Chapter 9 - Bond and Money Markets

Question 1

Money market instruments can be issued by (4)

Answer 1

• Government (treasury bills)
• Regional government bodies (local authority bills)
• Companies (bills of exchange, commercial paper)
• Banks (different types of deposit)

Question 2

4 Types of bank deposits

Answer 2

• call deposits
• notice deposits
• term deposits
• certificates of deposit

Question 3

Call deposits

Answer 3

Depositor has “instant access” to withdraw funds

Question 4

Notice deposits

Answer 4

Depositor has to give a period of notice before withdrawal

Question 5

Term deposits

Answer 5

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

Question 6

Certificates of deposit

Answer 6

• 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

Question 7

10 Investment and risk characteristics of money market instruments

Answer 7

• 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
• Short-term
• Low dealing expenses
• Liquid
• Normally highly marketable
• Returns normally taxed as income

(Apply SYSTEM T)

Question 8

5 Participants in money markets

Answer 8

• Clearing banks
• Central banks
• Other financial institutions & non-financial companies
• Companies
• Individuals

Question 9

Clearing banks as a player in the money markets

Answer 9

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

Question 10

Central banks as a player in the money markets

Answer 10

• 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

Question 11

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

Answer 11

P - Protect market value
O - Opportunities may occur (strong liquid base needed to partake in inc opportunities).
U - Uncertain outgo/ liability (GI companies)
R - Recently received cashflow
R - Risk aversion and preservation of nominal capital value
S - Short-term liability

Question 12

When are money market instruments attractive for institutions and investors?

Answer 12

G - general economic uncertainty. (stability of capital values are attractive to risk-averse investors)

R - start of recession (a fear that equity and bond prices [due to increased gvmt borrowing to finance deficits] will fall)

I- interest rates rising (might cause other asset values to fall - less economic activity and reduced company profits)

D - the domestic currency to weaken (makes overseas cash holdings attractive - hedges against local currency weakness. Gvmt may raise short-term interest rates to defend domestic currency).

Question 13

Circumstances under which money market instruments would be temporarily unattractive

Answer 13

!! 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

Question 14

Main risks for an institutional investor with all their assets in domestic money market instruments

Answer 14

• 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

Question 15

What does the term money markets cover? (2)

Answer 15

• Bank Deposits

- Short Term Securities

Question 16

SYSTEM T

Answer 16

Security (default risk)
Yield (real or nominal; expected return)
Spread (volatility of market values)
Term 
Expenses & Exchange Rate
Marketability & Liquidity
Tax

Question 17

Tools/Roles of Central Banks (in implementation of objectives)

Answer 17

• Manage liquidity and interest rates (i.e. money supply). Monetary Policies/”MM Operations”:
  > Set (overnight) repo rate and use repo and reverse repo arrangements
  > Sale and purchase of treasury bills (and possibly other instruments)
  > Commercial bank reserve requirements (‘reserve ratio’)
  > Printing money and quantitative easing
• Lender of last resort to maintain well-functioning banking system
• General oversight of financial sector (solvency etc)
• Management of currency stability and custodian of foreign reserves
• Manage GDP/unemployment (through monetary policy)

Question 18

Policy Objectives of Central Banks

Answer 18

• Inflation (Types: Demand-pull / Cost-push)
• Economic growth
• Exchange rate; implement foreign exchange laws
• Stability of the financial sector

Question 19

“bond”

Answer 19

An alternative term for a fixed-interest or index-linked security.

Question 20

Bonds are described by (2)

Answer 20

• type of organisation issuing the security, ex. government, local authority, corporate
• nature of the bond - fixed interest/index-linked

Question 21

“gilts”

Answer 21

UK government bonds

Question 22

Fixed-interest / conventional bond

Answer 22

Gives an income stream and final redemption proceeds that are fixed in monetary terms

Question 23

Index-linked bond

Answer 23

Gives an income stream and final redemption proceeds that are linked to an inflation index.

Question 24

3 Types of bond markets

Answer 24

• government bonds
• corporate bonds
• overseas government and corporate bonds

Question 25

7 Investment and risk characteristics of conventional government bonds.

Answer 25

- very good security (if politically stable) - yield (GRY) is fixed in nominal terms - lower expected returns than equities over the long term, but is expected to be more than money market instruments (if reinvested at GRY) - market values can be volatile, especially for longer-term bonds - due to demand/supply. Volatility might be problematic if liability needs to be met or solvency adequacy needs to be met). - mixture of terms: short, medium, long, undated (greater than 1 year; can be up to 30 or 40 years) - low dealing expenses & overseas bonds can be used to match foreign currency liabilities. - highly marketable - Individuals taxed on income and on capital returns. Institutional Investor pay uniform rate on total return (income + capital gains). (SYSTEM T)

Question 26

3 Types of corporate bonds

Answer 26

- Debentures - Unsecured loan stock - Subordinated debt

Question 27

Risk and investment characteristics of corporate bonds

Answer 27

``` Less: - secure - marketable - liquid than government bonds. Consequently, they generally offer a higher yield to investors. ```

Question 28

4 Theories put forward to explain the shape of the yield curve

Answer 28

L - Liquidity preference theory I - Inflation risk premium theory M - Market segmentation theory E - Expectations theory

Question 29

Approximate market expectation of future inflation

Answer 29

Difference between the conventional yield curve and the real yield curve.

Question 30

Gross Redemption Yield (in terms of governments bonds)

Answer 30

GRY is the IRR that is earned given the price paid and cashflows received… …but need to consider: reinvestment rates, defaults, whether held to maturity. GRY is in practice the starting point for determining price (=PV of expected CFs)… …GRY needs to be the return required by investors holding the bond to maturity… …GRY = risk free real rate + expected inflation + inflation risk premium

Question 31

``` Nominal Yield ("risky bond") Real vs Nominal Yield Relationship ```

Answer 31

Nominal GRY (required return) = Risk-free real yield + expected future inflation + bond risk premium Where bond risk premium = inflation risk premium + default / credit risk premium + marketability / illiquidity premium The size of this yield margin depends on both the security and marketability of the debt. Low security and marketability will lead to a large margin, whereas a large secure issue will trade at a small yield margin to the closest equivalent government bond

Question 32

Assessing Credit Risk for a Bond

Answer 32

- Income Cover - Operational Profit (bf interest, tax) / interest of loan and prior ranking loans - Capital Cover - Assets (excl intangibles and less current liabilities) / amount of loan and prior ranking loans - Ratings (which reflect some probability of default) - Bond terms (incl seniority, covenants, term to maturity)