Aida Osmeni
Howard Hansen
BU 434: Financial Markets II
11 February 2019
1) What are federal funds? How are they recorded on the balance sheets of
commercial banks?
Federal funds are short-term funds transferred between financial institutions usually for a
period of one day. One commercial bank may be short of reserves, requiring it to borrow
excess reserves from another bank that has a surplus. The commercial bank that borrows
fed funds incurs a liability on its balance sheet, “federal funds purchased,” while the
institution that lends the fed funds records an asset, “federal funds sold”.
2) Describe the trading process for repurchase agreements.
A repurchase agreement is an agreement involving the sale of securities by one party to
another with a promise to repurchase the securities at a specified price and on a specified
date in the future.
Repurchase agreements are arranged either directly between two parties or with the help
of brokers and dealers. Let’s say Bank A (buyer) has some idle funds in its deposit
accounts and they want to earn a small return until these funds are needed. Bank A
decides to buy a $75 million repurchase agreement of Treasury bonds from Bank B for
one day. Bank A arranges to purchase fed funds from Bank B (seller) with an agreement
that Bank B will repurchase the fed funds within a day. Once the transaction is agreed
upon, Bank A instructs its district Federal Reserve Bank to transfer $75 million in excess
reserves, via Fedwire, to Bank B’s reserve account. Bank B instructs its district Federal
Reserve Bank to transfer $75 million from its T-bond account via securities Fedwire to
Bank A’s T-bond account. Upon maturity of the repurchase agreement, these transactions
are reversed. Bank B transfers 75 million plus one day’s interest to the reserve account of
Bank A. Bank A transfers 75 million to Banks B’s T-Bond account.
3) What factors caused the amount of outstanding commercial paper to increase from
1992 through 2000 and in the mid 2000s? What factors cause the amount of
outstanding commercial paper to decrease from 2000 through 2004 and from 2007
through 2012?
Commercial paper is an unsecured short-term promissory note issued by a company to
raise short-term cash, often to finance working capital requirements.
Since 1992 companies with a strong credit rating realized that they can generally borrow
money at a lower interest rate by issuing commercial paper than by directly borrowing
from banks. This trend reflects the growth of the commercial paper market since 1992.
In the early 2000s there was a decrease in the number of eligible commercial papers
which contributed to a decrease in the size of the commercial paper market. This is
because the slowdown in the U.S. economy resulted in ratings downgrades for some of
the largest commercial paper issuers. They were forced to give up the cost advantage of
commercial paper and to move to the long-term debt markets to ensure they would have
access to cash.
Then, the mid 2000s saw a huge rise in the use of asset-backed commercial papers
(commercial paper collateralized by other financial assets). In the mid-2000s the
collateralized assets were mainly mortgage-backed securities.
In 2007-2008, many of these mortgage-backed securities performed more poorly than
expected. Billions of dollars of asset-backed commercial paper were tainted because
some of the proceeds were used to buy investment ties to U.S. subprime mortgages.
Issuers found buyer much less willing to purchase ABCP. The result was another big
drop in the dollar value of the commercial paper markets. In 2008, as investors worried
about the safety of their investments, they pulled out their money from the commercial
paper market, shrinking it by $52.1 billion.
Even as markets stabilized, outstanding values of financial and nonfinancial commercial
paper market continue to fall because negative and low positive economic growth
experienced for years after the crisis produced lower demand for funds and thus less of a
need to issue commercial paper. Furthermore, financial and nonfinancial firms held
record amounts of cash reserves and thus did not need to borrow as much in the shortterm commercial paper markets. Also, long-term debt rates were at historical lows which
became the choice of many corporations.
4) Who are the major issuers of and investors in money market securities?
Money market securities are financial debt instruments aimed at fulfilling the short term
needs for cash of a business. The maturity period of these debt instruments is generally
one year or less. The major money market participants are:
-
The U.S. Treasury
It raises significant amounts of money by issuing Treasury bills. Treasury bills allow
the U.S. government to raise money to meet unavoidable short0term expenditure
needs.
-
The Federal Reserve
The Federal Reserve holds Treasury Bills to conduct open market transactions
(purchasing Treasury bills when it wants to increase the money supply and selling
Treasury bills when it wants to decrease the money supply).
It also uses repos to smooth interest rates and money supply. In addition, it targets the
federal funds rate as part of its overall monetary policy strategy. It also operates the
discount window which it can use to influence the supply of bank reserves to
commercial banks and ultimately the demand for and supply of fed funds and repos.
-
Commercial Banks
They can participate as issuers and/or investors of almost all money market securities.
-
Money Market Mutual Funds
They purchase large amounts of money market securities and sell shares in these
pools based on the value of the underlying securities. They allow small investors to
invest in money market instruments. They provide an alternative investment
opportunity to interest-bearing deposits at commercial banks.
-
Brokers and Dealers
They serve as intermediaries and they have a key role in the secondary markets.
-
Corporations
They raise large amounts of funds in the money markets, primarily in the form of
commercial paper. Because their cash inflows rarely equal their cash outflows, they
often invest their excess cash funds in money market securities.
-
Individuals
They participate through direct investments or investments in money market mutual
funds.
-
Other financial institutions
Insurance companies invest in highly liquid money market securities because their
liability payments are relatively unpredictable.
Finance companies raise large amounts of funds in the money markets since they
cannot issue deposits.
5) Suppose a bank enters a repurchase agreement in which it agrees to buy Treasury
securities from a correspondent bank at a price of $24,950,000 with the promise to
buy them back at a price of $25,000,000.
a. Calculate the yield on the repo if it has a 7-day maturity.
i repo =
25,000,000 - 24,950,000 360
´
24,950,000
7
i repo = 0.1031
i repo = 10.31%
b. Calculate the yield on the repo of it has a 21-day maturity.
i repo =
25,000,000 - 24,950,000 360
´
24,950,000
21
i repo = 0.03435
i repo = 3.44%
6) A bank has issued a six-month, $2 million negotiable CD with a 0.52 percent quoted
annual interest rate.
a. Calculate the bond equivalent yield and the EAR on the CD.
365
)
360
iCD,be = 0.5272%
iCD,be = 0.52%(
iCD,be = 0.53%
EAR = (1+
0.005272 2
) -1
2
EAR = 0.005278
EAR = 0.5278%
b. How much will the negotiable CD holder receive at maturity?
FV = 2,000,000(1+
0.0052
)
2
FV = 2,005,278
c. Immediately after the CD is issued, the secondary market price on the $2 million
CD falls to $1,998,750. Calculate the new secondary market quoted yield, the
bond equivalent yield and the EAR on the $2 million face value CD.
2,005,272
i
(1+ CD,be )
2
2,005,272 - 1,998, 750
iCD,be =
999, 375
2,005,272 - 1,998, 750
iCD,be =
999, 375
iCD,be = 0.006526
1,998, 750 =
iCD,be = 0.6526%
iCD,sp = 0.6526%(
360
)
365
iCD,sp = 0.6436%
EAR = (1+
0.006526 2
) -1
2
EAR = 0.65366%