Question

1. A. Why is the bond equivalent yield of a T?bill higher than the yield calculated on a discount basis? (Some of the bond equivalent yields are the same as the discount yield in Exhibit 7.4 because the Wall Street Journal rounds the numbers presented and they aren’t really the same.)

B. Why do issues of securities by U.S. government agencies tend to have higher interest rates than similar issues of debt by the U.S. Treasury?

C.What did the Federal Reserve do to stabilize the money markets from 2007 to 2009?

Answer 1

A) The bond equivalent yield utilizes a 365 day year versus a 360 day year. Any seasonal yield multiplied by a smaller fraction, for example, 187/365 versus 187/360, will have a higher yield. Hence, the bond equivalent yield of a T Bill is higher than the yield calculated on a discount basis.

B) The U.S. Government agencies have the similiar guarantee of the Government securities but lower liquidity than U.S. Treasury securities of equivalent term. Government-sponsored agencies do not even have the explicit guarantee of the Government securities, nor the liquidity of U.S. Treasury issues. Hence, US Government agencies charge a higher interest rate than issues of US Treasury.

C) During the financial crisis from 2007 to 2009, Federal Reserve Bank took some of the unorthodox measures to stabilize the money market. Some of those measures were:

1) Expanding access to the discount window.

2) Auctioning short term loans to depositoryinstitutions through Term Auction Facility (TAF).

3) Paying interest on required and excess reserves of depository institutions.

4) Buying commercial paper directly from issuers though commercial paper funding facility (CPFF). The CPFF closed in 2010 and provided funds to non financial firms along with the financial firms.

5) In 2008, Federal Reserve set the target Fed Fund Rate between 0% to 0.25%. Moreover, it started focussing on acquiring long term assets viz MBS, Agency debt and Treasury notes and Bonds. The main purpose was to stabilize economy by not only to keeping the short term interest rates at low levels but also long term interest rates to encourage more investment.

6) To invest in these assets, the Fed has used enormous amounts of excess bank reserves keps on accounts with the Fed and also borrowed from Treasury. As markets returned to normalcy, banks expand lending and invest more in MBS and bonds. Even the risk apetite of the investor comes back.