(Topic 2) Money & Bond Markets Flashcards
The Money Market refers to the trading of short-term securities (maturity < 1 year). The instruments are held as part of bank reserves and can be used as collateral if banks need to raise funds from the CB. What are the instruments?
- Treasure bills
- Commercial paper
- Bankers’ acceptances
- Certificate of Deposit
- Eurocurrency Deposits
What are some Domestic Money Market Instruments?
- Treasury Bills (T-Bills)
- Commercial papers
- Banker’s acceptance
- Repo agreements
- Eurocurrency deposits
- Certificates of deposit (CDs)
T-Bills are issued by the treasury of the country concerned to finance national debt.
What are the characteristics of a Treasury Bill?
- Risk free (gov. guarantees to pay face value upon maturity)
- Highly liquid
- Discount securities (upon issue sold at discount to face value - size of discount a determinant of the yield on holding the T-Bill)
- Sold at discount to face value and makes no coupon payment
Yield (y) = (F-P/P)(365/t)100
What is the relationship between a T-Bill’s price and yield?
Inverse.
When purchasing price increases, yield will face, and vice-versa.
What are the ways that a T-Bill can be sold? (5)
- Public issue
- Tender issue
- Auction issue
- Direct placement
- Additional tranches of existing issues
What is Commercial Paper?
Unsecured promissory note issued by a company (with good credit ratings) into the money market - promising to pay to the purchases of the issue the face value of the paper which is sold at a discount on the market.
Usually less than 270 days of duration and typical maturity range is 30-60 days
What is the Interbank Money Market?
The market where commercial and investment banks as well as other non-bank financial intermediaries can lend and borrow money with each other.
It is predominantly a short-term market with most of the loans ranging from overnight to 14 days.
What is usually higher and more volatile, and why?
LIBOR or T-bills?
LIBOR is usually marginally higher and more volatile since all loans are unsecured.
What is a Banker’s Acceptance?
It facilitates a commercial trade transaction by having a bank’s guarantee for repaying the loan to the holder.
It can be traded on the secondary market at a discount of its face value.
What is a repo agreement?
The sale of a security with a commitment by the seller to repurchase the security at a specified price at a future date.
It is a collateralised loan with the seller handing over the security as collateral.
What is a certificate of deposit (CD)?
Usually issued by a bank to acknowledge that a specified sum of money has been deposited at the institution with a determined maturity and rate of interest.
What are some of the features of an international money market?
- A market in which borrowers and lenders of funds from different countries are brought together to exchange funds
- Consists of national currencies that are held on short-term deposit in countries other than the countries issue of the currency
What are Eurocurrency markets?
Banking markets which are conducted outside of the legal jurisdiction of the authorities of the currency that is used for banking transactions.
What is the Eurodollar?
A short term deposit or loan made in dollars outside the USA.
- Accounts for 65% of all Eurocurrency transactions
What are the features of the Eurodollar market?
- Majority of activity in London, Paris, Luxembourg and Frankfurt
- Lots of offshore banking centres
- Euro banks normally free of government regulation
- Pivotal rate of interest is LIBOR
What is the Dollar LIBOR ($LIBOR)?
- Short term interest rate on the dollar in Euromarket
- London Interbank Offered Rate
What is normally higher:
3-month $LIBOR or 3-month US Treasury Bill?
3-month $LIBOR
What is the value of the TED Spread?
3-month $LIBOR - 3-month US Treasury Bill
Treasury bill - Eurodollar spread
Why might the TED Spread increase?
- Funding has become more difficult in the interbank market
- Banks are becoming more distrustful of each other
What is the competitive advantage of Eurobanks? (Over US banks)
They have the ability to offer higher deposit rates and lower loan rates
What factors contribute to the competitive advantage of Eurobanks?
- They are free of regulation (+ have no minimum reserve requirements)
- Benefit from economies of scale
- Avoid much of the cost associated with domestic banking regulations (e.g. admin)
- Competition is greater than
In domestic banking, encouraging greater efficiency and competitive pricing - Do not have to pay deposit insurance
- Lending is almost exclusively to high quality customers (with low default risk)
What are the pros of Eurocurrency markets?
- Increases the range of facilities available to borrowers and lenders (domestically & internationally)
- Competitive interest rates
- Facilitates financial transfers between private economic agents (+ between countries, financing current accounts deficits with ease)
What are the drawbacks of Eurocurrency markets?
- Lack of regulation
- No access to lender of last resort
- High degree of interbank activity can lead to illegal activity
- Ticking time bomb underneath financial system
Within the bond market, fundamental forces determine the price of bonds issued by governments. Government bonds have ____ liquidity and ___ transaction costs relative to equities and corporate bonds.
High liquidity, low transaction costs
Government bonds provide a stream of regular income. ____ ____ and the ____ __ ____ equal to their face value.
Coupon payments and the payment upon maturity equal to their face value.
Pb = (CF1/1+r1)+(CF2/(1+r1)(1+r2))+…+(CFT/(1+r1)(1+r2)…(1+rT))
Government bonds are ___ risk assets.
The price of a financial asset should be determined by the ____ value of the asset’s expected cash flow.
Low risk
Present value
If the coupon (c) and yield (r) are constant,
Pb= Σ (c/(1+r)^t) + (M/(1+r)^T)
What does M, c, T, and t all stand for?
M = the value of the bond upon maturity c = the coupon T = the time to maturity t = interest rate
What observations can be made from the formula determining the price of a bond (Pb = f(c, M, r))?
- The bond price will be higher the greater the coupon (c) payment
- The bond price will be higher the greater the maturity value (M) of the bond
- The bond price will be higher the lower the interest rate (r)
- The bond price will be more volatile with IR change as maturity (T) of the bond increases
What is the simple yield (to maturity)?
It takes into account capital gains and losses on a bond. It assumes that the capital gain or loss on a bond occurs evenly over the remaining life of the bond.
What is the yield to maturity?
The rate of return on a bond expressed as a percentage per annum if its held until maturity. The completely yield measure since it takes into account the cash flows, the term to maturity, capital gain/loss and the fact that the received coupon can be reinvested to earn extra interest.
What is the par value relation?
Ratio of the current bond price to its maturity value (k=PB/M)
If:
- the ratio = 1, the bond is selling at “par”
- k>1 = “premium”
- k<1 = “discount”
Uncertainty contributes to bond price volatility, for example, interest rate uncertainty can lead to future bond price uncertainty. Bond prices (Pb) and interest rates (r) are ______ related.
However, the amount the Pb is affected by a change in r is affected by the ____ ___ ____ of the bond.
Inversely related, affected by the time to maturity of the bond.
What 2 factors deterring the price volatility of a bond?
- The coupon payments (-) [the lower the coupon, the greater volatility of price]
- Term to maturity (+) [the greater term to maturity, the greater the volatility]
There is a ______ _____ relationship between bond price and yield to maturity.
Negative convex relationship.
[the change in r has a more significant effect on prices of bonds with longer term to maturity]
The Macaulay Duration measures bond price volatility. Why do investors use it?
To calculate the risk of their investments and come up with appropriate investment strategies.
What are 2 important features of the Macaulay Duration?
- The duration is less than its term to maturity (D
What is the equation for the modified duration, and what does it measure?
Dmod = (D/1+y)
It measures the sensitivity of the price of a bond to changes in the rate of interest, measuring the slope of the price-yield curve.
The modified duration increases with 3 factors:
- The higher the term to maturity of the bond
- The lower the coupon payment
- The lower the initial yield
What risks are associated with corporate bonds?
- Common risk with treasury bonds (IR risk, reinvestment risk, inflation risk)
- Credit risk (default risk)
- Call risk (may exercise call provision - clause giving issuer of security right to redeem security prior to maturity)
- Event risk (unexpected event harms ability to repay debt)
What is a domestic bond?
A bond issued in the domestic currency by a domestic entity.
What is a foreign bond?
A bond issued in the domestic currency of a country by a foreign entity.
What is a Eurobond?
A bond that is sold by a domestic or foreign entity in a currency that is different from the country where the bond is issued, e.g. a dollar bond issued in London is a dollar denominated Eurobond.
What are the motivations behind International Capital Flows? (5)
- Trade financing motive (through borrowing)
- Borrowing or lending motive
- Speculative motive (profiting from changes)
- Hedging motive (avoid losses)
- Capital flight motive (protecting investor funds from tax, seizure by government, restrictions, or political risk)
What are the main incentives within the Eurobond market?
- Interest equalisation tax
- Withholding tax on foreign citizens that held US bonds
- Lower cost finance for well known companies
- Less stringent regulation/disclose requirements
- Financial innovation is crucial, enabling issuers to raise finance
