1. Money Markets

2. Chapter Outline Definition of Money Markets: Chapter Overview Money Markets Yields on Money Market Securities Money Market Securities Money Market Participants International Aspects of Money Markets

3. Definition of Money Markets Money market securities are generally fixed income securities provide safety of principle, liquidity and a predictable, albeit typically modest, yield little or no default risk

4. Money Markets Money markets exist because rarely do required cash disbursements occur at the same time and in the same amounts as cash inflows for corporations and institutions Money markets have developed to provide corporations, governments and institutions with safe, liquid investments Generally sold in large denominations, have low default risk Secondary markets are of paramount importance for money market instruments for liquidity purposes

5. Yields on Money Market Securities Effective annual returns: EAR= ( 1+i ) 365/h -1 365/h Discount rates (or discount yields) i dy =[(P f -P 0 )/P f ](360/h) i bey =[(P f -P 0 )/P 0 ](365/h) Single payment securities or loans (also called add ons) i bey =i spy (365/360) a bond equivalent yield

6. Example Single payment (add ons) P f = P 0  (1 + (a  t/360)) a = add on rate, t = days Discount instruments P 0 = P f  (1 – (d  t /360)) where d = discount, t = days For the CD: P 0 = $10,000; P f = $10,000  (1+(0.06  60/360)) =$10,100 The bond equivalent yield for the CD is ($10,100/$10,000) –1)  (365/60) = 6.08% For the T-bill: P f = $10,000; P 0 = $10,000  (1 – (0.059  180/360) = $9,705 The bond equivalent yield for the T-bill is ($10,000/$9,705) –1)  (365/180) = 6.16% Bond equivalent yield BEY = a  (365/360) The EAR may be found two ways: EAR = (P f / P 0 ) 365/ t –1or EAR = (1 + (BEY / m)) m – 1 ; where m = 365/t

7. Money Market Instruments Outstanding, December 1990 and 2004 (in billions of dollars) Amount Outstanding 1990 2004 Amount Outstanding 1990 2004 Rate of Return 1990 2004 Treasury bills $527.0 $ 981.9 6.68% 2.15% Federal funds and repurchase agreements 372.3 1,585.1 7.31 1.83 Commercial paper 537.8 1,309.7 8.14 1.89 Negotiable certificates of deposit 546.9 1,379.4 8.13 2.28 Banker’s acceptance 52.1 4.4 7.95 2.04

8. Money Market Securities Treasury Bills are short term obligations At the end of 2004 there was $981.9 billion outstanding comprising about 19% of total money market securities original issue maturities are 13 or 26 weeks. The minimum denomination is $1,000 and a round lot is $5 million. free of default risk and the 1 year T-Bill rate is often used as a measure of the short term ‘risk free rate.’ T-bills are sold to the highest bidder at auction, with a 35% limit Noncompetitive bids of up to $1 million can be made The Treasury is now using a single price auction, in past … Secondary market for 22 primary government security dealers, 500 smaller dealers Case: Salomon Brothers

9. T bill yields: T-bill prices (P 0 ) are calculated as P 0 = P F  (1 – (i*h/360)) bond equivalent yield in order to compare rate quotes on different instruments that use different quoting conventions. (P F –P 0 )/P 0 * (365/h)

10. Treasury Auction Results Nov 18,2004 (13 week TBill) Quantity of T-bills Bid Price 99.4975% 1 2 3 4 5 6 7 SCSC STST Noncompetitive Bids 99.48875% (P NC ) stop-out price (low bid accepted) $17,509.5m $19,254.8m

11. Secondary Market T-bill Transaction Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan Chase to Lehman Brothers Transaction recorded in Fed’s Book-Entry System J.P. Morgan Chase sells $10m. In T-bills Lehman Brothers buy $10m. In T-bills Fedwire Transaction Fedwire Transaction Individual buy $50,000 in T-bills Local Bank or Broker J.P. Morgan Chase sell $50,000 in T-bills FRBNY -$50,000 in T-bills from J.P. Morgan Chase’s account + $50,000 T-bill to Individual

12. Federal Funds: or fed funds, are short term unsecured loans These loans occur largely between institutions majority overnight loans, some ‘continuing contract’ Commercial banks majority of transactions Direct lending or borrowing institution or through a broker Fed funds are add on loan contracts Funds transfers occur over the FedWire A FI is not required to hold reserves at the Fed to participate in the fed funds market. Typical transactions are $5 million and up Many Fed fund loans are arranged through correspondent bank or brokers such as Garban-Intercapital Ltd. And RMJ Securities Corp.

13. Repurchase Agreements: an agreement where the seller of securities agrees to repurchase the securities at a preset price at a preset time (typically from 1 to 14 days). Reverse repos: purchase with the promise to resell Repos are collateralized loans The rate of interest paid on the repo is not a function of the rate of return on the underlying securities title to the securities passes to the lender of funds for the term of the agreement. Transfers may occur over the FedWire system. Denominations one week or less $25 million, longer: $10 million Repos are add on instruments Arranged either directly or through the help of a broker open market operations Yield on repurchase agreement: i RA = P f -P o * 360 P o h

14. Commercial Paper: is a short term unsecured promissory note issued by creditworthy corporations and financial institutions, to finance ST needs (WC) is rated by ratings agencies Low quality paper is often secured by bank lines of credit to obtain a better rating The maximum maturity is 270 days, commercial paper comprised about 25% of total money market securities in 2004, down from 2001 in absolute dollar amount and as a percentage of total money market securities. Commercial paper is a discount instrument and uses discount quotes similar to T–bills

15. Credit concerns and high profile downgrades of major paper issuers such as GM, Ford and Tyco … No active secondary market for commercial paper, Denominations range from $100,000 to $1 million, with the most common maturities in the 20 to 45 day range. 15% of issuers directly market their own paper, but the bulk is sold through brokers and dealers. i cp (dy)=P f -P o * 360 P o h icp(bey)=P f -P o * 365 P o h

16. Negotiable Certificates of Deposit: is a bearer certificate are negotiable instruments, specific maturity and interest rate negotiable CDs have a minimum denomination of $100,000, but denominations of $1 million are the most common maturities range from 1, 2, 3 and 6 months out to 1 year. Are add on rates 26% of money market securities in 2004 ‘substantial interest penalties for early withdrawal.’ About 15 dealers make a secondary market in CDs secondary market eliminates the problem of the interest penalty, Transfer done after custodian bank verifies and transfers money through Fed wire to issuing bank

17. Banker’s Acceptances (BAs): A time draft often used to facilitate international trade in goods and services with payment guaranteed by bank A sight draft A time draft BAs are time drafts BAs are bearer instruments and are fairly actively traded Maturities range from 30 to 270 days and BAs are bundled into round lots of $100,000 and $500,000. Interest rates are very close to T-bill rates because the risk of default is quite low

18. Creation of a BA

19. Money Market Participants The U.S. Treasury The Federal Reserve Commercial Banks Money Market Mutual Funds Brokers and Dealers: The twenty–two government securities dealers Cantor, Fitzgerald Securities, Garban-Intercapital, Liberty, RMJ Securities, and Hill Farber are money and security brokers Thousands of brokers and dealers who link buyers and sellers Corporations Other Financial Institutions

20. Euro Money Markets Eurocurrency deposits are deposits of currency held outside the home country. Eurodollar deposits are not subject to U.S. bank regulations. Eurodollar market has evolved as a source of overnight funding for international banks, and plays a role similar to fed funds loans in the U.S. The rate offered to lend these funds is the London InterBank Offer Rate (LIBOR).

21. Euro Money Market Securities Some of the major securities include: Eurodollar CDs: Dollar denominated deposits held outside the U.S. The maturity is typically less than one year. Rates on Eurodollar CDs are sometimes higher than domestic CD rates because of the lack of explicit deposit insurance and lower regulatory costs. Eurocommercial paper issued by commercial paper dealers: Technically, the term means commercial paper issued outside the borrower’s country of origin, but in their home currency. The term is coming to mean securities issued in Europe without involving a bank.