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

©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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-3 McGraw-Hill/Irwin Definition and Purpose of Money Markets 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-4 McGraw-Hill/Irwin Money Market Instruments Treasury Bills (TBs) Federal Funds (FFs) Repurchase Agreements (RAs) Commercial Papers (CP) Negotiable Certificates of Deposit (CD) Banker Acceptance (BA) Treasury Bills (TBs) Federal Funds (FFs) Repurchase Agreements (RAs) Commercial Papers (CP) Negotiable Certificates of Deposit (CD) Banker Acceptance (BA)

©2007, The McGraw-Hill Companies, All Rights Reserved 5-5 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-6 McGraw-Hill/Irwin Money Market Instruments Outstanding, December 1990 and 2004 (in billions of dollars) Amount Outstanding Amount Outstanding Rate of Return Treasury bills $527.0 $ % 2.15% Federal funds and repurchase agreements , Commercial paper , Negotiable certificates of deposit , Banker’s acceptance

©2007, The McGraw-Hill Companies, All Rights Reserved 5-7 McGraw-Hill/Irwin Treasury Bill Basics Issued by the 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-8 McGraw-Hill/Irwin The Auction Process for T-bills Amount of new 13-week and 26-week T-bills offered weekly Bids submitted by government securities dealers, financial and non-financial corporations and individuals Amount of new 13-week and 26-week T-bills offered weekly Bids submitted by government securities dealers, financial and non-financial corporations and individuals

©2007, The McGraw-Hill Companies, All Rights Reserved 5-9 McGraw-Hill/Irwin The Auction Process for T-bills 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-10 McGraw-Hill/Irwin Treasury Auction Results Nov 18,2004 Quantity of T-bills Bid Price % SCSC STST Noncompetitive Bids % (P NC ) stop-out price (low bid accepted) $17,509.5m $19,254.8m

©2007, The McGraw-Hill Companies, All Rights Reserved 5-11 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-12 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 (dealer) 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-13 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-14 McGraw-Hill/Irwin Bid and Ask Prices Bid price is the price at which TBs are purchased by the dealers. Ask price is the price at which TBs are sold by the dealers. Dealer’s profit is the bid-ask spread. Normally, the ask price exceeds the bid price.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-15 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,  360 = 2.19% $10, 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,  360 = 2.19% $10,

©2007, The McGraw-Hill Companies, All Rights Reserved 5-16 McGraw-Hill/Irwin Federal Funds 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-17 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-18 McGraw-Hill/Irwin Repurchase Agreements (RPs or Repos) 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 For example, open market transactions in which the Trading Desk purchases government securities with an agreement that the seller will repurchase them within a stated period of time. 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 For example, open market transactions in which the Trading Desk purchases government securities with an agreement that the seller will repurchase them within a stated period of time.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-19 McGraw-Hill/Irwin Repurchase Agreements (RPs or Repos) Essentially a collateralized fed funds loan with collateral in the form of securities (e.g. T-bills and Fannie Mae securities)

©2007, The McGraw-Hill Companies, All Rights Reserved 5-20 McGraw-Hill/Irwin Repurchase Agreements (RPs or Repos) Reverse repurchase agreement An agreement involving the purchase of securities by one party from another with the promise to sell them back. Reverse repurchase agreement An agreement involving the purchase of securities by one party from another with the promise to sell them back.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-21 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-22 McGraw-Hill/Irwin Commercial Paper 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-23 McGraw-Hill/Irwin Commercial Paper Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million Maturities of days (if maturity is greater than 270 days, SEC requires registration) Generally held until maturity so there is not an active secondary market Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million Maturities of days (if maturity is greater than 270 days, SEC requires registration) Generally held until maturity so there is not an active secondary market

©2007, The McGraw-Hill Companies, All Rights Reserved 5-24 McGraw-Hill/Irwin Trading Process for Commercial Paper CPs are sold either directly to investors 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-25 McGraw-Hill/Irwin Negotiable Certificates of Deposits A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market Bearer Instrument A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market Bearer Instrument

©2007, The McGraw-Hill Companies, All Rights Reserved 5-26 McGraw-Hill/Irwin Negotiable Certificates of Deposits 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-27 McGraw-Hill/Irwin Trading Process for NCDs Banks issuing NCDs post daily rates for the more popular maturities and subject to funding needs, try 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 Banks issuing NCDs post daily rates for the more popular maturities and subject to funding needs, try 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

©2007, The McGraw-Hill Companies, All Rights Reserved 5-28 McGraw-Hill/Irwin Trading Process for NCDs Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues

©2007, The McGraw-Hill Companies, All Rights Reserved 5-29 McGraw-Hill/Irwin Banker’s Acceptances 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) 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)

©2007, The McGraw-Hill Companies, All Rights Reserved 5-30 McGraw-Hill/Irwin Banker’s Acceptances Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Bankers Acceptances An order to pay a specified amount on a specified date in the future. Facilitates commercial trade transactions. Sold on a discounted basis prior to maturity.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-32 McGraw-Hill/Irwin Creation of Bankers Acceptances Importing of goods into the U.S. Exporting of goods from the U.S. to foreign entities Storing and shipping of goods between two foreign countries where neither the importer nor the exporter is a U.S. firm Storing and shipping of goods between two entities in the U.S.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-33 McGraw-Hill/Irwin Accepting Banks Created by all four groups of banks –money center banks –regional banks –Japanese banks –Yankee banks Eligible BAs can serve as collateral for discount window loans of the Fed. BA rate is determined in open market.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-34 McGraw-Hill/Irwin Dealers in Bankers Acceptances Banks may sell bankers acceptances –directly to investors –directly to dealers

©2007, The McGraw-Hill Companies, All Rights Reserved 5-35 McGraw-Hill/Irwin Risks in Bankers Acceptances Credit Risk –risk that neither borrower nor accepting bank will be able to pay the principal at maturity Yield includes premium for: –credit risk –liquidity risk

©2007, The McGraw-Hill Companies, All Rights Reserved 5-36 McGraw-Hill/Irwin 1. An exporter receives a letter of credit from the importer's bank. He ships goods and presents documentation (a draft, an invoice, and a copy of the bill of lading) to his own bank. 2. The exporter's bank pays the exporter cash by discounting the draft, which it in turn presents for payment to the importer's bank. Example

©2007, The McGraw-Hill Companies, All Rights Reserved 5-37 McGraw-Hill/Irwin 3. The importer's bank "accepts the draft," thereby creating a BA. It stipulates its willingness to pay at some specified time in the future. 4. The exporter's bank can either hold the BA until maturity or, more likely it will sell it immediately to the importer's bank. Example

©2007, The McGraw-Hill Companies, All Rights Reserved 5-38 McGraw-Hill/Irwin Example 5. Once the importer's bank has purchased back its BA, it can either hold it till maturity or sell it on the open market at a discount. 6. At maturity the importer's bank will collect from the importer and use those funds to pay the holder of the bankers acceptance.

©2007, The McGraw-Hill Companies, All Rights Reserved 5-39 McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved 5-40 McGraw-Hill/Irwin International Aspects of Money Markets 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