1. Chapter 14 The Money Market

2. Learning Objectives
To specify the important features of money markets.
Define the money market instruments by category.
Calculate the taxable-equivalent yield, yield from dividend capture, discount yield, coupon-equivalent yield, and effective annual yield.
Specify types of investment risk and their effects on yields.
To understand yield curves and the theories that explain them.

3. Nature of the Money Market
Primary and secondary markets
Wholesale and retail markets
Money market interest rates
Tax status
Market mechanics and intermediaries

4. Money Market Instruments
Bank instruments
Corporate instruments
Federal Government instruments
State and local instruments
Mixed instruments

5. Bank Instruments Instrument Denomination Maturity Risk
Certificates of Deposit Primary: $100, days to * FDIC
Secondary: $2-$5m 8 years * Fixed mat.
*Expro risk of
Time deposits Minimum set by 1 day to 3 Eurodollar
bank months deposits
Bankers Acceptances $500,000 to $1m Up to 270 * Bank secured
days * 2ndary mkt
Loan participations Varies 1 day to * Most have
3 years guarantor
* Illiquid
Securitized assets such Varies 1 year to * Diversified
as auto loans, etc years portfolio

6. Corporate Instruments
Instrument Denomination Maturity Risk
Commercial paper Primary: $100, to 270 days * Usually low
Secondary: $5m * Backup line
* Liquidity
function of
issuer
Floating-rate notes Primary: $1,000-$100,000 9 months to * Function of
Secondary: $5 million 30 years issuer
Common or No typical No maturity *Function of
preferred stock days issuer
* Function of
market

7. Federal Government Instruments
Instrument Denomination Maturity Risk
Treasury bills Primary: $10,000+ 3,6,12 months *No default
risk
*Some interest
rate risk
Treasury notes/bonds 2-yr notes: $5, Notes:2-5,7,10 yrs *No default
5-,7-,10-yr notes Bonds: >10 yrs *Interest rate
and bonds: $1, risk
Government agencies Primary: $1,000 Varies * Low default
Secondary: larger * Sporadic liq.
* Interest rate
risk function
of maturity
* Event risk

8. State and Local Government Instruments
Instrument Denomination Maturity Risk
Anticipation notes Primary: $5,000 Few weeks to * Low default
Secondary: $100,000 several years risk
* Liq. depends
on dealer
* Interest rate
risk function
of maturity
VRDNs Primary: $5,000-$100, years with * Low default
Secondary: $100,000 put. Interest and liq. risk
rate reset * Low liquidity
risk due to
rate reset
Tax-exempt CP Primary: $50,000-$100,000 Few days to * Same risk as
Secondary: $100,000 several years anticipation

9. Mixed Instruments Instrument Denomination Maturity Risk
MMMFs $10,000 for institutions days * No FDIC
* No liquidity
risk
* No interest
rate risk
Repurchase Agreements Typical: $1 million Mostly overnite * Depends on
Term RPs institution
generally 3 wks * Linked to
collateral
* Some liq risk
* Event risk
Sweep accounts None Overnight * Depends on
institution

10. Money Market Rate CalculationsD
Ycap = x Dividend capture yield (14.2)
P n
Ycap [1 - (.30 x T)]
Ycap-te = Tax-equivalent yield (14.3)
(1 -T)
Where: .30 is related to the dividend exclusion
T is the investors marginal tax rate
D is the dividend
P is the security price
n is the holding period

11. Money Market Rate Calculations
FV - P
Yd = x Discount yield (14.4)
FV n
FV - P
Yce = x Coupon-equivalent yield (14.5)
P n

12. Term Structure Theories
What explains the shape of the yield curve?
Yield,%
Time to Maturity

13. Term Structure: Unbiased Expectations
The prevailing yield curve is derived from the present short-term rate and expectations for rates that will exist in the future.
(1+tRn) = [(1+tR1)(1+t+1r1,t)(1+t+2r1,t)......] 1/n
Thus, long-term rates are higher than current short-term rates if future short-term rates are expected to be higher than current short-term rates...and long-term rates fall below current short-term rates if future expected short-term rates are expected to be less than the current level of short-term rates.

14. Term Structure: Liquidity Preference
Preference for liquidity is thought to characterize enough investors that the yield curve (in absence of expectations or other influences) should slope upward from left to right. The longer the maturity, the higher the premium demanded by investors.
Yield,%
Yield, %
Liquidity
Premium
Time to Maturity

15. Term Structure: Segmentation hypothesis
Instead of being close substitutes, securities with short, medium, and long maturities are seen by investors (fund suppliers) and issuers (fund demanders) as quite different.
The markets are thus separated, or segmented, by the self-limiting behavior of institutions staying within their preferred habitats.

16. Term Structure: Biased expectations
A combination of the unbiased expectations theory and the liquidity preference hypothesis.

17. Risk Structure of Interest Rates
Default risk
Liquidity risk
Interest rate risk
Reinvestment rate risk
Event risk
Foreign exchange and political risk

18. Risk-Return Assessment in Practice
Yield spread analysis
Safety ratings
Assessing liquidity risk

19. Summary We surveyed the menu of short-term investment alternatives
Investment objectives: corporate investors rank safety first, followed by liquidity and then yield.
We learned how to calculate various money market rates of return
We studied possible explanations for the shape of the yield curve
We concluded with a discussion of the risk structure of interest rates