Money markets ch. 9 (uts)


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Money markets ch. 9 (uts)

  1. 1. Chapter 6 Money MarketsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1
  2. 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 2
  3. 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 3
  4. 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 4
  5. 5. Money Market Securities (cont’d) 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 5
  6. 6. Money Market Securities (cont’d) Treasury bills (cont’d)  Pricing Treasury bills  The price is dependent on the investor’s required rate of return: Pm = Par /(1 + k )n  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 6
  7. 7. Computing the Price of aTreasury BillA one-year Treasury bill has a par value of$10,000. Investors require a return of 8 percenton the T-bill. What is the price investors would?be willing to pay for this T-bill Pm = Par /(1 + k )n = $10,000 /(1.08) = $9,259 7
  8. 8. Money Market Securities (cont’d) 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 8
  9. 9. Money Market Securities (cont’d) 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 9
  10. 10. Money Market Securities (cont’d) 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 10
  11. 11. Money Market Securities (cont’d) Treasury bills (cont’d)  Estimating the yield (cont’d)  The annualized yield is: SP − PP 365 YT = × PP n  Estimating the T-bill discount  The discount represents the percent discount of the purchase price from par value for newly-issued T-bills: Par − PP 360 T - bill discount = × Par n 11
  12. 12. Computing the Yield of aTreasury BillAn investor purchases a 91-day T-bill for $9,782. Ifthe T-bill is held to maturity, what is the yield?the investor would earn SP − PP 365 YT = × PP n 10,000 − 9,782 365 = × 9,782 91 = 8.94% 12
  13. 13. Estimating the T-Bill DiscountUsing the information from the previous example,?what is the T-bill discount Par − PP 360 T - bill discount = × Par n 10,000 − 9,782 360 = × 10,000 91 = 8.62% 13
  14. 14. Money Market Securities (cont’d) 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  Has no active secondary market  Is typically not purchased directly by individual investors 14
  15. 15. Money Market Securities (cont’d) 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 15
  16. 16. Money Market Securities (cont’d) 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  Some firms (such as finance companies) create in-house departments to place commercial paper 16
  17. 17. Money Market Securities (cont’d) 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 17
  18. 18. Estimating the CommercialPaper YieldAn investor purchases 120-day commercial paperwith a par value of $300,000 for a price of$289,000. What is the annualized commercial?paper yield 300,000 - 289,000 360 Ycp = × 289,000 120 = 11.42% 18
  19. 19. Money Market Securities (cont’d) 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 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 19
  20. 20. Money Market Securities (cont’d) 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 20
  21. 21. Money Market Securities (cont’d) 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 21
  22. 22. Money Market Securities (cont’d) 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 22
  23. 23. Money Market Securities (cont’d) 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 23
  24. 24. Money Market Securities (cont’d) 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 24
  25. 25. Estimating the Repo YieldAn investor initially purchased securities at a priceof $9,913,314, with an agreement to sell themback at a price of $10,000,000 at the end of a?90-day period. What is the repo rate SP − PP 360 Repo rate = × PP n 10,000,000 − 9,913,314 360 = × 9,913,314 90 = 3.50% 25
  26. 26. Money Market Securities (cont’d) 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 26
  27. 27. Money Market Securities (cont’d) 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 27
  28. 28. Money Market Securities (cont’d) 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 28
  29. 29. Money Market Securities (cont’d) 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 29
  30. 30. Sequence of Steps in the Creationof A Banker’s Acceptance 1 Purchase Order Importer Exporter 5 Shipment of Goods 4 L/C Notification2 L/C Application 6 Shipping Documents & Time Draft 3 L/C American Bank Shipping Documents Japanese Bank (Importer’s Bank) 7 & Time Draft Accepted (Exporter’s Bank) 30
  31. 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 31
  32. 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 32
  33. 33. Valuation of Money MarketSecurities 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 33
  34. 34. Valuation of Money MarketSecurities (cont’d) Explaining money market price movements  The price of a noninterest-paying money market security is: Pm = Par /(1 + k )n A change in the price can be modeled as: ∆Pm = f ( ∆k ) and ∆k = f ( ∆Rf , ∆RP ) 34
  35. 35. Valuation of Money MarketSecurities (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 35
  36. 36. 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 36
  37. 37. Interaction Among Money MarketYields 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 37
  38. 38. 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 38
  39. 39. 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 39
  40. 40. 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 40
  41. 41. 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 41
  42. 42. Globalization of Money Markets(cont’d) Performance of foreign money market securities  Measured by the effective yield (adjusted for the exchange rate Ye = (1 + Yf ) × (1 + %∆S ) − 1  Depends on:  The yield earned on the money market security in the foreign currency  The exchange rate effect 42
  43. 43. Computing the Effective YieldA U.S. investor buys euros for $1.15 and invests ina one-year European security with a yield of 8percent. After one year, the investor convertsthe proceeds from the investment back todollars at the spot rate of $1.16 per euro. What?is the effective yield earned by the investor Ye = (1 + Yf ) × (1 + %∆S ) − 1 = 1.08 × 1.0087 − 1 = 8.94% 43