Money Markets Explained

1
Chapter 6
Money Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2
Chapter Outline
 Money market securities
 Institutional use of money markets
 Valuation of money market securities
 Risk of money market securities
 Interaction among money market yields
 Globalization of money markets

3
Money Market Securities
 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

4
Money Market Securities (cont’d)
 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

5
 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

6
 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
n
m k
P )
1
/(
Par 


7
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?
259
,
9
$
)
08
.
1
/(
000
,
10
$
)
1
/(
Par



 n
m k
P

8
 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 Payments to the Treasury are withdrawn electronically from the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

9
 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

10
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

11
 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:
n
PP
PP
SP
YT
365



n
PP 360
Par
Par
discount
bill
-
T 



12
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?
%
94
.
8
91
365
782
,
9
782
,
9
000
,
10
365







n
PP
PP
SP
YT

13
Estimating the T-Bill Discount
Using the information from the previous example,
what is the T-bill discount?
%
62
.
8
91
360
000
,
10
782
,
9
000
,
10
360
Par
Par
discount
bill
-
T







n
PP

14
 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

15
 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

16
 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

17
 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

18
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?
%
42
.
11
120
360
289,000
289,000
-
300,000



cp
Y

19
 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

20
 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

21
 Negotiable certificates of deposit (NCDs)
(cont’d)
 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

22
 Negotiable certificates of deposit (NCDs)
(cont’d)
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

23
 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

24
 Repurchase agreements (cont’d)
 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

25
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?
%
50
.
3
90
360
9,913,314
314
,
913
,
9
000
,
000
,
10
360
rate
Repo







n
PP
PP
SP

26
 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

27
 Federal funds (cont’d)
 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

28
 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

29
 Banker’s acceptances (cont’d)
 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

30
Sequence of Steps in the Creation
of A Banker’s Acceptance
Importer Exporter
American Bank
(Importer’s Bank)
Japanese 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 & Time Draft

31
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

32
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

33
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

34
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:
n
m k
P )
1
/(
Par 

)
,
(
and
)
( RP
R
f
k
k
f
P f
m 







35
 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

36
 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

37
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

38
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

39
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

40
(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

41
(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

42
(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

43
(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
1
)
%
1
(
)
1
( 




 S
Y
Y f
e

44
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?
%
94
.
8
1
0087
.
1
08
.
1
1
)
%
1
(
)
1
(









 S
Y
Y f
e

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