Lecture 3 - Money and Bond Markets

Question 1

List all the UK Money Market Securities.

Answer 1

Treasury Bills, Commercial Paper, Certificates of Deposit and Interbank Market.

Question 2

List all the US Money Market Securities.

Answer 2

Treasury Bills, Certificates of Deposit, Commercial Paper, Eurodollars, Banker’s Acceptances, Brokers’ Calls and Repos.

Question 3

List all the Bond Market Securities.

Answer 3

The gilt edged securities, Treasury notes or bonds, federal agency bonds, municipal bonds, corporate bonds and asset backed bonds.

Question 4

What is the Money Market?

Answer 4

Includes short term, highly liquid and relatively low risk debt instruments.

Question 5

What is the role of money market instruments for short term financing?

Answer 5

Cash generator - return surplus funds to investors via a dividend.
Cash consumer - firms will look to borrow short term.

Question 6

Risk due to interest fluctuations…

Answer 6

Increases with maturity.

Question 7

Therefore, very short term securities…

Answer 7

Have almost no interest rate risk.

Question 8

Most money market securities are also highly marketable or liquid meaning that…

Answer 8

It is easy and cheap to sell the asset for cash.

This property is an attractive feature of securities used as temporary investments until cash is needed.

Question 9

What are Treasury bills?

Answer 9

Short term zero coupon marketable government debt, sold via discount houses to financial institutions. The discount house ‘discounts’ the bills: pays the issuer (the government) a sum less than the face value. The discount provides the rate of return. They have maturities of 4 weeks, 3, 6, or 12 months and are the safest and most liquid money market instrument.

Question 10

Who are Treasury bills used by?

Answer 10

The Bank of England as one possible monetary policy instrument. Commercial banks to offset daily fluctuations in balances. Discounts houses as finance for their lending activities.

Question 11

What is the interbank market?

Answer 11

Market in unsecured lending between banks with maturities from overnight to 3 months.

Question 12

What are certificates of deposit?

Answer 12

Time deposits at banks that cannot be withdrawn on demand. The bank pays interest and principal only at the maturity of the deposit. Short term CDs with maturities less than 3 months are actively traded, so a firm can easily sell the security if it needs cash.

Question 13

What is commercial paper?

Answer 13

Short term unsecured debt issued by large corporations. As there is no active traded, it has high marketability. Therefore, it would not be an appropriate investment for a firm that could not hold it until maturity.

Question 14

What is bankers’ acceptances?

Answer 14

Written demand that has been accepted by a bank to pay a given sum at a future date.

Question 15

What are eurodollars?

Answer 15

Dollar denominated time deposits of usually less than 6 months in foreign banks or foreign branches of US banks.

Question 16

What are Brokers’ calls?

Answer 16

Short term borrowing by brokers (usually for client margin accounts) from banks, repayable on call. Individuals may borrow on margin a part of the funds they use to buy their securities from their broker. The broker, in turn, may borrow funds from a bank (with an agreement to repay the bank immediately on call).

Question 17

What are repurchase agreements (repos)?

Answer 17

Short term sales of securities with an agreement to repurchase the securities at a higher price. They are in effect collateralised loans. A government bond dealer sells Treasury securities to an investor, with an agreement to repurchase them at a later date at a higher price. The increase in price serves as implicit interest, so the investor in effect is lending money to the dealer, first giving money to the dealer and later getting it back with interest. The bill serves as collateral for the loan: if the dealer fails, and cannot buy the bill back, the investor can keep it. They usually are very short term, with maturities of only a few days.

Question 18

As money market instruments do not pay interest, the return is…

Answer 18

The difference between the amount you pay and the amount you receive at maturity.

Question 19

When calculating the yield on money market instruments note that the return is always higher than the quoted discount because…

Answer 19

You pay less than face value when you buy the bond.

Question 20

What are bonds?

Answer 20

These are known as fixed interest securities and are claims on a specified periodic stream of cash flows.

Question 21

What is the bond market?

Answer 21

Governments and corporations borrow money by selling bonds to investors. When they issue bonds, they promise to make a series of interest payments and then to repay the debt. Most trading takes place over the counter.

Question 22

What is the face value, also known as principal or par value?

Answer 22

Payment at the maturity of the bond.

Question 23

What is a coupon?

Answer 23

The interest payments made to the bondholder.

Question 24

What is the coupon rate?

Answer 24

The annual interest payments to the bondholder, as a percentage of the face value.

Question 25

What are zero coupon bonds?

Answer 25

Pays no coupons, sells at discount, provides only payment of par value at maturity.

Question 26

What are coupon paying bonds?

Answer 26

Claim to the face value at some (maturity) date in the future, plus a regular (often semi annual) sequence of "interest" or coupon payment.

Question 27

What is the gilt edged market?

Answer 27

The UK government bond market. These are redeemable fixed interest securities issued by, or guaranteed, by the British government, on which are paid semi annual interest.

Question 28

What is the difference between Treasury notes and Treasury bonds?

Answer 28

Treasury notes are issued with maturities ranging up to 10 years, while bonds are issued with maturities ranging from 10 to 30 years.

Question 29

What are the similarities between Treasury notes and Treasury bills?

Answer 29

Both pay semi annual interest payments called coupon payments.

Question 30

What are corporate bonds?

Answer 30

Long term debt issued by private corporations typically paying semi annual coupons and returning the face value of the bond at maturity.

Question 31

What is default risk, also called credit risk?

Answer 31

The risk that a bond issuer may default on its bonds.

Question 32

What is default premium?

Answer 32

Companies need to compensate for default risk by promising a higher rate of interest on their bonds. The difference between the promised yield on a corporate bond and the yield on a US Treasury bond with the same coupon and maturity is a default premium.

Question 33

The greater the chance that the company will get into trouble...

Answer 33

The higher the default premium demanded by investors.

Question 34

What is investment grade?

Answer 34

Bonds rated Baa and above by Moody's or BBB or above by Standard & Poor's or Fitch.

Question 35

What are junk bonds?

Answer 35

Bonds rated below Baa or BBB.

Question 36

What are the three ways you can be protected against default risk?

Answer 36

Seniority - Some debts are subordinated. This is a debt owed to an unsecured creditor that in the event of a liquidation can only be paid after the claims of secured creditors have been met. Senior creditors are paid first and once they are satisfied the subordinated lender, holding a junior claim, is paid. Security - For example, mortgage acts as security for a house loan. If you default on the loan payments, the lender can seize your home. Companies may set aside some assets as security for the loan. These assets are termed collateral and the debt is said to be secured. In the event of default, the secured lender has first claim on the collateral but has the same claim as other lenders on the rest of the firm's assets. Protective Covenants - conditions imposed on borrowers to protect lenders from unreasonable risks. Companies that borrow in moderation are less likely to get into difficulties than those that have lots of debt. Hence why lenders usually restrict the amount of extra debt that the firm can issue.

Question 37

What are mortgage backed securities?

Answer 37

They are investments that are secured by mortgages. They are a type of asset-backed security. Instead of borrowing money directly, companies sometimes bundle a group of loans and sell the cash flows from these loans. Companies do not have to wait until loans are paid off; it can get its money now by selling mortgage pass through certificates backed by mortgage loans. The holders of these certificates are buying a share of the payments made by the underlying pool of mortgages. Instead of issuing one class of pass through certificates, companies have issued several different classes of security, known as collateralised debt obligations.

Question 38

What is the repo rate?

Answer 38

The interest rate implied by the difference between sale price and repurchase price of the security.

Question 39

What are special repos?

Answer 39

Repos of specified stock.