The Money Market
1
Copyright 2014 Diane Scott Docking
Learning Objectives



Define money markets
Identify the major types of money market
securities
Examine the process used to issue Treasury
securities
Copyright 2014 Diane Scott Docking
2
The Money Markets Defined



The term “money market” is a misnomer.
Money (currency) is not actually traded in the
money markets.
The securities in the money market are short
term with high liquidity; therefore, they are
close to being money.
Copyright 2014 Diane Scott Docking
3
Money Market Securities’ Characteristics


Maturity of ___________________from their
________ date.
Large primary market focus
l


Secondary market for securities
Money market securities are usually sold in
large denominations.
They have low default risk.
Copyright 2014 Diane Scott Docking
4
Money Market Instruments
1.
2.
3.
4.
5.
6.
7.
Treasury Bills
Federal Funds
Repurchase Agreements
Commercial Paper
Negotiable Certificates of Deposit
Banker’s Acceptance
Eurodollars
Copyright 2014 Diane Scott Docking
5
Treasury Bills






Issued to meet the short-term needs of the
________________
Standard Original Maturities of 4 weeks, 13 weeks
(three month), 26 weeks (six month), or 52 weeks
Denominations are $1,000; typical round lot is $5
million
Virtually default risk free
Interest earned is
at state and local
government level.
http://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm
Copyright 2014 Diane Scott Docking
6
Treasury Bills (continued)


security do not make
periodic interest payments.
Instead, the security holder receives interest at
the maturity date, the interest being the
difference between face value (maturity value
or par value) and the purchase price.
Copyright 2014 Diane Scott Docking
7
T-Bill Quote Example:
As of June 9, 2014:
Maturity
Bid
12/11/2014
0.045
Bond Equivalent Yield
Discount Rate
Asked
0.040
Chg
0.005
Asked Yield
0.041
Change from
yesterday’s closing
Asked Quote

Quote is end of day 6/9/2014, assume 2 days to settle (this can vary) so
day 1 = 6/11/2014…12/11/2014 is last trading day. So 184 days to
maturity.

http://online.wsj.com/mdc/public/page/2_3020-treasury.html?mod=wsj_mdc_additional_interestrates
Copyright 2014 Diane Scott Docking
8
Bid & Ask Facts

- what dealers will pay for security (or what investors can sell it for)
- what dealers will sell security for (or what investors can buy it for)

- is the dealers profit or markup
l
l

Bid price
Spread is
Ask price
in T-Bill market because market is so deep
Bid-ask quotes for T-bills are bid yields and ask yields
- Bid yields
- As yields
Ask yields
, prices
Copyright 2014 Diane Scott Docking
9
Calculating Yields/Prices on U.S. Treasury Bills

Treasury bills are priced on a discount rate
basis, idy or DR, is:
DR  i
dy

Discount
Face
where : Discount

360
n
 Face  Price
n  days to maturity
Price  Face  Discount
where : Discount
n 

  Face  i dy 
360 

Copyright 2014 Diane Scott Docking
10
Calculating Yields/Prices on U.S. Treasury Bills

The Wall Journal lists T-Bill yields on a bond equivalent basis (asked yield)
Asked yield  ibey 

Price

365
n
The effective annual return/rate
EAR  i eff

Discount

 ibey  

 1  

365
n



365
n
1
 Face 
 

 Price 
365
n
1
Relationship between DR and Asked Yield (ibey):
ibey 
DR  365
360   DR  n 
Copyright 2014 Diane Scott Docking
11
Wall Street Journal Example:

Cost to buy $1,000,000 of T-bills:
Discount

  $1,000,000

 . 0004 
184 
 $ 204 . 44

360 
Price  1, 000 , 000  204 . 44  __________ ____

Asked Yield calculation:
ibey 

204.44
999,795.56

365
 . 00040563
 0 . 040563 %  _______
184
Effective Return calculation:

EAR  1 

 . 00040563

 365 184

 

365
184
 1  0 . 040567 %
 1,000,000
EAR  
 999,795.56
Copyright 2014 Diane Scott Docking



365
184
 1  0 . 040567 %
12
Problem: Calculating the T-bill rates

You pay $996.37 for a 28-day T-bill. It is worth
$1,000 at maturity. What is its discount rate? Asked
Yield? Effective Annual Return?
Copyright 2014 Diane Scott Docking
13
Solution to Problem: Calculating the T-bill rates

What is its discount rate?
DR  i dy 
F P

360
F
n
where F = face, P = price, and n = days to maturity
DR  i dy 
1, 000  996 . 37
1, 000

360
 _________
28
Copyright 2014 Diane Scott Docking
14
Solution to Problem: Calculating the T-bill rates

What is its ask yield (or bond equivalent yield)?
ibey 
F P

365
P
n
where F = face, P = price, and n = days to maturity
ibey 
1, 000  996 . 37
996 . 37

365
 __________ _
28
Copyright 2014 Diane Scott Docking
15
Solution to Problem: Calculating the T-bill rates

What is its effective annual return?
EAR  i eff
EAR  i eff
 Face 
 

 Price 
 1,000 
 

 996.37 
365
n
1
365
28
 1  __________ _
Copyright 2014 Diane Scott Docking
16
T-Bill Auction
Noncompetitive Bidding




All non-competitive bids accepted.
Specify quantity only.
Maximum bid
.
Price is the competitive auction yield price.
Copyright 2014 Diane Scott Docking
17
T-Bill Auction
Competitive Bidding





Specify price (as a yield %) and quantity desired.
Minimum purchase $100
Single price auction used since 1998
Treasury accepts highest bids prices (lowest bid yields)
Maximum amount sold to any one buyer is 35% of
offering amount
Copyright 2014 Diane Scott Docking
18
Treasury
Bill
Offering
http://www.treasurydirect.gov/instit/annceresult/press/preanre/2014/A_20140123_4.pdf#page=1&zoom=auto,0,761
Copyright 2014 Diane Scott Docking
19
Treasury
Bill
Auction
Results
http://www.treasurydirect.gov/instit/annceresult/press/preanre/2014/R_20140127_2.pdf
Copyright 2014 Diane Scott Docking
20
T-Bill rates vs. Inflation
Copyright 2014 Diane Scott Docking
21
Example of a T-Bill Auction
The Treasury is auctioning off $120 million in 13-week (91 day)
T-bills. The following bids are received:
Noncompetitive bids: $10 million
Competitive bids:
Alpha Institution $42 mill.
4.000% bid yield
Delta Institution $10 mill.
4.200% bid yield
Gamma Fund
$20 mill.
4.250% bid yield
Beta Fund
$18 mill.
4.110% bid yield
Epsilon Fund
$40 mill.
4.200% bid yield
Chi Institution
$10 mill.
4.125% bid yield
Copyright 2014 Diane Scott Docking
22
Example of a T-Bill Auction (cont.)
1.
2.
3.
4.
5.
6.
Which institutions will have their bids filled? By how
much?
What is the “stopout rate” or “stop yield” or “high yield”?
What was the price paid by the winning bidders?
What is the $ amount of the funds received by the
Treasury?
What is the bank equivalent yield (i.e. ask yield)?
What is the Treasury’s annualized interest cost from this
auction (i.e., effective yield)?
Copyright 2014 Diane Scott Docking
23
Example of a T-Bill Auction (cont.)
1. Maximum bid amount = 35% x $120 million = $42 million
Amount available after non-competitive bids of $10 mill. filled = $110 million
Bidder
Bid Price
Alpha
4.000%
Beta
4.110%
Chi
4.125%
Delta
4.200%
Epsilon
4.200%
Gamma
4.250%
$ Amount Bid
Running Balance
2.
3. Discount
91 

 100  . 0420 
  1.061667
360


Price  1 00  1.061667
Copyright 2014 Diane Scott Docking
 ______
24
Example of a T-Bill Auction (cont.)
4.
Treasury receives:
91 

  $120 mill.  . 0420 
 $ 1.274 mill.

360 

Price  $120 mill.  $1.274  __________ ____
Discount
5.
Ask Yield:
ibey 
6.
1.274
118.726

365
 __________ __
91
Effective Yield:

EAR  1 

 . 0430

 365 91





365
91
 1  ______
or
 120 mill.

EAR  

 118.726 mill. 
Copyright 2014 Diane Scott Docking
365
91
 1  4.374%
25
Federal Funds


lending and borrowing
Fed district bank debits and credits accounts for purchase
(borrowing) and sale (lending)
•
•
Fed Funds _______________________- this is a bank liability.
Fed Funds _____________ - this is a bank asset.

Usually $5 million or more
Federal funds rate usually slightly higher than T-bill rate
Fed Funds target vs. Actual FF rate

ibey  i ff 365

Current FF target: http://www.frbdiscountwindow.org/
Effective FF rates:




360

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm
Copyright 2014 Diane Scott Docking
26
Repurchase Agreements (Repo)

Repo
l
l

Bank Financing – Source of funds – a bank liability
“Security sold under agreement to repurchase” at given
price in future.
Reverse Repo
l
l
Bank Investment/Loan – Use of funds – a bank asset
“Security purchased under agreement to resell” at given
price in future.
Copyright 2014 Diane Scott Docking
27
Repurchase Agreements (cont.)

Negotiated market rate.
l
l
l
l

Over telecommunications network
Dealers and brokers used or direct placement
No secondary market
Rate is lower than the fed funds rate, since it is backed up by a
security.
Used by:
l
l
l
Federal Reserve in open market operations.
Government securities dealers to secure funds to invest in new
Treasury issues.
Banks to secure funds to meet temporary liquidity needs as well as
lend funds when they have excess reserves.
Copyright 2014 Diane Scott Docking
28
Estimating Repo Rate

For Repurchase agreements:
Repo rate 
Prepo  P0
P0



x
360
n
Prepo= Repurchase price of security, which equals selling
price plus interest
P0= Sales price of the security
N=number of days to maturity
Copyright 2014 Diane Scott Docking
29
Example: Reverse Repurchase Agreement (Aka: Securities
Purchased Under Agreement to Resell)

Bank buys a security from a customer for $100,000 with the agreement to
sell it back to customer for $101,000 within 90 days.
l
l

Bank takes possession and title of security
In effect, a loan with collateral
Bank accounting entries:
Dr) Reverse Repurchase Agreements
Cr) Cash
...
Dr) Cash
Cr) Reverse Repurchase Agreements
Cr) Interest Revenue

$100,000
$100,000
$101,000
$100,000
1,000
Repo Rate:
Repo rate 
Prepo  P0
P0
x
360
n

101,000  100,000
100,000
Copyright 2014 Diane Scott Docking
x
360
 4%
90
30
Example: Repurchase Agreement (Aka: Securities Sold Under
Agreement to RePurchase)

Bank sold its own security to a dealer/bank for $100,000 with the
agreement to repurchase it within 90 days for $101,000. The value of the
securities that the bank sold was $120,000.
l
l

Bank releases possession and title of security
In effect, a bank debt with security used collateral
Bank accounting entries:
Dr) Cash
$100,000
Cr) Repurchase Agreement
Dr) Securities Sold Under Repo $120,000
Cr) AFS Securities
…..
Dr) Repurchase Agreement
$100,000
Dr) Interest Expense
1,000
Cr) Cash
Dr) AFS Securities
$120,000
Cr) Securities Sold Under Repo
Copyright 2014 Diane Scott Docking
$100,000
$120,000
$101,000
$120,000
31
Repurchase Agreement (Aka: Securities Sold Under Agreement
to RePurchase)

Bank sold its own security to a dealer/bank with the
agreement to repurchase it within so many days (say 90 days).

Repo Rate:
Repo rate 
PRepo  P0
P0
x
360
n

101,000  100,000
100,000
Copyright 2014 Diane Scott Docking
x
360
 4%
90
32
Commercial Paper







Alternative to bank loan
Short-term debt instrument
• Initial maturities ____________ days
• Usually ___________ days.
Used only by well-known and creditworthy firms
• ________________
• Credit ratings important
Minimum denominations of $100,000
Placement
• Directly by a sales force of the borrowing firm.
• Indirectly through dealers.
Not a large secondary market (generally held to maturity)
Sold at a discount from par – just like T-bills.
Copyright 2014 Diane Scott Docking
33
Commercial Paper Rates vs. Prime Rates
Copyright 2014 Diane Scott Docking
34
Commercial Paper Volume
Copyright 2014 Diane Scott Docking
(M&E, 7 ed., Ch. 11)
35
Commercial Paper (continued)

Directly-Placed Versus Dealer-Placed
Paper

Commercial paper is classified as either
l
l
directly placed paper is sold by the issuing firm
directly to investors without using a securities dealer
as an intermediary
dealer-placed instruments are when the issuer uses
the services of a security firm to sell its paper
Copyright 2014 Diane Scott Docking
36
Negotiable Certificates of Deposit

Development of the CD Market
l
l

Issued by Citibank in 1961.
Offset declining demand deposits as a source of funds.
CD Issuers
l
Money center banks and large regional banks are the
primary issuers of domestic CDs
Copyright 2014 Diane Scott Docking
37
Negotiable Certificates of Deposit

Characteristics of Negotiable CDs
l
Large denomination time deposit, less than six month's
maturity.
•
•
l
Negotiable - may be sold and traded before maturity.
•
•
l
minimum is ______ days
most are less than _________
Primary market - denominations of at least $100,000.
Secondary market - $1 million or more.
Issued at face value with coupon rate.
•
Interest computed on a 360 day year.
•
Rate negotiated between buyer and seller.
•
Rates higher than on T-Bills
o
higher credit risk, lower marketability and higher taxability.
Copyright 2014 Diane Scott Docking
38
Copyright 2014 Diane Scott Docking
39
Example 5-9 in text: Negotiable Certificates of Deposit
Q1: A bank has issued a 6-month (182 day), $1 million NCD
with a 0.72% annual interest rate. How much will the NCD
holder receive at maturity?
A:

 n
FV  Face   Face  i  
 360


,

where n  days to maturity

 182  
FV  $ 1, 000 , 000   $ 1, 000 , 000  0 . 0072  

360



 $ 1, 000 , 000  3 , 640

 $ 1, 003 , 640
Copyright 2014 Diane Scott Docking
40
Example 5-9 in text: Negotiable Certificates of Deposit
Q2: Immediately after the CD is issued, the secondary market
price falls to $999,651. What is the new yield on the CD?
A: 𝑖 =
360 𝐹𝑉
𝑛 𝑃𝑉
−1 =
360 1,003,640
182 999,651
− 1 = 0.7893%
Copyright 2014 Diane Scott Docking
41
Example 5-9 in text: Negotiable Certificates of Deposit
Q3: After the price drop, what is the EAR on the NCD?
A:
EAR  i eff

 ibey  

 1  

365
n




 . 007893
 1  
 365 182


 

365
n
1
365
182
 1  0 . 7909 %
Copyright 2014 Diane Scott Docking
42
Negotiable CD Rates
(M&E, 7ed., Ch. 11)
43
Copyright 2014 Diane Scott Docking
Comparing Money Market Securities : A comparison of rates
Copyright 2014 Diane Scott Docking
44
Bankers' Acceptances
1.
Time draft
1.
2.
2.
3.
4.
5.
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, 90 days –270 days max.
Copyright 2014 Diane Scott Docking
45
Exhibit: Bankers Acceptance (see chart next page)
1)
2)
3)
4)
5)
6)
7)
8)
9)
10)
11)
Importer (U.S.) places P.O. for goods.
Exporter (Japan) demands payment before shipment. So, Importer asks
American Bank to issue a Letter of Credit.
American Bank presents LOC to Japanese Bank.
Japanese Bank notifies Exporter that they have a LOC and okay to ship.
Exporter ships goods.
Exporter sends shipping documents and Time Draft (like an invoice) to
Japanese Bank.
Japanese Bank sends shipping documents and Time Draft to American Bank.
American Bank “stamps” Draft as “accepted” and a BA is created. American
Bank will pay owner of BA (i.e. the Draft) so many $ in n-days.
American Bank returns BA to Japanese Bank who gives it to Exporter.
Exporter can sell BA at its current discounted PV or hold it until maturity.
At maturity of BA, Importer pays American Bank, who pays holder of BA.
Copyright 2014 Diane Scott Docking
46
Exhibit: (Bankers Acceptance)
Purchase Order
5
Shipment of Goods
11 AB pays holder
of B/A at maturity
8
B/A created
American Bank
(Importer’s Bank)
3
B/A sent to Exporter who keeps or sells it
4
6
10
L/C
7 Shipping Documents & Time Draft
Draft Accepted (B/ACreated)
9
Copyright 2014 Diane Scott
Docking
Shipping Documents & Time Draft
2
L/C Notification
Exporter
L/C (Letter of Credit) Application
Importer
1
B/A sent to Japanese Bank
Japanese Bank
(Exporter’s Bank)
47
Banker’s Acceptance
4
8
Copyright 2014 Diane Scott Docking
Eurodollars

Deposits of U.S. dollars in banks located
outside the U.S.
l
London interbank bid rate (LIBID)
•
l
London interbank offer rate (LIBOR)
•



The rate paid by banks buying funds
The rate offered for sale of the funds (rate paid on ED)
Time deposits with fixed maturities
Largest short term security market in the
world
No reserve requirements at banks outside U.S.
Copyright 2014 Diane Scott Docking
49
Comparing Money Market Securities: Money Market Securities
and Their Depth
Copyright 2014 Diane Scott Docking
50