This chapter discusses the roles of governments and security dealers in the money market. It describes how governments, such as the U.S. Treasury, are major borrowers in the money market through instruments like Treasury bills. Security dealers facilitate trading and obtain funding through repurchase agreements to deal in government securities. The money market brings together temporary cash surpluses and deficits and is regulated by governments.

2. Chapter 10
Introduction to the Money Market
and the Roles Played by
Governments and Security Dealers

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 Learning Objectives 
• To understand the many roles and functions performed by the
money market.
• To identify the key money market players.
• To examine the roles that governments and security dealers
play in the functioning of the money market.
• To discover how Treasury bills and repurchase agreements
(RPs) arise through borrowing and lending in the money
market.

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Introduction
• All the transactions carried out in the financial markets seem
to be basically the same: borrowers issue securities that lenders
buy.
• However, the different purposes for which money is borrowed
can result in the creation of different kinds of financial assets
having different maturities, risks, etc.
• For instance, the money market is the market for short-term
(one year or less) credit.

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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.

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Key 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)

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Characteristics of the Money Market

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Characteristics of the Money Market
• 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.

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Types of Investment Risk

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Characteristics of the Money Market
• 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.

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Characteristics 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.

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Characteristics of the Money Market
• Federal funds are mainly deposit balances of commercial
banks held at regional Federal Reserve banks and at larger
correspondent banks across the U.S.
• Federal funds are often called immediately-available funds
because of the speed with which money moves from one
bank’s reserve account to that of another.

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Characteristics of the Money Market
• In contrast, funds transferred by checks are known as
clearinghouse funds. The clearinghouse is a location where
checks and other cash items are delivered and passed from one
depository institution to another.
• Clearinghouse funds are an acceptable means of payment for
most purposes, but not in the money market, where speed is of
essence. Clearinghouse funds also have an element of risk.

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Characteristics of the Money Market
• The money market is a wholesale market for funds – most
trading occurs in multiples of a million dollars.
• The market is dominated by a relatively small number of large
financial institutions that account for the bulk of federal funds
trading.
• Securities also move readily from sellers to buyers through the
market-making activities of major security dealers and
brokers.

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Characteristics of the Money Market
• And, of course, governments and central banks around the
world play major roles in the money market as the largest
borrowers and as regulators.

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Government Involvement in the Money
Market
• Governments set the rules of the money-market “game”
through regulation, and they consistently rank among the top
issuers of money market debt.
• Moreover, working through central banks, they help to shape
money market conditions and set the tone for daily borrowing
and lending activities.

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Government Involvement in the Money
Market
• Governments are usually most visible in the money market
when they borrow money.
• One of the largest borrowers in the money market of the
United States is the U.S. Treasury Department, which enters
the market weekly to sell Treasury bills.

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U.S. Treasury Bills
• U.S. 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.

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Volume of U.S. Treasury Bills Outstanding
Source: Board of Governors of the Federal Reserve System
* 2004 figures are for July 31, 2004

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Types of Treasury Bills
• Regular-series bills are issued routinely every week or month
in competitive auctions with original maturities of one month
(4 weeks), three months (13 weeks), and six months (26
weeks).
• Irregular-series bills are issued when the Treasury has an
emergency need for cash. These instruments include strip bills
and cash management bills.

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How Bills Are Sold
Source: U.S. Bureau of the Public Debt

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How Bills Are Sold

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Results of a Recent Bill Auction

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Calculating the Return on T-Bills
• T-bills do not carry a promised interest rate. Instead, they are
sold at a discount from their par or face value.
• Bill yields are determined by the bank discount method, which
does not compound interest 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 maturity

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Calculating the Return on T-Bills
• Because the rates of return on most other debt instruments are
not figured in the same way, 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

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Market Interest Rates on U.S. T-Bills
Source: Board of Governors of the Federal Reserve System
* 2004 figures are averages for January

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Investors in Treasury Bills
• T-bills are held mainly by commercial banks, nonfinancial
corporations, state and local governments, and the Federal
Reserve banks.
• Commercial banks and private corporations hold T-bills as a
reserve of liquidity.
• The Federal Reserve banks conduct part of their open market
operations in T-bills because of the depth and volume of
activity of the market.

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Primary Dealers in Government Securities
• Primary dealers are dealer firms that are qualified to trade
securities directly with the Federal Reserve Bank of New
York.
• Primary dealers agree to “meaningfully participate” in trading
with the Federal Reserve at any time the Fed wishes, to make
“realistic” bids, and to trade continuously in the full range of
government securities.

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Primary Dealers in Government Securities

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Primary Dealers in Government Securities
• Primary dealers have a significant incentive to attempt to
corner the government securities market and to collude and
place common bids, so that all the dealers can get some share
of the new securities to fill their customers’ orders and make a
profit.
• In the wake of a scandal involving Salomon Brothers in 1991,
auction rules were tightened and a market-surveillance
committee was created.

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Primary Dealers in Government Securities
• Then in 1998, the U.S. Treasury abandoned its first-price
sealed-bid, or English auction approach, in which each
successful bidder paid the price that it had bid.
• It adopted the uniform-price, or Dutch auction method, in
which all successful bidders receive securities at the same
price – the market-clearing or stop-out price.

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Dealers’ Borrowing and Lending Activities
In the Money Market
• The bulk of the dealers’ operating capital is obtained through
borrowings from commercial banks and other institutions.
• The two most heavily used sources of dealer funds are demand
loans from the largest banks and repurchase agreements with
banks and other lenders.
• A demand loan may be called in at any time if the banks need
cash urgently.

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Dealers’ Borrowing and Lending Activities
In the Money Market
• Under a repurchase agreement (RP or Repo), the dealer sells
securities to a lender but makes a commitment to buy back the
securities at a later date at a fixed price plus interest.
• RPs are 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.

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Dealers’ Borrowing and Lending Activities
In the Money Market
Example of a Typical RP Loan Transaction

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Dealers’ Borrowing and Lending Activities
In the Money Market
• Interest income from RPs
= Amount  Current  Number of days loaned .
of loan RP rate 360 days
• Periodically, RPs are marked to market. If the price of the
pledged securities has dropped, the borrower may have to
pledge additional collateral.

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Dealers’ Borrowing and Lending Activities
In the Money Market
• Traditional RPs are somewhat inflexible and most costly than
they need to be.
• Hence, a General Collateral Finance (GCF) Repo was created
in 1998.
• Working through a central clearinghouse, the new GCF Repos
dealers are given greater control over the pledged collateral.
Each dealer can also settle just the net amount owed to and
received from all other parties in the market.

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Sources of Dealer Income
• Dealers hope to earn a profit (the positive spread between the
bid and ask prices) from their market-making activities.
• By correctly anticipating interest rate movements, dealers may
earn sizable position profits too.
- If interest rates fall (and security prices rise), dealers will
experience capital gains on a long position (but losses on a short
position).

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Sources of Dealer Income
• Dealers also receive carry income, the difference between
interest earned on the securities they hold and their cost of
borrowing funds.
• In addition, dealers receive miscellaneous service fees for their
advice and assistance to customers.

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Sources of Dealer Income
• Some dealers try to stabilize their income by simultaneously
borrowing and lending money through a technique known as
matched book.
- Funds are borrowed through low-cost short-term RPs and then
loaned out through longer-term, higher-yielding RPs.

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Dealer Positions in Securities
• Dealer holdings of securities are both huge and subject to
erratic fluctuations, due mainly to interest rate movements and
expectations.
• Today, dealers make heavy use of interest rate hedging tools to
further protect their portfolios from losses due to changes in
interest rates.
- They are active participants in the financial futures markets and
are also making increased use of forward commitments.

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Government Security Brokers
• Government securities dealers usually trade among themselves
through brokers.
• Government security brokers do not take investment positions
themselves, but try to match bids and offers placed with them
by dealers and other investors.

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Markets on the Net
• Bond Market Association at www.bondmarket.com
• Browse Data of the Federal Reserve Board at
www.economagic.com/fedbog.htm
• U.S. Treasury Department Bureau of the Public Debt at
www.publicdebt.treas.gov
• Treasury Direct at www.Treasurydirect.gov
• Federal Reserve Bank of New York at www.ny.frb.org

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Markets on the Net
• Board of Governors of the Federal Reserve System at
www.federalreserve.gov
• Federal Deposit Insurance Corporation at www.fdic.gov
• Primary Dealers - Federal Reserve Bank of New York at
www.ny.frb.org/markets/pridealers-listing.htm

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Chapter Review
• Introduction: The Market for Short-Term Credit
• Characteristics of the Money Market
- What the Money Market Does
- The Need for a Money Market
- Key Borrowers and Lenders in the Money Market
- The Goals of Money Market Investors
- Types of Investment Risk that Investors Face

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Chapter Review
• Characteristics of the Money Market … continued
- Money Market Maturities
- Depth and Breadth of the Money Market
- The Speed of Money Market Payments: Federal Funds versus
Clearinghouse Funds
- A Market for Large Borrowers and Lenders

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Chapter Review
• Government Involvement in the Money Market
- The Roles that Governments Play in the Money Market
- Selling Treasury Bills to Money Market Investors: The Anchor
of the Money Market
- Calculating the Return on T-Bills
- Market Interest Rates on T-Bills
- Investors in T-Bills
• Primary Dealers in Government Securities

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Chapter Review
• Dealers’ Borrowing and Lending Activities in the Money
Market
- Demand Loans for Dealers
- Repurchase Agreements (RPs or REPOs) for Dealers and Other
Money Market Participants
- A New Type of RP: The GCF REPO
- Sources of Dealer Income
- Dealer Positions in Securities
- Dealer Transactions and Government Security Brokers