Money Markets


Money markets involve debt instruments with original
maturities of one year or less
Money market debt





issued by high-quality (i.e., low default risk) economic units that
require short-term funds
purchased by those that have excess short-term funds
little or no chance of loss of principal
low rates of return
Most money market instruments have active secondary
markets to provide liquidity
5-1
Money Market Yields

Money market securities use special rate quoting
conventions:



Discount yields (idy): Interest rate is quoted on an annual basis
assuming a 360 day year as a percent of redemption price or
face value
Single payment yields (ispy): Interest rate is quoted on an annual
basis assuming a 360 day year as a percent of purchase price
Both may be converted to a bond equivalent yield (ibey) for
comparison with bonds
5-2
Money Market Yields


Treasury bills and commercial paper rates are
quoted as discount yields
Discount yields (idy) use a 360-day year
( Pf  P0 ) 360
idy 

Pf
h
Pf = the face value of the security
P0 = the discount price of the security
h = the number of days until maturity
5-3
Money Market Yields

Compare discount securities to bonds with bond
equivalent yields (ibey)
(Pf  P0 ) 365
i bey 

P0
h

Convert bond equivalent yields into effective
annual returns (EAR)
ibey 

EAR  1 

 365 / h 
365/ h
1
5-4
Money Market Yields

Negotiable (or jumbo) CDs and fed funds are money
market securities that pay interest only at maturity. These
use single-payment yields (ispy)
(Pf  P0 ) 360
ispy 

P0
h
5-5
Sample Calculations of Money
Market Yields

A $1M investment in 90 day commercial paper has a 2%
discount yield, what is the current price of the CP?
( Pf  P0 ) 360
idy 

Pf
h
0.02 
($1M  P0 ) 360

;P0  $995,000
$1M
90
5-6
Money Market Instruments
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
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

Treasury bills (T-bills)
Federal funds (fed funds)
Repurchase agreements (repos or RP)
Commercial paper (CP)
Negotiable certificates of deposit (CD)
Banker acceptances (BA)
5-7
Treasury Bills (T-Bills)




T-Bills are short-term debt obligations
issued by the U.S. federal government
T-bills are virtually default risk free, are
highly liquid, and have little interest rate risk
The Federal Reserve buys and sells T-bills
to implement monetary policy (open market
operation)
Strong international demand for T-bills as
safe haven investment
5-8
T-Bill Auctions
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13- and 26-week T-bills are auctioned weekly
Bids are submitted by government securities
dealers, financial and nonfinancial corporations,
and individuals
Bids can be competitive or noncompetitive


competitive bids specify the bid price and the desired
quantity of T-bills
noncompetitive bidders get preferential allocation and
agree to pay the lowest price of the winning competitive
bids
5-9
The Secondary Market for T-Bills


The secondary market for T-bills is the largest of
any U.S. money market instrument
22 primary dealers “make” a market in T-bills by
buying the majority sold at auction and by creating
an active secondary market



primary dealers trade for themselves and for customers
T-bill purchases and sales are book-entry transactions
conducted over Fedwire
T-Bills are sold on a discount basis
5-10
Federal Funds




The federal funds (fed funds) rate is the target rate in the
conduct of monetary policy
Fed fund transactions are short-term (mostly overnight)
unsecured loans
Banks with excess reserves lend fed funds, while banks with
deficient reserves borrow fed funds
Multimillion dollar loans may be arranged in a matter of
minutes
5-11
Repurchase Agreement


A repurchase agreement (repo or RP) is the sale of a
security with an agreement to buy the security back at a
set price in the future
Repos are short-term collateralized loans (typical collateral
is U.S. Treasury securities)
 Similar to a fed fund loan, but collateralized
 Funds may be transferred over FedWire system
 If collateralized by risky assets, the repo may involve a
‘haircut’
5-12
Repurchase Agreement


Typical denominations on repos of one week or less are
$25 million and longer term repos usually have $10 million
denominations
A reverse repurchase agreement is the purchase of a
security with an agreement to sell it back in the future
5-13
Commercial Paper




Commercial Paper (CP) is unsecured short-term corporate
debt issued by financially reputable companies to raise shortterm funds (e.g., for working capital)
Generally sold in denominations of $100,000 to $1 million
with maturities between 1 and 270 days
CP is usually sold to investors indirectly
CP is usually held by investors until maturity and has no
active secondary market
5-14
Negotiable Certificate of Deposit




A negotiable certificate of deposit (CD) is a bankissued time deposit that specifies the interest rate
and the maturity date
CDs are bearer instruments and thus are salable
Denominations range from $100,000 to $10 million;
$1 million being the most common. Smaller
denomination CDs you can normally see are not
negotiable.
Often purchased by money market mutual funds
with pools of funds from individual investors
5-15
Banker’s Acceptance



A Banker’s Acceptance (BA) is a time draft payable
(IOU) to a seller of goods with payment guaranteed by a
bank
Used in international trade transactions to finance – you
may not trust your counterpart, so a bank is involved.
Banker’s acceptances are bearer instruments and salable
5-16
2011 Money Market Yields
Instrument
Rate
Federal
Funds*
Commercial
Paper
CDs
0.11%
0.17%
0.23%
Euro CP
1.18%
Banker’s
Acceptances
Euro$
Repo*
0.22%
0.25%
0.08%
Instrument
Rate
LIBOR
0.27375%
Instrument
Treasury
Bills**
Inflation***
Rate
0.060
2.7%
Data from the Wall Street Journal Online Money Rates Section April 2011. Rates are
for 3 month maturities except as noted.
•Overnight; ** 13 week, *** Year over year, all items as measured by the CPI
•LIBOR=London Interbank Offered Rate=the rate the banks in London charge for their
short-term lending/borrowing
5-17
Money Market Securities
Outstanding
Instrument
Treasury Bills
Fed funds & Repos
Commercial Paper
Negotiable CDs
Banker's Acceptances
Total
Instrument
Treasury Bills
Fed funds & Repos
Commercial Paper
Negotiable CDs
Banker's Acceptances
Billions $
2004
2007
$ 982
$1,010
1,585
2,731
1,310
2,109
1,379
2,149
4
1
$5,260
$8,000
2010
$1,856
1,656
1.083
1,822
1
$6,418
% of Total in Given Year
2004
2007
19%
13%
30%
34%
25%
26%
26%
27%
0.1%
0.0%
100%
100%
2010
29%
26%
17%
28%
0.0%
100%
1990
$ 527
372
538
547
52
$2,036
1990
26%
18%
26%
27%
3%
100%
Source: Text
5-18