1. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-1 McGraw-Hill/Irwin Chapter Five Money Markets

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-2 McGraw-Hill/Irwin Definition and Purpose of Money Markets The Money Markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations, FIs and governments Only High-Quality Entities can borrow in the Money Markets and individual issues are large Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon The Money Markets essentially serve to allocate the nation’s supply of liquid funds among major short-term lenders and borrowers The Money Markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations, FIs and governments Only High-Quality Entities can borrow in the Money Markets and individual issues are large Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon The Money Markets essentially serve to allocate the nation’s supply of liquid funds among major short-term lenders and borrowers

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-3 McGraw-Hill/Irwin Definition of Money Markets Money market securities are generally fixed income securities that have an original issue maturity of one year or less, thus they have little price risk. Money markets primarily exist to minimize the cost of maintaining liquidity for financial, non-financial and government institutions and to provide borrowers with low cost, short term sources of funds. Money market securities should thus provide safety of principle, liquidity and a predictable, albeit typically modest, yield

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-4 McGraw-Hill/Irwin Why Money markets Money markets exist because rarely do required cash disbursements occur at the same time and in the same amounts as cash inflows for corporations and institutions. At times units will have excess cash that is not immediately needed, and other economic units will need to borrow cash for a short period of time. Thus, entities must maintain liquid sources of funds. In addition, precautionary amounts of funds beyond planned liquidity needs must be maintained because expected cash inflows and required cash disbursements cannot be predicted with perfect accuracy

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-5 McGraw-Hill/Irwin opportunity cost The opportunity cost of keeping cash on hand can be quite high. The opportunity cost is the rate of return that could be earned in the highest valued alternative if liquidity balances did not have to be maintained. Money markets have developed to provide corporations, governments and institutions with safe, liquid investments (or sources of funds for borrowers) that minimize the opportunity cost of maintaining liquidity.

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-6 McGraw-Hill/Irwin Secondary markets Secondary markets, or some other method of quickly recovering the investment at short notice, are of paramount importance for money market instruments because much of the funds invested in money markets may be needed by the lender for unexpected liquidity needs. Money market securities also have little or no default risk. With the focus on liquidity and safety, the rate of return on money market securities is expected to be significantly less than promised yields on capital market instruments.

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-7 McGraw-Hill/Irwin Yields on Money Market Securities Many money market securities use special quoting conventions –Discount Yields –Single-Payment Yields –Equivalent Annual Return

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-8 McGraw-Hill/Irwin Discount rates Discount rates (or discount yields) quote the interest rate as an annualized percentage of the sale (redemption) price of the security assuming there are only 360 days in a year. Even if the security matures in 90 days, the rate quote is as if the security matured in one year.

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-9 McGraw-Hill/Irwin Single payment securities Single payment securities or loans (also called add ons) quote the rate as an annualized percentage of the purchase price of the security, assuming there are only 360 days in a year.

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-10 McGraw-Hill/Irwin A calculation for restating semi-annual, quarterly, or monthly discount-bond or note yields into an annual yield. For a fixed income security with a par value of $1000, the calculation is as follows: ((1000- purchase price)/ purchase price)*365/days to maturity

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-11 McGraw-Hill/Irwin The total amount of money market securities outstanding in 2004 in the major money markets was over $5,260 billion. This represents a compound annual growth rate of 7% over the period 1990 to 2004.

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-12 McGraw-Hill/Irwin Money Market Instruments Treasury Bills Federal Funds Repurchase Agreements Commercial Paper Negotiable Certificates of Deposit Banker Acceptances Treasury Bills Federal Funds Repurchase Agreements Commercial Paper Negotiable Certificates of Deposit Banker Acceptances

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-13 McGraw-Hill/Irwin Treasury Bills T-bills are short term obligations of the U.S. government used to finance government spending needs. At the end of 2004 there was $981.9 billion outstanding comprising about 19% of total money market securities. Original issue maturities are 13 or 26 weeks. The minimum denomination is $1,000 and a round lot is $5 million. T-bills are thought to be free of default risk and the 1 year T-Bill rate is often used as a measure of the short term ‘risk free rate.’

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-14 McGraw-Hill/Irwin T-Bills Auction Each week new 13 and 26 week T-bills are offered for sale at competitive auction. T-bills are sold to the highest bidder at auction, but no one bidder can purchase more than 35% of the total amount in any one auction. Noncompetitive bids of up to $1 million can be made. The Treasury is now using a single price auction. In the past Treasury securities were sold at a discriminating auction where high bidders paid higher prices, and lower bidders paid lower prices. Noncompetitive bidders paid the average price of the accepted bids

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-15 McGraw-Hill/Irwin Treasury Auction Results Nov 18,2004 Quantity of T-bills Bid Price 99.4975% 1 2 3 4 5 6 7 SCSC STST Noncompetitive Bids 99.48875% (P NC ) stop-out price (low bid accepted) $17,509.5m $19,254.8m

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-16 McGraw-Hill/Irwin Why single price auction In the Treasury single price auction the lowest bid price accepted becomes the price that all winning bidders pay. There are two purported advantages of a single price auction over a discriminating auction: 1.A greater number of bidders have their bids filled and 2. More aggressive bidding occurs under the single price format resulting in a higher average price paid by investors.

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-17 McGraw-Hill/Irwin The secondary market for T-bills The secondary market for T-bills is the largest of any money market security. There are 22 primary government security dealers who purchase the new issues and about 500 smaller dealers who actively participate in trading T-bills. The FedWire is often used for trades between dealers and other institutions.

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-18 McGraw-Hill/Irwin Secondary Market T-bill Transaction Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan Chase to Lehman Brothers Transaction recorded in Fed’s Book-Entry System J.P. Morgan Chase sells $10m. In T-bills Lehman Brothers buy $10m. In T-bills Fedwire Transaction Fedwire Transaction Individual buy $50,000 in T-bills Local Bank or Broker J.P. Morgan Chase sell $50,000 in T-bills FRBNY -$50,000 in T-bills from J.P. Morgan Chase’s account + $50,000 T-bill to Individual

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-19 McGraw-Hill/Irwin Case: Salomon Brothers In violation of regulations, Salomon Brothers (Chase/Solomon) bought about 80% of one Treasury auction in an attempt to squeeze the market. Many T-bills are sold on a ‘when issued’ basis by dealers who anticipate obtaining them at auction (i.e. T-bills are often sold short before they are issued). Since Salomon obtained so much of the auction, other dealers could not meet their prior short sale obligations and had to pay a premium price to Salomon to obtain the bills which the dealers had already agreed to deliver to customers. The government forced Salomon to give up their profits from the squeeze and pay fines. The biggest loss was to Salomon’s reputation.

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-20 McGraw-Hill/Irwin Discount instruments T-bills are discount instruments. T-bill prices (P0) are calculated as P0 = PF  (1 – (i*h/360)) where i is the discount quote, h is the maturity in days and PF is the face value of the bill. One should calculate the bond equivalent yield in order to compare rate quotes on different instruments that use different quoting conventions. The bond equivalent yield for a T–bill can be calculated as (PF–P0)/P0 * (365/h).

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-21 McGraw-Hill/Irwin Treasury Bill Basics Summary Issued by the U.S. Treasury to cover government budget deficits and to refinance maturing debt Standard Original Maturities of 13 weeks, 26 weeks, or 52 weeks Denominations are $1,000 but typical round lot is $5 million Virtually default risk free Issued by the U.S. Treasury to cover government budget deficits and to refinance maturing debt Standard Original Maturities of 13 weeks, 26 weeks, or 52 weeks Denominations are $1,000 but typical round lot is $5 million Virtually default risk free

22. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-22 McGraw-Hill/Irwin The Secondary Market for T-bills The largest of any U.S. money market security Approximately 30 financial institutions “make” a market in T-bills by buying and selling securities for their own accounts and by trading for their customers, including depository institutions, insurance companies, pensions funds, etc. T-bills are the FOMC’s instrument of choice for its open market operations The largest of any U.S. money market security Approximately 30 financial institutions “make” a market in T-bills by buying and selling securities for their own accounts and by trading for their customers, including depository institutions, insurance companies, pensions funds, etc. T-bills are the FOMC’s instrument of choice for its open market operations

23. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-23 McGraw-Hill/Irwin The Auction Process for T-bills Amount of new 13-week and 26-week T-bills offered announced weekly Bids submitted by government securities dealers, financial and nonfinancial corporations and individuals Individual competitive bidders limited to 35% total issue size, can submit more than one bid, allocations made beginning with highest bidder Noncompetitive bidders indicate quantity desired and agree to pay a weighted-average of the rate on winning competitive bids; get preferential allocation Amount of new 13-week and 26-week T-bills offered announced weekly Bids submitted by government securities dealers, financial and nonfinancial corporations and individuals Individual competitive bidders limited to 35% total issue size, can submit more than one bid, allocations made beginning with highest bidder Noncompetitive bidders indicate quantity desired and agree to pay a weighted-average of the rate on winning competitive bids; get preferential allocation

24. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-24 McGraw-Hill/Irwin T-bill Rates and Yields No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value T-bill rates are quoted in Wall Street Journal Discount Yield Asked Spread No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value T-bill rates are quoted in Wall Street Journal Discount Yield Asked Spread

25. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-25 McGraw-Hill/Irwin Calculating T-bill Yields from Discount Rates i T-bill (dy) = P F - P O  360 P F h Where: i T-bill = Annualized yield on the T-bill P F = Price (face value) paid to the T-bill holder P O = Purchase price of the T-bill h = Number of days until the T-bill matures Example: i T-bill (dy) = $10,000 - $9,905.71  360 = 2.19% $10,000 155 i T-bill (dy) = P F - P O  360 P F h Where: i T-bill = Annualized yield on the T-bill P F = Price (face value) paid to the T-bill holder P O = Purchase price of the T-bill h = Number of days until the T-bill matures Example: i T-bill (dy) = $10,000 - $9,905.71  360 = 2.19% $10,000 155

26. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-26 McGraw-Hill/Irwin Federal Funds Fed funds, together with repurchase agreements, comprise about 30% of total money market securities. Federal funds, or fed funds, are short term unsecured loans of deposits held at the Federal Reserve (i.e. loans of excess reserves. These loans occur largely between institutions. Small banks often make loans to their correspondent banks when local loan demand is insufficient

27. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-27 McGraw-Hill/Irwin ‘bullet’ loans The majority of fed funds are overnight loans, although many are made on ‘continuing contract.’(Continuing contract means that unless the borrower or lender notifies the other party the loan will automatically be renewed daily) Fed funds are add on loan contracts (single payment or ‘bullet’ loans) and follow the convention of quoting all rates on an annual basis assuming a 360 day year.

28. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-28 McGraw-Hill/Irwin equivalent yield To convert a fed funds rate quote to a bond equivalent yield take the rate quote and multiplied it by 365/360. Many fed fund loans are arranged through correspondent banks or through brokers such as Garban-Intercapital Ltd. and RMJ Securities Corp. The typical brokerage fee may be as small as 50 cents per million dollars.

29. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-29 McGraw-Hill/Irwin Funds transfers Funds transfers occur over the FedWire and transactions can be completed very quickly (in a matter of minutes). A FI is not required to hold reserves at the Fed to participate in the fed funds market; deposits at banks are often used in place of deposits at the Federal Reserve. Typical transactions are $5 million and up.

30. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-30 McGraw-Hill/Irwin Federal Funds Summary Short-term funds transferred between FIs, usually for a period of one day Federal Funds rate –the interest rate for borrowing fed funds –a focus or target rate in the conduct of monetary policy Federal Funds Yields –single-payment loans –Fed fund transactions take the form of short- term (mostly overnight) unsecured loans Short-term funds transferred between FIs, usually for a period of one day Federal Funds rate –the interest rate for borrowing fed funds –a focus or target rate in the conduct of monetary policy Federal Funds Yields –single-payment loans –Fed fund transactions take the form of short- term (mostly overnight) unsecured loans

31. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-31 McGraw-Hill/Irwin Trading in the Fed Funds Market Commercial banks conduct the majority of transactions in the fed funds market Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Fed funds transactions can be initiated by either the lending or borrowing institution or handled through a broker Correspondent banks – banks with reciprocal accounts and agreements Commercial banks conduct the majority of transactions in the fed funds market Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Fed funds transactions can be initiated by either the lending or borrowing institution or handled through a broker Correspondent banks – banks with reciprocal accounts and agreements

32. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-32 McGraw-Hill/Irwin Repurchase Agreements A repurchase agreement (repo or RP) is an agreement where the seller of securities agrees to repurchase the securities at a preset price at a preset time (typically from 1 to 14 days). Repos are in effect, collateralized loans similar to fed funds loans. The seller is borrowing. money and pledging the securities as collateral and the buyer (who is said to be engaging in a reverse repo) is lending money. The interest rate is determined by setting the buy and sell price of the securities.

33. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-33 McGraw-Hill/Irwin Repo interest rate The rate of interest paid on the repo is not a function of the rate of return on the underlying securities. If risky securities are pledged as collateral, the fund’s lender may require a larger ‘haircut,’ i.e. repos normally have to be slightly overcollateralized. For instance, to borrow $100 the repo seller would have to sell securities currently worth $102, for a $2 haircut. The repo is a ‘real’ sale in the sense that title to the securities passes to the lender of funds for the term of the agreement.

34. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-34 McGraw-Hill/Irwin Repo Pricing and Transfers Transfers may occur over the FedWire system. Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations. Repos are add on instruments (single payment loans) with yields that average about 25 basis points less than fed funds loans due to the repo collateral. Repos take longer to arrange than fed funds and fed funds loans are more likely to be used when funds are needed immediately.

35. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-35 McGraw-Hill/Irwin Repurchase Agreements (RPs or Repos) Summary An agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price on a specified date Essentially a collateralized fed funds loan with collateral in the form of securities (e.g. T-bills and Fannie Mae securities) Reverse repurchase agreement An agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price on a specified date Essentially a collateralized fed funds loan with collateral in the form of securities (e.g. T-bills and Fannie Mae securities) Reverse repurchase agreement

36. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-36 McGraw-Hill/Irwin Trading Process for Repurchase Agreements Arranged either directly between two parties or with the help of brokers and dealers The repo buyer arranges to purchase T-bills from the repo seller with an agreement that the seller will repurchase the T-bills within a stated period of time Arranged either directly between two parties or with the help of brokers and dealers The repo buyer arranges to purchase T-bills from the repo seller with an agreement that the seller will repurchase the T-bills within a stated period of time

37. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-37 McGraw-Hill/Irwin Commercial Paper Commercial paper is a short term unsecured promissory note issued by creditworthy corporations and financial institutions. Because the notes are unsecured and are not very liquid, commercial paper is rated by ratings agencies. The paper rating strongly affects the cost of financing with commercial paper. Low quality paper is often secured by bank lines of credit to obtain a better rating. The spread between prime grade and medium grade paper has averaged about 22 basis points per year

38. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-38 McGraw-Hill/Irwin Maturity of CP The maximum maturity is 270 days (most are less) because the SEC requires formal registration of securities with maturities greater than 270 days. Commercial paper comprised about 25% of total money market securities in 2004, down from 2001 in absolute dollar amount and as a percentage of total money market securities.

39. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-39 McGraw-Hill/Irwin Discount instrument Commercial paper is a discount instrument and uses discount quotes similar to T–bills Credit concerns coupled with some high profile downgrades of major paper issuers such as GM, Ford and Tyco have reduced the amount of commercial paper in the past several years.

40. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-40 McGraw-Hill/Irwin History The commercial paper market has developed to provide corporations with an alternative to short term bank loans. Commercial paper outstanding grew tremendously in the 1990s because large, creditworthy paper issuers were able to obtain lower cost financing by issuing paper rather than borrowing from banks.

41. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-41 McGraw-Hill/Irwin no active secondary market Commercial paper is issued in denominations ranging from $100,000 to $1 million, with the most common maturities in the 20 to 45 day range. About 15% of issuers directly market their own paper, but the bulk is sold through brokers and dealers. There is no active secondary market for commercial paper, partly because commercial paper dealers will redeem paper from the buyers if the buyer needs the money prior to maturity.

42. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-42 McGraw-Hill/Irwin Commercial Paper Summary An unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements The largest (in terms of dollar value) of the money market instruments Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million with maturities of 1-270 days (if maturity is greater than 270 days, SEC requires registration) Generally held until maturity so there is not an active secondary market An unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements The largest (in terms of dollar value) of the money market instruments Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million with maturities of 1-270 days (if maturity is greater than 270 days, SEC requires registration) Generally held until maturity so there is not an active secondary market

43. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-43 McGraw-Hill/Irwin Trading Process for Commercial Paper CPs are sold either directly to investors (25%) or indirectly through brokers and dealers such as investment banks or major bank subsidiaries Selling through brokers more expensive for issuer due to underwriting costs CPs are sold either directly to investors (25%) or indirectly through brokers and dealers such as investment banks or major bank subsidiaries Selling through brokers more expensive for issuer due to underwriting costs

44. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-44 McGraw-Hill/Irwin Negotiable Certificates of Deposit A negotiable certificate of deposit is a bearer certificate indicating that a time deposit has been made at the issuing bank which the bearer (holder) can collect at maturity. Large CDs are negotiable instruments. Negotiable CDs have a minimum denomination of $100,000, but denominations of $1 million are the most common. Maturities range from 1, 2, 3 and 6 months out to 1 year

45. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-45 McGraw-Hill/Irwin CD rates Negotiable CD rates are add on rates (single-payment loans) quoted using the 360 day convention.(CDs with maturity greater than one year area not bullet loans, rather they usually pay interest semiannually) They comprised about 26% of money market securities in 2004.

46. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-46 McGraw-Hill/Irwin CD draw funds that would be invested in non- bank money market securities. Large well known banks, particularly New York banks, often can pay lower interest rates on their CDs than other lesser well known institutions. About 15 dealers make a secondary market in CDs, although it is not very active. CDs are required to have ‘substantial interest penalties for early withdrawal.’ The secondary market eliminates the problem of the interest penalty, and has increased bank’s ability to draw funds that would otherwise be invested in non-bank money market securities.

47. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-47 McGraw-Hill/Irwin Trading Process for NCDs Banks issuing NCDs post daily rates for the more popular maturities and subject to funding needs, tries to sell to investors who are likely to hold them as investments rather than sell them to the secondary market In some cases, the bank and investor negotiate the size, rate and maturity Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues Banks issuing NCDs post daily rates for the more popular maturities and subject to funding needs, tries to sell to investors who are likely to hold them as investments rather than sell them to the secondary market In some cases, the bank and investor negotiate the size, rate and maturity Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues

48. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-48 McGraw-Hill/Irwin Negotiable Certificates of Deposits Summary A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market Bearer Instrument Denominations range from $100,000 to $10 million; $1 million being the most common Often purchased by money market mutual funds with pools of funds from individual investors A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market Bearer Instrument Denominations range from $100,000 to $10 million; $1 million being the most common Often purchased by money market mutual funds with pools of funds from individual investors

49. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-49 McGraw-Hill/Irwin Banker’s Acceptances (BAs) Drafts are often used to facilitate international trade in goods and services. The seller of the goods writes either a time draft or a sight draft payable by the buyer of the goods or services. A sight draft is a claim that becomes due and payable upon presentation to the buyer. A time draft is a claim that becomes due and payable at a certain future date specified on the draft.

50. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-50 McGraw-Hill/Irwin Because the seller normally will not know the creditworthiness of the buyer (and credit investigation costs can be quite high), the seller may be reluctant to ship the goods unless payment can be guaranteed by a third party. Banker’s acceptances are a certain kind of time draft where a bank has agreed to pay the seller of the goods the amount owed if the buyer cannot or will not pay on the date due. The draft is backed by a letter of credit drawn on the buyer’s bank, ensuring that the bank will “accept” the draft drawn up by the seller. Once the seller can prove that the goods have been shipped in accordance with the contract and the proper paperwork has been presented to the buyer, the time draft can be sold as a discount instrument

51. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-51 McGraw-Hill/Irwin The seller of the goods can wait until maturity to receive payment, or more likely can discount the note to the bank and receive the discounted face amount immediately. The bank can then hold the acceptance or sell it. BAs are bearer instruments and are fairly actively traded. Maturities range from 30 to 270 days and BAs are bundled into round lots of $100,000 and $500,000. Interest rates are very close to T-bill rates because the risk of default is quite low as the BA is backed by the importer and a large bank and the value of the goods. The amount of BAs outstanding is quite small compared to the other money market instruments (less than 1% of the total money market securities outstanding).

52. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-52 McGraw-Hill/Irwin schematic of the creation of a BA

53. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-53 McGraw-Hill/Irwin 1.Purchase order sent by U.S. buyer to Chinese seller 2.Chinese seller requests a letter of credit 3.Notification of letter of credit and draft authorization 4.Order shipped 5.Time draft and shipping papers sent to Chinese seller’s bank 6.Time draft and shipping papers sent to U.S. bank; banker’s acceptance created 7.Payments sent to foreign bank (immediately if Chinese seller wishes to discount the draft and collect immediately, at maturity if not) 8.Payments sent to Chinese seller (see #7) 9.Payment to U.S. bank by U.S. buyer at maturity, paid in full 10.Shipping papers delivered

54. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-54 McGraw-Hill/Irwin Banker’s Acceptances summary A time draft payable to a seller of goods with payment guaranteed by a bank Arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer A time draft payable to a seller of goods with payment guaranteed by a bank Arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer

55. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-55 McGraw-Hill/Irwin Money Market Instruments Outstanding, December 1990 and 2004 (in billions of dollars) Amount Outstanding 1990 2004 Amount Outstanding 1990 2004 Rate of Return 1990 2004 Treasury bills $527.0 $ 981.9 6.68% 2.15% Federal funds and repurchase agreements 372.3 1,585.1 7.31 1.83 Commercial paper 537.8 1,309.7 8.14 1.89 Negotiable certificates of deposit 546.9 1,379.4 8.13 2.28 Banker’s acceptance 52.1 4.4 7.95 2.04

56. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-56 McGraw-Hill/Irwin Comparison of Money Market Securities Most money market securities have high denominations, or high round lots, low default risk, low interest rates and short maturities. The different instruments have evolved to fill certain niches or needs.

57. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-57 McGraw-Hill/Irwin The differences. The securities’ secondary markets show more variation. T-bills are the most actively traded money market security. CDs and BAs are less actively traded, in part because money market mutual funds and other buyers have been using a buy and hold strategy for these securities. Commercial paper is usually redeemed by the seller upon the buyer’s request so no secondary market is needed

58. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-58 McGraw-Hill/Irwin No secondary markets Fed funds and repos tend to be short term and so no secondary market has developed for these instruments

59. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-59 McGraw-Hill/Irwin Money Market Participants A- The U.S. Treasury The Treasury issues T-bills to provide funds throughout the year. Since the bulk of individual income tax receipts occur in the spring and corporations and self- employed individuals generally pay taxes quarterly. But government expenditures however occur throughout the year and the Treasury uses T- bills to provide financing over the intervening periods when income is not received.

60. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-60 McGraw-Hill/Irwin B- The Federal Reserve The Fed is a major participant in the money market. The Fed’s open market operations are conducted using T- bills, T-notes and T-bonds, and Fed policy often involves repurchase agreements. Moreover, the Fed currently targets the fed funds rate and actively intervenes in money markets to manipulate this rate. C- Commercial Banks Banks both issue and invest in CDs, fed funds, BAs and repos. Banks use the money markets to manage and minimize their excess reserves position and to meet short term deficits in reserves.

61. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-61 McGraw-Hill/Irwin D _ Money Market Mutual Funds Money market mutual funds (MMMFs) pool investors’ funds and purchase money market securities. Because most money market securities are high denomination, the MMMFs allow the small investor to participate in a variety of money market securities that would otherwise be too expensive for the typical individual. Investors in MMMFs may earn slightly higher rates than on bank accounts but must forego bank deposit insurance. Most MMMFs allow limited check writing, low cost investment and free movement of funds between funds in the same family.

62. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-62 McGraw-Hill/Irwin E – Brokers and Dealers Major brokers and dealers include: The twenty–two government securities dealers who make a market in T-bills assist the Treasury by purchasing its securities and assist the Fed in implementing open market operations. Cantor, Fitzgerald Securities, Garban-Intercapital, Liberty, RMJ Securities, and Hill Farber are money and security brokers. They are major players in the secondary market for government securities and they serve as brokers in the fed funds market. They do not trade for their own account and maintain anonymity of the principles in trades they broker. Thousands of brokers and dealers who link buyers and sellers.

63. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-63 McGraw-Hill/Irwin F- Corporations Non-financial corporations raise large amounts of money in the commercial paper markets and invest in other money market securities. G- Other Financial Institutions Insurance firms, particularly property and casualty insurers, maintain large liquidity balances. Money market mutual funds invest in these securities and finance companies must raise large amounts of funds in the commercial paper market because they cannot accept deposits.

64. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-64 McGraw-Hill/Irwin Money Market Participants Instrument Treasury bills Federal funds Repurchase agreement Commercial Paper Negotiable CDs Banker’s acceptances Principal Issuer U.S. Treasury Commercial banks FRS; Comm banks; Brokers and dealers; Other FIs Comm banks Other FIs; Corps Commercial banks Principal Investor FRS; Comm banks; MF’s Brokers and dealers; Other FIs; Corp’s Commercial banks FRS, Comm banks; MF’s Brokers and dealers Other FIs, Corp’s Brokers and dealers;MF’s Corporations Brokers and dealers;MF’s Corps; Other FIs Comm banks; Corp’s; Brokers and dealers

65. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-65 McGraw-Hill/Irwin International Aspects of Money Markets Investments in Treasury securities comprise the largest segment. With the introduction of the euro net issuance of international debt denominated in euros has grown tremendously rapidly. It is likely that money markets denominated in euros will continue to grow in importance

66. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-66 McGraw-Hill/Irwin Euro Money Market Securities –Euro Money Market Securities Some of the major securities include: Eurodollar CDs: Dollar denominated deposits held outside the U.S. The maturity is typically less than one year. Rates on Eurodollar CDs are sometimes higher than domestic CD rates because of the lack of explicit deposit insurance and lower regulatory costs.

67. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-67 McGraw-Hill/Irwin Eurocommercial paper Eurocommercial paper issued by commercial paper dealers: Technically, the term means commercial paper issued outside the borrower’s country of origin, but in their home currency. The term is coming to mean securities issued in Europe without involving a bank.

68. ©2007, The McGraw-Hill Companies, All Rights Reserved 5-68 McGraw-Hill/Irwin International Aspects of Money Markets summary While U.S. money markets are the largest, the international market is growing –U.S. securities bought/sold by foreign investors –foreign money market securities Euro money market instruments –Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP London Interbank Offered Rate (LIBOR) –the rate paid on Eurodollars While U.S. money markets are the largest, the international market is growing –U.S. securities bought/sold by foreign investors –foreign money market securities Euro money market instruments –Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP London Interbank Offered Rate (LIBOR) –the rate paid on Eurodollars