Chapter 11: Money Markets, Short-Term Investing and Borrowing Outline: Global Money Markets Short-Term Money Markets in the U.S. Managing Short-Term Investments Pricing and Yields on Short-Term Investments Managing Short-Term Financing v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 1

Money Market Participants Issuers of money markets: Government entities, securities dealers, commercial banks, corporations Investors are lenders; issuers are borrowers Individuals who invest are lending Broker-dealers As brokers, trade on behalf of customers As dealers, trade for their own account Place majority of new issues in primary market and provide liquidity in secondary markets Take positions in securities (ask price/bid price) v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 2

Money Market Instruments CP ABCP Bank Obligations Government Paper FRNs Repos Maturity Overnight–270 days 1 day–2 years 4–52 weeks Variable Wholly negotiable Issued by Companies Banks Government/public Companies/ FIs Interest rate Fixed Negotiable Interest paid On maturity During or maturity Issued Discount Interest Secured No Yes Yes/no Access to capital before maturity Sell on secondary market CDs sell on secondary market Sell on secondary; periodic reset dates Risks Credit, price Credit, liquidity, price Credit, liquidity Price v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 3

Standard and Asset-Backed CP ABCP Overnight to 270 days, but most issued < 45 days Can be sold on secondary market, but most held to maturity Unsecured CP tends to be highly liquid and have broad range of maturities Diversifiable risk Europe and U.S. have highly developed markets Disadvantage is it is not asset-backed; could have credit enhancement Secured against short-term trade receivables Single seller Multi-seller More security than CP and liquidity support (credit enhancement) facilitates timely repayment More complex, requires specialist appraisal and credit monitoring; moderately higher return v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 4

Bank Obligations Banks raise funds in money markets. Time deposits: Savings accounts, certificates of deposit (CDs), negotiable CDs ($100,000 or more) Active secondary market for negotiable CDs Repurchase agreements (repos) Eurodollar deposits Banker’s acceptances (BAs) Time draft issued by purchaser and accepted by bank Unconditional promise to pay at maturity Holder can hold to maturity or sell at discount v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 5

Discussion Question Which of the following typically has longer maturities for money market instruments and is based on LIBOR or Euribor but also has a wider bid-offer spread so regular trading can erode its yield advantage quickly? Government paper Floating rate notes (FRNs) Retail CDs Answer: b v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 6

Repurchase Agreements (Repos) Bank or securities dealer sells government securities to an investor and agrees to repurchase them later at a slightly higher price. Reverse repo is opposite side of same transaction. Can be based on any agreed-upon security. Types: Overnight Term (2 days or longer) Open (no maturity date, can be terminated by either party on day-to-day basis) Ample room to tailor maturity and interest. Legal possession provides comfort because underlying can be sold. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 7

Money Market Funds (MMFs) Commingled pools of money market instruments in which investors have an ownership interest Local or foreign currency (if allowed) NAV set at one unit of the currency Funds can differ in: Risk Maturity Return Professionally managed, marketable securities portfolio at low cost May be more cost-effective than managing short-term investment portfolio Administratively easy Daily liquidity; pay dividends Low minimum investment When interest rates are falling, can extend maturities to lock in yields Large scale = competitive trading v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 8

Short-Duration Mutual Funds Invest in securities with maturities that exceed most money market instruments Average maturity 1 to 3 years Instruments include government issues, CDs, CP Offer higher average returns but also a higher risk of fluctuating NAV: Not configured to maintain a fixed unit NAV May be used for matching strategy v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 9

Short-Term Money Markets in the U.S.: Commercial Book-Entry System Nearly all short-term securities issued in book-entry form: Registered and transferred electronically by U.S. Treasury (Treasury securities only) or Commercial Book-Entry System (CBES) Simultaneous transfer of securities against settlement of funds National Book-Entry System (NBES) Depository institutions— hold book- entry accounts Brokers, dealers, banks—maintain book-entry accounts for individual customers v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 10

Depository Trust and Clearing Corporation (DTCC) DTCC works through subsidiaries to provide: Clearing, settlement and information services for: Equities Corporate and municipal bonds Government and mortgage-backed securities Money market instruments OTC derivatives Legal depository Custody and asset servicing Industry-owned Operates on at-cost basis SEC-registered services DTCC Depository Trust Company (DTC) National Securities Clearing Corporation (NSCC) v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 11

U.S. Treasury Bills (T-Bills) Exempt from state tax for most U.S. investors May have franchise tax Money market instruments Original maturities < 1 year (4, 13, 26, 52 weeks) Multiple-price, sealed-bid auction Competitive or non-competitive Daily dealer bid and ask yield quotes v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 12

Commercial Paper (CP) and the U.S. Money Market Unsecured promissory note Major issuers in the U.S. are corporations, bank holding companies, and non-bank finance companies Public market: 270 days or less SEC code: Section 3[a]3 for public issue, Section 4[2] for private issue Among highest yields in money market Default risk Limited secondary market Evaluated by rating agencies (can be credit-enhanced) v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 13

U.S. Federal Agency and Government-Sponsored Enterprise (GSE) Securities Guarantees backed by full faith and credit of U.S. government. Ginnie Mae (GNMA) provides liquidity through its MBS program. Real estate mortgage investment conduits (REMICs) Interest rate related price and prepayment risks Pools of mortgages (tranches) allow risk control VA guarantees REMICs issued through Vendee Mortgage Trust. GSEs are private companies providing funds for loans in housing, education and agriculture. Strong implication government would intervene in crisis. Fannie Mae, Federal Farm Credit Banks Funding Corporation, Freddie Mac, Federal Home Loan Banks Office of Finance. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 14

Municipal Notes, VRDOs and Tax-Exempt CP Issued by state and local governments or their agencies (up to 270 days for CP). Many are exempt from federal and/or state income taxes in state of issuance. Provide interim financing for general obligation bond projects. VRDOs issued as long-term bonds with a put. Active secondary market for short-term municipal obligations. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 15

Short-Term Investment Policy Investment objectives Permissible and prohibited investments Minimum/acceptable security ratings Maximum maturity for individual securities and maximum duration for portfolio Maximum percentage amounts of portfolio that may be invested in individual securities, companies, instrument classes, geographic areas, industries Specific responsibilities for implementing policy Methods of monitoring compliance with policies, procedures, internal controls Provisions for performance measurement, evaluation, reporting Guidance for classification of investments per FASB and GASB rules Responsibilities and reporting requirements for custodians and broker- dealers v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 16

Investment Strategies Buy-and-hold-to-maturity: conservative investor Matching: Purchasing securities that mature when funds are required to meet an expected obligation or obligations Actively managed: aggressive investor Two strategies for buying highly liquid, marketable securities (T-bills) that mature on a different day from when the investor intends to sell Normal yield curve: Purchase maturities past capital need, sell early Inverted yield curve: Purchase maturities shorter than capital need, then reinvest Tax-based: high-tax-bracket investor Tax-advantaged mutual funds Dividend capture v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 17

Discussion Question Answer: b Which of the following securities safekeeping and custody services methods is generally less costly but also more risky due to the higher risk of fraud? Engage a third party to provide custodial services for an investor (corporate trust department of a commercial bank). Keep securities at the institution (usually a brokerage firm) from which they were purchased. Answer: b v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 18

Investment Risk Considerations: Credit or Default Risk Risk that payments on a security will not be made under the original terms Credit evaluation assesses default likelihood Credit ratings based on default risk, seniority and any collateral by Nationally Recognized Statistical Rating Organizations (NRSROs): Moody’s Standard and Poor’s (S&P) Fitch Dominion (DBRS) and other 6 Credit enhancement v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 19

Discussion Question What is the primary benefit of a borrower receiving credit support? Answer: Because the borrower’s debt assumes the credit rating of the guarantor, the borrowing cost may be reduced or the marketability of the debt enhanced. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 20

Investment Risk Considerations: Asset Liquidity Risk Risk that a security cannot be sold quickly without an unacceptable loss Marketability Existence of active secondary market? Unrated securities may not be liquid; must perform credit analysis. Maturity Date on which obligation is settled. Holding investments over longer time periods increases price risk. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 21

Investment Risk Considerations: Other Risks Price/interest rate risk Risk that arises when interest rates for securities that are identical or nearly identical to portfolio securities change Longer maturities subject to more price risk Threat that interest rates may rise during holding period of fixed-rate security Reinvestment risk Foreign exchange (FX) risk Risk of change in FX rates between currency of security and company’s local currency v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 22

Yield Curves v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 23

Taxable Equivalent Yield (TEY) Example: Taxable security = 4.60% yield. Tax-exempt security (of similar risk and maturity) = 3.20% yield. Firm’s marginal income tax rate is 35%. The tax-exempt security should be chosen because it has a higher effective after-tax yield. The after-tax yield of the taxable security is .046(1 – 0.35), or 2.99%. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 24

Holding Period Yield (HPY) HPY example: 90-day $100,000 T-bill purchased for $98,800 v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 25

Discussion Question Which of the following is true of T-Bills, CP and BAs? They pay unregulated rates of interest based on current market value. They do not pay interest; rather, they are issued at less than par value (the discount) and pay par value at maturity. They pay a semiannual coupon. Answer: b. They are all discounted instruments. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 26

Dollar Discount and Discount Rate Example: $1,000,000 par (or face) value 182-day T-bill is sold for $974,216 HPY = 0.0265 and 360-day basis yield = 5.24% v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 27

Dollar Discount and Money Market Yield The dollar discount can be related to the discount rate by rearranging the discount rate equation from the prior slide. Example from prior slide: 182-day $1,000,000 T-bill with a discount rate of 5.1% = $25,784 dollar discount. The money market yield (360-day year): v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 28

Bond Equivalent Yield Bond equivalent yield, or annual yield to an investor, using a 365-day-per-year follows. Example from prior slides: 182-day $1,000,000 T-bill, $974,216 invested. Method 1 v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 29

T-Bill Quotes Maturity Date Days to Maturity Bid Discount Ask Discount Dealers buy and sell T-bills in a secondary market. Bid quote is the discount at which a dealer will buy a T-bill. Ask quote is the discount at which a dealer will sell a T-bill. Ask yield is the yield to an investor purchasing a T-bill at the ask discount. Ask yield is quoted on a 365-day-per-year basis. Maturity Date Days to Maturity Bid Discount Ask Discount Ask Yield (%) Feb 20 29 1.14 1.13 1.15 Feb 27 36 Mar 06 43 1.12 v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 30

Short-Term Funding Alternatives Trade credit Internal borrowing Selling of receivables Commercial bank credit Loan syndications and participations Line of credit Revolving credit agreement Single payment notes Repurchase agreement (repo) Commercial paper (CP) issuance Asset-based borrowing v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 31

Selling of Receivables Factoring The sale or transfer of A/R to a third party, who charges a percentage commission to the borrower on the amount of A/R (depending on the quality of A/R, not company’s financial statements); with or without recourse. Securitization Company issues debt securities backed by a pool of receivables; suitable assets usually have a predictable cash flow stream to retire the issue and a historical record of low losses. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 32

Commercial Bank Credit: Loan Syndication and Participation Loan participation Multiple financial institutions (syndicate) share a single credit facility. An agent acts as an intermediary. All syndicate members share documentation; each lender has a promissory note. A financial institution purchases interest in another lender’s credit facility. The purchaser is called the participant; the seller is the lead institution. A participant does not have a separate note. Direct lending relationship Indirect lending relationship v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 33

Line of Credit Key Characteristics Lender gives access to funds up to a maximum amount over a specified period. May be committed or uncommitted line: Committed obligates the buyer to provide funding as long as the buyer is not in default. Uncommitted can be cancelled by the lender at any time. Usually revolving. May be secured or unsecured. Usually has a 30- to 60-day clean-up period. Basic cost components: All-in rate of interest Commitment fees Compensating balances v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 34

Commercial Paper (CP) Issuance In practice, many CP issuers roll over outstanding balances at maturity to new CP issue. To do this: Maintain CP backup lines of credit. Issuer must carry strong credit rating or get higher rating through credit enhancement (standby L/C). Issued at discount + dealer fees, backup credit facility fees, rating agency charges and credit enhancement costs. Therefore rarely used for less than $50 million. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 35

Annual Cost for Commercial Paper (CP) Example: A company issues $20 million of CP with a 20-day maturity at a discount of 5.40%. Part 1 of 4: v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 36

Annual Cost for a Line of Credit A line of credit lender charges interest and a commitment fee on the line. Interest is charged on the used portion of the line. The commitment fee may be charged on the line or its unused portion. The overall interest rate on the line is determined by the total interest paid on the line’s used portion and the amount paid for the commitment fee relative to the average used portion of the credit line over the borrowing period. v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 37