Money Markets and Interst Rates

Question 1

What is Money? Conversely, what is not money?

Answer 1

• Money is anything that is generally accepted as a payment for goods or services
• Money is not wealth (total collection of property that stores value) or income (flow of earning per unit of time)

Question 2

What are some of the Properties of Money?

Answer 2

• Medium of Exchange: Easily standardised, widely accepted, promotes specialisation and reduces transaction costs
• Unit of Account: Measures the values in an economy, reduces transactional costs
• Store of Value: Used to save purchasing power over time (i.e. bonds)
• Money is the most liquid asset, but you can lose money to inflation

Question 3

What is some of the evolution of the payment system?

Answer 3

• COMMODITY MONEY: Valuable, standardised and divisible
• FIAT MONEY: Paper money decreed by Government as legal tender
• CHEQUES: An instruction to transfer money from your account
• Electronics: E-Money, online transfers, debit card

Question 4

Are we moving cashless?

Answer 4

• E-Money is more convenient, but given the population parameters, it is unlikely for society to go utterly cashless (old people)
• E-Money usage will increase

Question 5

Why doesn’t Bitcoin uphold the traditional money properties?

Answer 5

• Bitcoin was created in 2009 as a decentralised currency
• The unit of account and store of value don’t hold
• Bitcoin is more of an investment decision as opposed to money

Question 6

How do you define money?

Answer 6

• Each central bank have different definitions. This is the Bank of England’s
• M0: Cash outside BoE (Currency+deposits) + Bank’s operational deposits in BoE
• M4: Notes, Coins + Deposits + Bonds + Claims on UK MFIs on repos and such
• M0 is more liquid
• M0/M4 can move in different directions in SR, so the characterisation of money is important for policy makers

Question 7

What are Present Values? What are the equations for interest rate and Future/Present Value?

Answer 7

• Present Values: Value today of money that is promised and made in the future
• Used to compare payments made at different times
• i = interest payments / original deposit
• Fv = Pv (1+r)^n
• Pv = Fv / (1+r)^n

Question 8

What are types of Credit Market instruments?

Answer 8

• Simple Loan: Amount borrowed and an interest payment that must be paid
• Fixed Payment Loan: Amount borrowed paid back in equal instalments
• Coupon Bonds: Bondholder receives fixed interest payment until specific final amount (face value)
• Discount Bonds: Bond bough at below-face value price and Face Value is repaid at maturity

Question 9

How do you calculate the yield for the these Credit Market instruments?

Answer 9

• Yield: Maturity can be calculated (IRR)
• Interest rate required to have a 0 NPV

Question 10

How do you calculate simple IRR?

Answer 10

• Original value = New Value / (1+r) ^n

Question 11

How do you calculate fixed payment IRR?

Answer 11

• Loan Value = Σ (Future Payment /[1+r]^n)

Question 12

How do you calculate Coupon Bond IRR?

Answer 12

• Price of Coupon Bond = Σ (Yearly Coupon Payment /[1+r]^n) + Face Value / (1+r)^n

Question 13

When Coupon Bond = Face Value Price, What happens to Yield:Maturity?

Answer 13

• Yield:Maturity = Coupon Rate
• Price of Coupon Bond and Yield:Maturity are negatively related

Question 14

What is Perpetuity/Consol?

Answer 14

• Bond with no maturity date and no repayment of principal that makes fixed payment of £C
• So Pc = C / ic
• This is only an approximation and this works best in the long-run

Question 15

How do you calculate Discount Bond IRR?

Answer 15

• P = F / (1+r)

Question 16

What is the equation for Rates of Returns?

Answer 16

• R = (C + Pt+1 - Pt) / Pt
• R = Return from holing an asset from t-> t+1
• C = Coupon Payment
• Pt = Price of Asset at time t
• Pt+1 = Price of Asset at time t+1

Question 17

If Return = IRR, what is the condition that also has to be adhered to?

Answer 17

• If the Holding Period = Time to Maturity
• If time to maturity > holding period, increased in interest, bond price down
• The longer the maturity, the larger the % change in price with respect to changes in interest
• The longer the maturity, the rate of return when the interest rate increased
• Bond with a high initial coupon rate can still have a negative return if
  i increases (fall in price)

Question 18

What is the difference between Nominal and Real interest rate (also mention ex-ante and ex-post) ?

Answer 18

• Nominal Interest Rate: Does not take into account for inflation
• Real Interest Rate: Adjusted for changes in prices and reflects co-borrowing
• Ex-Ante Real Interest Rate: Adjusted for EXPECTED price changes
• Ex-Post Real Interest Rate: Adjusted for ACTUAL price changes

Question 19

What are interest rate risks? When might some of these occur/not occur?

Answer 19

• Prices and returns for long-term bonds are more volatile than shorter-term bonds- less affected by changes in rate
• No interest rate risk for any bond when the time to maturity = holding period

Question 20

What are Money Markets? What are some properties of Money Markets?

Answer 20

• Highly Liquid and Short-Term
• Often sold in large denominations
• Low default risk
• Mature in <1yr from original date [often <120 days]
• Active secondary market, ideal for firms/FIs to warehouse surplus funds and investments that provides a higher return than cash
• Participants: Treasury, Business, Commerical Banks
• Money markets instruments show how liquid money market is§

Question 21

What are Treasury Bills? Whats the formula?

Answer 21

• Issued by Govt. short-term government bonds so no risk
• Bills are issued at a discount from value at maturity-> 0% interest
• i(discount) = F-P / P x 360/n
• i(investment) = F-P / P x 365/n
• i(discount) = annualized discount rate
• F = face or maturity value
• P = purchase price
• n = number of days until maturity
• 360 is an underestimate, and 365 is about right, so the investment rate is more representative of what investors will return

Question 22

What is the Federal Funds Market?

Answer 22

• Short-term funds transferred [loaned/borrowed] between financial institutions
• PURPOSE: to meet reserves requirement by giving overnight, unsecured investments
  -This is important to give us a good estimate of the short-term interest rates
• The forces of supply and demand set the fed funds interest rate

Question 23

What are Repos Markets? What is the formula?

Answer 23

• Repo is a repurchase agreement
• Anyone can participate (not just banks)
• Seller of securities agree to buy back this security at a pre-agreed price at a pre-agreed time
• The difference is the ‘haircut’ - depends on the borrower default or recovery value
• Repo Rate = (Pf - Pn) / Pn x 365/(Tf - Tn)
• Pf = Price at Tf and Pn = Price at Tn

Question 24

What are CoDs Markets? Whats the formula?

Answer 24

• CoD = Certificates of Deposits: Bank-issued securities that document a deposit & set r% and maturity date
• Lender has instant access to funds by selling CoD
• BUT: lower IR, CoDs need large denominations (>£50,000)
• Can be bought and sold until maturity

Question 25

What are Commercial Paper Markets? Whats the formula?

Answer 25

• Unsecured, short-term promissory notes issued by firms at a discounted basis (similar to Treasury Bills)
• The charged interest reflects the rate of risk
• Market includes commercial banks, insurance companies, pension funds…