This document outlines key aspects of money market securities and the money markets. It discusses the main types of money market securities including treasury bills, commercial paper, negotiable certificates of deposit, repurchase agreements, federal funds, and banker's acceptances. It also examines how various financial institutions use money markets and how money market securities are valued based on factors like interest rates, risk, and credit risk. Additionally, it explores the globalization of money markets over time.
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) risk
ii. Liquidity – short maturity and strong secondary
market
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6. Treasury Bills
Pricing 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
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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
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10. Commercial Paper
Who is the issuer?;
Common investors;
See Exhibit 6.4
Common maturities; and
Secondary market activity
Ratings:
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.
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11. Commercial Paper
Credit 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.
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13. Negotiable Certificates of Deposits
(NCDs)
Who is the issuer?;
Common investors;
See Exhibit 6.4
Common maturities; and
Secondary market activity
Estimating 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.
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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
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16. Repurchase Agreements
Who is the issuer?;
Common investors;
See Exhibit 6.4
Common maturities; and
Secondary market activity
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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. 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
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19. Exhibit 6.3
Sequence of The Japanese exporter is
unfamiliar with the imported
Steps in the
Creation of
Banker’s
Acceptance
The bank acts as
a guarantor.
20. Institutional Use of Money Markets
Types of Financial Institutions:
i. Commercial Banks
ii. Finance companies
iii. Money market mutual funds
iv. Insurance companies
v. 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
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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
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24. Valuation of Money Market Securities
Impact 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
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.
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