Money Markets
Money Markets
• Short-term debt instruments
• Maturity of < 1 year
• Services immediate cash needs
– Borrowers need short-term “working capital”
– Lenders need an interest-earning “parking space” for excess
funds
• Instruments trade in an active secondary market
– Liquid market provides easy entry & exit for participants
– Speed and efficiency of transactions allows cash to be “active”
even for very short periods of time (over night).
• Market size in 2008: .$ 8 Trillion
Money Markets
Large denominations
– Units of $1 - $10 million
– Transactions costs low in relative terms
– Individual investors do not participate in this market
Low default risk
– Only high quality borrower participate
– Low time maturities reduce the risk of “changes” in borrower
quality
Insensitive to interest rate changes
– Maturity (< 1 year) too short to be adversely affected, in general,
by changes in rates
Money Market Securities
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Treasury Bills
Federal Funds
Repurchase agreements
Commercial paper
Negotiable Certificates of Deposit (CDs)
Bankers acceptances
All of these instruments are what comprise YOUR money
market investment account at your local bank
Money Market Participants
(excluding brokers/dealers)
Security
Borrower (issuer)
Lender (investor)
Treasury bills
U.S. Treasury (Federal
Government)
Commercial banks,
Mutual Funds,
Corporations, etc.
Federal Funds &
Commercial banks,
Repurchase agreements other FIs
Commercial banks,
other FIs
Commercial paper
Corporations,
Commercial banks
Corporations, Mutual
funds, other FIs
Negotiable CDs
Commercial banks
Corporations, Mutual
funds, other FIs
Bankers acceptances
Commercial banks
Corporations,
Community banks
Treasury securities
Issued by Federal Government:
•
Finance annual deficits (budget shortfalls)
•
Refinance maturing debt
Standard maturities:
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4, 13, 26 or 52 weeks (1, 3, 6, 12 months)
Denominations:
•
Face value $1,000
•
Round lots are sold as $5 million (new issues)
Risk:
•
Assumed risk/default free
Interest rate:
•
No coupon payment
•
T-bills sold at a discount to face value (implied rate of return)
Treasury Auctions
(Primary Market)
Auction cycle:
Weekly for 4, 13 & 26 week securities
Auction process: Single price auction (all winning bidders by the same)
Competitive bids
1.
2.
3.
Requires $1 million minimum bid, generally made by dealers and large institutions
Bidders submit a quantity and lowest yield (highest price) that they are willing to
accept
No single bidder can win more than 35% of the issue.
Non-competitive bids:
1.
2.
3.
Purchasers seeking less than $1 million do not participate in the auction
Indicate the quantity of securities desired to be purchased at the stop yield
Get preferential allocation (all bids are met)
Non-public bids:
1.
2.
The Federal Reserve Bank participates in this market (open market transactions)
and submits the quantity that they wish to purchase
This quantity is guaranteed similar to non-competitive bids.
Treasury Auctions
Winning bid:
1.
2.
Competitive bids are sorted from lowest to
highest yield (highest to lowest price)
After non-competitive and non-public
purchaser orders are filled, the Treasury
accepts the highest price (lowest yield) bids
until the issuance is completed
3.
The highest yield accepted by the treasury
is the “stop yield”
4.
Bidders above the stop yield are “shut out”
5.
Bidders at the stop yield have their orders
filled on a pro rata basis
yield (%)
3.50
3.52
3.54
3.57
3.60
3.61
3.62
3.63
3.64
3.65
> $7.5 Billion
st op yield
percent
of face
value
stop yield
Pro rated
Source: www.publicdebt.treas.gov
Treasury Auctions
Noncompetitive Bids
$239 million
total
Bid Price
(% of face)
1
competitive
2
3
4
winners
99.6633222%
Stop yield
losers
5
6
7
$15,761 million
$15,522 million
Quantity of
T-bills
Secondary Treasury Market
Largest of any Money Market security:
Participants: Buy for their own account or on behalf of their customers
1.
2.
3.
4.
Government approved dealers (approx 20, designated by the NYFRB)
Secondary dealers (approx 500 trade in secondary market)
Commercial banks, insurance companies, pension funds
Federal reserve bank
Trading: takes place between…
1.
2.
3.
Primary market dealers (fed wire transfers requiring no paper work)
Dealers and their customers
Volume greater than $100 billion daily (larger than NYSE)
Prices: determine the interest rate paid (T-bills are sold at discount)
1.
Dealers earn a bid-ask spread in secondary market
Regulation: Very little government oversight since traders are large institutions
Secondary Treasury Market
J.P. Morgan Chase
sells $10m. In T-bills
Between government security
dealers
Lehman Brothers
buy $10m. In T-bills
Federal Reserve Bank of New York
Transfers $10m. In T-bills from
J.P. Morgan Chase to Lehman Brothers
Transaction recorded in Fed’s Book-Entry System
Purchase by individual
Individual
buy $50,000
in T-bills
Local Bank
or Broker
J.P. Morgan
Chase
sell $50,000
in T-bills
Source: reprinted from Saunders Cornett “Financial Markets and Institutions, 3rd
Edition”, McGraw-Hill Irwin, 2006.
FRBNY
-$50,000 in T-bills
from J.P. Morgan
Chase’s account
+ $50,000 T-bill
to Individual
Federal Funds
Short term transactions between financial institutions:
1.
2.
3.
4.
Term is generally over night/week-end
Not backed by collateral - unsecured loans
Highly liquid market
Depository institutions use this market to buy/sell excess deposits in order to
manage their liabilities.
5. For banks, this is sometimes referred to as “hot money”
Federal Fund Yields:
1. No coupon payment - sold at a discount
2. Quoted rates assume a 360 day year, conversion  ibond = iff (365/360)
Federal Funds Market:
1. Trades take place between banks that buy/sell excess reserves held at their
federal reserve bank
2. Banks or FIs that are not FRB members can use a correspondent bank (that is a
member) to conduct the transaction
3. Transactions take place over the Fedwire
Repurchase agreements
Definition: selling an asset with an explicit agreement to repurchase the asset
after a set period of time
Example: A bank has deficient reserves and needs to borrow overnight.
1. Bank A sells a treasury security to Bank B at P0
2. Bank A agrees to buy the treasury back at a higher price Pf > P0
3. Bank B earns a rate of return implied by the difference in prices
iRA =
Pf – P0
360
x
P0
days
4. Since the loan is backed by collateral, the rate is usually lower than the
rate available in the Federal Funds market
5. Fed conducts open market transactions through RAs, using transactions
that are generally less than 15 days.
Commercial Paper
Unsecured short-term promissory note:
1.
2.
3.
4.
Terms:
1.
2.
3.
4.
5.
Generally issued by corporations or financial institutions
Sold directly to institutions or through dealers
Is the largest (total $ value) of the money market securities
Funds used to finance working capital requirements
Sold in denominations of $100k, $250k, $500k and $1 million.
Maturity less than 270 days (registration required otherwise)
Common maturities are between 20 and 45 days
Sold at discount and held to maturity – no active secondary market
Yields are quoted based on 360 day year
Issuers need good reputation to issue:
1. Issuers must have excellent credit and be rated by a rating agency
2. Low cost alternative to bank loans, but requires that lenders can tell your “type” –
the adverse selection problem
3. Firms in trouble are immediately cut off from this market in the same way that
troubled banks are quickly cut off from the federal funds market
• Tyco’s downgrade from tier 1 to tier 3 forced them out of the market
Negotiable Certificates of Deposits (CDs)
A bank issued time deposit: Not a demand deposit
1.
2.
3.
4.
Fixed interest rate and maturity
Terms are negotiable (e.g. 6 month at 4.1% or 1 year at 5.2%)
Common maturities are less than 12 months
These funds are more “certain” to banks that demand deposits that can leave at
any time.
Terms and Trading:
1.
2.
3.
4.
Most CDs are sold directly to investors who hold to maturity
Investors receive both principal and interest
Rates are quoted using a 360 day year
A network of about 15 brokers/dealers make a secondary market
Risk:
1. Small CDs are similar to demand deposits wrt insurance
2. Large CDs (called Jumbo CDs) are not federally insured through FDIC
3. Large banks, with perceived lower risk due to too-big-to-fail (TBTF) doctrine, often
have lower rates than smaller banks
Bankers Acceptance
Banks act as intermediaries between trading partners:
1. Banks guarantee payments to secure orders of goods from manufacturers
2. Are a type of “letter of credit” that guarantees a payment by the bank on a specific
date
3. Particularly useful between foreign trading partners where there is a high level of
asymmetric information – Banks resolve this AI
Example:
1. Lubbock Acme Enterprises orders 50,000 Red Raider flags from a Peruvian textile
manufacturer
2. The Peruvian manufacturer pulls out a globe to figure out where Lubbock is – they
have no idea who the buyer is.
3. Since the Peruvian manufacturer has to retool the factor to make the flags, they
want some guarantee that Lubbock Acme is actually going to pay
4. Lubbock Acme doesn’t want to pay until they know that they are going to get the
goods delivered as promised.
5. Bank of America steps in as intermediary with a contract that provides a credible
delivery of payment once the goods are delivered.
6. Bank of America agrees to pay the amount of the BA if the Lubbock Acme fails to
pay
Bankers Acceptance
Locality of BAs: San Francisco, New York and Chicago originate most BAs
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Only the largest banks engage in this market
Trading:
1. Trading of BAs take place on secondary markets until such time that the payment is
delivered
2. Maturity is typically 30 to 270 days
3. Denominations are bundled into $100,000 and $500,000 levels for trading
4. If the manufacturer has an immediate need for cash, they can sell the BA prior to
delivery of the goods.
Risk: Default risk is low since both the bank and importer must default on payment, and
resulting interest rates are low
Eurodollars
Eurodollar: U.S. dollars held as deposits in foreign banks
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Risk:
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Corporations often find it more convenient to hold deposits at foreign banks to
facilitate payments in their foreign operations
Can be held in U.S. bank branches or foreign banks
Dollar denominated deposits are referred to as Eurodollars
They are not subject to reserve requirements
Nor are they eligible for FDIC depositor insurance (U.S. government is not interested
in protecting foreign depositors)
The resulting rates paid on Euro dollars are higher (higher risk)
Trading:
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Over night trading as in the Federal Funds market
Eurodollars are traded in London, and the rates offered are referred to as LIBOR
(London Interbank Offered Rate)
Rates are tied closely to the Fed Funds rate
Should the LIBOR rate drop relative to the Fed Funds rate, U.S. banks can
balance their reserves in the Eurodollar market (arbitrage)
Money Market Rates