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The Money Market 1 Copyright 2014 Diane Scott Docking.

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1 The Money Market 1 Copyright 2014 Diane Scott Docking

2 2 Learning Objectives  Define money markets  Identify the major types of money market securities  Examine the process used to issue Treasury securities

3 Copyright 2014 Diane Scott Docking3 The Money Markets Defined  The term “money market” is a misnomer.  Money (currency) is not actually traded in the money markets.  The securities in the money market are short term with high liquidity; therefore, they are close to being money.

4 Copyright 2014 Diane Scott Docking4 Money Market Securities’ Characteristics  Maturity of ___________________from their ________ date.  Large primary market focus l Secondary market for securities  Money market securities are usually sold in large denominations.  They have low default risk.

5 Copyright 2014 Diane Scott Docking5 Money Market Instruments 1. Treasury Bills 2. Federal Funds 3. Repurchase Agreements 4. Commercial Paper 5. Negotiable Certificates of Deposit 6. Banker’s Acceptance 7. Eurodollars

6 Copyright 2014 Diane Scott Docking6 Treasury Bills  Issued to meet the short-term needs of the ________________  Standard Original Maturities of 4 weeks, 13 weeks (three month), 26 weeks (six month), or 52 weeks  Denominations are $1,000; typical round lot is $5 million  Virtually default risk free  Interest earned is at state and local government level. 

7 Copyright 2014 Diane Scott Docking Treasury Bills (continued)  security do not make periodic interest payments.  Instead, the security holder receives interest at the maturity date, the interest being the difference between face value (maturity value or par value) and the purchase price. 7

8 Copyright 2014 Diane Scott Docking8 T-Bill Quote Example: As of June 9, 2014: MaturityBidAsked ChgAsked Yield 12/11/  Quote is end of day 6/9/2014, assume 2 days to settle (this can vary) so day 1 = 6/11/2014…12/11/2014 is last trading day. So 184 days to maturity.  Discount Rate Bond Equivalent Yield Change from yesterday’s closing Asked Quote

9 Copyright 2014 Diane Scott Docking9 Bid & Ask Facts  - what dealers will pay for security (or what investors can sell it for) - what dealers will sell security for (or what investors can buy it for)  - is the dealers profit or markup l Bid price Ask price l Spread is in T-Bill market because market is so deep  Bid-ask quotes for T-bills are bid yields and ask yields - Bid yields Ask yields - As yields, prices

10 Copyright 2014 Diane Scott Docking 10 Calculating Yields/Prices on U.S. Treasury Bills  Treasury bills are priced on a discount rate basis, i dy or DR, is:

11 Copyright 2014 Diane Scott Docking11 Calculating Yields/Prices on U.S. Treasury Bills  The Wall Journal lists T-Bill yields on a bond equivalent basis (asked yield)  The effective annual return/rate  Relationship between DR and Asked Yield (i bey ):

12 Copyright 2014 Diane Scott Docking12 Wall Street Journal Example:  Cost to buy $1,000,000 of T-bills:  Asked Yield calculation:  Effective Return calculation:

13 Copyright 2014 Diane Scott Docking13 Problem: Calculating the T-bill rates  You pay $ for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? Asked Yield? Effective Annual Return?

14 Copyright 2014 Diane Scott Docking14 Solution to Problem: Calculating the T-bill rates  What is its discount rate? where F = face, P = price, and n = days to maturity

15 Copyright 2014 Diane Scott Docking15 Solution to Problem: Calculating the T-bill rates  What is its ask yield (or bond equivalent yield)? where F = face, P = price, and n = days to maturity

16 Copyright 2014 Diane Scott Docking16 Solution to Problem: Calculating the T-bill rates  What is its effective annual return?

17 Copyright 2014 Diane Scott Docking17 T-Bill Auction  All non-competitive bids accepted.  Specify quantity only.  Maximum bid.  Price is the competitive auction yield price. Noncompetitive Bidding

18 Copyright 2014 Diane Scott Docking 18 T-Bill Auction  Specify price (as a yield %) and quantity desired.  Minimum purchase $100  Single price auction used since 1998  Treasury accepts highest bids prices (lowest bid yields)  Maximum amount sold to any one buyer is 35% of offering amount Competitive Bidding

19 Treasury Bill Offering Copyright 2014 Diane Scott Docking 19

20 Treasury Bill Auction Results Copyright 2014 Diane Scott Docking 20

21 T-Bill rates vs. Inflation Copyright 2014 Diane Scott Docking 21

22 Copyright 2014 Diane Scott Docking22 Example of a T-Bill Auction The Treasury is auctioning off $120 million in 13-week (91 day) T-bills. The following bids are received: Noncompetitive bids: $10 million Competitive bids: Alpha Institution $42 mill.4.000% bid yield Delta Institution $10 mill.4.200% bid yield Gamma Fund $20 mill.4.250% bid yield Beta Fund $18 mill.4.110% bid yield Epsilon Fund $40 mill.4.200% bid yield Chi Institution $10 mill.4.125% bid yield

23 Copyright 2014 Diane Scott Docking23 Example of a T-Bill Auction (cont.) 1. Which institutions will have their bids filled? By how much? 2. What is the “stopout rate” or “stop yield” or “high yield”? 3. What was the price paid by the winning bidders? 4. What is the $ amount of the funds received by the Treasury? 5. What is the bank equivalent yield (i.e. ask yield)? 6. What is the Treasury’s annualized interest cost from this auction (i.e., effective yield)?

24 Copyright 2014 Diane Scott Docking24 Example of a T-Bill Auction (cont.) 1. Maximum bid amount = 35% x $120 million = $42 million Amount available after non-competitive bids of $10 mill. filled = $110 million BidderBid Price$ Amount BidRunning Balance Alpha4.000% Beta4.110% Chi4.125% Delta4.200% Epsilon4.200% Gamma4.250%

25 Copyright 2014 Diane Scott Docking25 Example of a T-Bill Auction (cont.) 4. Treasury receives: 5. Ask Yield: 6. Effective Yield: or

26 Copyright 2014 Diane Scott Docking26 Federal Funds  lending and borrowing  Fed district bank debits and credits accounts for purchase (borrowing) and sale (lending) Fed Funds _______________________- this is a bank liability. Fed Funds _____________ - this is a bank asset.  Usually $5 million or more  Federal funds rate usually slightly higher than T-bill rate  Fed Funds target vs. Actual FF rate   Current FF target:  Effective FF rates:

27 Copyright 2014 Diane Scott Docking27 Repurchase Agreements (Repo)  Repo l Bank Financing – Source of funds – a bank liability l “Security sold under agreement to repurchase” at given price in future.  Reverse Repo l Bank Investment/Loan – Use of funds – a bank asset l “Security purchased under agreement to resell” at given price in future.

28 Copyright 2014 Diane Scott Docking28 Repurchase Agreements (cont.)  Negotiated market rate. l Over telecommunications network l Dealers and brokers used or direct placement l No secondary market l Rate is lower than the fed funds rate, since it is backed up by a security.  Used by: l Federal Reserve in open market operations. l Government securities dealers to secure funds to invest in new Treasury issues. l Banks to secure funds to meet temporary liquidity needs as well as lend funds when they have excess reserves.

29 Copyright 2014 Diane Scott Docking29 Estimating Repo Rate  For Repurchase agreements:  P repo = Repurchase price of security, which equals selling price plus interest  P 0 = Sales price of the security  N=number of days to maturity

30 Copyright 2014 Diane Scott Docking30 Example: Reverse Repurchase Agreement (Aka: Securities Purchased Under Agreement to Resell)  Bank buys a security from a customer for $100,000 with the agreement to sell it back to customer for $101,000 within 90 days. l Bank takes possession and title of security l In effect, a loan with collateral  Bank accounting entries: Dr) Reverse Repurchase Agreements$100,000 Cr) Cash$100, Dr) Cash$101,000 Cr) Reverse Repurchase Agreements$100,000 Cr) Interest Revenue 1,000  Repo Rate:

31 Copyright 2014 Diane Scott Docking31 Example: Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase)  Bank sold its own security to a dealer/bank for $100,000 with the agreement to repurchase it within 90 days for $101,000. The value of the securities that the bank sold was $120,000. l Bank releases possession and title of security l In effect, a bank debt with security used collateral  Bank accounting entries: Dr) Cash$100,000 Cr) Repurchase Agreement $100,000 Dr) Securities Sold Under Repo $120,000 Cr) AFS Securities $120,000 ….. Dr) Repurchase Agreement$100,000 Dr) Interest Expense 1,000 Cr) Cash $101,000 Dr) AFS Securities$120,000 Cr) Securities Sold Under Repo $120,000

32 Copyright 2014 Diane Scott Docking32 Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase)  Bank sold its own security to a dealer/bank with the agreement to repurchase it within so many days (say 90 days).  Repo Rate:

33 Copyright 2014 Diane Scott Docking33 Commercial Paper  Alternative to bank loan  Short-term debt instrument Initial maturities ____________ days Usually ___________ days.  Used only by well-known and creditworthy firms ________________ Credit ratings important  Minimum denominations of $100,000  Placement Directly by a sales force of the borrowing firm. Indirectly through dealers.  Not a large secondary market (generally held to maturity)  Sold at a discount from par – just like T-bills.

34 Commercial Paper Rates vs. Prime Rates 34Copyright 2014 Diane Scott Docking

35 Commercial Paper Volume (M&E, 7 ed., Ch. 11) 35Copyright 2014 Diane Scott Docking

36 Commercial Paper (continued)  Directly-Placed Versus Dealer-Placed Paper  Commercial paper is classified as either l directly placed paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary l dealer-placed instruments are when the issuer uses the services of a security firm to sell its paper 36

37 Copyright 2014 Diane Scott Docking37 Negotiable Certificates of Deposit  Development of the CD Market l Issued by Citibank in l Offset declining demand deposits as a source of funds.  CD Issuers l Money center banks and large regional banks are the primary issuers of domestic CDs

38 Copyright 2014 Diane Scott Docking38 Negotiable Certificates of Deposit  Characteristics of Negotiable CDs l Large denomination time deposit, less than six month's maturity. minimum is ______ days most are less than _________ l Negotiable - may be sold and traded before maturity. Primary market - denominations of at least $100,000. Secondary market - $1 million or more. l Issued at face value with coupon rate. Interest computed on a 360 day year. Rate negotiated between buyer and seller. Rates higher than on T-Bills o higher credit risk, lower marketability and higher taxability.

39 Copyright 2014 Diane Scott Docking 39

40 Copyright 2014 Diane Scott Docking40 Example 5-9 in text: Negotiable Certificates of Deposit Q1: A bank has issued a 6-month (182 day), $1 million NCD with a 0.72% annual interest rate. How much will the NCD holder receive at maturity? A:

41 Copyright 2014 Diane Scott Docking41 Example 5-9 in text: Negotiable Certificates of Deposit

42 Copyright 2014 Diane Scott Docking42 Example 5-9 in text: Negotiable Certificates of Deposit Q3: After the price drop, what is the EAR on the NCD? A:

43 Negotiable CD Rates (M&E, 7ed., Ch. 11) 43 Copyright 2014 Diane Scott Docking

44 Comparing Money Market Securities : A comparison of rates 44Copyright 2014 Diane Scott Docking

45 45 Bankers' Acceptances 1. Time draft 1. Drafts are drawn on and/or accepted by commercial bank. 2. Direct liability of bank. 2. Mostly relate to international trade. 3. Secondary market - dealer market. 4. Discounted in market to reflect yield. 5. Standard maturities of 30, 60, 90 days –270 days max.

46 Copyright 2014 Diane Scott Docking46 Exhibit: Bankers Acceptance (see chart next page) 1) Importer (U.S.) places P.O. for goods. 2) Exporter (Japan) demands payment before shipment. So, Importer asks American Bank to issue a Letter of Credit. 3) American Bank presents LOC to Japanese Bank. 4) Japanese Bank notifies Exporter that they have a LOC and okay to ship. 5) Exporter ships goods. 6) Exporter sends shipping documents and Time Draft (like an invoice) to Japanese Bank. 7) Japanese Bank sends shipping documents and Time Draft to American Bank. 8) American Bank “stamps” Draft as “accepted” and a BA is created. American Bank will pay owner of BA (i.e. the Draft) so many $ in n-days. 9) American Bank returns BA to Japanese Bank who gives it to Exporter. 10) Exporter can sell BA at its current discounted PV or hold it until maturity. 11) At maturity of BA, Importer pays American Bank, who pays holder of BA.

47 Copyright 2014 Diane Scott Docking 47 Exhibit: (Bankers Acceptance) a 1 Purchase Order Shipment of Goods 5 L/C3 Shipping Documents &Time Draft DraftAccepted (B/A Created) 7 Japanese Bank (Exporter’s Bank) American Bank (Importer’s Bank) ImporterExporter 2 L/C (Letter of Credit) Application 4 L/C Notification 6 Shipping Documents & Time Draft B/A sent to Japanese Bank9 10 B/A sent to Exporter who keeps or sells it AB pays holder of B/A at maturity 11B/A created8

48 Banker’s Acceptance Copyright 2014 Diane Scott Docking 48

49 49 Eurodollars  Deposits of U.S. dollars in banks located outside the U.S. l London interbank bid rate (LIBID) The rate paid by banks buying funds l London interbank offer rate (LIBOR) The rate offered for sale of the funds (rate paid on ED)  Time deposits with fixed maturities  Largest short term security market in the world  No reserve requirements at banks outside U.S.

50 Comparing Money Market Securities: Money Market Securities and Their Depth 50Copyright 2014 Diane Scott Docking


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