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Money markets


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Money markets

  1. 1. GD 20503Financial Markets and Institutions 1
  2. 2. Outlines: Types of Money Market Securities Institutional Use of Money Markets Valuation of Money Market Securities Globalization of Money Markets 2
  3. 3. Types of Money Market Securities Treasury Bills Commercial Paper Negotiable Certificates of Deposit (NCDs) Repurchase Agreements Federal Funds Banker’s Acceptance 3
  4. 4. Exhibit 6.1 How Money Markets Facilitate the Flow ofFunds
  5. 5. Treasury Bills Who is the issuer?; Common investors; See Exhibit 6.4 Common maturities; and Secondary market activity T-bills are attractive to investors because:i. They are backed by the federal government and they are virtually free of credit (default) riskii. Liquidity – short maturity and strong secondary market 5
  6. 6. Treasury BillsPricing T-bills: T-bills do not pay interest. They are priced at a discount from their pay value Example (p.127): if investors require a 7% annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is P = $10,000/1.07 = $9,345.79 6
  7. 7. Treasury Bills 7
  8. 8. Treasury Bills 8
  9. 9. Exhibit 6.4 Survey of Commonly Issued Money Market Securities Securities Issued by Common Common Secondary investors Maturities Market Activity T-bills Federal government Households, 13 weeks, 26 weeks, 1 High firm and year financial institutions NCDs Large banks and saving Firms 2 week to 1 year Moderate institutions Commercial Bank holding companies, Firms 1 day to 270 days Low paper finance companies and other companies Banker’s Banks Firms 30 days to 270 days High acceptance Federal funds Depository institutions Depository 1 day to 7 days Nonexistent institutions Repurchase Firms and financial Firms and 1 day to 15 days Nonexistent agreements institutions financial institutions 9
  10. 10. Commercial Paper Who is the issuer?; Common investors; See Exhibit 6.4 Common maturities; and Secondary market activityRatings: Since commercial paper is issued by corporations that are susceptible to business failure, the commercial paper could possibly default Thus, the rating serves as an indicator of the potential risk of default. 10
  11. 11. Commercial PaperCredit Risk during the Credit Crisis: Historically the percentage of issues that have defaulted is very rare, as most issuers of commercial paper are very strong financially. However, during the credit crisis in 2008, Lehman Brothers (a large securities firm) defaulted.Yield Curve: The curve is typically established for a maturity range from 0 to 90 days. 11
  12. 12. Commercial Paper 12
  13. 13. Negotiable Certificates of Deposits(NCDs) Who is the issuer?; Common investors; See Exhibit 6.4 Common maturities; and Secondary market activityEstimating the Yield: NCDs provide a return in the form of interest along with the difference between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase price. 13
  14. 14. Negotiable Certificates of Deposits(NCDs) 14
  15. 15. Repurchase Agreements With a repurchase agreements (or repo), one party sells securities to another with an agreement to repurchase the securities at a specified date and price The repo transaction represents a loan backed by the securities. If the borrower defaults on the loan, lender has claim to the securities. Most repo transactions use government securities. A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them 15
  16. 16. Repurchase Agreements Who is the issuer?; Common investors; See Exhibit 6.4 Common maturities; and Secondary market activity 16
  17. 17. Federal Funds Who is the issuer?; Common investors; See Exhibit 6.4 Common maturities; and Secondary market activity The federal funds market allows depository institutions to effectively lend or borrow short- term from each other at the so-called federal funds rate. The federal funds rate is normally slightly higher than the T-bill rate. 17
  18. 18. Banker’s Acceptance A banker’s acceptance indicates that a bank accept responsibility for a future payment (the bank acts as a guarantor). It is commonly used for international trade transactions Who is the issuer?; Common investors; See Exhibit 6.4 Common maturities; and Secondary market activity 18
  19. 19. Exhibit 6.3Sequence of The Japanese exporter is unfamiliar with the importedSteps in theCreation ofBanker’sAcceptance The bank acts as a guarantor.
  20. 20. Institutional Use of Money Markets Types of Financial Institutions:i. Commercial Banksii. Finance companiesiii. Money market mutual fundsiv. Insurance companiesv. Pension funds Financial institutions purchase money market securities in order to simultaneously earn a return and maintain adequate liquidity. They issue money market securities when experiencing a temporary shortage of cash 20
  21. 21. Exhibit 6.5 Institutional Use of Money Markets 21
  22. 22. Valuation of Money Market Securities Market Price of Money Market Security (Pm) Pm = Par / (1 + k)n where: Par = par value or principal amount at maturity k = required rate of return by investors n = time to maturity A change in Pm Pm f ( R f , RP ) where: Rf = risk free interest rate RP = risk premium 22
  23. 23. Exhibit 6.6 Framework for Pricing Money MarketSecurities
  24. 24. Valuation of Money Market SecuritiesImpact of Changes in Credit Risk: Lehman Brothers’ Default: Lehman Brothers filed for bankruptcy in Sept 2008 – it shocked the commercial paper market – investors were unwilling to invest in commercial paper – many firms were no longer able to rely on commercial paper market for short-term funding. Risk Premium among Money Market Securities: During periods of heightened uncertainty about the economy, investors tend to shift from risky money market securities to Treasury securities. 24
  25. 25. Exhibit 6.7 Money Market Yields (3-Month Maturity)
  26. 26. Valuation of Money Market Securities Interest Rate Risk: If short-term interest rates increase, the required rate of return on money market securities will increase and the price of the money market securities will decrease (see the valuation formula). Although money market securities values are sensitive to interest rate movements in the same direction as bonds, they are not as sensitive as bond values to interest rate movements. 26
  27. 27. Globalization of Money MarketsExhibit 6.9 International Money Market Rates over Time