I. Money Market Securities Definition Money market securities are financial instruments with maturity of one year or less.
Instruments and Participants –Domestic Money Market Instruments Principal Borrowers Treasury billsU.S. Government Commercial paperNon-financial and financial businesses Negotiable CDsBanks Repurchase agreementsSecurities dealers, banks, non- financial corporations, governments
Instruments Principal Borrowers Federal fundsBanks Bankers acceptancesNon-financial and financial businesses Discount windowBanks Municipal NotesState and local governments Government sponsoredFarm Credit System, Federal Enterprise securities Home Loan Bank System, Federal National Mortgage Association
Instruments Principal Borrowers Shares in money marketMoney market funds, local instruments government investment pools, short-term investment funds Futures contractsDealers, banks (principal users) Futures optionsDealers, banks (principal users) SwapsBanks (principal dealers)
–International Money Market Instruments Instruments Principal Borrowers EurodollarsBanks Eurodollar CDsBanks Euronotes Euro-commercial paperNon-financial and financial businesses
Dearlers –Reporting Dealers Securities firms which are on the Federal Reserves regular reporting list. –Primary Dealers (Recognized Dealers) Securities firms and commercial banks that the Federal Reserve will deal with in implementing its open market operations.
–Government Brokers Brokers used by primary dealers trading Treasury securities with each other. –Other Dealers and Brokers
T-Bill Rate (T-Bill Discount, or Yield on a Bank Discount Basis) T-bill Rate = [(par - PP) / par] (360 / n) = [dollar discount/ par] (360 / n), where par = par value, PP = purchase price, and n = holding period in days.
Example: par = $100,000, PP = $97,569, and n = 100 days. Yield = [($100,000- $97,569)/ $100,000] (360 / 100) = 8.75%.
Dollar Discount Dollar Discount = T-bill Rate par (n /360)
Example: T-bill Rate = 8.75%, par = $100,000, and n = 100 days. Dollar Discount = 0.0875 $100,000 (100/360) = $2,431. Purchase price = par value - dollar discount = $100,000 - $2,431 = $97,569.
Yield T-bill Yield = [(SP - PP) / PP] (365 / n), where SP = selling price, PP = purchase price, and n = holding period in days.
Yield on a Bank Discount Basis –Risk premium Higher premium during recessionary years Higher premium during financial crises Higher premium for high-risk issuers –Liquidity premium –Fixed rate vs floating rate
Determinants of repo rates: –Creditworthiness of the issuer –Type of collateral –Federal funds rate The repo rate is usually 25 basis points below the funds rate because a repo has collateral, while a federal funds transaction is unsecured.
VI. Federal Funds Participants Depository institutions Brokers Characteristics –Short-term borrowing of immediate availability –Borrowed only by depository institutions –Exempted from reserve requirements
Maturity –Overnight federal funds (3/4 of the total federal funds) –Continuing contract federal funds (automatically renewed overnight federal funds) –Term federal funds: few days to six months
Security –Unsecured federal funds –Secured federal funds Federal Funds Transfer –Adjusting reserve accounts through Fedwire –Reclassifying the demand deposits of a respondent bank
Federal Funds Rate – Higher than repo rate and Treasury bill rate. – Higher volatility than other money market rates because it is affected by changes in monetary policy.
VII. Bankers Acceptances Issuers Exporters Importers Commercial banks
1. Purchase order Importer Exporter 5. Shipment of goods 6. Shipping 2. L/C 4. L/C documents application notification & time draft 3. L/C Importers bankExporters bank 7. Shipping documents & draft acceptance
Acceptance financing The use of bankers acceptances to finance commercial transaction. – Importing goods into the U.S. – Exporting goods from the U.S. – Storing and shipping goods between foreign countries (third country acceptances)
Maturity –30 to 270 days –Federal Reserve eligibility requirement A Bankers acceptance with maturity longer than six months do not meet the eligibility requirement as collateral at the discount window.
Placement –Directly placed by Accepting banks An accepting bank is a bank which creates bankers acceptances. –Dealer placed * Unsold acceptances created by large accepting banks *Acceptances created by smaller accepting banks * Acceptances created by Yankee banks (U.S. branches of foreign banks)
Rates –Higher than T-bill rate *Risk premium - Higher default risk than T- bills. *Liquidity premium- Less developed secondary market. –Commission charged by accepting banks *U.S. banks - 25 to 30 basis points *Japanese banks - 10 to 15 basis points –Dealers Spread - 12.5 to 87.5 basis points
VIII. Eurocurrency Participants Governments Large financial institutions Commercial banks (Eurobanks) Organized exchanges Institutional investors Large corporations
Euro CDs –Types *Fixed -rate CDs *Floating-rate CDs (FRCDs) The rate adjusts periodically to the London Interbank Offer Rate (LIBOR).
–Yield Euro CDs offer a higher yield than domestic CDs for three reasons: *Reserve requirements imposed on domestic CDs *FDIC insurance premium for covering domestic CDs *Sovereign risk Euro CDs are obligations that are payable by an entity operating under a foreign jurisdiction, and their claim may not be enforced by the foreign government.
Euronotes –Participants Borrowers Underwritten or committed note issuance facility (a syndicate formed by a group of banks) Investors
IX. Euro-Commercial Paper (Euro-CP) Participants Borrowers Dealers Investors
Maturity Euro-commercial paper has longer maturity ( i.e., longer than 270 days) than that of U.S. commercial paper, and therefore has a more active secondary market.
Placement Euro-commercial paper is almost always dealer-placed. The commission ranges between 5 and 10 basis points of the face value. Yield Euro-commercial paper is typically between 50 and 100 basis points above LIBOR.
VIII. Valuation of Money Market Instruments Market Value P = Par / (1 + i) n, where P = price of the money market instrument, Par = par value, i = required annual rate of return, and n = time to maturity (a fraction of one year).
Example: Par = $10,000, i = 7%, and n = 1 year. P = $10,000/ (1 + 0.07) 1 = $9,345.79.
Price Determinants P = ƒ( i) = ƒ( R f, DP, LP), where P = change in price, i = change in required rate of return, R f = change in risk-free rate, DP = change in default risk premium, and LP = change in liquidity premium.
–Determinants of risk-free rate *Economic growth *Inflation *Money supply –Determinants of default risk premium *Economic conditions *Conditions in the firms industry (degree of competition, etc.) *Firm-specific conditions (debt level, management, etc.)