Chapter Six
Money Markets
© 2001 South-Western College Publishing Company
Chapter Objectives
 Provide a background on money market
securities
 Explain how institutional investors use money
markets
 Explain the globalization of money markets
2
Money Market Securities
 Maturity of a year or less
 Issued by corporations and governments that
need short-term funds
 Investors find out about new issues in the
primary market via a telecommunications
network
 Purchased by corporations and financial
institutions
 Secondary market for securities exists
3
Money Market Securities
 Treasury bills
Issued to meet the short term needs of the
U.S. government
Attractive to investors
• Liquidity
• Fairly safe from default risk due to
government backing
• Strong secondary market exists
4
Money Market Securities
 Treasury bill auction competitive bids (Fill bids in
amount determined by Treasury borrowing
needs)
Bid process used to sell T-bills
Bids submitted to Federal Reserve banks by
the deadline
Bid process
• Accepts highest bids
• Accepts bids until generates total needed
5
Money Market Securities
 Estimating T-bill yield
No coupon payments
Par or face value received at maturity
Yield at issue is the difference between the
selling price and par or face value
If sold prior to maturity in secondary market
• Yield based on the difference between
price you paid to buy T-bill and price you
sold it for
6
Money Market Securities
 Calculating T-bill yields
Annualized yield
YT =
SP - PP
PP

365
n
YT = The annualized yield from investing in a T-bill
SP = Selling price
PP = Purchase price
n = number of days of the investment (holding period)
7
Money Market Securities
 Calculating T-bill yields
T-bill discount for a newly issued security
T-bill discount =
Par - PP
PP

360
n
T-bill discount = percent discount of the purchase price from par
Par = Face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
8
Money Market Securities
 Commercial paper
Short-term debt instrument
Used only by well-known and creditworthy
firms
Unsecured
Minimum denominations of $100,000
Not an active secondary market
9
Money Market Securities
 Commercial paper ratings
Past defaults means a rating for default risk
helps investors evaluate risks and issuers sell
the securities
Ratings agencies assign a grade based on
credit risk
 Commercial paper placement choices
Direct placement
Commercial paper dealers
10
Money Market Securities
 Backing commercial paper with a line of credit
Used in case they can’t roll over or reissue
new debt at a reasonable rate
Rating change would affect cost
Bank gives issuer right but not obligation to
borrow a certain amount for a specified period
of time
Bank charges fees
11
Money Market Securities
 Estimating commercial paper yields
YCP =
Par - PP
PP

360
n
YCP = Commercial paper yield
Par = Face value at maturity
PP = Purchase price
n = number of days to maturity
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Money Market Securities
 Negotiable certificates of deposit NCDs
Issued by large commercial banks
Minimum denomination of $100,000 but $1
million more common
Purchased by nonfinancial corporations or
money market funds
Secondary market exists but issuers don’t
like new issues to compete with previous
issues in the secondary market
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Money Market Securities
 NCD placement
Direct placement
Use a correspondent institution specializing
in placement
Sell to securities dealers who resell
Sell direct to investors at a higher price
 NCD premiums
Rate above T-bill rate to compensate for less
liquidity and safety
14
Money Market Securities
 Repurchase agreements
Sell a security with the agreement to
repurchase it at a specified date and price
Borrower defaults, lender has security
Reverse repo name for transaction from
lender
Negotiated over telecommunications network
Dealers and brokers used or direct placement
No secondary market
15
Money Market Securities
 Estimating repurchase agreement yields
Repo Rate =
SP - PP
PP

360
n
Repo Rate = Yield on the repurchase agreement
SP = Selling price
PP = Purchase price
n = number of days to maturity
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Money Market Securities
 Federal funds
Depository institutions use to borrow and lend
short-term funds with each other
Federal funds rate usually slightly higher than
T-bill rate
Fed district bank debits and credits accounts
Federal funds brokers may match up buyers
and sellers using telecommunications network
Usually $5 million or more
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Money Market Securities
 Banker’s acceptances
A bank takes responsibility for a future
payment
Usually result from international transactions
Exporters send goods to a foreign destination
and want payment assurance before sending
Bank stamps a draft from the importer
ACCEPTED and obligates the bank to make
good on the payment at a specific time
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Money Market Securities
 Banker’s acceptances
Exporter can hold until the date or sell before
maturity
If sold to get the cash before maturity, price
received is a discount from draft’s total
Return is based on calculations for other
discount securities
 Similar to the commercial paper example
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Institutional use of Money Markets
 Used by many kinds of institutional investors
both to invest and borrow
 Money market securities enhance liquidity
Newly issued securities raise cash
Buyers of securities generate cash when
they liquidate they holdings
 Active secondary market helps liquidity
 Short-term maturity enhances liquidity
20
Valuation of Market Securities
 Many money market securities do not make
interest payments
 Value is the present value of the security at
maturity
 Par or face value is the future value of a lump
sum
 Discount rate is rate investors require
 Like bonds, an inverse relationship between
price and yield
21
Interaction Among Money Market
Yields
 Securities in the money market have
interrelated yields
Investors can substitute among securities
Investors trade if a price and yield disparity
occurs among securities
 Economic uncertainty causes an investor shift to
securities with lower possible risk of default
22
Globalization of Money Markets
 Some segmentation remains in the global
money market
 Rates among countries have become more
interrelated over time
 Increase in the flow of funds
Tax differences among countries
Speculation on exchange rate changes
Reduced government barriers
23
Globalization of Money Markets
 Eurodollar deposits and Euronotes
Dollar deposits in banks outside the U.S.
Increased because of international trade
growth
No reserve requirements at banks outside
U.S.
 Eurodollar Loans
Channel funds to other multinationals that
need short-term financing
24
Globalization of Money Markets
 Eurodollar deposits and Euronotes
 Eurocurrency market consists of several banks
that with loans and deposits denominated in
Eurocurrencies
 Eurodollar CDs
Secondary market
Some have floating rates tied to LIBOR or
London Interbank Offer Rate
 Eurocredit market offers longer maturity loans
25
Globalization of Money Markets
 Euro-commercial paper
Issued without the backing of a banking
syndicate
Maturity tailored to investors
Dealers that place paper created a secondary
market
26
Globalization of Money Markets
 Performance of international securities
 Effective yield for international securities has
two components
The yield earned on the investment
denominated in the currency of the
investment
The exchange rate effect
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