1. Chapter 6: Money Markets

2. Chapter 6: Money Markets
Chapter Outline:
Money Market Securities.
Institutional Use of Money Markets.
Valuation of Money Market Securities.
Risk of Money Market Securities.
Globalization of Money Market.

3. Money Market Securities
Treasury Bills.
Commercial Papers.
Negotiable Certificate of Deposit.
Repurchase Agreements.
Federal Funds.
Banker’s Acceptances.

4. Money Market Securities
Have maturities within one year
Are issued by corporations and governments to obtain short-term funds
Are commonly purchased by corporations and government agencies that have funds available for a short-term period
Provide liquidity to investors

5. Treasury Bills Are issued by the U.S. Treasury
Are sold weekly through an auction
Have a par value of $1,000
Are attractive to investors because they are backed by the federal government and are free of default risk
Are liquid
Can be sold in the secondary market through government security dealers

6. Treasury Bills (cont’d)
Investors in Treasury bills:
Depository institutions because T-bills can be easily liquidated
Other financial institutions in case cash outflows exceed cash inflows
Individuals with substantial savings for liquidity purposes
Corporations to have easy access to funding for unanticipated expenses

7. Treasury Bills (cont’d)
Pricing Treasury bills
The price is dependent on the investor’s required rate of return:
Treasury bills do not pay interest
To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested

8. Computing the Price of a Treasury Bill
A one-year Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill?

9. Treasury Bills (cont’d)
Treasury bill auction
Investors submit bids on T-bill applications for the maturity of their choice
Applications can be obtained from a Federal Reserve district or branch bank
Financial institutions can submit their bids using the Treasury Automated Auction Processing System (TAAPS-Link)
Institutions must set up an account with the Treasury
Payments to the Treasury are withdrawn electronically from the account
Payments received from the Treasury are deposited into the account

10. Treasury Bills (cont’d)
Treasury bill auction (cont’d)
Weekly auctions include 13-week and 26-week T-bills
4-week T-bills are offered when the Treasury anticipates a short-term cash deficiency
Cash management bills are also occasionally offered
Investors can submit competitive or noncompetitive bids
The bids of noncompetitive bidders are accepted
The highest competitive bids are accepted
Any bids below the cutoff are not accepted
Since 1998, the lowest competitive bid is the price applied to all competitive and noncompetitive bids

11. Treasury Bills (cont’d)
Estimating the yield
T-bills are sold at a discount from par value
The yield is influenced by the difference between the selling price and the purchase price
If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price

12. Treasury Bills (cont’d)
Estimating the yield (cont’d)
The annualized yield is:
Estimating the T-bill discount
The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:

13. Computing the Yield of a Treasury Bill
An investor purchases a 91-day T-bill for $9,782. If the T-bill is held to maturity, what is the yield the investor would earn?

14. Estimating the T-Bill Discount
Using the information from the previous example, what is the T-bill discount?

15. Commercial Paper
Is a short-term debt instrument issued by well-known, creditworthy firms
Is typically unsecured
Is issued to provide liquidity to finance a firm’s investment in inventory and accounts receivable
Is an alternative to short-term bank loans
Has a minimum denomination of $100,000
Has a typical maturity between 20 and 270 days
Is issued by financial institutions such as finance companies and bank holding companies
Has no active secondary market
Is typically not purchased directly by individual investors

16. Commercial Paper (cont’d)
Ratings
The risk of default depends on the issuer’s financial condition and cash flow
Commercial paper rating serves as an indicator of the potential risk of default
Corporations can more easily place commercial paper that is assigned a top-tier rating
Junk commercial paper is rated low or not rated at all

17. Commercial Paper (cont’d)
Volume of Commercial paper:
Has increased substantially over time
Is commonly reduced during recessionary periods
Placement:
Some firms place commercial paper directly with investors
Most firms rely on commercial paper dealers to sell it
Some firms (such as finance companies) create in-house departments to place commercial paper

18. Commercial Paper (cont’d)
Backing Commercial Paper:
Issuers typically maintain a backup line of credit
Allows the company the right to borrow a specified maximum amount of funds over a specified period of time
Involves a fee in the form of a direct percentage or in the form of required compensating balances
Estimating the yield
The yield on commercial paper is slightly higher than on a T-bill
The nominal return is the difference between the price paid and the par value

19. Estimating the Commercial Paper Yield
An investor purchases 120-day commercial paper with a par value of $300,000 for a price of $289,000. What is the annualized commercial paper yield?

20. Commercial Paper (cont’d)
The commercial paper yield curve:
Illustrates the yield offered on commercial paper at various maturities
Is typically established for a maturity range from 0 to 90 days
Is important because it may influence the maturity that is used by firms that issue CP
Is similar to the short-term range of the Treasury yield curve
Is affected by short-term interest rate expectations
Is similar to the yield curve on other money market instruments

21. Negotiable Certificates of Deposit (NCDs):
Are issued by large commercial banks and other depository institutions as a short-term source of funds
Have a minimum denomination of $100,000
Are often purchased by nonfinancial corporations
Are sometimes purchased by money market funds
Have a typical maturity between two weeks and one year
Have a secondary market

22. Negotiable Certificates of Deposit (NCDs):
Placement
Directly
Through a correspondent institution
Through securities dealers
Premium
NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety
Premiums are generally higher during recessionary periods

23. Negotiable Certificates of Deposit (NCDs):
Yield
NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price
If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate

24. Repurchase Agreements
One party sells securities to another with an agreement to repurchase them at a specified date and price
Essentially a loan backed by securities
A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them
Bank, S&Ls, and money market funds often participate in repos
Transactions amounts are usually for $10 million or more
Common maturities are from 1 day to 15 days and for one, three, and six months
There is no secondary market for repos

25. Repurchase Agreements
Placement
Repo transactions are negotiated through a telecommunications network with dealers and repo brokers
When a borrowing firm can find a counterparty to a repo transaction, it avoids the transaction fee
Some companies use in-house departments
Estimating the yield
The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with a 360-day year

26. Estimating the Repo Yield
An investor initially purchased securities at a price of $9,913,314, with an agreement to sell them back at a price of $10,000,000 at the end of a 90-day period. What is the repo rate?

27. Federal Funds
The federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate
The rate is influenced by the supply and demand for funds in the federal funds market
The Fed adjusts the amount of funds in depository institutions to influence the rate
All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions
The fed funds rate is typically slightly higher than the T-bill rate

28. Federal Funds
Two depository institutions communicate directly through a communications network or through a federal funds broker
The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institution’s reserve account by the amount of the loan
Commercial banks are the most active participants in the federal funds market
Most loan transactions are or $5 million or more and usually have one- to seven-day maturities

29. Banker’s Acceptances
Indicate that a bank accepts responsibility for a future payments
Are commonly used for international trade transactions
An unknown importer’s bank may serve as the guarantor
Exporters frequently sell an acceptance before the payment date
Have a return equal to the difference between the discounted price paid and the amount to be received in the future
Have an active secondary market facilitated by dealers

30. Banker’s Acceptances Steps involved in banker’s acceptances
First, the U.S. importer places a purchase order for goods
The importer asks its bank to issue a letter of credit (L/C) on its behalf
Represents a commitment by that bank to back the payment owed to the foreign exporter
The L/C is presented to the exporter’s bank
The exporter sends the goods to the importer and the shipping documents to its bank
The shipping documents are passed along to the importer’s bank

31. Sequence of Steps in the Creation of A Banker’s Acceptance1
Purchase Order
Importer
Exporter
Shipment of Goods 5 4
L/C Notification 2
L/C Application 6
Shipping Documents & Time Draft 3
L/C
American Bank
(Importer’s Bank)
Japanese Bank
(Exporter’s Bank)
Shipping Documents
& Time Draft Accepted 7

32. Institutional Use of Money Markets
Financial institutions purchase money market securities to earn a return and maintain adequate liquidity
Institutions issue money market securities when experiencing a temporary shortage of cash
Money market securities enhance liquidity:
Newly-issued securities generate cash
Institutions that previously purchased securities will generate cash upon liquidation
Most institutions hold either securities that have very active secondary markets or securities with short-term maturities

33. Institutional Use of Money Markets (cont’d)
Financial institutions with uncertain cash in- and outflows maintain additional money market securities
Institutions that purchase securities act as a creditor to the initial issuer
Some institutions issue their own money market instruments to obtain cash
Many money market transaction involve two financial institutions

34. Valuation of Money Market Securities
For money market securities making no interest payments, the value reflects the present value of a future lump-sum payment
The discount rate is the required rate of return by investors

35. Valuation of Money Market Securities (cont’d)
Explaining money market price movements
The price of a noninterest-paying money market security is:
A change in the price can be modeled as:

36. Valuation of Money Market Securities (cont’d)
Explaining money market price movements (cont’d)
Impact of September 11
The weak economy combined with this event caused investors to transfer funds into money market securities
The additional demand placed upward pressure on their price and downward pressure on their yields
The Fed added liquidity to the banking system and reduced the federal funds rate

37. Valuation of Money Market Securities (cont’d)
Indicators of future money market security prices
Economic growth is monitored since it signals changes in short-term interest rates and the required return from investing in money market securities
Employment
GDP
Retail sales
Industrial production
Consumer confidence
Indicators of inflation

38. Risk of Money Market Securities
Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk
Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default
Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuer’s financial condition is limited
Measuring risk
Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates

39. Interaction Among Money Market Yields
Money market instruments are substitutes for each other
Market forces will correct disparities in yield and the yields among securities tend to be similar
In periods of heightened uncertainty, investors tend to shift from risky money market securities to Treasuries
Flight to quality
Creates a greater differential between yields

40. Globalization of Money Markets
Interest rate differentials occur because geographic markets are somewhat segmented
Interest rates have become more highly correlated:
Conversion to the euro
The flow of funds between countries has increased because of:
Tax differences
Speculation on exchange rate movements
A reduction in government barriers
Eurodollar deposits, Euronotes, and Euro-commercial paper are widely traded in international money markets

41. Globalization of Money Markets (cont’d)
Eurodollar deposits and Euronotes
Eurodollar certificates of deposit are U.S. dollar deposits in non-U.S. banks
Have increased because of increasing international trade and historical U.S. interest rate ceilings
In the Eurodollar market, banks channel deposited funds to other firms that need to borrow them in the form of Eurodollar loans
Typical transactions are $1 million or more
Eurodollar CDs are not subject to reserve requirements
Interest rates are attractive for both depositors and borrowers
Rates offered on Eurodollar deposits are slightly higher than NCD rates

42. Globalization of Money Markets (cont’d)
Eurodollar deposits and Euronotes (cont’d)
Investors in fixed-rate Eurodollar CDs are adversely affected by rising market rates
Issuers of fixed-rate Eurodollar CDs are adversely affected by declining rates
Eurodollar-floating-rate CDs (FRCDs) periodically adjust to LIBOR
The Eurocurrency market is made up of Eurobanks that accept large deposits and provide large loans in foreign currencies
Loans in the Eurocredit market have longer maturities than loans in the Eurocurrency market
Short-term Euronotes are issued in bearer form with maturities of one, three, and six months

43. Globalization of Money Markets (cont’d)
Euro-commercial paper (Euro-CP):
Is issued without the backing of a banking syndicate
Has maturities tailored to satisfy investors
Has a secondary market run by CP dealers
Has a rate 50 to 100 basis points above LIBOR
Is sold by dealers at a transaction cost between 5 and 10 basis points of the face value

44. Globalization of Money Markets (cont’d)
Performance of foreign money market securities
Measured by the effective yield (adjusted for the exchange rate
Depends on:
The yield earned on the money market security in the foreign currency
The exchange rate effect

45. Computing the Effective Yield
A U.S. investor buys euros for $1.15 and invests in a one-year European security with a yield of 8 percent. After one year, the investor converts the proceeds from the investment back to dollars at the spot rate of $1.16 per euro. What is the effective yield earned by the investor?

46. End of Chapter 6