Chapter 05 - Money Markets
Answers to Chapter 5 Questions
1. First, money market instruments are generally sold in large denominations (often in units of $1
million to $10 million). Most money market participants want or need to borrow large amounts
of cash. So that transactions costs are low relative to the interest paid. The size of these initial
transactions prohibits most individual investors from investing directly in money market
securities. Rather, individuals generally only invest in money market securities indirectly with
the help of financial institutions such as money market mutual funds.
Second, money market securities have low default risk; the risk of late or nonpayment of
principal and/or interest is generally small. Since cash lent in the money markets must be
available for a quick return to the lender, money market instruments can generally be issued only
by high quality borrowers with little risk of default.
Finally, money market securities must have an original maturity of one year or less. Recall from
Chapter 3 that the longer the maturity of a debt security, the greater is its interest rate risk and the
higher its required rate of return (the higher its liquidity risk premium). Given that adverse price
movements resulting from interest rate changes are smaller for short term securities, the short
term maturity of money market instruments helps lower the risk that interest rate changes will
significantly affect the security=s market value and price.
2. The discount yield differs from a true rate of return (or bond equivalent yield) for two
reasons: i) the base price used is the face value of the security and not the purchase price of the
security and ii) a 360-day year is used. The bond equivalent yield uses a 365-day year and the
purchase price, rather than the face value of the security, is used as the base price. Treasury bills
are quoted on a discount yield basis.
3. There are several features of a discount yield that prohibit it from being compared to yields on
other (nondiscount) securities. The nominal interest rate on nondiscount securities is referred to
as the bond equivalent yield and is calculated as follows:
ibey = [ (Pf - Po)/ Po](365/h)
Notice the discount yield uses the terminal price (or face value) as the base price in calculating a
nominal interest rate. Typically, nominal rates are based on the purchase price of a security.
Further, and as already mentioned, discount yields use a 360-day rather than a 365-day year. An
appropriate comparison of nominal interest rates on discount securities versus nondiscount
securities would require that the discount yield be converted to a bond equivalent yield in the
following manner:
ibey = idy (Pf/Po)(365/360)
Finally, neither of these yields considers the compounding of interest rates during the (less than
one year) investment horizon. The EAR on a discount security would be calculated by applying
the bond equivalent yield for the discount security to the EAR equation.
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