funds
- default free interest rates = revealed by trading in Treasury bonds, with the three-year and 10-year yields being the benchmark rates (market for treasury bonds is very liquid and this enhances the quality of price discovery)
- credit risk premiums = revealed by trading in semi-government and non-government bonds (these have a degree of credit risk and so trade at higher yields than treasury bonds)
- credit spreads = show the margin above the default free rate a borrower has to pay because of their credit rating (narrow before GFC increased sharply during GFC)
Trading and settlement in bond markets?
wholesale, OTC market where dealers are market makers that operate according to AFMA protocols
dealers quote bid-offer yields on a semi annual compound basis
standard parcel size is $10m
settlement is arranged by Austraclear on a T+3 / RTGS basis
Treasury bonds:
Why?
Type of bond?
How are treasury bonds issued?
why = to raise funds for government + to benefit financial system even if government does not require funds (price discovery of default free rates)
Type of bond = fixed rate bond = investors can choose from a wide range of bond series distinguished by different maturity dates (new series can be added, and more bonds can be issued of existing series)
Issued through competitive tender to the LOWEST bidder (because bids are in terms of interest rates (obviously lower interest rates = less the government has to pay in interest = preferable)
semi-government bonds: who? Bond type? Yields vs Treasury bonds? How are they issued?
Who = issued by state borrowing authorities (such as NSW T-corp) or state agencies
Bonds = medium or long term, with fixed or floating coupon rates
Yields = exceed those on treasury bonds
issuance = through dealer panels, often as a closed auction and these dealers make the secondary market
Non-government bonds: Financials (such as ADIs)? Kangaroo bonds issued by non-residents? Non-financial companies? MBS
financials = mainly issuance of floating-rate medium term notes by the majors (decline in issuance reflects the greater reliance on deposits)
Kangaroo = Aud denominated bonds issued in australia by non-residentss = swap aud payments for USD payments with australian borrowers (mainly banks) who have borrowed USD
NF-companies = high issuing costs, so issue in large amounts. Some lower rated issuers have their credit standing improved by credit wrapping such as bank guarantees.
ratings agencies: What is a rating? Rating of Aussie bonds good or bad? Yield vs credit risk vs ratings? Remember Bonds are subject to review and can be changed + cost is paid by the issuer
A rating is an informed opinion about the credit risk of a security from a ratings agency (based on their analysis) of qualitative and quantitative factors)
Aussie bonds = mostly high rating
Higher credit risk = lower rating = higher yield
Calculating bond prices: Which formula is used? Format for market yield? When are coupons paid? How do we price bonds? Bond settlement? When will Bond price be at a premium to face value?
Formula = RBA formula
market yield = semi-annual compound rate
Coupons paid = twice a year on a date and month that aligns with the bonds maturity date
Bond pricing = priced per $100 of face value, but to 6dp
Bond settlement = settle on a T+3 basis with the price calculated on the settlement day using the yield agreed to on the trade date.
Premium = when coupon rate exceeds the market yield
Bond investments:
What are the returns from a bond investment?
Reinvestment risk?
Price risk?
returns = 1) coupons received 2) interest earned on the reinvestment of the coupons (in the same bonds) 3) the bonds face value or selling price
reinvestment risk = the risk of reinvesting the coupons at a lower yield than the purchase yield
price risk = the risk of a capital loss if the bond is sold at a higher market yield (than the purchase yield) = longer bond is held the smaller the price risk is = active investors accept price risk hoping to sell when the market yield is lower than the purchase yield
The main functions of the foreign exchange market (three)?
Wholesale FX market?
- to facilitate cross-currency payments arising from imports, exports and financing flows (No loans in FX markets + FX markets are needed for trading and financial dealings with other countries)
- to reveal the value of currencies
- to allow traders to manage their FX risks
Wholsale FX = mostly trading of currencies between banks = largest financial market when valued by turnover
Exchange rates: trade weighted index? Floating exchange rates history? Two determining roles of exchange rates? Exchange rate preferences (exporters, importers, businesses)
Trade weighted index = values the AUD against an index of foreign currencies weighted according to their role in trade
History Frates = before 1970 fixed rates, after 1970 floating exchange rates discovered through trading in FX markets.
Roles = domestic value of goods and services bought and solid in foreign currencies + foreign assets and liabilities of local entities
business = stable exporter = low importer = high
Reading exchange rate quotations?
Bid-offer quotes?
Cross rates?
Quotations = commodity currency (one being bought and sold) is quoted first and is priced in the terms currency = AUD/USD 0.9595 = use reciprocal to find the quote i.e. USD/AUD = 1/0.9595 = 1.0422
Bid offer quotes = FX dealers quote bids (their buying price) and offers their selling price in that order i.e. AUD/NZD 1.1525-31 = bid of 1.1525 and offer of 1.1531 = Mid-point of 1.1528
Cross rates = a term referring to non-usd exchange rates, but can also mean non-euro rates or non-aud rates. = can be calculated using simple maths and cross multiplication
FX contracts:
What?
How to distinguish between the different types contracts?
What are the different types?
Elaborate on differences between the types of contracts?
FX contract = contracts to exchange an agreed amount of one currency for an agreed amount of another
Distinguish = according to settlement date
Types = spot (settlement 2 business days later), 1-month forward (1 month and 2 business days later), 2-month forward (two months and 2 business days later), etc.
spot = dealers store FX reserves in low risk securities
