Chapter 6
Money Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
Chapter Outline
Money market securities
 Institutional use of money markets
 Valuation of money market securities
 Risk of money market securities
 Interaction among money market yields
 Globalization of money markets

2
Money Market Securities

Money market securities:
 Have
maturities within one year
 Are issued by corporations and governments
to obtain short-term funds
 Are commonly purchased by corporations and
government agencies that have funds
available for a short-term period
 Provide liquidity to investors
3
Money Market Securities (cont’d)

Treasury bills:
 Are
issued by the U.S. Treasury
 Are sold weekly through an auction
 Have a par value of $1,000
 Are attractive to investors because they are backed
by the federal government and are free of default risk
 Are liquid
 Can be sold in the secondary market through
government security dealers
4
Money Market Securities (cont’d)

Treasury bills (cont’d)
 Investors




in Treasury bills
Depository institutions because T-bills can be easily
liquidated
Other financial institutions in case cash outflows exceed cash
inflows
Individuals with substantial savings for liquidity purposes
Corporations to have easy access to funding for
unanticipated expenses
5
Money Market Securities (cont’d)

Treasury bills (cont’d)
 Pricing

Treasury bills
The price is dependent on the investor’s required rate of
return:
Pm  Par /(1  k )n


Treasury bills do not pay interest
To price a T-bill with a maturity less than one year, the
annualized return can be reduced by the fraction of the
year in which funds would be invested
6
Computing the Price of a
Treasury Bill
A one-year Treasury bill has a par value of
$10,000. Investors require a return of 8 percent
on the T-bill. What is the price investors would
be willing to pay for this T-bill?
Pm  Par /(1  k )n
 $10,000 /(1.08 )
 $9,259
7
Money Market Securities (cont’d)

Treasury bills (cont’d)
 Treasury bill auction
 Investors submit bids on T-bill applications for the maturity of
their choice
 Applications can be obtained from a Federal Reserve district
or branch bank
 Financial institutions can submit their bids using the Treasury
Automated Auction Processing System (TAAPS-Link)



Institutions must set up an account with the Treasury
Payments to the Treasury are withdrawn electronically from the
account
Payments received from the Treasury are deposited into the
account
8
Money Market Securities (cont’d)

Treasury bills (cont’d)
 Treasury bill auction (cont’d)
 Weekly auctions include 13-week and 26-week T-bills
 4-week T-bills are offered when the Treasury anticipates a
short-term cash deficiency
 Cash management bills are also occasionally offered
 Investors can submit competitive or noncompetitive bids
 The bids of noncompetitive bidders are accepted
 The highest competitive bids are accepted
 Any bids below the cutoff are not accepted
 Since 1998, the lowest competitive bid is the price applied to
all competitive and noncompetitive bids
9
Money Market Securities (cont’d)

Treasury bills (cont’d)
 Estimating

the yield
T-bills are sold at a discount from par value
The yield is influenced by the difference between the
selling price and the purchase price
 If a newly-issued T-bill is purchased and held until
maturity, the yield is based on the difference between par
value and the purchase price

10
Money Market Securities (cont’d)

Treasury bills (cont’d)
 Estimating

the yield (cont’d)
The annualized yield is:
YT 
 Estimating

SP  PP 365

PP
n
the T-bill discount
The discount represents the percent discount of the
purchase price from par value for newly-issued T-bills:
Par  PP 360
T - bill discount 

Par
n
11
Computing the Yield of a
Treasury Bill
An investor purchases a 91-day T-bill for $9,782. If
the T-bill is held to maturity, what is the yield
the investor would earn?
SP  PP 365

PP
n
10,000  9,782 365


9,782
91
 8.94%
YT 
12
Estimating the T-Bill Discount
Using the information from the previous example,
what is the T-bill discount?
Par  PP 360

Par
n
10,000  9,782 360


10,000
91
 8.62%
T - bill discount 
13
Money Market Securities (cont’d)

Commercial paper:









Is a short-term debt instrument issued by well-known,
creditworthy firms
Is typically unsecured
Is issued to provide liquidity to finance a firm’s investment in
inventory and accounts receivable
Is an alternative to short-term bank loans
Has a minimum denomination of $100,000
Has a typical maturity between 20 and 270 days
Is issued by financial institutions such as finance companies and
bank holding companies
Has no active secondary market
Is typically not purchased directly by individual investors
14
Money Market Securities (cont’d)

Commercial paper (cont’d)
 Ratings




The risk of default depends on the issuer’s financial condition
and cash flow
Commercial paper rating serves as an indicator of the
potential risk of default
Corporations can more easily place commercial paper that is
assigned a top-tier rating
Junk commercial paper is rated low or not rated at all
15
Money Market Securities (cont’d)

Commercial paper (cont’d)
 Volume


of commercial paper:
Has increased substantially over time
Is commonly reduced during recessionary periods
 Placement



Some firms place commercial paper directly with investors
Most firms rely on commercial paper dealers to sell it
Some firms (such as finance companies) create in-house
departments to place commercial paper
16
Money Market Securities (cont’d)

Commercial paper (cont’d)
 Backing commercial paper
 Issuers typically maintain a backup line of credit


Allows the company the right to borrow a specified maximum
amount of funds over a specified period of time
Involves a fee in the form of a direct percentage or in the form
of required compensating balances
 Estimating the yield
 The yield on commercial paper is slightly higher than on a Tbill
 The nominal return is the difference between the price paid
and the par value
17
Estimating the Commercial
Paper Yield
An investor purchases 120-day commercial paper
with a par value of $300,000 for a price of
$289,000. What is the annualized commercial
paper yield?
Ycp
300,000 - 289,000 360


289,000
120
 11.42%
18
Money Market Securities (cont’d)

Commercial paper (cont’d)
 The commercial paper yield curve:
 Illustrates the yield offered on commercial paper at various
maturities
 Is typically established for a maturity range from 0 to 90 days
 Is important because it may influence the maturity that is
used by firms that issue CP
 Is similar to the short-term range of the Treasury yield curve
 Is affected by short-term interest rate expectations
 Is similar to the yield curve on other money market
instruments
19
Money Market Securities (cont’d)

Negotiable certificates of deposit (NCDs):
 Are
issued by large commercial banks and other
depository institutions as a short-term source of funds
 Have a minimum denomination of $100,000
 Are often purchased by nonfinancial corporations
 Are sometimes purchased by money market funds
 Have a typical maturity between two weeks and one
year
 Have a secondary market
20
Money Market Securities (cont’d)

Negotiable certificates of deposit (NCDs)
(cont’d)
 Placement
 Directly
 Through a correspondent institution
 Through securities dealers
 Premium
 NCDs offer a premium above the T-bill yield to compensate
for less liquidity and safety
 Premiums are generally higher during recessionary periods
21
Money Market Securities (cont’d)

Negotiable certificates of deposit (NCDs)
(cont’d)
 Yield
NCDs provide a return in the form of interest and
the difference between the price at which the NCD
was redeemed or sold and the purchase price
 If investors purchase a NCD and hold it until
maturity, their annualized yield is the interest rate

22
Money Market Securities (cont’d)

Repurchase agreements

One party sells securities to another with an agreement to
repurchase them at a specified date and price






Essentially a loan backed by securities
A reverse repo refers to the purchase of securities by one party
from another with an agreement to sell them
Bank, S&Ls, and money market funds often participate in repos
Transactions amounts are usually for $10 million or more
Common maturities are from 1 day to 15 days and for one, three,
and six months
There is no secondary market for repos
23
Money Market Securities (cont’d)

Repurchase agreements (cont’d)
 Placement
 Repo transactions are negotiated through a
telecommunications network with dealers and repo brokers
 When a borrowing firm can find a counterparty to a repo
transaction, it avoids the transaction fee

Some companies use in-house departments
 Estimating the yield
 The repo yield is determined by the difference between the
initial selling price and the repurchase price, annualized with
a 360-day year
24
Estimating the Repo Yield
An investor initially purchased securities at a price
of $9,913,314, with an agreement to sell them
back at a price of $10,000,000 at the end of a
90-day period. What is the repo rate?
SP  PP 360

PP
n
10,000,000  9,913,314 360


9,913,314
90
 3.50%
Repo rate 
25
Money Market Securities (cont’d)

Federal funds
 The
federal funds market allows depository
institutions to lend or borrow short-term funds from
each other at the federal funds rate




The rate is influenced by the supply and demand for funds in
the federal funds market
The Fed adjusts the amount of funds in depository
institutions to influence the rate
All firms monitor the fed funds rate because the Fed
manipulates it to affect economic conditions
The fed funds rate is typically slightly higher than the T-bill
rate
26
Money Market Securities (cont’d)

Federal funds (cont’d)
 Two
depository institutions communicate directly
through a communications network or through a
federal funds broker
 The lending institution instructs its Fed district bank to
debit its reserve account and to credit the borrowing
institution’s reserve account by the amount of the loan
 Commercial banks are the most active participants in
the federal funds market
 Most loan transactions are or $5 million or more and
usually have one- to seven-day maturities
27
Money Market Securities (cont’d)

Banker’s acceptances:


Indicate that a bank accepts responsibility for a future payments
Are commonly used for international trade transactions




An unknown importer’s bank may serve as the guarantor
Exporters frequently sell an acceptance before the payment date
Have a return equal to the difference between the discounted
price paid and the amount to be received in the future
Have an active secondary market facilitated by dealers
28
Money Market Securities (cont’d)

Banker’s acceptances (cont’d)
 Steps involved in banker’s acceptances
 First, the U.S. importer places a purchase order for goods
 The importer asks its bank to issue a letter of credit (L/C) on
its behalf




Represents a commitment by that bank to back the payment
owed to the foreign exporter
The L/C is presented to the exporter’s bank
The exporter sends the goods to the importer and the
shipping documents to its bank
The shipping documents are passed along to the importer’s
bank
29
Sequence of Steps in the Creation
of A Banker’s Acceptance
Purchase Order
1
Importer
Shipment of Goods
5
2
Exporter
4
L/C Notification
6
Shipping Documents & Time Draft
L/C Application
3
American Bank
(Importer’s Bank)
L/C
Shipping Documents
7 & Time Draft Accepted
Japanese Bank
(Exporter’s Bank)
30
Institutional Use of Money Markets



Financial institutions purchase money market securities
to earn a return and maintain adequate liquidity
Institutions issue money market securities when
experiencing a temporary shortage of cash
Money market securities enhance liquidity:



Newly-issued securities generate cash
Institutions that previously purchased securities will generate
cash upon liquidation
Most institutions hold either securities that have very active
secondary markets or securities with short-term maturities
31
Institutional Use of Money Markets
(cont’d)




Financial institutions with uncertain cash in- and
outflows maintain additional money market
securities
Institutions that purchase securities act as a
creditor to the initial issuer
Some institutions issue their own money market
instruments to obtain cash
Many money market transaction involve two
financial institutions
32
Valuation of Money Market
Securities

For money market securities making no
interest payments, the value reflects the
present value of a future lump-sum
payment
 The
discount rate is the required rate of return
by investors
33
Valuation of Money Market
Securities (cont’d)

Explaining money market price movements
 The
price of a noninterest-paying money market
security is:
Pm  Par /(1  k )n
 A change
in the price can be modeled as:
Pm  f ( k ) and k  f ( Rf , RP )
34
Valuation of Money Market
Securities (cont’d)

Explaining money market price movements
(cont’d)
 Impact



of September 11
The weak economy combined with this event caused
investors to transfer funds into money market securities
The additional demand placed upward pressure on their
price and downward pressure on their yields
The Fed added liquidity to the banking system and
reduced the federal funds rate
35
Valuation of Money Market
Securities (cont’d)

Indicators of future money market security prices

Economic growth is monitored since it signals changes in
short-term interest rates and the required return from
investing in money market securities






Employment
GDP
Retail sales
Industrial production
Consumer confidence
Indicators of inflation
36
Risk of Money Market Securities

Because of the short maturity, money market
securities are generally not subject to interest rate
risk, but they are subject to default risk



Investors commonly invest in securities that offer a slightly
higher yield than T-bills and are very unlikely to default
Although investors can assess economic and firm-specific
conditions to determine credit risk, information about the
issuer’s financial condition is limited
Measuring risk

Money market participants can use sensitivity analysis to
determine how the value of money market securities may
change in response to a change in interest rates
37
Interaction Among Money Market
Yields

Money market instruments are substitutes for
each other
 Market
forces will correct disparities in yield and
the yields among securities tend to be similar

In periods of heightened uncertainty,
investors tend to shift from risky money
market securities to Treasuries
 Flight
to quality
 Creates a greater differential between yields
38
Globalization of Money Markets


Interest rate differentials occur because geographic
markets are somewhat segmented
Interest rates have become more highly correlated:


Conversion to the euro
The flow of funds between countries has increased because
of:




Tax differences
Speculation on exchange rate movements
A reduction in government barriers
Eurodollar deposits, Euronotes, and Euro-commercial paper
are widely traded in international money markets
39
Globalization of Money Markets
(cont’d)

Eurodollar deposits and Euronotes

Eurodollar certificates of deposit are U.S. dollar deposits
in non-U.S. banks


Have increased because of increasing international trade and
historical U.S. interest rate ceilings
In the Eurodollar market, banks channel deposited funds to
other firms that need to borrow them in the form of
Eurodollar loans




Typical transactions are $1 million or more
Eurodollar CDs are not subject to reserve requirements
Interest rates are attractive for both depositors and borrowers
Rates offered on Eurodollar deposits are slightly higher than
NCD rates
40
Globalization of Money Markets
(cont’d)

Eurodollar deposits and Euronotes (cont’d)


Investors in fixed-rate Eurodollar CDs are adversely affected
by rising market rates
Issuers of fixed-rate Eurodollar CDs are adversely affected
by declining rates




Eurodollar-floating-rate CDs (FRCDs) periodically adjust to
LIBOR
The Eurocurrency market is made up of Eurobanks that
accept large deposits and provide large loans in foreign
currencies
Loans in the Eurocredit market have longer maturities than
loans in the Eurocurrency market
Short-term Euronotes are issued in bearer form with
maturities of one, three, and six months
41
Globalization of Money Markets
(cont’d)

Euro-commercial paper (Euro-CP):
 Is
issued without the backing of a banking
syndicate
 Has maturities tailored to satisfy investors
 Has a secondary market run by CP dealers
 Has a rate 50 to 100 basis points above LIBOR
 Is sold by dealers at a transaction cost between 5
and 10 basis points of the face value
42
Globalization of Money Markets
(cont’d)

Performance of foreign money market
securities
 Measured
by the effective yield (adjusted for the
exchange rate
Ye  (1  Yf )  (1  %S )  1
 Depends


on:
The yield earned on the money market security in the
foreign currency
The exchange rate effect
43
Computing the Effective Yield
A U.S. investor buys euros for $1.15 and invests in
a one-year European security with a yield of 8
percent. After one year, the investor converts
the proceeds from the investment back to
dollars at the spot rate of $1.16 per euro. What
is the effective yield earned by the investor?
Ye  (1  Yf )  (1  %S )  1
 1.08  1.0087  1
 8.94%
44