1 Chapter 2 MONEY MARKETS

2 Money Markets-Definition Markets for short term debt (maturity less than 1 year). Bear low credit and price risks. Thus, are highly marketable instruments (very liquid markets). Issued in very large denominations (face values) Actively participated by money market funds and commercial banks.

3 Money Market- Instruments 1.Treasury Bills (T-Bills) 2.Certificate of Deposit (CD) 3.Commercial Paper (CP) 4.Banker’s Acceptances (BA) 5.Fed Funds 6.Repurchase Agreements (Repos)

4 Money Market- Instruments 1.Treasury Bills – Issued by the full faith and backing of the U.S. government, in maturities of 4,13, 26 and 52 weeks. – Considered to have no default risk, as U.S govt. can print more dollars to retire debt (however, subject to inflation risk). – Also, referred to as risk-free securities. – Issued as discounted securities (paying a single cash flow, face value, on maturity). Trade at prices lower than face value. – Difference between face value and price equals return on the security.

Treasury Bills …continued Quoted on a bank discount basis, not on price. D=dollar discount. F=face value. t=number of days remaining to maturity. 5

Treasury Bills …continued Example: T-bill having 100 days to maturity, face value=$100,000 and selling for $99,100 is quoted at : Problems with quoted yield as a return measure: -Based on face value not price (investment). -Annualized on 360-day year (as opposed to actual 365 or 366(leap year, Feb=29 days) days). 6

Treasury Bills …continued Alternative return measures 1)Bond Equivalent Yield (BEY): compares T-bill yields to T-Bonds 2)CD Equivalent yield (CDEY): compares T-bill yields to other money market instruments. 7

Treasury Bills …continued 8

9 Money Market- Instruments 2.Certificate of Deposit (CD) –Are deposits placed with commercial banks for a fixed time period (Time Deposits) –Non-tradable securities. –Penalty on early withdrawal. –Insured by Federal Deposit Insurance Corporation (FDIC) for amounts up to $250,000 (raised from $100,000 in the last quarter of 2008).

10 Money Market- Instruments 3.Commercial Paper (CP) –Discounted securities issued by financial and non financial (corporations) firms. –Publicly traded debt instruments. –Less liquid than T-Bills as subject to credit risk (usually held to maturity by investors). –Unsecured, ranging in maturity in the U.S. from 30 to 270 days. –Became popular in the 80s, when rising costs of bank loans made it cheaper for firms with stronger credit quality to borrow directly from investors than from banks.

Commercial Paper….contd Uses of short terms funds by corporations: Financing working capital needs. Bridge financing (e.g. a subsequent bond issue or an upcoming corporate takeover). Uses of short term funds by financial firms: Fund loans to corporations (commercial banks). Provide funding for debt securities held as investments (e.g. CP issued by Ford Credit to extend auto financing to its customers). 11

Commercial Paper ….contd Commercial paper is unsecured: Issued by good quality firms subject to low default risk and credit rating changes. Riskier borrowers improve credit quality by 1.Getting a bank to guarantee repayment by issuing a letter of credit (LOC paper) for a fee. 2. Or by collateralizing the issue with high quality assets (asset-backed commercial paper). 12

13 Money Market- Instruments 4.Banker’s Acceptance (BA) –Effectively, bank guaranteed (IOUs) issued by corporations. –Used in financing of international trade. –Importers receiving trade credit issue IOUs in favor of their exporters. –The IOUs are accepted by the importers’ (borrower’s) bank, replacing the importers’ credit with that of the accepting bank. –Accepted IOUs (or BA) can be easily converted into cash by exporters via the process of “discounting” in the secondary money markets.

14 Money Market- Instruments 5.Fed Funds –Funds loaned between depository institutions maintaining reserve accounts with the Federal Reserve Bank (FRB), for periods of usually one day. –Used to meet bank reserve requirements. (Member-banks of the FRB are required to maintain a certain percent of their deposits as “reserves” in an account with FRB, paying zero interest). –Unsecured loans.

15 Money Market- Instruments 6.Repurchase Agreements (Repos) –Single most important source of financing for government securities’ dealers. –Secured lending transactions. –As a result, repo rates are generally lower than Fed Funds rates (unsecured loans). Alternatives to Repo Markets for Funding dealer securities’ inventory: Bank loans. Commercial Paper (or asset-backed commercial paper (ABCP)).

16 Money Market- Instruments Repo Transaction- Structure –Involves two parties, A and B. –Collateralized loans backed by “acceptable” securities (T- bills, T-Bonds, CP, ABCP, etc). –Acceptable securities: (highly liquid + low credit risk). Party A (Borrower) –Owns the securities. –Needs cash to pay for these securities. Party B (Lender) –Is cash surplus. –Looking to lend on a secured basis.

17 Repurchase Agreement (Repos):Definition (Party A) sells securities to (Party B) and agrees to repurchase those securities at a later date, on an agreed price. Party A (Borrower, is called Repo Investor) Borrows cash and delivers (lends) securities. Party B (Lender, is called Reverse Repo Investor) Lends cash and receives (borrows) securities. Reverse Repurchase Agreement : Definition (Party B) buys securities from (Party A) and agrees to resell those securities at a later date, on an agreed price. Money Market- Instruments

18 Repo – Collateral –All cash flows (coupon payments) on the collateral are collected by the repo investors. –On repo termination date, if borrowers fail to repay loan (i.e. defaults), lenders can sell the collateral to recover their loan and interest amounts. –Reverse repo investors (lenders) do not loan full value against collateral, but keep a certain margin as haircut (difference between the loan amount and the value of the collateral). –Lenders protect themselves against default risk by  Taking sufficient haircut to protect against a price decline, in the event of a forced liquidation of the collateral, and by  Daily marking to market (MTM) collateral: requiring borrowers to post more collateral when value of the existing collateral drops significantly.

19 Repo—contd… Repos- Types - Maturity equal to one day, Overnight Repos. -Generally rolled-over (or re-issued) the next day on the request of the repo investor (borrower). -Subject to high roll-over risk. -Overnight Repos against safe government securities are excellent investment opportunities, as they are secured loans, bearing low collateral price risk. –Maturity greater than one day, Term Repos.

Repo—contd… Determinants of the Repo Rate: Quality of the collateral. Term of the Repo (tied to the general level of interest rates in the economy for longer maturities). Collateral delivery requirements (whether “delivered out” or “held in custody” with a trustee under a tri-party agreement for the reverse repo investor). Availability of the collateral (whether the security is in much demand, “hot or special” or not, “general”. Special collateral have lower repo rates). Prevailing Fed Funds rate. 20

21 Profits for Repo Investors: CARRY –Profit on a repo trade is called Carry. –Carry = Difference between dollar Interest Income accrued on collateral less repo interest (cost of financing the trade). –Positive Carry: Accrued Income > repo interest –Negative Carry: Accrued Interest < repo interest

22 Repo- Calculations Value of Collateral= (Gross Price) * (# of bonds). Loan Amount = (1-Haircut %) * (Value of Collateral) Future Repayment = Loan Amount plus Repo Interest. Where: Gross price= clean price plus accrued interest. Clean Price= quoted price of the collateral security.

Repo- Example Suppose, Citibank finances 100,000 units of a 10%, 5 year T-Bond, trading at a quoted price of 102% of face value (FV=$1,000), through an overnight repo with Goldman Sachs. The repo rate and the haircut are 5%. Compute: 1.The loan amount under the repo? 2.The bank’s equity stake in the repo trade? 3.Interest repaid on the repo loan? 4.Future repayment amount under the repo? 5.Write out the Repo Contract. 6.Carry on the trade for the repo investor? 23

Repo- Example 1.Loan Amount (100,000*1020*0.95) $96,900,000 2.Bank’s equity (100,000*1020*0.05) $5,100,000 3.Repo Interest ($96,900,000*0.05*1/360) $13,458 4.Future Repayment Amount (96,900, ,458) $96,913,458 24

Repo Contract Repo investor Citibank Rev. Repo investor Goldman Sachs SecurityT-Bonds # of bonds100,000 units Unit Selling Price $ ($96,900,000/100,000) Unit Repurchase Price$ ($96,913,458 /100,000) Tenor 1 day 25

Repo Example-Carry One day’s Accrued Interest on 10%, 5 Year, T-Bond. 1 unit ((10%*1000)/365)= $ ,000 units =$27,397 One day’s Repo Interest =($13,458) CARRY (positive) $13,939 Simple annualized Return (13,939/5,100,00)*365= 99.78% 26