1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. PART FIVE FINANCIAL MARKETS

2. Copyright © 2012 Pearson Prentice Hall. All rights reserved. CHAPTER 11 The Money Markets

3. © 2012 Pearson Prentice Hall. All rights reserved. 11-2 Now that’s a lot! In its 2009 annual report, Microsoft listed $25 billion in short-term securities on its balance sheet, plus $6 billion in actual cash equivalents. Microsoft does not keep this in its local bank. But where?

4. © 2012 Pearson Prentice Hall. All rights reserved. 11-3 Chapter Preview  We review the money markets and the securities that are traded there. In addition, we discuss why the money markets are important in our financial system. Topics include: ─The Money Markets Defined ─The Purpose of Money Markets ─Who Participates in Money Markets? ─Money Market Instruments ─Comparing Money Market Securities

5. 4/38 Money Markets (MM) Defined  Term “money market” is a misnomer ─ Money (currency) is not traded in the MM ─ Securities traded in MM are close to being money -Short term -High liquidity  Instruments traded in an active secondary market ─ Liquid market provides easy entry & exit for participants ─ Speed and efficiency of transactions allows cash to “active” even for very short periods of time (over night) ─ MM securities very flexible instruments use to fill in short-term financial needs  Market size in 2004: $5.3 trillion

6. 5/38 CHARACTERISTICS OF MM 1.Traded in large denominations ─ Units of $1million - $10 million ─ Transactions costs low in relative terms ─ Individual investors do not participate in this market 2.Low default risk ─ Only high quality borrower participate ─ Low time maturities reduce the risk of “changes” in borrower quality 3.Mature less than a year ─ Maturity (< 1 year) too short to be adversely affected, in general, by changes in rates ( although most mature in less than 120 days ) ─ Insensitive to interest rate changes

7. © 2012 Pearson Prentice Hall. All rights reserved. 11-6 The Money Markets Defined: Why Do We Need Money Markets? In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits. Banks also have an information advantage on the credit-worthiness of participants. Banks do mediate between savers and borrowers; however, they are heavily regulated. This creates a distinct cost advantage for money markets over banks.

8. © 2012 Pearson Prentice Hall. All rights reserved. 11-7 The Money Markets Defined: Cost Advantages  Reserve requirements create additional expense for banks that money markets do not have  Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets, especially in the 1970s and 1980s. When interest rates rose, depositors moved their money from banks to money markets to earn a higher interest rate.

9. © 2012 Pearson Prentice Hall. All rights reserved. 11-8 The Money Markets Defined: Cost Advantages  Even today, the cost structure of banks limits their competitiveness to situations where their informational advantages outweighs their regulatory costs.  Figure 11.1 shows that limits on interest banks could offer was not relevant until the 1950s. But in the decades that followed, the problem became apparent.

10. © 2012 Pearson Prentice Hall. All rights reserved. 11-9 3-month T-bill rates and Interest Rate Ceilings

11. 10/38 Purposes of MM 1.Lenders (SU): need an interest-earning “parking space” for excess funds, MM provides a place for warehousing surplus funds until they are needed ─ Interim investment that gives return compared to just holding cash ─ Idle cash = an opportunity cost: lost interest income ─ MM reduces this opportunity cost ─ To be able to act quickly to take advantage of any investment opportunities 2.Borrowers (DU): need short-term “working capital”, MM provides low- cost source of temporary funds. Why need funds quickly and in short period of time? ─ Timing of cash inflows and outflows are not well synchronized ─ Revenues come in once in a year, while expenses throughout the year ─ Money markets provide a way to solve these cash-timing problems

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13. 12/38 Who Participates in the MM?  Things to note: ─ Govt is always a borrower – only sell securities ─ Central banks use mm to conduct monetary operations (influence the ms) ─ Banks use mm to manage their liquidity and trade on behalf of their customers ─ Businesses involve in mm as part of their cash management system

14. © 2012 Pearson Prentice Hall. All rights reserved. 11-13 Who Participates in the Money Markets?: A Sample from the Wall Street Journal

15. © 2012 Pearson Prentice Hall. All rights reserved. 11-14 Money Market Instruments  We will examine each of these in the following slides: ─Treasury Bills ─Federal Funds ─Repurchase Agreements ─Negotiable Certificates of Deposit ─Commercial Paper ─Eurodollars

16. 15/38 15 MM Instrument 1: Treasury securities Issued by Federal Government Finance annual deficits (budget shortfalls) Re-finance maturing debt Denominations Face value $1,000 Round lots are sold as $5 million (new issues) Risk Assumed risk/default free-guaranteed by Government Interest rate No coupon payment: no interest payments T-Bills are issued at a discount: investor pays less for the security than it will be worth when it matures (FV), and increase in price provides a return.

17. © 2012 Pearson Prentice Hall. All rights reserved. 11-16 Money Market Instruments: Treasury Bills Discounting Example  You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate?

18. © 2012 Pearson Prentice Hall. All rights reserved. 11-17 Money Market Instruments: Treasury Bills Discounting Example  You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its annualized yield?

19. © 2012 Pearson Prentice Hall. All rights reserved. 11-18 Money Market Instruments: Treasury Bill Auctions  T-bills are auctioned to the dealers every Thursday.  The Treasury may accept both competitive and noncompetitive bids, and the price everyone pays is the highest yield paid to any accepted bid.

20. © 2012 Pearson Prentice Hall. All rights reserved. 11-19 Money Market Instruments: Treasury Bill Auctions Example  The Treasury auctioned $2.5 billion par value 91-day T-bills, the following bids were received: BidderBid AmountBid Price 1$500 million$0.9940 2$750 million$0.9901 3$1.5 billion$0.9925 4$1 billion$0.9936 5$600 million$0.9939  The Treasury also received $750 million in noncompetitive bids. Who will receive T-bills, what quantity, and at what price?

21. © 2012 Pearson Prentice Hall. All rights reserved. 11-20 Money Market Instruments: Treasury Bill Auctions Example  The Treasury accepts the following bids: Bidder Bid Amount Bid Price 1$500 million $0.9940 5$600 million $0.9939 4$650 million $0.9936  Both the competitive and noncompetitive bidders pay the highest yield—based on the price of 0.9936:

22. © 2012 Pearson Prentice Hall. All rights reserved. 11-21 Money Market Instruments: Treasury Bill Rates  The next slide shows the results of several Treasury bill auctions, from 2007.  It also shows some other data about each auction. Do you know what each term means?

23. © 2012 Pearson Prentice Hall. All rights reserved. 11-22 Money Market Instruments: Treasury Bill Auction Results

24. © 2012 Pearson Prentice Hall. All rights reserved. 11-23 Money Market Instruments: Treasury Bill Rates The next slide shows actual T-bill rates and the annual rate of inflation from 1973 through 2010. Notice that the inflation rate exceeds the rate on T-bills in several on the years. This indicates a negative real return for T-bill investors during these periods.

25. © 2012 Pearson Prentice Hall. All rights reserved. 11-24 Money Market Instruments: Treasury Bills

26. 25/38 MM Instrument 2 Fed Funds  Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day  Similar to Malaysian inter-bank funds  Used by banks to meet short-term needs to meet reserve requirements. Unsecured lending: oral commitment between buyers and sellers The next slide shows actual fed funds rates and T-bill rates 1990 through 2010. Notice that the two rates track fairly closely. What does this suggest about the market for T-bills and the market for fed funds?

27. © 2012 Pearson Prentice Hall. All rights reserved. 11-26 Money Market Instruments: Fed Funds Rates

28. 27/38 MM Instrument 3: Repurchase Agreements Definition: selling an asset with an explicit agreement to repurchase the asset after a set period of time; Repos: sell with a promise to buy back (collateralized loan) These work similar to the market for fed funds, but nonbanks can participate.A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price. Example: Bank A has deficient reserves and needs to borrow overnight. 1.Bank A sells a treasury security to Bank B at P 0 2.Bank A agrees to buy the treasury back at a higher price P f > P 0 3.Bank B earns a rate of return implied by the difference in prices 4.Since the loan is backed by collateral, the rate is usually lower than the rate available in the Fed Funds market 5.Fed conducts open market transactions through RAs, using transactions that are generally less than 15 days i RA = P f – P 0 P0P0 360 days x

29. 28/38 MM Instrument 4: Negotiable Certificates of Deposits (CDs) A bank issued time deposit 1.Fixed interest rate and maturity 2.Terms are negotiable (e.g. 6 month at 4.1% or 1 year at 5.2%) 3.Common maturities are less than 12 months 4.These funds are more “certain” to banks that demand deposits that can leave at any time Terms and Trading 1.Most CDs are sold directly to investors who hold to maturity 2.Investors receive both principal and interest 3.Rates are quoted using a 360 day year 4.A network of about 15 brokers/dealers make a secondary market; Can be traded over and over again as long as it is profitable to trade the instrument Risk 1.Large CDs (called Jumbo CDs) are not federally insured through Federal Deposit Insurance Corporation (FDIC ) 2.Large banks, with perceived lower risk due to too-big-to-fail (TBTF) doctrine, often have lower rates than smaller banks

30. © 2012 Pearson Prentice Hall. All rights reserved. 11-29 Money Market Instruments: Negotiable Certificates of Deposit  A bank-issued security that documents a deposit and specifies the interest rate and the maturity date  Denominations range from $100,000 to $10 million

31. © 2012 Pearson Prentice Hall. All rights reserved. 11-30 Money Market Instruments: Negotiable Certificates of Deposit The next slide shows actual CD rates and T-bill rates 1990 through 2010. Again, notice that the two rates track fairly closely. What does this suggest about the market for T-bills and the market for CDs?

32. © 2012 Pearson Prentice Hall. All rights reserved. 11-31 Money Market Instruments: Negotiable CD Rates

33. 32/38 MM Instrument 5: Commercial Paper Unsecured short-term promissory note 1.Generally issued by corporations or financial institutions 2.Sold directly to institutions or through dealers 3.Funds used to finance working capital requirement Terms 1.Sold in denominations of $100k, $250k, $500k and $1 million 2.Maturity less than 270 days (registration required otherwise) 3.Common maturities are between 20 and 45 days 4.Sold at discount and held to maturity – no active secondary market 5.Yields are quoted based on 360 day year Issuers need good reputation to issue 1.Issuers must have excellent credit and be rated by a rating agency 2.Low cost alternative to bank loans 3.Firms in trouble are immediately cut off from this market

34. 33/38 MM Instrument 5: Commercial Paper  Unsecured promissory notes, issued by corporations, that mature in no more than 270 days  Use of commercial paper increased significantly in early 1980s because of rising cost of bank loans  The next slide shows actual commercial paper rates and the prime rates 1990 through 2010. Although the two track closely in terms of movements, notice that difference between the two remains roughly 200 basis points.

35. © 2012 Pearson Prentice Hall. All rights reserved. 11-34 Money Market Instruments: Commercial Paper Rates

36. © 2012 Pearson Prentice Hall. All rights reserved. 11-35 Money Market Instruments: Commercial Paper The next slide shows actual commercial paper volume by year from 1990 through 2010. Notice that the volume fell significantly during the recent economic recession. Even so, the annual market is still quite large, at well over $1.5 trillion outstanding.

37. © 2012 Pearson Prentice Hall. All rights reserved. 11-36 Money Market Instruments: Commercial Paper Volume

38. © 2012 Pearson Prentice Hall. All rights reserved. 11-37 Money Market Instruments: Commercial Paper A special type of commercial paper, known as asset-backed commercial paper (ABCP), played a key role in the financial crisis in 2008. These were backed by securitized mortgages, often difficult to understand. This special part of the commercial paper market accounted for about $1 trillion.

39. © 2012 Pearson Prentice Hall. All rights reserved. 11-38 Money Market Instruments: Commercial Paper When the poor quality of the underlying assets was exposed, a run on ABCP began. Because ABCP was held by many money market mutual funds (MMMFs), these funds also experienced a run. The government eventually had to step in to prevent the collapse of the MMMF market.

40. 39/38 MM Instrument 6: Bankers Acceptance Definition oAn order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods oOften used when buyers / sellers of expensive goods living in different countries Banks act as intermediaries between trading partners oBanks guarantee payments to secure orders of goods from manufacturers oIs a type of “letter of credit” that guarantees a payment by bank on a specific date oParticularly useful between foreign trading partners where there is a high level of asymmetric information – Banks resolve this AI

41. 40/38 MM Instrument 6: Bankers Acceptance Example: 1. Enterprise A orders 50,000 shirts from a Peruvian textile manufacturer 2. The Peruvian manufacturer pulls out a globe to figure out where Ent A is – they have no idea who the buyer is 3. Since the Peruvian manufacturer has to allocate resources to make the shirts, they want some guarantee that Ent A is actually going to pay 4. Ent A doesn’t want to pay until they know that they are going to get the goods delivered as promised 5. Bank steps in as intermediary with a contract that provides a credible delivery of payment once the goods are delivered. 6. Bank agrees to pay the amount of the BA if the Ent A fails to pay

42. 41/38 MM Instrument 6: Banker’s Acceptances  Advantages of BA: ─ Exporter paid immediately ─ Exporter shielded from foreign exchange risk ─ Exporter does not have to assess the financial security of the importer ─ Importer’s bank guarantees payment ─ Crucial to international trade

43. 42/38 MM Instrument 6: Banker’s Acceptances  There is an active secondary market for banker’s acceptances until they mature. The terms of note indicate that the bearer, whoever that is, will be paid upon maturity  If the manufacturer has an immediate need for cash, they can sell the BA prior to delivery of the goods  Trading: ─ Trading of BAs take place on secondary markets until such time that the payment is delivered ─ Maturity is typically 30 to 270 days ─ Denominations are bundled into $100,000 and $500,000 levels for trading

44. 43/38 MM Instrument 7: Eurodollars (ED)  EDs represent dollar-denominated deposits held in banks in other countries than the US  Market is essential since many foreign contracts call for payment is U.S. dollars due to stability of the dollar relative to other currencies  ED market has continued to grow rapidly because US depositors receive a higher rate of return on a dollar deposit in the ED market than in the US market  Market for ED is free of regulation: foreign banks are not subject to the same regulations restricting U.S. banks ─ Banks can operate on narrower margins than their counterparts in the USmargins ─ ED market has expanded largely as a way of circumventing regulatory costs

45. 44/38 MM Instrument 7 Eurodollars o Average ED deposit is very large (in the millions) and has a maturity of less than six months o There are ED time deposit and ED certificate of deposit. A ED CD is basically the same as a US CD, except that it's the liability of a non-U.S. bank o Because ED CDs are typically less liquid, they tend to offer higher yields o ED market is obviously out of reach for all but large institutions. Individuals can invest in this market is indirectly through a money market fund o Trading of ED:  Over-night trading as in the fed funds market  Traded in London and rates offered are referred to as LIBOR (London Interbank Offered Rate), closely tied to the Fed Funds rate

46. © 2012 Pearson Prentice Hall. All rights reserved. 11-45 Money Market Instruments: Eurodollars Rates  London interbank bid rate (LIBID) ─The rate paid by banks buying funds  London interbank offer rate (LIBOR) ─The rate offered for sale of the funds  Time deposits with fixed maturities ─Largest short term security in the world

47. © 2012 Pearson Prentice Hall. All rights reserved. 11-46 Global: Birth of the Eurodollar  The Eurodollar market is one of the most important financial markets, but oddly enough, it was fathered by the Soviet Union.  In the 1950s, the USSR had accumulated large dollar deposits, but all were in US banks. They feared the US might seize them, but still wanted dollars. So, the USSR transferred the dollars to European banks, creating the Eurodollar market.

48. © 2012 Pearson Prentice Hall. All rights reserved. 11-47 Comparing Money Market Securities  The next slide shows a comparison of various money market rates from 1990 through 2010.  Notice that no real pattern is present among the rates, indicating that investor preferences to the features on the instruments fluctuates.

49. © 2012 Pearson Prentice Hall. All rights reserved. 11-48 Comparing Money Market Securities : A comparison of rates

50. © 2012 Pearson Prentice Hall. All rights reserved. 11-49 Comparing Money Market Securities  Liquidity is also an important feature, which is closely tied to the depth of the secondary market for the various instruments.  The next slide summarizes the types of securities, issuers, buyers, maturity, and secondary market characteristics.

51. 50/38 Returns on Money Market Instruments

52. 51/38  Deposits: normal and fixed  Bankers Acceptances  Negotiable Instruments of Deposits  Commercial Papers  Treasury Bills  Bank Negara Bills  Cagamas Notes  Islamic money market instruments MM PRODUCTS IN MALAYSIA

53. © 2012 Pearson Prentice Hall. All rights reserved. 11-52 Chapter Summary  The Money Markets Defined ─Short-term instruments ─Most have a low default probability  The Purpose of Money Markets ─Used to “warehouse” funds ─Returns are low because of low risk and high liquidity

54. © 2012 Pearson Prentice Hall. All rights reserved. 11-53 Chapter Summary (cont.)  Who Participates in Money Markets? ─U.S. Treasury ─Commercial banks ─Businesses ─Individuals (through mutual funds)  Money Market Instruments ─Include T-bills, fed funds, etc.

55. Chapter Summary (cont.)  Comparing Money Market Securities ─Issuers range from the US government to banks to large corporations ─Mature in as little as 1 day to as long as 1 year ─The secondary market liquidity varies substantially 11-54 © 2012 Pearson Prentice Hall. All rights reserved.