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MGT 470 Ch 11 Money Mkts (me8ed) v1.0 Feb 16 1 Money Markets Defined: The term “money market” is a misnomer, no money/currency is actually traded In these markets short-term, highly liquid securities are traded usually sold in large denominations they have low default risk they mature in one year or less from original issue date; most have maturity less than 120 days These are considered “cash equivalents” hence the term “money market” Money market transactions do not occur in one particular place; they are usually done via phone or internet Money market securities have an active secondary market this makes money market securities very flexible instruments to use to fill short-term financial needs Money markets are wholesale markets most transactions are in excess of $1 million since most investors can’t afford that much for one investment, large banks and brokerage houses bring together many investors; hence money market mutual funds Liquidity: Economic definition: A measure of the ease with which an asset can be turned into a means of payment Business definition: the ability to convert a non-cash asset into cash quickly and without significant loss in value Funding Liquidity: the ability to borrow money to buy securities or make loans Corporate Liquidity: the ability to use cash reserves to deal with an unforeseen liability or exploit an unforeseen opportunity Ch 11: The Money Markets
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MGT 470 Ch 11 Money Mkts (me8ed) v1.0 Feb 16 2 Why Do Money Markets Exist? The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders banks earn profits by capitalizing on economies of scale while providing this service however, the banking industry is subject to more regulations and government costs than are money markets Money markets have a cost advantage over the banking industry money that banks are required to set aside to meet federal reserve requirements is not available for investing; thus banks offer lower interest rate to depositors money markets have no such requirement The Purpose of Money Markets They are a very good place to temporarily store money until it’s needed The goal of most money market investors is not to earn high returns the time may not be right to invest in other activities or securities so they temporarily store money thus they only require a return that is better than simply holding cash Borrower-spenders find money markets a great source for low-cost short-term loans The high liquidity of money markets is very attractive to corporations
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MGT 470 Ch 11 Money Mkts (me8ed) v1.0 Feb 16 3 Who Participates in Money Markets?
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MGT 470 Ch 11 Money Mkts (me8ed) v1.0 Feb 16 4 Money Market Instruments Treasury Bills: Short-term bonds issued by the U.S. government the most widely held and most liquid security in the world typically maturities are: 28-, 91- and 182-day typical denominations are $100 and $1,000 sold as Original Issue Discount (OID) bonds sold at weekly auctions in the primary market Repurchase Agreements (Repos): work like federal funds except non- bank entities can purchase them a firm sells securities (usually treasuries) and agrees to buy back those securities at a specified future date (not at a specified price) usually have a very short term of 3 to 14 days repos work essentially as a short term collateralized loan securities dealers use repos to manage their liquidity and to take advantage of anticipated interest rate changes Negotiable Certificates of Deposits (CDs): is a bank-issued security that documents a deposit and specifies the interest rate and the maturity date because a maturity date is specified, a CD is a “term security” as opposed to a demand deposit typical denominations range from $100k to $10m
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MGT 470 Ch 11 Money Mkts (me8ed) v1.0 Feb 16 5 Money Market Instruments (continued) Commercial Paper securities: are unsecured promissory notes issued by corporations that mature in 270 days or less; most are for 20 to 45 days because these are unsecured loans, only the most credit worthy firms may issue them the term is less than 270 days in order to avoid registering the security issue with the SEC; this lowers transaction costs non-bank firms use commercial paper to fund the loans they extend to their customers most issuers of commercial paper back them up with a line of credit at a bank; this lowers the risk to the purchaser of commercial paper Asset-backed Commercial Paper (ABCP) are backed (collateralized) by some bundle of assets such as securitized mortgages Banker’s Acceptances: an order to pay a specified amount of money to the bearer on a given date used to finance goods that have not yet been transferred from the seller to the buyer became very widely used in the ‘60’s to finance international commerce because they are payable to the bearer, they can be bought and sold until they mature
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MGT 470 Ch 11 Money Mkts (me8ed) v1.0 Feb 16 6 Benchmark Short-term Interest Rates Federal Funds Rate: The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. the federal funds rate is generally only applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other the federal funds rate is one of the most influential interest rates in the U.S. economy Why? the Fed’s Federal Open Market Committee (FOMC) sets the target value for the federal funds rate the current federal funds target rate is 0.5000%, set December 2015 Prime Rate: The prime rate is the rate that commercial banks charge their most credit-worthy customers. In the United States, the prime rate runs approximately 300 basis points (or 3 percentage points) above the federal funds rate LIBOR: is a rate that some of the world’s leading banks charge each other for short-term loans. stands for London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar, Euro, pound sterling, Japanese yen and Swiss franc serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months there are a total of 35 different LIBOR rates each business day; the most commonly quoted rate is the three-month U.S. dollar rate
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