The effect of interest compounding available in shorter maturities must be incorporated in the rate for longer maturities. For example, a succession of three one-month investments generates interest at the end of the first and second months. This interest can be reinvested for two months and one month respectively. On the other hand, a three-month investment will usually pay interest only at the end of the third month, upon maturity. To make a succession of three one-month investments comparable to one three-month investment, the rate on the three-month security must offer a compensation for the forgone reinvestment.
Exhibit 7.4 shows schematic yield curves under different market expectations and assuming the presence of a premium for longer maturities. Thus, the difference in yield between shorter- and longer-term maturities when the yield curve is upward-sloping (A and B) is larger than the negative difference between the two ends of the market when the curve is downward-slowing (C and D),4
CREDITWORTHINESS AND MARKET LIQUIDITY
At any time, different money market instruments with the same maturity date will carry different interest rates. The differences among these forex newsrates reflect the creditworthiness of the borrowers and the liquidity of the instruments.
Creditworthiness measures the chance that the borrower will not repay the loan in its totality at maturity. Different sectors in the economy can be ranked in general according to their creditworthiness. Among the major sectors we obtain the following ranking: first, the federal government, which is usually considered to have practically no risk of default; second, major commercial banks, which are insured by various agencies; and, finally, the major companies in the corporate industrial sector.
The creditworthiness of the borrower can be improved by securing the loan with collateral. This collateral, which can be in the form of bank deposits, securities, or real goods, would be available to the lender in case of default on the loan, so the lender would receive some compensation before being treated as one among many other general creditors.
The presence of collateral is reflected in the names used in the jargon of money market participants. For example, a money market instrument with collateral is called a two-name paper or two-ways out. The expression denotes that the loan has been secured two ways: (1) with collateral and (2) with the borrower's promise to pay. Thus, a one-name paper or a one-way out would be an instrument without any collateral. The only thing standing behind this paper is the borrower's promise to pay.
The other major factor affecting the differences in rates casinocharge to various participants in the money market for instruments with the same maturity is liquidity. Liquidity is the ability to convert a financial instrument into cash quickly at the prevailing market rates; that is to say, without appreciable loss in value. A relatively large market with many buyers and sellers trading all the time is a liquid market. In this market it is easy to find a buyer for an instrument at the prevailing market rate.
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