Adopted from “Financial Markets and Institutions” – Mishkin & Eakins (9E)

For TCHE401/TCH401E Classes in FTU only, no further distribution/reproduction allowed.

In its 2016 annual report, Alphabet (Google) listed $58 billion in
short-term securities on its balance sheet, plus $14 billion in
actual cash equivalents. Apple does not keep this in its local bank.
But where?
This is, of course, this topic of chapter 11—Money Markets.
We review the money markets and the securities that are traded
there. In addition, we discuss why the money markets are
important in our financial system. Topics include:
The Money Markets Defined
The Purpose of Money Markets
Who Participates in Money Markets?
Money Market Instruments
Comparing Money Market Securities
The term “money market” is a misnomer. Money (currency) is not
actually traded in the money markets.
The securities in the money market are short term with high
liquidity; therefore, they are close to being money.
Money Markets Defined
1. Usually sold in large denominations ($1,000,000 or more)
2. Low default risk
3. Mature in one year or less from their issue date, although most mature in
less than 120 days
The banking industry should handle the needs for short-term.
Banks have an information advantage.
Banks, however, are heavily regulated.
Creates a distinct cost advantage for money markets over banks.
Reserve requirements create additional expense for banks that
money markets do not have
Regulations on the level of interest banks could offer depositors
lead to a significant growth in money markets
When interest rates rose, depositors moved their money from banks to
money markets.
The cost structure of banks limits their competitiveness to
situations where their informational advantages outweighs their
regulatory costs.
Limits on interest banks could offer was not relevant until the 1950s. In the
decades that followed, the problem became apparent.
Investors in Money Market: Provides a place for warehousing
surplus funds for short periods of time
Borrowers from money market provide low-cost source of
temporary funds
Corporations and U.S. government use these markets because the
timing of cash inflows and outflows are not well synchronized.
Money markets provide a way to solve these cash-timing
problems.
Instrument Interest Rate (%)

Prime rate 3.50

Federal funds 0.37

Commercial Paper 0.55

London interbank offer rate 0.44

Eurodollar 0.48

Treasury bills (4 week) 0.24

We will discuss, in turn, each of the major borrowers and lenders
in the money market.
First, let’s examine some of the current rates offered in the U.S.
money markets.
Participant Role

U.S. Treasury Department Sells U.S. Treasury securities to

fund the national debt

Federal Reserve System Buys and sells U.S. Treasury

securities as its primary method
of controlling interest rates

Commercial banks Buy U.S. Treasury securities; sell

certificates of deposit and make
short-term loans; offer
individual investors accounts
that invest in money market
securities
Participant Role
Businesses Buy and sell various short-term
securities as a regular part of
their cash management
Investment companies (brokerage Trade on behalf of commercial
firms) accounts

Finance companies (commercial Lend funds to individuals

leasing companies)
Insurance companies (property and Maintain liquidity needed to
casualty insurance companies) meet unexpected
demands
Participant Role
Pension funds Sells U.S. Treasury securities to
fund the national debt

Individuals Buys and sells U.S. Treasury

securities as its primary method
of controlling interest rates

Money market mutual funds Allow small investors to

participate in the money market
by aggregating their funds to
invest in large-denomination
money market securities
We will examine each of these in the following slides:
Treasury Bills
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper
Banker’s Acceptance
Eurodollars
T-bills have 28-day maturities through 12- month maturities.
Discounting: When an investor pays less for the security than it
will be worth when it matures, and the increase in price provides a
return. This is common to short-term securities because they often
mature before the issuer can mail out interest checks.
You pay $999.813 for a 28-day T-bill. It is worth $1,000 at
maturity. What is its discount rate?
idiscount = (1,000 − 996.73) / 1,000 × 360/28
= 4.665%
You pay $999.813 for a 28-day T-bill. It is worth $1,000 at
maturity. What is its investment rate?
iyt = (1,000 − 996.73) / 996.73 × 366/28 = 4.76%
Security Issue Maturity Discount Investment Price per CUSIP
Term Date Date Rate Rate $100

28 day 5/19/201 6/16/2016 0.240 0.243 99.981333 912796HX0

6
91 day 5/19/201 8/18/2016 0.275 0.279 99.930486 912796HA0
6

182 day 5/19/201 11/17/201 0.370 0.376 99.812944 912796JU4

6 6

28 day 5/19/201 6/9/2016 0.245 0.248 99.980944 912796HW2

6

91 day 5/19/201 8/11/2016 0.240 0.243 99.939333 912796JF7

6
T-bills are auctioned to the dealers every Thursday.
The Treasury may accept both competitive and noncompetitive
bids, and the price everyone pays is the highest yield paid to any
accepted bid.
The Treasury auctioned $2.5 billion par value
91-day T-bills, the following bids were received:

Bidder Bid Amount Bid Price

1 $500 million $0.9940
2 $750 million $0.9901
3 $1.5 billion $0.9925
4 $1 billion $0.9936
5 $600 million $0.9939

The Treasury also received $750 million in noncompetitive bids.

Who will receive T-bills, what quantity, and at what price?
The Treasury accepts the following bids:

Bidder Bid Amount Bid Price

1 $500 million $0.9940
5 $600 million $0.9939
4 $650 million $0.9936

Both the competitive and noncompetitive bidders pay the highest

yield—based on the price of 0.9936:
In 1991, Salomon Smith Barney violated Treasury auction rules to
corner the auction on an $11 billion issue.
Several top Salomon officials were forced to retire (or fired) as a
result of the incident.
The Treasury also changed the auction rules to ensure a
competitive auction.
Short-term funds transferred (loaned or borrowed) between
financial institutions, usually for a period of one day.
Used by banks to meet short-term needs to meet reserve
requirements.
The next slide shows actual fed funds rates and T-bill rates 1990
through 2016.
Notice that the two rates track fairly closely. What does this
suggest about the market for T-bills and the market for fed funds?
These work similar to the market for fed funds, but nonbanks can
participate.
A firm sells Treasury securities, but agrees to buy them back at a
certain date (usually 3–14 days later) for a certain price.
This set-up makes a repo agreements essentially a short-term
collateralized loan.
This is one market the Fed may use to conduct its monetary policy,
whereby the Fed purchases/sells Treasury securities in the repo
market.
A bank-issued security that documents a deposit and specifies the
interest rate and the maturity date
Denominations range from $100,000 to $10 million
Unsecured promissory notes, issued by corporations, that mature
in no more than
270 days.
The use of commercial paper increased significantly in the early
1980s because of the rising cost of bank loans.
Commercial paper volume:
fell significantly during the recent economic recession
annual market is still large, at well over $0.85 trillion outstanding
A special type of commercial paper, known as asset-backed
commercial paper (ABCP)
played a key role in the financial crisis in 2008 backed by securitized
mortgages
often difficult to understand
accounted for about $1 trillion

When the poor quality of the underlying assets was exposed, a run
on ABCP began. Because ABCP was held by many money market
mutual funds (MMMFs), these funds also experienced a run. The
government eventually had to step in to prevent the collapse of the
MMMF market.
An order to pay a specified amount to the bearer on a given date if
specified conditions have been met, usually delivery of promised
goods.
These are often used when buyers / sellers of expensive goods live
in different countries.
1. Exporter paid immediately
2. Exporter shielded from foreign exchange risk
3. Exporter does not have to assess the financial security of the
importer
4. Importer’s bank guarantees payment
5. Crucial to international trade
As seen, banker’s acceptances avoid the need to establish the
credit-worthiness of a customer living abroad.
There is also an active secondary market for banker’s acceptances
until they mature. The terms of note indicate that the bearer,
whoever that is, will be paid upon maturity.
Eurodollars represent Dollar denominated deposits held in foreign
banks.
The market is essential since many foreign contracts call for
payment is U.S. dollars due to the stability of the dollar, relative to
other currencies.
The Eurodollar market has continued to grow rapidly because
depositors receive a higher rate of return on a dollar deposit in the
Eurodollar market than in the domestic market.
Multinational banks are not subject to the same regulations
restricting U.S. banks and because they are willing to accept
narrower spreads between the interest paid on deposits and the
interest earned on loans.
London interbank bid rate (LIBID)
The rate paid by banks buying funds
London interbank offer rate (LIBOR)
The rate offered for sale of the funds
Time deposits with fixed maturities
Largest short term security in the world
The Eurodollar market is one of the most important financial
markets, but oddly enough, it was fathered by the Soviet Union.
In the 1950s, the USSR had accumulated large dollar deposits, but
all were in US banks. They feared the US might seize them, but still
wanted dollars. So, the USSR transferred the dollars to European
banks, creating the Eurodollar market.
Liquidity is also an important feature, which is closely tied to the
depth of the secondary market for the various instruments.
Money Market Issuer Buyer Usual Maturity Secondary
Security Market
Treasury bills U.S. government Consumers and 4, 13, 26, and 52 Excellent
companies weeks
Federal funds Banks Banks 1 to 7 days None
Repurchase Businesses and Businesses and 1 to 15 days Good
agreements banks banks
Negotiable CDs Large money Businesses 14 to 120 days Good
center banks
Commercial Finance Businesses 1 to 270 days Poor
paper companies and
businesses
Banker’s Banks Businesses 30 to 180 days Good
acceptances
Eurodollar Non-U.S. banks Businesses, 1 day to 1 year Poor
deposits governments, and
banks
The Money Markets Defined
Short-term instruments
Most have a low default probability
The Purpose of Money Markets
Used to “warehouse” funds
Returns are low because of low risk and high liquidity
Who Participates in Money Markets?
U.S. Treasury
Commercial banks
Businesses
Individuals (through mutual funds)
Money Market Instruments
Include T-bills, fed funds, etc.
Comparing Money Market Securities
Issuers range from the US government to banks to large corporations
Mature in as little as 1 day to as long as 1 year
The secondary market liquidity varies substantially