week 7

Money market maturity

Maturity <1

Bond market maturity

Maturity >1

Money market types of instruments

Commercial papers

NCDs

T-bills or T-note

Repo

Bond market types of instruments

Corporate bonds.

T-bonds

Money market Main role

• Providing a way for economic units to undertake liquidity management.

• allowing economic units to manage the mismatches that occur between cash payments and cash receipts and thereby solve their liquidity problems

Bond market Main role

Allows corporates and governments to maturity match by funding long-term assets with long-term liabilities

Money market Market participants

• Commercial banks

• The RBA with T-note

• The Commonwealth government with T-note

• Corporations

Bond market Market participants

• Issuer: Commonwealth and state governments and corporates

• Buyers: mainly individuals and households

Bond ratings

the future risk potential of the bonds. low rating company, high risk, high interest rate

Three prominent bond rating agencies

Standard & Poor’s, Moody’s, and Fitch Investor Services.

Standard & Poor’s corporate bond ratings

AAA, AA, A, BBB, BB, B, CCC, CC, C, D

Lower bond rating indicates

higher probability of default. It also means that the rate of return demanded by the capital markets will be higher on such bonds.

inverse relationship between bond value and interest rate (market yield)

As the coupon payments are fixed, if interest rate (or market yield) increases, investors would prefer to pay less for the bond to achieve the higher rate of return, vice versa. If the coupon rate equals the interest rate, investors would pay the face value of the bond.  As the market yield falls in the previous part, hence the price of bond increases

Suppose the credit risk of Misun Company unexpectedly increased. Holding other factors constant, how would this change affect the Required Rate of Return and the Internal Rate of Return of this project? Explain briefly

·      The required rate of return will increase (0.5 marks). Creditors would require a higher return due to the higher possibility of the company failing to pay back what they have borrowed (0.5 marks).

·      Shareholders would also require a higher return due to the increased risk as larger amounts of interest are committed to being paid to creditors (0.5 marks).

·      No change to IRR (0.5 marks). IRR is determined only by the cash flows of the project. It is not affected by the cost of the capital (1 mark)