MONEY MARKETS
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1. Money market securities are debt securities with a maturity
of one year or less.
2. Issued in the primary market through a telecommunications
network by the Treasury, corporations, and financial
intermediaries that wish to obtain short-term financing.
3. Are commonly purchased by households, corporations, and
governments that have funds available for a short time
period.
4. Can be sold in the secondary market and are liquid.
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The more popular money market securities are:
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
Treasury bills (T-bills)

Commercial paper

Negotiable certificates of deposit

Repurchase agreements

Federal funds

Banker’s acceptances
1.
Issued when the U.S. government needs to borrow funds.
2.
The Treasury issues T-bills with 4-week, 13-week, and 26week maturities on a weekly basis.
3.
The par value (amount received by investors at maturity) of
T-bills was historically a minimum of $10,000, but now it is
$1,000 and multiples of $1,000.
4.
Are sold at a discount from par value, and the gain is the
difference between par value and the price paid
5.
Backed by the federal government and are virtually free of
credit (default) risk.
6.
Highly liquid, due to short maturity and strong secondary
market.
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3.
Treasury Bill Auction (Exhibit 6.2)
a. Investors can submit bids online for newly issued T-bills at
www.treasurydirect.gov.
b. Investors have the option of bidding competitively or
noncompetitively.
c.
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Sold via Dutch Auction
2.
Pricing Treasury Bills
a. Priced at a discount from their par value
b. Price depends on the investor’s required rate of return
c.
Value of a T-bill is the present value of the par value
Example: If investors require a 7 percent annualized return on a
one-year T-bill with a $10,000 par value, the price that they are
willing to pay is:
P = $10,000 / (1.07)
P = $9,345.79
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4.
Estimating the Yield
SP  PP 365
YT 

PP
n
where
SP  selling price
PP  purchase price
n  number of days of the investment (holding period)
5.
Estimating the Treasury Bill Discount
Par  PP 360
YT 

PP
n
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B.
Commercial Paper
 For most creditworthy companies - Short-term debt instrument
issued by well-known, creditworthy firms and is typically unsecured.
 100 to 150 basis points less than the prime
 No secondary market (mostly direct placement)
 Yield computed the same way as T-Bills
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1. Ratings
 Assigned by rating agencies such as Moody’s Investors
Service, Standard & Poor’s Corporation, and Fitch Investor
Service.
 Serves as an indicator of the potential risk of default.
2. Credit Risk during the Credit Crisis
 Historically the percentage of issues that have defaulted is
very low.
 During the credit crisis on Sept 15,2008, Lehman Brothers
(a large securities firm) failed.
 Reserve Primary Fund – broke the buck – “shadow
banking system.”
1.
Credit risk following Lehman’s default
 Institutional investors were less willing to invest in commercial
paper because of concerns that other firms might default. As a
result, many firms were no longer able to rely on the
commercial paper market for short-term funding.
 The Emergency Economic Stabilization Act of 2008 was
enacted, which helped to stabilize the money markets.
 In November 2008, the Fed began to purchase commercial
paper issued by highly rated firms to increase liquidity in the
commercial paper market.
2.
Risk Premiums among Money Market Securities
a. During periods of heightened uncertainty, investors shift from
risky money market securities to Treasury securities in a flight
to quality.
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1.
If short-term interest rates increase, the required rate of
return on money market securities will increase and the
prices of money market securities will decrease.
2.
An increase in interest rates is not as harmful to a money
market security as it is to a longer term bond.
3.
Measuring Interest Rate Risk
 Participants in the money markets can use sensitivity analysis to
determine how the value of money market securities may
change in response to a change in interest rates.
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C. Negotiable Certificates of Deposit (NCD)
 Large dollar amount certificates designed to be negotiable
 Specialized secondary market
 YNCD = (SP – PP + Interest) / PP.
D.
Banker's Acceptances
 Finance import activity
 Products form the collateral for the BA
 Rates quoted in WSJ and elsewhere
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Repurchase Agreements (repo)
E.
One party sells securities to another with an agreement to
repurchase the securities at a specified date and price.
 Underlying instrument is a treasury bill or bond
 Contracts designed for very short periods of investment
 Reverse Repo

F. Federal Funds
 The market for lending excess reserves, frequently over-night
 Some funds lent by the Federal Reserve on an over-night basis
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 Enables depository institutions to lend or borrow short-term
funds from each other at the federal funds rate.
 The Federal Reserve adjusts the amount of funds in
depository institutions in order to influence the federal funds.
 The rate is normally slightly higher than the T-bill rate at any
given time.
 Commercial banks are the most active participants.
 The volume of interbank loans on commercial bank balance
sheets over time is an indication of the importance of lending
between depository institutions.
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G.Comparison of Money Market Securities
 Most liquid are T-Bills
 Best yields are from BA's
 Money Market funds will have all in their portfolio
H.Institutional Use of Money Market Securities
 Provide method for investors to keep excess cash balances
working
 Provide a method for limiting interest rate risk
 Provide an additional investment vehicle for portfolios
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
Eurodollar Deposits and Euro notes
 Foreign deposits denominated in dollars
 Notes issued in European financial markets but
denominated in dollars

Euro-commercial Paper
 Potential hedge vehicle
 Dealers provide a secondary market

Lack of Regulatory Oversight
 Increased risks
 Source of competitive edge for foreign banks
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What are the 4 main types of money market instruments?

What premiums do investors extract for reduced liquidity?
Increases in default risk?

Who issues commercial paper? Why is c-paper preferred to
borrowing at prime?

How does the Repurchase (repo) agreement work?

Why are Fed funds important to financial institutions?

What are Eurodollar deposits and why are they important?

Q&A: 4,8,12 Interpreting: a, b, c

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