Chapter 9 - Bond and Money Markets

Question 1

Money market instruments can be issued by:

Answer 1

Government (treasury bills)
Regional government bodies (local authority bills)
Companies (bills of exchange, commercial paper)
Banks (different types of deposit)
Money market instruments are highly liquid and short term.

Question 2

3 types of cash on deposits

Answer 2

call deposits
notice deposits
term deposits

Question 2

Define a Call deposit

Answer 2

Depositor has “instant access” to withdraw funds.

Question 2

Define a Notice deposits

Answer 2

Depositor has to give a period of notice before withdrawel

Question 2

Define a Term deposit

Answer 2

Depositor has no access to the capiral sum earlier than the maturity of the deposit

Question 2

10 investment and risk characteristics of money market instruments

Answer 2

Security: good as term is very short, depends on the borrower though
Yield (real vs nominal): return is through income, level of income has a loose, indirect link with inflation. Positive real return
Yield (expected return relative to other assets): Lower expected returns than equities or bonds over the long term (lower risk of default)
Spread: stable market values (short term)
Term: short-term
Expenses: low dealing expenses
Exchange rate: currency risk, currency movements very difficult to predict.
Marketability: normally highly marketable but unquoted. Traded through an interbank
Tax: Returns usually taxed as income
Liquid

Question 3

Who are the key players in the money market

Answer 3

Clearing banks
Central banks

Question 4

Central banks as a player in the money markets

Answer 4

Act as lender 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.

Question 4

Clearing banks as a player in the money markets

Answer 4

Use money market instruments to lend excess liquid funds and to borrow when they need short-term funds

Question 5

Uses of Money Market Instruments (why do investors hold them?)

Answer 5

POURS
* Protect market value
* Opportunities may occur, liquid
* Uncertain outgo / liability
* Recently received cashflow
* Short-term liability

Question 7

When are money market instruments attractive for institutions and investors?

Answer 7

GRID
* General economic uncertainty (risk-averse investors)
* Recession (a fear that equity and bond prices will fall).
* Interest rates rising will depress bond, equity markets
* Domestic currency to weaken (makes overseas cash holdings attractive and it may be followed by rising interest rates)

Question 8

Circumstances under which money market instruments would be temporarily unattractive

Answer 8

Flip the reasons for grid around
* General economic certainty
* End of a recession / start of a boom
* Expectations of falling interest rates
* Expectations of a strengthening domestic currency
* If the investor is not risk averse or concerend with liquidity

Question 9

Bonds are described by

Answer 9

type of organisation issuing the seccurity, e.g. government, local authority, corporate
nature of the bond- fixed interest / index-linked

Question 10

3 Types of bond markets

Answer 10

market ingovernment bonds. listed in country of origin
market in corporate bonds, listed in country of origin
market in overseas government and corporate bonds, listed in country of origin

Question 11

Investment and risk characteristics of conventional government bonds

Answer 11

Security: very good (if politically stable)
Yield (real vs nominal): fixed in nominal terms, uncertain in real terms (inflation)
Yield (expected return relative to other assets): lower expected returns than equities over the long term. (Hold when GRY is falling, buy when high)
Spread: Market values can be volatile, especially for longer-term bonds
Term: mixture of terms, short, medium, long, undated
Expenses: low dealing costs
Exchange rate: currency risk. Risk for investor who is investing in bonds denominated in one currency but who has liabilities denominated in another.
Marketability: High, Investors can deal in large quantities with little impact on price
Tax: Income and capital gains. Pension funds may be exempt from tax on bonds

Question 12

3 Types of corporate bonds

Answer 12

Depentures
Unsecured loan stock
Subordinated debt

Question 13

Risk and investment characteristics of corporate bonds

Answer 13

Less:
* secure (depends on type of debt security considered, issuing company, term)
* marketable (size of issue is smaller)
* liquid (more volatile)
than government bonds
Consequently, they generally offer a higher yield to investors.

Question 14

Outline 3 situations when index linked bonds will appear relatively more attractive to an investor than conventional bonds

Answer 14

When the investor needs to match real liabilities and hence requires inflation protection

When the investor expects the future inflation to be higher than that currently predicted in the market

When the investor expects the inflation risk premum to be higher than that currently predicted in the market

Question 15

Under what circumstance would an investor find conventional bonds attractive

Answer 15

1. If there is a reduction in the expected inflation or a smaller inflation risk premium
2. If the investors expectation of future inflation is lower than the difference between the nominal yield and the real yield

Question 15

Factors leading to more uncertainty about future inflation

Answer 15

1. Lower commitment to reducing inflation by the government
2. Loose monetary policy
3. Depreciating domestic currency
4. Rapid economic growth

Question 16

Write down an equation stating the link between nominal yields and real yields

Answer 16

Nominal Yield = Risk-free real yield + Expected future inflation + inflation risk premium