1. 5-1 Money Markets Money markets involve debt instruments with original maturities of one year or less Money market debt issued by high-quality (i.e., low default risk) economic units that require short-term funds purchased by those that have excess short-term funds little or no chance of loss of principal low rates of return Most money market instruments have active secondary markets to provide liquidity Money markets involve debt instruments with original maturities of one year or less Money market debt issued by high-quality (i.e., low default risk) economic units that require short-term funds purchased by those that have excess short-term funds little or no chance of loss of principal low rates of return Most money market instruments have active secondary markets to provide liquidity

2. 5-2 Money Market Yields Money market securities use special rate quoting conventions: Discount yields (i dy ): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of redemption price or face value Single payment yields (i spy ): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of purchase price Both may be converted to a bond equivalent yield (i bey ) for comparison with bonds Money market securities use special rate quoting conventions: Discount yields (i dy ): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of redemption price or face value Single payment yields (i spy ): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of purchase price Both may be converted to a bond equivalent yield (i bey ) for comparison with bonds

3. 5-3 Money Market Yields Treasury bills and commercial paper rates are quoted as discount yields Discount yields (i dy ) use a 360-day year P f = the face value of the security P 0 = the discount price of the security h = the number of days until maturity Treasury bills and commercial paper rates are quoted as discount yields Discount yields (i dy ) use a 360-day year P f = the face value of the security P 0 = the discount price of the security h = the number of days until maturity

4. 5-4 Money Market Yields Compare discount securities to bonds with bond equivalent yields (i bey ) Convert bond equivalent yields into effective annual returns (EAR) Compare discount securities to bonds with bond equivalent yields (i bey ) Convert bond equivalent yields into effective annual returns (EAR)

5. 5-5 Money Market Yields Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (i spy )

6. 5-6 Sample Calculations of Money Market Yields A $1M investment in 90 day commercial paper has a 2% discount yield, what is the current price of the CP?

7. 5-7 Money Market Instruments Treasury bills (T-bills) Federal funds (fed funds) Repurchase agreements (repos or RP) Commercial paper (CP) Negotiable certificates of deposit (CD) Banker acceptances (BA) Treasury bills (T-bills) Federal funds (fed funds) Repurchase agreements (repos or RP) Commercial paper (CP) Negotiable certificates of deposit (CD) Banker acceptances (BA)

8. 5-8 Treasury Bills (T-Bills) T-Bills are short-term debt obligations issued by the U.S. federal government T-bills are virtually default risk free, are highly liquid, and have little interest rate risk The Federal Reserve buys and sells T-bills to implement monetary policy (open market operation) Strong international demand for T-bills as safe haven investment T-Bills are short-term debt obligations issued by the U.S. federal government T-bills are virtually default risk free, are highly liquid, and have little interest rate risk The Federal Reserve buys and sells T-bills to implement monetary policy (open market operation) Strong international demand for T-bills as safe haven investment

9. 5-9 T-Bill Auctions 13- and 26-week T-bills are auctioned weekly Bids are submitted by government securities dealers, financial and nonfinancial corporations, and individuals Bids can be competitive or noncompetitive competitive bids specify the bid price and the desired quantity of T-bills noncompetitive bidders get preferential allocation and agree to pay the lowest price of the winning competitive bids 13- and 26-week T-bills are auctioned weekly Bids are submitted by government securities dealers, financial and nonfinancial corporations, and individuals Bids can be competitive or noncompetitive competitive bids specify the bid price and the desired quantity of T-bills noncompetitive bidders get preferential allocation and agree to pay the lowest price of the winning competitive bids

10. 5-10 The Secondary Market for T-Bills The secondary market for T-bills is the largest of any U.S. money market instrument 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market primary dealers trade for themselves and for customers T-bill purchases and sales are book-entry transactions conducted over Fedwire T-Bills are sold on a discount basis The secondary market for T-bills is the largest of any U.S. money market instrument 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market primary dealers trade for themselves and for customers T-bill purchases and sales are book-entry transactions conducted over Fedwire T-Bills are sold on a discount basis

11. 5-11 Federal Funds The federal funds (fed funds) rate is the target rate in the conduct of monetary policy Fed fund transactions are short-term (mostly overnight) unsecured loans Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Multimillion dollar loans may be arranged in a matter of minutes The federal funds (fed funds) rate is the target rate in the conduct of monetary policy Fed fund transactions are short-term (mostly overnight) unsecured loans Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Multimillion dollar loans may be arranged in a matter of minutes

12. 5-12 Repurchase Agreement A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities) Similar to a fed fund loan, but collateralized Funds may be transferred over FedWire system If collateralized by risky assets, the repo may involve a ‘haircut’ A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities) Similar to a fed fund loan, but collateralized Funds may be transferred over FedWire system If collateralized by risky assets, the repo may involve a ‘haircut’

13. 5-13 Repurchase Agreement Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations A reverse repurchase agreement is the purchase of a security with an agreement to sell it back in the future Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations A reverse repurchase agreement is the purchase of a security with an agreement to sell it back in the future

14. 5-14 Commercial Paper Commercial Paper (CP) is unsecured short-term corporate debt issued by financially reputable companies to raise short- term funds (e.g., for working capital) Generally sold in denominations of $100,000 to $1 million with maturities between 1 and 270 days CP is usually sold to investors indirectly CP is usually held by investors until maturity and has no active secondary market Commercial Paper (CP) is unsecured short-term corporate debt issued by financially reputable companies to raise short- term funds (e.g., for working capital) Generally sold in denominations of $100,000 to $1 million with maturities between 1 and 270 days CP is usually sold to investors indirectly CP is usually held by investors until maturity and has no active secondary market

15. 5-15 Negotiable Certificate of Deposit A negotiable certificate of deposit (CD) is a bank- issued time deposit that specifies the interest rate and the maturity date CDs are bearer instruments and thus are salable Denominations range from $100,000 to $10 million; $1 million being the most common. Smaller denomination CDs you can normally see are not negotiable. Often purchased by money market mutual funds with pools of funds from individual investors A negotiable certificate of deposit (CD) is a bank- issued time deposit that specifies the interest rate and the maturity date CDs are bearer instruments and thus are salable Denominations range from $100,000 to $10 million; $1 million being the most common. Smaller denomination CDs you can normally see are not negotiable. Often purchased by money market mutual funds with pools of funds from individual investors

16. 5-16 Banker’s Acceptance A Banker’s Acceptance (BA) is a time draft payable (IOU) to a seller of goods with payment guaranteed by a bank Used in international trade transactions to finance – you may not trust your counterpart, so a bank is involved. Banker’s acceptances are bearer instruments and salable A Banker’s Acceptance (BA) is a time draft payable (IOU) to a seller of goods with payment guaranteed by a bank Used in international trade transactions to finance – you may not trust your counterpart, so a bank is involved. Banker’s acceptances are bearer instruments and salable

17. 5-17 2011 Money Market Yields Instrument Federal Funds* Commercial PaperCDsEuro CP Rate 0.11%0.17%0.23% 1.18% InstrumentLIBOR Banker’s AcceptancesEuro$Repo* Rate 0.27375% 0.22%0.25%0.08% Instrument Treasury Bills** Inflation*** Rate 0.060 2.7% Data from the Wall Street Journal Online Money Rates Section April 2011. Rates are for 3 month maturities except as noted. Overnight; ** 13 week, *** Year over year, all items as measured by the CPI LIBOR=London Interbank Offered Rate=the rate the banks in London charge for their short-term lending/borrowing

18. 5-18 Money Market Securities Outstanding Billions $ Instrument1990200420072010 Treasury Bills$ 527$ 982$1,010$1,856 Fed funds & Repos3721,5852,7311,656 Commercial Paper5381,3102,1091.083 Negotiable CDs5471,3792,1491,822 Banker's Acceptances52411 Total$2,036$5,260$8,000$6,418 % of Total in Given Year Instrument199020042007 2010 Treasury Bills26%19%13%29% Fed funds & Repos18%30%34%26% Commercial Paper26%25%26%17% Negotiable CDs27%26%27%28% Banker's Acceptances3%0.1%0.0% 100% Source: Text