Chapter 10
Money Market and Instruments
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Learning Objectives 
 To understand the many roles and
functions performed by the money market.
 To identify the key money market players.
 Money Market Instruments
10-3
Introduction
 All the transactions in the financial markets may
appear to be 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, etc.
 For instance, the money market is the market for
short-term (one year or less) credit and is
designed to provide needs for working capital
10-4
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
10-5
Key Borrowers and Lenders
in the Money Market
Government
Treasuries
(borrowing and
redeeming
securities)
Corporate Borrowers
& Cash-Management
Customers Needing to
Invest Cash Surpluses
Security
Dealers &
Brokers
Nonbank
Financial
Institutions
Money
Center
Banks
Central Banks
(supplying funds and information
and promoting market stability)
10-6
Characteristics of the
Money Market
10-7
Characteristics of the
Money Market
 Funds invested in the money market
represent temporary cash surpluses
 Usually surpluses needed in the near future
 Investors are especially sensitive to risk
 Investors seek mainly safety and liquidity
 Ensure surpluses are accessible when needed
 Opportunity to earn interest income is secondary
10-8
Types of Risk Confronting Investors
Types of Risk Confronting Investors
10-10
Characteristics of the
Money Market
 Original maturity is the interval of time between
the issue date of a security and its promised
redemption date
 It can extend up to one year
 It can be as short as overnight
 Actual maturity is the interval of time between
the current date and the promised redemption
date of a security
 Thousands of money market instruments
outstanding
 Some reach maturity every day
10-11
Characteristics of the
Money Market
 Money market is extremely broad and deep
 It can absorb a large volume of transactions
 Transactions have 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
 Telephone
 Computer network
 Hence alert to any bargains
10-12
Characteristics of the
Money Market
 Federal funds are mainly deposit
balances of commercial banks held at
the central bank and at larger
correspondent banks across a country.
 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.
10-13
Correspondent banks
 Correspondent banks are used by domestic
banks in order to service transactions
originating in foreign countries, and act as a
domestic bank's agent abroad. This is done
because the domestic bank may have limited
access to foreign financial markets, and
cannot service its client accounts without
opening up a branch in another country.
Bank Clearing House
Characteristics of the
Money Market
 Clearinghouse funds
 Alternate structure to the federal funds
 The clearinghouse is a location where
checks and other cash items are delivered
and passed from one financial
organization to another
 Clearinghouse funds are an acceptable
means of payment for most purposes
 Too slow for the money market
 Clearinghouse funds also have an element
of risk
10-16
Characteristics of the
Money Market
 The money market is a wholesale market for
funds
 Most trading occurs in multiples of a million dollars
 Dominated by a relatively small number of large
financial institutions . Securities also move readily
from sellers to buyers through the market-makers
 Major security dealers
 Brokers
10-17
Characteristics of the
Money Market
 Governments and central banks around the
world play major roles in the money market
as the largest borrowers and as regulators.
10-18
Treasury Bills
 Treasury bills (T-bills)
 Direct obligations of the government
 Have an original maturity of one year or less
 Tax revenues or any other source of government
funds may be used to repay the debt
 They carry great weight in the financial system
 Zero (or nearly zero) default risk
 Ready marketability
 High liquidity
10-19
Types of Treasury Bills
 Regular-series bills are issued routinely
every week or month
 In competitive auctions
 Various original maturities
 One month (4 weeks)
 Three months (13 weeks)
 Six months (26 weeks)
 Most revenues from the six month maturity
10-20
Types of Treasury Bills
Irregular-series bills are issued when the
Treasury has an emergency cash need
 Strip bills
 Package of offered bills
 Investor bids for a package of different
maturities
 Cash management bills
 Reopening an issue of bills that were sold
in a prior week
 Issued at the actual maturity of the original
issue
10-21
U.S. Treasury Bills:
Total Amount Outstanding
Source: Board of Governors of the Federal Reserve System
* 2006 figures are for the third quarter of 2006
10-22
U.S. Treasury Bills:
Total Amount Outstanding
How U.S. T-Bills are Sold
 T-bills sold using an auction
 Marketplace sets the bill prices and yields
 New regular bill issues announced by Treasury
 On Thursday of every week except holidays
 Bids due the following Monday before 1 p.m.
EST
 Must be filed with one of the regional Federal
Reserve banks or branches, or the Treasury
10-25
How Bills are Sold
Accepts two types of offers
 Competitive tender
 Submitted by large investors
 Typically millions of dollars
 Bid a discount rate of interest (DR)
 Compete for limited supply
 Noncompetitive tender
 Normally under $1 million
 Small investors accept price
determined by the auction
10-26
Investors in Treasury Bills
 T-bills are held mainly by commercial banks,
nonfinancial corporations, state and local
governments, and the central banks
 Commercial banks and private corporations
hold T-bills as a reserve of liquidity
 The central banks conduct part of their open
market operations in T-bills because of the
depth and volume of activity of the market
10-27
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
 Heavily used two sources of funds
 Demand loans from the largest banks
 May be called at any time if bank needs funds
 Virtually riskless since collateralized
 Repurchase agreements with banks and other
lenders
10-28
Dealers’ Borrowing and Lending
Activities In the Money Market
 Repurchase agreements (RP or Repo)
 Dealer sells securities to a lender
 Makes a commitment to buy back the
 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, …)
 Continuing contracts may be terminated by either
party on short notice.
10-29
Dealers’ Borrowing and Lending
Activities In the Money Market
 Interest income from RPs
= Amount  Current  Number of days
RP rate
loaned
360 days
(Amt of loan)
https://www.youtube.com/watch?v=QB7jhqkGHVU
https://www.youtube.com/watch?v=wI1XdCm3At4
10-30
Commercial Paper
 In the global money market, commercial paper is an
unsecured promissory note with a fixed maturity of 1 to
270 days. Commercial Paper is a money-market security
issued (sold) by large banks and corporations to get
money to meet short term debt obligations (for example,
payroll) to pay the face amount on the maturity date
specified on the note.
 Since it is not backed by collateral, only firms with
excellent credit ratings from a recognized rating agency
will be able to sell their commercial paper at a reasonable
price. Commercial paper is usually sold at a discount from
face value, and carries higher interest repayment dates
than bonds.
Banker’s Acceptance
 A banker's acceptance, or BA, is a negotiable instrument
or time draft drawn on and accepted by a bank. It is an
order by the drawer to the bank to pay a specified sum of
money on a specified date to a named person or to the
bearer of the draft. Upon acceptance, which occurs when
an authorized bank accepts and signs it, the draft
becomes a primary and unconditional liability of the bank.
 The accepted draft may be readily sold in an active
market. A banker's acceptance is also a money market
instrument – a short-term discount instrument that
usually arises in the course of international trade.
Eurocurrency Deposit
 A short-term certificate of deposit with a
fixed interest rate made in a currency
outside the jurisdiction of the issuing central
bank. For example, one may purchase a CD
in U.S. dollars and deposit it in a bank in
Great Britain. Eurocurrency deposits help
persons and businesses hedge against
short-term fluctuations in exchange rates.
Markets on the Net
 Board of Governors of the Federal Reserve
System at www.federalreserve.gov
 Browse Data of the Federal Reserve Board at
www.economagic.com/fedbog.htm
 European Central Bank at www.ecb.eu
 Federal Reserve Bank of New York at
www.ny.frb.org
 Investopedia at www.investopedia.com
10-34
Markets on the Net
 Federal Deposit Insurance Corporation at
www.fdic.gov
 Primary Dealers - Federal Reserve Bank of
New York at
www.ny.frb.org/markets/pridealerslisting.htm
 U.S. Treasury Department Bureau of the
Public Debt at www.publicdebt.treas.gov
 Treasury Direct at www.Treasurydirect.gov
10-35
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
10-36
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
10-37
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
10-38
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 
Par value
360
Days to maturity
.
10-39
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 Tbills
= Par value – Purchase price 
Purchase price
365
Days to maturity
.
10-40