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Debt Securities (The short-term money market (Characteristics (Low default…
Debt Securities
The short-term money market
Securities= discount securities
Treasury notes
Commercial paper
Promissory notes
Short maturity <1 year
Do not pay a coupon, but return is earned, discount on face value
The price you pay is smaller than the amount you get back
Traded OTC
Features
Provision of short-term liquidity for the economy
Capital can be obtained quickly
Liquidity is essential through
Trade
Working capital management
Characteristics
Low default risk & transaction costs
Large denominations with standardised attributes
Short-term, standardised maturities
High marketability & deep pool of buyers and sellers
Cheaper than long-term market
The bond market
Securities= bonds
Maturity >1 year
Coupon
Make periodic interest payments
Traded OTC on public exchanges
Borrowing in the MM and Bond market is cheaper than the equivalent borrowing from a bank
Direct financing is cheaper than indirect financing
Allow corporates and governments to maturity match
Finance using debt securities
Are in effect borrowing money
Done by issuing then selling debt securitires
Upon sale, issuer receives capital from the buyer and agrees to pay the buyer a return over the life of the security
At the end, the issuer returns the capital to the holder of the security
Such debt securities are liabilities to the issuer
Financing through debt securities= direct finance
Borrowing money from bank= indirect finance
Debt securities Life cycle 1
Deficit unit
is called the issuer, organiser, seller of the debt security
Surplus unit
Is called the buyer or holder of the debt security
is lending money as an investment
Debt securities is an asset
Debt securities life cycle 2
After its creation and initial sale, the security could be sold to another holder and sold on multiple times till maturity
What determines the price the buyer of a debt security pays?
The intrinsic value of the security
The maturity of the security
The yield of the security
Understanding the relationship between YTM and bond prices
Affected by
risk-free rate of return Rf
inflation premium
Risk premium
Liquidity risk
YTM vs. Coupon Rate vs. Price
YTM= Coupon rate
The bond buyer requires a yield equal to what the interest earned provides.
YTM>Coupon Rate
The bond buyer requires a yield greater than what the interest earned provides
When YTM< Coupon rate
The bond buyer requires a yield smaller than what the interest earned provides
Why would a bond buyer willing to buy a lower yield?
The debt security is an auction market
YTM< Coupon rate and higher price paid > face value
Amongst multiple buyers for the same bond
Process for buying bonds is a competitive auction market
Face value
The money you get back when the security matures