FMI week 6 Fixed income market
Money market
Purpose
borrowing or investing for short periods
adjust their liquidity positions
Characteristics
No interim payments(coupons)
minimal credit risks
Trade over the counter(OTC) with large sizes.
Instruments
Treasury notes
issued by AOFM use to finance commonwealth government
No coupon payment
Short maturity
no default risk, referred as risk-free rate in asset valuation
Venue: can be traded in both primary and secondary markets
Bank Bill Swap Rate(BBSW)
short term money market benchmark interest rate to price floating rate loans
Bank accepted bill: a draft that borrower promises payment to lender at future date guaranteed by bank.
Negotiable Certificate of Deposits(Negotiable CDs): short term notes issued by banks to investors.
Both can be traded on secondary market
Repurchase agreement(Repo)
an agreement to sell security(collateral) and promised to buy back to the buyer at a predetermined price in the future
margin reflects default probability
essentially a short term collaterlized loan
Commercial paper
corporation issued short term unsecured zero-coupon borrowing/
sold at discount.
less liquid than T-notes
Bond market
Long term borrowing
Government and corporations borrow from individuals and households
Instruments
Treasury Bonds
long term government issued to fund expenditure
long term maturity 5-15 years
risk free, backed by commonwealth government
coupon payment, interim semi-annual payment
typically as collateral in repo
Treasury Index Bonds(TIBs)
similar with government bonds but cash flow changes with inflation rate and coupons are paid quarterly
yield provides direct measure of real interest rate
corporation bonds
help corporations to borrow to fund investments and match maturity date with economic life of the project
typically issued in $1000
Foreign bonds
Eurobond: issued in different currency of home country
Offshore bond:issued outside of the home country but denominated in home country currency. such as Kangaroo bonds issued by foreign entities in AU with AUD
Sovereign bond: debt issued by national government within a given country and denominated in a foreign currency
Purpose
Diverse currency base
gain foreign market
Bond pricing
T notes calculation
T bonds calculation
Bond risks and risk management
Promised yield(YTM): return earned if borrower makes all cash payments, interest rate does not change over time and investor hold until maturity
Realized yield(RY): cash flow actually received and coupon reinvested at new ytm.
Interest rate risk: risk related to changes in interest rate that cause a bond's RY different from YTM.
Price risks: increase in interest rate led to capital losses which cause RY decreases.
Reinvestment risks: increase interest rate lead to higher reinvestment return on coupon payments leads to RY to raise
two risks partially offset each other
Default risks: possibility that a borrower fail to pay back some or all interest/principle as promised.
use Duration to mitigate
Duration gap: difference between duration of assets and liabilities
if positive duration: Dasset > Dliability, interest raise result greater loss of value for assets than liability, if fall vice versa.
if negative duration: Dasset< Dliability, interest raise liability lose more value than assets, if fall vice versa.
duration matching to mitigate interest rate risks
Market risks: losses arising from movements from market
operational risks: losses due to inadequate internal process
Bond rating signals default risk of a bond issuer.
Liquidity/marketability risk: cost and quickness with which investors can resell a securities.
Term Structure of Interest rate
The yield curve
Term structure model
Bond pricing model: early work using one factor short rate model, later use multifactor models
Yield curve and business cycle
a graph shows relationship between yield and term to maturity
time to maturity as horizontal axis, yield to maturity as vertical axis
theory that tries to explain the yield curve, and make prediction about its behaviour
Expectation theory: yield curve determined by investors expectations of future interest rate.
Liquidity Premium theory: investors are averse to uncertainty about future interest rate, so compensated with low long term bond prices(higher yield).
Market segmentation/preferred habitant theory: long term and short term bonds are not substitutes.
Normal yield curve: long term yield> short term
Steep yield curve: long term >> short term
Flat yield curve: long term = short term
inverted yield curve: long term< short term
inverted yield curve may predict US recession, but not for AU due to its long term is driven by US long term and domestic consideration.