Money Markets

Financial Markets and Institutions, 10e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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• Money market securities
• Institutional use of money markets
• Valuation of money market securities
• Risk of money market securities
• Interaction among money market yields

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3
• Money market securities:
• Have maturities within one year
• Are issued by corporations and governments to obtain short-term funds
• Are commonly purchased by corporations and government agencies that
have funds available for a short-term period
• Provide liquidity to investors

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 $ to buy T-bills
Spending on
$
U.S. Treasury Government
Households, Programs
Corporations,
and Spending to Support
Government $
$ to buy Money Existing Business
Agencies That Corporations Operations or
Have Short- Market Securities
Expansions
Term Funds $ loans
Available $ to buy Money Financial
Market Securities Intermediaries
$ loans

$ Spending on Cars,
Households Homes, Credit
Cards, etc

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• Treasury bills:
• Are issued by the U.S. Treasury
• Are sold weekly through an auction
• Have a par value of $1,000
• Are attractive to investors because they are backed by the
federal government and are free of default risk
• Are liquid
• Can be sold in the secondary market through government
security dealers

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• Treasury bills (cont’d)
• Investors in Treasury bills
• Depository institutions because T-bills can be easily liquidated
• Other financial institutions in case cash outflows exceed cash inflows
• Individuals with substantial savings for liquidity purposes
• Corporations to have easy access to funding for unanticipated
expenses

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• Treasury bills (cont’d)
• Pricing Treasury bills
• The price is dependent on the investor’s required rate of return:

Pm  Par /(1  k )n
• Treasury bills do not pay interest
• To price a T-bill with a maturity less than one year, the annualized
return can be reduced by the fraction of the year in which funds
would be invested

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A one-year Treasury bill has a par value of $10,000.
Investors require a return of 8 percent on the T-bill.
What is the price investors would be willing to pay
for this T-bill?

Pm  Par /(1  k )n
 $10,000 /(1.08)
 $9,259

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• Treasury bills (cont’d)
• Treasury bill auction
• Investors submit bids on T-bill applications for the maturity of their
choice
• Applications can be obtained from a Federal Reserve district or
branch bank
• Financial institutions can submit their bids using the Treasury Automated
Auction Processing System (TAAPS-Link)
• Institutions must set up an account with the Treasury
• Payments to the Treasury are withdrawn electronically from the account
• Payments received from the Treasury are deposited into the account

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• Treasury bills (cont’d)
• Treasury bill auction (cont’d)
• Weekly auctions include 13-week and 26-week T-bills
• 4-week T-bills are offered when the Treasury anticipates a short-term
cash deficiency
• Cash management bills are also occasionally offered
• Investors can submit competitive or noncompetitive bids
• The bids of noncompetitive bidders are accepted
• The highest competitive bids are accepted
• Any bids below the cutoff are not accepted
• Since 1998, the lowest competitive bid is the price applied to all
competitive and noncompetitive bids

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• Treasury bills (cont’d)
• Estimating the yield
• T-bills are sold at a discount from par value
• The yield is influenced by the difference between the selling price and the
purchase price
• If a newly-issued T-bill is purchased and held until maturity, the yield is
based on the difference between par value and the purchase price

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• Treasury bills (cont’d)
• Estimating the yield (cont’d)
• The annualized yield is:

SP  PP 365
YT  
PP n

• Estimating the T-bill discount

• The discount represents the percent discount of the purchase price
from par value for newly-issued T-bills:
Par  PP 360
T - bill discount  
Par n
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An investor purchases a 91-day T-bill for $9,782. If the
T-bill is held to maturity, what is the yield the investor
would earn?
SP  PP 365
YT  
PP n
10,000  9,782 365
 
9,782 91
 8.94%

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Using the information from the previous example, what is
the T-bill discount?

Par  PP 360
T - bill discount  
Par n
10,000  9,782 360
 
10,000 91
 8.62%

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• Commercial paper:
• Is a short-term debt instrument issued by well-known, creditworthy firms
• Is typically unsecured
• Is issued to provide liquidity to finance a firm’s investment in inventory and
accounts receivable
• Is an alternative to short-term bank loans
• Has a minimum denomination of $100,000
• Has a typical maturity between 20 and 270 days
• Has no active secondary market
• Is typically not purchased directly by individual investors

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• Commercial paper (cont’d)
• Ratings
• The risk of default depends on the issuer’s financial condition and cash
flow
• Commercial paper rating serves as an indicator of the potential risk of
default
• Corporations can more easily place commercial paper that is assigned
a top-tier rating
• Junk commercial paper is rated low or not rated at all

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• Commercial paper (cont’d)
• Volume of commercial paper:
• Has increased substantially over time
• Is commonly reduced during recessionary periods
• Placement
• Some firms place commercial paper directly with investors
• Most firms rely on commercial paper dealers to sell
• Some firms (such as finance companies) create in-house departments
to place commercial paper

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• Commercial paper (cont’d)
• Backing commercial paper
• Issuers typically maintain a backup line of credit
• Allows the company the right to borrow a specified maximum amount of
funds over a specified period of time
• Involves a fee in the form of a direct percentage or in the form of required
compensating balances
• Estimating the yield
• The yield on commercial paper is slightly higher than on a T-bill
• The nominal return is the difference between the price paid and the
par value

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An investor purchases 120-day commercial paper with a
par value of $300,000 for a price of $289,000.
What is the annualized commercial paper yield?

300,000 - 289,000 360

Ycp  
289,000 120
 11.42%

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• Commercial paper (cont’d)
• The commercial paper yield curve:
• Illustrates the yield offered on commercial paper at various maturities
• Is typically established for a maturity range from 0 to 90 days
• Is similar to the short-term range of the Treasury yield curve
• Is affected by short-term interest rate expectations
• Is similar to the yield curve on other money market instruments

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• Negotiable certificates of deposit (NCDs):
• Are issued by large commercial banks and other depository
institutions as a short-term source of funds
• Have a minimum denomination of $100,000
• Are often purchased by nonfinancial corporations
• Are sometimes purchased by money market funds
• Have a typical maturity between two weeks and one year
• Have a secondary market

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• Negotiable certificates of deposit (NCDs) (cont’d)
• Placement
• Directly
• Through a correspondent institution
• Through securities dealers
• Premium
• NCDs offer a premium above the T-bill yield to compensate for less
liquidity and safety

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• Negotiable certificates of deposit (NCDs) (cont’d)
• Yield
• NCDs provide a return in the form of interest and the difference
between the price at which the NCD was redeemed or sold and the
purchase price
• If investors purchase a NCD and hold it until maturity, their annualized
yield is the interest rate

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• Repurchase agreements
• One party sells securities to another with an agreement to repurchase
them at a specified date and price
• Essentially a loan backed by securities
• A reverse repo refers to the purchase of securities by one party from
another with an agreement to sell them
• Bank, S&Ls, and money market funds often participate in repos
• Transactions amounts are usually for $10 million or more
• Common maturities are from 1 day to 15 days and for one, three, and six
months
• There is no secondary market for repos

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• Repurchase agreements (cont’d)
• Placement
• Repo transactions are negotiated through a telecommunications
network with dealers and repo brokers
• When a borrowing firm can find a counterparty to a repo transaction,
it avoids the transaction fee
• Some companies use in-house departments
• Estimating the yield
• The repo yield is determined by the difference between the initial
selling price and the repurchase price, annualized with a 360-day
year

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An investor initially purchased securities at a price of
$9,913,314, with an agreement to sell them back at
a price of $10,000,000 at the end of a 90-day
period. What is the repo rate?
SP  PP 360
Repo rate  
PP n
10,000,000  9,913,314 360
 
9,913,314 90
 3.50%
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• Federal funds
• The federal funds market allows depository institutions to lend
or borrow short-term funds from each other at the federal
funds rate
• The rate is influenced by the supply and demand for funds in the
federal funds market
• The Fed adjusts the amount of funds in depository institutions to
influence the rate
• All firms monitor the fed funds rate because the Fed manipulates it to
affect economic conditions
• The fed funds rate is typically slightly higher than the T-bill rate

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• Federal funds (cont’d)
• Two depository institutions communicate directly through a
communications network or through a federal funds broker
• The lending institution instructs its Fed district bank to debit its
reserve account and to credit the borrowing institution’s
reserve account by the amount of the loan
• Commercial banks are the most active participants in the
federal funds market
• Most loan transactions are or $5 million or more and usually
have one- to seven-day maturities

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• Banker’s acceptances:
• Indicate that a bank accepts responsibility for a future
payments
• Are commonly used for international trade transactions
• An unknown importer’s bank may serve as the guarantor
• Exporters frequently sell an acceptance before the payment date
• Have a return equal to the difference between the discounted
price paid and the amount to be received in the future
• Have an active secondary market facilitated by dealers

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• Banker’s acceptances (cont’d)
• Steps involved in banker’s acceptances
• First, the U.S. importer places a purchase order for goods
• The importer asks its bank to issue a letter of credit (L/C) on its behalf
• Represents a commitment by that bank to back the payment owed to the
foreign exporter
• The L/C is presented to the exporter’s bank
• The exporter sends the goods to the importer and the shipping
documents to its bank
• The shipping documents are passed along to the importer’s bank

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 1 Purchase Order
Importer Exporter
5 Shipment of Goods

4 L/C Notification
2 L/C Application
6 Shipping Documents & Time Draft

3 L/C
American Bank Shipping Documents
Japanese Bank
(Importer’s Bank) 7 & Time Draft Accepted
(Exporter’s Bank)

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SECURITIES ISSUED BY COMMON COMMON SECONDARY
INVESTORS MATURITIE MARKET
S ACTIVITY
Treasury bills Federal Government Households, 13 weeks, High
firms, and 26 weeks, 1
financial year
institutions
Negotiable Large banks and savings Firms 2 weeks to Moderate
certificates of institutions 1 year
deposit (NCDs)
Commercial Bank holding companies. Firms 1 day to Low
paper Finance companies, and other 270 days
companies
Banker’s Banks )exporting firms can sell Firms 30 days to High
acceptances the acceptances at a discount 270 days
to obtain funds)
Federal Funds Depository institutions Depository 1 day to 7 Nonexistent
Institution days
Repurchase Firms and financial institutions Firms and 1 day to 15 Nonexistent
Agreements financial days
institutions 33
• Financial institutions purchase money market securities to earn a
return and maintain adequate liquidity
• Institutions issue money market securities when experiencing a
temporary shortage of cash
• Money market securities enhance liquidity:
• Newly-issued securities generate cash
• Institutions that previously purchased securities will generate cash upon
liquidation
• Most institutions hold either securities that have very active secondary
markets or securities with short-term maturities

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• Financial institutions with uncertain cash in- and
outflows maintain additional money market securities
• Institutions that purchase securities act as a creditor to
the initial issuer
• Some institutions issue their own money market
instruments to obtain cash

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• For money market securities making no interest payments, the
value reflects the present value of a future lump-sum payment
• The discount rate is the required rate of return by investors

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• Explaining money market price movements
• The price of a noninterest-paying money market security
is:
Pm  Par /(1  k )n

• A change in the price can be modeled as:

Pm  f ( k ) and k  f ( Rf , RP )

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• Indicators of future money market security prices
• Economic growth is monitored since it signals changes in short-term
interest rates and the required return from investing in money market
securities
• Employment
• GDP
• Retail sales
• Industrial production
• Consumer confidence
• Indicators of inflation

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• Because of the short maturity, money market securities are
generally not subject to interest rate risk, but they are
subject to default risk
• Investors commonly invest in securities that offer a slightly higher yield
than T-bills and are very unlikely to default
• Although investors can assess economic and firm-specific conditions to
determine credit risk, information about the issuer’s financial condition
is limited
• Measuring risk
• Money market participants can use sensitivity analysis to determine
how the value of money market securities may change in response to
a change in interest rates

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• Money market instruments are substitutes for each
other
• Market forces will correct disparities in yield and the
yields among securities tend to be similar
• In periods of heightened uncertainty, investors tend
to shift from risky money market securities to
Treasuries
• Flight to quality
• Creates a greater differential between yields

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• Interest rate differentials occur because geographic markets
are somewhat segmented
• Interest rates have become more highly correlated:
• Conversion to the euro
• The flow of funds between countries has increased because of:
• Tax differences
• Speculation on exchange rate movements
• A reduction in government barriers
• Eurodollar deposits, Euronotes, and Euro-commercial paper are
widely traded in international money markets

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• Eurodollar deposits and Euronotes
• Eurodollar certificates of deposit are U.S. dollar deposits in non-U.S.
banks
• Have increased because of increasing international trade and historical
U.S. interest rate ceilings
• In the Eurodollar market, banks channel deposited funds to other
firms that need to borrow them in the form of Eurodollar loans
• Typical transactions are $1 million or more
• Eurodollar CDs are not subject to reserve requirements
• Interest rates are attractive for both depositors and borrowers
• Rates offered on Eurodollar deposits are slightly higher than NCD rates

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• Eurodollar deposits and Euronotes (cont’d)
• Investors in fixed-rate Eurodollar CDs are adversely affected by
rising market rates
• Issuers of fixed-rate Eurodollar CDs are adversely affected by
declining rates
• Eurodollar-floating-rate CDs (FRCDs) periodically adjust to LIBOR
• The Eurocurrency market is made up of Eurobanks that accept large
deposits and provide large loans in foreign currencies
• Loans in the Eurocredit market have longer maturities than loans in
the Eurocurrency market
• Short-term Euronotes are issued in bearer form with maturities of
one, three, and six months

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• Euro-commercial paper (Euro-CP):
• Is issued without the backing of a banking syndicate
• Has maturities tailored to satisfy investors
• Has a secondary market run by CP dealers
• Has a rate 50 to 100 basis points above LIBOR
• Is sold by dealers at a transaction cost between 5 and 10
basis points of the face value

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• Performance of foreign money market securities
• Measured by the effective yield (adjusted for the
exchange rate
Ye  (1  Yf )  (1  %S )  1
• Depends on:
• The yield earned on the money market security in the foreign
currency
• The exchange rate effect

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A U.S. investor buys euros for $1.15 and invests in a
one-year European security with a yield of 8
percent. After one year, the investor converts the
proceeds from the investment back to dollars at the
spot rate of $1.16 per euro. What is the effective
yield earned by the investor?
Ye  (1  Yf )  (1  %S )  1
 1.08  1.0087  1
 8.94%
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