1. Chapter Five
Money Markets
McGraw-Hill/Irwin

2. Money Markets
Liquid funds flow between short-term borrowers and lenders through 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 economic units that have excess short-term funds
low rates of return
Money market instruments have active secondary markets which provides liquidity

3. Money Market Yields
Money market securities use special rate quoting conventions:
Discount yields (idy): 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 (ispy): 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 (ibey) for comparison with bonds
Note that ibey is an APR.

4. Money Market Yields
Treasury bills and commercial paper are bought and sold on a discount basis
Discount yields (idy) use a 360-day year
Pf = the face value of the security
P0 = the discount price of the security
h = the number of days until maturity

5. Money Market Yields
Compare discount securities to U.S. Treasury bonds with bond equivalent yields (ibey)
Convert bond equivalent yields into effective annual returns (EAR)

6. Example: T-Bill
Face value = $10,000; Maturity = 73 days; Sells for $9,800
Discount yield:
Period yield = (10,000-9,800)/10,000 = 2%
Annualized = 2% x 360/73 = 9.863%
Bond Equivalent Yield:
Period yield = (10,000 – 9,800)/9,800 = %
Annualized = % x 365/73 = %
Effective Annual Yield:
= ( %)365/ = %

7. Money Market Yields
Money market securities (Negotiable or jumbo)CDs and fed funds that pay interest only at maturity use single-payment yields (ispy) (e.g., jumbo CDs and fed funds)
since ispy uses a 360 day year, compare to bonds by converting to a 365 day year
to directly convert a single-payment yield to an effective annual return

8. Example: CD Yield Face: 10,000; maturity 73 days; pays 6%
Interest for the period = 6%x73/360=1.22% or $ 21.67
Bond Equivalent Yield:
= 6% x 365/360 = %
Effective Annual Yield
Note: no of periods/year = 365/73 = 5
= ( %) = %

9. 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 (ispy)
to convert a single-payment yield to a bond equivalent yield:
to directly convert a single payment yield to an EAR:

10. Sample Calculations of Money Market Yields
A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the commercial paper:
The bond equivalent yield for the commercial paper is 2.038%

11. Sample Calculations of Money Market Yields
A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the CD:
The bond equivalent yield for the CD is %
The commercial paper has the better return since its bond equivalent yield is 2.038%

12. 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)

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

14. 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

15. T-Bill Auctions T-Bill Auctions
Noncompetitive Bids
Bid Price 1 SC ST 2 3 4 5 6
Stop-out
price (PNC) 7
Quantity of
T-bills

17. 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

18. Transaction Between Primary Dealers
J.P. Morgan Chase Sell $10 million in T-Bills
Lehman Brothers Buy $10 million in T-Bills
Interbank Transaction
Fedwire
Fedwire
Federal Reserve Bank of NY
Transfers $10 million from Chase to Lehman
Transaction Recorded in Fed’s Book Entry System

19. Purchase by Individual
Buy $50,000 in T-Bills
Local Bank or Broker
Primary Dealer
JP Morgan Chase
Sells $50,000 in T-Bills
FRBNY
-$50,000 in T-Bills from JP Morgan
+ $50,000 in T-Bills to Individual
Fedwire
Wire Transfer
Engraved T-Bill

20. T-Bill Prices
T-Bill prices can be calculated from quotes (e.g., from The Wall Street Journal) by rearranging the discount yield equation
Or by rearranging the bond equivalent yield equation

21. Example: T-Bill Prices
30 days TB, Face value=$10,000, sells at 6%
Price?
= $10,000 - $10,000 x 6% (30/360)
= $9,950

22. 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
Fed funds are single-payment loans and thus use single-payment yields
Multimillion dollar loans may be arranged in a matter of minutes

23. FEDERAL FUNDS TRANSACTIONS
J.P. Morgan Chase
Lends (Sell) $75 million in Federal Funds
Bank of America
Borrows (Buy) $75 million in Federal Funds
FRBNY
Today:
Takes $75 mil. From reserve account of JPM
Tomorrow:
Adds $75 mil. plus one day’s interest to JPM account
FRB of San Francisco
Today:
Adds $75 mil. To reserve account of BOA
Tomorrow:
Takes $75 mil. plus one day’s interest from BOA account
Fedwire
Fedwire

24. 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’

25. 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 opposite side of a repo (i.e., it is the purchase of a security with an agreement to sell it back in the future)
The repo rate is typically lower than the Fed funds rate because repos are collateralized loans.

26. Repurchase Agreement
The yield on repurchase agreements (iRA) uses a 360-day year like the discount rate, but uses the current price in the denominator like the bond equivalent yield
Pf = the repurchase price of the security
P0 = the selling price of the security
h = the number of days until the repo matures

27. Repurchase Agreement J.P. Morgan Chase Buys $75 million Repo
Bank of America
Sells $75 million Repo
FRBNY
Today:
$75 mil. reserve account of JPM
+ $75 mil to T-Bill account of JPM
Tomorrow:
+ $75 mil. plus one day’s interest to JPM reserve a/c
- $75 mil to T-Bill account of JPM
FRB of San Francisco
Today:
+$75 mil. reserve account of BOA
- $75 mil to T-Bill account of BOA
Tomorrow:
- $75 mil. plus one day’s interest to BOA reserve a/c
+ $75 mil to T-Bill account of BOA
Fedwire
Fedwire

28. Commercial Paper
Commercial paper (CP) is the largest money market in terms of dollars outstanding
CP is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital)
Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days
CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time)
CP is usually held by investors until maturity and has no active secondary market
Yields are quoted on a discount basis (like T-bills)

29. Asset-Backed Commercial Paper
A type of commercial paper that is backed by assets of the issuing firm
Grew very rapidly prior to the financial crisis peaking at $2.16 trillion, much of it was backed by mortgage investments
The market collapsed during the financial crisis

30. 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 in the secondary market
Denominations range from $100,000 to $10 million; $1 million being the most common
Often purchased by money market mutual funds with pools of funds from individual investors

31. Banker’s Acceptance
A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank
Used in international trade transactions to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer)
Foreign exporters prefer that banks act as payment guarantors before sending goods to importers
Banker’s acceptances are bearer instruments and thus are salable in secondary markets

32. Creation of a Banker’s Acceptance
Purchase order sent by U.S. buyer to Chinese seller
Chinese seller requests a letter of credit
Notification of letter of credit and draft authorization
Order shipped
Time draft and shipping papers sent to Chinese seller’s bank
Time draft and shipping papers sent to U.S. bank; banker’s acceptance created
Payments sent to foreign bank (immediately if Chinese seller wishes to discount the draft and collect immediately, at maturity if not)
Payments sent to Chinese seller (see #7)
Payment to U.S. bank by U.S. buyer at maturity, paid in full
0 Shipping papers delivered

34. Money Market Participants
The U.S. Treasury
The Federal Reserve
Commercial banks
Money market mutual funds
Brokers and dealers
Corporations
Other financial institutions
Individuals

35. International Money Markets
U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market
The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR)
Eurodollar Certificates of Deposits are U.S. dollar denominated CDs held in foreign banks
Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

36. 2011 Money Market Yields Instrument Federal Funds* Commercial Paper
CDs
Euro CP
Rate
0.11%
0.17%
0.23%
1.18%
LIBOR
Banker’s
Acceptances
Euro$
Repo* %
0.22%
0.25%
0.08%
Treasury Bills**
Inflation***
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

37. Rates for maturities of 3 months - November 2004
Instrument
Federal Funds*
Commercial
Paper
CDs
Euro CP
Rate
2.06%
2.38%
3.03%
4.69%
LIBOR
Banker’s
Acceptances
Euro$
T–bill** %
2.75%
2.70%
1.80%

38. Money Market Securities Outstanding
Billions $
Instrument
1990
2004
2007
2010
Treasury Bills
$ 527
$ 982
$1,010
$1,856
Fed funds & Repos
372
1,585
2,731
1,656
Commercial Paper
538
1,310
2,109
1.083
Negotiable CDs
547
1,379
2,149
1,822
Banker's Acceptances 52 4 1
Total
$2,036
$5,260
$8,000
$6,418
% of Total in Given Year
26%
19%
13%
29%
18%
30%
34%
25%
17%
27%
28% 3%
0.1%
0.0%
100%
The increase in Treasury Bills is due to increased government borrowing during and after the financial crisis. The decline in Fed funds and repos coincides with the growth of excess reserves held by banks. Commercial paper amounts declined with the financial crisis due to default risk concerns as did the quantity of negotiable CDs.
See the Instructor’s Manual for potential reasons for the decline in Banker’s Acceptances
Source: Text

39. International Money Markets
U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market
The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR)
Eurodollar Certificates of Deposit are U.S. dollar-denominated CDs held in foreign banks
Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

40. International Money Markets

41. PROBLEMS

42. Discount yield: idy = (($1m. - $973,750)/$1m.)(360/65) = 14.538%
Bond equivalent yield: ibey = (($1m. - $973,750)/$973,750)(365/65)
= %
EAR: EAR = ( /(365/65))365/ = %

43. The nominal bond equivalent yield is calculated as
ibey = 6.56%(365/360) = 6.651%
The EAR on the CD is calculated as
EAR = (1 + (.06651)/(365/115))365/ = 6.804%

44. The yield on this repo to the bank is calculated as follows
iRA = $25,000,000 - $24,950,000 x 360 = 10.31%
$24,950,
b. The yield on this repo to the bank is calculated as follows
iRA = $25,000,000 - $24,950,000 x 360 = 3.44%
$24,950,

45. The return on the commercial paper is calculated as
icp(dy) = $500,000 - $495, = 8.00%
$500,
And
icp(bey) = $500,000 - $495, = 8.19%
$495,

46. a. Before the rate change, the CD holder will receive
FV = $500,000 ( /3) = $509,167
in four months in exchange for $500,000 deposited in the bank today.
Immediately after the market rate on the CD rises to 6 percent, the CD value decreases to
PV = 509,167/( /3) = $499,183.33
b. Immediately after the market rate on the CD falls to 5.25 percent, the CD value decreases to
PV = 509,167/( /3) = $500,409.83