Money markets Flashcards
What are the three well known traits of money markets? (3)
- Usually sold in large denominations
- Low default risk
- Matures in on year or less from issue date
Why do we need money markets? (7)
- the banking industry should handle the needs for short term
- Banks have an information advantage
- Banks are however very regulated
- creates a distinct cost advantage for money markets over banks
- reserve requirements create a additional expenses that money markets don’t have
- Due to level of interest offered by banks, money markets became more attractive= when they rose, people moved money to money markets
- cost structure of banks limits their competitiveness to situations where their info advantage outweighs regulatory costs
What do the roles fulfil in the money market? (2)
Lenders/investors: buy money market securities, this provides them a place to store their assets and make short term returns rather than keeping surplus of cash with no return.
borrowers: sell money market securities, which provides them with a low cost temporary fund.
Who needs cash? (3)
- cash outflows and inflows are not perfectly synchronised
- this asynchronisation of cash flow may imply occasional cash shortages
- Money markets find solutions to these cash timing problems for institutions facing these flows
What are money market funds?
- an opened ended mutual fund that invests in short term debt securities such as commerical paper and treasury bills
- as safe as bank deposits but provides a higher yield
- unlike other funds, they look to maintain 1 $ per share to distribute dividends to share holders = when this can’t happen they’ve broken the buck.
What is a bond? (5)
- Long term, more than one year debt security
- used by issuers to borrow funds for long term investments
- Investors buy portions of this debt
- Issuers pay investors interest rate in the form of coupons
- when bond matures issuers pay back the initial face value of the bond
= coupon and maturity are the two key components of bonds
What are treasury bills? (3)
- debt obligations issues by the us government, to finance their operations.
- they are the safest form of investment: government rarely defaults
- they are usually prices at a lower rate than their value, providing an interest in the difference one earn when they are paid back
- tax is only deductible at national level (not in county and state)
What are municipal bonds? (3)
- issues by local county and state government
- finances public interest projects
- tax-free municipal interest rate
What are corporate bonds?
- issued by corporations
- usually pay semi-annual coupons
- degree of risk varies with each bonds, and in turn the interest rate as well with level of risk.
- low risk= AAA and high risk= BBB
What are bond ratings? (3)
- grade given to bond that indicates their credit quality
- the lower the default likelihood, the higher the rating and credit quality
- provided by independent rating services: Moodys and fitch, S&P’s
What are junk bonds? (2)
- Debts that are rated below BBB
2. often trust and insurance companies are not allowed to invest in junk bonds
What is bond pricing? and what three steps does it involve? (2 + 3)
- no different than pricing any set of cash flows
- the price of bond today= the PV of its future cash flows, discounted at an interest rate which reflects its level of risk
Steps
- Identify the cash flows of the bond
- determine the appropriate discount rate
- Discount the cashflows based on the determined discount rate
How is bonds prices in relations to face value and yield? (3)
- We say that the bond is selling at par if 𝑃 = 𝐹.
- We say that the bond is selling below par (or at a discount) if 𝑃 < 𝐹.
- We say that a bond is selling above par if 𝑃 > 𝐹
What about the economics of YTM? (3)
- the riskier the security, the higher the yield required by investors
- the more liquid the market for a money market security, the lower the yield to maturity asked for
- the longer the maturity, the higher the yield asked for
What are the risks of holding a bond? (2)
- credit or default risk: the risk that the payer will default on the payment of interest or principal
- interest rate risk: bond prices have an inverse relationship with YTM, when interest rate falls bond prices go up and vice versa
