CHAPTER
6
© 2003 South-Western/Thomson Learning
Money
Markets
Chapter Objectives
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Provide a background on money market
securities
Explain how institutional investors use money
markets
Explain the globalization of money markets
Money Market Securities
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Maturity of a year or less
Debt securities issued by corporations and
governments that need short-term funds
Large primary market focus
Purchased by corporations and financial
institutions
Secondary market for securities
Money Market Securities
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Treasury Bills
Commercial paper
Negotiable certificates of deposits
Repurchase agreements
Federal funds
Banker’s acceptances
Money Market Securities
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Treasury bills
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Issued to meet the short-term needs of the U.S.
government
Attractive to investors
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Minimal default risk—backed by Federal Government
Excellent liquidity for investors
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Short-term maturity
Very good secondary market
Money Market Securities
Competitive Bidding
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Treasury bill auction (fill bids in amount
determined by Treasury borrowing needs)
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Bid process used to sell T-bills
Bids submitted to Federal Reserve banks by the
deadline
Bid process
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Accepts highest bids
Accepts bids until Treasury needs generated
Money Market Securities
Noncompetitive Bidding
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Treasury bill auction—noncompetitive bids
($1 million limit)
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May be used to make sure bid is accepted
Price is the weighted average of the accepted competitive
bids
Investors do not know the price in advance so they submit
check for full par value
After the auction, investor receives check from the
Treasury covering the difference between par and the
actual price
Money Market Securities
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Estimating T-bill yield
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No coupon payments
Par or face value received at maturity
Yield at issue is the difference between the selling
price and par or face value adjusted for time
If sold prior to maturity in secondary market
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Yield based on the difference between price paid for Tbill and selling price adjusted for time
Money Market Securities
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Calculating T-Bill Annualized Yield
YT =
SP – PP
PP

365
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YT = The annualized yield from investing in a T-bill
SP = Selling price
PP = Purchase price
n = number of days of the investment (holding period)
Money Market Securities
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T-bill yield for a newly issued security
T-bill discount =
Par – PP
PP

360
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T-bill discount = percent discount of the purchase price from par
Par = Face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
Money Market Securities
Commercial Paper
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Short-term debt instrument
Alternative to bank loan
Dealer placed vs. directly placed
Used only by well-known and creditworthy firms
Unsecured
Minimum denominations of $100,000
Not a large secondary market
Money Market Securities
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Commercial paper backed by bank lines of
credit
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Bank line used if company loses credit rating
Bank lends to pay off commercial paper
Bank charges fees for guaranteed line of credit
Money Market Securities
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Estimating commercial paper yields
YCP =
Par – PP
PP

360
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YCP = Commercial paper yield
Par = Face value at maturity
PP = Purchase price
n = number of days to maturity
Money Market Securities
Negotiable Certificates of Deposit (NCD)
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Issued by large commercial banks
Minimum denomination of $100,000 but $1
million more common
Purchased by nonfinancial corporations or money
market funds
Secondary markets supported by dealers in
security
Money Market Securities
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NCD placement
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Direct placement
Use a correspondent institution specializing in
placement
Sell to securities dealers who resell
Sell direct to investors at a higher price
NCD premiums
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Rate above T-bill rate to compensate for lower
liquidity and safety
Money Market Securities
Repurchase Agreements
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Sell a security with the agreement to repurchase it
at a specified date and price
Borrower defaults, lender has security
Reverse repo name for transaction from lender
Negotiated over telecommunications network
Dealers and brokers used or direct placement
No secondary market
Money Market Securities
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Estimating repurchase agreement yields
Repo Rate =
SP – PP
PP

360
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Repo Rate = Yield on the repurchase agreement
SP = Selling price
PP = Purchase price
n = number of days to maturity
Money Market Securities
Federal Funds
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Interbank lending and borrowing
Federal funds rate usually slightly higher than Tbill rate
Fed district bank debits and credits accounts for
purchase (borrowing) and sale (lending)
Federal funds brokers may match up buyers and
sellers using telecommunications network
Usually $5 million or more
Exhibit 6.5
Purchase Order
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Shipment of Goods
3
American Bank
(Importer’s Bank)
Shipping Documents & Time Draft
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L/C Notification
Exporter
L/C (Letter of Credit) Application
Importer
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4
6
L/C
7 Shipping Documents & Time Draft
Draft Accepted (B/ACreated)
Japanese Bank
(Exporter’s Bank)
Money Market Securities
Bankers Acceptance
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A bank takes responsibility for a future payment of
trade bill of exchange
Used mostly in international transactions
Exporters send goods to a foreign destination and
want payment assurance before sending
Bank stamps a time draft from the importer
ACCEPTED and obligates the bank to make good
on the payment at a specific time
Money Market Securities
Bankers Acceptance
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Exporter can hold until the date or sell before
maturity
If sold to get the cash before maturity, price
received is a discount from draft’s total
Return is based on calculations for other discount
securities
Similar to the commercial paper example
Major Participants in Money Market
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Participants
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Commercial banks
Finance, industrial, and service companies
Federal and state governments
Money market mutual funds
All other financial institutions (investing)
Short-term investing for income and liquidity
Short-term financing for short and permanent needs
Large transaction size and telecommunication
network
Valuation of Money Market Securities
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Present value of future cash flows at maturity
(zero coupon)
Value (price) inversely related to discount rate
or yield
Money market security prices more stable than
longer term bonds
Yields = risk-free rate + default risk premium
Exhibit 6.7
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Short-Term
Risk-Free
Interest
Rate
(T-bill Rate)
Issuer’s
Industry
Conditions
Issuer’s
Unique
Conditions
Risk
Premium
of Issuer
Required Return
on the Money
Market Security
Price of the
Money Market
Security
Interaction Among Money Market
Yields
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Securities are close investment substitutes
Investors trade to maintain yield differentials
T-Bill is the benchmark yield in money market
Yield changes in T-bills quickly impacts other
securities via dealer trading
Yield differentials determined by risk
differences between securities
Default risk premiums vary inversely with
economic conditions
Globalization of Money Markets
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Money market rates vary by country
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Segmented markets
Tax differences
Estimated exchange rates
Government barriers to capital flows
Deregulation Improves Financial Integration
Capital Flows To Highest Rate of Return
Globalization of Money Markets
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Eurodollar deposits and Euronotes
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Dollar deposits in banks outside the U.S.
Increased because of international trade growth
and U.S. trade deficits over time
No reserve requirements at banks outside U.S.
Eurodollar Loans
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Channel funds to other multinationals that need
short-term financing
Globalization of Money Markets
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Euro-commercial paper
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Issued without the backing of a banking syndicate
Maturity tailored to investors
Dealers that place paper create a secondary market
Rates range between 50 and 100 basis points
above the LIBOR rate
Globalization of Money Markets
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Performance of international securities
Effective yield for international securities has
two components
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The yield earned on the investment denominated
in the currency of the investment
The exchange rate effect
Globalization of Money Markets
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Yf
Performance of international securities
Yield for an international investment
=
SPf – PPf
PPf
Yf = Foreign investment’s yield
SPf = Investment’s foreign currency selling price
PPf = Investment’s foreign currency purchase
Globalization of Money Markets
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The exchange rate effect (%S) measures the
percentage change in the spot during the
investment period
Ye  (1  Yf )  (1  %S )  1
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% S measures the expected percent change in
the currency
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Currency appreciated, % S is positive and adds to net
yield
Currency depreciated, % S is negative and reduces net
yield
Chapter Concepts Summary
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Surplus units channel investments to securities
issued by deficit units
Debt securities markets
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Money Market
Capital Market
Money market securities
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Short-term
High quality
Very good liquidity