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6 Money Markets. Chapter Objectives Provide a background on money market securities Explain how institutional investors use money markets Explain the.

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Presentation on theme: "6 Money Markets. Chapter Objectives Provide a background on money market securities Explain how institutional investors use money markets Explain the."— Presentation transcript:

1 6 Money Markets

2 Chapter Objectives Provide a background on money market securities Explain how institutional investors use money markets Explain the globalization of money markets

3 Money Market Securities Maturity of a year or less Debt securities issued by corporations and governments that need short-term funds Large primary market focus Purchased by corporations and financial institutions Secondary market for securities

4 4 Money Market Securities Treasury Bills Commercial paper Negotiable certificates of deposits Repurchase agreements Federal funds Bankers acceptances

5 Money Market Securities Treasury bills Issued to meet the short-term needs of the U.S. government Attractive to investors Minimal default riskbacked by Federal Government Excellent liquidity for investors Short-term maturity Very good secondary market

6 Money Market Securities Treasury bill auction (fill bids in amount determined by Treasury borrowing needs) Bid process used to sell T-bills Bids submitted to Federal Reserve banks by the deadline Bid process Accepts highest bids Accepts bids until Treasury needs generated Competitive Bidding

7 Money Market Securities Treasury bill auctionnoncompetitive bids ($1 million limit) May be used to make sure bid is accepted Price is the weighted average of the accepted competitive bids Investors do not know the price in advance so they submit check for full par value After the auction, investor receives check from the Treasury covering the difference between par and the actual price Noncompetitive Bidding

8 Money Market Securities Estimating T-bill yield No coupon payments Par or face value received at maturitymaturity Yield at issue is the difference between the selling price and par or face value adjusted for time If sold prior to maturity in secondary market Yield based on the difference between price paid for T-bill and selling price adjusted for time

9 Money Market Securities Calculating T-Bill Annualized Yield YTYT SP – PP PP 365 n Y T = The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period) =

10 Money Market Securities T-bill yield for a newly issued security Par – PP PP 360 n T-bill discount = percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity T-bill discount=

11 Money Market Securities Short-term debt instrument Alternative to bank loan Dealer placed vs. directly placed Used only by well-known and creditworthy firms Unsecured Minimum denominations of $100,000 Not a large secondary market Commercial Paper

12 Money Market Securities Commercial paper backed by bank lines of credit Bank line used if company loses credit rating Bank lends to pay off commercial paper Bank charges fees for guaranteed line of credit

13 Money Market Securities Estimating commercial paper yields (same as t-bill) Y CP Par – PP PP 360 n Y CP = Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity =

14 Money Market Securities Issued by large commercial banks Minimum denomination of $100,000 but $1 million more common Purchased by nonfinancial corporations or money market funds Secondary markets supported by dealers in security Negotiable Certificates of Deposit (NCD)

15 Money Market Securities NCD placement Direct placement Use a correspondent institution specializing in placement Sell to securities dealers who resell Sell direct to investors at a higher price NCD premiums Rate above T-bill rate to compensate for lower liquidity and safety

16 Money Market Securities Sell a security with the agreement to repurchase it at a specified date and price Borrower defaults, lender has security Reverse repo name for transaction from lender Negotiated over telecommunications network Dealers and brokers used or direct placement No secondary market Repurchase Agreements

17 Money Market Securities Estimating repurchase agreement yields Repo Rate SP – PP PP 360 n Repo Rate = Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity =

18 Exhibit 6.5 a 1 Purchase Order Shipment of Goods 5 L/C3 Shipping Documents &Time Draft DraftAccepted (B/A Created) 7 Japanese Bank (Exporters Bank) American Bank (Importers Bank) ImporterExporter 2 L/C (Letter of Credit) Application 4 L/C Notification 6 Shipping Documents & Time Draft

19 Money Market Securities A bank takes responsibility for a future payment of trade bill of exchange Used mostly in international transactions Exporters send goods to a foreign destination and want payment assurance before sending Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time Bankers Acceptance

20 Money Market Securities Exporter can hold until the date or sell before maturity If sold to get the cash before maturity, price received is a discount from drafts total Return is based on calculations for other discount securities Similar to the commercial paper example Bankers Acceptance

21 21 Major Participants in Money Market Participants Commercial banks Finance, industrial, and service companies Federal and state governments Money market mutual funds All other financial institutions (investing) Short-term investing for income and liquidity Short-term financing for short and permanent needs Large transaction size and telecommunication network

22 22 Valuation of Money Market Securities Present value of future cash flows at maturity (zero coupon) Value (price) inversely related to discount rate or yield Money market security prices more stable than longer term bonds Yields = risk-free rate + default risk premium

23 Exhibit 6.7 a International Economic Conditions U.S. Fiscal Policy Issuers Industry Conditions Risk Premium of Issuer Short-Term Risk-Free Interest Rate (T-bill Rate) Issuers Unique Conditions U.S. Monetary Policy U.S. Economic Conditions Required Return on the Money Market Security Price of the Money Market Security

24 24 Interaction Among Money Market Yields Securities are close investment substitutes Investors trade to maintain yield differentials T-Bill is the benchmark yield in money market Yield changes in T-bills quickly impacts other securities via dealer trading Yield differentials determined by risk differences between securities Default risk premiums vary inversely with economic conditions

25 25 Globalization of Money Markets Money market rates vary by country Segmented markets Tax differences Estimated exchange rates Government barriers to capital flows Deregulation Improves Financial Integration Capital Flows To Highest Rate of Return

26 Globalization of Money Markets Performance of international securities Effective yield for international securities has two components The yield earned on the investment denominated in the currency of the investment The exchange rate effect

27 Globalization of Money Markets Performance of international securities Yield for an international investment YfYf SP f – PP f PP f Y f = Foreign investments yield SP f = Investments foreign currency selling price PP f = Investments foreign currency purchase =

28 Globalization of Money Markets The exchange rate effect (%ΔS) measures the percentage change in the spot during the investment period % ΔS measures the expected percent change in the currency Currency appreciated, % ΔS is positive and adds to net yield Currency depreciated, % ΔS is negative and reduces net yield

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