Purpose of different yield in money market instruments

nsivakr
Posts: 6
Joined: Sun May 06, 2012 12:11 am

Purpose of different yield in money market instruments

There are multiple yields and formulas associated with money market instruments namely
a) Bank discount yield
b) Holding Period yield
c) Money market yield
d) Effective yield

Why do we need four different yields / discount rates? What is the purpose/use of these different yields.

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content.pristine
Finance Junkie
Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

Re: Purpose of different yield in money market instruments

Hi Nsivakr,

I know there are too many ways to measure the yield on money markets
The main reason for this is because money market instruments last for less than a year so we are looking at the best way to represent them even with the added complications of different day count conversions.

I'm not going into the formulas because they are all there in your book. Lets discuss them case by case so you can understand how each one has evolved.

1. Holding Period Yield
This is the most basic way to calculate how much return you have earned. In fact, we use HPR to get our return for most financial assets.
You don't take the time into account. What I mean by this is lets say I have 2 MM securities, A and B. Both of them have an HPR of 8%. If I ask you to take an investment decision on this alone because we don't know the investment horizon in each. I could have earned 8% in one month with A and 8% in 9 months with B. HPR is not enough..

2. Bank Discount Yield
This adds in the time factor. Now, we CAN take an investment decision based on this. However, this is not accurate, as we have Face Value as our denominator. This is however, very simple to calculate even mentally. We do not use compounding here. Assumes a 360 day year.

3. Money Market Yield
This is a shade better, as in more accurate than Bank Discount as the denominator is the purchase price and not the face value. Again, we do not use any compounding here. Assumes a 360 day year.

4. Bond Equivalent Yield
Here we use a 365 day year but do not consider compounding.

5. Effective Annual Yield
This is another improvement over the money market yield. We consider compounding in this measure. This is the most accurate of the 4. Unfortunately, it is not as simple to calculate as the other measures. Assumes a 365 day year.

For your exam, you should know how to convert one measure to another in order to strike a comparison between two securities.
Hope this helped you get a broader picture

nsivakr
Posts: 6
Joined: Sun May 06, 2012 12:11 am

Re: Purpose of different yield in money market instruments

Thanks for the detailed explanation.

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