12
Chapter
Money Market Instruments:
Commercial Paper, Federal Agency
Securities, Bankers’ Acceptances, and
Eurocurrency Deposits
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
12 - 2
 Learning Objectives 
 To discover the important roles that large
corporations, government agencies and banks
play in the money market.
 To explore the nature and characteristics of
commercial paper.
 To learn how federal agencies aid various
economic sectors in finding low-cost credit.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 3
 Learning Objectives 
 To see the trend toward the internationalization
of the money market, and examine how
bankers’ acceptances and Eurodeposits are
employed in aiding both domestic and
international trade.
 To understand how the transfers of money
from one spending unit to another across
international boundaries can impact a nation’s
economy.
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Commercial Paper
 Commercial paper consists of short-term,
unsecured promissory notes issued by wellknown and financially strong companies.
 Commercial paper is traded mainly in the
primary market. Opportunities for resale in the
secondary market are more limited.
 Commercial paper is rated prime, desirable, or
satisfactory, depending on the credit standing
of the issuing company.
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Types of Commercial Paper
 There are two major types of commercial
paper.
 Direct paper is issued mainly by large finance
companies and bank holding companies
directly to the investor.
 Dealer paper, or industrial paper, is issued by
security dealers on behalf of their corporate
customers (mainly nonfinancial companies and
smaller financial companies).
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12 - 6
Structure of the Commercial Paper Market
Supply Side
Demand Side
Issuers of
commercial paper
Direct or finance
Finance
paper
companies
Bank holding
companies
Paper
Nonfinancial
dealer
firms
Dealer or houses
industrial
paper
McGraw Hill / Irwin
Investors in
commercial paper
Money market
funds
Banks
Insurance
companies
Pension funds
Industrial
companies
Other investors
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12 - 7
Maturities & Rate of Return
 Maturities of U.S. commercial paper range
from three days (“weekend paper”) to nine
months.
 Most commercial paper is issued at a discount
from par, and yields to the investor are
calculated by the bank discount method, just
like Treasury bills.
360
DR = Par value – Purchase price 
Par value
Days to maturity
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.
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Growth of Commercial Paper
 The volume of commercial paper has grown
rapidly due to its relatively low cost and high
quality, as well as the expanding use of credit
enhancements.
Year
1960
1970
1980
1990
2000
2001
McGraw Hill / Irwin
Outstanding Volume
of Paper in the U.S.
$
4.5 billion
33.4
124.4
562.7
Effect of
1,615.3
weaker economy
1,438.8
& terrorism
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 9
Market Yields on Commercial Paper
%
9
8
7
6
5
Federal Funds
Commercial Paper
Bankers' Acceptances
Bank Prime Loans
Treasury Bills
4
3
2
1991
1993
1995
1997
1999
2001
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
12 - 10
Commercial Paper
Advantages
 Relatively low interest rates
 Flexible interest rates - choice of dealer or
direct paper
 Large amounts may be borrowed conveniently
 The ability to issue paper gives considerable
leverage when negotiating with banks
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Commercial Paper
Disadvantages
 Risk of alienating banks whose loans may be
needed when an emergency develops
 May be difficult to raise funds in the paper
market at times
 Commercial paper must generally remain
outstanding until maturity - does not permit
early retirement without penalty
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Continuing Innovation in the Paper Market
 Innovations and extensions of the paper market
include:
Master note – the investing firm agrees to take
some paper each day up to an agreed-upon
maximum amount
 Medium-term notes – 9-month to 10-year notes
 Asset-backed commercial paper – loans or credit
receivables are pooled and paper is then issued as a
claim against that pool

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Federal Agency Securities
 Certain sectors of the economy, such as
agriculture, housing, small businesses, and
college students, appear to have an unusually
difficult time raising funds in the money and
capital markets.
 Beginning in 1916, the U.S. federal
government created special agencies to make
direct loans or guarantee private loans to these
“disadvantaged” borrowers.
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Types of Federal Credit Agencies
 Government-sponsored agencies are federally
chartered but privately owned. Their
borrowing and lending activities are not
reflected in the federal government’s budget.
 Examples:
Federal Farm Credit Banks (FFCB)
 Federal Home Loan Mortgage Corp (Freddie Mac)
 Student Loan Marketing Association (Sallie Mae)
 Financing Assistance Corporation (FAC)

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Types of Federal Credit Agencies
 Federal agencies are legally a part of the
government structure, and their borrowing and
lending activities are included in the federal
budget.
 Examples:
Export-Import Bank (EXIM)
 Farmers Home Administration (FMHA)
 Government National Mortgage Association
(Ginnie Mae)
 Federal Deposit Insurance Corporation (FDIC)

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The Roles of Federal Credit Agencies
Performing the Roles of a Financial Intermediary
Borrowing funds
from the open
market and from
other government
agencies
McGraw Hill / Irwin
Granting loans to
disadvantaged
sectors
Federal &
governmentsponsored
credit
agencies
Guaranteeing
loans made by
other lenders
Buying loans
from the
secondary market
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 17
Federal Agency Securities
 The agency market has soared in recent years,
with the volume of outstanding securities
climbing from about $2 billion during the
1950s to almost $2 trillion today.
 Agency securities are generally short to
medium term in maturity (running out to about
10 years).
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The Marketing of Agency Issues
 The most active buyers of agency securities
include banks, state and local governments,
government trust funds, and the Federal
Reserve System.
 The Federal Reserve is authorized to conduct
open market operations in agency IOUs.
 Major securities dealers who handle U.S.
government securities also generally trade in
agency issues.
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12 - 19
Bankers’ Acceptances
 A bankers’ acceptance is a time draft drawn on
and endorsed by an importer’s bank.
 Acceptances are used in international trade
because most exporters are uncertain of the
credit standing of their importers.
 The issuing bank unconditionally guarantees to
pay the face value of the acceptance when it
matures, thus shielding exporters and investors
in international markets from default risk.
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Bankers’ Acceptances
 Acceptances carry maturities ranging from 30
to 270 days, with 90 days being the most
common.
 They are traded among financial institutions,
industrial corporations, and securities dealers
as a high-quality investment and source of
ready cash.
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12 - 21
How Acceptances Arise
Importer applies for line of credit
Importer’s bank issues letter of credit in favor of exporter
Letter of credit authorizes the drawing of a time draft
Importer’s bank accepts time draft from exporter’s bank
Importer’s bank pays exporter’s bank discounted value of
bankers’ acceptance, and then holds or sells it
Bankers’ acceptance is redeemed at maturity
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The Growth and Decline of Acceptance Financing
 The volume of US$ acceptances outstanding
grew rapidly, from less than $400 million in
1950, to slightly more than $7 billion in 1970,
and almost $80 billion in 1984.
 Then the volume declined sharply to $10
billion in 2000, as several leading export
nations entered a recession, as economic
problems developed in Asia, and as businesses
turn to other payment and financing methods.
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12 - 23
Acceptance Rates
 Acceptances do not carry a fixed rate of
interest, but are sold at a discount in the open
market like Treasury bills.
 The yield on acceptances is usually only
slightly higher than the yield on Treasury bills,
and close to the negotiable CD rates offered by
major banks, because of the high credit quality
of the banks that issue the acceptances and
CDs.
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12 - 24
Acceptance Rates
%
6.5
6
5.5
5
4.5
Commercial Paper
Bankers' Acceptances
Treasury Bills
Certificates of Deposit
4
3.5
3
1991
1993
1995
1997
1999
2001
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
12 - 25
Investors in Acceptances
 Investors in acceptances include banks,
industrial corporations, money market mutual
funds, local governments, federal agencies,
and insurance companies.
 To many investors, acceptances are a close
substitute for Treasury bills, negotiable CDs,
or commercial paper in terms of quality,
although the acceptance market is far smaller
in terms of the volume of trading.
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12 - 26
Eurocurrency Deposits
 The Eurocurrency market has arisen because
of the tremendous need worldwide for funds
denominated in dollars, Euros, pounds, and
other relatively stable currencies.
 The Eurocurrency market represents the
largest of all money markets worldwide, with
total funds probably in excess of $4 trillion.
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12 - 27
Eurocurrency Deposits
 Eurodollars are deposits of U.S. dollars in
banks located outside the U.S.
 The large majority of Eurodollar deposits are
held in Europe, although Europe’s share of the
total is declining.
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Eurocurrency Deposits
 Eurodollars and other Eurocurrency deposits
are continually on the move in the form of
loans.
 They are employed to finance the import and
export of goods, to supplement government tax
revenues, to provide working capital for the
foreign operations of multinational
corporations, and to provide liquid reserves for
the largest banks.
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12 - 29
Eurocurrency Deposits
 When a dollar deposit is moved to a bank
located outside the U.S., that bank then holds
claim to the original dollar deposit in the U.S.
 When a Eurodollar loan is made, the borrower
receives a claim against dollars deposited in
U.S. banks.
 Funds are merely passed from one U.S. bank
to another. The total amount of dollar deposits
and U.S. bank reserves remains unchanged.
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12 - 30
Eurocurrency Maturities and Risks
 Most Eurocurrency deposits are short-term
deposits ranging from overnight to one year,
although a small percentage are long-term time
deposits.
 Eurocurrency deposits are known to be volatile
and highly sensitive to fluctuations in interest
rates and currency prices. They also carry
political risk and default risk.
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The Supply of Eurocurrency Deposits
 Eurocurrency deposits come from …
foreign investment
 tourism
 balance of payments (trade) settlements
 interbank funds
 government funds
 large corporations’ cash balances
 central banks supplying or absorbing funds from
the banking system

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12 - 32
Eurodollars in U.S. Domestic Bank Operations
 Since the late 1960s, U.S. banks have drawn
heavily on Eurodollar deposits as a means of
adjusting their domestic reserve positions.
 Eurodollars usually carry higher reported
interest rates than many other sources of bank
reserves. However, there are fewer legal
restrictions on the borrowing of Eurodollars.
 U.S. banks also aid their customers in
acquiring Eurocurrency deposits and loans.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 33
Interest Rates on Eurodollar Deposits
%
6.5
6
5.5
5
4.5
Treasury Bills
Certificates of Deposit
Federal Funds
Eurodollar Deposits (London)
4
3.5
3
1991
1993
1995
1997
1999
2001
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
12 - 34
Benefits and Costs of the Eurocurrency Markets
Benefits
 Makes possible an efficient mobilization of
funds around the globe.
 Encourages international cooperation among
nations.
 Creates a cash-management source to aid the
financial operations of corporations and
governments around the globe.
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12 - 35
Benefits and Costs of the Eurocurrency Markets
Costs
 The capacity to mobilize massive amounts of
funds may contribute to instability in currency
values.
 Monetary and fiscal policies designed to cure
domestic economic problems may not achieve
their desired impact.
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12 - 36
Money and Capital Markets in Cyberspace
 More information about the various money
market instruments can be found at:

http://www.investopedia.com/university/moneyma
rket/

http://www.ny.frb.org/pihome/fedpoint/

http://www.federalreserve.gov/releases/

http://www.fanniemae.com/

http://www.freddiemac.com/

http://www.bis.org/publ/
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12 - 37
Chapter Review
 Commercial Paper
What Is Commercial Paper?
 Types of Commercial Paper
 Structure of the Commercial Paper Market
 Maturities & Rate of Return on Commercial Paper
 Growth of Commercial Paper
 Market Yields on Commercial Paper
 Advantages & Disadvantages
 Continuing Innovation in the Paper Market

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 38
Chapter Review
 Federal Agency Securities
Types of Federal Credit Agencies
 The Roles of Federal Credit Agencies
 Growth of the Agency Market
 Terms on Agency Securities
 The Marketing of Agency Issues

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 39
Chapter Review
 Bankers’ Acceptances
Why Acceptances Are Used in International Trade
 How Acceptances Arise
 The Growth and Decline of Acceptance Financing
 Acceptance Rates
 Investors in Acceptances

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
12 - 40
Chapter Review
 Eurocurrency Deposits
What is a Eurodollar?
 The Creation of Eurocurrency Deposits
 Eurocurrency Maturities and Risks
 The Supply of Eurocurrency Deposits
 Eurodollars in U.S. Domestic Bank Operations
 Benefits and Costs of the Eurocurrency Markets

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.