Fin221: CHAPTER 7
The Money Markets
Overview of the Money Market
•
•
•
•
•
•
•
•
•
Short-term debt market -- most under 120 days.
A few high quality borrowers.
Many diverse investors.
Standardized securities -- one security is a close
substitute for another.
Good marketability -- secondary market.
Large, wholesale open-market transactions.
Many brokers and dealers are competitively
involved in the money market.
Payment in Federal Funds - immediately available
funds.
Physical possession of securities seldom made
2
Money Market Securities Outstanding
3
Economic Role of Money Market (MM)
• The money market is a market for liquidity
– Liquidity is stored in MM by investing in MM
securities.
– Liquidity is bought in MM by issuing securities
(borrowing).
• Liquidity status of commercial banks is
reflected.
• Provides a place for Fed’s reserve
transactions (open market transactions)
• Indicator of economic conditions.
4
Money Market Instruments (securities)
• Characteristics of Money Market Instruments
 Low default risk.
 Short maturity.
 High marketability.
• The major money market instruments include
Treasury bills (T-bills), repurchase agreements,
commercial papers, Negotiable CDs, Banker’s
acceptances -- etc.
5
Treasury Bills
• Characteristics
– Sold on discount basis.
– Maturities up to one year.
– Minimum denomination is usually $10,000, but
smaller investors can invest in multiples of
$1,000 through the Treasury Direct Program
offered by the Fed.
– Lowest interest rate of all MM securities is the
3-month T-Bill
– T-bills are sold through an auction process
using both competitive and noncompetitive
bids.
6
Auctioning New Bills
• Competitive Bids
– Specify price and quantity desired.
– Minimum $10,000 & in multiples of $5,000 above
$10,000.
– Mostly professionals - dealers & banks.
– No more than 35 percent of an issue is sold under the
competitive bidding process in order to ensure a
competitive secondary market.
• Non-competitive Bids
– All non-competitive bids accepted.
– Specify quantity only.
– Maximum $1,000,000.
– Mostly individuals & small investors.
– Pays weighted average price of competitive bids
accepted.
7
Treasury Bills
• Pricing Treasury Bills
– Treasury bills are priced on a bank discount rate
basis, a traditional yield calculation.
– The bank discount rate, yd , is:
y 
d
Par  Price
360

 100%
Par
Days To Maturity
8
Treasury Bills
– The Wall Journal lists T-Bill yields on a bond
equivalent basis where the discounted price is
the denominator and 365 days is used as the
annualizer.
Par  Price
365
y 

 100%
be
Price
Days To Maturity
– The effective annual yield assuming
compounding a year is:
Effective Yield = [(Face Value/Price)365/D -1] x 100%.
9
Repurchase Agreements (Repo)
• Bank Financing - Source of funds
– Security sold under agreement to repurchase at given
price in future.
– Way to include corporate business in Federal Funds
market.
– Negotiated market rate.
• Bank Investment – Reverse Repo
– Security purchased under agreement to resell at given
price in future.
– Smaller banks are able to invest excess liquidity in a
secured investment.
10
Repurchase Agreements (Repo)
• The interest rate on a repo is lower than the fed
funds rate, since it is backed up by a security.
• Repos are used by the Federal Reserve in open
market operations.
• Government securities dealers use repos to
secure funds to invest in new Treasury issues.
• Banks participate in the repo market to secure
funds to meet temporary liquidity needs as well
as lend funds when they have excess reserves.
11
Commercial Paper
•
•
•
•
•
•
Short term (one to 270 days); Unsecured.
Large denominations ($100,000 and up)
Issued by high - quality borrowers.
A wholesale money market instrument.
Sold at a discount from par, directly or dealer sold.
Backed by bank lines of credit, which support or
guarantee quality.
• Credit ratings important for commercial paper issuance.
• Placement
– Directly by a sales force of the borrowing firm.
– Indirectly through dealers.
12
The Commercial Paper Market
• Major investors
–
–
–
–
–
Commercial banks.
Insurance companies.
Nonfinancial business firms.
Bank trust departments.
State and local pension funds.
• Banks are involved
–
–
–
–
Backup lines of credit.
Act as agents in issuance.
Hold notes in safekeeping.
Facilitate payment in Federal Funds.
13
The Commercial Paper Market
• Like T-Bills commercial papers are sold on a
discount basis, & the same formula could be used
to calculate the yield of CP
Yield = ([(Face value - purchase price)/ Face value]
X 360/ No. of days to maturity) X 100%
• Similarly a bond equivalent yield can be
calculated for CPs.
14
Negotiable Certificates of Deposit
• Characteristics of Negotiable CDs
– Large denomination time deposit, less than six month's
maturity.
– Negotiable - may be sold and traded before maturity.
– Issued at face value with coupon rate.
– Interest computed on a 360 day year.
– Primary market sales have CDs of denominations of at
least $100,000.
– Secondary market deals are for $1 million or more.
– Payment by banks from fed funds in NY.
– Interest rates on CDs are higher than on T-Bills - higher
credit risk, lower marketability and higher taxability.
15
Negotiable Certificates of Deposit
• Development of the CD Market
– Issued by Citibank in 1961.
– Offset declining demand deposits as a source of funds.
• The CD Market
– Rate negotiated between buyer and seller.
– Market is sensitive to rates above or below the market
rates.
– Rates are lower for money center banks and are tiered
upward for regional banks.
– Purchased mainly by corporate businesses.
16
Bankers' Acceptances
• Time draft - order to pay in future.
• 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, or 90 days max of 180.
17
Creating a Banker's Acceptance
• Importer initiates purchase from foreign exporter,
payable in future. Importer needs financing;
exporter needs assurance of payment in future.
• Importer's bank writes irrevocable letter of credit for
exporter
– Specifies purchase order.
– Authorizes exporter to draw time draft on bank.
• Importer's bank accepts draft (liability to pay) and
creates a banker's acceptance.
• Advantage of a banker's acceptance (BA)
– Exporter receives funds by selling BA in the market.
– Exporter eliminates foreign exchange risk.
– Importer's bank guarantees payment of draft in future.
18
Tracing a Banker’s Acceptance Transaction
19
Money Market Participants
Major Participants in the Money Market
include:
•
•
•
•
Commercial Banks
The Central Bank (The Fed)
Dealers in MM Securities
Major corporations
20
Commercial Banks
• Most important participant in the MM
• Bank assets or investments
– Treasury bills.
– Agency securities.
– Bankers' acceptances (from other banks).
– Federal Funds sold.
– Repurchase agreements (securities
purchased under agreements to resell).
21
Commercial Banks,cont.
• Bank liabilities or borrowing
– Negotiable CDs.
– Commercial paper.
– Bankers' acceptances.
– Federal Funds purchased.
– Repurchase agreements (securities sold
under agreements to repurchase).
• MM securities provides sources and uses
of liquidity due to wide fluctuations in loans
and deposits.
22
The Central Bank (The Fed) in the Money
Markets
• Money market securities is the major asset
category of the Central Bank.
• Open-market operations (buying and selling
of MM securities by Fed) is the primary tool
for implementing monetary policy.
– Purchase - increases member bank reserves.
– Sale - decreases member bank reserves.
23
Dealers in MM Securities
• Involved in both primary and secondary
markets.
• Purchases new treasury debt and resells it
(primary).
• "Makes a market" by buying/selling (dealer)
securities (bid/ask).
• Purchases are financed by repurchase
agreements or fed funds.
• Dealers have a very small capital base and
are highly leveraged.
24
Money Market Position of Major Participants
25
Interrelationship of Money Market Interest
Rates
• Various MM instruments are close
substitutes in investment portfolios.
• Interest rates move together over time.
• Deviations from traditional spreads are
quickly eliminated by interest rate
arbitrage.
26