1. CHAPTER 7
Money Markets

2. Overview of the Money Market
Short-term debt market - most under 120 days.
A few high quality borrowers.
Many diverse investors.
Standardized securities -- one security is a close substitute for another.
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3. Overview of the Money Market (concluded)
Good marketability - secondary market.
Large, wholesale open-market transactions.
Many brokers and dealers are competitively involved in the money market.
Physical possession of securities seldom occurs - centralized safekeeping.
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4. Economic Role of Money Market (MM)
The most important economic function of the money markets is to provide an efficient means for adjusting liquidity. They allow economic units to bridge the gap between the cash inflow and outflows, thereby solving the liquidity problems.
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).
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5. Characteristics of Money Market Instruments
Low default risk.
Short maturity (low price risk).
High marketability.
Large denominations.
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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.
Considered free of default risk.
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7. How to Read T-Bill Quotes
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U.S. Treasury Bills
Pricing Treasury Bills
1. Treasury bills are priced on a bank discount rate basis, a traditional yield calculation.
The bank discount rate, yd , is:
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U.S. Treasury Bills
2. 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:
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Example
Example 1: You are given the following data:
Face price = 10,000, buying price = 9760, days to maturity = 100. what is the yield on a bond – equivalent basis?
YBE = [(Face Value - Price)/Price] x [(365/Days to Maturity) ] x 100%
YBE = [(10000 – 9760) / 9760] [365 / 100] [100%]
= (0.025 )(3.65)(100%) = 8.9%
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U.S. Treasury Bills
A T-bill’s price can be computed by using the discount yield:
Or by using the bond equivalent yield basis:
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12. Copyright© 2006 John Wiley & Sons, Inc.
Example
Example 2: You are given the following data:
Face price = 10,000, days till maturity = 91 and yield = 8.19%. what is buying price on a bond – equivalent basis?
Price = [face price] / [1 + (YBE * days to Maturity / 365)
= /
= 9800
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13. 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.
The interest rate on a repo is lower than the fed funds rate, since it is backed up by a security.
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14. Repurchase Agreements (concluded)
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.
Repos are used to shorten the actual maturity of a security to meet the needs of both borrowers and lenders.
Example: If you want to invest for only 3 days, you can either buy a T.Bill and sell it after 3 days but this will involves price risk if the interest rate changes during the 3 days, or you can invest in 3 days repo, eliminating all price risk.
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15. Yield on Repurchase Agreements (Repo)
The yield on a repo is calculated as follows:
Where:
Prepo = repurchase price of the security, which equals the selling price plus interest.
P0 = sale price of the security
n = number of days to maturity
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Yield on Repo- Example
Example:
A commercial bank does a reverse repo with one of corporate customers who needs funds for 3 days. The bank agrees to buy treasury securities at $1,000,000 and promise to sell securities back at $1,000,145 after 3 Days. What is the yield on the reverse repo?
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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.
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Commercial Papers
Commercial papers are sold on discount basis.
the formula for the discount yield (ydp) :
Where Pf is the face price, P0 is the purchase price and n is the number of days to maturity.
the formula for purchase price on discount yield basis:
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Commercial Papers
the formula for the bond equivalent yield (ybe) :
Where Pf is the face price, P0 is the purchase price and n is the number of days to maturity.
the formula for purchase price on bond equivalent yield basis:
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Bankers' Acceptances
Time draft - order to pay in future.
The bank accepts the responsibility to repay the face value at maturity to the holder of the time draft.
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.
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21. 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.
Once the bank authorize the time draft, it send it to the exporter.
Once the goods are shipped, the exporter transfer the documents and the time draft to its local bank.
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22. Creating a Banker's Acceptance (concluded)
The exporter’s bank will pay the exporter immediate cash, but of a discount amount.
The exporter bank will send the time draft and all the documents to the importer bank, who will accept the draft.
At maturity, the importer bank will pay the exporter bank the face value of the time draft.
The importer is responsible to pay his bank the amount at maturity.
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23. Creating a Banker's Acceptance (concluded)
Advantages of a BA:
Exporter receives funds by selling BA in the market.
Exporter eliminates foreign exchange risk, because a local bank pays in domestic funds.
Importer's bank guarantees payment of draft in future.
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24. Tracing a Banker’s Acceptance Transaction
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MM participants
Commercial Banks.
The Federal Reserve System.
The US Treasury and Treasury Security Dealers.
Corporations
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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).
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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.
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28. The Federal Reserve System
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.
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29. 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.
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