Duration and Interest-Rate RiskDuration is a useful concept to measure interest-rate risk,because it provides a good approximation, particularly when interest-rate changes are small.ΔP = (Pt+1– Pt) = change in price of the security.The greater the duration of a security, the greater the percentage change in the market value of a security for a given change in interest rates. Therefore, the greater the duration of a security, the greater the interest-rate risk. Because the multiplier (DUR) has a stronger effect.Nominal vs. Real Interest RatesUntil now we have talked about interest rates not taking in consideration inflation, we need to distinguish between nominal and real interest rates.So, we have: inominal= ir+ πe-------------------> ireal= in- πeChapter 11THE MONEY MARKETS DEFINEDMoney markets are called in this way, not because real money is traded here, but because the securities that do trade there are short-term and highly liquid. Money markets securities have three basic characteristics in common:-They are sold in large denominations-They have low default risk-They mature in one year or lessfrom the issue dateMoney markets instruments are generally used to fill short-term financial need (supply side) or to temporally “warehouse” surplus funds (demand side). Traders usually arrange purchases over-the-counter,
over the phone and complete them electronically. Because of this they have an attractive secondary market. Money markets are wholesale markets,this means that most transactions are above $1 million.In addition, in situations where the asymmetric information problem is not severe, the money market have a distinct cost advantage over banks in providing short-term funds.Money Markets Cost AdvantagesAfter the Great Depression, a lot of banking regulations came up (1930s); the aim was to reduce competition between banks.-Glass-Steagall Act 1933: - No interest on checking accounts- Interest rate ceilings on savings depositsWhen money market interest exceeded the deposit rate ceiling, money markets became very attractive. Though, interest rate ceilings were abandoned in 1986. Nevertheless money markets enjoy a cost advantages over banks.THE PURPOSE OF THE MONEY MARKETSThe goal of most investors in the money markets who are temporarily warehousing funds is to use the money markets as an interim investment that provides a higher return than holding money in banks. The money markets provide a means to invest idle funds (represent an opportunity cost in terms of lost interest income) to reduce this opportunity cost.Also, most investment funds and financial intermediaries also hold money market securities to meet investment or deposit outflows.PARTECIPANTS IN THE MONEY MARKETSU.S. TreasuryIt is always a demander of money and never a supplier. It issues T-Bills and other types of securities. This short-term issues enable the government to raise funds until the tax revenues are received.