Chapter 5 Tutorial solutions

Q-7: Identify some of the common characteristics

of money market securities observed in the
market place.
Answer: Money market securities relate to the short-term trading of
cash. That is, money market securities mature in 12 months time or
less. These securities are pure-discount securities as they involve only
a single cash flow at maturity. Those who trade in the money market
can deal both in cash and in money market securities. It is important to
note that cash is treated like any other commodity in this market and
so a trader who needs cash for some purpose will be buying cash. This
is equivalent to borrowing money. A trader who is selling cash is
actually lending money because they give an agreed amount of money
to another trader in the market on the promise that the initial amount
plus interest will be returned at an agreed future time.

Q-8: List and explain the risks that a money

market security investor assumes.
Answer: The major risks associated with money market securities are
interest rate risk, default risk, inflation risk, foreign exchange risk and
marketability risk. Interest rate risk relates to the uncertainty as to the
future value of the money market security. This is caused by changes in
yields. Default risk can be significant when investing in corporate
securities (such as promissory notes), but tends to be less of a concern
for government issued securities (e.g. Treasury notes). Inflation risk is
caused by the fact that yields are quoted in nominal terms, but
investors may be more concerned about the real rate of return on an
investment. All else equal, the greater the rate of expected inflation is,
the smaller the real rate of return. Exchange rate risk pertains to
foreign securities (e.g. Eurocurrencies). Finally, there is marketability or
liquidity risk. This is caused by thin trading and can result in a liquidity
premium being built into the price of the security.

Q-12: Lists the four main terms structure theories and

explain their impact on the predictive power of yield
curve.
The four basic theories of the term structure are the expectations
theory, the liquidity premium theory, the segmentation theory and
the preferred habitat theory. These theories are concerned with the
1

relationship found between yield and time to maturity for assets,

identical in all but time to maturity.

The Expectations Theory suggests that longer maturity yields

are a function of the current yield and expected future yields. In
this theory the expected future yields are unbiased predictors of
realised future yields. Investors are assumed to care only about
the expected return from the security. For example under this
theory the yield on a six-month bill could be equated with a
series of two consecutive three-month investments. Thus the sixmonth yield prediction for a period 12 months hence is:
(1+12y18)

(1+0y18) / (1+0y12)

The second theory includes an adjustment for risk and is

called the Liquidity Premium Theory. In this theory an
additional term is added to compensate a short-term investor for
holding a security with a term to maturity that does not match
the investors preferred investment horizon. In this theory it is
assumed the majority of investors require the shorter term bonds
and thus the longer term yields exhibit a liquidity premium, which
tends to increase the longer the time to maturity. In this case a
premium is required to encourage investors to buy the 18-month
bond instead of the 12-month bond and so the forecast requires
an estimate of the liquidity premium (LP):
(1+12y18)

(1+0y18) / [(1+0y12) x (1+LP)]

In effect, the liquidity premium drives a wedge between the short

rates and the long rates, providing one reason for the failure of
the expectations theory to adequately explain or predict future
interest yields.

The segmented market theory is consistent with the observed

concentration of investors in particular segments of the term
structure. Risk aversion results in market participants only
operating at that position on the yield curve that most suits their
business needs. This grouping of participants could lead to quite
separate markets operating at different positions on the yield
curve with substantial risk premiums required to encourage
participants to move out of their optimal segment of the market.
The use of the yield curve for forecasting purposes is limited in
this model as expected future yields may bear little resemblance
to the relationship between currently observed yields suggested
by the expectations hypothesis.

The final theory is the preferred habitat theory. In this

theory participants match asset life and liability life to establish
the lowest possible risk position. Substantial premiums may be
required to encourage participants to invest in other than the
preferred habitat and so risk premiums would tend to be greatest
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where demand is least. This theory is similar to the liquidity

premium theory but it allows both positive and negative
premiums to exist rather than the positive premium predicted by
the liquidity premium theory. The premium is set by supply and
demand in particular interest rate habitats. If there is borrowing
pressure (lenders selling bonds) the rates will rise (prices will
fall). If there is investing pressure (investors buying bonds) the
rates will fall (prices will rise). Again, predictive power of the term
structure is under some doubt with this theory.

Q-15: The current price of a just-issued 13-week Treasury

$100,000. What is the yield on the note?

Answer: The current price of a 13-week Treasury note is $98 000 with a
face value of $100 000. What is the yield on the note? (There are 91
days to maturity (13 x 7).)
yield

=
=
=

((face value / price) 1) x 365/91

((100 000 / 98 000) 1) x 365/91
0.08186 or 8.19%

Research indicates the possibility of interest

rates rising by 20 basis points in the next few
minutes. What profit is earned per $100 000 for
a 90-day bank accepted bill assuming the
current yield on these bills is 7.5%?

Q-16

Q-16 Answer:
As the yield is expected to rise the price is expected to fall. Thus
to earn a profit on this information it would be necessary to either
short sell bills or sell bills already held with a view buying back at
the lower price after rates adjust

current price is $98 184.26 with a 20-point increase the yield

increases from 7.5% to 7.7% (0.0750 + 0.0020) which gives a price
(after the 20 point change in yield) of $98 136.75. hence, the fall in
price is $47.51
This is the profit, before transaction costs, obtained from the short
sale or the sale of currently held bills and repurchase of bills after
the information release.

Question
17:

A $100,000 90-day bill with a yield of 8% is purchased now

Assuming the term structure is flat at 8%, and does not c
life of the security, in 30 days' time the price
of the bill:
(a) is
unchanged
(b) increases
(c) decreases
(d) cannot be determined with the available
information.
Answer 17:

a Is unchanged. FALSE. The price must change

because the time to maturity has changed and so

the interest rate to maturity has also changed.

b Increases. TRUE. As the time to maturity has

decreased and the term structure is flat at 8% then
the yield to maturity must have decreased and so
the price must increase.

Price now
maturity is 90 days)
Price in 30 days
maturity is 60 days)
Price increase

$98 065.56

(time

to

$98 702.00

(time

to

$636.44

c Decreases. FALSE. Yield to maturity has not

increased with the fall in time to maturity.
d Cannot be determined with the available
information. FALSE. Sufficient information is
available.