Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 7
Money Markets
Overview of the Money Market
Short-term debt market - most under 120
days.
A few high quality borrowers.
Many diverse investors.
Informal market centered in New York City.
Standardized securities -- one security is a
close substitute for another.
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Overview of the Money Market (concluded)
Good marketability - secondary market.
Large, wholesale open-market transactions.
Many brokers and dealers are competitively
involved in the money market.
Payment in Federal Funds - immediately
available funds.
Physical possession of securities seldom
made - centralized safekeeping.
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Money Market Securities Outstanding
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Economic Role of Money Market (MM)
The money market is a market for liquidity
Liquidity is stored in MM by investing in MM
securities.
Liquidity is bought in MM by issuing securities
(borrowing).
Liquidity status of commercial banks is
reflected
Provides a place for Fed’s reserve
transactions (open market transactions)
Indicator of economic conditions
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Characteristics of Money Market Instruments
Low default risk.
Short maturity.
High marketability.
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U.S. Treasury Bills
Characteristics
Sold on discount basis.
Maturities up to one year.
Minimum denomination is usually $10,000, but
smaller investors can invest in multiples of
$1,000 through the Treasury Direct Program
offered by the Fed.
Lowest interest rate of all MM securities is the
3-month T-Bill
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How to Read T-Bill Quotes
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U.S. Treasury Bills
Pricing Treasury Bills
Treasury bills are priced on a bank discount
rate basis, a traditional yield calculation.
The bank discount rate, yd , is:
Par  Price
360
y 

 100%
d
Par
Days To Maturity
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U.S. Treasury Bills
The Wall Journal lists T-Bill yields on a bond
equivalent basis where the discounted price is
the denominator and 365 days is used as the
annualizer.
Par  Price
365
y 

 100%
be
Price
Days To Maturity
The effective annual yield assuming
compounding a year is:
Effective Yield = [(Face Value/Price)365/D -1] x 100%.
Copyright© 2006 John Wiley & Sons, Inc.
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Auctioning New Bills
Weekly sale by U. S. Treasury of three- and
six-month maturities; longer-term bills,
monthly or quarterly.
T-bills are sold through an auction process
using both competitive and noncompetitive
bids.
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Auctioning New Bills contd.
Competitive Bids
Specify price and quantity desired.
Minimum $10,000 & in multiples of
$5,000 above $10,000.
Mostly professionals - dealers & banks.
No more than 35 percent of an issue is
sold under the competitive bidding
process in order to ensure a competitive
secondary market.
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Auctioning New Bills contd.
Non-competitive Bids
All non-competitive bids accepted.
Specify quantity only.
Maximum $1,000,000.
Mostly individuals & small investors.
Pays weighted average price of
competitive bids accepted.
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Book-entry Securities
No physical securities: only record entries.
Book-entry record keeping
Most of marketable Treasury debt is now in
book- entry form.
Participants in Treasury Direct program are
book-entry accounts.
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Types of Federal Agencies
Farm credit agencies - loans to farmers.
Housing credit agencies - loans and
secondary market support for mortgage
market.
Other agencies - special purposes.
Federal Financing Bank - purchases
securities of agencies and issues its own
obligations.
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Characteristics of Agency Debt
Most are not guaranteed by federal
government; federal guarantee implied, not
explicit.
Marketability varies with the development
of the secondary market.
Yields are higher than T-Bills.
Slightly greater default risk.
Slightly lower marketability.
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Negotiable Certificates of Deposit
Characteristics of Negotiable CDs
Large denomination time deposit, less than six month's
maturity.
Negotiable - may be sold and traded before maturity.
Issued at face value with coupon rate.
Interest computed on a 360 day year.
Primary market sales have CDs of denominations of at
least $100,000.
Secondary market deals are for $1 million or more.
Payment by banks from fed funds in NY.
Interest rates on CDs are higher than on T-Bills higher credit risk, lower marketability and higher
taxability.
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Negotiable Certificates of Deposit
Development of the CD Market
Issued by Citibank in 1961.
Offset declining demand deposits as a source of funds.
The CD Market
Rate negotiated between buyer and seller.
Market is sensitive to rates above or below the market
rates.
Rates are lower for money center banks and are tiered
upward for regional banks.
Purchased mainly by corporate businesses.
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Commercial Paper
Short term - one to 270 days.
Unsecured.
Large denominations -- $100,000 and up.
Issued by high - quality borrowers.
A wholesale money market instrument - few
personal investors.
Sold at a discount from par.
Directly or dealer sold.
Backed by bank lines of credit.
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The Commercial Paper Market
Major investors
Commercial banks.
Insurance companies.
Nonfinancial business firms.
Bank trust departments.
State and local pension funds.
Banks are involved
Backup lines of credit.
Act as agents in issuance.
Hold notes in safekeeping.
Facilitate payment in Federal Funds.
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The Commercial Paper Market (concluded)
Credit ratings important for commercial
paper issuance.
Backup lines of credit from banks support
or guarantee quality.
Placement
Directly by a sales force of the borrowing firm.
Indirectly through dealers.
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Bankers' Acceptances
Time draft - order to pay in future.
Drafts are drawn on and/or accepted by
commercial bank.
Direct liability of bank.
Mostly relate to international trade.
Secondary market - dealer market.
Discounted in market to reflect yield.
Standard maturities of 30, 60, or 90 days max of 180.
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Creating a Banker's Acceptance
Importer initiates purchase from foreign
exporter, payable in future.
Importer needs financing; exporter needs
assurance of payment in future.
Importer's bank writes irrevocable letter of
credit for exporter
Specifies purchase order.
Authorizes exporter to draw time draft on bank.
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Creating a Banker's Acceptance (concluded)
Importer's bank accepts draft (liability to
pay) and creates a banker's acceptance.
Advantage of a banker's acceptance (BA)
Exporter receives funds by selling BA in the
market.
Exporter eliminates foreign exchange risk.
Importer's bank guarantees payment of draft in
future.
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Tracing a Banker’s Acceptance Transaction
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Federal Funds
Characteristics of Federal Funds
Market for depository institutions.
Most liquid of all financial assets.
Related to monetary policy implementation.
Yields related to the level of excess bank reserves.
Originally a market for excess reserves - Now a
source of investment (federal funds sold) and
continued financing (federal funds purchased).
Most are one-day, unsecured Loans.
Bookkeeping entry -interest paid separately.
Traded in Fed Funds or Immediately Available
Funds.
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Repurchase Agreements (Repo)
Bank Financing - Source of funds
Security sold under agreement to repurchase at
given price in future.
Way to include corporate business in Federal
Funds market.
Negotiated market rate.
Bank Investment – Reverse Repo
Security purchased under agreement to resell at
given price in future.
Smaller banks are able to invest excess liquidity
in a secured investment.
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Repurchase Agreements (concluded)
The interest rate on a repo is lower than the
fed funds rate, since it is backed up by a
security.
Repos are used by the Federal Reserve in
open market operations.
Government securities dealers use repos to
secure funds to invest in new Treasury
issues.
Banks participate in the repo market to
secure funds to meet temporary liquidity
needs as well as lend funds when they have
excess reserves.
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Money Market Position of Major Participants
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Commercial Banks
Most important participant in the MM
Bank assets or investments
Treasury bills.
Agency securities.
Bankers' acceptances (from other banks).
Federal Funds sold.
Repurchase agreements (securities purchased
under agreements to resell).
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Commercial Banks,cont.
Bank liabilities or borrowing
Negotiable CDs.
Commercial paper.
Bankers' acceptances.
Federal Funds purchased.
Repurchase agreements (securities sold under
agreements to repurchase).
MM securities provides sources and uses of
liquidity due to wide fluctuations in loans
and deposits.
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The Federal Reserve in the Money Markets
Money market securities is the major asset
category of the Fed.
Open-market operations (buying and selling
of MM securities by Fed) is the primary
tool for implementing monetary policy.
Purchase - increases member bank reserves.
Sale - decreases member bank reserves.
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Dealers in U.S. Securities
Involved in both primary and secondary
markets.
Purchases new treasury debt and resells it
(primary).
"Makes a market" by buying/selling (dealer)
securities (bid/ask).
Purchases are financed by repurchase
agreements or fed funds.
Dealers have a very small capital base and
are highly leveraged.
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Interrelationship of Money Market Interest Rates
Various MM instruments are close
substitutes in investment portfolios.
Interest rates move together over time.
Deviations from traditional spreads are
quickly eliminated by interest rate
arbitrage.
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