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1 Modern Financial Markets: Prices, Yields, and Risk Analysis Blackwell, Griffiths and Winters Chapter 12 Money Market Risk Management.

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Presentation on theme: "1 Modern Financial Markets: Prices, Yields, and Risk Analysis Blackwell, Griffiths and Winters Chapter 12 Money Market Risk Management."— Presentation transcript:

1 1 Modern Financial Markets: Prices, Yields, and Risk Analysis Blackwell, Griffiths and Winters Chapter 12 Money Market Risk Management

2 2 Learning Objectives 1.Risk focus comes from trading for liquidity 2.Concerns of money market investors 3.Managing default risk 4.Interest rate risk 5.Money market mutual funds

3 3 Introduction This is our first chapter on managing risk in a specific market. In each risk management chapter we focus on the risk associated with owning a financial instrument from a specific market and the various techniques available to manage the risk. This chapter is on risk management in the money markets.

4 4 Introduction (cont.) Managing risk in the money markets is very different from managing risk in the other financial markets. The difference stems from the unique role of the money markets as markets for trading liquidity. This results in most of the risk management in money markets occurring before the investment is made instead of during ownership.

5 5 Introduction (cont.) Example Charles Schwab describes the goal of their money market mutual fund as ‘highest current income consistent with stability of capital and liquidity.’ They further state that ‘to pursue its goal, the fund invests in high-quality short-term money market investments.’

6 6 Introduction (cont.) Example What Schwab is telling investors is that Schwab picks securities with a focus on low default risk and high marketability and then, within those constraints, they try to generate as high a return as possible. Put another way, earnings are not the primary goal of this fund and instead earnings are secondary to the preservation of capital and the ability to access that capital when needed.

7 7 Trading Liquidity Being a market for liquidity creates a unique environment for managing risk. With long-term cash excesses, investors place their cash at risk and then manage the risks of ownership over the life of the investment. With temporary excesses, investors analyze the borrowers and the market mechanisms before the investment to ensure that the risk exposure of their cash is at a minimum.

8 8 Risks important to money market investors When investors are storing a temporary cash surplus, they focus on the protection of their cash, which leads to concerns about two types of risk: 1.liquidity risk and 2.default risk.

9 9 Liquidity Risk Liquidity is related to converting an asset to cash; an asset is considered highly liquid if it can be quickly converted to cash without a major price concession. Money market investors are concerned about liquidity because they are storing temporary cash surpluses that are needed to meet expected near-term obligations. Thus, money market investors require high degree of liquidity.

10 10 Liquidity Risk (cont.) There are two components to managing liquidity risk in the money markets. First, money market securities are short-term debt contracts so the borrower has a contractual obligation to return the investor’s cash a specific point in time with the return date based on the investor’s need for their cash.

11 11 Liquidity Risk (cont.) However, the investor may need their cash sooner than expected, which leads to the second component for managing liquidity risk. Second, is a highly liquid secondary market, which means a market where money market investors can quickly sell their securities without a price concession.

12 12 Liquidity Risk (cont.) The secondary market for money market securities is a dealer market where the dealers stand ready to trade (‘make a market’) at their quoted bid and ask prices. People often assume that large trading volume is necessary for secondary market liquidity. However, this is not the case in dealer markets like the money markets if dealers stand ready to trade.

13 13 Liquidity Risk (cont.) Dealers stand ready to trade by quoting bid and ask prices for T-bills, commercial paper, negotiable CDs, bankers’ acceptances, and short-term agency debt. In repurchase agreements (repos) and Fed funds the nature of the transactions precludes a secondary market.

14 14 Liquidity Risk (cont.) Without a secondary market in repos and Fed funds, the need for liquidity is addressed by having the majority of the instruments have a maturity of one day. This way the investors get their cash back each day and therefore the opportunity to decide each day whether to loan the cash or hold the cash.

15 15 Default Risk The general definition of default is when a borrower fails to meet any part of the debt contract. In long-term debt default often occurs because of the violation of a contract covenant. The short-term nature of the money markets precludes the need for covenants, so default in the money market is associated with failure to make the scheduled payment.

16 16 Default Risk (cont.) Government and Agency Default Risk Treasury bills are considered default-free because they are backed by the full faith and credit of the U.S. government. Federally-owned agency debt is also default-free because these agency are part of the federal government. Federally-sponsored agency debt is not default-free because these agencies are privately owned. However, this debt is viewed as having an implicit guarantee.

17 17 Default Risk (cont.) Commercial Paper, Negotiable CDs and Bankers’ Acceptances These securities are different forms of corporate debt and therefore have default risk. Money market investors limit their exposure to default risk in these securities by only lending to the highest quality borrowers. This is a clear example of managing risk before the investment.

18 18 Default Risk (cont.) Commercial Paper, Negotiable CDs and Bankers’ Acceptances (cont.) To assess credit quality, the credit rating agencies providing rating for companies wanting to issue commercial papers and banks wanting to issue tradable short-term debt. As an example of only lending to the highest quality borrowers, over 97% of all commercial paper is issued by borrowers in the two lowest default risk rating categories.

19 19 Default Risk (cont.) Fed funds The Fed funds market is for trading of reserve deposits held at a Federal Reserve Bank and is done to manage a bank’s reserves for settlement. Fed funds trades are loans of reserve deposits between banks. Default risk is handled by requiring each loan be made under a pre- existing line of credit between the borrowing and lending bank.

20 20 Default Risk (cont.) Fed funds (cont.) To borrow Fed funds from a bank, the borrowing bank requests a credit relationship with the lending bank. The lending bank does a credit analysis of the borrower, which results in a two step decision: Step 1Yes or No on extending a line of credit to the borrower. Step 2If Yes, then set the borrowing limit on the line of credit.

21 21 Default Risk (cont.) Fed funds (cont.) Having a pre-existing line of credit for borrowers in the Fed funds market facilitates trading in this market because the decision to provide credit has already been made. So, when a request for Fed funds comes into a bank, the person that processes the request simply checks for the existence of a line of credit for the borrower and the amount of funds available under the line.

22 22 Default Risk (cont.) Repos A repo is an agreement to sell securities with a simultaneous agreement to buy them back at a future date. This is a logical equivalent of a collateralized loan Thus, the lender of cash in a repo is secured by the securities in the repo.

23 23 Default Risk (cont.) Repos (cont.) The market convention in repos is to minimize the lender’s (investor’s) exposure to default risk, which is done through a set of three rules that define the process for the collateral. Rule 1The market value of the collateral must exceed the market value of the loan.

24 24 Default Risk (cont.) Repos (cont.) Rule 2If the value of collateral falls below the amount of the loan, then the lender requests either additional collateral or repayment of a portion of the loan. Rule 3The collateral is held by a third- party trustee, which prevents the collateral from being pledged against more than one loan.

25 25 Interest Rate Risk All debt securities are exposed to interest rate risk because their values change with market rates. Investors are concerned about having to sell a security at an unfavorable price because of an increase in interest rates. Interest rate risk is not a primary concern to money market investors because almost all investments are held to maturity. If it is a concern, derivatives can be used to hedge interest rate risk in money market securities.

26 26 Money Market Mutual Funds A mutual fund is a portfolio of securities. A money market mutual fund is a portfolio of money market securities.

27 27 Money Market Mutual Funds (cont.) Two primary benefits of mutual funds are: 1.low minimum investment increments, which is particularly important in the money markets because of the large denominations for most money market securities and 2.low cost of diversification. However, the usual benefits of diversification do not apply in the money markets because losses in one security cannot be offset by gains in another.

28 28 Money Market Mutual Funds (cont.) The money market mutual fund industry views any loss as unacceptable because the competing financial product is insured bank deposits. Thus, the concern for the industry is that if investors become worried about losses, they switch from money market mutual funds to bank deposits.

29 29 Money Market Mutual Funds (cont.) To provide investors with the information to assess the risk of a mutual fund, the money market mutual funds report their portfolio allocations. Two examples appear in Figure 12-2

30 30 Money Market Mutual Funds (cont.) J. P. Morgan Prime Money Market Fund Floating Rate Notes43.8% Commercial Paper37.1% Certificates of Deposit12.0% Time Deposits4.2% Repurchase Agreements1.9% Corporate Bonds1.0% Strong Heritage Money Fund Commercial Paper89.0% Government Agency Issues5.9% Variable Rate Put Bonds5.1%

31 31 Money Market Mutual Funds (cont.) It is clear from the allocations that these two funds invest almost exclusively in the traditional money market securities. It is also clear that the two funds have very different asset allocations. However, it is not clear which funds is more risky. Accordingly, Moody’s has begun rating money market mutual funds for default risk.

32 32 Money Market Mutual Funds (cont.) The Moody’s rating for each fund are: Aaa for the J.P. Morgan fund and Aa for the Strong fund. This suggests that the Strong funds has more default risk.

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