Financial Markets and Institutions 6th Edition PowerPoint Slides for: Financial Markets and Institutions 6th Edition By Jeff Madura Prepared by David R. Durst The University of Akron

Money Markets 6

Chapter Objectives Provide a background on money market securities Explain how institutional investors use money markets Explain the globalization of money markets

Money Market Securities Maturity of a year or less Debt securities issued by corporations and governments that need short-term funds Large primary market focus Purchased by corporations and financial institutions Secondary market for securities

Money Market Securities Treasury Bills Commercial paper Negotiable certificates of deposits Repurchase agreements Federal funds Banker’s acceptances

Money Market Securities Treasury bills Issued to meet the short-term needs of the U.S. government Attractive to investors Minimal default risk—backed by Federal Government Excellent liquidity for investors Short-term maturity Very good secondary market

Money Market Securities Treasury bill auction (fill bids in amount determined by Treasury borrowing needs) Bid process used to sell T-bills Bids submitted to Federal Reserve banks by the deadline Bid process Accepts highest bids Accepts bids until Treasury needs generated Competitive Bidding

Money Market Securities Treasury bill auction—noncompetitive bids ($1 million limit) May be used to make sure bid is accepted Price is the weighted average of the accepted competitive bids 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

Money Market Securities Estimating T-bill yield No coupon payments Par or face value received at maturity Yield at issue is the difference between the selling price and par or face value adjusted for time If sold prior to maturity in secondary market Yield based on the difference between price paid for T-bill and selling price adjusted for time

Money Market Securities Calculating T-Bill Annualized Yield SP – PP 365 YT  = PP n YT = The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period)

Money Market Securities T-bill yield for a newly issued security Par – PP 360 T-bill discount =  PP n T-bill discount = percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity

Money Market Securities Short-term debt instrument Alternative to bank loan Dealer placed vs. directly placed Used only by well-known and creditworthy firms Unsecured Minimum denominations of $100,000 Not a large secondary market Commercial Paper

Money Market Securities Commercial paper backed by bank lines of credit Bank line used if company loses credit rating Bank lends to pay off commercial paper Bank charges fees for guaranteed line of credit

Money Market Securities Estimating commercial paper yields Par – PP 360 YCP  = PP n YCP = Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity

Money Market Securities Issued by large commercial banks Minimum denomination of $100,000 but $1 million more common Purchased by nonfinancial corporations or money market funds Secondary markets supported by dealers in security Negotiable Certificates of Deposit (NCD)

Money Market Securities NCD placement Direct placement Use a correspondent institution specializing in placement Sell to securities dealers who resell Sell direct to investors at a higher price NCD premiums Rate above T-bill rate to compensate for lower liquidity and safety

Money Market Securities Sell a security with the agreement to repurchase it at a specified date and price Borrower defaults, lender has security Reverse repo name for transaction from lender Negotiated over telecommunications network Dealers and brokers used or direct placement No secondary market Repurchase Agreements

Money Market Securities Estimating repurchase agreement yields SP – PP 360 Repo Rate =  PP n Repo Rate = Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity

Money Market Securities Interbank lending and borrowing Federal funds rate usually slightly higher than T-bill rate Fed district bank debits and credits accounts for purchase (borrowing) and sale (lending) Federal funds brokers may match up buyers and sellers using telecommunications network Usually $5 million or more Federal Funds

Exhibit 6.5 a Importer Exporter American Bank (Importer’s Bank) 1 Purchase Order Exporter Shipment of Goods 5 2 L/C (Letter of Credit) Application 6 Shipping Documents & Time Draft 4 L/C Notification American Bank (Importer’s Bank) Japanese Bank (Exporter’s Bank) L/C 3 Shipping Documents & T ime Draft Draft Accepted (B/A Created) 7

Money Market Securities A bank takes responsibility for a future payment of trade bill of exchange Used mostly in international transactions Exporters send goods to a foreign destination and want payment assurance before sending Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time Bankers Acceptance

Money Market Securities Exporter can hold until the date or sell before maturity If sold to get the cash before maturity, price received is a discount from draft’s total Return is based on calculations for other discount securities Similar to the commercial paper example Bankers Acceptance

Major Participants in Money Market Commercial banks Finance, industrial, and service companies Federal and state governments Money market mutual funds All other financial institutions (investing) Short-term investing for income and liquidity Short-term financing for short and permanent needs Large transaction size and telecommunication network

Valuation of Money Market Securities Present value of future cash flows at maturity (zero coupon) Value (price) inversely related to discount rate or yield Money market security prices more stable than longer term bonds Yields = risk-free rate + default risk premium

Exhibit 6.7 a International Economic Conditions U.S. Fiscal Policy Monetary Policy U.S. Economic Conditions Issuer’s Industry Conditions Issuer’s Unique Conditions Short-T erm Risk-Free Interest Rate (T -bill Rate) Risk Premium of Issuer Required Return on the Money Market Security Price of the Money Market Security

Interaction Among Money Market Yields Securities are close investment substitutes Investors trade to maintain yield differentials T-Bill is the benchmark yield in money market Yield changes in T-bills quickly impacts other securities via dealer trading Yield differentials determined by risk differences between securities Default risk premiums vary inversely with economic conditions

Globalization of Money Markets Money market rates vary by country Segmented markets Tax differences Estimated exchange rates Government barriers to capital flows Deregulation Improves Financial Integration Capital Flows To Highest Rate of Return

Globalization of Money Markets Eurodollar deposits and Euronotes Dollar deposits in banks outside the U.S. Increased because of international trade growth and U.S. trade deficits over time No reserve requirements at banks outside U.S. Eurodollar Loans Channel funds to other multinationals that need short-term financing

Globalization of Money Markets Euro-commercial paper Issued without the backing of a banking syndicate Maturity tailored to investors Dealers that place paper create a secondary market Rates range between 50 and 100 basis points above the LIBOR rate

Globalization of Money Markets Performance of international securities Effective yield for international securities has two components The yield earned on the investment denominated in the currency of the investment The exchange rate effect

Globalization of Money Markets Performance of international securities Yield for an international investment SPf – PPf Yf = PPf Yf = Foreign investment’s yield SPf = Investment’s foreign currency selling price PPf = Investment’s foreign currency purchase

Globalization of Money Markets The exchange rate effect (%S) measures the percentage change in the spot during the investment period % S measures the expected percent change in the currency Currency appreciated, % S is positive and adds to net yield Currency depreciated, % S is negative and reduces net yield

Chapter Concepts Summary Surplus units channel investments to securities issued by deficit units Debt securities markets Money Market Capital Market Money market securities Short-term High quality Very good liquidity