Week 7

Week 7

1. Consider reasons for government debt markets and government borrowing requirement.

   • Government must fund any shortfalls in short-term (within the year) liquidity requirements with the issue of short-term debt securities, and any shortfall in its loing-term (full year) capital expenditure requirements and commitments with the issue of long-term debt securities. Shortfall: - occurs if there is a mismatch between the timing of government expenses and receipts within the year. Capital expenditure shortfall: - occurs when a budget is in deficit (occurs when a government's expenditure exceed its revenue over a fiscal year).
   • There are 2 main forms of debt securities: 1. Treasury bonds (or T-bonds) for full-financial-year financing 2. Treasury notes (or T-notes) for within-year or intra-year financing.
   • Reasons to hold government securities
     • Instruments issued are Treasury bonds and they are bought mainly by commercial banks, other financial institutions and portfolio managers for: - liquidity management: - portfolio investments - risk management - payments system requirements - prudential requirements.
     • Reasons not to hold government securities
       • Budget surpluses and debt reduction policies have limited the supply of government securities: - Long-dated bonds are now issued every two years, ensuring sufficient securities to support 10-year bond futures contracts - Government intends to issue about $55 billion of Treasury bonds to ensure a deep and liquid market - Crowding-out effect (occurs when government borrows a large proportion of the total funds available for invesment) > Government demand for debt financing reduces amount of funds available for investment in private sector > Minimised in times of strong fiscal management
     • Treasury Bonds (T-bonds)
       • The interest coupon issued by Commonwealth Government are called treasury bonds. Treasury bonds are medium to long-term securities and currently issue straight bonds; that is, the bond pays a periodic fixed-interest payment (coupon payment - normally paid every 6 months) and the principle is repaid at maturity. Example: The holder of a 5% bond is guaranteed $25 every six months on a $1,000 face value bond. At the maturity date, the holder will receive the face value of $1,000 plus the final coupon payment.
       • Before 1984
         • Until 1984 either bearer bond or inscribed stock. Bearer Bonds: - physical stcok is issued; current holder (who is unregistered therefore, no records kept of the owner) is presumed to have legal entitlement Inscribed stock: - the physical bond is not issued; ownership is registered electronically with the registry.
       • After 1984
         • Since 1984 inscribed stock, which has the following advantages: - Less costly to maintain register of bond holders - Ownership of bearer bonds not registered, facilitating tax evasion and money laundering - Protected from risk of theft, destruction and misplacement.
       • Primary market transaction
         • Primary market issue of treasury bonds is known as the tender system. The federal treasurer has the power to decide on the timing of each tender,a dn the maturities, coupons and quantities of bonds to be marketed. This is currently managed through the Australian Office of Financiao Management (AOFM).
         • Fixed-coupon treasury bond bid conditions include the following: - Removes rate setting from political arena - Bids submitted through Yieldbroker DEBTS System - Minimum $1 million, thereafter multiples of $1 million - Bids made in terms of yield to maturity, not price - Bids are accepted in ascending order of yield, i.e. lowest-yield bid (highest price) first, until issue fully subscribed
       • Who buys treasury bonds?
         • Significant holders of treasury bonds areL - reserve banks - banks - life offices - other private fianancial institutions - government financial institutions - other public authorities - other holders etc...
       • Secondary market transactions
         • Secondary markets (markets through which previously issued securities are traded) treasury bonds can be bought and sold as: - On-exchange transactions: > buying and selling securities on a formal exchange such as a stock exchange. - Over-the-counter transactions: > Buying ans selling of securities conducted directly; no formal exchange; mostly between institutional investors.
         • Reasons for participating in secondary markets
           • Individuals and institutions may participate in the secondary market for the following reasons: - funding requirements - liquidity needs - reserve requirements - interest rate expectations - to maintain the maturity profile of a bond portfolio.
       • Pricing treasury bonds
         • Treasury bonds are quoted in terms of their redemption yield or yeild to maturity. Redemption yield: - the total return (interest and capital gains) received if a security is held at maturity. Yield: - this is the return (interest and capital gains) recieved by an investor over the holding period on an initial amount invested.
         • Treasy bond have fixed-interest therefore, interest coupon will not change during the term of the bond. However, current market interest rates change over time. Since the coupon payment cannot change, the price of the existing bonds will change if current market rates change. Therefore, the rate of the fixed coupon will generally be different from the actual yeild to maturity.
   • Borrowing requirement: within the financial year
     • Within financial year: - Matching principle - Borrow to finance short-term mismatches between receipts and payments; i.e. manage day-to-day liquidity - Roll over existing debt - Instruments issued for intra-year budgetary purposes are short term; i.e. Treasury notes (T-notes)
     • Treasury Notes (T-note)
       • T-note are short-term securities that may be issued by the Commonwealth Government, through the AOFM, in order to manage the within-year timing mismatches of the government's revenue and expenses cash flows. T-note issues have a variable term-to-maturity in order to coincide with the government’s revenue receipt dates. T-notes may be redeemed at maturity date or by sale in the secondary market. T-notes are sold below their face value therefore, the return is the difference between the purchase price and the price at which the T-note is sold.
       • Primary market
         • Tendering process: - Minimum parcel of $1 million face value, thereafter multiples of $1 million via the AOFM tender system in terms of yield to maturity. - Bids accepted in ascending order of yield, i.e. lowest-yield bid (highest price) first, until issue is fully subscribed. - T-note purchases settled through Austraclear settlement system.
       • Pricing treasury notes
   • Budget Deficit - occurs when a government's expenditure exceed its revenue over a fiscal year. BUdget Surplus - occurs when government revenues exceed expenditures over a fiscal year

2. Outline features of the main Commonwealth government debt instruments, issuance process, participants and related calculations.

3. Describe the purpose and structure of state government central borrowing authorities.

   • State Government Securities
     • State government finance needs are similar to those of the Commonwealth. Each state has formed a central borrowing authority to facilitate debt management programs (e.g. Treasury Corporation of Victoria). Issue similar securities as the Commonwealth, i.e.: -  medium-term notes and longer-term bonds (referred to as semi-government securities) - discount securities. Cost of debt (determined by credit rating agencies) is higher than it is for the Commonwealth.
     • Benefits of central borrowing authorities
       • - Maximise economies of scale - Access international markets - Better manage the timing of debt issues and associated cash flows - Remove potential for competition between different issuers within the same state and achieve a lower average cost of funds - Size of the single debt issues larger than the borrowings of individual state authorities - More effective use of tender and dealer panels - Encourages a secondary market
     • Central borrowing authority: established by each state and territory government to manage debt programs
     • Central borrowing authories have a choice of public or private, underwritten of non-underwritten placements
       • public—prospectus, advertising and marketing private—information memorandum, quicker, cheaper underwritten—appoint a tender and dealer panels to place issues and create a secondary market by quoting bid and offer prices non-underwritten—issue attractive to institutional investors owing to investment-grade credit rating.

4. Outline monetary policy techniques used by the RBA to influence interest rates, including open market operations and the impacts on system liquidity

   • The reserve bank changes the rat through the conducts of its open market operations and its ability to control liquidity of the financial system on a day-to-day basis.
   • Actions of the RBA that influence interest rates in order to achieve the following economic objectives: - stability of the currency - maintenance of full employment - economic prosperity and welfare of the Australian people > maintain inflation within a 2–3% range over the business cycle.
   • Monetary Policy
     • Monetary policy affects the level of short-term interest rates. A central bank is able to influence the level of short-term interest rates (cash rate) by adjusting the level of liquidity in the financial system. Monetary policy seeks to target the level of inflation in order to achieve economic growth, high employment and a stable currency.
     • Cash rate: - The interest rate on unsecured overnight loans between banks.
   • Operating Market Operations
     • The reserve banks uses its open market operations to manage monetary conditions. These operations allow the central bank to manage the overall supply of funds available in the money market in order to keep the overnight cash rate consistent with the desired stance of monetary policy. Operation markets are conducted by: 1. Repurchase agreements (repos) on nominated debt securities 2. Outright or direct transactions in short-dated CGSs 3. Foreign exchange swap
     • The conduct these operations, reserve bank needs to hold and manage a portfolio of CGS. Is must also ensure the maintenance of liquidity in the market of CGE, by making purchases in the secondary market and at times takes an allotment at tender in a primary issue, for the effectiveness of its operations. Resrve banks need a large and stable demand for money-market cash at all times so that it can operate with predictable effects on money-market conditions.
     • 1. Repurchase agreements (repos) on nominated debt securities
       • Reserve bank agrees to buy certain securities today at their current price on the condition that they are repurchased at a specified later date.
     • 2. Outright or direct transactions in short-dated CGSs
       • Reserve bank reduces the supply funds in the money market, while purchases inject additional funds. - A reduction in the money supply will place an upward pressure on the overnight cash rate to a level targeted by the Reserve Bank to achieve its monetary policy objectives. - An increase in the money supply will place a downward pressure on the  overnight cash rate to a level targeted by the Reserve Bank to achieve its monetary policy objectives.
     • 3. Foreign exchange swap
       • Similar to repo, except that the Reserve Bank will agree to a foreign currency for AUD on the understanding that the transaction will be reserved at a specified exchange rate at a later date.
     • The overnight market is the component of the money market involving the shortest term loan. Lenders agree to lend borrowers funds only "overnight" i.e. the borrower must repay the borrowed funds plus interest at the start of business the next day.
   • Impacts of Financial System Liquidity
     • Factors impacting on the liquidity of the financial system (or money base) are: 1. Commonwealth Government budget deficits or surpluses 2. Official (RBA) FX transactions 3. Net sales of CGSs and repurchase agreements These 3 systems effect the daily money-market cash position.
     • 1. Commonwealth Government budget deficits or surpluses
       • Commonwealth Government budget deficits or surpluses: - taxation receipts - government securities - budget recurrent expenditures - budget capital expenditures
     • 2. Official (RBA) FX transactions
       • sales (purchases) of FX reduce (increase) financial system liquidity. sales of FX by the RBA reduce system liquidity, which can be neutralised through market operations by selling CGSs.
     • 3. Net sales of CGSs and repurchase agreements

5. Describe the purpose and operation of the payments system.