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.
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.
