Chap 5 Money Bond Markets

Money and Bond
Markets
GT 20903
Financial Markets and Institutions
1
Learning Objectives:
To describe the
To describe the
features of the key
purpose of money and
money market
bond markets
securities and bonds
To explain the To explain how money

valuation of money markets and bonds
market securities and have become globally
bonds integrated
2
1. What are Money Market Securities
• Short-term debt instruments that are used by issuers to

finance their short-term cash flow needs.
• These instruments typically have high liquidity and low risk,
and they generally mature in one year or less from their
issue date.
• They are considered a safe investment compared to stocks
or long-term bonds because of their short maturities and
strong credit quality.
3
1. What are Bonds?
• Bonds are long-term debt instruments issued by

corporations, governments, and other entities to finance
operations, projects, and expansion.
• Unlike money market securities, bonds usually have longer
maturities, ranging from one year to 30 years or more.
• Bonds pay periodic interest payments to investors, known as
coupon payments, and return the principal amount, also
known as the face value, at maturity.
4
2. Key Securities in the Money Market
• Treasury Bills (T-bills): Short-term government securities

issued at a discount from the face value and mature without
paying interest.
• Commercial Paper: Unsecured, short-term debt issued by
corporations.
• Certificates of Deposit (CDs): Time deposits with banks that
offer a fixed interest rate for a specified term.
• Banker's Acceptances: Short-term debt that is guaranteed
by a bank.
• Repurchase Agreements (Repos): Short-term borrowing for
dealers in government securities. The dealer sells the
government securities to investors on an overnight basis and
buys them back the following day
5
Money Market Yields (3-Month Maturity)
2. Key Securities in the Bond Market
• Government Bonds: Issued by national governments, often

considered the safest bonds because they are backed by the
government's power to tax.
• Corporate Bonds: Issued by companies. They are riskier than
government bonds and thus typically offer higher yields.
• Municipal Bonds: Issued by states, cities, or other local
government entities. These often provide tax-free interest
income for investors.
• Sovereign Bonds: Issued by a national government in a
foreign currency, often targeted to international investors.
7
Corporate Bond Interest Rates, 1973-2006
Debt
Rating
Return
8
3. Purpose of the Money Market
• Provides a mechanism for governments, corporations, and

other institutions to manage their short-term funding needs.
• Central banks often participate in money markets to
implement monetary policy.
9
3. Purpose of the Bond Market
• Facilitates long-term financing for governments and

corporations.
• Provides opportunities for income through interest
payments and potential capital gains.
• Provides options for managing various financial risks.
10
How do I make money in bonds?
11
4. How Money Markets Facilitate the Flow of Funds
Surplus Units Deficit Units

4. How Bond Markets Facilitate the Flow of Funds
Surplus Units Deficit Units
13
5. Valuation of
Money Market
Securities
14
Market Price of Money Market
Security (Pm)
• Pm = Par / (1 + k)n
Valuation of • where: Par = par value or principal
amount at maturity
Money Market • k = required rate of return by investors
Securities • n = time to maturity
Pm should equal the present

value of their future cash flows
15
Valuation of Money Market Securities
• A change in Pm can be modeled as

DP b = f (DR f , DRP)
where: Rf = risk free interest rate - -
RP = risk premium
• Risk premium a form of compensation for investors who

tolerate the extra risk - compared to that of a risk-free asset -
in a given investment.
16
Example:
• Assume investor requires a 5 percent
annualized return on a one-year
Valuation Treasury bill with a RM100,000 par
value. He will be willing to pay the
of Money price
Market • Pm = Par / (1 + k)n

Securities • Pm = 100,000 / (1 + 0.05)
= RM95,238
17
The price is determined as the present value of
the future cash flows to be received.
Valuation Since the Treasury bill does not pay interest,
of Money investors will pay a price for a one-year security

that will ensure that the amount they receive
one year later will generate the desired return.
Market If investor requires a return higher than 5
Securities percent, he will discount the par value at a
higher return rate.
- Example
[continued] This will result in a lower price to be paid today.
18
5. Valuation of
Bonds
19
How are Bonds Priced?
Current price of a bond (PV)
C C C + par
PV = + + ... +
(1 + k ) (1 + k )
1 2
(1 + k )n
C = coupon payment paid in each period

Par = par value/face value
k = required rate of return
n = number of period to maturity
• Example: Assume the following
information for an existing bond that
provides annual coupon payments:
i. Par value = $1,000
ii. Coupon rate = 4%
iii. Maturity = 4 years
iv. Yield to maturity = 4%
What is the present value of the bond?
YTM
Price
YTM
Price
Relationship between Coupon Rate,
Required Return, and Bond Price
1. Bonds selling at par
Ø If coupon rate equals the required rate, the

price of the bond is equal to par value
2. Bonds selling below par
Ø If coupon rate is below required rate, present value of the

bond is below par
Ø Known as a discount bonds

3. Bonds selling above par
Ø If the coupon rate is above the required rate, the price of the
bond is above the par
Ø known as a premium bond

6. Factors Affecting
Money Market Prices
26
Factors Affecting the Prices of Money
Market Securities
1. Factors That Affect the Risk-Free Rate
a. Inflationary Expectations (positive effect)
b. Economic Growth (positive effect)
c. Money Supply Growth (uncertain effect).
Ø An increase in the money supply could reduce interest
rates
Ø However, if investors expect that an increase in the
money supply will cause higher inflation, interest rates
will likely increase (theory of rational expectations)
(please refer to the topic: Central Banking and Monetary
Policy)
d. Federal Government Budget Deficit (positive effect)
Framework for Pricing Money Market Securities
Factors Affecting the Prices of Money
Market Securities
2. Factors That Affect the Credit (Default) Risk Premium
a. Economic Growth (negative effect). Strong economic
growth tends to improve a firm’s cash flows and
reduce the probability that the firm will default on its
bet payments and vice versa.
b. Changes in the Ratings over Time.
c. Impact of Issuer-Specific Characteristics (such as a
change in its capital structure) on Credit Risk
6. Factors Affecting
Bond Prices
30
Factors Affecting Bond Prices
1. Factors That Affect the Risk-Free Rate
a. Inflationary Expectations (positive effect)
b. Economic Growth (positive effect)
c. Money Supply Growth (uncertain effect).
Ø An increase in the money supply could reduce interest
rates
Ø However, if investors expect that an increase in the
money supply will cause higher inflation, interest rates
will likely increase (theory of rational expectations)
(please refer to the topic: Central Banking and
Monetary Policy)
d. Federal Government Budget Deficit (positive effect)
Factors Affecting Bond
Price Movements
Factors Affecting Bond Prices
2. Factors That Affect the Credit (Default) Risk

Premium
a. Economic Growth (negative effect). Strong
economic growth tends to improve a firm’s cash
flows and reduce the probability that the firm will
default on its bet payments and vice versa.
b. Changes in the Ratings over Time.
c. Impact of Issuer-Specific Characteristics (such as a
change in its capital structure) on Credit Risk.
Price Movements
Price Movements
Key Takeaways
the purpose of money and bond markets
the features of the key money market securities and bonds
the valuation of money market securities and bonds
factors affecting money market and bond prices
36
Next Lecture:
Stock Markets
37

Chap 5 Money Bond Markets

Uploaded by

Copyright:

Available Formats

Chap 5 Money Bond Markets

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chap 5 Money Bond Markets

Uploaded by

Copyright:

Available Formats

Money and Bond

To explain the To explain how money

• Short-term debt instruments that are used by issuers to

• Bonds are long-term debt instruments issued by

• Treasury Bills (T-bills): Short-term government securities

• Government Bonds: Issued by national governments, often

• Provides a mechanism for governments, corporations, and

• Facilitates long-term financing for governments and

Surplus Units Deficit Units

Surplus Units Deficit Units

Pm should equal the present

• A change in Pm can be modeled as

• Risk premium a form of compensation for investors who

Market • Pm = Par / (1 + k)n

Valuation Since the Treasury bill does not pay interest,

of Money investors will pay a price for a one-year security

Current price of a bond (PV)

C = coupon payment paid in each period

1. Bonds selling at par

Ø If coupon rate equals the required rate, the

2. Bonds selling below par

Ø If coupon rate is below required rate, present value of the

Ø Known as a discount bonds

3. Bonds selling above par

Ø known as a premium bond

2. Factors That Affect the Credit (Default) Risk

the purpose of money and bond markets

the features of the key money market securities and bonds

the valuation of money market securities and bonds

factors affecting money market and bond prices

You might also like