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Money Markets. I. Money Market Securities Definition Money market securities are financial instruments with maturity of one year or less.

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Presentation on theme: "Money Markets. I. Money Market Securities Definition Money market securities are financial instruments with maturity of one year or less."— Presentation transcript:

1 Money Markets

2 I. Money Market Securities Definition Money market securities are financial instruments with maturity of one year or less.

3 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

4 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

5 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)

6 –International Money Market Instruments Instruments Principal Borrowers EurodollarsBanks Eurodollar CDsBanks Euronotes Euro-commercial paperNon-financial and financial businesses

7 Characteristics –High degree of safety –Active secondary market –Telephone network

8 II. Treasury Bills Maturity –Regular issues 91-day billsIssued weekly 182-day billsIssued weekly 51-week billsIssued monthly –Irregular issues

9 Denominations $10,000 $15,000 $50,000 $100,000 $500,000 $1,000,000 round lot: $5,000,000

10 Auction –Non-competitive Bidding ($1,000,000 or less) Direct purchase from Federal Reserve Banks Indirect purchase through brokers

11 –Competitive Bidding Amount (in bil.)BidRemark $ %lowest yield,/highest price average yield/ average price stop yield/ stop price

12 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.

13 –Government Brokers Brokers used by primary dealers trading Treasury securities with each other. –Other Dealers and Brokers

14 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.

15 Example: par = $100,000, PP = $97,569, and n = 100 days. Yield = [($100,000- $97,569)/ $100,000] (360 / 100) = 8.75%.

16 Dollar Discount Dollar Discount = T-bill Rate par (n /360)

17 Example: T-bill Rate = 8.75%, par = $100,000, and n = 100 days. Dollar Discount = $100,000 (100/360) = $2,431. Purchase price = par value - dollar discount = $100,000 - $2,431 = $97,569.

18 Yield T-bill Yield = [(SP - PP) / PP] (365 / n), where SP = selling price, PP = purchase price, and n = holding period in days.

19 Example: SP = $10,000, PP = $9,600, and n = 182 days. Yield = [($10,000 - $9,600)/ $9,600] (365 / 182) = 8.36%

20 III. Commercial Paper Issuers Finance companies Bank holding companies Industrial companies Foreign corporations (Yankee commercial paper)

21 Maturity –Not Registered One day to 270 days, normally between 20 and 45 days. –Registered Over 270 days

22 Denominations Minimum$25,000 Minimum round lot$100,000 Typicalmultiples of $1 million

23 Rating McCarthy, Crisanti & CategoryDuff & Phelps Fitch MoodysS&PMaffei InvestmentDuff 1+ F-1+A-1+ GradeDuff 1 F-1 P-1A-1 MCM 1 Duff 1- Duff 2 F-2 P-2A-2 MCM 2 Duff 3 F-3 P-3A-3 MCM 3 Non-invest. GradeDuff 4 F-S NP(NotB MCM 4 Prime) C MCM 5 In defaultDuff 5 D D MCM 6

24 Placement –Directly Placed Commercial Paper –Dealer-Placed Commercial Paper

25 Backing –Reasons Credit enhancement Rollover risk –Types of Credit-Supported commercial paper Credit-Supported commercial paper (line of credit paper) Fee (0.5%) Compensating balances Asset-backed commercial paper

26 Yield Yield = [(par - PP) / PP] (360 / n), where par = par value, PP = purchase price, and n = holding period in days.

27 Example: par = $5,000,000, PP = $4,850,000, and n = 90 days. Yield = [($5,000,000 - $4,850,000) / $4,850,000] (360 / 90) = 12.37%

28 IV. Negotiable Certificates of Deposit (NCDs) Issuers –Domestic market Commercial banks Thrift institutions (thrift CDs) U.S. branches of foreign banks (Yankee CDs) –Foreign markets (Euro CDs)

29 Maturity Short-term: two weeks to one year Long-term: term CDs Denominations Minimum$100,000 Typical$1,000,000

30 Placement –Directly placed NCDs –Dealer placed NCDs

31 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

32 V. Repurchase Agreements (RPs) Issuers –Financial institutions Commercial banks Thrifts Money market funds Securities dealers –Non-financial institutions Municipalities Businesses

33 Maturity –Overnight repos –Term repos Two to fifteen days One, three and six months Denominations Typical$10 million or higher

34 Yield or Repo Rate Repo Rate = [(SP - PP) / PP] (360 / n), where SP = selling price collected by an investor, PP = purchase price paid by an investor, and n = holding period in days.

35 Example: SP = $10,000,000, PP = $9,852,217, and n = 60 days. Yield = [($ 10,000,000-$ 9,852,217)/$ 9,852,217] (360 / 60) = 9%

36 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.

37 VI. Federal Funds Participants Depository institutions Brokers Characteristics –Short-term borrowing of immediate availability –Borrowed only by depository institutions –Exempted from reserve requirements

38 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

39 Denominations Typical$5,000,000 Placement –Directly placed –Broker-placed

40 Security –Unsecured federal funds –Secured federal funds Federal Funds Transfer –Adjusting reserve accounts through Fedwire –Reclassifying the demand deposits of a respondent bank

41 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.

42 VII. Bankers Acceptances Issuers Exporters Importers Commercial banks

43 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

44 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)

45 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.

46 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)

47 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 to 87.5 basis points

48 VIII. Eurocurrency Participants Governments Large financial institutions Commercial banks (Eurobanks) Organized exchanges Institutional investors Large corporations

49 Related Markets –Foreign exchange market –Eurocurrency market –Eurocredit market –Euro CD market –Euronote market –Currency forward market –Currency Futures market –Currency options market –Currency swap market

50 Euro CDs –Types *Fixed -rate CDs *Floating-rate CDs (FRCDs) The rate adjusts periodically to the London Interbank Offer Rate (LIBOR).

51 –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.

52 Euronotes –Participants Borrowers Underwritten or committed note issuance facility (a syndicate formed by a group of banks) Investors

53 –Maturity One month Three months Six months

54 IX. Euro-Commercial Paper (Euro-CP) Participants Borrowers Dealers Investors

55 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.

56 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.

57 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).

58 Example: Par = $10,000, i = 7%, and n = 1 year. P = $10,000/ ( ) 1 = $9,

59 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.

60 –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.)


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