Menu
Home
Log in / Register
 
Home arrow Economics arrow Bond Math
< Prev   CONTENTS   Next >

CHAPTER 1 Money Market Interest Rates

An interest rate is a summary statistic about the cash flows on a debt security such as a loan or a bond. As a statistic, it is a number that we calculate. An objective of this chapter is to demonstrate that there are many ways to do this calculation. Like many statistics, an interest rate can be deceiving and misleading. Nevertheless, we need interest rates to make financial decisions about borrowing and lending money and about buying and selling securities. To avoid being deceived or misled, we need to understand how interest rates are calculated.

It is useful to divide the world of debt securities into short-term money markets and long-term bond markets. The former is the home of money market instruments such as Treasury bills, commercial paper, bankers acceptances, bank certificates of deposit, and overnight and term sale-repurchase agreements (called “repos”). The latter is where we find coupon-bearing notes and bonds that are issued by the Treasury, corporations, federal agencies, and municipalities. The key reference interest rate in the U.S. money market is 3-month LIBOR (the London Interbank offer rate); the benchmark bond yield is on 10-year Treasuries.

This chapter is on money market interest rates. Although the money market usually is defined as securities maturing in one year or less, much of the activity is in short-term instruments, from overnight out to six months. The typical motivation for both issuers and investors is cash management arising from the mismatch in the timing of revenues and expenses. Therefore, primary investor concerns are liquidity and safety. The instruments themselves are straightforward and entail just two cash flows, the purchase price and a known redemption amount at maturity.

Let's start with a practical money market investment problem. A fund manager has about $1 million to invest and needs to choose between two 6-month securities: (1) commercial paper (CP) quoted at 3.80% and (2) a bank certificate of deposit (CD) quoted at 3.90%. Assuming that the credit risks are the same and any differences in liquidity and taxation are immaterial, which investment offers the better rate of return, the CP at 3.80% or the CD at 3.90%? To the uninitiated, this must seem like a trick question – surely, 3.90% is higher than 3.80%. If we are correct in our assessment that the risks are the same, the CD appears to pick up an extra 10 basis points. The initiated know that first it is time for a bit of bond math.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Philosophy
Political science
Psychology
Religion
Sociology
Travel