Other asset classes

Question 1

Liquidity is:

Answer 1

The ease with which you can convert cash at a fair price.

Question 2

Why hold cash?

Answer 2

• Liquidity – instant access, fast access e.g. short-notice
• Emergency funds, planned spending, security
• No volatility – safe
• Generates income as a rate of interest
- Fixed or variable

Question 3

Risks

Answer 3

• Potential default of the deposit taker
- Financial Services Compensation Scheme
• Inflation and tax reducing returns
- Real returns after tax can be negative
• Interest rates changes affecting returns

Question 4

Cash deposit accounts:

Answer 4

Interest returns on cash can be affected by the size and term of the deposit:
• Larger deposits and longer terms attract higher rates of interest

Question 5

Additional risks of depositing cash overseas:

Answer 5

Additional risk including:
• FX risk
• Withholding tax
• Exchange controls restricting repatriation

Question 6

Process for treasury bills -

Answer 6

1. Treasury issues a 90-day T-Bill with face value of £100,000.
2. Investor pays £98,500 for the bill (after deducting a £1,500 discount, which is approximately 3 months’ interest at 6% pa).
3. Investor holds the T-bill for the entire 90-day period.
4. Investor redeems T-bill and receives the full face value. The difference between this and the £98,500 originally paid is the investor’s return.

Question 7

Treasury bills:

Answer 7

Short-term unsecured debt - 1 month to 12 months.
Zero-coupon - issued at discount redeemed at par.
Benchmark risk-free rate

Question 8

Issuance process for treasury bills:

Answer 8

Treasury bill issues in the UK are known as ‘tenders’, held by the DMO (debt management office) at the end of the week (usually a Friday).
These tenders are open to bids from eligible bidders which include all of the major banks.
The bids are tendered competitively – the highest prices bid win and if successful participants pay the price they bid.

Question 9

Commercial paper features:

Answer 9

• Discount security by companies
• Unsecured, short term debt
  • Up to 1 year (typically 3 months)
• Commercial paper programme is typically a rolling dice programme, not all at once.

Question 10

Commercial Paper programme:

Answer 10

An on-going programme where the issuer advertises the rates at which it is willing to issue paper for various terms. Buyers can purchase the paper whenever they have funds to invest.
Programmes may be promoted by dealers, in which case the paper is called dealer paper.
Larger issuers, especially finance companies, have the market presence to issue their paper directly to investors. Their paper is called direct paper.

Question 11

Rollover risk

Answer 11

Where a company uses a new issue of CPs to pay off the existing CPs, it rolls over the debt. The risk associated with being unable to issue enough CPs to cover the existing issue is called rollover risk.

Question 12

Repo market components

Answer 12

The sale and the repurchase. The difference between the sale price and repurchase price is the repo rate (the interest paid for borrowing money).

Question 13

Terms of a repo

Answer 13

An open repo is where there is no fixed time for repurchase. Maturity dates in excess of overnight are called term repos. Repos may be used as a method of borrowing funds (using gilts as collateral) and reverse repos to cover a short position taken on by a market maker in the course of its market making activities.

Question 14

FX background:

Answer 14

OTC market
Major international banks
Spot market and forward market
Any foreign currency rate which does not involve the US dollar.

Question 15

Factors affecting foreign exchange rates

Answer 15

Demand
• Exporting goods: overseas markets need sterling to pay for UK goods
• Foreign investment: overseas investors want to invest capital into the UK
• Speculation
Supply
• Importing goods: converting sterling into an overseas currency will increase supply of sterling
• Investing overseas: UK residents want to invest capital into overseas assets
• Speculation
Impact
• More demand for the currency increases its value
- Can reduce exports and foreign investment
• More supply of a currency will diminish its value
- Can reduce imports as overseas goods look expensive
Currency rate management by the central bank
Other factors
Release of key economic data (or forward guidance) by central banks and governments can have a significant effect on the FX market. For example, when the US Labour Department issues its monthly employment data, (the Non-Farms Payroll (NFP) report), on the first Friday of each month at 8:30 Eastern time.

Question 16

Forward rate pip adjustment

Answer 16

Generally

• Pips are either added to or subtracted from the spot rate
• Forward rates can expressed as a two way pip adjustment to the spot’s bid and offer

Question 17

Carry trade:

Answer 17

A carry trade in FX involves the borrowing of funds in a currency where the rate of interest is relatively low and then purchasing securities, often government bonds, which have relatively high yields.

Question 18

Minimum denomination UK T-bill:

Answer 18

£25,000