PART 2.

PRINCIPLE OF PASSIVE MANAGEMENT AND ASSET PRICING

CHAP 5. MONEY MARKET SECURITIES
1. Introduction:
The money market allows financial institutions, corporations and individuals to meet their short-term
investing and borrowing requirements.
Money market securities are short-term in nature (less than 12 months).
Securities traded in the money market include:

 commercial bills
 promissory notes
 Treasury notes.
2. Money Market Securities:
A money market security is a security in which the issuer promises to repay to the investor the amount
borrowed (principal / face value) plus interest over a specified time.
Trading cash is equivalent to borrowing or lending.
Interest rates on money market instruments are quoted on a nominal annual basis.
It is also possible to invest in an overnight security in the money market.
Example: A 3.02% 7-day money market investment of $25m will pay interest of:
nominal rate per annum = 3.02%
interest rate for 7-days = 3.02 x (7/365)
= 0.0579178082191781%
interest amount = 25m x 7/365 x 3.02%
= $14 479.45.
Therefore, after 7-days, the $25m investment returns:
final payment = principal + interest
= $25m + $14 479.45
= $25 014 479.45.
3. Valuation of Money Market Securities:
The general valuation formula is:
THIS FORMULA FOR SHORT TERM DEBT ONLY:
 ( UK and Australia market) – Add on method
For US market: P =FV * (1 -y*d/360) – Discount method
P = price
FV = face value (or principal)
d = number of days to maturity
y = yield (nominal % per annum). – required return(r), y/100 = y% ( ->ko thực sự chia cho 100)
r = y * term
FOR LONG TERM DEBT:
P = FV/ (1 + r) ^ t
Holding Period Return:
– If a security is held for less than the time to maturity, the yield will generally differ from
the quoted yield to maturity.
– The holding period return provides a measure of the return of a security over the
investment period (rather than the life of the security).
= (FV – P) / P = HRt = ln (Pt / Pt-1)
Effective Annual Rate : EAR = (1+r)^ d/365 -1
When yield increase -> Price decreases ( same with other cases)
Sensitivity of money market security price to changes in yield:

 Elasticity measures the percentage change in security price given a 1% change in the yield.


Or E = %change in P/ % change in (1+yield)
dP/ P = (P1 – P0 )/ P0

d(1+y)/(1+y) = [(1+y1) – (1+y0)]/ (1+y0)

 dy
=
( [ 1+
90
365 )(
∗4 % − 1+
90
365
∗3.5 % ] )
1+ y 90
1+( ∗3.5 %)
365
E < 0 => Negative relationship
Even if not given Negative E -> automatically change to Negative E ( Negative relationship)
4. Risk attached to money market securities:
For money market securities the major risks are:
• Interest rate risk: (due to volatility of interest rate) -risk is the volatility and fluctuate in r
– is uncertainty as to the future value of the money market security
– is due to changes in yields.
• Default risk: likelihood bankruptcy of issuers
– Not so important for Treasury notes, which are government securities with little
likelihood of default.
– The risk of default can be significant when investing in corporate securities such as
promissory notes
 Use cherry bill or cherry bill for risk-free asset.
 High default risk -> high use
– Rating agencies such as Moody’s, Standard and Poor’s, and Dunn and Bradstreet provide
a service to investors by grading different types of debt.
 Moody’s provides short-term debt ratings where the short-term ratings refer to
the issuer’s ability to meet all short-term obligations.

 Inflation risk
o This risk relates to the underlying rate of inflation.

o The greater the rate of inflation, the smaller the real rate of return.

o Yields are quoted in nominal terms, but investors care about real rate of return.

 Hence, the larger the relative rate of inflation, for fixed nominal yield, the smaller
the real rate of return.
o Often called the Fisher effect, inflation risk is defined as follows:
 • Exchange rate risk: (Ex rate fluctuate -> adverse effects)
– is relevant for foreign securities (e.g. Eurocurrencies).
• Marketability or liquidity risk ( cannot covert )
– is caused by thin trading
– liquidity premium may be built into price.

5. Estimating Yield Curve:

Yield curve is the relationship between yield and time to maturity.
– It is assumed that securities differ only in terms of their time to maturity.
– If the yield curve and the time to maturity is known for a money market security, the
security yield can be read from an appropriate yield curve.
– The yield curve is used for pricing bonds not currently traded.

• Non-linear model : (this is economical technique)

– where:
• a1, a2, a3, a4 = parameters to be estimated (by NLLS)
• tj = time to maturity of the zero-coupon security
• exp(.) = exponential function
• y(tj) = nominal yield per annum.
6. Theories of term structure:
These theories provide an explanation for the shape and predictive power of the yield curve.
The four basic theories of the term structure are:

 the expectations theory

 liquidity premium
  segmentation
 preferred habitat.
a. The expectations theory:
Longer term rates are simply combinations of shorter term rates.
Investors are hence indifferent between holding long and short-term securities.

1R2 mean that the interest rate at 2nd period from what we have at the end of 1st period
1+ R2=¿ ¿ or

1+ E ¿
0R1: shorter term rate observed now

0R2: longer term rate observed now

1R2: long term rate observed next period

• where aRb is the yield observed at time a with maturity at time b
• where a>0, this indicates a future yield.
Ex: Expectation for year 3:

0 1 2 3
R year 0-1 :3%
R year 0-2 : 4%
R year 0-3 : 5%
R 2-3 ? => dùng 0-2 và 0-3 để tìm 2-3 => fill in the gap
¿)^2 = (1+5%)*(1+1R2)
b. The liquidity premium
 Investors are compensated for holding a security that does not match the investors preferred
investment horizon.
 It is assumed that most investors prefer short-term to longer-term investments.

 (1+ 0R2) = (1+ 0R1)(1+E(1R2)(1+1lp2))

 where 1lp2 is the liquidity premium (lp) required to attract an investor over the second
period, rather than just the first period.
c. Segmentation
o Short rate is not related to the long rate in any direct manner as these rates are assumed to be set in
different markets subject to different supply and demand effects.
o The implicit forward rate is not necessarily equal to the expected spot rate.
 Market can be divided for sub market ( long and short term interest rate)-> NO relationship between
long and short term rate, as they depend on suppliers.
d. Preferred habitat
 Premium (PR) is required to attract investors away from their preferred investment term.
 The implicit forward rate is not necessarily equal to the expected spot rate.