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Financial Markets 2014 > Topic 2 - Government debt, monetary policy and interest rates > Flashcards

Topic 2 - Government debt, monetary policy and interest rates Flashcards

1
Q

2.01 - Governments manage spending and economic conditions through what two policies?

A
  • Fiscal policy - annual incomes and government expenditure

* Monetary policy - short-term interest rates by way of adjusting the level of financial system liquidity

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2
Q

2.02 - When does a borrowing requirement arise for a government and what does this give rise to over a full financial year?

A

When the government’s expenditures exceed its revenue during the period and over a full financial year this gives rise to a budget deficit.

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3
Q

2.03 - Governments will borrow and spend to boost the economy to move a country out of a recession. Generally what functions does a government have in regards to borrowing and lending?

A
  • borrow to finance deficits
  • rollover existing bonds that mature
  • retire debt if the budget is in surplus
  • issue Treasury bonds which are bought by banks and other financial institutions.
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4
Q

2.04 - Why are treasury bonds an attractive investment for banks and other financial institutions?

A
  • assist with liquidity management
  • portfolio investment purposes
  • risk management
  • payment systems requirements
  • meet prudential requirements
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5
Q

2.05 - What was the problem in Australia caused by long periods of Government surplus? and how was this dealt with?

A

The supply of government securities was limited as the government didn’t need the finance. Policy was introduced to ensure long dated bonds were issued at least every two years, ensuring sufficient securities to support 10 year bond futures contracts

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6
Q

2.06 - How was the strategy of issuing long dated bonds at least every two years impacted by the GFC?

A

The issue of approx $55B in Treasury bonds target level was swept away and the government issued approximately 136B.

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7
Q

2.07 - What is the effect of a high government deficit on the economy?

A

When government deficit is high, the government demand for debt funding will reduce the amount of funds available in the private sector and therefore limit growth within the economy (the crowding out effect).

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8
Q

2.08 - The government also needs short term borrowing within a financial year - why?

A

To finance short-term mismatches between receipts and payments (day-to-day liquidity). The government will also rollover existing debt.

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9
Q

2.09 - What instruments are issued for intra-year budgetary purposes?

A

Treasury notes (T-notes)

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10
Q

2.10 - The government issue both coupons and discount securities in what two main forms?

A
  • Treasury bonds (T-Bonds) for full financial year financing

* Treasury notes (T-Notes) for intra-year financing

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11
Q

2.11 - What are the features of a T-Bond?

A
  • It is a coupon instrument (regular half yearly interest)
  • Coupon payment = coupon rate x face value of bond
  • Face value of bond is redeemed at maturity date
  • It can be sold in a secondary market.
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12
Q

2.12 - What is the formula to calculate the price of a T-bond?

A

P=PVi + PFf - Price = price value of coupon (where coupon = coupon rate x face value of bond) X Price value of the face value of the bond.

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13
Q

2.13 - What are T-notes?

A

Short term discount securities issued by government through the Australian Office of Financial Management (AOFM)

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14
Q

2.14 - What are the features of a T-Note?

A
  • variable term to maturity to coincide with Govt Revenue receipt dates
  • may be redeemed at maturity date
  • can be sold in secondary market
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15
Q

2.15 - How are T-notes sold?

A

Using a tender system which ensures full subscription. Bids are accepted in ascending order of yield and settled through Austrader in parcels of $1m

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16
Q

2.16 - How did the GFC affect the trade of T-notes?

A

No T-Notes were issued for several years after 2003 because of government surplus, but this changed considerably during and after the GFC.

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17
Q

2.17 - How do state Governments raise finance?

A

Through a central borrowing authority to facilitate debt management programs. They issue medium term notes and longer term bonds known as semi-government securities and discounted securities.

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18
Q

2.18 - State Government debt issues may be offered in what four ways?

A
  • Public or Private

* Underwritten or Not Underwritten

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19
Q

2.19 - The RBA that influence interest rates to achieve what economic objectives?

A
  • Stability of the currency
  • Maintenance of full employment
  • Economic prosperity and the welfare of Aust people
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20
Q

2.20 - What is the RBA aiming for in order to achieve economic prosperity and welfare of the Aust people?

A

Maintain inflation within a 2-3% range over the business cycle.

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21
Q

2.21 - How does the RBA tighten monetary policy and what is the flow on effects?

A

RBA sells Commonwealth Government Securities (CGS) and this reduces the money supply. This causes investment and household spending to decrease.

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22
Q

2.22 - How are Open Market Operations (OMOs) conducted?

A

Repurchase agreements (repos) on nominated debt securities and outright (direct) transactions in short-dated CGSs.

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23
Q

2.23 - Explain how CGS purchases and sales affect money supply?

A

CGS purchases inject and increase money supply

CGS sales reduce money supply.

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24
Q

2.24 - Why does the RBA manage a portfolio of CGS?

A

To maintain system liquidity and give effect to monetary policy. The RBA does this by purchasing through the secondary market and occasionally taking an allotment at tender in a primary issue.

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25
Q

2.25 - What factors impact on the liquidity of the financial system (or money base)?

A
  • Commonwealth government budget deficits or surpluses
  • Official (RBA) FX transactions
  • Net sales of CGS and repurchase agreements
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26
Q

2.26 - Why may a central bank want to increase interest rates?

A
  • inflation above target range
  • excessive growth in GDP
  • a large deficit in the balance of payments
  • Rapid growth in credit and debt levels
  • Excessive downward pressure on FX markets
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27
Q

2.27 - What is the impact that an increase in interests rates (tightening monetary policy) will have?

A
  • it will increase long-term interest rates
  • slow consumer spending - reducing inflation and demand for imports
  • Decrease the size of the current account
  • Possibly attract foreign investment causing the domestic currency to appreciate
28
Q

2.28 - What are the three effects of changes interest rates?

A

1) liquidity effect
2) income effect
3) inflation effect

29
Q

2.29 - What is the liquidity effect in relation to changes of interest rates?

A

RBA’s market operations affect the money supply and therefore the system liquidity. Eg. RBA increases rates (tightens) by selling CGS.

30
Q

2.30 - What is the income effect in relation to changes in interest rates?

A

A flow on from the liquidity effect. If interest rates rise, then economic activity will decrease allowing rates to ease.

31
Q

2.31 - What is the inflation effect in relation to changes in interest rates?

A

As economic growth decreases, demand for loans also decreases causing an ease in inflation rates.

32
Q

2.32 - Why are economic indicators important?

A

Because research indicates that it may take up to two years for monetary policy to fully work through an economy meaning that forecasts well into the future are required.

33
Q

2.33 - What are the three main economic indicators?

A
  • Coincident indicator
  • Leading indicator
  • Lagging indicator
34
Q

2.34 - What is a coincident indicator?

A

It is an indicator where the economic variables change at the same time as the business cycle changes.

35
Q

2.35 - What is a leading indicator?

A

An indicator where the economic variables change before a change in the business cycle.

36
Q

2.36 - What is a lagging indicator?

A

An indicator where the economic variables change after the business cycle has changed.

37
Q

2.37 - What are the difficulties that exist with using economic indicators?

A
  • The extent of the timing lead or lag of indicators are often unknown
  • Indicators are not usually consistently performing.
38
Q

2.38 - What is the loanable funds (LF) approach to interest rate determination?

A

Uses loanable funds (which are those funds in the financial system for lending) and the assumption of a downward sloping demand and upward sloping supply diagram. This indicates that shifts in demand or supply will affect interest rates.

39
Q

2.39 - Why is the loanable funds (LF) approach the preferred way to explain and forecast interest rates?

A
  • Because it is preferred by financial market analysts

* It is conceptually a simplistic model.

40
Q

2.40 - What are the two sectors that have a net demand for loanable funds (LF) and why?

A
  • Business - to finance short term working capital and long term capital investment.
  • Government - to finance the deficit and intra-year liquidity.
    Demand for LF = G+B
41
Q

2.41 - How does the demand for business finance slope on a supply demand diagram?

A

Downwards, because all else being constant the lower the interest rate the greater the demand, therefore the slope is downward.

42
Q

2.42 - How is the demand for government finance slope on a supply demand diagram?

A

It is independent of the interest rate so is represented as a vertical line moving left or right unless the budget is in surplus and then the G line would disappear.

43
Q

2.43 - The supply of loanable funds (LF) comprises of what three principal sources?

A

1) savings from the household sector (S)
2) changes in the money supply
3) Dis-hoarding (D)

44
Q

2.44 - What is hoarding?

A

It is the proportion of total savings in the economy held as currency.

45
Q

2.45 - What is dis-hoarding and when does dis-hoarding occur?

A

It is when currency holdings decrease and occurs as interest rates rise and more securities are purchased for the higher yields available.

46
Q

2.46 - How is the slope of savings drawn on a supply demand diagram? and what about money supply?

A
  • Savings is upward as interest rates increase, people will save more.
  • Money supply is independent of interest rates so when added it simply moves the curve right.

Note: Dis-hoarding changes the slope of Savings + Money Supply to be more horizontal. So as interest rates increase more funds are made available in the financial system.

47
Q

2.47 - Describe the features of Loanable funds equilibrium?

A

It is temporary because the supply and demand curves are not independent.

  • The level of dis-hoarding will change
  • Money supply is unlikely to increase proportionately in subsequent periods
  • Business and government demands change.
48
Q

2.48 - What are two disturbances that could also impact interest rates?

A
  • Expected increases in economic activity

* Inflationary pressures

49
Q

2.49 - What is yield?

A

It is the total return on an investment, comprising interest received and any capital gain (or loss).

50
Q

2.50 - What is the yield curve?

A

A graph which depicts at a point in time, yields on identical securities with different terms to maturity.

51
Q

2.51 - What are the three different types of yield curve that could be seen and what do they show?

A
  • Normal / positive - longer term interest rates are higher than shorter term rates
  • Inverse / negative - longer term interest rates are less than shorter term rates
  • Humped - Shape of the yield curve changes over time from normal to inverse or vice versa.
52
Q

4.52 - The fact that the shape of a yield curve changes over time suggests that monetary policy interest rate changes are not the only factor affecting interest rates. There are three main theories, what are they?

A
  • Expectations theory
  • Market segmentation theory
  • Liquidity premium theory
53
Q

2.53 - What is expectations theory?

A

It explains the shape of a yield curve through current and future short-term interest rates. So it holds that longer term rates will be equal to the average of the short term rates over the period.

54
Q

2.54 - What assumptions is expectations theory built upon?

A
  • there is a large number of homogenous investors
  • no transaction costs or impediments to interest rates moving at their competitive equilibrium levels
  • that investors aim to maximise returns and view all bonds as perfect substitutes regardless of term to maturity
55
Q

2.55 - Expectations theory expects the yield curve to be inverse in what situation?

A

If the market expects future short term rates to be lower than current short-term rates.

56
Q

2.56 - What is segmented market theory?

A

This theory assumes that market participants will be motivated to reduce the risk of their portfolio by minimising exposure to fluctuations in prices and yields.

57
Q

2.57 - What two assumptions of expectations theory does segmented market theory reject?

A
  • that all bonds are perfect substitutes

* that investors are indifferent to holding investments for short or long term.

58
Q

2.58 - If the central bank was to increase the supply of Treasury bonds with 1 year maturity, how would segmented market theory suggest people will behave? and how is this different to what expectations theory would suggest?

A
  • Suggests short term yields would rise and long term yields would stay the same. Liquidity remains static but short term interest rates would expand and long term interest rates will contract.
  • Expectations theory suggests no effect on expectations about future short-term rates and therefore no effect on the economy.
59
Q

2.59 - The emphasis on the segmented markets theory on risk management denies the existence of investors seeking what?

A
  • arbitrage opportunities

* speculative profit

60
Q

2.60 - What does the liquidity premium theory assume?

A

Investors prefer shorter term instruments which have greater liquidity and less maturity and interest rate risk and therefore require compensation for investing longer term.

61
Q

2.61 - What does the ‘liquidity premium’ in the liquidity premium theory refer to?

A

The compensation due in terms of interest rate to compensate the investor for taking a longer term investment.

62
Q

2.62 - What is default risk and how does this affect the yield curve?

A

Default risk is the risk that the borrower (issuer) will fail to meet their payment obligations. The higher the risk the higher the interest rate required to entice investment.

63
Q

2.63 - How was interest rate risk viewed during the GFC?

A

It was important. As credit risks emerged during 2007 and 2008 interest rates rose sharply, which exposed borrowers to higher costs.

64
Q

2.64 - The identification and management of interest rate risk is important for firms and financial institutions. What are the two forms that interest rate risks take?

A
  • Reinvestment risk - impact of change in interest rates on a firm’s future cash flows
  • Price risk - impact of change in interest rates on the value of a firm’s assets and liabilities.
65
Q

2.65 - What is the relationship that exists between interest rates and security prices?

A

Inverse - where a rise in interest rates occurs, a fall in the value of the asset or liability will occur. Or vice versa.

Financial Markets 2014 (8 decks)

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