CHAPTER 6 Money Markets

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

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

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

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

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

Money Market Securities n Treasury bill auction—noncompetitive bids ($1 million limit) l May be used to make sure bid is accepted l Price is the weighted average of the accepted competitive bids l Investors do not know the price in advance so they submit check for full par value l After the auction, investor receives check from the Treasury covering the difference between par and the actual price Noncompetitive Bidding

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

Money Market Securities n Calculating T-Bill Annualized Yield YTYT  SP – PP PP 365 n Y T = 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 n T-bill yield for a newly issued security Par – PP PP 360 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 T-bill discount= 

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

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

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

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

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

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

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

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

Exhibit 6.5 a 1 Purchase Order Shipment of Goods 5 L/C3 Shipping Documents &Time Draft DraftAccepted (B/A Created) 7 Japanese Bank (Exporter’s Bank) American Bank (Importer’s Bank) ImporterExporter 2 L/C (Letter of Credit) Application 4 L/C Notification 6 Shipping Documents & Time Draft

Money Market Securities l A bank takes responsibility for a future payment of trade bill of exchange l Used mostly in international transactions l Exporters send goods to a foreign destination and want payment assurance before sending l 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 l Exporter can hold until the date or sell before maturity l If sold to get the cash before maturity, price received is a discount from draft’s total l Return is based on calculations for other discount securities l Similar to the commercial paper example Bankers Acceptance

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

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

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

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

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

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

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

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

Globalization of Money Markets n Performance of international securities n Yield for an international investment YfYf SP f – PP f PP f Y f = Foreign investment’s yield SP f = Investment’s foreign currency selling price PP f = Investment’s foreign currency purchase =

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

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