Chapter Five
Money Markets
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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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Definition of Money Markets
•
•
•
Money market securities are generally fixed income
securities that have an original issue maturity of one year
or less, thus they have little price risk.
Money markets primarily exist to minimize the cost of
maintaining liquidity for financial, non-financial and
government institutions and to provide borrowers with
low cost, short term sources of funds.
Money market securities should thus provide safety of
principle, liquidity and a predictable, albeit typically
modest, yield
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Why Money markets
• Money markets exist because rarely do required cash
disbursements occur at the same time and in the same
amounts as cash inflows for corporations and institutions.
• At times units will have excess cash that is not
immediately needed, and other economic units will need to
borrow cash for a short period of time.
• Thus, entities must maintain liquid sources of funds.
• In addition, precautionary amounts of funds beyond
planned liquidity needs must be maintained because
expected cash inflows and required cash disbursements
cannot be predicted with perfect accuracy
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opportunity cost
• The opportunity cost of keeping cash on hand
can be quite high. The opportunity cost is the rate
of return that could be earned in the highest valued
alternative if liquidity balances did not have to be
maintained.
• Money markets have developed to provide
corporations, governments and institutions with
safe, liquid investments (or sources of funds for
borrowers) that minimize the opportunity cost of
maintaining liquidity.
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Secondary markets
• Secondary markets, or some other method of
quickly recovering the investment at short notice,
are of paramount importance for money market
instruments because much of the funds invested in
money markets may be needed by the lender for
unexpected liquidity needs.
• Money market securities also have little or no
default risk.
• With the focus on liquidity and safety, the rate of
return on money market securities is expected to
be significantly less than promised yields on
capital market instruments.
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Yields on Money Market Securities
Many money market securities use special
quoting conventions
– Discount Yields
– Single-Payment Yields
– Equivalent Annual Return
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Discount rates
• Discount rates (or discount yields) quote
the interest rate as an annualized percentage
of the sale (redemption) price of the security
assuming there are only 360 days in a year.
Even if the security matures in 90 days, the
rate quote is as if the security matured in
one year.
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Single payment securities
• Single payment securities or loans (also
called add ons) quote the rate as an
annualized percentage of the purchase price
of the security, assuming there are only 360
days in a year.
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• A calculation for restating semi-annual, quarterly,
or monthly discount-bond or note yields into an
annual yield. For a fixed income security with a
par value of $1000, the calculation is as follows:
((1000- purchase price)/ purchase price)*365/days
to maturity
•
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• The total amount of money market
securities outstanding in 2004 in the major
money markets was over $5,260 billion.
• This represents a compound annual growth
rate of 7% over the period 1990 to 2004.
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Money Market Instruments
•
•
•
•
•
•
Treasury Bills
Federal Funds
Repurchase Agreements
Commercial Paper
Negotiable Certificates of Deposit
Banker Acceptances
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Treasury Bills
• T-bills are short term obligations of the U.S. government
used to finance government spending needs.
• At the end of 2004 there was $981.9 billion outstanding
comprising about 19% of total money market securities.
• Original issue maturities are 13 or 26 weeks.
• The minimum denomination is $1,000 and a round lot is
$5 million.
• T-bills are thought to be free of default risk and the 1 year
T-Bill rate is often used as a measure of the short term
‘risk free rate.’
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T-Bills Auction
• Each week new 13 and 26 week T-bills are offered for sale
at competitive auction.
• T-bills are sold to the highest bidder at auction, but no one
bidder can purchase more than 35% of the total amount in
any one auction.
• Noncompetitive bids of up to $1 million can be made.
• The Treasury is now using a single price auction.
• In the past Treasury securities were sold at a discriminating
auction where high bidders paid higher prices, and lower
bidders paid lower prices. Noncompetitive bidders paid the
average price of the accepted bids
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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
McGraw-Hill/Irwin
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$19,254.8m
Quantity of
T-bills
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Why single price auction
• In the Treasury single price auction the lowest bid
price accepted becomes the price that all winning
bidders pay. There are two purported advantages
of a single price auction over a discriminating
auction:
• 1. A greater number of bidders have their bids
filled and
• 2. More aggressive bidding occurs under the
single price format resulting in a higher average
price paid by investors.
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The secondary market for T-bills
• The secondary market for T-bills is the
largest of any money market security.
• There are 22 primary government security
dealers who purchase the new issues and
about 500 smaller dealers who actively
participate in trading T-bills.
• The FedWire is often used for trades
between dealers and other institutions.
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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
McGraw-Hill/Irwin
J.P. Morgan
Chase
sell $50,000
in T-bills
Local Bank
or Broker
5-18
FRBNY
-$50,000 in T-bills
from J.P. Morgan
Chase’s account
+ $50,000 T-bill
to Individual
©2007, The McGraw-Hill Companies, All Rights Reserved
Case: Salomon Brothers
• In violation of regulations, Salomon Brothers
(Chase/Solomon) bought about 80% of one Treasury
auction in an attempt to squeeze the market. Many T-bills
are sold on a ‘when issued’ basis by dealers who anticipate
obtaining them at auction (i.e. T-bills are often sold short
before they are issued). Since Salomon obtained so much
of the auction, other dealers could not meet their prior
short sale obligations and had to pay a premium price to
Salomon to obtain the bills which the dealers had already
agreed to deliver to customers. The government forced
Salomon to give up their profits from the squeeze and pay
fines. The biggest loss was to Salomon’s reputation.
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Discount instruments
• T-bills are discount instruments.
• T-bill prices (P0) are calculated as P0 = PF  (1 –
(i*h/360)) where i is the discount quote, h is the
maturity in days and PF is the face value of the
bill.
• One should calculate the bond equivalent yield in
order to compare rate quotes on different
instruments that use different quoting conventions.
• The bond equivalent yield for a T–bill can be
calculated as (PF–P0)/P0 * (365/h).
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Treasury Bill Basics Summary
• 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 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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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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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
• Asked
• Spread
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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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Federal Funds
• Fed funds, together with repurchase agreements,
comprise about 30% of total money market
securities.
• Federal funds, or fed funds, are short term
unsecured loans of deposits held at the Federal
Reserve (i.e. loans of excess reserves.
• These loans occur largely between institutions.
• Small banks often make loans to their
correspondent banks when local loan demand is
insufficient
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‘bullet’ loans
• The majority of fed funds are overnight loans,
although many are made on ‘continuing
contract.’(Continuing contract means that unless
the borrower or lender notifies the other party the
loan will automatically be renewed daily)
• Fed funds are add on loan contracts (single
payment or ‘bullet’ loans) and follow the
convention of quoting all rates on an annual basis
assuming a 360 day year.
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equivalent yield
• To convert a fed funds rate quote to a bond
equivalent yield take the rate quote and
multiplied it by 365/360.
• Many fed fund loans are arranged through
correspondent banks or through brokers
such as Garban-Intercapital Ltd. and RMJ
Securities Corp.
• The typical brokerage fee may be as small
as 50 cents per million dollars.
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Funds transfers
• Funds transfers occur over the FedWire and
transactions can be completed very quickly
(in a matter of minutes).
• A FI is not required to hold reserves at the
Fed to participate in the fed funds market;
deposits at banks are often used in place of
deposits at the Federal Reserve.
• Typical transactions are $5 million and up.
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Federal Funds Summary
• 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
– Fed fund transactions take the form of shortterm (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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Repurchase Agreements
• A repurchase agreement (repo or RP) is an agreement
where the seller of securities agrees to repurchase the
securities at a preset price at a preset time (typically from 1
to 14 days).
• Repos are in effect, collateralized loans similar to fed
funds loans.
• The seller is borrowing.
• money and pledging the securities as collateral and the
buyer (who is said to be engaging in a reverse repo) is
lending money.
• The interest rate is determined by setting the buy and sell
price of the securities.
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Repo interest rate
• The rate of interest paid on the repo is not a function of the
rate of return on the underlying securities.
• If risky securities are pledged as collateral, the fund’s
lender may require a larger ‘haircut,’ i.e. repos normally
have to be slightly overcollateralized.
• For instance, to borrow $100 the repo seller would have to
sell securities currently worth $102, for a $2 haircut.
• The repo is a ‘real’ sale in the sense that title to the
securities passes to the lender of funds for the term of the
agreement.
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Repo Pricing and Transfers
• Transfers may occur over the FedWire system.
• Typical denominations on repos of one week or
less are $25 million and longer term repos usually
have $10 million denominations.
• Repos are add on instruments (single payment
loans) with yields that average about 25 basis
points less than fed funds loans due to the repo
collateral.
• Repos take longer to arrange than fed funds and
fed funds loans are more likely to be used when
funds are needed immediately.
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Repurchase Agreements (RPs or Repos)
Summary
• 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
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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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Commercial Paper
• Commercial paper is a short term unsecured promissory
note issued by creditworthy corporations and financial
institutions.
• Because the notes are unsecured and are not very liquid,
commercial paper is rated by ratings agencies.
• The paper rating strongly affects the cost of financing with
commercial paper.
• Low quality paper is often secured by bank lines of credit
to obtain a better rating.
• The spread between prime grade and medium grade paper
has averaged about 22 basis points per year
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Maturity of CP
• The maximum maturity is 270 days (most
are less) because the SEC requires formal
registration of securities with maturities
greater than 270 days.
• Commercial paper comprised about 25% of
total money market securities in 2004, down
from 2001 in absolute dollar amount and as
a percentage of total money market
securities.
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Discount instrument
• Commercial paper is a discount instrument
and uses discount quotes similar to T–bills
• Credit concerns coupled with some high
profile downgrades of major paper issuers
such as GM, Ford and Tyco have reduced
the amount of commercial paper in the past
several years.
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History
• The commercial paper market has
developed to provide corporations with an
alternative to short term bank loans.
• Commercial paper outstanding grew
tremendously in the 1990s because large,
creditworthy paper issuers were able to
obtain lower cost financing by issuing paper
rather than borrowing from banks.
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no active secondary market
• Commercial paper is issued in denominations
ranging from $100,000 to $1 million, with the
most common maturities in the 20 to 45 day range.
• About 15% of issuers directly market their own
paper, but the bulk is sold through brokers and
dealers.
• There is no active secondary market for
commercial paper, partly because commercial
paper dealers will redeem paper from the buyers if
the buyer needs the money prior to maturity.
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Commercial Paper Summary
• 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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Negotiable Certificates of Deposit
• A negotiable certificate of deposit is a bearer
certificate indicating that a time deposit has been
made at the issuing bank which the bearer (holder)
can collect at maturity.
• Large CDs are negotiable instruments. Negotiable
CDs have a minimum denomination of $100,000,
but denominations of $1 million are the most
common.
• Maturities range from 1, 2, 3 and 6 months out to
1 year
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CD rates
• Negotiable CD rates are add on rates
(single-payment loans) quoted using the 360
day convention.(CDs with maturity greater than one year area
not bullet loans, rather they usually pay interest semiannually)
• They comprised about 26% of money
market securities in 2004.
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CD draw funds that would be invested in nonbank money market securities.
• Large well known banks, particularly New York
banks, often can pay lower interest rates on their
CDs than other lesser well known institutions.
• About 15 dealers make a secondary market in
CDs, although it is not very active.
• CDs are required to have ‘substantial interest
penalties for early withdrawal.’
• The secondary market eliminates the problem of
the interest penalty, and has increased bank’s
ability to draw funds that would otherwise be
invested in non-bank money market securities.
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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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Negotiable Certificates of Deposits
Summary
• A bank-issued time deposit that specifies an
interest rate and maturity date and is negotiable
in the secondary market
• Bearer Instrument
• 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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Banker’s Acceptances (BAs)
• Drafts are often used to facilitate international
trade in goods and services.
• The seller of the goods writes either a time draft or
a sight draft payable by the buyer of the goods or
services.
• A sight draft is a claim that becomes due and
payable upon presentation to the buyer.
• A time draft is a claim that becomes due and
payable at a certain future date specified on the
draft.
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• Because the seller normally will not know the
creditworthiness of the buyer (and credit investigation costs
can be quite high), the seller may be reluctant to ship the
goods unless payment can be guaranteed by a third party.
• Banker’s acceptances are a certain kind of time draft where
a bank has agreed to pay the seller of the goods the amount
owed if the buyer cannot or will not pay on the date due.
• The draft is backed by a letter of credit drawn on the
buyer’s bank, ensuring that the bank will “accept” the draft
drawn up by the seller.
• Once the seller can prove that the goods have been shipped
in accordance with the contract and the proper paperwork
has been presented to the buyer, the time draft can be sold as
a discount instrument
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• The seller of the goods can wait until maturity to receive
payment, or more likely can discount the note to the bank
and receive the discounted face amount immediately.
• The bank can then hold the acceptance or sell it.
• BAs are bearer instruments and are fairly actively traded.
• Maturities range from 30 to 270 days and BAs are
bundled into round lots of $100,000 and $500,000.
• Interest rates are very close to T-bill rates because the risk
of default is quite low as the BA is backed by the importer
and a large bank and the value of the goods.
• The amount of BAs outstanding is quite small compared
to the other money market instruments (less than 1% of
the total money market securities outstanding).
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schematic of the creation of a BA
U.S. buyer
(importer)
1
10
3
2
9
4
6
U.S. bank
(importer’s bank)
McGraw-Hill/Irwin
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5-52
Chinese seller
(exporter)
5
8
Chinese bank
(exporter’s bank)
©2007, The McGraw-Hill Companies, All Rights Reserved
1.
2.
3.
4.
5.
6.
Purchase order sent by U.S. buyer to Chinese seller
Chinese seller requests a letter of credit
Notification of letter of credit and draft authorization
Order shipped
Time draft and shipping papers sent to Chinese seller’s bank
Time draft and shipping papers sent to U.S. bank; banker’s
acceptance created
7. Payments sent to foreign bank (immediately if Chinese
seller wishes to discount the draft and collect immediately,
at maturity if not)
8. Payments sent to Chinese seller (see #7)
9. Payment to U.S. bank by U.S. buyer at maturity, paid in full
10. Shipping papers delivered
McGraw-Hill/Irwin
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Banker’s Acceptances summary
• 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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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
$527.0
Federal funds and
repurchase agreements 372.3
Commercial paper
537.8
Negotiable certificates
of deposit
546.9
Banker’s acceptance
52.1
McGraw-Hill/Irwin
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$ 981.9
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Comparison of Money Market
Securities
• Most money market securities have high
denominations, or high round lots, low
default risk, low interest rates and short
maturities.
• The different instruments have evolved to
fill certain niches or needs.
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The differences.
• The securities’ secondary markets show more
variation.
• T-bills are the most actively traded money market
security.
• CDs and BAs are less actively traded, in part
because money market mutual funds and other
buyers have been using a buy and hold strategy for
these securities.
• Commercial paper is usually redeemed by the
seller upon the buyer’s request so no secondary
market is needed
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No secondary markets
• Fed funds and repos tend to be short term
and so no secondary market has developed
for these instruments
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Money Market Participants
A- The U.S. Treasury
•
•
•
The Treasury issues T-bills to provide funds
throughout the year.
Since the bulk of individual income tax receipts
occur in the spring and corporations and selfemployed individuals generally pay taxes
quarterly.
But government expenditures however occur
throughout the year and the Treasury uses T-bills
to provide financing over the intervening periods
when income is not received.
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B- The Federal Reserve
•
•
The Fed is a major participant in the money market. The
Fed’s open market operations are conducted using Tbills, T-notes and T-bonds, and Fed policy often involves
repurchase agreements.
Moreover, the Fed currently targets the fed funds rate
and actively intervenes in money markets to manipulate
this rate.
C- Commercial Banks
•
•
Banks both issue and invest in CDs, fed funds, BAs and
repos.
Banks use the money markets to manage and minimize
their excess reserves position and to meet short term
deficits in reserves.
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D_ Money
•
•
•
•
Market Mutual Funds
Money market mutual funds (MMMFs) pool
investors’ funds and purchase money market
securities.
Because most money market securities are high
denomination, the MMMFs allow the small
investor to participate in a variety of money
market securities that would otherwise be too
expensive for the typical individual.
Investors in MMMFs may earn slightly higher
rates than on bank accounts but must forego bank
deposit insurance.
Most MMMFs allow limited check writing, low
cost investment and free movement of funds
between funds in the same family.
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•
•
•
•
E – Brokers and Dealers
Major brokers and dealers include:
The twenty–two government securities dealers who
make a market in T-bills assist the Treasury by
purchasing its securities and assist the Fed in
implementing open market operations.
Cantor, Fitzgerald Securities, Garban-Intercapital,
Liberty, RMJ Securities, and Hill Farber are money and
security brokers. They are major players in the
secondary market for government securities and they
serve as brokers in the fed funds market. They do not
trade for their own account and maintain anonymity of
the principles in trades they broker.
Thousands of brokers and dealers who link buyers and
sellers.
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F- Corporations
•
Non-financial corporations raise large amounts
of money in the commercial paper markets and
invest in other money market securities.
G- Other Financial Institutions
•
Insurance firms, particularly property and
casualty insurers, maintain large liquidity
balances. Money market mutual funds invest in
these securities and finance companies must
raise large amounts of funds in the commercial
paper market because they cannot accept
deposits.
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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; MF’s
Brokers and dealers;
Other FIs; Corp’s
Commercial banks
FRS, Comm banks; MF’s
Brokers and dealers
Other FIs, Corp’s
Brokers and dealers;MF’s
Corporations
Brokers and dealers;MF’s
Corps; Other FIs
Comm banks; Corp’s;
Brokers and dealers
Commercial Paper
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International Aspects of Money
Markets
• Investments in Treasury securities comprise
the largest segment.
• With the introduction of the euro net
issuance of international debt denominated
in euros has grown tremendously rapidly. It
is likely that money markets denominated in
euros will continue to grow in importance
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Euro Money Market Securities
– Euro Money Market Securities
•
•
Some of the major securities include:
Eurodollar CDs: Dollar denominated deposits
held outside the U.S. The maturity is typically
less than one year.
Rates on Eurodollar CDs are sometimes higher
than domestic CD rates because of the lack of
explicit deposit insurance and lower regulatory
costs.
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Eurocommercial paper
• Eurocommercial paper issued by
commercial paper dealers:
• Technically, the term means commercial
paper issued outside the borrower’s country
of origin, but in their home currency. The
term is coming to mean securities issued in
Europe without involving a bank.
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International Aspects of Money
Markets summary
• 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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