Chapter Five

1
Chapter Five
Money Markets
2
Definition and Purpose of Money Markets

• The Money Markets are associated with the
  issuance and trading of short-term (less than 1
  year) debt obligations of large corporations, FIs
  and governments
• Only High-Quality Entities can borrow in the
  Money Markets and individual issues are large
• Investors in Money Market Instruments include
  corporations and FIs who have idle cash but are
  restricted to a short-term investment horizon
• The Money Markets essentially serve to allocate
  the nations supply of liquid funds among major
  short-term lenders and borrowers

3
Money Market Instruments

• Treasury Bills - short-term obligations issued by
  the U.S. government
• Federal Funds - short-term funds transferred
  between financial institutions usually for no
  more than one day
• Repurchase Agreements - agreement involving the
  sale of securities between parties with a promise
  to repurchase the security at a specific date and
  price
• Commercial Paper - short-term unsecured
  promissory notes issued by a company to raise
  short-term cash
• Negotiable Certificates of Deposit - negotiable
  bank-issued time deposit with specified interest
  rate and maturity
• Banker Acceptances - time draft payable to seller
  of goods, with payment guaranteed by a bank

4
Money Market Instruments Outstanding,December
1990 and 2004 (in billions of dollars)
Amount Outstanding
1990
2004
Rate of Return 1990 2004
Treasury bills 527.0
981.9 6.68 2.15
Federal funds and repurchase
agreements 372.3 1,585.1
7.31 1.83 Commercial paper
537.8 1,309.7 8.14
1.89 Negotiable certificates of
deposit 546.9
1,379.4 8.13 2.28
Bankers acceptance 52.1
4.4 7.95 2.04
5
Treasury Bill Basics

• Issued by the U.S. Treasury to cover government
  budget deficits and to refinance maturing debt
• Standard Original Maturities of 13 weeks, 26
  weeks, or 52 weeks
• Denominations are 1,000 but typical round lot is
  5 million
• Virtually default risk free

6
The Auction Process for T-bills

• Amount of new 13-week and 26-week T-bills offered
  announced weekly
• Bids submitted by government securities dealers,
  financial and nonfinancial corporations and
  individuals
• Individual competitive bidders limited to 35
  total issue size, can submit more than one bid,
  allocations made beginning with highest bidder
• Noncompetitive bidders indicate quantity desired
  and agree to pay the lowest price of the winning
  competitive bids get preferential allocation

7
Treasury Auction Results
Bid Price 99.583
Noncompetitive Bids
1
SC
ST
2
3
4
99.573 (PNC) stop-out price (low bid accepted)
5
6
7
Quantity of T-bills
15,734.1m
14,088.3m
8
The Secondary Market for T-bills

• The largest of any U.S. money market security
• Approximately 30 financial institutions make a
  market in T-bills by buying and selling
  securities for their own accounts and by trading
  for their customers, including depository
  institutions, insurance companies, pensions
  funds, etc.
• T-bills are the FOMCs instrument of choice for
  its open market operations

9
Secondary Market T-bill Transaction
J.P. Morgan Chase sells 10m. In T-bills
Goldman buy 10m. In T-bills
Fedwire Transaction
Federal Reserve Bank of New York Transfers 10m.
In T-bills from J.P. Morgan Chase to
Goldman Transaction recorded in Feds Book-Entry
System
Fedwire Transaction
FRBNY -50,000 in T-bills from J.P.
Morgan Chases account 50,000 T-bill to
Individual
Individual buy 50,000 in T-bills
J.P. Morgan Chase sell 50,000 in T-bills
Local Bank or Broker
10
T-bill Rates and Yields

• No interest paid on T-bills (coupon rate is
  zero), issued at a discount from their par (or
  face) value
• T-bill rates are quoted in Wall Street Journal
• Discount Yield (based on 360 days)
• the price dealers are willing to pay T-bill
  holders to purchase their T-bills for them
• Asked
• the discount yield based on the current purchase
  price set by dealers that is available to
  investors
• Spread
• the percentage difference in the ask and bid
  yield part of transaction cost the profit for
  dealers

11
T-Bill Prices

• T-Bill prices can be calculated from quotes
  (e.g., from The Wall Street Journal) by
  rearranging the discount yield equation
• Or by rearranging the bond equivalent yield
  equation

12
Calculating T-bill Yields from Discount Rates
iT-bill(dy) PF P0 ?
360
PF h Where iT-bill
Annualized yield on the T-bill
PF Price (face value) paid to the T-bill
holder P0 Purchase price of
the T-bill h Number of days
until the T-bill matures Example iT-bill(dy)
10,000 - 9,650 ? 360 6.92
10,000
182
13
Federal Funds

• Short-term funds transferred between FIs, usually
  for a period of one day
• Federal Funds rate
• the interest rate for borrowing fed funds
• a focus or target rate in the conduct of monetary
  policy
• Federal Funds Yields
• single-payment loans - they pay interest only
  once, at maturity.
• Fed fund transactions take the form of short-term
  (mostly overnight) unsecured loans

14
Trading in the Fed Funds Market

• Commercial banks conduct the majority of
  transactions in the fed funds market
• Banks with excess reserves lend fed funds, while
  banks with deficient reserves borrow fed funds
• Fed funds transactions can be initiated by either
  the lending or borrowing institution or handled
  through a broker

15
Repurchase Agreements (RPs or Repos)

• An agreement involving the sale of securities by
  one party to another with a promise to repurchase
  the securities at a specified price on a
  specified date
• Essentially a collateralized fed funds loan with
  collateral in the form of securities (e.g.
  T-bills and Fannie Mae securities)
• Reverse repurchase agreement
• involves the purchase of securities between
  parties with the promise to sell them back at a
  given date in the future

16
Repurchase Agreement

• The yield on repurchase agreements (iRA) uses a
  360-day year like the discount rate, but uses the
  current price in the denominator like the bond
  equivalent yield
• Pf the repurchase price of the security
• P0 the selling price of the security
• h the number of days until the repo matures

17
Trading Process for Repurchase Agreements

• Arranged either directly between two parties or
  with the help of brokers and dealers
• The repo buyer arranges to purchase T-bills from
  the repo seller with an agreement that the seller
  will repurchase the T-bills within a stated
  period of time

18
Commercial Paper

• An unsecured short-term promissory note issued by
  a corporation to raise short-term cash, often to
  finance working capital requirements
• The largest (in terms of dollar value) of the
  money market instruments
• Generally sold in denominations of 100,000,
  250,000, 500,000 and 1 million with maturities
  of 1-270 days (if maturity is greater than 270
  days, SEC requires registration)
• Generally held until maturity so there is not an
  active secondary market

19
Trading Process for Commercial Paper

• CPs are sold either directly to investors (25)
  or indirectly through brokers and dealers such as
  investment banks or major bank subsidiaries
• Selling through brokers more expensive for issuer
  due to underwriting costs

20
Negotiable Certificates of Deposits

• A bank-issued time deposit that specifies an
  interest rate and maturity date and is negotiable
  in the secondary market
• Bearer Instrument
• whoever holds the CD when it matures receives the
  principal and interest
• Denominations range from 100,000 to 10 million
  1 million being the most common
• Often purchased by money market mutual funds with
  pools of funds from individual investors

21
Trading Process for NCDs

• Banks issuing NCDs post daily rates for the more
  popular maturities and subject to funding needs,
  tries to sell to investors who are likely to hold
  them as investments rather than sell them to the
  secondary market
• In some cases, the bank and investor negotiate
  the size, rate and maturity
• Secondary market consists of a linked network of
  approximately 15 brokers and allows investors to
  buy existing CDs rather than new issues

22
Bankers Acceptances

• Time draft a draft which is payable at a
  specified time in the future, or under certain
  circumstances
• A time draft payable to a seller of goods with
  payment guaranteed by a bank
• 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 prefer that banks act as
  guarantors for payment before sending goods to
  importer

23
Trading Process for BAs
1
Domestic Importer
Foreign Exporter
4
3
8
10
2
9
5
U.S. Bank
Foreign Bank
6
7
1. Purchase order sent 2. Letter of credit
requested 3. Notification of letter credit
and draft authorization 4. Order shipped 5.
Time draft and shipping papers sent to
foreign bank
6. Time draft and shipping papers sent to
U.S. bank BA created 7. Payments sent to
foreign bank 8. Payments sent foreign exporter
9. Payment to U.S. bank 10. Shipping papers
delivered
24
Money Market Participants
Instrument Treasury bills Federal
funds Repurchase agreement Commercial
Paper Negotiable CDs Bankers acceptances
Principal Issuer U.S. Treasury Commercial
banks FRS Comm banks Brokers and dealers Other
FIs Comm banks Other FIs Corps Commercial
banks Commercial banks
Principal Investor FRS Comm banks Brokers and
dealers Other FIs Corps Commercial banks FRS,
Comm banks Brokers and dealers Other FIs,
Corps Brokers and dealers Corporations Brokers
and dealers Corps Other FIs Comm banks
Corps Brokers and dealers
25
International Aspects of Money Markets

• While U.S. money markets are the largest, the
  international market is growing
• U.S. securities bought/sold by foreign investors
• foreign money market securities
• Euro money market instruments
• Eurodollar deposits, Eurodollar CDs, Euro notes,
  Euro CP
• London Interbank Offered Rate (LIBOR)
• the rate paid on Eurodollars

26
Euronotes and Euro CPs
Amount outstanding
Amount outstanding
Type of instrument 1995
2001 Euronotes 45.5
154.4 Currency type U.S. dollar
27.9 59.5 Euro currencies
0.5 43.6 Pound Sterling
32.8 Japanese yen
0.4 11.3 Other
16.7 7.2 Issuer type
FIs 41.4
132.8 Gov/state agencies 0.4
11.3 International Inst 1.2
0.5 Corporations 2.5
9.8
Type of instrument 1995 2001 Euro
CP 87.0
243.1 Currency type U.S. dollar
55.7 102.7 Euro currencies
9.1 80.5 Pound Sterling
29.1 Japanese
yen 2.1 13.6
Other 20.0
17.2 Issuer type FIs
40.5 184.4 Gov/state agencies
14.2 17.3 International inst
2.1 4.4 Corporate
issuers 30.2 36.9