The Money Market 1 Copyright 2013 Diane Scott Docking

2 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.

Copyright 2013 Diane Scott Docking 3 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 ________ denominations. They have ______ default risk.

Copyright 2013 Diane Scott Docking 4 Money Market Instruments 1. Treasury Bills 2. Federal Funds 3. Repurchase Agreements 4. Commercial Paper 5. Negotiable Certificates of Deposit 6. Bankers Acceptance 7. Eurodollars

Copyright 2013 Diane Scott Docking 5 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.

Copyright 2013 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 6

Copyright 2013 Diane Scott Docking 7 T-Bill Quote Example: As of July 29, 2013: MaturityBidAsked ChgAsked Yield 02/06/ Quote is end of day 07/29/2013, assume 2 days to settle (this can vary) so day 1 = 7/31/2013…02/06/2014 is last trading day. So 191 days to maturity. Discount Rate Bond Equivalent Yield Change from yesterdays closing Ask Yield

Copyright 2013 Diane Scott Docking 8 Treasury Bills 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

Copyright 2013 Diane Scott Docking 9 Calculating Yields/Prices on U.S. Treasury Bills Treasury bills are priced on a discount rate basis, i dy or DR, is:

Copyright 2013 Diane Scott Docking 10 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 Relationship between DR and Asked Yield (i bey ):

Copyright 2013 Diane Scott Docking 11 Wall Street Journal Example: Cost to buy $1,000,000 of T-bills: Ask Yield calculation: Effective Return calculation:

Copyright 2013 Diane Scott Docking 12 Problem: T-bill You pay $ for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? Ask Yield? Effective Annual Return?

Copyright 2013 Diane Scott Docking 13 Solution to Problem: T-bill What is its discount rate?

Copyright 2013 Diane Scott Docking 14 Solution to Problem: T-bill What is its ask yield (or bond equivalent yield)?

Copyright 2013 Diane Scott Docking 15 Solution to Problem: T-bill What is its effective annual return?

Copyright 2013 Diane Scott Docking 16 T-Bill Auction All non-competitive bids accepted. Specify quantity only. Maximum bid. Price is the competitive auction yield price. Investors do not know the price in advance so they submit check for full par value After the auction, investor receives check from the Treasury covering the difference between par and the actual price Noncompetitive Bidding

Copyright 2013 Diane Scott Docking 17 T-Bill Auction Specify price (as a yield %) and quantity desired. Minimum purchase $1,000 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

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Treasury Bill Auction Results (M&E 7ed, Ch.11) 19 Copyright 2013 Diane Scott Docking

Treasury Bills Rates (M&E, 7ed Ch. 11) 20 Copyright 2013 Diane Scott Docking

21 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

Copyright 2013 Diane Scott Docking 22 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 Treasurys annualized interest cost from this auction (i.e., effective yield)?

Copyright 2013 Diane Scott Docking 23 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%

Copyright 2013 Diane Scott Docking 24 Example of a T-Bill Auction (cont.) 4. Treasury receives: 5. Ask Yield: 6. Effective Yield: or

Copyright 2013 Diane Scott Docking 25 Federal Funds Interbank 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:

Fed Funds Rates (M&E, ed. 7, Ch. 11) 26 Copyright 2013 Diane Scott Docking

27 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.

Copyright 2013 Diane Scott Docking 28 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.

Copyright 2013 Diane Scott Docking 29 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

Copyright 2013 Diane Scott Docking 30 Reverse Repurchase Agreement (Aka: Securities Purchased Under Agreement to Resell) Bank buys a security from a customer with the agreement to sell it back to customer within so many days (say 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:

Copyright 2013 Diane Scott Docking 31 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). 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

Copyright 2013 Diane Scott Docking 32 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:

Copyright 2013 Diane Scott Docking 33 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.

Commercial Paper Rates (M&E, 7 ed., Ch. 11) 34 Copyright 2013 Diane Scott Docking

Commercial Paper Volume (M&E, 7 ed., Ch. 11) 35 Copyright 2013 Diane Scott Docking

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

Copyright 2013 Diane Scott Docking 37 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

Copyright 2013 Diane Scott Docking 38 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 year 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.

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Copyright 2013 Diane Scott Docking 40 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:

Copyright 2013 Diane Scott Docking 41 Example 5-9 in text: Negotiable Certificates of Deposit A:

Copyright 2013 Diane Scott Docking 42 Example 5-9 in text: Negotiable Certificates of Deposit

Copyright 2013 Diane Scott Docking 43 Example 5-9 in text: Negotiable Certificates of Deposit Q3: After the price drop, what is the EAR on the NCD? A:

Negotiable CD Rates (M&E, 7ed., Ch. 11) 44 Copyright 2013 Diane Scott Docking

Comparing Money Market Securities : A comparison of rates 45 Copyright 2013 Diane Scott Docking

46 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.

Copyright 2013 Diane Scott Docking 47 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 LC to Japanese Bank. 4) Japanese Bank notifies Exporter that they have a LC and okay to ship. 5) Exporter ships goods. 6) Exporter sends shipping documents to Japanese Bank. 7) Japanese Bank sends shipping documents and Time Draft (like an invoice) 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.

Copyright 2013 Diane Scott Docking 48 Exhibit: (Bankers Acceptance) a 1 Purchase Order Shipment of Goods 5 L/C3 Shipping Documents &Time Draft DraftAccepted (B/A Created) 7 Japanese Bank (Exporters Bank) American Bank (Importers 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

Bankers Acceptance Copyright 2013 Diane Scott Docking 49

50 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.

Comparing Money Market Securities: Money Market Securities and Their Depth 51 Copyright 2013 Diane Scott Docking