Chapter 9 Flashcards
(15 cards)
Types of cash on deposit instruments: (4)
- Call deposits depositor has instant access to withdraw funds
- Notice deposits - depositor has to give a period of notice before withdrawal
- Term deposits - depositors has no access to the capital sum earlier than the maturity of the deposit
- Interest rates on bank deposits may be fixed or variable over the term of investment
Types of money market instruments: (4)
- Treasury bills (issued by government)
- Local authority bills (issued by regional government bodies)
- Bills of exchange (issued by companies)
- Commercial paper (issued by companies)
The 3 main players in the money market
- Clearing banks - use money market instruments to lend excess liquid funds and borrow short term funds
- Central banks - lenders of last resort providing liquidity to the banking system, buy and sell bills to establish short term interest rates
- other financial institutions and non-financial companies - lend and borrow short term funds
Investment and risk characteristics of cash on deposit and money market instruments: (10)
- normally good security as term is very short but will depend on the borrower
- All return is through income (or capital gain that can be considered as income)
- level of income has a loose, indirect link wih inflation
- lower expected returns than equities or bonds over the long term
- stable market values
- short terms
- low dealing costs
- liquid
- highly marketable
- returns normally taxed as income
Reasons for holding cash on deposit and money market instruments:
- Preservation of nominal value of capital and risk aversion
- Recent cashflow
- Opportunities of investing can be taken advantage of
- Uncertain outgo
- Known short term commitments
- Institution has received funds which are awaiting investment i some other asset category
Economic circumstances i which cash and money market instruments are attractive: (REDS)
- Rising interest rates (fall in other asset values)
- general Economic uncertainty (risk aversion)
- Depreciation of domestic currency (which makes overseas cash holdings attractive)
- Start of an economic recession (with fear that equity and possibly bond prices will fall)
Types of bonds:
- Fixed interest bonds/conventional bonds
- gives income stream and final redemption proceeds that are fixed in monetary terms. - Corporate bonds
- gives income stream and final redemption proceeds that are fixed in monetary terms. - Index-linked bonds
-gives as income stream and final redemption proceeds that are linked to an inflation index.
Investment and risk characteristics of fixed-interest government bonds: (7)
▪ Very good security (in politically stable countries)
▪ Yield (gross redemption yield) is fixed in nominal terms.
* Nominal yield = risk-free real yield + expected inflation +
inflation risk premium.
▪ Lower expected returns than equities over the long term.
▪ Market values can be volatile especially for longer-term bonds.
▪ Mixture of terms: short, medium, long, undated (irredeemable)
▪ Low dealing costs.
▪ Highly marketable.
Characteristics of corporate bonds:
-less secure (depends on the company issuing them), less marketable, less liquid (since market values are more volatile/less predictable), higher gross redemption yield (compensates for the above especially if company has lower credit rating) than government bonds
- Investors would generally require a higher yield in order to hold them.
Outline the information and assumptions that are required in order to value an index-linked bond: (6)
- future inflation rates - measured by price index (used for indexing coupons and redemption payments)
- nominal values of the coupons and redemption payments
- the outstanding term of the index-linked bond
- The vale of the price index used to calculate the next coupon payment
- the time of the next coupon payment
- the yield used to discount the future cashflows
relative attractiveness of fixed-interest and index-linked bonds
- if the expected future inflation is lower than that implied by the difference between the nominal and real yields in the market will find fixed-interest bonds more attractive (Inflation-linked bonds are overpriced)
- Index linked bonds more attractive:
-the need to match real liabilities
-future inflation expected to be higher than expected
-investor expects the inflation risk premium to be higher than that currently predicted in the market
4 economic circumstances that tend to cause greater uncertainty over future expected inflation (index-linked bonds attractive):
- less government commitment
- loose monetary policy
- devaluation of the domestic currency
- rapid economic growth
What does the size of the inflation risk premium reflect?
o The inflation risk premium reflects the additional yield required by investors
with real liabilities for taking on the risk of uncertain future inflation.
o The size of the inflation risk premium is determined by:
▪ The degree of uncertainty about future inflation.
▪ The balance between the number of investors who require a fixed
return and investors who require a real return.
o If the inflation risk premium is ignored, the difference between nominal and
real yields gives an estimate of the market’s expectations for inflation.
What is a gross redemption yield (GRY)?
o This is the return an investor would expect to get on a bond if they held it until
redemption.
o This assumes that they could reinvest the coupons at exactly the same rate, it
ignores expenses, tax, and default risk.
o It can be defined as the yield that equates the price of the bond with the
discounted value of the interest and capital proceeds on the bond.
What is meant by a lag in the indexation?
o This refers to the use of an index from an earlier period when cashflows form an index-linked bond don’t relate to the inflation index at the time of payment, due to delays in calculating the index.
o There is effectively no inflation protection during the last months before bond
redemption (where the number of months equals the period of the lag).
o This means an investor is exposed to the erosion of the real value if inflation is
higher than expected during that period.
