Answers to Chapter 5

Questions:

1. First, money market instruments are generally sold in large denominations (often in units of $1 million to $10
million). Most money market participants want or need to borrow large amounts of cash so that transactions costs
are low relative to the interest paid. The size of these initial transactions prohibits most individual investors from
investing directly in money market securities. Rather, individuals generally only invest in money market securities
indirectly with the help of financial institutions such as money market mutual funds.

Second, money market securities have low default risk; the risk of late or nonpayment of principal and/or interest is
generally small. Since cash lent in the money markets must be available for a quick return to the lender, money
market instruments can generally be issued only by high quality borrowers with little risk of default.

Finally, money market securities must have an original maturity of one year or less. Recall from Chapter 3 that the
longer the maturity of a debt security, the greater is its interest rate risk and the higher its required rate of return (the
higher its liquidity risk premium). Given that adverse price movements resulting from interest rate changes are
smaller for short term securities, the short term maturity of money market instruments helps lower the risk that
interest rate changes will significantly affect the security’s market value and price.

2. The discount yield differs from a bond equivalent yield for two reasons: i) the base price used is the face value of
the security and not the purchase price of the security and ii) a 360-day year is used. The bond equivalent yield uses
a 365-day year and the purchase price, rather than the face value of the security, is used as the base price. Treasury
bills are quoted on a discount yield basis.

3. There are several features of a discount yield that prohibit it from being compared to yields on other
(nondiscount) securities. Specifically, the discount yield uses the terminal price (or face value) as the base price in
calculating a nominal interest rate. Typically, nominal rates are based on the purchase price of a security. Further,
and as already mentioned, discount yields use a 360-day rather than a 365-day year. An appropriate comparison of
nominal interest rates on discount securities versus nondiscount securities would require that the discount yield be
converted to a bond equivalent yield in the following manner:

ibe = id (Pf/Po)(365/360)

Finally, neither of these yields considers the compounding of interest rates during the (less than one year)
investment horizon. The EAR on a discount security would be calculated by applying the bond equivalent yield for
the discount security to the EAR equation.

4. Single-payment securities pay interest only once, at maturity. Quoted interest rates on single-payment securities
assume a 360-day year. Therefore, to compare single-payment yields with bond equivalent yields, the quoted single-
payment yield must be converted into a bond equivalent rate or yield. The conversion of a single-payment yield to a
bond equivalent rate is calculated as follows: ibe = isp (365/360).

5. The U.S. Treasury has a formal process by which it sells new issues of Treasury bills through its regular Treasury
bill auctions. Every week (usually on a Thursday) the amount of new 91-day and 182-day T-bills the Treasury will
offer for sale is announced. Bids may be submitted by government securities dealers, financial and nonfinancial
corporations, and individuals and must be received by a Federal Reserve Bank by the 1 pm Monday following the
auction announcement. Allocations and prices are announced the following morning (Tuesday). In addition auctions
of 52-week (1-year) T-bills are conducted by the U.S. Treasury on a monthly basis.

6. Submitted bids can be either competitive bids or noncompetitive bids. Competitive bids specify the amount of
par value of bills desired (the minimum is $100) and the discount yield (in increments of 0.005%), rather than the
price. The amount of noncompetitive bids is subtracted from the total face value of the auctioned bills, with the
remainder to be allocated to competitive bidders. Competitive bids are then ranked from the lowest discount yield
(highest price) to the highest yield (lowest price). The cut-off yield (the yield of the last accepted bid) is the highest
accepted discount yield; it is known as the stop-out yield or stop-out rate of the auction. It determines the price per
$100 that every successful bidder pays. All bids with yields above the stop-out yields are rejected. If the amount of
competitive bids at the stop-out yield exceeds the amount of bills remaining to be allocated after the superior bids
have been allocated, the bids at the stop-out rate are distributed on a pro-rata basis. For example, if the bids at the
stop-out yield total $5 billion of par value, but there is only $3 billion of par value remaining after satisfying
noncompetitive bids and competitive bids with lower yields (higher prices), then the bidders whose yield turned out
to be the stop-out yield will receive 60 percent of their desired allocations ($3 billion/$5 billion). This proportion is
reported as ‘allotted at high’ in the U.S. Treasury auction result announcements. Bidders cannot submit negative
yields in T-bill auctions, but may submit a yield of zero, which means that they are willing to pay face value and
earn no income from the bills. Competitive bids are generally used by large investors and government securities
dealers, and make up the majority of the auction market.

Noncompetitive bids are limited to $5 million; they specify only the desired amount of the face value of the bills.
Noncompetitive bids usually represent a small portion of total Treasury bills auctioned. If the amount of
noncompetitive bids exceeds the amount of bills auctioned, all noncompetitive bids would be satisfied on a pro-rata
basis, all competitive bids would be rejected, and the price of the bills would be set at par, reflecting a yield of zero.
Noncompetitive bids allow small investors to participate in the T-bill auction market without incurring large risks.
That is, small investors who are unfamiliar with money market interest rate movements can use a noncompetitive
bid to avoid bidding a price too low to receive any of the T-bills or bidding too high and paying more than the “fair”
market price.

7. The secondary market for T-bills is the largest of any U.S. money market security. At the heart of this market are
those securities dealers designated as primary government securities dealers by the Federal Reserve Bank of New
York (consisting of 21 financial institutions) who purchase the majority of the T-bills sold competitively at auction
and who create an active secondary market. In addition, there are many (approximately 500) smaller dealers who
directly trade in the secondary market. Primary dealers make a market for T-bills by buying and selling securities for
their own account and by trading for their customers, including depository institutions, insurance companies,
pension funds, and so on. T-bill transactions by primary dealers averaged $714 billion per day in June 2013. The T-
bill market is decentralized, with most trading transacted over the telephone. Brokers keep track of the market via
closed circuit television screens located in the trading rooms of the primary dealers. These television screens display
bid and asked prices available at any point in time. Treasury markets are generally open from 9:00 A.M. to 3:30
P.M. EST.

Secondary market T-bill transactions between primary government securities dealers are conducted over the Federal
Reserve’s wire transfer service and are recorded via the Federal Reserve’s book-entry system. A bank or broker that
is not a primary government securities dealer or a secondary market dealer must contact (via phone, fax, or wire)
one of these dealers to complete the transaction. T-bill dealers maintain records identifying owners of all Treasury
securities held in its account in the book-entry system.

8. Federal funds are not formal securities. Rather, fed funds are short term loans between financial institutions,
usually for a period of one day. The institution that borrows fed funds incurs a liability on its balance sheet, “federal
funds purchased,” while the institutions that lends the fed funds records an asset, “federal funds sold.”

9. Two forms of federal funds transactions are commonly used: i) negotiations between two commercial banks
often takes place directly over the telephone between the “money dealers” of the banks involved or ii) the
transaction may occur through a fed funds broker. Figure 5-3 illustrates the two methods through which a fed funds
transaction can occur. For example, a bank that finds itself with $75 million in excess reserves can call its
correspondent banks to see if they need overnight reserves. The bank will then sell its excess reserves to those
correspondent banks that offer the highest rates for these fed funds. When a transaction is agreed upon, the lending
bank instructs its district Federal Reserve Bank to transfer the $75 million in excess reserves to the borrowing
bank’s reserve account at its Federal Reserve Bank. The Federal Reserve System’s wire transfer network, Fedwire,
is used to complete the transfer of funds. The next day the funds are transferred back, via Fedwire, from the
borrowing bank to the lending bank’s reserve account at the Federal Reserve Bank plus one day’s interest.
Overnight fed fund loans will likely be based on an oral agreement between the two parties and are generally
unsecured. Increasingly, participants in the fed funds markets do not hold balances at the Federal Reserve. In this
case the fed funds transaction is settled in immediately available funds: fed funds on deposit at the lending bank that
may be transferred or withdrawn with no delay. In this case a federal funds broker, typically a commercial bank,
matches up institutions using a telecommunications network that links federal funds brokers with participating
institutions. Upon maturity of the fed funds loan, the borrowing bank’s fed fund demand deposit account at the
lending bank is debited for the total value of the loan and the lending bank pays the borrowing bank an interest
payment for the use of the fed funds.

10. One of the primary risks of the interbank lending system is that the borrowing bank does not have to pledge
collateral for the funds it receives, which are usually in millions of dollars. While the Fed has the ability to use open
market operations to influence the interest rates banks charge each other and can introduce new capital to encourage
banks to lend, the interbank loans are conducted with little scrutiny between parties. The financial crisis of 2008‐
2009 produced unprecedented and persistent strains in interbank lending and exposed problems produced by banks
that were heavily leveraged with fed funds. The financial crisis created a huge demand for liquid assets across the
entire financial system. Rather than lend excess funds in the interbank market, banks preferred to hold onto liquid
assets just in case their own needs might increase. Banks also grew concerned about the risks of borrowing banks
and became increasingly unwilling to lend, even very high interest rates, as the level of confidence in the banking
system plunged. Interbank loans fell to $153 billion in June 2010 from a peak of $494 billion in September 2008, the
month that Lehman Brothers declared bankruptcy. Unable to borrow in the interbank market, U.S. banks turned to
the Fed for short-term borrowing, and the Fed obliged. At height of the financial crisis, the Fed unexpectedly
announced that it would drop its target fed funds rate to a range between zero and one-quarter of 1 percent. (The rate
remained at these historically low levels into 2013, and it was not until June 2013 that the Fed announced it might
begin to allow rates to increase by the end of the year.) Eventually, unprecedented actions by the Fed to add liquidity
and guarantee bank debt were able to counter the record strains in the interbank market. However, the financial
crisis made it painfully clear that financial institutions cannot always count on being able to borrow at a low cost
when needed.

11. A repurchase agreement (repos or RPs) is an agreement involving the sale of securities by one party to another
with a promise to repurchase the securities at a specified price and on a specified date in the future. Thus, a
repurchase agreement is essentially a collateralized fed funds loan backed by the securities. The securities used most
often in repos are U.S. Treasury securities (e.g., T-bills) and government agency securities (e.g., Fannie Mae). A
reverse repurchase agreement (reverse repo) is an agreement involving the purchase of securities by one party from
another with the promise to sell them back at a given date in the future.

12. Repurchase agreements are arranged either directly between two parties or with the help of brokers and dealers.
Figure 5–4 illustrates a $75 million repurchase agreement of Treasury bonds arranged directly between two parties
(e.g., J.P. Morgan Chase and Bank of America). The repo buyer, J.P. Morgan Chase, arranges to purchase fed funds
from the repo seller, Bank of America, with an agreement that the seller will repurchase the fed funds within a stated
period of time—one day. The repo is collateralized with T-bonds. In most repurchase agreements, the repo buyer
acquires title to the securities for the term of the agreement.

Once the transaction is agreed upon, the repo buyer, J.P. Morgan Chase, instructs its district Federal Reserve Bank
(the FRBNY) to transfer $75 million in excess reserves, via Fedwire, to the repo seller’s reserve account. The repo
seller, Bank of America, instructs its district Federal Reserve Bank (the FRB of San Francisco) to transfer $75
million from its T-bond account via securities Fedwire to the repo buyer’s T-bond account. Upon maturity of the
repo (one day in this example), these transactions are reversed. In addition, the repo seller transfers additional funds
(representing one day’s interest) from its reserve account to the reserve account of the repo buyer.

13. This 270 day maximum is due to a Securities and Exchange Commission (SEC) rule that securities with a
maturity of more than 270 days must go through the time consuming and costly registration process to become a
public debt offering (i.e., a corporate bond).

14. Because commercial paper is not actively traded and because it is also unsecured debt, the credit rating of the
issuing company is of particular importance in determining the marketability of a commercial paper issue. Credit
ratings provide potential investors with information regarding the ability of the issuing firm to repay the borrowed
funds, as promised, and to compare the commercial paper issues of different companies. Several credit rating firms
rate commercial paper issues (e.g., Standard & Poor’s, Moody’s, and Fitch Investor Service). Virtually all
companies that issue commercial paper obtain ratings from at least one rating services company and most obtain two
rating evaluations. The better the credit rating on a commercial paper issue the lower the interest rate on the issue.
15. One reason for the growth of the commercial paper markets is that companies with strong credit ratings can
generally borrow money at a lower interest rate by issuing commercial paper than by directly borrowing (via loans)
from banks. Indeed, although business loans were the major asset on bank balance sheets between 1965 and 1990,
they have dropped in importance since 1990. Companies have replaced this bank debt with commercial paper. This
trend reflects the growth of the commercial paper market.

In the early 2000s, the slowdown in the U.S. economy resulted in ratings downgrades for some of the largest
commercial paper issuers. For example, the downgrade of General Motors and Ford from a tier-one to tier-two
commercial paper issuer had a huge impact on the commercial paper markets. The result is that these commercial
paper issuers were forced to give up the cost advantage of commercial paper and to move to the long-term debt
markets to ensure they would have access to cash. The decrease in the number of eligible commercial paper issuers
in the early 2000s resulted in a decrease in the size of the commercial paper market for the first time in 40 years. The
mid-2000s saw a huge rise in the use of asset-backed commercial paper (ABCP). In July 2007, $1.19 trillion of the
total $2.16 trillion commercial paper outstanding was ABCP. ABCP is collateralized by other financial assets of the
issuer. The financial assets that serve as collateral for ABCP are ordinarily a mix of many different assets, which are
jointly judged to have a low risk of bankruptcy by a ratings agency. In the mid-2000s, the collateralized assets were
mainly mortgage-backed securities. However, in 2007–2008 many of these mortgage-backed securities performed
more poorly than expected. Billions of dollars of asset-backed commercial paper were tainted because some of the
proceeds were used to buy investments tied to U.S. subprime mortgages. Issuers found buyers much less willing to
purchase ABCP. The result was another big drop in the dollar value of the commercial paper markets. [In June 2013,
just $391 billion of ABCP was outstanding (of the total $1.08 trillion commercial paper market)].

In addition, on September 16, 2008 (one day after Lehman Brothers filed for bankruptcy), Reserve Primary Fund,
the oldest money market fund in the United States saw its shares fall to 97 cents (below the $1.00 book value) after
writing off debt issued by Lehman Brothers. Resulting investor anxiety about Reserve Primary Fund spread to other
funds, and money market mutual funds withdrawals skyrocketed. Fund investors pulled out a record $144.5 billion
during the week ending Wednesday, September 17 (redemptions during the week of September 10 totaled just $7.1
billion) as investors worried about the safety of even these safest investments. Money market mutual funds
participate heavily in the commercial paper market. As investors pulled their money from these funds, the
commercial paper market shrank by $52.1 billion for the week (through Wednesday). These outflows severely
undermined the stability of short-term funding markets, upon which many financial institutions and large
corporations rely heavily to meet their short-term borrowing needs. In response, the Federal Reserve Board
announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that complemented the Federal
Reserve’s existing credit facilities, to help provide liquidity to short-term funding markets. Under the plan, the
Federal Reserve stepped in to purchase commercial paper and other short-term debt.

Even as markets stabilized after the financial crisis, outstanding values of financial and non-financial commercial
paper continued to fall: from over $2.16 trillion at its peak in July 2007, the commercial paper market has fallen to
$1.76 trillion in July 2008, $1.21 trillion in July 2009, and just $0.99 trillion in July 2013. Reasons for this include a
combination of related factors. First, negative and low positive economic growth experienced for years after the
financial crisis produced lower demand for funds and thus less of a need to issue commercial paper. Second,
financial and non-financial firms held record amounts of cash reserves after the financial crisis and thus did not need
to borrow as much in the short-term commercial paper markets. Finally, long-term debt rates were at historical lows
after the financial crisis. As a result, many corporations increased their issuance of longer term debt so as to lock in
their financing costs at these low rates for many years: the financial crisis showed how risky rolling over short-term
borrowings can be.

16. The bank and the CD investor directly negotiate a rate, the maturity and, the size of the CD. Once this is done,
the issuing bank delivers the CD to a “custodian” bank specified by the investor. The custodian bank verifies the
CD, debits the amount to the investor’s account, and credits the amount to the issuing bank. This is done though the
Fedwire system, i.e., by transferring fed funds from the custodian bank’s reserve account at the Fed to the issuing
bank’s reserve account.

17. Most banker’s acceptances 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 often prefer
that banks act as guarantors for payment before sending goods to domestic importers, particularly when the foreign
supplier has not previously done business with the domestic importer on a regular basis. The U.S. bank ensures the
international transaction by stamping “Accepted” on a trade draft between the exporter and the importer, signifying
its obligation to pay the foreign exporter (or its bank) on a specified date should the importer fail to pay for the
goods. Foreign exporters can then hold the banker’s acceptance until the date specified on the trade draft or, if they
have an immediate need for cash, can sell the acceptance before that date at a discount from the face value to a buyer
in the money market (e.g., a bank). In this case, the ultimate bearer will receive the face value of the banker’s
acceptance on maturity.

18. The major money market participants are the U.S. Treasury, the Federal Reserve, commercial banks, money
market mutual funds, brokers and dealers, corporations, other financial institutions, such as insurance companies,
and individuals. The U.S. Treasury raises significant amounts of funds in the money market when it issues T-bills.
T-bills are the most actively traded of the money market securities. T-bills allow the U.S. government to raise
money to meet unavoidable expenditure needs prior to the receipt of tax revenues. Tax receipts are generally
concentrated around quarterly dates, but government expenditures are more evenly distributed over the year.

The Federal Reserve is a key participant in the money markets. The Federal Reserve holds T-bills (as well as T-
notes and T-bonds) to conduct open market transactions: purchasing T-bills when it wants to increase the money
supply and selling T-bills when it wants to decrease the money supply. The Federal Reserve often uses repurchase
agreements and reverse repos to temporarily smooth interest rates and the money supply. Moreover, the Fed targets
the federal funds rate on interbank loans as part of its overall monetary policy strategy, which can in turn affect other
money market rates. Finally, the Fed operates the discount window which it can use to influence the supply of bank
reserves to commercial banks and ultimately the demand for and supply of fed funds and the fed funds rate.

Commercial banks are the most diverse group of participants in the money markets. Banks participate as issuers
and/or investors of almost all money market instruments. For example, banks are the major issuers of negotiable
CDs, banker’s acceptances, federal funds, and repurchase agreements. The importance of banks in the money
markets is driven in part by their need to meet regulatory imposed reserve requirements. For example, during
periods of economic expansion, heavy loan demand can produce reserve deficiencies for banks (i.e., their actual
reserve holdings are pushed below the minimums required by regulation). Additional reserves can be obtained by
borrowing fed funds from other banks, engaging in a reverse repurchase agreement, selling negotiable CDs, or
selling commercial paper. Conversely, during contractionary periods, many banks have excess reserves which they
can use to purchase Treasury securities, trade fed funds, engage in a repo, etc.

Money market mutual funds purchase large amounts of money market securities and sell shares in these pools based
on the value of their underlying (money market) securities. In doing so, money market mutual funds allow small
investors to invest in money market instruments. Money market mutual funds provide an alternative investment
opportunity to interest-bearing deposits at commercial banks.

Brokers and dealers services are important to the smooth functioning of money markets. We have alluded to various
categories of brokers and dealers in the chapter. First, are the 30 primary government security dealers. This group of
participants plays a key role in marketing new issues of Treasury bills (and other Treasury securities). Primary
government securities dealers also make the market in Treasury bills; buying securities from the Federal Reserve
when they are issued and selling them in the secondary market. Secondary market transactions in the T-bill markets
are transacted in the trading rooms of these primary dealers. These dealers also assist the Federal Reserve when it
uses the repo market to temporarily increase or decrease the supply of bank reserves available. The second group of
brokers and dealers are money and security brokers. These brokers play a major role in linking buyers and sellers in
the fed funds market and assist secondary trading in other money market securities as well. The third group of
brokers and dealers are the thousands of brokers and dealers who act as intermediaries in the money markets by
linking buyers and sellers of money market securities. This group of brokers and dealers often act as the
intermediaries for smaller investors who do not have sufficient funds to invest in primary issues of money market
securities or who simply want to invest in the money markets.

Nonfinancial and financial corporations raise large amounts of funds in the money markets, primarily in the form of
commercial paper. The volume of commercial paper issued by corporations has been so large that there is now more
commercial paper outstanding than any other type of money market security. Because corporate cash inflows rarely
equal their cash outflows, they often invest their excess cash funds in money market securities, especially T-bills,
repos, commercial paper, negotiable CDs, and banker’s acceptances.

Because their liability payments are relatively unpredictable, property-casualty (PC) insurance companies, and to a
lesser extent life insurance companies, must maintain large balances of liquid assets. To accomplish this insurance
companies invest heavily in highly liquid money market securities, especially T-bills, repos, commercial paper and
negotiable CDs. Since finance companies are not banks and cannot issue deposits, they raise large amounts of funds
in the money markets, especially through the issuance of commercial paper. Finally money market mutual funds
purchase large amounts of money market securities and sell shares in these pools based on the value of their
underlying (money market) securities. In doing so, money market mutual funds allow small investors to invest in
money market instruments.

Individual investors participate in the money markets through direct investments in these securities (e.g., negotiable
CDs) or through investments in money market mutual funds, which contain a mix of all types of money market
securities.

19. One of the more grievous actions by some global investment banks during the financial crisis was the
manipulation of the LIBOR. LIBOR is the average of the interest rates submitted by major banks in the United
States, Europe, and the United Kingdom in a variety of major currencies such as the dollar, euro, and yen. The
scandal arose when it was discovered that banks had been manipulating the LIBOR rate so as to make either profits
on its derivative positions (such as interest rate swaps) or to make the bank look stronger for reputational reasons. It
is estimated that the banks involved made at least $75 billion on the manipulations. The scandal became widely
public in June 2012 when British investment bank Barclays agreed to pay $450 million to settle allegations by U.S.
and British authorities that some of its traders attempted to manipulate LIBOR rates to increase the bank’s profits
and reduce concerns about its stability during the financial crisis.

Concerns were also raised about the failure of British and U.S. regulators to stop the manipulation of LIBOR when
there was evidence that both were aware of it. In July 2012, a former trader stated that LIBOR manipulation had
been occurring since at least 1991. In July 2012, the Federal Reserve Bank of New York released documents dated
as far back as 2007 showing that they knew that banks were misreporting their borrowing costs when setting
LIBOR. Yet, no action was taken. Similarly, documents from the Bank of England indicated that the bank knew as
early as November 2007 that the LIBOR rate was being manipulated. It was not until June 2012 that Barclays
became the first bank to agree to settle LIBOR manipulation allegations. In December 2012, UBS agreed to pay
about $1.5 billion to settle charges that it manipulated LIBOR. Also in December, the U.S. Justice Department
charged Tom Hayes, a former UBS and Citigroup trader, with conspiracy to commit fraud by manipulating the
LIBOR (in June 2013, he was charged with eight counts of fraud as part of the U.K. investigation). In February
2013, the Royal Bank of Scotland also decided to settle at a cost of $610 million. Also in early 2013, Deutsche Bank
stated that it had set aside money to cover potential fines associated with its role in the manipulation of the LIBOR.

Since its inception in the 1980s, LIBOR was managed by the British Bankers' Association (a London-based trade
group whose members are some of the world's biggest banks). As a result of the LIBOR scandal, British authorities
started looking for a new owner for LIBOR in 2012. In July 2013, the British government announced that LIBOR
would be sold to NYSE Euronext. Further, while ownership of LIBOR would be based in the U.S., responsibility for
regulating it would remain in the U.K.

20. Eurodollar certificates of deposits (CDs) are U.S. dollar denominated CDs in foreign banks. Maturities on
Eurodollar CDs are less than one year and most have a maturity of one week to six months. Because these securities
are deposited in non-U.S. banks, Eurodollar CDs are not subject to reserve requirements in the same manner as U.S.
deposits. This allows the rate offered on Eurodollar CDs to be somewhat higher than on comparable U.S. bank
issued CDs. However, U.S. deposits are insured up to certain amounts while Eurodollar CDs are not, which lowers
the Eurodollar CD rate compared to U.S. bank issued CDs. Eurocommercial paper (Euro-CP) is issued by dealers of
commercial paper without involving a bank. The Eurocommercial paper rate is generally about one-half to one
percent above the LIBOR rate.
Problems:

1. Discount yield: iT-bill, d = (($1m. - $973,750)/$1m.)(360/65) = 14.538%

Bond equivalent yield: iT-bill, be = (($1m. - $973,750)/$973,750)(365/65) = 15.138%
EAR: EAR = (1 + 0.15138/(365/65))365/65 - 1 = 16.111%

2. Discount yield: icp, d = (($5m. – 0.98625($5m.))/$5m.)(360/136) = 3.640%

Bond equivalent yield: icp, be = (($5m. - 0.98625($5m.))/0.98625($5m.)))(365/136) = 3.742%
EAR: EAR = (1 + 0.03742/(365/136))365/136 - 1 = 3.786%

3. The nominal bond equivalent yield is calculated as:

iCD, be = 6.56%(365/360) = 6.651%

The EAR on the CD is calculated as:

EAR = (1 + (0.06651)/(365/115))365/115 - 1 = 6.804%

4. The nominal bond equivalent yield is calculated as:

iff, be = 0.25%(365/360) = 0.2535%

The EAR on the CD is calculated as:

EAR = (1 + (0.002535)/(365/3))365/3 - 1 = 0.2538%

5. iT-bill, d = ((10,000 - 9,875)/10,000) (360/68) = 6.62%

6. a. The T-bill’s quoted yield is calculated as

iT-bill, d = $10,000 - $9,765 x 360 = 6.768%

$10,000 125

b. The T-bill’s bond equivalent yield is calculated as

iT-bill, be = $10,000 - $9,765 x 365 = 7.027%

$9,765 125

7. a. The T-bill’s quoted yield is calculated as

iT-bill, d = $10,000 - $9,965 x 360 = 1.326%

$10,000 95

b. The T-bill’s bond equivalent yield is calculated as

iT-bill, be = $10,000 - $9,965 x 365 = 1.349%

$9,965 95

c. The T-bill’s bond EAR is calculated as

EAR = [1 + .01349/(365/95)]365/95 - 1 = 1.356%

8. a. The T-bill ask price is calculated as

Po = $10,000 - [ 0.00020 x 102 x $10,000] = $9,999.43

360
 b. The T-bill bid price is calculated as

Po = $10,000 - [ 0.00085 x 179 x $10,000] = $9,995.77

360

9. EXCEL Problem: Bid Price = $9,993.81

Bid Price = $9,984.51
Bid Price = $9,969.03
Bid Price = $9,938.06
Bid Price = $9,845.14

10. a. iT-bill, d = ($100,000-$95,850)/$100,000) x (360/225) = 6.64%

iT-bill, be = ($100,000-$95,850)/$95,850) x (365/225) = 7.02%
EAR = [1 + 0.0702/(365/225)]365/225 - 1 = 7.11%

b. iT-bill, d = ($100,000-$95,850)/$100,000) x (360/300) = 4.98%

iT-bill, be = ($100,000-$95,850)/$95,850) x (365/300) = 5.27%
EAR = [1 + 0.0527/(365/300)]365/300 - 1 = 5.29%

11. EXCEL Problem: Yield = 4.014%

Yield = 1.606%
Yield = 0.803%
Yield = 0.401%
Yield = 0.161%

12. iff, be = 2.25%(365/360) = 2.28125%

iff, be = 3.75%(365/360) = 3.80%

13. iff, be = 0.97%(365/360) = 0.98347%

Remembering that fed funds are generally lent for one day, The EAR on the fed funds can then be calculated as:

EAR = [1 + 0.00098347/(365/1)]365/1 - 1 = 0.98395%

14. a. The yield on this repo to the bank is calculated as follows

irepo, sp = $25,000,000 - $24,950,000 x 360 = 10.31%

$24,950,000 7

b. The yield on this repo to the bank is calculated as follows

irepo, sp = $25,000,000 - $24,950,000 x 360 = 3.44%

$24,950,000 21

15. a. irepo, be = 10.31%(365/360) = 10.45%

EAR = [1 + 0.1045/(365/7)]365/7 - 1 = 11.10%

b. irepo, be = 3.44%(365/360) = 3.48%

EAR = [1 + 0.0348/(365/21)]365/21 - 1 = 3.54%

16. The discount yield on the commercial paper is calculated as

 icp, d = $500,000 - $495,000 x 360 = 8.00%
$500,000 45
And the bond equivalent yield is:
icp, be = $500,000 - $495,000 x 365 = 8.19%
$495,000 45

17. The discount yield on the commercial paper is calculated as:

icp, d = $1,000,000 - $995,235 x 360 = 1.3723%

$1,000,000 125
And the bond equivalent yield is:
icp, be = $1,000,000 - $995,235 x 365 = 1.3980%
$995,235 125
Finally, the EAR on the commercial paper is:
EAR = [1 + 0.013980/(365/125)]365/125 - 1 = 1.4045%

18. a. iCD, be = 0.52%(365/360) = 0.527%

EAR = [1 + 0.00527/2]2 - 1 = 0.528%

b. FV = $2m. (1 + 0.00528/2) = $2,005,279

c. $2,005,279/(1 + iCD, be/2)) = $1,998,750 => iCD, be = 0.6533%

The single payment yield increases to: iCD, sp = 0.6533%(360/365) = 0.6444%

and the EAR becomes: EAR = [1 + 0.006533/2]2 - 1 = 0.6544%

19. a. iCD, be = 0.35%(365/360) = 0.3549%

EAR = [1 + 0.003549/2]2 - 1 = 0.3552%

b. FV = $5m. (1 + 0.003552/2) = $5,008,879

c. $5,008,879/(1 + iCD, be/2)) = $4,994,500 => iCD, be = 0.5758%

The single payment yield increases to: iCD, sp = 0.5758%(360/365) = 0.5679%

and the EAR becomes: EAR = [1 + 0.005758/2]2 - 1 = 0.5766%

20. a. Before the rate change, the CD holder will receive

FV = $500,000 (1 + 0.055/4) = $506,875

in four months in exchange for $500,000 deposited in the bank today. Immediately after the market rate on the CD
rises to 6 percent, the CD value decreases to

PV = 506,875/(1 + 0.06/4) = $499,384.24

b. Immediately after the market rate on the CD falls to 5.25 percent, the CD value decreases to

PV = 506,875/(1 + 0.0525/4) = $500,308.45