Authorised Deposit-Taking Institutions PDF

Module 3 Authorised Deposit-Taking Institutions Part A. Introduction to Intermediation E.g. banks and play a big role in financial system. What is Intermediation? Intermediation or indirect financing is where financial institutions (mostly banks) acquire funds from surplus units, mainly as deposits...

Module 3 Authorised Deposit-Taking Institutions Part A. Introduction to Intermediation E.g. banks and play a big role in financial system. What is Intermediation? Intermediation or indirect financing is where financial institutions (mostly banks) acquire funds from surplus units, mainly as deposits and make loans to deficit units. ADIs are the only instructions authorised to undertake banking business We refer to all ADIs as banks, including credit unions and building societies ADIs facilitate the flow of funds between surplus and deficit units rather than directly through an exchange Benefits of Intermediation Banks manage mismatch of preferences between surplus and deficit They transform; - Many small deposit balances into fewer larger loans - Short term deposits into long-term loans - Deficit unit risk into risk that is acceptable by depositors - Returns that are acceptable by surplus to borrowing costs acceptable by deficit Banks face challenge of balancing demand for depositing to demand of loans Banks manage balance sheets by adjusting interest rates offering a range of deposits and loan products and managing liquidity and funding risk Banks earn a spread between interest rate they charge borrowers and rate they pay depositors Bank Balance Sheet Banks face a maturity mismatch between their assets (mostly long term loans) and liabilities (mostly short term deposits or securities) Maturity Mismatch Maturity Mismatch; Loans may have long time period whereas deposits at have a short time period. E.g. mortgages (loans) vs deposits (short term deposits and individual would make through a banking app which can be withdrawn quickly) - Banks need to match maturity dates of assets and liabilities as best they can - They need to ensure sufficient funds are available to meet short term obligations like deposit withdrawals, whilst also earning enough incomes from larger assets to cover costs Maturity mismatch poses two risks; - A liquidity risk of not having sufficient funds to withdraw - A funding risk of not being able to rollover maturing sources of funds. - As bank hold long term assets but have mainly short term deposits, they are vulnerable to a change in market conditions such as interest rates, which can effect their ability to obtain funding - E.g: loan money for 5%, pay 3% on deposits, have guaranteed income of 2% - If interest rates increase 6%, these deposits have to keep track of int rate - As loan rates are fixed, banks are paying a higher int rate on deposits and are receiving low interest. Rates on loan made. - This means banks are left with funding shortfall. Net Interest Income Bank earns net interest income: The interest received on bank assets minus the interest paid on bank liabilities - Can be expressed as a margin (or spread). The difference between the average interest rate earned and the average interest rate paid by banks on their funds. - Margin of the major banks has declined over period 1999 to 2022] - Bank fees (such as accounting servicing fees) also form part of the cost of intermediation. Net income represent the net revenue a bank makes on it’s interest earning activities, after deducting the interest paid on it’s funding services. Net Interest Income helps evaluate the profitability of a bank, and can indicate that a bank is effectively managing their funding and income sources. - Investors are looking for strong or weak net interest income. - If strong banks are effective at managing, - If weak they aren’t managing well and suggests challenges of liquidity, credit risk and interest rate risk. Primary driver of bank earnings Deposits in bank are used to finance the mortgages. - Banks pay interest on deposits and earn interest on loans. Interest income can be affected by interest rate changes, changes in credit quality of borrowers and shift in demand for loans and deposits. From 2000 to 2022, domestic banks’ major banks’ net interest margin, have decreased since 2000 mainly due to; 1 Low interest rates over last 20 years - Interest rates have increased in last year. Worldwide too due to global financial crisis in 1980 - As interest rates were low, this led to lower yields on loans and investments for banks whilst rates paid on deposits and other funding sources have remained relatively stable. - Low interest rate environment will have a low interest rate margin too 2 Competition - Banking industry has become increasingly competitive with new entrants - Big 4, fintech companies, online banks that have challenge traditional banks for market share - Put pressure on banks to lower int. Rates to attract and keep new and current customers 3 Regulatory Changes in Response to GFC - In response to GFC, regulators have implemented stricter capital and liquidity requirements for banks - Regulators require banks have to keep certain amount of capital in reserve incase investors or depositors would want money back. - Banks have thus shifted their funding sources to more expensive, less flexible forms of funding such as long term debt and equity 4 Changing Customer Preferences - Customers increasingly demanded more convenient and accessible banking services like global banking and digital payments - Banks have had to invest in technology and infrastructure to meet demands - Has put pressure in NIM Australia’s Banking System APRA (Australian Prudential Regulatory Authority) places ADIs into one of five subgroups; 1 Australian Owned ADIs; - Big Four who are financial conglomerates; Commonwealth, WBC, NAB, ANZ - Others including MQB 2 Foreign Subsidiary Banks; - Provide retail banking services - Oversees but have subsidiary in Australia - APRA allows you to do retail banking (individual households and clients) if you have a Subsidiary - E.g. ING, HSBC, Rabobank 3 Branches of Foreign Banks; - Provide investment banking services for business clients (importer/exporter that facilitates foreign transactions) - E.g. BNP, Paribas, Deutsche Bank 4 Restricted ADIs; - Operating under Limited Services like probation period - Banks or newly listed banks that operate and would eventually become possibly complete Australian owned ADIs. - E.g. Avenue Bank 5 Provides of Purchased Payment Facilities; - Facilitate payments - Not a strict bank, don’t borrow money or invest - e.g. PayPal APRA oversees and regulates finance banks and other financial institutions in Australia APRA promotes safety and soundness of financial system by setting prudential standards- setting standards the ensure financial instructions comply with them. Part B. The Sources of Bank Funding (Equity & Liabilities) Bank Balance Sheet Sources of Funding (Liabilities and Equity) owed money. Where they get their money from sources of funding - Retail deposits - Financial Markets - ST Debt - NCDs - LT Debt - Bonds - Securitisation - Equity In Aus Currently, most banks get only from domestic deposits, households, companies that keep money at bank as deposit. Then ST Debt, LT Debt, Equity, Securitisation and Term Funding Facilities. - Prior to GFC, major source of bank funding was the financing markets (ST Debt + LT Debt = financial markets) - Now fallen to around 28% as of mid 2022 The crisis in these markets caused banks to change their funding sources and domestic retail deposits are now seen as more reliable source of funding - Now around 60% as of mid 2022 - Banks paid higher interest rates to attract more deposits. E.g. banks have higher savings rates for savers, depositors to attract Banks rely more now on retail deposits Banks pay higher interest rates to attract more deposits Retail Deposits All bank accounts are; 1 Very safe; Risk taking by banks is constrained by APRA prudential supervision. Deposits up to $250K are insured by government. Increases stability and attractiveness - Banks play major role in stability of financial systems. Match deposits with surplus and deficit units and this is the governments guarantee that this system will be sustained long term. 2 Liquid; All deposits can be withdrawn by depositor 3 Pay Interest; and/or provide non cash benefits such as payment services. Fixed term and some savings accounts serve an investment purpose - 25% of SMSFs assets are bank deposits Defensive investments, meaning low interest and return and capital stability Attitudes to deposits changed as a result of heavy losses during GFC and by intro in 2008 of Aus Gov guarantee of deposits up to $250K Financial Markets Debt markets both domestic and overseas, are divided into short term and long term securities. Banks borrow from financial markets to; - Diversify their funding sources beyond deposits - Extend maturity of liabilities - Raise additional funds that can be lent out Funding decisions will be influenced by relative cost of funds, reliability of funding sources and regulatory requirements. Major banks tend not to borrow a lot of equity Major banks have ability to borrow offshore as they have higher credit rating than smaller domestic banks - Seen as too big to fail - Raise large amounts and so achieve economics of scale in relation to their issuing of costs This gives them a funding advantage over smaller competitors Short Term Debt ST Debt securities are usually unsecured promises by issuer to pay face value on maturity - No Interest payment, int embedded into face value. - Lender pays less to borrower and borrower pays more to include interest, risk at the end. - FV - PV = Interest Main ST Security issues by banks domestically is negotiable certificates of deposits (NCDs) such as treasury bills. Main offshore source is commercial paper, mostly in US dollars Banks rely less on ST markets since GFC to reduce their funding risk Negotiable Certificate of Deposit - A wholesale deposit ($5 mill or more) that has a fixed term with an agreed interest rate that can be traded in the money market. - It is effectively a promissory note where bank promises to repay the deposit with interest on the maturity date - NCDs cannot be withdrawn before maturity, but can be traded in the money market to provide the depositor with liquidity (can trade for cash) - Negotiable as they can be bought or sold in secondary market before they mature. - Higher interst rates than traditional savings rates with maturity from days to years with majority under a year. - Bought by institutional investors such as company and financial institutions - Not often traded by individual households. Long Term Debt Bond is a long term security where borrower makes regular interest repayments to their holder and pay face value upon maturity Banks issue domestic and offshore bonds Usually large amounts with terms of four to six years Most are unsecured though banks also issue smaller amounts of covered, hybrid and asset-backed bonds. Securitisation Residential Mortgage Backed Securities (RMBS or MBS) Issued through securitisation which is the process of assigning cash flows form illiquid assets (holding loans) to securities (MBS) that are sold to investors. Banks pol together their assets in forms of the mortgages they have and sell it through mortgage backed securities. Enables ADI to sell large bundle of their existing housing loans Securitisation is conducted by special purpose vehicles (SPVs) who issue mortgage backed securities. The loans become property of investors in the MBS - They receive most of the borrower’s repayments. Equity Equity comprises proceeds from he issue of shares and retained earnings, it is considered a permanent source of funds, given it doesn’t repay Shareholders require higher returns than debt holders given they face greater risk - Major banks ROE around 12-15% Equity strengthens a bank’s financial positions, protects debt holders including depositors and as such, APRA enforces minimum capital requirements. Part C: The Use of Funds Uses of Funds (assets) - Securities - Housing Loans - Other Loans; Household Loans & Business Loans Securities APRA requires 20% of bank assets to be held as cash and liquid securities - Include money market securities, government bonds, notes and coins, ES funds and loans to the overnight market. - Reason; store of liquidity (to help manage outflows), to trade in markets, to earn income on low risk/return investments. Housing Loans As of June 2022, - Loans to owner occupiers were 65% of housing loans - Most have a reducible structure (meaning loan is repaid over term) - Can have a range of optional features such as redraw facilities and mortgage offset accounts - Remaining 34% are investment loans (to help investor purchase property for rent) - Interest only loan has continued to fall overall (13.9% in 2021) however, represents 19% of new loans. Interest Only Loan; borrower’s repayments interest only and do not reduce principal - Borrower may intend to rollover loan at maturity or repay it by selling the property Return to the Investor; The net rental income (after all costs, including interest) and maybe capital gains or losses, form the change in the property’s value. When property’s net rental income is negative, the loss can be offset against other income in a practice known as negative gearing Negative Gearing; investor buys property and rents the property to receive rental income. If rental income is less than interest on loan and other expenses such as maintenance and management fees exceeds the rental income, then there would be a negative net rental income, less than cost of property - Investor can claim loss against taxable income which can reduce overall tax liability. - Controversial as wealthier society now get tax advantage. - Investor is making ST loss but relying on overall LT cost. Prudent Lending Standards (APRA) Other countries have poor lending practices and we don’t have this as APRA has prudent lending standards APRA guidelines to ensure banks maintain responsible lending practices National Consumer Credit Protection Act (NCCPA) APRA has authority to oversee and regulate lenders to ensure they’re acting in best interest of customers and financial system APRAs lending standards require lenders (banks) and banks have to assess Borrower’s ability to repay loan. This assessment is based on 1. Income 2. Expenses and 3.Other Financial Commitments Banks must verify income and expenses and including verifying payslips Ensures repayment capacity Can;t rely on theory of value increasing due to GFC Bank looks as borrowers ability to repay loan such as expenses; credit, school expenses Stress testing to assess ability to meet loan repayment in event of changes in financial situation e.g. job loss These standards are set to ensure loans are suitable for borrowers Housing Loans (Continued) Most widely used indicator of ousting interest rates is a lender’s standard variable rate (SVR) - SVR; is a type of interest rate charged on mortgages that fluctuates over time based on changes in the banks; base rate or market conditions - Most borrowers receive discounts which mean they pay less than the SVR e.g. SVR + 2% or SVR - 1% - Anything between 5-8% in Aus Important indication of lending quality is proportion of non-performing loans (Where borrowers are 90days or more behind on payments) - These have been low for decades ( 11 274 86-18088. , $1 , 274 86. Effective Interest Rate on Retail Deposits Y in reffective -) > - 0 06183 or. - periods - = ~ 1/2 C7 (nom-rate -rateloper , pl (A) , period) , , e 6 18%. NCDs Bank of China (Aus) Limited; Subsidiary of Bank of China. Does this in order to accept deposits - Can only accept deposits in Australia if there is an Australian subsidiary of the overseas company. - Bank of China Limited may only be conducting wholesale or banking business in Australia. - Bank of China Aus accepts retail deposits Term deposit investment is fixed NCD is a deposit for a fixed term but is negotiable meaning you can sell it in a secondary market. NCD = Simple interest Part C: The Use of Funds What are the 3 Main Purposes of Banks’ Holding of Securities? As a store of liquidity (to assist in managing the maturity mismatch between deposits and loans) As an inventory of securities to trade (in their role as dealers) As low-risk interest earning investments What is the Difference in Approaches of Banks When Lending to Small as Opposed to Large Business? When lending to small businesses, banks offer loans that are standardised in terms of the loan and application process and usually seek to secure the loan with a mortgage over the borrower’s property. Loans to large businesses, are arranged on a case by case basis, with an interest rate partially determined by the risk of the loan. The lender will generally seek security, though this may be in the form of a covenant or a negative pledge. Part A - Introduction to Intermediation 1. Intermediation 2. Benefits of Intermediation 3. Bank balance intro to assets and liabilities and identification of maturity mismatch 4. Net interest income - How banks make their money - Smaller spread = bank is better capable of managing their finances - Decrease in NII earned from GFC - Regulation of amount of cash kept on hand/liquid - Decrease in interest rates to remain competitive - Lower interest rates due to GFC - Changing customer preferences cause banks to invest in new infrastructure like more online services 5. Australian Banking Services/Types 1-5 Part B - Sources of Bank Funding 1. Bank Balance Sheet - Equities & Liabilities; - Retail Deposits - Financial markets - ST Debt - LT Debt - Securitisation - Illiquid assets sold to investors as mortgage backed loans. - Equity Part C - The Use of Funds 1. Bank Balance Sheet - Assets - Securities - Housing Loans - Other Loans; - Household Loans - Business Loans - Secure - Unsecured Calculations Calculation of Interest on Retail Deposits Compound interest basis; - FV = PV(1+r/n)^t/n -$10 PV r HN 0 = 06/365. 2(365) : FV 000 , 6% - (1 738 = %) = 10000 - $11, 274 86. 73. Int earned 11 = 274 86-10000. , $1 - 274 86. , Effective Interest Rate on Retail Deposits Annual or nominal rate is the amount quoted by the bank however as this compounds throughout the year, the effective rate is higher. - Reffective = ( F/P )^ (1/t) - 1 reffective -[(** )" -1) Using previous example FX = PV- t 86. 10000 2 = : 11 , 274 reflective 1486 : 0 86183 Or ~. PV ↑ = t - FV 1000 = 0 : -. 05/365 3(365) 1096 10. 1000 (1" b) $1 161 82 = , reflective :. (*) "t -I 16183) -. ~ 6 8512). : 5 13 %. 6 18 %. Negotiable Certificates of Deposit - NCDs Money market transactions use Simple interest - FV = PV(1+(r x days/days in year)) PV ↑ $10 , 000 000 : , 0 844 = F x. $10 - * , / 1 10 + x 9 5)) 188 493 15 ,. this to surplus as pays bank maturity. x60365 0 845 =. P) 10188493 150 =. (0 045 It. $10 ~ , x Hs) 034 267 87 ,. earned interest of : They have 1+ 10034267 87 -16008006 =. $34 267 07 - , p 844 10 , 188 , 493 15 = r F. When an NCD is sold, its price (P) is calculated as - PV = FV / (1 + (r x days/day in year )) F : 98/365 10000000 =. $1 , 000 , 000 : 0 = PV BUY : Pey-. 06 F (48/365) 1800000 (1 + 0 06 +. 000000 , interest earned $985 = 933) $990 - s : 485 , 421 77. = $4 817 15. , - , DV)) (r = + 421 17. , 233 32. 990133. 32 + try)) Housing Loans In a reducible loan, the loan payments, which form an annuity are calculated as; PMT (coupon) regular & loan amount ↑ PV * 6 :. n(t) R PMT 1) / 600000 = r = = 063/12 25(12) = 308 = 10 00003/12) e. $1 988 29 -. , * = ↓ : $575 008 0 866/12 ,. n(t) R 25(12) = = 300 , 0000 360) $3 918 : = ,. 45 1 basis Mint - What If RBA raises ratel 6 6% ~ new rate 575000.. R : I' , r + 8 15 %. It = 280 000 = 0 One month before ,. n(t) 072/12 25(12) = ; 0000-300) n A = $2 , 01: e 77 t BUTafter6 Years,6(2) = A = 2014. ↑ Perod 2 -(2) 85/' : * & 25 basis Points ; 100-300 = A. by.. 249 , 956 85. 4 = A maturity 204185) tig : pass meaning there are 228 remaining a Module 4 - Fixed Income RBA are a central bank. They oversee monetary policy and regulate banks and ensure financial stability. Money Market Identify and Explain the Contributions of the Money Market to the Financial System Part A. The Role of the Money Market The money market is the market for Short Term Debt Securities. Money market is the smallest of the markets we consider, but important due to it;s relationship with the banking system, with the RBA and as the market where Short Term Interest Rate Benchmarks are determined Biggest participants in the money market is the RBA. - RBA participates due to this being one of the ways they can control monetary policy.. - Through this they can manage the Australian dollar and our credit system It is not a retail market, meaning it does not serve household, but is mainly used by banks, the RBA and fund managers APRA regulates and supervises the financial markets and institutions financing moneymarketiation financing -Through direct Indirect - - The Role of the Money Market 1 Contribution to the Flow of Funds; Arranges direct financing through the issue of short term debt securities and is a low risk asset class for investors. - The money market enables direct financing in wholesale amounts through the issue of low risk, ST, tradable debt securities. 1 The largest issuers are the banks, who issue negotiable certificates of deposits (NCDs) 2 Banks also help companies borrow from the market through their acceptance of bills (Bank Accepted Bills - BABs) - Banks don’t issue these, they endorse the companies who issue them. Banks endorsing increases credit worthiness 3 State and Commonwealth governments also use the market. Aus Government issues short term securities called Treasury Notes. - Government issue these to help manage their short term cash flow needs specifically to fund government expenditure in the short term. - We have three different short term money market instruments as they are unique in that thy are issued by three different Instructions. - As these ST term instruments are expire over 30, 60, 90 day time periods, they are then rolled over and so financing can be provided for longer periods of time. Wouldn’t need to issue a new one, this is important for institutions that finance themselves - Fund managers have investment portfolios on behalf of clients and they invest in the ST term instruments in the money market to access Short Term gains and to add liquidity t the portfolio in addition to shares and long term bonds as these are illiquid. - The GFC highlighted how the financial markets have a need for risk assessment and regulation due to market stability and this is done through the money market. 2 Contributions to the Banking System; Provides the banking systems with a source of wholesale funds and a low risk market for their liquid reserves. - The money market holds the banking system’s liquid reserves including loans to the inter-bank overnight market and securities that can be used in repos with the RBA. Enables banks to meet their reserve requirements. Reserves can be fulfilled by participating in the money market - Banks use repurpose agreements where they sell securities to mainly RBA with an agreement to repurchase them later to provide ST funding. - The money market is a source of funds for banks. They raise funds through the issue of NCDs and it enables banks to sell the bills they accept to investors. 3 Benchmark Rates; Performs price discovery by identifying short term benchmark rates - A benchmark rate is important as in the financial market, its important for us to have a single rate to which we can anchor other rates from - A base rate is taken and this is used as an anchor any rates from - Money market assigned this anchor rate through The Bank Bill Swap rate (BBSW) which is a key financial rate over the short term. - BBSW is relatively new in Aus as a benchmark and is trustworthy and more accurate. We used to have LIBOR (London Inter Bank Offered Rate) but there was too much manipulation by dealers causing 9b$ worth of fines. LIBOR revealed vulnerability in global financial markets and highlighted the need for Aus to have top quality oversight and regulatory such as ASIC. They ensure we have fair practice in financial markets. - BBSW is the rate at which BABs and NCDs are transacted in the market. They are calculated for 1-6 month tenor - BBSW is administered by ASC Benchmarks LTD - BBSW is designed to measure the price at which Prime Bank eligible securities trade in the open market between 8:30 and 10am on a Sydney business day. Top NCDs would trade at these rates. 4 Relationship with the RBA; Enables the RBA to implement monetary policy and so influence the economy. - The money market is the main channel through which the RBA’s monetary policy is transmitted Part B. Money Market Securities - Less than 1 year, single FV PMT at end. Different between PV and FV is INT. Involves Short Term securities with maturity term less than a year and make a single face value payment at maturity They are issued at a discount to their face value - Investors earn a return by purchasing them and later reselling for a higher price, or by holding them until they mature and receiving their face value. Money market securities have low credit risk even though they are mostly unsecured. Issued by institutions that are very credit worthy, trustworthy e.g. government and banks 1) Bank Securities a) NCDs - Issued predominantly by financial institutions; mostly banks. - By banks issuing NCDs, it helps diversify their funding sources meaning they dont rely just on deposits - APRA participate and monitor the NCDs to ensure the safety and stability of the financial institutions along with the banks that issue the NCDs. - Funds deposited for fixed time - Tradeable certificate issued stating amount to be repaid on maturity date. Info - NCDs represent over 80% of money market securities. Weight demonstrates importance of facilitating ST financing and managing liquidity - Wholesale buyers of NCDs are then enabled to sell or trade the NCDs in 2nd market to enhance liquidity - They become a source of bank funds b) Bank Accepted Bills (BABs) - A legal commitment by a third party to stand behind a borrower’s obligation to pay the bill’s face value at the specified future date - Alternative source of funds for borrowers to a bank loan - Bank guarantee the bills (issued by commercial borrowers and accepted by banks) will be redeemed at maturity. - Not a source of bank funds. - BAB issues by company but company has lack of credibility and instrument is not as liquid as an NCD, therefore bank guarantees the BAB will be paid when it matures. As the bank guarantees this, this then becomes lower risk and more liquid meaning it can then be traded in the money market. - Serve as way for borrowers to access ST funds with benefit of endorsement from established bank for a commission - If payment cant be honoured, bank will step in and accept it - Attractive for borrowers looking for ST term financing, looking for lower cost loans - Reduces credit risk for investors of BABs and new credit risk depends on credit standing of accepting bank - Borrowers pay acceptance fee normally as an add no yield Info - Like loans, BAB process exposes bank’s to borrower’s credit risk but differs as accept can sell bills to investors in the money market so that the borrower’s funds are supplied by investors. - Bill acceptance numbers and BABs sold has fallen since GFC - BAB trades as an unsecured instrument but acceptor usually requires security for the borrower. Bill Facilities - Borrowers use bills to raise funds for longer periods than the bill term by using a bill facility; An agreement by acceptor to rollover bills on maturity date for an agreed period. - New bills are issued to raise funds to repay the maturing bills - Int PMTs are required at each rollover date, equal to FV less proceeds from replacement bill or FV of previous bill. - Useful for cash flow - People rollover instead of borrowing for the total period as borrowers may not know the total amount of money they’ll need for 270 days and can therefore only estimate for 90. 2) Treasury Notes - ST Securities issued by the Treasury on behalf of Cmwlth Gov - Help Gov meet ST finance needs - Issued through competitive tender where bids invited form money market dealers - Lowest bidders are successful given bids are expressed as yields - T-Notes are considered risk free and so trade below the Bank Bill Swap Rate. - Risk free as its highly unlikely that Aus gov will fail on debt obligations Procedure - As a registered market participant like a financial institution, they would go online submit a bid and whichever bid that pays the highest yield will be successful. 3) Other Non-Gov Issues Securities a) Commercial Paper; Raise ST funds for working capital, to finance debtors/inventory - Promissory notes issued by low risk, non financial companies - Trade at yields around or above BBSW, depending on issuer risk - Bank acceptance Bills are guaranteed by bank but commercial paper is not - Higher yield and can effect credit worthiness of issuing company b) Asset Backed Commercial Paper - Promissory notes issued by SPVs and secured by specified assets, mainly residential mortgages. - Issued by company - Can buy it form financial institution and if the company defaults, there will be a security linked to it 4) Repurchase Agreements - Repos are an arrangement to sell securities on the basis that they are repurchased at a later date at a higher agreed price - Provides short term finance for seller (the security issuer) from the buyer (cash provider) - Periods vary from intra-day, 1/2/3 day, to a number of months - MST repos use Commonwealth Gov bonds - They are used extensively by RBA but also by fund managers and bond dealers. - RBA involvement enables them to infer short term interest rates and manage stability in financial system. - Contract where deficit/seller/securities provider will sell asset like government bonds as collateral to surplus/buyer/cash provider, with the intention of buying it back from them the following day or over a short time period. The seller will repay buyer the funds for the bonds returned plus the interest for holding them. - Repo rate is interest paid - Ability for banks to use gov bonds as collateral in repos enhances market liquidity and supports efficient trading in these securities. - Diversity in participants use of repos identifies importance of having financial stability and liquidity - E.g. April 2027 Aus Treasury bonds used as the repo collateral to borrow 1 mil for 5 days -> Cost of funds or int rate is 2.25% Money Market - Retail Investments (ETFs) Where individual retail deposits are pooled so that they can take part in investing in higher return money market instruments like; - AAA - Australian High interest cash - BILL - iShares Core Cash ETF - ISEC - ishares Enhanced Cash ETF They offer advantages go like liquidity, diversification, ease of trading Describe the Money Market’s Trading and Settlement Arrangements Part C. Trading and Settlement Arrangements An OTC market is where money market instruments trade in OTC is where dealers trade on their own behalf in making a market for wholesale clients - The main dealers are the majors, foreign-owned banks, specialist investment and merchant banks - They trade from their own dealing rooms mostly by phone OTC markets provide flexibility, but provide risk including counter party risk form transacting with someone else. Trading protocols specified by AFMA Dealers hold an inventory of securities (and so can provide immediacy) and earn interest and trading income. Dealer s quote their bid and offer yields as a simple interest yield. - Usually spread is only a few basis points - Yields and prices are inversely related, they bid high and offer low - The yield is then used to calculate the settlement price, helps know efficiency of market - Buy at a higher yield = low price, sell at a lower yield - higher price Austraclear is the market’s clearinghouse and arranges settlement on a same day (T + 0) basis. They ensure we have smooth functioning of financial markets by management settlement clearing and transitioning Calculate and Analyse the Returns from Investments in Short Term Securities Part D. Investment Yields Main component of investment returns is the interest earned - this is implicit, since security prices trend up over time to their FV - If securities are held to maturity, interest is only return; Therefore, they earn the yield at which securities were purchased. Fixed income - income received in form of interest If security was held for full maturity, investor receives interest earned along with final face value of instrument. Becomes predictable stream of income for investors. Fin Maths Yield to Maturity (YTM); Analysing Holding Period Investment Yields - When securities are sold before maturity, the return to investors will conclude interest but may also include capital gains or losses. - Risk of capital loss is price risk - Capital gains and losses rise form changes in the market yield - If a security is sold at a lower yield (than purchased), a capital gain is achieved and vice versa - Sold at lower yield than purchased = Capital gain. OR Sold at higher yield than purchased = Capital Loss - Actual yield achieved is holding period yield and is usually different from the YTM at commencement Price Risk in Holding Period Yields - Price risk arises from random movements in int rates, it’s impact is reflect in security’s tick value - Tick Value is the change in price caused by a one basis point change in yield - it is the smallest change that can arise in the market value or a security. - Observe; Tick values and price risk ate greater for longer term securities * price risk can be avoided by holding security until maturity - Yield of 5% changing to 5.01% will cause a price decrease Explain the Influence of Monetary Policy on Shot Term Interest Rates Part E. Short-Term Interest rates and Monetary Policy Monetary Policy The main objective of monetary policy is low inflation with a target range of 2%-3% on average, over the medium term - Other objectives are low unemployment and stable economic growth - The RBA’s tool is the target cash rate; which it reviews at it’s monthly meeting and adjusts; - Upwards if inflationary pressures exceed it’s target - Downwards when the economy could grow faster without posing an inflation problem - Aus gov and RBA work together in mission to achieve economic and monetary policy objectives that benefit Australia 3 Objectives of Monetary Policy and the Principal Objective The RBA aims in the implementation of monetary policy are; - Low inflation, low unemployment, level of economic growth that is consistent with low finlation Its principal objective is low inflation, specifically to maintain an inflation rate of between 2-3% on average over the medium term. Relationship with the RBA Monetary policy exerts considerable influence on the economy through a complex transmission process. - First Phase; - Cash rate setting impacts Interest rates generally - Second Phase; - Interest rates generally impacts Economic activity and inflation setting Implementing Monetary-Policy Decisions RBA announces at 2:30pm on the 1st Tuesday of every month, except January, the board’s decision on the cash rate. If the cash rate is changed, the next day, it conducts market operations to ensure the new target is reached - To increase the cash rate, the RBA uses repos “sell securities” to withdraw funds from the interbank market and similarly, repos “buy securities” to decrease the cash rate. The Relationship Between the Cash Rate and the Main Short Term Interest Rates The main interest rates influenced by the cash rate are; 1 Bank Bill Swap Rate 2 Variable Rates on Housing Loans 3 Variable rates on Business Loans Influence of Monetary Policy on Short Term Interest Rates Business cycle and risk premiums impact short term rates but monetary policy has greatest influence The aim of monetary policy is to keep inflation within a zone of 2-3% over medium term. RBA is responsible for implementing this and does so by changing its cash rate target and by conducting market operations like repos buy and sell agreements to reinforce the movement in the cash rate to align with the new target rate. Changes to the cash rate influence interest rates general over a short time period, these impact the economy and inflation over a longer time period. Workshop Notes Part B. Money Market Securities Bank Securities 1) Negotiable Certificates of Deposits - Funds are deposited for a fixed time and a tradeable certificate is issued stating the amount to be repaid and maturity date - NCDs represent over 80% of securities in money market - Wholesale deposits become tradeable securities - They are a source of banks funding. - Formula - Example 1) 90 Day NCD with FV of $100 at yield of 6% p.a P 100 = 1 p = (6 86 99/365) + x. $98 54. 2) 90 Day NCD with FV of $100 at yield 3% p.a p 18 G = (0 83x 90/365) $99 27 1 P = +.. 2) Bank Accepted Bills - Alternative source of funds to borrowers apart from a bank loan - Bank guarantees the bills but are issued by commercial borrowers and accepted by banks\ - Redeemed at maturity - Not a source of bank funding as the money doesn’t come from them. - Formula; Price Paid (P) by an investor for BABs is calculated as; - Example ↑ 1 3% 1) A bank accepts a company’s 90 day bill with FV of $10mil for an acceptance fee of 130bps and sells it in the money market at 3%. What is the Price paid by buyer? What is amount received by borrower?. Ppaidby bUyer = D =10000000/365) $9 : , 926 5: , Methodand - Amount received by : p 18600000 = borrower : Bank acceptance fee (10 1 = -. $9 03 + 0 , =. 813) x 98/365) 926, 571 $31. 00 -$9 486 00 ,. $9 , 895 , 085 2) 3) 895 085 88 ,. , amount F/1 + paid by buyer of bl ol diny) (Mrate Amount received by borrower is forfee fund Acceptor = /1 ((Mrace DP) : + PV+accep = lang) He= Borrower PV-buyer P 3 90 days - Bill Facility Example 1) NAB agrees to establish a 270 day bill facility for a company using 90 day bank bills - FV is $5 mil ad company is charged acceptance fee of 95 basis points (0.95%) - First parcel is issued at market yield of 3%, second at 3.25% and third at 3.50% - What are the bill proceeds? What are the net cash flows for the company over the 270 days? x Bill proceeds 8- 98d P Pl * remember 5008 888 - , 7+ (0 03. 44 = , : 0 0895) 98/365] +. ↳ 951 , 771 88. bill rollover usee Initial #) as borrowed amount Pz 5006 088 = 1 P3 + (8 8323 x , 8 8845 98/365 x.. $4 - 948 , 758 88. 5000000 : -" ,888350. 0095 x 97 e difference Net Cash HOWS are all Int. PMTs The risk -Pay $5M-P2 = Pal $5M-P3 $54,268 $51 , 168 / f Receive P, u Rose new interest rate at each rollover as intial rate Pay $5M during no longer currenta feasible.' With P1U growing Intrakes the borrowers will lose more in Int us I ( 277 188 9f financing strategy that borrowers must = ( in this opposed bill to just borrowing a. longer period Part C. Trading and Settlement Arrangements Demonstration of the Dealer’s Spread - Example 1) Suppose a dealer buys a parcel of $50 million 90 day NCDs at their bid of 3.89% and sells the parcel a short time alter at their offer of 3.85%. The dealer’s buying price is? Their selling price is? How much have they made? I bod what they're willing1 Duy bills for 50000000 p = , bid 16 $49 ↓ ~ Potter · Round 6389 + 98/365 574 967 37 ,. , 50000 806 : -. ↓ /3. 8385 x 98/365) $49 , 529 , 886 Trip Profit : ~ =. 09 (sell) Offer $49 $4 , 529 886 89. , 838 7. , bid - (bub) price - $49 574 967 37 , ,. What is a Security’s Tick Value and how Does it Reflect the Price Risk of an Investment in the Security? The tick value is the change in a security’s price that arises from a one basis point change in the yield. It is an indication of price risk, with greater tick values (price changes) reflecting greater risk. Greater tick value means it is subject to grater price changes Tick values and price risk are positively related to the security’s term - Example: Tick Value 1) Compare the Tick Value of a $100million Parcel of 180 day BABs with that of a $100 Million parcel of 30 day BABs given the interest rate increased from 3.50% to 3.51% Part D. Yield Investments Yield to Maturity - Formula - Example #F 1) Demonstrate that a purchase of a $10million parcel of 90 day NCDs at 6.5% and held until maturity, will earn a YTM of 6.5% him rearranged) P, = roo 365) - > = $9 872 , 154 28. , (400000 2g 1) x -. - 0 865. 6 5%. Holding Period Yield (HPY) - Example 1) Suppose the 90 day security purchased at 6.5% for $9,842,254.28 was sold 20 days later at 6%. The holding period yield would be calculated as? How much has the investment earned? What are its components? Psell: , 1000000/305) $9 - = HPV V = 886 240 52 ,. , 18888888 I 9886240 54 1) 365 = 0 0816 or 8 16% :. -.. Investment has earned 8 16% 80 $43, 986 In => This has interest a capitul gain component... 2) Calculate the holding period yield, the accrued interest and the capital gains or loss form an investment in a 90 day bill with a face value of $50 million purchased at 3.20% and sold 30 days later at 3.30% Puy a) 50000000 = 1 +0 032. ↑ sell HPV(r) b) : 98/366) 50000000 = 30 nays/ er1 + + 0. 833 (1 + - = 60/362) P sell-Pbuy or = 738, 230 53 , 688 , 568 81.. 53 in 2. 98 % price of 30 over 30 day investment sry price days , 49688568 81. - = 832 assuming $179 market. We know interest accumulated was gain) Profit loss is : or Loss = 49 738 , 230 53 ,. price of beig in of 30 as interest. 58 accumulated - , - - - $179 , 794 121 , 662 52 119 , 744 58 $8 , 132 86 - Loss :. , Therefore capital Bell-Pany = - b) al in 794 58 we know investment made profit of 49738230 53 44608568 81 $121 662 52. yield remained. , lossi one a) FROM Cap Gain s 1) -. /$50680688 18 x68/365) ↓.. 49688568 81 - 1+ Cap Gain $49 , as 2) , ) 35 149738730 earned is change price end purchase yield = $49 = int interest = - ($5010 1.. mil. 032 x60/365) = - $8 , 132 06. (los) price a end of 38 ds 3) Suppose that the 90 day base bill swap rate just increased from 3.80% to 4.1%.What does this imply for the prospective investors, and the investors holding money market securities? - A rate rise is good for prospective investors since it increases the interest return from future investments. - It is bad for existing investors because it lowers their selling price (due to inverse relationship between prices and interest rates) if they choose to sell before maturity