1. Chapter 11: Money Markets, Short-Term Investing and Borrowing
Outline:
Global Money Markets
Short-Term Money Markets in the U.S.
Managing Short-Term Investments
Pricing and Yields on Short-Term Investments
Managing Short-Term Financing
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2. Money Market Participants
Issuers of money markets:
Government entities, securities dealers, commercial banks, corporations
Investors are lenders; issuers are borrowers
Individuals who invest are lending
Broker-dealers
As brokers, trade on behalf of customers
As dealers, trade for their own account
Place majority of new issues in primary market and provide liquidity in secondary markets
Take positions in securities (ask price/bid price)
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3. Money Market InstrumentsCP
ABCP
Bank Obligations
Government Paper
FRNs
Repos
Maturity
Overnight–270 days
1 day–2 years
4–52 weeks
Variable
Wholly negotiable
Issued by
Companies
Banks
Government/public
Companies/ FIs
Interest rate
Fixed
Negotiable
Interest paid
On maturity
During or maturity
Issued
Discount
Interest
Secured No
Yes
Yes/no
Access to capital before maturity
Sell on secondary market
CDs sell on secondary market
Sell on secondary; periodic reset dates
Risks
Credit, price
Credit, liquidity, price
Credit, liquidity
Price
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4. Standard and Asset-Backed CP
ABCP
Overnight to 270 days, but most issued < 45 days
Can be sold on secondary market, but most held to maturity
Unsecured CP tends to be highly liquid and have broad range of maturities
Diversifiable risk
Europe and U.S. have highly developed markets
Disadvantage is it is not asset-backed; could have credit enhancement
Secured against short-term trade receivables
Single seller
Multi-seller
More security than CP and liquidity support (credit enhancement) facilitates timely repayment
More complex, requires specialist appraisal and credit monitoring; moderately higher return
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5. Bank Obligations Banks raise funds in money markets. Time deposits:
Savings accounts, certificates of deposit (CDs), negotiable CDs ($100,000 or more)
Active secondary market for negotiable CDs
Repurchase agreements (repos)
Eurodollar deposits
Banker’s acceptances (BAs)
Time draft issued by purchaser and accepted by bank
Unconditional promise to pay at maturity
Holder can hold to maturity or sell at discount
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

6. Discussion Question
Which of the following typically has longer maturities for money market instruments and is based on LIBOR or Euribor but also has a wider bid-offer spread so regular trading can erode its yield advantage quickly?
Government paper
Floating rate notes (FRNs)
Retail CDs
Answer: b
v3.0 © 2011 Association for Financial Professionals. All rights reserved Session 8: Module 5, Chapter

7. Repurchase Agreements (Repos)
Bank or securities dealer sells government securities to an investor and agrees to repurchase them later at a slightly higher price.
Reverse repo is opposite side of same transaction.
Can be based on any agreed-upon security.
Types:
Overnight
Term (2 days or longer)
Open (no maturity date, can be terminated by either party on day-to-day basis)
Ample room to tailor maturity and interest.
Legal possession provides comfort because underlying can be sold.
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8. Money Market Funds (MMFs)
Commingled pools of money market instruments in which investors have an ownership interest
Local or foreign currency (if allowed)
NAV set at one unit of the currency
Funds can differ in:
Risk
Maturity
Return
Professionally managed, marketable securities portfolio at low cost
May be more cost-effective than managing short-term investment portfolio
Administratively easy
Daily liquidity; pay dividends
Low minimum investment
When interest rates are falling, can extend maturities to lock in yields
Large scale = competitive trading
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

9. Short-Duration Mutual Funds
Invest in securities with maturities that exceed most money market instruments
Average maturity 1 to 3 years
Instruments include government issues, CDs, CP
Offer higher average returns but also a higher risk of fluctuating NAV:
Not configured to maintain a fixed unit NAV
May be used for matching strategy
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

10. Short-Term Money Markets in the U.S.: Commercial Book-Entry System
Nearly all short-term securities issued in book-entry form:
Registered and transferred electronically by U.S. Treasury (Treasury securities only) or Commercial Book-Entry System (CBES)
Simultaneous transfer of securities against settlement of funds
National Book-Entry System (NBES)
Depository institutions— hold book- entry accounts
Brokers, dealers, banks—maintain book-entry accounts for individual customers
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11. Depository Trust and Clearing Corporation (DTCC)
DTCC works through subsidiaries to provide:
Clearing, settlement and information services for:
Equities
Corporate and municipal bonds
Government and mortgage-backed securities
Money market instruments
OTC derivatives
Legal depository
Custody and asset servicing
Industry-owned
Operates on at-cost basis
SEC-registered services
DTCC
Depository Trust Company (DTC)
National Securities Clearing Corporation (NSCC)
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12. U.S. Treasury Bills (T-Bills)
Exempt from state tax for most U.S. investors
May have franchise tax
Money market instruments
Original maturities < 1 year (4, 13, 26, 52 weeks)
Multiple-price, sealed-bid auction
Competitive or non-competitive
Daily dealer bid and ask yield quotes
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13. Commercial Paper (CP) and the U.S. Money Market
Unsecured promissory note
Major issuers in the U.S. are corporations, bank holding companies, and non-bank finance companies
Public market: 270 days or less
SEC code: Section 3[a]3 for public issue, Section 4[2] for private issue
Among highest yields in money market
Default risk
Limited secondary market
Evaluated by rating agencies (can be credit-enhanced)
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14. U.S. Federal Agency and Government-Sponsored Enterprise (GSE) Securities
Guarantees backed by full faith and credit of U.S. government.
Ginnie Mae (GNMA) provides liquidity through its MBS program.
Real estate mortgage investment conduits (REMICs)
Interest rate related price and prepayment risks
Pools of mortgages (tranches) allow risk control
VA guarantees REMICs issued through Vendee Mortgage Trust.
GSEs are private companies providing funds for loans in housing, education and agriculture.
Strong implication government would intervene in crisis.
Fannie Mae, Federal Farm Credit Banks Funding Corporation, Freddie Mac, Federal Home Loan Banks Office of Finance.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

15. Municipal Notes, VRDOs and Tax-Exempt CP
Issued by state and local governments or their agencies (up to 270 days for CP).
Many are exempt from federal and/or state income taxes in state of issuance.
Provide interim financing for general obligation bond projects.
VRDOs issued as long-term bonds with a put.
Active secondary market for short-term municipal obligations.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

16. Short-Term Investment Policy
Investment objectives
Permissible and prohibited investments
Minimum/acceptable security ratings
Maximum maturity for individual securities and maximum duration for portfolio
Maximum percentage amounts of portfolio that may be invested in individual securities, companies, instrument classes, geographic areas, industries
Specific responsibilities for implementing policy
Methods of monitoring compliance with policies, procedures, internal controls
Provisions for performance measurement, evaluation, reporting
Guidance for classification of investments per FASB and GASB rules
Responsibilities and reporting requirements for custodians and broker- dealers
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17. Investment Strategies
Buy-and-hold-to-maturity: conservative investor
Matching: Purchasing securities that mature when funds are required to meet an expected obligation or obligations
Actively managed: aggressive investor
Two strategies for buying highly liquid, marketable securities (T-bills) that mature on a different day from when the investor intends to sell
Normal yield curve: Purchase maturities past capital need, sell early
Inverted yield curve: Purchase maturities shorter than capital need, then reinvest
Tax-based: high-tax-bracket investor
Tax-advantaged mutual funds
Dividend capture
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18. Discussion Question Answer: b
Which of the following securities safekeeping and custody services methods is generally less costly but also more risky due to the higher risk of fraud?
Engage a third party to provide custodial services for an investor (corporate trust department of a commercial bank).
Keep securities at the institution (usually a brokerage firm) from which they were purchased.
Answer: b
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19. Investment Risk Considerations: Credit or Default Risk
Risk that payments on a security will not be made under the original terms
Credit evaluation assesses default likelihood
Credit ratings based on default risk, seniority and any collateral by Nationally Recognized Statistical Rating Organizations (NRSROs):
Moody’s
Standard and Poor’s (S&P)
Fitch
Dominion (DBRS) and other 6
Credit enhancement
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20. Discussion Question
What is the primary benefit of a borrower receiving credit support?
Answer:
Because the borrower’s debt assumes the credit rating of the guarantor, the borrowing cost may be reduced or the marketability of the debt enhanced.
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21. Investment Risk Considerations: Asset Liquidity Risk
Risk that a security cannot be sold quickly without an unacceptable loss
Marketability
Existence of active secondary market?
Unrated securities may not be liquid; must perform credit analysis.
Maturity
Date on which obligation is settled.
Holding investments over longer time periods increases price risk.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

22. Investment Risk Considerations: Other Risks
Price/interest rate risk
Risk that arises when interest rates for securities that are identical or nearly identical to portfolio securities change
Longer maturities subject to more price risk
Threat that interest rates may rise during holding period of fixed-rate security
Reinvestment risk
Foreign exchange (FX) risk
Risk of change in FX rates between currency of security and company’s local currency
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23. Yield Curves
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24. Taxable Equivalent Yield (TEY)
Example:
Taxable security = 4.60% yield.
Tax-exempt security (of similar risk and maturity) = 3.20% yield.
Firm’s marginal income tax rate is 35%.
The tax-exempt security should be chosen because it has a higher effective after-tax yield. The after-tax yield of the taxable security is .046(1 – 0.35), or 2.99%.
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25. Holding Period Yield (HPY)
HPY example: 90-day $100,000 T-bill purchased for $98,800
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26. Discussion Question
Which of the following is true of T-Bills, CP and BAs?
They pay unregulated rates of interest based on current market value.
They do not pay interest; rather, they are issued at less than par value (the discount) and pay par value at maturity.
They pay a semiannual coupon.
Answer: b. They are all discounted instruments.
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27. Dollar Discount and Discount Rate
Example: $1,000,000 par (or face) value 182-day T-bill is sold for $974,216
HPY = and 360-day basis yield = 5.24%
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

28. Dollar Discount and Money Market Yield
The dollar discount can be related to the discount rate by rearranging the discount rate equation from the prior slide. Example from prior slide: 182-day $1,000,000 T-bill with a discount rate of 5.1% = $25,784 dollar discount.
The money market yield (360-day year):
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

29. Bond Equivalent Yield
Bond equivalent yield, or annual yield to an investor, using a 365-day-per-year follows.
Example from prior slides: 182-day $1,000,000 T-bill, $974,216 invested.
Method 1
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30. T-Bill Quotes Maturity Date Days to Maturity Bid Discount Ask Discount
Dealers buy and sell T-bills in a secondary market.
Bid quote is the discount at which a dealer will buy a T-bill.
Ask quote is the discount at which a dealer will sell a T-bill.
Ask yield is the yield to an investor purchasing a T-bill at the ask discount.
Ask yield is quoted on a 365-day-per-year basis.
Maturity Date
Days to Maturity
Bid Discount
Ask Discount
Ask Yield (%)
Feb 20 29
1.14
1.13
1.15
Feb 27 36
Mar 06 43
1.12
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

31. Short-Term Funding Alternatives
Trade credit
Internal borrowing
Selling of receivables
Commercial bank credit
Loan syndications and participations
Line of credit
Revolving credit agreement
Single payment notes
Repurchase agreement (repo)
Commercial paper (CP) issuance
Asset-based borrowing
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

32. Selling of Receivables
Factoring
The sale or transfer of A/R to a third party, who charges a percentage commission to the borrower on the amount of A/R (depending on the quality of A/R, not company’s financial statements); with or without recourse.
Securitization
Company issues debt securities backed by a pool of receivables; suitable assets usually have a predictable cash flow stream to retire the issue and a historical record of low losses.
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33. Commercial Bank Credit: Loan Syndication and Participation
Loan participation
Multiple financial institutions (syndicate) share a single credit facility.
An agent acts as an intermediary.
All syndicate members share documentation; each lender has a promissory note.
A financial institution purchases interest in another lender’s credit facility.
The purchaser is called the participant; the seller is the lead institution.
A participant does not have a separate note.
Direct lending relationship
Indirect lending relationship
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34. Line of Credit Key Characteristics
Lender gives access to funds up to a maximum amount over a specified period.
May be committed or uncommitted line:
Committed obligates the buyer to provide funding as long as the buyer is not in default.
Uncommitted can be cancelled by the lender at any time.
Usually revolving.
May be secured or unsecured.
Usually has a 30- to 60-day clean-up period.
Basic cost components:
All-in rate of interest
Commitment fees
Compensating balances
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

35. Commercial Paper (CP) Issuance
In practice, many CP issuers roll over outstanding balances at maturity to new CP issue. To do this:
Maintain CP backup lines of credit.
Issuer must carry strong credit rating or get higher rating through credit enhancement (standby L/C).
Issued at discount + dealer fees, backup credit facility fees, rating agency charges and credit enhancement costs.
Therefore rarely used for less than $50 million.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter

36. Annual Cost for Commercial Paper (CP)
Example: A company issues $20 million of CP with a 20-day maturity at a discount of 5.40%.
Part 1 of 4:
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37. Annual Cost for a Line of Credit
A line of credit lender charges interest and a commitment fee on the line.
Interest is charged on the used portion of the line.
The commitment fee may be charged on the line or its unused portion.
The overall interest rate on the line is determined by the total interest paid on the line’s used portion and the amount paid for the commitment fee relative to the average used portion of the credit line over the borrowing period.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter