Money Markets and Interst Rates Flashcards
Week 2
1
Q
What is Money? Conversely, what is not money?
A
- 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)
2
Q
What are some of the Properties of Money?
A
- 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
3
Q
What is some of the evolution of the payment system?
A
- 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
4
Q
Are we moving cashless?
A
- 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
5
Q
Why doesn’t Bitcoin uphold the traditional money properties?
A
- 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
6
Q
How do you define money (M0…)?
A
- 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
7
Q
What are Present Values? What are the equations for interest rate and Future/Present Value?
A
- 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
8
Q
What are types of Credit Market instruments?
A
- 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
9
Q
How do you calculate the yield for the these Credit Market instruments?
A
- Yield: Maturity can be calculated (IRR)
- Interest rate required to have a 0 NPV
10
Q
How do you calculate simple IRR?
A
- Original value = New Value / (1+r) ^n
11
Q
How do you calculate fixed payment IRR?
A
- Loan Value = Σ (Future Payment /[1+r]^n)
12
Q
How do you calculate Coupon Bond IRR?
A
- Price of Coupon Bond = Σ (Yearly Coupon Payment /[1+r]^n) + Face Value / (1+r)^n
13
Q
When Coupon Bond = Face Value Price, What happens to Yield:Maturity?
A
- Yield:Maturity = Coupon Rate
- Price of Coupon Bond and Yield:Maturity are negatively related
14
Q
What is Perpetuity/Consol?
A
- 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
15
Q
How do you calculate Discount Bond IRR?
A
- Pv = Fv / (1+r)^n
16
Q
What is the equation for Rates of Returns [same as EMH] ?
A
- 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
17
Q
If Return = IRR, what is the condition that also has to be adhered to?
A
- 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)
18
Q
What is the difference between Nominal and Real interest rate (also mention ex-ante and ex-post) ?
A
- 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
19
Q
What are interest rate risks? When might some of these occur/not occur?
A
- 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
20
Q
What are Money Markets? What are some properties of Money Markets?
A
- 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
21
Q
What are Treasury Bills? Whats the formula?
A
- 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
22
Q
What is the Federal Funds Market [LIBOR in the UK]? What is it used for?
A
- 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
23
Q
What are Repos Markets? What is the formula?
A
- 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
24
Q
What are CoDs Markets?
A
- 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
25
Q
What are Commercial Paper Markets?
A
- 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…
