CHAPTER 7 Money Markets Copyright© 2012 John Wiley & Sons, Inc

Overview of the Money Market Short-term debt market - most under 120 days. A few high quality borrowers. Many diverse investors. Informal market centered in New York City. Standardized securities -- one security is a close substitute for another. Copyright© 2012 John Wiley & Sons, Inc 2

Overview of the Money Market, cont. Good marketability - secondary market. Large, wholesale open-market transactions. Many brokers and dealers are competitively involved in the money market. Payments in immediately available funds. Physical possession of securities seldom occurs - centralized safekeeping. Copyright© 2012 John Wiley & Sons, Inc 3

Money Market Securities Outstanding Copyright© 2012 John Wiley & Sons, Inc 4

Economic Role of Money Market (MM) The money market is a market for liquidity. Liquidity is stored in MM by investing in MM securities. Liquidity is bought in MM by issuing securities (borrowing). Provides a place for Fed’s reserve transactions (open market operations). Indicator of economic conditions. Copyright© 2012 John Wiley & Sons, Inc 5

Characteristics of Money Market Instruments Low default risk. Short maturity. High marketability. Copyright© 2012 John Wiley & Sons, Inc 6

Characteristics of money market instruments Copyright© 2012 John Wiley & Sons, Inc 7

U.S. Treasury Bills Characteristics Sold on discount basis. Maturities up to one year. Minimum denomination is usually $10,000, but smaller investors can invest in multiples of $1,000 through the Treasury Direct Program offered by the Fed. Considered free of default risk. Copyright© 2012 John Wiley & Sons, Inc 8

How to Read T-Bill Quotes Copyright© 2012 John Wiley & Sons, Inc 9

U.S. Treasury Bills Pricing Treasury Bills Treasury bills are priced on a bank discount rate basis, a traditional yield calculation. The bank discount rate, y d, is: Copyright© 2012 John Wiley & Sons, Inc 10

U.S. Treasury Bills The Wall Street Journal reports T-Bill yields on a bond equivalent basis where the discounted price is the denominator and 365 days is used as the annualizer: The effective annual yield assuming compounding a year is: Effective Yield = [(Face Value/Price) 365/D -1] x 100%. Copyright© 2012 John Wiley & Sons, Inc 11

Auctioning New Bills Weekly sale by U. S. Treasury of 4-, 13-, and 26-week maturities. T-bills are sold through an auction process using both competitive and noncompetitive bids. Copyright© 2012 John Wiley & Sons, Inc 12

Auctioning New Bills, cont. Competitive Bids Specify price and quantity desired. Minimum $10,000 & in multiples of $5,000 above $10,000. Mostly professionals - dealers & banks. No more than 35% of an issue is sold under the competitive bidding process in order to ensure a competitive secondary market. Copyright© 2012 John Wiley & Sons, Inc 13

Auctioning New Bills, cont. Non-competitive Bids All non-competitive bids accepted. Specify quantity only. Maximum $5,000,000. Mostly individuals & small investors. Copyright© 2012 John Wiley & Sons, Inc 14

Book-entry Securities No physical securities: only record entries. Book-entry record keeping. Most of marketable Treasury debt is now in book- entry form. Participants in Treasury Direct Program are book-entry accounts. Copyright© 2012 John Wiley & Sons, Inc 15

Types of Federal Agencies Farm credit agencies - loans to farmers. Housing credit agencies - loans and secondary market support for mortgage market. Other agencies - special purposes. Federal Financing Bank - purchases securities of agencies and issues its own obligations. Copyright© 2012 John Wiley & Sons, Inc 16

Characteristics of Agency Debt Government-owned agencies have an explicit guarantee of the government. Government-sponsored agencies are perceived to have an implicit guarantee of the government. Marketability varies with the development of the secondary market. Yields are higher than T-Bills. Greater default risk & lower marketability. Copyright© 2012 John Wiley & Sons, Inc 17

Federal Funds Short-term interbank loans. Market for depository institutions. Most liquid of all financial assets. Related to monetary policy implementation. Yields related to the level of excess bank reserves. Originally a market for excess reserves - Now a source of investment (federal funds sold) and continued financing (federal funds purchased). Most are one-day, unsecured loans. Settled in immediately available funds. Copyright© 2012 John Wiley & Sons, Inc 18

Repurchase Agreements (Repo) Sale of security with agreement to buy it back later at a higher price. Difference in prices is interest. Securities serve as collateral. Bank Financing - Source of funds Way to pay interest to corporate customers. Negotiated market rate. Bank Investment - Reverse Repo Security purchased under agreement to resell at given price in future. Smaller banks are able to invest excess liquidity in a secured investment. Copyright© 2012 John Wiley & Sons, Inc 19

Repurchase Agreements, cont. The interest rate on a repo is lower than the fed funds rate, since it is backed up by a security. Repos are used by the Federal Reserve in open market operations. Government securities dealers use repos to secure funds to invest in new Treasury issues. Banks participate in the repo market to secure funds to meet temporary liquidity needs as well as lend funds when they have excess reserves. Copyright© 2012 John Wiley & Sons, Inc 20

Commercial Paper Unsecured corporate debt. Maturities are 1 to 270 days. Large denominations -- $100,000 and up. Issued by high-quality borrowers. A wholesale money market instrument - few individual investors. Sold at a discount from par. Copyright© 2012 John Wiley & Sons, Inc 21

The Commercial Paper Market Major investors Commercial banks. Insurance companies. Nonfinancial business firms. Bank trust departments. State and local pension funds. Banks are involved Backup lines of credit. Act as agents in issuance. Hold notes in safekeeping. Copyright© 2012 John Wiley & Sons, Inc 22

The Commercial Paper Market, cont. Credit ratings important for commercial paper issuance. Over 95% of issues are in the top two rating categories. Backup lines of credit from banks support or guarantee quality. Placement Directly by a sales force of the borrowing firm. Indirectly through dealers. Copyright© 2012 John Wiley & Sons, Inc 23

Negotiable Certificates of Deposit Characteristics of Negotiable CDs Large time deposits (> $100,000), maturity less than six months. Negotiable - may be sold and traded before maturity. Issued at face value, interest is based on a 360-day year. Secondary market deals are for $1 million or more. Interest rates depend on the issuing bank’s creditworthiness. Yields are higher than on T-Bills - higher credit risk, lower marketability, and higher taxability. Copyright© 2012 John Wiley & Sons, Inc 24

Negotiable Certificates of Deposit Development of the NCD Market First issued by Citibank in Offset declining demand deposits as a source of funds. The NCD Market Rate negotiated between buyer and seller. Market is sensitive to rates above or below the market rates. Rates are lower for money center banks and are tiered upward for regional banks. Purchased mainly by corporate businesses. Copyright© 2012 John Wiley & Sons, Inc 25

Bankers' Acceptances Time draft - order to pay in future. Drafts are drawn on and/or accepted by commercial bank. Direct liability of bank. Mostly relate to international trade. Secondary market - dealer market. Discounted in market to reflect yield. Standard maturities of 30, 60, or 90 days - max of 180. Copyright© 2012 John Wiley & Sons, Inc 26

Creating a Banker's Acceptance Importer initiates purchase from foreign exporter, payable in future. Importer needs financing; exporter needs assurance of payment in future. Importer's bank writes irrevocable letter of credit for exporter Specifies purchase order. Authorizes exporter to draw time draft on bank. Copyright© 2012 John Wiley & Sons, Inc 27

Creating a Banker's Acceptance, cont. Importer's bank accepts draft (liability to pay) and creates a banker's acceptance (BA). Advantages of a BA: Exporter receives funds by selling BA in the market. Exporter eliminates foreign exchange risk. Importer's bank guarantees payment of draft in future. Copyright© 2012 John Wiley & Sons, Inc 28

Tracing a Banker’s Acceptance Transaction Copyright© 2012 John Wiley & Sons, Inc 29

Money Market Position of Major Participants Copyright© 2012 John Wiley & Sons, Inc 30

Commercial Banks Most important participant in the MM Bank assets or investments Treasury bills. Agency securities. Bankers’ acceptances (from other banks). Federal Funds sold. Reverse repurchase agreements (securities purchased under agreements to resell). Copyright© 2012 John Wiley & Sons, Inc 31

Commercial Banks, cont. Bank liabilities or borrowing Negotiable CDs. Commercial paper. Bankers' acceptances. Federal Funds purchased. Repurchase agreements (securities sold under agreements to repurchase). Due to fluctuations in loans and deposits banks need MM securities to provide sources and uses of liquidity. Copyright© 2012 John Wiley & Sons, Inc 32

The Federal Reserve in the Money Markets MM securities are the major asset category of the Fed. Open-market operations (buying and selling of MM securities by Fed) is the primary tool for implementing monetary policy. Purchase - increases member bank reserves. Sale - decreases member bank reserves. Copyright© 2012 John Wiley & Sons, Inc 33

Dealers in U.S. Securities Involved in both primary and secondary markets. Purchase new Treasury debt and resell it (primary market). "Make a market" by buying/selling (dealer) securities (secondary market). Purchases are financed by repurchase agreements or fed funds. Dealers have a small capital base and are highly leveraged. Copyright© 2012 John Wiley & Sons, Inc 34

Money Market Mutual Funds (MMMFs) Investment funds that pool funds from numerous investors and invest in money market instruments. Portfolios of liquid investments with low default risk. Provide investors with check-writing abilities/Alternative to bank deposits. Copyright© 2012 John Wiley & Sons, Inc 35

The impact of the Crisis on the Money Markets Treasury Bills Commercial Paper Federal Funds and Repurchase Agreements The Federal Reserve Copyright© 2012 John Wiley & Sons, Inc 36

Relationship of Money Market Interest Rates Due to similarities in general characteristics, various MM instruments are close substitutes in investment portfolios. MM interest rates move together over time. Deviations from traditional spreads are quickly eliminated by interest rate arbitrage. Copyright© 2012 John Wiley & Sons, Inc 37

Relationship of Money Market Interest Rates Copyright© 2012 John Wiley & Sons, Inc 38