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Brailsford3eSM_Ch05 - Chapter 5 Money market securities...

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Copyright © 2006 Nelson Australia Pty Limited Chapter 5 Money market securities Learning objectives After the completion of this chapter, you should be able to: understand the relationship between interest rates and money market security prices value money market securities estimate holding period returns identify the major risks faced when investing in money market securities understand how the yield curve is estimated list and discuss the main term structure theories understand a simple approach to estimating the effect of changes in interest rates on price. Key points 1 Money-market securities are priced using simple-interest formula. Hence, there is an inverse relationship between yield and time to maturity. 2 Risks of money market securities include interest rate risk, default risk, exchange rate risk and liquidity risk. 3 Future interest rates are related to current rates via the term structure. Chapter outline 5.1 Introduction 1 Money market allows institutions and individuals to meet short-term borrowing and lending requirements. 2 Securities traded have maturities less than 12 months and include commercial bills, promissory notes and treasury notes. 5.2 Money market securities 1 Money market securities are priced using simple interest. 5.3 The valuation of money market securities 1 Elasticity measures changes in price due to changes in yield. 2 Changes in security price are due to movement in time to maturity and in yields. 3 Returns for money market securities not held to maturity are known as holding (period) return. 5.4 Risks attached to money market securities 1 Risks of money market securities include interest rate risk, default risk, inflation risk and liquidity risk.
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2 Investments: Concepts and Applications Solutions Manual Copyright © 2006 Nelson Australia Pty Limited 2 Foreign issued money market securities may also face exchange rate risk and foreign interest rate risk. 5.5 Estimating the yield curve 1 Yield curve captures relationship between yield and time to maturity. 2 Common models used to estimate yield curve include non-linear, quadratic approximation and piece-wise linear. 5.6 Theories of the term structure 1 Term structure theories provide explanation for observed shape of yield curve. 2 Four basic theories include; expectations theory, liquidity premium, segmentation and preferred habitat. 5.7 A model of interest rates 1 Simplest model of interest rates assumes a one factor model. 2 Interest rate changes due to drift and stochastic Weiner process. Solutions to text problems Problems and applications 1 Money market securities involve an initial cash flow from the buyer (lender) to the seller (borrower) with repayment of the loan, including interest at maturity. These might be discount bonds where the face value of the bond is paid at maturity or bullet bonds where the face value plus interest is paid at maturity. The zero coupon bond is probably one of the simplest forms of debt traded in the Australian money market. Other examples include commercial bills, treasury notes and promissory notes.
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