Assingment on money market


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Money Market

Assingment on money market

  1. 1. ASSIGNMENT ON Money Market Course Title: Financial Institutions & Markets Course Code: E-603Submitted By:Md. AmanullahID: 10254015Year of Study: 5th Batch 4th SemesterEMBA ProgramDept. of Finance and BankingRajshahi University Submitted to: Professor Dr. A.H.M. Ziaul Haq Dept. of Finance and Banking Rajshahi University Date of Submission: Saturday, May 19, 2012 Rajshahi University 1 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  2. 2. Contents Introduction What is Money market? What the Money Market does? Why is such a Market needed? The Need for a Money Market Who are the Principal Borrowers and Lenders in the Money Market? Who Participates in the Money Markets? The Goals of Money Market Investors What kind of risk do investors face in the financial markets? Money Market Maturities Depth and Breadth of the Money Market Money Market Instruments Certificate of deposit. Repurchase agreements Commercial paper Treasury bill. References 2 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  3. 3. Introduction:The financial markets channel savings to those individuals and institutions needingmore funds for spending than are provided by their current incomes.The financial markets make possible the exchange of current income for futureincome and the transformation of savings into investment so that production,employment, and income can grow.A financial market is a market in which people and entitiescan trade financial securities, commodities, and other fungible items of value atlow transaction costs and at prices that reflect supply and demand. Securitiesinclude stocks and bonds, and commodities include precious metals or agriculturalgoods.There are both general markets (where many commodities are traded) andspecialized markets (where only one commodity is traded). Markets work byplacing many interested buyers and sellers, including households, firms, andgovernment agencies, in one "place", thus making it easier for them to find eachother. An economy which relies primarily on interactions between buyers andsellers to allocate resources is known as a market economy in contrast either toa command economy or to a non-market economy such as a gift economy.In finance, financial markets facilitate: The raising of capital (in the capital markets) The transfer of risk (in the derivatives markets) Price discovery Global transactions with integration of financial markets The transfer of liquidity (in the money markets) International trade (in the currency markets) Financial Market Money market Capital Market 3 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University
  4. 4. Money Market: Money market means market where money or its equivalent can be traded. Money issynonym of liquidity. Money market consists of financial institutions and dealers in money orcredit who wish to generate liquidity. It is better known as a place where large institutionsand government manage their short term cash needs. For generation of liquidity, short termborrowing and lending is done by these financial institutions and dealers. Money Market ispart of financial market where instruments with high liquidity and very short term maturitiesare traded. Due to highly liquid nature of securities and their short term maturities, moneymarket is treated as a safe place. Hence, money market is a market where short termobligations such as treasury bills, commercial papers and bankers acceptances are bought andsold.Money markets exist to facilitate efficient transfer of short-term funds between holders andborrowers of cash assets. For the lender/investor, it provides a good return on their funds. Forthe borrower, it enables rapid and relatively inexpensive acquisition of cash to cover short-term liabilities. One of the primary functions of money market is to provide focal point forRBI’s intervention for influencing liquidity and general levels of interest rates in theeconomy. RBI being the main constituent in the money market aims at ensuring that liquidityand short term interest rates are consistent with the monetary policy objectives.Money Market & Capital Market: Money Market is a place for short term lending andborrowing, typically within a year. It deals in short term debt financing and investments. Onthe other hand, Capital Market refers to stock market, which refers to trading in shares andbonds of companies on recognized stock exchanges. Individual players cannot invest inmoney market as the value of investments is large, on the other hand, in capital market,anybody can make investments through a broker. Stock Market is associated with high riskand high return as against money market which is more secure. Further, in case of moneymarket, deals are transacted on phone or through electronic systems as against capital marketwhere trading is through recognized stock exchanges. The money market consists of financialinstitutions and dealers in money or credit who wish to either borrow or lend. Participantsborrow and lend for short periods of time, typically up to thirteen months. Money markettrades in short-term financial instruments commonly called "paper." This contrasts with thecapital market for longer-term funding, which is supplied by bonds and equity. The core ofthe money market consists of interbank lending--banks borrowing and lending to each otherusing commercial paper, repurchase agreements and similar instruments. These instrumentsare often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate(LIBOR) for the appropriate term and currency.What is Money market?  The money market is the market for short-term (one year or less) credit. 4 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  5. 5.  The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames.What the Money Market does?  The money market, like all financial markets, provides a channel for the exchange of financial assets for money. To meet short-term cash needs  The money market is the mechanism through which holders of temporary cash surpluses meet holders of temporary cash deficits.Why is such a Market needed?  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.  To cover the wages and salaries of government employees, office supplies, repairs, and fuel costs as well as unexpected expense.The Need for a Money Market • Need for short term funds by Banks. • Outlet for deploying funds on short term basis . • Optimize the yield on temporary surplus funds • Regulate the liquidity and interest rates in the conduct of monetary policy to achieve the broad objective of price stability, efficient allocation of credit and a stable foreign exchange marketWho are the Principal Borrowers and Lenders in the Money Market? 5 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University
  6. 6. Who Participates in the Money Markets? 1. Central Bank 2. Commercial Banks, Co-operative Banks, Finance, industrial and service companies, Money market mutual funds and Primary Dealers are allowed to borrow and lend. 3. Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders. 4. Individuals, firms, companies, corporate bodies, trusts and institutions can purchase the treasury bills, CPs and CDs. 5. All other financial institutions (investing) 6. Short-term investing for income and liquidity 7. Short-term financing for short and permanent needs 8. Large transaction size and telecommunication networkThe Goals of Money Market Investors:  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 to meet tax obligation, cover wage and salary costs, pay stockholder dividends, and so one. money market investors are especially sensitive to risk.What kind of risk do investors face in the financial markets?  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.  Inflation risk – The risk that increases in the general price level will reduce the purchasing power of earnings from the investment. 6 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  7. 7.  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.Money Market Maturities Money market investments cover a relatively narrow range of maturities – one year or less.  Original Maturity- The interval of time between the issue date of a security and the date on which the borrower promises to redeem it is the security  Actual maturity- refers to the number of days, months, or years between today and the date the security Money Market Maturities  Money market investments cover a relatively narrow range of maturities – one year or less.  Original Maturity- The interval of time between the issue date of a security and the date on which the borrower promises to redeem it is the security  Actual maturity- refers to the number of days, months, or years between today and the date the security  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.Depth and Breadth of the Money Market  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.  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. 7 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  8. 8. Money Market Instruments Certificate of deposit - Time deposit, commonly offered to consumers by banks, thrift institutions, and credit unions. It is a short term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in form of a certificate entitling the bearer to receive interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any denomination. They are stamped and transferred by endorsement. Its term generally ranges from three months to five years and restricts the holders to withdraw funds on demand. However, on payment of certain penalty the money can be withdrawn on demand also. The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk. While buying Certificate of Deposit, return method should be seen. Returns can be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more than once in a year, it is beneficial to opt APY over APR. A certificate of deposit (CD) is an interest-bearing receipt for funds left with a depository institution for a set period of time. True money market CDs are negotiable CDs that may be sold any number of times before maturity and that carry a minimum denomination of $100,000.They were introduced in 1961 to attract lost deposits back into the banking system. CD interest rates are computed as a yield to maturity (ytm) on a 360-day basis. Interest income = term in days  deposit principal  promised ytm 360 In secondary market trading, the bank discount rate (DR) is used as a measure of CD yields. DR = Par value – Purchase price  360 . Par value days to maturity The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions. Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market. 8 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  9. 9. The Market Structure for Negotiable CDsBankers are becoming increasingly innovative in packaging CDs to meet the needs ofcustomers.New types of CDs include variable-rate CDs, rollover or rolypoly CDs, jumbo CDs,Yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising-rate CDs, andforeign index CDs. Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.Repurchase transactions, called Repo or Reverse Repo are transactions or short termloans in which two parties agree to sell and repurchase the same security. They areusually used for overnight borrowing. Repo/Reverse Repo transactions can be done onlybetween the parties approved by RBI and in RBI approved securities viz. GOI and StateGovt. Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchaseagreement the seller sells specified securities with an agreement to repurchase the same ata mutually decided future date and price. Similarly, the buyer purchases the securitieswith an agreement to resell the same to the seller on an agreed date at a predeterminedprice. Such a transaction is called a Repo when viewed from the perspective of the sellerof the securities and Reverse Repo when viewed from the perspective of the buyer of thesecurities. Thus, whether a given agreement is termed as a Repo or Reverse Repo dependson which party initiated the transaction. The lender or buyer in a Repo is entitled toreceive compensation for use of funds provided to the counterparty. Effectively the seller 9 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University
  10. 10. of the security borrows money for a period of time (Repo period) at a particular rate ofinterest mutually agreed with the buyer of the security who has lent the funds to the seller.The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by thecounterparties independently of the coupon rate or rates of the underlying securities and isinfluenced by overall money market conditions.Under a repurchase agreement (RP), the dealer sells securities to a lender but makes acommitment to buy back the securities at a later date at a fixed price plus interest.RPs is simply a temporary extension of credit collateralized by marketable securities.Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months, …)while continuing contracts may be terminated by either party on short notice.Interest income from RPs= Amount of loan  Current RP rate  Number of days loaned 360 daysPeriodically, RPs are marked to market. If the price of the pledged securities has dropped,the borrower may have to pledge additional collateral. Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value. Commercial paper consists of short- term, unsecured promissory notes issued by well-known and financially strong companies.Commercial paper is traded mainly in the primary market. Opportunities for resale in thesecondary market are more limited.Commercial paper is rated prime, desirable, or satisfactory, depending on the creditstanding of the issuing company.Types of Commercial Paper:There are two major types of commercial paper.Direct paper is issued mainly by large finance companies and bank holding companiesdirectly to the investor.Dealer paper, or industrial paper, is issued by security dealers on behalf of theircorporate customers (mainly nonfinancial companies and smaller financial companies). 10 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  11. 11. Structure of the Commercial Paper Market: Maturities & Rate of ReturnMaturities of U.S. commercial paper range from three days (“weekend paper”) to ninemonths.Most commercial paper is issued at a discount from par, and yields to the investor arecalculated by the bank discount method, just like Treasury bills. DR = Par value – Purchase price  360 . Par value Days to maturity Advantages Relatively low interest rates Flexible interest rates - choice of dealer or direct paper Large amounts may be borrowed conveniently The ability to issue paper gives considerable leverage when negotiating with banks Disadvantages Risk of alienating banks whose loans may be needed when an emergency develops May be difficult to raise funds in the paper market at times 11 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University
  12. 12.  Commercial paper must generally remain outstanding until maturity - does not permit early retirement without penalty Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months. Treasury bills (T-bills) are direct obligations of the U.S. government that have an original maturity of one year or less.Tax revenues or any other source of government funds may be used to repay the holders of these financial instruments.They carry great weight in the financial system due to their zero (or nearly zero) default risk, ready marketability, and high liquidity.Types of Treasury Bills:Regular-series bills are issued routinely every week or month in competitive auctionswith original maturities of three months (13 weeks), six months (26 weeks), and one year(52 weeks).Irregular-series bills are issued only when the Treasury has a special cash need. Theseinstruments include strip bills and cash management bills.How Bills Are SoldT-bills do not carry a promised interest rate. Instead, they are sold at a discount from theirpar or face value. 12 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  13. 13. Bill yields are determined by the bank discount method, which does not compoundinterest rates and uses a 360-day year for simplicity.The bank discount rate (DR) on T-bills = Par value – Purchase price  360 . Par value Days to maturityBecause the rates of return on most other debt instruments are not figured in the sameway, comparisons with other securities cannot be made directly.The investment yield or rate (IR) on T-bills = Par value – Purchase price  365 . Purchase price Days to maturity Bankers’ AcceptancesIt is a short term credit investment created by a non financial firm and guaranteed by abank to make payment. It is simply a bill of exchange drawn by a person and accepted bya bank. It is a buyer’s promise to pay to the seller a certain specified amount at certaindate. The same is guaranteed by the banker of the buyer in exchange for a claim on thegoods as collateral. The person drawing the bill must have a good credit rating otherwisethe Banker’s Acceptance will not be tradable. The most common term for theseinstruments is 90 days. However, they can very from 30 days to180 days. Forcorporations, it acts as a negotiable time draft for financing imports, exports and othertransactions in goods and is highly useful when the credit worthiness of the foreign tradeparty is unknown. The seller need not hold it until maturity and can sell off the same insecondary market at discount from the face value to liquidate its receivables.A bankers’ acceptance is a time draft drawn on and endorsed by an importer’s bank.Acceptances are used in international trade because most exporters are uncertain of thecredit standing of their importers.The issuing bank unconditionally guarantees to pay the face value of the acceptance whenit matures, thus shielding exporters and investors in international markets from defaultrisk.Acceptances carry maturities ranging from 30 to 270 days, with 90 days being the mostcommon.They are traded among financial institutions, industrial corporations, and securitiesdealers as a high-quality investment and source of ready cash. 13 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB:
  14. 14. The money market is a wholesale market for funds – most trading occurs in multiples of amillion dollars.The market is dominated by a relatively small number of large financial institutions thataccount for the bulk of federal funds trading.Securities also move readily from sellers to buyers through the market-making activitiesof major security dealers and brokers.And, of course, governments and central banks around the world play major roles in themoney market as the largest borrowers and as regulators. The money market supplies thecash needs of short-term borrowers and provides savers who hold temporary cashsurpluses with an interest-bearing outlet for their funds. 14 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University
  15. 15. Reference: 1. Money and Capital Market Peter S. Rose Milton H. Marquis 2. Capital Budgeting and long-term Financing Decisions Neil Seitz Mitch Ellison 3. 4. 5. 15 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University www. , FB: