Chapter Five
Money Markets
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Chapter Outline
1. Overview
2. Treasury Bill
3. Federal Fund
4. Repurchase Agreement
5. Commercial Paper
6. Negotiable CD
7. Banker’s Acceptance
8. International Money Market
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1. Definition and Purpose of Money Markets
• The Money Markets are associated with the issuance and trading of
short-term (less than 1 year) debt obligations of large corporations,
FIs and governments
• Only High-Quality Entities can borrow in the Money Markets and
individual issues are large
• Investors in Money Market Instruments include corporations and
FIs who have idle cash but are restricted to a short-term investment
horizon
• The Money Markets essentially serve to allocate the nation’s
supply of liquid funds among major short-term lenders and
borrowers
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Money Market Instruments
• Treasury Bills - short-term obligations issued by the U.S.
government
• Federal Funds - short-term funds transferred between financial
institutions usually for no more than one day
• Repurchase Agreements - agreement involving the sale of
securities between parties with a promise to repurchase the
security at a specific date and price
• Commercial Paper - short-term unsecured promissory notes
issued by a company to raise short-term cash
• Negotiable Certificates of Deposit - negotiable bank-issued
time deposit with specified interest rate and maturity
• Banker Acceptances - time draft payable to seller of goods, with
payment guaranteed by a bank
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Money Market Participants
Instrument
Principal Issuer
Principal Investor
Treasury bills
U.S. Treasury
Federal funds
Repurchase agreement
Negotiable CDs
Commercial banks
FRS; Comm banks;
Brokers and dealers;
Other FIs
Comm banks
Other FIs; Corps
Commercial banks
Banker’s acceptances
Commercial banks
FRS; Comm banks;
Brokers and dealers;
Other FIs; Corp’s
Commercial banks
FRS, Comm banks
Brokers and dealers
Other FIs, Corp’s
Brokers and dealers
Corporations
Brokers and dealers;
Corps; Other FIs
Comm banks; Corp’s;
Brokers and dealers
Commercial Paper
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Methods of calculating yields
• Treasury Bills - discount yield, 360 day basis. Also as bond
equivalent basis using 365 day basis
• Federal Funds - bond equivalent basis, 360 day basis
• Repurchase Agreements - bond equivalent basis, 360 day basis
• Commercial Paper - discount yield, 360 day basis
• Negotiable Certificates of Deposit - discount yield, 360 day
basis
• Banker Acceptances - discount yield, 360 day basis
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Money Market Instruments Outstanding,
December 1990 and 2004 (in billions of dollars)
Amount Outstanding
Rate of Return
1990
1990
2004
6.68%
2.15%
1,585.1
1,309.7
7.31
8.14
1.83
1.89
1,379.4
4.4
8.13
7.95
2.28
2.04
2004
Treasury bills
$527.0
Federal funds and
repurchase agreements 372.3
Commercial paper
537.8
Negotiable certificates
of deposit
546.9
Banker’s acceptance
52.1
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$ 981.9
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2. Treasury Bill Basics
• Issued by the U.S. Treasury to cover government
budget deficits and to refinance maturing debt
• Standard Original Maturities of 13 weeks, 26
weeks, or 52 weeks
• Denominations are $1,000 but typical round lot is
$5 million
• Virtually default risk free
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The Auction Process for T-bills
• Amount of new 13-week and 26-week T-bills offered
announced weekly
• Bids submitted by government securities dealers,
financial and nonfinancial corporations and individuals
• Individual competitive bidders limited to 35% total
issue size, can submit more than one bid, allocations
made beginning with highest bidder
• Noncompetitive bidders indicate quantity desired and
agree to pay a weighted-average of the rate on winning
competitive bids; get preferential allocation
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Treasury Auction Results Nov 18,2004
Bid Price
Noncompetitive Bids
99.4975% 1
SC
2
ST
3
99.48875%
(PNC)
stop-out
price (low
bid
accepted)
4
5
6
7
$17,509.5m
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$19,254.8m
Quantity of
T-bills
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The Secondary Market for T-bills
• The largest of any U.S. money market security
• Approximately 30 financial institutions “make” a
market in T-bills by buying and selling securities for
their own accounts and by trading for their customers,
including depository institutions, insurance companies,
pensions funds, etc.
• T-bills are the FOMC’s instrument of choice for its
open market operations
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Secondary Market T-bill Transaction
J.P. Morgan Chase
sells $10m. In T-bills
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
Individual
buy $50,000
in T-bills
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J.P. Morgan
Chase
sell $50,000
in T-bills
Local Bank
or Broker
5-12
FRBNY
-$50,000 in T-bills
from J.P. Morgan
Chase’s account
+ $50,000 T-bill
to Individual
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
T-bill Rates and Yields
• No interest paid on T-bills (coupon rate is zero),
issued at a discount from their par (or face) value
• T-bill rates are quoted in Wall Street Journal
• Discount Yield
– the price dealers are willing to pay T-bill holders to purchase
their T-bills for them
• Asked
– the discount yield based on the current purchase price set by
dealers that is available to investors
• Spread
– the percentage difference in the ask and bid yield; part of
transaction cost; the profit for dealers
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Calculating T-bill Yields from Discount
Rates
iT-bill(dy) = PF - PO
PF
Where:

360
h
iT-bill= Annualized yield on the T-bill
PF = Price (face value) paid to the T-bill holder
PO = Purchase price of the T-bill
h = Number of days until the T-bill matures
Example: iT-bill(dy) = $10,000 - $9,905.71  360 = 2.19%
$10,000
155
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3. Federal Funds
• Short-term funds transferred between FIs, usually for
a period of one day
• Federal Funds rate
– the interest rate for borrowing fed funds
– a focus or target rate in the conduct of monetary
policy
• Federal Funds Yields
– single-payment loans - they pay interest only once, at
maturity.
– Fed fund transactions take the form of short-term
(mostly overnight) unsecured loans
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Trading in the Fed Funds Market
• Commercial banks conduct the majority of
transactions in the fed funds market
• Banks with excess reserves lend fed funds, while
banks with deficient reserves borrow fed funds
• Fed funds transactions can be initiated by either the
lending or borrowing institution or handled through
a broker
• Correspondent banks – banks with reciprocal
accounts and agreements
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A Federal Funds Transaction
J.P. Morgan Chase
Bank of America
Lends Fed Funds
Borrows Fed Funds
FRBNY
Today: -$75M from R/A of
JP Morgan Chase
Day+1: +$75M + Int. to R/A
of JP Morgan Chase
McGraw-Hill /Irwin
Fedwire Transaction
Fedwire T-bill
5-17
FRB of San Francisco
Today: +$75 in R/A of BOA
Day+1:-($75M + Int.) from R/A of
BOA
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4. Repurchase Agreements (RPs or Repos)
• An agreement involving the sale of securities by
one party to another with a promise to repurchase
the securities at a specified price on a specified
date
• Essentially a collateralized fed funds loan with
collateral in the form of securities (e.g. T-bills and
Fannie Mae securities)
• Reverse repurchase agreement
– involves the purchase of securities between parties with the
promise to sell them back at a given date in the future
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Trading Process for Repurchase Agreements
• Arranged either directly between two parties
or with the help of brokers and dealers
• The repo buyer arranges to purchase T-bills
from the repo seller with an agreement that
the seller will repurchase the T-bills within a
stated period of time
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A Repurchase Agreement Transaction
J.P. Morgan
Bank of America
Buys a $75M Repo
Sells a $75M Repo
FRBNY
Today: -$75 from R/A of JP Morgan
+$75M to T-Bond Account
of JP Morgan
Day+1: +$75M + Int. to JP Morgan
- $75M to T-Bond Account
of JP Morgan
McGraw-Hill /Irwin
Fedwire cash
Fedwire T-bill
Fedwire cash
Fedwire T-bill
5-20
FRBNY
Today: +$75 from R/A of JP Morgan
-$75M to T-Bond Account
of JP Morgan
Day+1:-$75M + Int. to JP Morgan
+ $75M to T-Bond Account
of JP Morgan
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5. Commercial Paper
• An unsecured short-term promissory note issued by a
corporation to raise short-term cash, often to finance
working capital requirements
• The largest (in terms of dollar value) of the money
market instruments
• Generally sold in denominations of $100,000,
$250,000, $500,000 and $1 million with maturities of
1-270 days (if maturity is greater than 270 days, SEC
requires registration)
• Generally held until maturity so there is not an active
secondary market
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Trading Process for Commercial Paper
• CPs are sold either directly to investors (25%)
or indirectly through brokers and dealers such
as investment banks or major bank
subsidiaries
• Selling through brokers more expensive for
issuer due to underwriting costs
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6. Negotiable Certificates of Deposits
• A bank-issued time deposit that specifies an interest
rate and maturity date and is negotiable in the
secondary market
• Bearer Instrument
– whoever holds the CD when it matures receives the principal
and interest
• Denominations range from $100,000 to $10 million;
$1 million being the most common
• Often purchased by money market mutual funds with
pools of funds from individual investors
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Trading Process for NCDs
• Banks issuing NCDs post daily rates for the more
popular maturities and subject to funding needs,
tries to sell to investors who are likely to hold
them as investments rather than sell them to the
secondary market
• In some cases, the bank and investor negotiate the
size, rate and maturity
• Secondary market consists of a linked network of
approximately 15 brokers and allows investors to
buy existing CD’s rather than new issues
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7. Banker’s Acceptances
• A time draft payable to a seller of goods with
payment guaranteed by a bank
• Arise from international trade transactions and
are used to finance trade in goods that have yet
to be shipped from a foreign exporter (seller) to
a domestic importer (buyer)
• Foreign exporters prefer that banks act as
guarantors for payment before sending goods to
importer
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Trading Process for BAs
1
Domestic
Importer
2
9
Foreign
Exporter
4
3
10
8
5
U.S.
Bank
6
Foreign
Bank
7
1. Purchase order sent
2. Letter of credit requested
3. Notification of letter credit
and draft authorization
4. Order shipped
5. Time draft and shipping papers
sent to foreign bank
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6. Time draft and shipping papers sent
to U.S. bank; BA created
7. Payments sent to foreign bank
8. Payments sent foreign exporter
9. Payment to U.S. bank
10. Shipping papers delivered
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8. International Aspects of Money Markets
• While U.S. money markets are the largest, the
international market is growing
– U.S. securities bought/sold by foreign investors
– foreign money market securities
• Euro money market instruments
– Eurodollar deposits, Eurodollar CDs, Euro notes,
Euro CP
• London Interbank Offered Rate (LIBOR)
– the rate paid on Eurodollars
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Euronotes and Euro CPs
Amount outstanding
Amount outstanding
Type of instrument
1995
2001
Type of instrument
1995
2001
Euronotes
Currency type
U.S. dollar
Euro currencies
Pound Sterling
Japanese yen
Other
Issuer type
FIs
Gov/state agencies
International Inst
Corporations
$45.5
$154.4
$87.0
$243.1
27.9
0.5
55.7
9.1
0.4
16.7
59.5
43.6
32.8
11.3
7.2
102.7
80.5
29.1
13.6
17.2
41.4
0.4
1.2
2.5
132.8
11.3
0.5
9.8
Euro CP
Currency type
U.S. dollar
Euro currencies
Pound Sterling
Japanese yen
Other
Issuer type
FIs
Gov/state agencies
International inst
Corporate issuers
McGraw-Hill /Irwin
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2.1
20.0
40.5
14.2
2.1
30.2
184.4
17.3
4.4
36.9
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