Money Markets

Transactions; Yield calculations (day count); Benchmarks; Futures & Forwards;

OTC & Exchange; Margins

Money Market Introduction

Each currency has its own money market in which transactions are concluded in the local currency. These money
markets are called local money markets. The country of domicile of the market parties is not relevant in this respect.
For example, if a British company issues commercial paper in USD in the United States, then this is a local
commercial CP since it is issued in the US. And if, for instance, a US citizen invests in a EUR denominated deposit in
Frankfurt, then this is a domestic deposit.
If, on the other hand, a party performs a transaction in a currency outside the country where the currency is the local
currency, then the word ‘euro’ is added to this transaction. If for example an UK company issues a CP denominated in
US dollars in the UK, then this is a eurodollar CP. And if a US company invests in a USD deposit with a Singapore
bank, this is referred to as a eurodollar deposit.
This USD deposit is legally not subject to the cash reserve requirements of the Fed, but to the cash reserve
requirement of the central bank of Singapore.

Money Market Products

Two different types of instruments are traded on the money market: bilateral loans and short-term tradable securities
(also referred to as marketable or negotiable securities). Examples of loans are deposits and repurchase agreements
(repos). With these instruments an amount of money is borrowed/lent and is paid back at the maturity date including
interest. The difference between deposits and repurchase agreements is that the latter are collateralized. Both
instruments entail a bilateral contract that cannot be traded.
Money market papers are tradable short-term securities that are bought at a market price. At the maturity date, the
issuer buys the paper back for a pre-agreed amount. During the term of the security, it can be traded. The return of a
money market paper is the difference between the price for which the security is bought and the price for which it is
sold.

Money market deposit

A deposit is a loan where usually a nominal amount is invested for a fixed term and yield. The lender benefits from a
higher interest rate compared to a current bank account. Regular terms for deposits are 1,2 and 3 weeks and 1 to 12
months. The minimum period for a deposit is one day. Examples of deposits with a term of one day are overnight
deposits starting today, tom/next deposits starting next business day and spot/next deposits, starting from 2 business
days. The start and end date is a business day, meaning that the central bank payment system is operational.
Generally, no collateral is requested for a deposit.
Some deposits have an undetermined term that can be ended at the request of the investor. A call deposit is payable
on demand with a specified cut-off time, for example 12.00 AM. A notice deposit can be demanded after one or two
days.
A deposit is not tradable and can, in principle, not be redeemed before the maturity date. But if a depositor wants to
early terminate a bank deposit, the bank pays the lower of the fair value or the book value at requested redemption
date. The fair value is the present value of the final proceeds using the current interest rate for the remaining period.
The book value is the nominal amount plus the accrued interest until the moment that the deposit is cancelled.

Repo: Collateralized Loan

A repurchase agreement (repo) and a sell/buy back are both forms of short-term loans in which securities (usually
bonds) are provided as collateral. In a repo party (1) provides collateral in exchange for borrowing money and is called
the repo seller (of the collateral). Party (2), the repo buyer, lends the money in return for the legal ownership of the
collateral. The collateral protects the buyer for default of the seller. Since a repo is conceptually nothing more or less

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than a loan, a coupon is paid at maturity. Because the repo is traded on the money market the correspondent day
count conventions are used to calculate the interest coupon: actual/360 or actual/365. Nowadays most repos are
concluded for liquidity management purposes, to borrow money.
Though any security may be used in a repo as collateral, most used are highly liquid securities, such as treasury
bonds. Highly liquid securities are easily sold in the market in event of default or can be bought is the buyer has
created a short position in the repo security.

International Interest Day Count Conventions

Yields are always stated on an annual basis and they should be adjusted for the part of the year that they apply to. A
rate of 3% for 1 year means that you earn 3% if you invest the money for one year and that the return of 3% applies
for the whole investment period of 1 year. If you would invest 100 million, your return would be 3% of 100 million, i.e. 3
million. If you invest for six months, the 3% only applies for 6 months, for half a year. The return would be 0.5 x 3% of
100 million, 1.5 million. This adjustment for the period is applied by using the day count fraction.
In the first example the day count fraction was 1 and in the second example the day count fraction was 0.5.
There are different methods for calculating day count fractions, the day count conventions. Two types of day count
conventions are used in the money market: actual/360 and actual/365. With both conventions, for the number of
interest days the actual number of days is counted from the start date to the maturity date, including all week-ends
and bank holidays. The difference is that for the first convention the number of days in a year (the year basis) is set at
360 and for the second at 365.
In the fixed income or capital market where bonds and interest rate swaps art traded, two different day count
conventions are used to calculate the accrued interest. Actual/actual and 30/360. The 30/360 convention is also
referred to as bond basis.

Money Market Benchmarks

Money market benchmarks are used as the reference for fixing the interest rate for financial instruments with a floating
interest rate condition. These benchmarks are also used for historical information about the development of money
market interest rates.
EURIBOR and LIBOR are benchmarks for interbank deposits with a term from a week to one year for certain regular
periods. Until 1 February 2014, LIBOR was set by the British Banker’ Association (BBA) and the Exchange and Money
Markets Committee (FX&MMC). Today LIBOR is set by the Intercontinental Exchange (ICE). Examples for overnight
investments money market benchmarks are the Sterling Overnight Index Average, SONIA, the Swiss Average Rate
Overnight SARON, the Tokyo Overnight average rate TONAR and EONIA, the European Overnight Index Average
that will be replaced by the €ster, the euro short term rate, that is published by the European Central bank since
October 2019.
The secured overnight financing rate, or SOFR, is based on transactions in the USA Treasury repurchase market,
where investors offer banks overnight loans backed by their bond assets as collateral. The Federal Reserve Bank of
New York began publishing SOFR in April 2018 as part of an effort to replace LIBOR.
Benchmark rates are not tradable and will not change on a trading day after being published. No money market trader
is obliged to conclude transactions at a benchmark rate.
For trading, each bank or other trader has its own money market rates which it publishes via Electronic Broker
systems or direct trading systems. Unlike the benchmark rates, these rates fluctuate constantly during the course of a
trading day.

Money Market Derivatives: FRA and STIR

A future is an exchange traded contract to Buy / Sell a certain amount of commodities or financial values
at a specific fixed price that is agreed at issue date. Forwards are traded bilateral by professional parties (such as
banks, financial institutions, traders) on the Over the Counter market (OTC). To manage the risk in fluctuations of
money market interest rates, futures and forwards were introduced.

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Forward Rate Agreements were introduced in London in 1983 at the suggestion of a broking company as the “Over
the Counter” answer to the Futures Market which was experiencing tremendous growth since its beginnings in 1982.
Initially all banks worked out their own terms and conditions and there were many occasions when transactions could
not be completed because of differing terms between the participants much to the frustration of all involved. The
British Bankers Association responded with the publishing of standard terms and conditions in early 1984 – FRABBA.
The former BBA's functions are now undertaken by UK Finance.

Money market forward: Forward Rate Agreement (FRA)

A Forward Rate Agreement (FRA) is an “Off-balance sheet” (no exchange of principal amount takes place) agreement
between two counterparties, usually bank-to-bank or bank-to-corporate-customer, developed to protect the parties
against a future adverse movement in interest rates.
Counterparties to an FRA agree an interest rate to be applied to a notional deposit of an agreed principal amount for a
specified period of time from a specified future date, known as the settlement date.
An FRA can be variously compared to a forward/forward deposit, without resultant transfer of funds or a Financial
Futures contract dealt between to parties outside a Futures Exchange and without any margin requirements.

Please note that the principal of EUR 10 mln is a notional amount: they are not paid at t=0 and t=6m and is only used
to calculate the interest rate amounts

Example 3s vs 6s FRA

An example of a typical FRA quoted period would be three months forward against six months forward, which would
be described in the market as “3 against 6 months FRA” or “3 / 6” or “3 X 6” or “3s v. 6s” - said as “threes to sixes”.
The numbers in the description of the period do NOT relate to the calendar months numbers but to the time gaps as
described above.
There are 2 terms for FRAs: the contract term and the underlying period. The contract terms is from the contract date
to the fixing date. The underlying period starts on the settlement date. The contract term of a ‘3s v 9s’ FRA, for
instance, is three months and the underlying period is six months. The fixing is two days before the start date of the
underlying period and the settlement takes place on the start date of the underlying period.
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To illustrate a : ‘3x6’ FRA 4,5%
Contract rate = 4,5%); Contract period = 3 months from start (spot, two business days form dealing date); Underlying
period = 3 months from start (6 minus 3 months); Settlement date = end of contract period, i.e. 3 months from spot;
Reference benchmark rate (e.g. LIBOR or EURIBOR) agreed in contract.

Example of settlement of an FRA

Under FRABBA terms if the current EURIBOR is higher than the FRA contractual rate, the Buyer of the FRA is
reimbursed with the discounted difference (present value calculation) and the FRA notional principal.

To calculate the settlement amount at the end of the contract period following formula is used:

Example: Bought 3x6 FRA 3%; Notional EUR 10 mln; Underlying period = 92 days; EURIBOR Fixing end of contract
date = 4%.
The Settlement at end of contract date is::
• Settlement amount = [EUR 10 million x (4% - 3%) x 92/360] / (1 + 0,04 x 92/360) = EUR 25.297
• The buyer of the FRA receives EUR 25.297 because EURIBOR > FRA Contract %

Money Market Futures: Shor term interest rate future (STIR)

Money market futures, also referred to as STIR futures (short-term interest rate futures), are conceptually the same
instruments as Forward Rate Agreements (FRAs) and used to manage short term interest risk. The main difference is
that FRAs are traded over the counter (OTC) and that money market futures are traded on an exchange. The major
benefits of trading via an exchange are the high market liquidity and the absence of credit risk. Bought futures
contracts can be sold to the exchange and sold futures contracts can be bought back from the exchange at any time
during their lifetime. This is referred to as closing the futures contract or offsetting it. If a party closes a futures
contract, the original contract becomes void. The last date on which trading may take place is called the expiry date.
Because financial futures are exclusively traded on exchanges, they have standardized conditions. Futures have, for
instance, standardized contract amounts. Parties that want to conclude a futures contract need only indicate how
many contracts they would like to sell or buy. Also the length of the underlying period is standardized, i.e. 1 month or 3
months and the underlying periods always start on the third Wednesday of a month (expiration date). For the three
month futures, only a limited number of underlying periods are traded.
The standard cycle for the three month STIR futures is March, June, September, December with underlying periods
from the third Wednesday of March until the third Wednesday of June et cetera. The expiry dates can be as far in the
future as 10 years.
Usually apart from the standard underlying periods, in the short term also contracts with other expiry dates are traded.
For instance, if it is April 2016 then for the 3 month Eurodollar future not only the Jun, Sep and Dec futures are traded
for 2016 but also the May, Jul, Aug and Oct futures with underlying periods from the 3rd Wednesday of May to the 3rd
Wednesday of August et cetera. The expiry dates for these additionally traded contracts are referred to as serial
months.

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Futures: Exchange and Clearing House
Because futures are traded on an exchange, only members of the exchange can trade directly in futures. Members
can indicate the prices at which they would like to conclude contracts, i.e. they can place an order. Non-members
must involve a member to get their transactions concluded. The member then is referred to as broker.
The clearing for exchange traded transactions is done by a central counterparty (CCP). The CCP concludes two
contracts simultaneously: the selling exchange member sells the traded instrument to the clearing house and the
buying exchange member buys it from the clearing house.
The advantage of this is that the CCP can cancel out the transactions that it has concluded with each party so that, at
the end of the trading day, for each party and for each traded financial instrument, only one quantity to deliver or to be
received can be calculated and then finally, based on the transactions for all instruments combined, one sum of
money to be paid or received can be calculated. This is referred to as netting. Example of CCP’s are LCH.Clearnet,
CME Clearing and ICE Clearing Singapore.
Some futures are traded on more than one exchange. This is the case, for instance, for Eurodollar futures which are
amongst others traded on CME and on SMX. The counterparty for these contracts are CME Clearing and ICE
Clearing Singapore respectively. CME and SMX have an agreement that futures contracts that are concluded on one
both exchanges can be offset by a transaction on the other exchange, although the central clearing counterparty is not
the same. This is referred to as fungibility.

Margins
The central clearing house carries the risk that the clearing members might be unable to meet their obligations.
Therefore, it takes a risk mitigating measure, i.e. the required margin. There are two kinds of margins: the initial
margin and the variation margin. The initial margin is a cash deposit that the clearing house requires as a collateral on
the moment of concluding a futures contract. This amount must be transferred to an account that a clearing member
holds with the CCP, i.e. the margin account. After a contract has expired, the clearing member is allowed to transfer
the initial margin from its margin account to its own account with the central bank or a correspondent bank. This also
happens if the clearing member closes his position early. The amount of initial margin is based on the volatility and the
market liquidity of the underlying value.
Variation margin, or margin call, refers to the daily settlement of profits and losses of a futures contract. At the end of
each trading day, the closing price for a futures contract is determined. If the closing price is higher than the closing
price from the previous day, the clearing member who has bought a future has made a profit. The clearing house then
credits the margin account of the clearing member. However, If the closing price has decreased, the clearing house
asks the clearing member to transfer extra money to its margin account (‘to make a margin call’), and immediately
debits the margin account of this member in favour of a clearing member whose position was at a gain that day. On
the expiry date of a futures contract, only the result for the final day is settled.
Sometimes an exchange only asks a member to pay a variation margin if the balance on the margin account would
become lower that a certain pre-agreed percentage of the initial margin. This level is referred to as maintenance
margin. If this level is breached, however, then a margin payment is required to set the balance on the margin account
exactly at the level of the initial margin again.

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