CHAPTER 7 Money Markets

Overview of the Money Market Short-term debt market - most under 120 days. A few high quality borrowers. Many diverse investors. Standardized securities -- one security is a close substitute for another. Copyright© 2008 John Wiley & Sons, Inc.

Overview of the Money Market (concluded) Good marketability - secondary market. Large, wholesale open-market transactions. Many brokers and dealers are competitively involved in the money market. Physical possession of securities seldom occurs - centralized safekeeping. Copyright© 2008 John Wiley & Sons, Inc.

Economic Role of Money Market (MM) The most important economic function of the money markets is to provide an efficient means for adjusting liquidity. They allow economic units to bridge the gap between the cash inflow and outflows, thereby solving the liquidity problems. The money market is a market for liquidity Liquidity is stored in MM by investing in MM securities. Liquidity is bought in MM by issuing securities (borrowing). Copyright© 2008 John Wiley & Sons, Inc.

Characteristics of Money Market Instruments Low default risk. Short maturity (low price risk). High marketability. Large denominations. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. U.S. Treasury Bills Characteristics Sold on discount basis. Maturities up to one year. Minimum denomination is usually $10,000, but smaller investors can invest in multiples of $1,000. Considered free of default risk. Copyright© 2008 John Wiley & Sons, Inc.

How to Read T-Bill Quotes Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. U.S. Treasury Bills Pricing Treasury Bills 1. Treasury bills are priced on a bank discount rate basis, a traditional yield calculation. The bank discount rate, yd , is: Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. U.S. Treasury Bills 2. The Wall Street Journal reports T-Bill yields on a bond equivalent basis where the discounted price is the denominator and 365 days is used as the annualizer: Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Example Example 1: You are given the following data: Face price = 10,000, buying price = 9760, days to maturity = 100. what is the yield on a bond – equivalent basis? YBE = [(Face Value - Price)/Price] x [(365/Days to Maturity) ] x 100% YBE = [(10000 – 9760) / 9760] [365 / 100] [100%] = (0.025 )(3.65)(100%) = 8.9% Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. U.S. Treasury Bills A T-bill’s price can be computed by using the discount yield: Or by using the bond equivalent yield basis: Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Example Example 2: You are given the following data: Face price = 10,000, days till maturity = 91 and yield = 8.19%. what is buying price on a bond – equivalent basis? Price = [face price] / [1 + (YBE * days to Maturity / 365) = 10000 / 1.0204 = 9800 Copyright© 2006 John Wiley & Sons, Inc.

Repurchase Agreements (Repo) Sale of security with agreement to buy it back later at a higher price. Difference in prices is interest Securities serve as collateral Bank Financing - Source of funds. The interest rate on a repo is lower than the fed funds rate, since it is backed up by a security. Copyright© 2008 John Wiley & Sons, Inc.

Repurchase Agreements (concluded) 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. Repos are used to shorten the actual maturity of a security to meet the needs of both borrowers and lenders. Example: If you want to invest for only 3 days, you can either buy a T.Bill and sell it after 3 days but this will involves price risk if the interest rate changes during the 3 days, or you can invest in 3 days repo, eliminating all price risk. Copyright© 2008 John Wiley & Sons, Inc.

Yield on Repurchase Agreements (Repo) The yield on a repo is calculated as follows: Where: Prepo = repurchase price of the security, which equals the selling price plus interest. P0 = sale price of the security n = number of days to maturity Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Yield on Repo- Example Example: A commercial bank does a reverse repo with one of corporate customers who needs funds for 3 days. The bank agrees to buy treasury securities at $1,000,000 and promise to sell securities back at $1,000,145 after 3 Days. What is the yield on the reverse repo? Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. Commercial Paper Unsecured corporate debt. Maturities are 1 to 270 days. Large denominations -- $100,000 and up. Issued by high-quality borrowers. A wholesale money market instrument - few individual investors. Sold at a discount from par. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Commercial Papers Commercial papers are sold on discount basis. the formula for the discount yield (ydp) : Where Pf is the face price, P0 is the purchase price and n is the number of days to maturity. the formula for purchase price on discount yield basis: Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Commercial Papers the formula for the bond equivalent yield (ybe) : Where Pf is the face price, P0 is the purchase price and n is the number of days to maturity. the formula for purchase price on bond equivalent yield basis: Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. Bankers' Acceptances Time draft - order to pay in future. The bank accepts the responsibility to repay the face value at maturity to the holder of the time draft. Direct liability of bank. Mostly relate to international trade. Secondary market - dealer market. Discounted in market to reflect yield. Standard maturities of 30, 60, or 90 days -max of 180. Copyright© 2008 John Wiley & Sons, Inc.

Creating a Banker's Acceptance Importer initiates purchase from foreign exporter, payable in future. Importer needs financing; exporter needs assurance of payment in future. Importer's bank writes irrevocable letter of credit for exporter Specifies purchase order. Authorizes exporter to draw time draft on bank. Once the bank authorize the time draft, it send it to the exporter. Once the goods are shipped, the exporter transfer the documents and the time draft to its local bank. Copyright© 2008 John Wiley & Sons, Inc.

Creating a Banker's Acceptance (concluded) The exporter’s bank will pay the exporter immediate cash, but of a discount amount. The exporter bank will send the time draft and all the documents to the importer bank, who will accept the draft. At maturity, the importer bank will pay the exporter bank the face value of the time draft. The importer is responsible to pay his bank the amount at maturity. Copyright© 2006 John Wiley & Sons, Inc.

Creating a Banker's Acceptance (concluded) Advantages of a BA: Exporter receives funds by selling BA in the market. Exporter eliminates foreign exchange risk, because a local bank pays in domestic funds. Importer's bank guarantees payment of draft in future. Copyright© 2008 John Wiley & Sons, Inc.

Tracing a Banker’s Acceptance Transaction Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. MM participants Commercial Banks. The Federal Reserve System. The US Treasury and Treasury Security Dealers. Corporations Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. Commercial Banks Most important participant in the MM Bank assets or investments Treasury bills. Agency securities. Bankers' acceptances (from other banks). Federal Funds sold. Reverse repurchase agreements (securities purchased under agreements to resell). Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. Commercial Banks,cont. Bank liabilities or borrowing Negotiable CDs. Commercial paper. Bankers' acceptances. Federal Funds purchased. Repurchase agreements (securities sold under agreements to repurchase). Due to fluctuations in loans and deposits banks need MM securities to provide sources and uses of liquidity. Copyright© 2008 John Wiley & Sons, Inc.

The Federal Reserve System MM securities are the major asset category of the Fed. Open-market operations (buying and selling of MM securities by Fed) is the primary tool for implementing monetary policy. Purchase - increases member bank reserves. Sale - decreases member bank reserves. Copyright© 2008 John Wiley & Sons, Inc.

Dealers in U.S. Securities Involved in both primary and secondary markets. Purchase new Treasury debt and resell it (primary market). "Make a market" by buying/selling (dealer) securities (secondary market). Purchases are financed by repurchase agreements or fed funds. Dealers have a small capital base and are highly leveraged. Copyright© 2008 John Wiley & Sons, Inc.