Summary Actuarial Risk Management - Investments

CHAPTER 9 – BOND & MONEY MARKETS

CASH ON DEPOSIT:

● The term deposit will have the highest interest rate so that we compensate the depositor for
less flexibility of their funds when compared to the notice and call depositors.

● The borrower could pay the depositor interest at a fixed or variable rate but may need to
disclose possible changes.

TYPES OF CASH ON DEPOSIT:

CALL DEPOSITS

- The depositor has instant access to withdraw capital

NOTICE DEPOSITS

- The depositor must give a period of notice before withdrawal

TERM DEPOSITS

- The depositor doesn’t have access to the capital sum for a fixed term – i.e. until the
deposit matures

MONEY MARKETS:

MONEY MARKET INSTRUMENTS ARE:

- Highly liquid
- Short-term

TYPES OF MONEY MARKET INSTRUMENTS

● Treasury bills (government)

● commercial paper (corporates).

● Certificates of deposits

● Bills of exchange


KEY PLAYERS IN THE MONEY MARKET:

CLEARING BANKS:
- Clearing banks use MM to lend excess liquid funds and borrow when short-term funds
are needed.
- Act as an intermediary

CENTRAL BANKS:

, - The central banks act as lenders of the last resort to provide liquidity to the banking
sector.
- The central bank basically only operates in the MM by selling and purchasing of T-bills.
- Selling of treasury bills :
− Central bank will receive cash from money market
− Makes cash scarcer
− Drives interest rates up
- Buying back treasury bills:
− Increases cash supply in the market
− Drives interest rates down

UNDERSTANDING INVESTMENT & RISK CHARACTERISTICS OF CASH DEPOSITS AND
MM: [SYSTEM - T]

Security The level of security depends on the borrower (i.e. issues the instrument).
The government will be safer than a small company seeking investments.

Yield - The yield from cash on deposit will be approximately equal to the short-
term interest rate set by the authorities.

- Bills are usually issued at a discount and redeemed at face value and
provide nominal returns.

- Cash at deposit and MM tend to provide positive real returns (net of
inflation), because short term interest rates tend to be higher when
inflation is higher.

- Because MM and cash at deposit investments have a low risk of default,
they usually have lower returns than other investments.

Spread - MM and cash on deposit instruments are very short term and therefore
have little volatility.

- Call deposits have no volatility.

Term - Short-term in nature.

Expenses - There are fairly minimal expenses for cash at deposit and MM
investments.

Exchange - Currency risk = the risk of a fluctuation in foreign currency.
rate
- Cash on deposit and MM instruments can be bought at a wide variety of
currencies.

Marketabilit - Very marketable
y
- However usually traded through an interbank money market rather than

, an exchange market.

Tax - The return form MM and cash deposits is treated as income for tax
purposes.

- Income tax is usually more than capital gains tax.




Acronym for understanding the characteristics of any investment: {SYSTEM T}

» S –> security (default risk)
» Y –> yield (discuss both if yield is in real vs nominal terms and how returns compare
to other assets)
» S –> spread (volatility of the market)
» T –> term (short, medium, long)
» E –> expenses or exchange rate
» M –> marketability
» T –> tax

ATTRACTION OF CASH ON DEPOSIT & MONEY MARKET ACCOUNTS:


ARGUMENTS AGAINST HOLDING HIGH PROPORTION OF ASSETS AS CASH:

● Cash provides a low expected return

● It may not be easy to match liabilities using cash investments



ARGUMENTS FOR HOLDING CASH INVESTMENTS:

KNOWN SHORT-TERM COMMITMENTS

− cash investments match well to short-term liabilities

UNCERTAIN OUTGO

− institutions with a high degree of uncertainty in their liabilities book will hold a
minimum cash level to meet unexpected liability repayments

OPPORTUNITIES

− having a strong liquidity base will allow companies the ability to take
advantage of new investment opportunities as they arise

RECENT CASHFLOW

− Investor may have recently received a large cash inflow and will not
necessarily purchase assets immediately

, SOME INVESTORS ARE RISK AVERSE

− Have a larger proportion of investments in cash

ECONOMIC CIRCUMSTANCES THAT MAKE CASH AND MONEY MARKET INSTRUMENTS
ATTRACTIVE:

RISING INTEREST RATES

- higher interest the increases bond yields and makes fixed-interest bonds cheaper
- equity market also suffers a fall in market values due to increased interest rates
− higher interest rates depress economic activity, reducing companies’ profits

RECESSIONS

- investors hold cash because domestic markets are likely to do bad and will struggle to
make profits

DEPRECIATION IN DOMESTIC CURRENCY

- domestic currency depreciation will signal a drop in value for other investment types
which makes cash more attractive to hold and a depreciation in domestic currency is an
appreciation of foreign currency
- short term interest rates may be raised by government to defend currency
- Cash investment in a stronger currency could prove attractive , even if interest rates
abroad are lower

GENERAL ECONOMIC UNCERTAINTY

- Stability of cash values will make cash investment attractive to risk averse investors and
will be enhanced during periods of economic uncertainty.

BOND MARKETS:

TYPES:

● Fixed interest/ conventional bonds security – the return is fixed and based on a
predetermined interest rate.

● Index-linked bond security – the return is variable and based on a specific index (e.g.
inflation linked)



FIXED INTEREST (CONVENTIONAL) BONDS:

● Governments/ corporates raise money by issuing a bond.

● Nominal refers to the amount of a bond and is quoted on the bond certificate.

● Gross redemption yield – the return the investor expects to get for the bond if held to
redemption and ignore tax, expenses and default risk.

● The investor buys the bond.