Money and Fixed-Income Market Fed Funds Treasury Bills Rates and Yields Repos and Reverses Fixed-Income Securities

Investments 22 Introduction  Money Market  Cash equivalents, short-term (maturity  1 year), liquid (marketable), low-risk debt securities  Instruments  Federal funds  Treasury bills (T-bills)  Certificate of deposit  Commercial paper  Bankers’ acceptances  Eurodollars  Repurchase agreements (repos) and reverses  Brokers’ calls

Investments 23 Federal Funds  Rate charged for Federal Funds among the banks  Most widely quoted “Fed” rate  Is it set really set by the Fed? Effective Rate vs. Target Rate (Aug 27, 2008)

Investments 24 Treasury Bills  Definition  Short-term Gov. security issued at discount  e.g., pay $900 today for 1yr T-bill of $1000 par value  Characteristics  Highly liquid  Extremely safe (virtually risk free)  Exempt of state and local taxes  Initial maturity at 4, 13, and 26 weeks Pay $900 TodayMaturity Receive $1000 face (par) value

Investments 25 Treasury Bills  Quotation  Market convention is to use rate rather than price for T-bill quote  Bank Discount Rate (BD)  r BD : bank discount rate  F: face value (par)  P: price  n: days to maturity

Investments 26 Treasury Bills  Example  A 90-day T-Bill of par $10,000 trades at $9,600. What’s the bank discount rate?  n = 90, F = $10,000, P = $9,600  Annualized return on the investment?  r BEY : bond equivalent yield (APR)

Investments 27 Treasury Bills  Bond Equivalent Yield (BEY)  Measures (simple) annualized return on T-bill investment  Facilitates comparison of yields between T-bill and T-bond  Bank discount rate is NOT a true interest rate  Bank discount rates are converted to yields  Bonds quoted in yields  Converted Yields = Bond Equivalent Yield

Investments 28 Treasury Bills  Sample quotes from WSJ (Sep ) Actual # days – 2Bank discount rateBond Equivalent yield

Investments 29 Treasury Bills  What about price?  9/1/05, on WSJ you see 12/1/05 T-bill is quoted at 3.43% (ask). How much does it cost to buy $1,000 par of that T-bill?  F = $1,000, r BD = 3.43%, n = 91, P = ?  Bond equivalent yield

Investments 210 Certificates of Deposit (CD)  Issued by  Denomination  Maturity  Liquidity  Default risk  Interest type  Taxation Depository Institutions Any, $100,000 or more are marketable Varies, typically 14 day minimum 3 months or less are liquid, if negotiable First $100,000 ($250,000) is insured Add on Interest income is fully taxable

Investments 211 Commercial Paper  Issued by  Maturity  Denomination  Liquidity  Default risk  Interest type  Taxation Large creditworthy corporations and financial institutions Maximum 270 days, usually 1 to 2 months Minimum $100,000 3 months or less are liquid if marketable Unsecured, Rated, Mostly high quality Discount Interest income is fully taxable New Innovation: Asset backed commercial paper is backed by a loan or security. In summer 2007 asset backed CP market collapsed when subprime collateral values fell.

Investments 212 Repos and Reverses  Repo screen from Bloomberg: 8/19/99

Investments 213 Repos and Reverses  Repurchase Agreement (Repo)  Sale of high grade security with agreement to buy it back at higher prices  Repo rate:  Repo dealer’s borrowing rate implied in the repo price differentials.  Convention: 360 day Repo Dealer Lender Repo Dealer Treasury Security Cash (P ) Treasury Security Cash (F ) Day 0 : Day n :

Investments 214 Repos and Reverses  Reverse Repo  Purchase of high grade security with agreement to sell it back at higher prices  Rev/Repo rate: repo dealers’ lending rate implied in the price differentials Repo Dealer Borrower Repo Dealer Treasury Security Cash (P ) Treasury Security Cash (F ) Day 0 : Day n :

Investments 215 Repos and Reverse  Example  You have $2M worth of 26 weeks T-bill you’d like to hold to maturity. However, you need $2M cash urgently for a week. What to do?  (Term) Reverse/Repo  Day 0: Get $2M from a repo dealer by giving him T-bill  Look at the reverse/repo rate to determine the amount of money to pay back  Day 7: get the T-bill back by paying $2,001,925 to the repo dealer

Investments 216 Money Market Instrument Yields  Yields on money market instruments are not always directly comparable! Factors influencing “quoted” yields  Par value vs. investment value  360 vs. 365 days assumed in a year (366 leap year)  Simple vs. Compound Interest

Investments 217 Major Components of the Money Market

Investments 218 MMMF and the Credit Crisis of 2008  Between 2005 and 2008 money market mutual funds (MMMFs) grew by 88%.  MMMFs had their own crisis in 2008 when Lehman Brothers filed for bankruptcy on September 15.  Some funds had invested heavily in Lehman’s commercial paper.  On Sept. 16, Reserve Primary fund “broke the buck.” What does this mean?  A run on money market funds ensued, and unsecured money market rates jumped up.  The U.S. Treasury temporarily offered to insure all money funds (close to $3.4 trillion) to stop the run.

Investments 219 Spreads on CDs and Treasury Bills

Investments 220 Fixed-Income Securities  Publicly Issued  Treasury Notes and Bonds  Agency Issues (Federal Government)  Municipal Bonds  Federal tax exemption  Local and state tax exemption for state residents  Privately Issued  Corporate Bonds  Mortgage-Backed Securities

Investments 221 Fixed-Income Securities  What are they?  A security promising full payment of coupon and principal according to a fixed time schedule  E.g., A 10 year $10,000 T-note with 6¼% coupon  Three Prominent Characteristics  Principal  Face value of a bond  Interest  Coupon of a bond  Maturity  Life span of a bond