1. Money Market Instruments Blackwell, Griffiths and Winters, Chapter 4, and other material 1

2. Definition of the Money Markets The money markets are the markets for short-term debt with short-term being defined as an initial maturity of one year or less. If a security has an initial maturity of more than one year, it is part of the Capital Markets (bonds, stocks and mortgages are the primary capital market securities). The economic role of the money markets is to facilitate the trading of liquidity. In the money markets, investors (lenders) with temporary cash surpluses make these surpluses available to borrowers with temporary cash shortages. Since the investors (lenders) have the cash, they get to set the rules for the market Since their cash surplus is only temporary, they want to ensure that their cash gets repaid to them when they need it. 2

3. The Money Market Recap Financial characteristics: Low default risk Low price risk (relatively short duration High marketability Organizational characteristics: Each instrument is distinct Standardized contracts No formal organization -- an OTC market Wholesale markets Activity focused in the dealer or trading rooms of financial institutions 3

4. Key Money Market Instruments Treasury Bills Negotiable CDs Domestic Yankee Thrift Bankers Acceptance Domestic Yankee Short-Term Agency Paper Discount Notes Consolidated Discount Notes Consolidated Systemwide Discount Notes Short-Term Tax-Exempt Securities (Munis) TANs BANs RANs Repurchase Agreements (RPs) Reverse Repurchase Agreements (REPOs) Eurodollar Deposits (Euros) Time Deposits Negotiable CDs Federal Funds 4

5. Quotes Money Market: Yield Capital Market Price as a proportion of face value 102:28 is a security price at 102 28/32 % of its face value For a $1000 security, its dollar price would be: $1028.75 5

6. Yields for Money Market Instrument Bank Discount Basis Bond equivalent Basis 6

7. Discount Versus Bond Equivalent Yields Bank Discount Basis Treasury Bills Commercial Paper Finance Paper Bankers Acceptances Agency securities RPs/Repos Bond equivalent basis CDs Eurodollars Federal funds 7

8. Bank Discount Yield: Terms Face value (maturity value)F PriceP DiscountD Yield on Discount BasisY d (decimal basis) Days to maturityt 8

9. Calculating the Price and the Bond Equivalent Yield Quote is on a bank discount basis. Investor needs to calculate The security’s price The yield on a bond equivalent basis First step is to calculate the discount D = Y d x F x (t/360) Next Step is to calculate the price P = F - D Final step is the calculation of the bond equivalent yield Y = (365 x Y d ) / (360 - t x Y d ) (decimal basis) To convert to percentage basis, multiply by 100 9

10. Resolving 365 versus 360 day years Bank discount yield represents a discount yield over a 360 day year. In effect, 360 days are used to calculate “daily interest payment” and daily interest pay is paid over 365 Hence the bond equivalent yield is larger than the discount yield for two reasons: It is computed on the price, not the face value It is paid over 365 days 10

11. An Example Bank Discount Quote for a bill maturing in 65 days Days to maturity65 Ask discount yield5.36 D = 0.0536 x 100 (65/360) = 0.9678 11

12. Continued P = 100 -.9678 = 99.0322 per $100 of face value For a Treasury Bill with a face value of $100,000, the price would be: $99032.02=$100,000 x.990322 Y = ( (365 x.0536) / (360 - (65 x.0536))) = 5.49% Effective Annual Yield = (1 +.0541/(365/65)) (365/65) = 1.0551 or 5.51% 12

13. Effective Annual Yield Bond Equivalent Yield does not take into effect compounding of interest earned Effective annual yield = (1 + Y/(365/t)) 365/t - 1 For this bill, effective annual yield is: 5.62%= ((1 + (.0549 / (365/65)) 365/65 - 1) x 100 13

14. Review of Primary and Secondary Markets Primary market: The market where a security is sold for the first time Secondary market: The market where previously issued securities are bought and sold Role of Secondary market Provide Liquidity to a security Offer guidance to the primary market as to the proper price Disseminates information 14

15. Treasury Bills Characteristics Short-term debt instruments issued in huge volume by the US Treasury on a bank discount basis Virtually no default risk, little price (interest rate) risk and extremely liquid Extreme liquidity stems from the extent, depth and resiliency of the secondary market for these instruments These instruments are considered the ideal money market instrument Book entry Markets Primary market: Auction basis conducted by the Federal Reserve Bank of New York on behalf of the US Treasury Monthly auction of 4 week Treasury bill Secondary market OTC All major banks act as dealers Dealers are the market-markets in the secondary market 15

16. Primary Market Competitive Bids Specify price and quantity desired. Minimum $10,000 & in multiples of $5,000 above $10,000. Mostly professionals - dealers & banks. No more than 35 percent of an issue is sold to one entity under the competitive bidding process in order to ensure a competitive secondary market. Non-competitive Bids All non-competitive bids accepted. Specify quantity only. Minimum $1,000 Maximum $1,000,000. Mostly individuals & small investors. Pays stop-out (highest) rate of competitive auction 16

17. Auction of Treasury Bills Initial maturity 1.13-weeks; often referred to as three-month or 91-days, but the Treasury uses weeks because they believe that provides the most accurate description. 2.26-weeks(six-months) 3.52-weeks(one-year) 4.4 weeks Two types of bids in T-bill auctions: 1.Competitive bids, which specifies quantity of T-bills sought and discount rate, and 2.Non-competitive bids, which specify only the quantity of T-bills sought. 17

18. T-bill Auction Process (cont.) Steps in the Auction Process 1.Fill all non-competitive bids (up to the $5 million) and set aside to assign price later. 2.Sort the competitive bids on bid price (high to low) (same as discount rate low to high) and assign the remainder of the available bills to competitive bidders starting with the highest price and moving down the list of bid prices. 3.The last competitive bid price accepted is referred to as the stop-out price, which is the lowest price accepted for the auction. 4.Assign all (non-competitive and competitive) accepted bids the stop-out price. This is referred to as uniform-price auction. This is used to eliminate the ‘winner’s curse that occurs in multiple-price auctions. 18

19. 19 T-bill Default Risk Treasury bills are backed by the full faith and credit of the U.S. government. The U.S. government has never failed to pay its debts, so T-bills are considered default free. T-bills are often referred to as risk-free, but they are not because all debt instruments are exposed to interest rate risk.

20. Commercial and Finance Paper Characteristics Characteristics Short-term unsecured debt Initial maturity less than 270 days Commercial paper: issued by nonfinancial firms Finance paper: issued by financial institutions Captive Independent Subsidiaries of parent firm Separate corporation Bank-related 20

21. Commercial and Finance Paper Markets Primary Direct Placement Sales force that sells the paper directly to investors Dealer placed Paper placed with investors by dealer This is a form of underwriting Banks prohibited under Glass- Steagall from engaging in this activity But permitted under the Section 20 loop-hole of the Bank Holding Company Act Fully permiited under the FMA Secondary No formal secondary market, through there is limited trading in the secondary market Paper is typically sold to investors that plan to hold it to maturity Some issues have “programs” in which investors regularly role over maturing commercial paper for new commercial paper Commercial paper dealers are expected to make a market in their clients’ commercial paper as of June 2000, over 80% of outstanding commercial paper was dealer-placed. 21

22. Commercial Paper Commercial paper is unsecured corporate debt issued to finance short-term working capital. Commercial paper is used as an alternative to bank loans. an attractive alternative because it carries a lower interest rate but it is only available to low default risk businesses Money market investors only loan their money to low default risk borrowers. The credit rating agencies rate all commercial paper in a manner similar to the bond ratings discussed in Chapter 3. 22

23. 23 Commercial Paper Ratings (Figure 4-4) RatingDescription Moody’s Prime-1Superior ability to repay senior short-term debt Prime-2Strong ability to repay senior short-term debt Prime-3Acceptable ability to repay senior short-term debt Not PrimeIssuer not in Prime rating categories Standard and Poor’s A-1Strong capacity to meet financial commitments A-2Satisfactory capacity to meet financial commitments A-3Adequate capacity to meet financial commitments BVulnerable and has significant speculative characteristics CCurrently vulnerable to nonpayment

24. Bankers Acceptances Created by banks on behalf of companies engaged in trading and/or storage of goods The are negotiated time drafts drawn on and accepted by a bank, discounted and sold to investors, and redeemed by the bank at maturity for the full face value Used to finance the import, export, transfer and storage of goods Draft is accepted when drawee bank agrees to pay at maturity. Generally purchased by investors through dealers Obligation of drawee bank 24

25. Large Negotiable CDs Characteristics Characteristics Certificate of deposit (CDs) were first issued in the early 1900s to corporate customers but were not negotiable Certificate is issued by a depository institution and states the principal, interest rate, and maturity date The Federal Reserve considers large those CDs with a stated principal of $100,000 or more Typically issued with principal of $1 million or more Issuers: Domestic banks and US branches of foreign banks (Yankee CDs) and Thrifts Background Typical investors are large corporation and large institutional investors. Until 1961, investors had no choice but to hold CDs to maturity In 1961,Citibank negotiated an agreement with the primary dealers in Treasury securities to deal (maintain a secondary market) in negotiable CDs Subject to Regulation Q until 1970, when deregulated in response to the commercial paper crisis Importance to depository institutions rose progressively until deregulation of other deposit rates 25

26. Large Negotiable CDs Primary Markets Primary market Directly to investors, but some small amount through dealers Issuers post rates by maturity Posted rate is typically a bit below the secondary market rate so that the issuer can offer higher rates to preferred customers Tiering emerged in 1980s in response to the bank crisis in Texas and other oil and agriculture states and the deepening thrift crisis Prime or top-tiered issuers Less default risk Greater marketability Nonprime issuers Secondary market Secondary market was very liquid during 1960s and 1970s Liquidity is marginal now since only a few dealers make a market in negotiable CDs Large CDs are not as important today as they were in the 1960s and 1970s 26

27. Maturity Typically less than 1 year Interest is paid at maturity and based on 360 day year Some use of term CDs with maturity greater than 1 year Interest on term CDs is paid semi-annually 27

28. Large Negotiable CDs CD Quotes Quotes are on a simple interest basis These are known as “add-on” securities, where the interest earned over the life of the instrument is added to the initial investment Illustration: Suppose that a new-issue CD with principal of $100,000 has a 90-day maturity and a yield of 5.375% Its maturity value would be FV = 100000 x (1 +.05375*(90/360)) = 100000 x (1.013438) = 101343.75 28

29. Secondary Market Price The secondary market price of a CD includes the accrued interest. Take the CD in the previous slide and assume that 60 days remain until maturity The quoted secondary market yield is 5.50% Its price is found by: 29

30. Secondary Market Price Continued = 100000 x 1.0134375 /1.009167 = 100000 x 1.004232 = 100423.20 30

31. Repurchase Agreements Characteristics Temporary sale of a security with the agreement to buy it back at a specified date and at a specified price A repurchase agreement amounts to a collaterialized loan. The seller of the security is the borrower the buyer of the security is the lender From the buyers point of view, the transaction is a reverse repurchase agreement 31

32. Repurchase Agreements (Repo) Bank Financing - Source of funds Security sold under agreement to repurchase at given price in future. Way to include corporate business in Federal Funds market. Negotiated market rate. Bank Investment – Reverse Repo Security purchased under agreement to resell at given price in future. Smaller banks are able to invest excess liquidity in a secured investment. The interest rate on a repo is lower than the fed funds rate, since it is backed up by a security. Repos are used by the Federal Reserve in open market operations. Government securities dealers use repos to secure funds to invest in new Treasury issues. Banks participate in the repo market to secure funds to meet temporary liquidity needs as well as lend funds when they have excess reserves. 32

33. Credit/Default Risk If borrower defaults, the lender keeps the collateral Lender is protected by Over collateralization Value of the loan is less than the value of the security sold Collateral is market to market if the RP is for more than one day If value falls below value of the “loan” Margin call, i.e., more collateral is supplied or The RP is Repriced 33

34. Collateral Typically Treasury bills But it can be almost any asset Treasury coupon Agency issues Mortgage bank securities Commercial paper Amount of collateral is influenced by the risk inherent in the collateral The greater the price risk and credit risk of the collateral the more collateral must be held against the value of the “loan” Who holds the collateral? Buyer takes possession; this is often impractical Segregated account collateral place in segregated account and managed by the seller Custodial account: collateral is held at the borrower’s (the seller’s) clearing bank This provides strong protection against default losses. However, repo traders still advise that repos should only be conducted with parties that are known to be creditworthy 34

35. 35 Marketability of Repos There is no secondary market in repos. A repo is a loan with specific collateral, which prevents trading the claim in a secondary market. The term of the a repo is set to match the timing desired by the lender, but should the lender need the funds back early, the borrower typically accommodates this need.

36. 36 Federal Reserve’s Use of Repos The Fed conducts open market operations to adjust the money supply. Open market operations are the buying or selling of securities. The Fed does two types of open market operations: (1) permanent and (2) temporary. It uses repos for temporary open market operations because repos automatically reverse itself and therefore are by definition temporary.

37. Eurodollar Deposits Characteristics Characteristics Term deposits denominated in dollars in banks outside the US Part of the Eurocurrency market This is the market for deposits denominated in a given currency in banks outside the currency’s home country Before the Euro, Euro-mark deposits are deposits denominate in marks in banks outside of Germany The primary market for Eurocurrencies is very active Markets Euro TDs: Eurodollar time deposits Primary market: directly to investors No secondary market Euro CDs: Eurodollar negotiable CDs Primary market: directly to investors or through dealers Secondary market 37

38. Yields on Eurodollar Deposits Versus Domestic Deposits Reflect such factors as: Sovereign risk of country in which the Eurodeposit is held E,g., UK versus Switzerland The bank business funded by the Eurodollar deposit compared with the business funded by domestic deposits Credit risk Sovereign risk of off-shore lending ventures FDIC premiums are on domestic deposits, no premiums paid on foreign deposits of US banks Liquidity of secondary market 38

39. Short-term Government Agency Securities Short-term debt issued by government agencies and sponsored government agencies on a bank discount basis Government agency: agency owned in whole or part by a department of the US Government Debt issued by government agencies is guaranteed by the full faith and credit of the US Government Sponsored government agency: firm that is publicly chartered (by Congress) but privately owned Debt issued by sponsored agencies is guaranteed by the sponsored agency; it is not guaranteed by the US Government Primary market Underwriting through investment banks Secondary Market Liquidity varies among issuer Well developed secondary markets for short-term debt issued by Federal Land Banks, Federal Intermediary Banks, Banks for Cooperatives, FHLB, and FNMA Even with a well-developed secondary market, the rate on agency debt trades at a positive spread to Treasury’s 39

40. Types of Federal Agencies General types Farm credit agencies - loans to farmers. Housing credit agencies - loans and secondary market support for mortgage market. Other agencies - special purposes. Federal Financing Bank - purchases securities of agencies and issues its own obligations. Background Except for GNMA, marketable agency debt is issued by sponsored agencies These are not guaranteed by federal government; implied federal guarantee is presumed by many investors Marketability varies with the development of the secondary market. Yields are higher than T-Bills. Slightly greater default risk. Slightly lower marketability. 40

41. Federal Funds Characteristics Traditionally use: Short-term unsecured loans among depository institutions Federal funds bought: a bank borrows Federal Funds from another bank; this is a liability on the books of the borrowing banks Federal funds sold: a bank lends Federal Funds to another bank; this is an asset on the books of the lending bank This is a highly liquid market; some see it as the most liquid money market market The rate on Federal funds is closely related to the conduct of monetary policy 41

42. Federal Funds Characteristics of Federal Funds Market for depository institutions. Most liquid of all financial assets. Related to monetary policy implementation. Yields related to the level of excess bank reserves. Originally a market for excess reserves - Now a source of investment (federal funds sold) and continued financing (federal funds purchased). Most are one-day, unsecured Loans. Bookkeeping entry -interest paid separately. Traded in Fed Funds or Immediately Available Funds. Bank Financing - Source of funds Federal funds purchased Short-term (usually overnight) unsecured borrowing by one bank from another bank. A bank liability Bank Investment – Use of Funds Federal funds sold Short-term (usually overnight) unsecured loan from one bank to another bank. A bank asset. 42

43. 43 Fed Funds Default Risk Fed funds trades are unsecured inter-bank loans. Because the traded funds are part of the settlement process, the lenders in this market will only accept low risk borrowers. This is accomplished through pre-screening each borrower for a line of credit and only allowing a borrower to acquire Fed funds in amounts available under the line of credit.

44. Marketability of Fed Funds Because Fed funds are interbank loans done under a line of credit for a specific borrower, there is no secondary market in Fed funds. Liquidity is achieved by having almost all Fed funds loans have a maturity of one day (often referred to as overnight loans). Fed funds loans are referred to as overnight loans because historically funds borrowed during a day were repaid at the beginning of the next business day. However, when the Fed implemented fees for daylight overdrafts, the Fed funds market moved to 24-hour loans where the loan is repaid 24 hours after it was made. 44

45. Short-Term Muni Market Types Tax Anticipation Notes Bond Anticipation Notes Revenue Anticipation Notes Primary market: underwritten by dealers or a syndication of dealers No secondary market Used to provide working capital or fill short-term funding need Discount notes may be offered on a continuous basis, much the same as banks offer CDs Short-term bonds require notification 45