25556 Chap.9 Money Market Yields and the Cash Rate
Money Market Yields and the Cash Rate
The second half of Topic 4 is where the money market arithmetic lives. A discount security pays one amount at maturity, so its interest is built into the gap between the purchase price and face value.
Held to maturity, it earns exactly the yield it was bought at; sold early, it earns a holding period yield that blends interest with a capital gain or loss, which is the source of price risk.
This chapter sets out the three formulas for price, yield to maturity and holding period yield, uses them forwards and backwards on one NCD, and shows how far the return swings with the selling yield.
It then explains the Reserve Bank's inflation target, how a cash rate decision is enforced through market operations, and how the change passes to BBSW, loan rates, spending and finally inflation.
What this chapter covers
- 01
Interest built into a discount price
- 02
Yield to maturity on a money market security
- 03
Holding period yield and price risk
- 04
Tick value and time to maturity
- 05
The inflation target and the cash rate
- 06
How market operations move short-term rates
Worked example · free
Find the day 50 sale yield that keeps the $5 million 120-day NCD at 4.40%
- 1Purchase price: 5,000,000 divided by (1 + 0.044 × 120/365) = $4,928,702.60.
- 1Price needed on day 50 for a 4.40% holding return: 4,928,702.60 × (1 + 0.044 × 50/365) = $4,958,409.85.
- 1Matching sale yield with 70 days left: (5,000,000 divided by 4,958,409.85 − 1) × 365/70 = 4.37%.
- 1Pricing the 4.80% sale: 5,000,000 divided by (1 + 0.048 × 70/365) = $4,954,392.44, which is $4,017.41 short of the price needed.
Key terms
- Holding period yield
- The annualised return actually earned on a security sold before it matures, combining interest with any capital gain or loss.
- Price risk
- Exposure to a capital loss because the market yield may have risen by the time a security is sold.
- Tick value
- The dollar change in a security's price caused by a one basis point move in its yield.
- Market operations
- Purchases and sales of securities, often through repos, that the RBA uses to keep the cash rate at its target.
- Inflation target
- The RBA's goal of keeping consumer price inflation between 2% and 3% on average over the medium term.
Money Market Yields and the Cash Rate FAQ
Why does a money market investment held to maturity have no price risk?
At maturity the issuer pays the face value regardless of what market yields have done, so the purchase yield is locked in. Price risk only appears when the security must be sold early, because the selling price then depends on the yield prevailing on that day.
How do you calculate a holding period yield on a bank bill or NCD?
Price the security on the purchase date and on the sale date with the discount formula, using the days remaining at each point. Then divide the sale price by the purchase price, subtract one, and multiply by 365 over the number of days actually held.
Why is the tick value larger for a longer security?
A one basis point change affects the discount over every remaining day, so the more days left until maturity, the larger the dollar price change. A bill with 150 days left therefore moves more for each basis point than one with 20 days left and the same face value.
How does the RBA raise the cash rate in practice?
After announcing a higher target, it sells securities under repurchase agreements, which withdraws cash from the interbank market. With less cash available, banks charge each other more for overnight loans and the cash rate rises towards the new target. To lower the rate it does the reverse and buys securities.
Which interest rates follow the cash rate most closely?
The bank bill swap rate and the variable rates on business and housing loans respond quickly. Spending and inflation react much later, which is why policy works with a long lag between the decision and its full effect on the economy and on prices.
Exam move
Practise the three money market formulas as one family: price from yield, yield from price, and holding yield from two prices. For every question, write the face value, the days remaining and the days held on separate lines before touching the calculator.
Then rework one security forwards and backwards, as in the break-even example, so you can find a selling yield from a target return as easily as a return from a selling yield. Finally, draw the policy chain from memory, from the board decision through market operations to inflation, and attach one sentence to each arrow saying what changes and how quickly.
Working through Money Market Yields and the Cash Rate in 25556? Sia is AskSia’s AI Finance tutor — ask any 25556 Money Market Yields and the Cash Rate question and get a clear, step-by-step explanation grounded in how 25556 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
