1. The U.S. Treasury: Types of Markets and Auctions Petar Petrov ECON 1465, Fall 2010 Brown University

2. What is a Treasury U.S. Government debt obligations backed by its full faith and credit Bills ( 5y), TIPS Very low risk associated Used for funding government projects Used for controlling money supply Over $2 trillion in securities are issued every year

3. Types by issue date While issued: when the issue is announced but the auction is not yet carried out On-the-run: the current newest issue of a particular type of securities Off-the-run: when a newer issue of the same type of securities is auctioned, the old ones become off-the-run

4. Markets for Treasuries Primary market – Auctions Frequency: 4-, 13-, 26-week bills – weekly, 52-week, 2-, 3-, 5- and 7-year notes – monthly, 10- and 30-year bonds – biannually Competitive bidders (18 primary dealers) post a pair of bid-quantity, representing the quantity they want to buy at that price, multiple bids possible Noncompetitive bidders post a quantity they want to buy, all of them win at a price which is the quantity weighted average of the competitive bids

5. Markets for Treasuries Secondary Markets: over the counter and electronically organized systems by interdealers Federal Bank of NY – biggest trader Primary dealers act as market makers, providing bid-ask quotes, holding inventory Biggest market in the world, relatively liquid

6. Markets for Treasuries When-issued Market: a forward market between the primary dealers and their institutional investors Quantity in the futures: ranging from a small one to several times the size of the issue Starts at the announcement of the auction and ends and settles at the date of the issue Close to the Chicago Board of Trade Treasuries futures market

7. Types of Auctions: Discriminatory price Competitive bidders place bid-quantity sealed bids Each winning competitive bidder pays the bid he submitted Noncompetitive bidders pay a quantity- weighted average of the winning competitive bids

8. Types of Auctions: Uniform price Competitive bidders place bid-quantity sealed bids Each winning competitive bidder pays the highest loosing bid Noncompetitive bidders pay a quantity- weighted average of the winning competitive bids

9. Common properties of auctions The common value assumption: no matter how much they pay in the auction, the buyers face the same value in the secondary market Asymmetry of information: each buyer has a unbiased private value of the uniform unknown value they are going to face on the secondary market. The average of all those values is believed to be close to the actual value

10. Problems with the markets: The purpose of Treasuries and incentives The main purpose of the Treasuries is to raise funds for the U.S. Government in order to fund its projects and programs, thus revenue maximization is the main problem The seller must set the right incentives and lower the risk for the buyers as much as possible in order for them not to underbid

11. Problems with the markets: The cost of gathering information Proprietary forecasting models or purchasing information from an outside source are costly Forward and futures markets have implied volatility because of speculators that do not cover their bets These costs are offset by underbidding The seller should release as much information as possible about the auctions and securities issued The government should facilitate the forward and futures market, lower the risk involved in participating in them in order to make the signals more stable, significant and reliable

12. Problems with the markets: The cost of reselling Discriminatory auctions favor fewer buyers, which face bigger losses if they cannot sell their inventories Tending to those transactions has a cost The cost must be offset by underbidding It is proposed that the seller might save up to 75 basis points if he switches to uniform price auctions

13. Problems with the markets: Sending signals to the secondary market Competitive sellers want to clear part of their inventories and thus if they have a firm belief of a drop of interest rates and thus a hike in prices, they would like to signal that Assuming investors learn from auction results, a good way of signaling is through the bids made A higher bid, however, costs the bidders more in a discriminatory auction, so they tend to shed their bids more In contrast, the desire to signal information results in a more aggressive bidding strategies in the uniform price auctions, resulting in higher revenues

14. Problems with the markets: Winners Curse The Winners Curse is the situation in which the winning bidders pay more than the shared average price of the item Bidders fear of the Winners Curse makes them lower their bids Winners Curse is directly proportional to uncertainty

15. Problems with the markets: Winners Curse Seller– disclose honest and complete information about the auction and expectation of the secondary-market price Uniform price auctions decrease the fear of the Winners Curse since all the bidders pay the bid of the first looser, which makes them bid closer to their real expectations of the secondary-market price an leads to a overall more aggressive bidding strategies

16. Problems with the markets: Noncompetitive bidding and squizes Noncompetitive behavior/lack of participants disturbs the efficient allocation of the securities among investors in the secondary market Uniform price auctions discourage this kind of auction, because costs of participation are lower, allowing more bidders, and the incentives of a dealer to break out of a ring are higher, since he only pays the uniform price, while still winning by overbidding

17. Empirical Data: Difference in under pricing between the auctions Time of dayDiscriminatoryUniformDifferenceP-value 12:50 – 1:000.590.320.270.024 12:30 – 1:000.610.400.220.072 1:00 – 1:300.860.320.530.000 Under pricing is measured in basis points and is defined as the auction yield minus the average when-issued yield close to the 1:00 auction time. The auction yield is the average winning yield for discriminatory auctions and the market-clearing yield for uniform-price auctions Yield is reversely proportional to prices!

18. Conclusion Uniform price auctions show better results and effectively deal with more problems Maximum amount of information should be disclosed to the public For future research: move away from static auctions and look into ascending or descending auctions as they give stronger signals to the secondary market and better information to the participating bidders, diminishing the Winners Curse, while have ambiguous effects on some of the problems

19. Questoins?