Money and the Capital Markets

Question 1 – the key differences between the money and the capital markets are:

· Liquidity – money markets are more liquid, because

· Length of transactions – money market transactions are mostly short (or very short) term, unlike capital markets

· Access – only banks, governments and very large corporations access the money market, making it

· Security – a very safe market

In terms of the reasons for accessing the money market, then all participants can go in as listed and explained on page 118 of H&B. These participants are:

· Lenders and borrowers

· Brokers

· Issuing houses

· Market-makers

· Arbitrageurs

· Speculators

· Hedgers

Question 2 – PH&B for money market instruments issued at a discount and on a yield basis

When an instrument is issued on a yield basis, the initial amount transferred is the face value of the instrument and the repayment is made for the face value plus the interest. When an instrument is issued on a discount basis, the initial amount transacted is the face value minus the discount and at redemption the amount exchanged is the face value.

As an example of a quoted 5% and assuming a face value of £1,000. This makes the redemption value of the CD equal to £1,050 and the issue amount of the treasury bill equal to £950.

As such the return of the CD will be (1,050 – 1,000) / 1,000 = 5%, while the return of the treasury bill will be (1,000 – 950) / 950 approx.= 5.263%

This is what will always happen, i.e. the instrument issued at a discount will offer a higher return if the quoted rate is the same

Question 3 – In order to address this question, we need to understand that the impact is not a “direct one, as we are discussing long term interest rates and Commercial paper is a short-term instrument.

Companies issue a mix of short and long-term debt, depending on their investment needs and the type of assets they own, but that mix is flexible. As such, if there is a sentiment in the market that long term interest rates are likely to be going down, companies will be shifting some of the debt they need to issue from long to short term. Considering the issuers of debt instruments are the ones making it available in the market, i.e. the supply side, we should see an increase in the supply of commercial paper.

Question 4 – A large sale of Government bonds increases the supply of low-risk instruments for investors, which is likely to reduce the demand for money market instruments, as investors have a safer alternative for their available funds.

As for the first part of the question, the answer is a little trickier, as it depends on the current situation in the market. While logic indicates that increasing the supply of financial instruments allows investors a more diverse range of investment alternatives, thus leading them to invest more resulting in an increase in liquidity, there is the danger that, if the market is already very liquid, this large issue will divert funds from other investments thus commitment significant cash resources to these bonds resulting in a reduction in liquidity in the market.

Question 5 – H&B for a more detailed discussion of central bank’s implementation of monetary policy and its impact on the money markets. The key instruments are:

· Setting of interest rates

· Lending via “discount window”

· Open market operations

· Repurchase agreements