Money Market

Money Market
Presented by:
Mohammad Maksudul Huq
Chowdhury

Topics to be covered:
 Overview of Money Markets
 Characteristics of Money Markets
 Money market funds (MMFs) vs. bank deposits
 Money Market Securities
 Institutional Use of Money Markets
 Globalization of Money Markets

Overview of Money Market
The money market is a segment of the financial market in which
financial instruments with high liquidity and very short
maturities are traded. The money market is used by participants
as a means for borrowing and lending in the short term, from
several days to just under a year. Money market securities consist
of negotiable certificates of deposits (CDs), banker's
acceptances, Treasury bills, commercial paper, municipal notes,
repurchase agreements (repos). Money market investments are
also called cash investments because of their short maturities.

cont….
Money markets are used to facilitate the transfer of short-term
funds from individuals, corporations, or governments with excess
funds to those with deficient funds. Even investors who focus on
long-term securities tend to hold some money market securities.
Money markets enable financial market participants to maintain
liquidity.

cont …
In Bangladesh, the money market comprises banks and financial
institutions as intermediaries, 20 of them are primary dealers in
treasury securities. Interbank clean and repo based lending, Call
money, BB's repo, reverse repo auctions, BB bills auctions,
treasury bills auctions are primary operations in the money
market, there is also active secondary trade in treasury bills (up
to 1 year maturity).

Borrowers and Lenders in the Money Market
Central Banks
(supplying funds and information
and promoting market stability)
Corporate Borrowers
& Cash -Management
Customers Needing to
Invest Cash Surpluses
Security
Dealers &
Brokers
Money
Center
Banks
Nonbank
Financial
Institutions
(mutual funds,
insurers, etc.)
Government
Treasuries
(borrowing and
redeeming
securities)

Participants
 Commercial banks
 Finance, industrial, and service companies
 Governments
 Money market mutual funds
 All other financial institutions (investing)

The Purpose of Money Markets
 Provides a place for warehousing surplus funds for short periods
of time.
 Borrowers from money market provide low-cost source of
temporary funds.
 Corporations and government use these markets because the
timing of cash inflows and outflows are not well synchronized.
Money markets provide a way to solve these cash-timing
problems.

Characteristics of the Money Market
 The money market is the mechanism through which holders of
temporary cash surpluses meet holders of temporary cash
deficits.
 The money market arises because for most individuals and
institutions, cash inflows and outflows are rarely in perfect
harmony with each other, and the holding of idle surplus cash is
expensive.
 Money market investors seek mainly safety and liquidity, plus
the opportunity to earn some interest income.
 Because funds invested in the money market represent only
temporary cash surpluses and are usually needed in the near
future, money market investors are especially sensitive to risk.

cont….
 Original maturities on money market instruments range from as
short as one day on many loans to banks and security dealers to a
full year on some bank deposits and T-bills.
 But because there are so many money market securities
outstanding, some of which reach maturity each day, investors
have a wide menu of actual maturities from which to make their
selections.
 The money market is extremely broad and deep. It can absorb a
large volume of transactions with only small effects on security
prices and interest rates.

cont….
 The money market is also very efficient. Securities dealers, major
banks, and funds brokers maintain constant contact with one
another through a vast telephone and computer network and are
hence alert to any bargains.
 In contrast, funds transferred by checks are known as
clearinghouse funds. The clearing house is a location where
checks and other cash items are delivered and passed from one
depository institution to another.
 Clearing house funds are an acceptable means of payment for
most purposes, but not in the money market, where speed is of
essence. Clearing house funds also have an element of risk.

cont….
 The money market is a wholesale market for funds – most
trading occurs in large volume.
 The market is dominated by a relatively small number of large
financial institutions that account for the bulk funds trading.
 Securities also move readily from sellers to buyers through the
market-making activities of major security dealers and brokers.
 And, of course, governments and central banks around the world
play major roles in the money market as the largest borrowers
and as regulators.

Types of Investment Risk
 Market risk – The risk that the market value of an asset will
decline, resulting in a capital loss when sold. Also called interest
rate risk.
 Reinvestment risk – The risk that an investor will be forced to
place earnings from a security into a lower-yielding investment
because interest rates have fallen.
 Default risk – The probability that a borrower fails to meet one
or more promised principal or interest payments on a security.

Types of Investment Risk
 Inflation risk – The risk that increases in the general price level
will reduce the purchasing power of earnings from the
investment.
 Currency risk – The risk that adverse movements in the price of
a currency will reduce the net rate of return from a foreign
investment. Also called exchange rate risk.
 Political risk – The probability that changes in government laws
or regulations will reduce the expected return from an
investment.

The Pattern of Money Market
Interest Rates
 The foundation of the market’s structure is the level of yields on
Treasury bills.
 Most other yields in the money market are scaled upward from
Treasury bill rates.
 The key price and yield determinants are safety, liquidity,
marketability, and taxability.

Functions of Money Markets
 Transfer Funds (savers to borrowers)
 Serves as a pricing benchmark
 Facilitates monetary policy by allowing the Central Bank to
control inflation by buying and selling money market
instruments
 Provide liquidity to investors
 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

Money market funds (MMFs) vs.
Bank Deposits
Similarly to banks, MMFs play a role in the monetary system of
the economy. Money market funds also present several features
that make them similar to bank deposits: in particular, they offer
preservation of principal and immediate liquidity. In some
jurisdictions, MMFs also offer transaction account services and
play a role in the payment system.

Bank Deposits cont…
MMFs also perform bank-like functions because of their role in
credit transformation: Through MMFs, investors earn returns
from a credit, maturity or liquidity mismatch between the
investor funding and the investments from which the return is
generated. Additionally, investors may redeem their investments
on demand, even though MMF assets are longer term. However,
compared to banks, the extent of this transformation is reduced
in the case of MMFs, which have to comply with strict
requirements in terms of duration (e.g., the weighted average
maturity of an MMF pool is generally 60 days) and credit quality.

Bank Deposits
An additional difference from banks is that MMFs do not
generally employ leverage (although they may, like any other
lender in the markets, contribute to the building-up of leverage
in the system). Also, investors in MMFs are shareholders, not
creditors, and the MMF [sponsor/operator] is subject to a
fiduciary duty to treat its shareholders fairly. Moreover, banks
may hold long-term, often highly non-transparent investments
and may have substantial off-balance sheet commitments.

Money Market Securities
Money market instruments are defined as debt instruments with
a maturity of one year or less.
 Treasury Bills
 Commercial paper
 Negotiable certificates of deposits
 Repurchase agreements
 Banker’s acceptances

Treasury bills:
 Are issued by the Central Bank to fulfill the requirement of
government.
 Are sold weekly through an auction
 Have a par value of $1,000 and multiples
 Are attractive to investors because they are backed by the
government and are free of default risk
 Are liquid
 Can be sold in the secondary market through government
security dealers (Under process @ Bangladesh money
market).

 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

 Pricing Treasury bills
 T-bills do not pay interest; instead they are priced at a
discount from par value.
 The price is dependent on the investor’s required rate of
return:
 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
n
m kP )1/(Par 

Computing the Price of a Treasury Bills:
A one-year Treasury bill has a par value of $10,000. Investors
require a return of 8 percent on the T-bill. What is the price
investors would be willing to pay for this T-bill?
259,9$
)08.1/(000,10$
)1/(Par


 n
m kP

 Treasury bill auction
 Investors submit bids on T-bill applications for the
maturity of their choice
 Financial institutions can submit their bids using the
Treasury Automated Auction Processing System
 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

 Treasury bill auction
 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 non-competitive
bids
 The bids of non-competitive bidders are accepted
 The highest competitive bids are accepted
 Any bids below the cut-off are not accepted

 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
 The annualized yield is:
`Where, SP = Selling Price
PP = Purchase Price
n = holding period
nPP
PPSP
YT
365




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 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

Commercial paper:
 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

Commercial paper:
 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

Commercial paper:
 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

Commercial paper:
 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 day commercial paper with a 120
an investor purchase. What is the annualized $289,000
for a price of $300,000 par value of commercial paper
yield:
%42.11
120
360
289,000
289,000-300,000

cpY

Negotiable certificates of deposit (NCDs):
 Are issued by large commercial banks and other depository
institutions as a short-term source of funds
 Are often purchased by non-financial corporations
 Are sometimes purchased by money market funds
 Have a typical maturity between two weeks and one year
 Have a secondary market

 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

 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

Repurchase Agreement
Repo can be defined as an agreement in which one party sells
securities or other assets to a counterparty, and simultaneously
commits to repurchase the same or similar assets from the
counterparty, at an agreed future date or on demand, at a
repurchase price equal to the original sale price plus a return on
the use of the sale proceeds during the term of the repo.

Between the sale and the repurchase:
 The seller gets the use of the cash proceeds of the sale of the
assets.
 The buyer gets legal title to the assets received in exchange for
the cash it has paid. The buyer holds the assets in the first
instance as collateral. If the seller defaults on the repurchase, the
buyer can liquidate the assets to recover some or all of its cash. In
addition, because the buyer owns the collateral assets, the buyer
can re-use them during the term of the repo by selling the assets
outright, repoing them or pledging them to a third party. The
buyer must buy back the assets by the end of the repo, in order to
be able to sell them back to the seller.

Between the sale and the repurchase:
‘Repo’ is the generic term for two equivalent instruments:
• Repurchase agreements (also known as ‘classic repos’)
• Buy/sell-backs
Repurchase agreements and buy/sell-backs share the same basic
legal and operational mechanisms (i.e. a sale of assets and a
commitment by the seller to repurchase those assets from the
buyer at a later date). The principal differences between a
repurchase agreement and a buy/sell-back is that, repurchase
agreements are always documented (i.e. they are evidenced by a
written contract), whereas traditional buy/sell-backs are not.

Consequently, the two legs of a repurchase agreement are part of
a single legal contract, whereas the two legs of a traditional,
undocumented buy/sell-back are implicitly separate contracts.
Many of the terms used in the market to describe repos are taken
from standard legal agreements, such as the Global Master
Repurchase Agreement (GMRA), which are commonly used to
document transactions in the international repo market.

 Seller : Collateral-provider, cash-taker (borrower).
 Buyer : Collateral-taker, cash-provider (lender).
 Purchase : Sale of assets at the start of a repo.
 Repurchase : Repurchase of assets at the end of a repo.
 Purchase date: Value date: the date on which cash and assets
are actually exchanged.
 Repurchase date: Maturity date: the date on which cash and
assets are returned to their original owners.
 Purchase price: Cash value paid by the buyer of assets to the
seller on the purchase date.

 Repurchase price: Cash value paid by the seller of assets to the
buyer on the repurchase date: equal to the purchase price plus a
return on the use of the cash over the term of the repo. In
buy/sell-backs, the repurchase price may be net of coupon or
dividend payments made on the assets during the term of the
repo
 Collateral: Assets sold in a repo on the purchase date.
 Equivalent collateral: Assets repurchased in a repo by the seller
on the repurchase date.
 Repo rate: Percentage per annum rate of return paid by the
seller for the use of the cash over the term of a repurchase
agreement and included in the repurchase price.

Although the term ‘repo’ is applied to the whole transaction, it is
market convention to specifically describe the seller’s side of the
transaction as the ‘repo’ and the buyer’s side as the ‘reverse repo’.
Dealers talk about sellers ‘repoing out’ collateral and buyers
‘reversing’ in collateral.

Comparing repurchase agreements and buy/sell-backs
There is much confusion about the differences between
repurchase agreements and buy/sell-backs. Comparisons are
complicated by the fact that buy/sell-backs can now be
documented (so that there are three types of repo: repurchase
agreements, undocumented buy/sell-backs, and documented
buy/sell-backs). Undocumented buy/sell-backs, which are the
traditional form of the instrument, have a number of legal and
operational drawbacks in comparison with repurchase
agreements and documented buy/sell-backs.

Banker’s Acceptance
 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

 Steps involved in banker’s acceptances
 First, the 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

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

Call Money Markets
Inter Bank Clean Markets

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

Institutional Use of Money Markets
 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

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

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.
 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

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

Globalization of Money Markets
As international trade and financing have grown, money markets
have developed in Europe, Asia and South America.
International banks facilitate the international money markets
by accepting deposits and providing loans in a wide variety of
currencies.
 Interest rate differentials occur because geographic markets
are somewhat segmented

Globalization of Money Markets
 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, Euro notes, and Euro-commercial paper are
widely traded in international money markets

Eurodollar deposits and Euro notes
 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

Eurodollar deposits and Euro notes
 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 Euro-banks that
accept large deposits and provide large loans in foreign
currencies
 Loans in the Euro credit market have longer maturities than
loans in the Eurocurrency market
 Short-term Euro notes are issued in bearer form with
maturities of one, three, and six months

London Interbank Market
Some large London banks act as brokers in the interbank
Eurodollar market. Banks from around the world buy and
sell overnight funds in the market. The rate paid by banks
buying funds is the London Interbank bid rate (LIBID).
Funds are offered for sale in this market at the London
Interbank offer rate (LIBOR). The spread between LIBID and
LIBOR seldom exceeds 0.125%.

London Interbank Market
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

Money Market

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