Money market instruments can be issued by (4)
- Government (treasury bills)
- Regional government bodies (local authority bills)
- Companies (bills of exchange, commercial paper)
- Banks (different types of deposit)
4 Types of bank deposits
- call deposits
- notice deposits
- term deposits
- certificates of deposit
Depositor has “instant access” to withdraw funds
Depositor has to give a period of notice before withdrawal
Depositor has no access to the capital sum earlier than the maturity of the deposit.
Certificates of deposit
- Tradable notes.
- Short term security issued by banks showing a stated amount of money has been deposited for a specified term and rate of interest.
- Interest payable on maturity
- Kind of like a tradeable term deposit
10 Investment and risk characteristics of money market instruments
- normally good security as term is very short, depends on the borrower though
- Return is through income
- Level of income has a loose, indirect link with inflation
- Lower expected returns than equities or bonds over the long term
- Stable market values
- Low dealing expenses
- Normally highly marketable
- Returns normally taxed as income
5 Participants in money markets
- Clearing banks
- Central banks
- Other financial institutions & non-financial companies
Clearing banks as a player in the money markets
Use money market instruments to lend excess liquid funds and to borrow when they need short-term funds
Central banks as a player in the money markets
Act as lenders of last resort,
stand ready to provide liquidity to the banking system when required, and who buy and sell bills to establish the level of short-term interest rates
Uses of Money Market Instruments (why do investors hold them?)
P - Protect market value O - Opportunities may occur, liquid U - Uncertain outgo/ liability R - Recently received cashflow S - Short-term liability
When are money market instruments attractive for institutions and investors?
G - general economic uncertainty.
R - start of recession (a fear that equity and bond prices will fall)
I- interest rates rising (might cause other asset values to fall)
D - the domestic currency to weaken (makes overseas cash holdings attractive. And it may be followed by rising interest rates)
Circumstances under which money market instruments would be temporarily unattractive
- flip the reasons for grid around
- General economic Certainty
- Expectations of falling interest rates
- The end of a recession / start of a boom
- Expectations of a strengthening domestic currency
- If the investor is not risk averse or not concerned with liquidity
Main risks for an institutional investor with all their assets in domestic money market instruments
- Cash instruments are short-term investments and hence there is a mismatch by term with the investor’s liabilities
- Means that the investor’s assets will have to be reinvested many times at currently unknown future interest rates (high level of reinvestment risk)
- Holding all assets in one type of investment results in a lack of diversification. Al the investments will be positively correlated, resulting in a concentration of risk
What does the term money markets cover? (2)
- Bank Deposits
- Short Term Securities
An alternative term for a fixed-interest or index-linked security.
Bonds are described by (2)
- type of organisation issuing the security, ex. government, local authority, corporate
- nature of the bond - fixed interest/index-linked
UK government bonds
Fixed-interest / conventional bond
Gives an income stream and final redemption proceeds that are fixed in monetary terms
Gives an income stream and final redemption proceeds that are linked to an inflation index.
3 Types of bond markets
- government bonds
- corporate bonds
- overseas government and corporate bonds
7 Investment and risk characteristics of conventional government bonds.
- very good security (if politically stable)
- yield (GRY) is fixed in nominal terms
- 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
- low dealing expenses
- highly marketable
3 Types of corporate bonds
- Unsecured loan stock
- Subordinated debt
Risk and investment characteristics of corporate bonds
Less: - secure - marketable - liquid than government bonds. Consequently, they generally offer a higher yield to investors.
4 Theories put forward to explain the shape of the yield curve
L - Liquidity preference theory
I - Inflation risk premium theory
M - Market segmentation theory
E - Expectations theory
Describes the shape of the yield curve is determined by economic factors, which drive the market’s EXPECTATIONS for future short-term interest rates
Liquidity preference theory
Investors require an additional yield on less liquid (longer-term) bonds.
Inflation risk premium theory
Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.
Market segmentation theory
Yields at each term are determined by supply and demand at that term.
Demand comes principally from institutional investors trying to match liabilities.
Real yield curve
Plot of real gross redemption yields on index-linked bonds against term to maturity.
Approximate market expectation of future inflation
Difference between the conventional yield curve and the real yield curve.