Question

4. Provide a brief definition/description for each of the following securities. Your answers must indicate issuer(s), major investors, typical initial maturity, default risk, liquidity risk, and any other key information about that security. (5 points each) 1. Federal funds 2. Commercial paper 3. Corporate bonds 4. Treasury notes

Answer 1

• Federal funds: Federal funds are funds that are borrowed by banks to meet their lending and reserve needs. The federal funds are generally borrowed for very short term overnight or one day. The bank who has excess reserve lends to another bank who needs to meet the criteria or need it. The default risk for federal funds loan is normally very low because the funds are borrowed for very short-term period. They are also called overnight loan because of their maturity structure. The rate at which these loans are given or borrowed are called federal funds rate. When the rates on federal funds are low that implies expansionary monetary policy.
• Commercial paper: Commercial paper is also a short-term instrument issued by corporations to meet their working capital needs. The commercial paper is an unsecured instrument so it is generally issued by high credit worthy instruments. The maturity of a commercial paper can range from 90 days to 270 days but they are generally less than a year. The default risk on commercial paper is low because it is only issued by high credit worthy instruments. This is instruments is mainly used for meeting the working capital needs. The investors in commercial paper range from retail investors to large financial institutions.
• Corporates bonds: Corporate bonds are debt which are issued by corporations to meet the financing of long-term investment. The corporate bonds are of maturity greater than a year and it can range between 5 year to 30 years. The default risk on corporate bond are slightly high that is why the yield on corporate bonds are higher than sovereign bonds. There might also be the liquidity risk because the once the bonds are issued and after some time the liquidity in the bond’s falls. The investors for corporates can be retail investors, high net worth individuals or financial institutions.
• Treasury notes: Treasury notes are issued by the government and the maturity on it normally ranges from one year to ten years. Treasury notes are similar to any other bonds but since they are issued by the government the default risk on the treasury bonds is very less. There is also very high liquidity for treasury notes in the market. The investors in treasury notes vary similar to other instruments but large financial institutions are very keen on having treasury notes in their portfolio as a way to manage risk of their overall portfolio.