Chapter 2: Description of Key Markets

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Chapter 2 Description of Key Markets

• - THE MONEY MARKET
• Shane Whelan, L527

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The Money Markets

• Players in money markets
• Central banks
• Governments
• Banks and other deposit takers
• Companies financial and otherwise
• Public agencies and bodies local authorities,
  supranational organisations
• Money brokers
• Dominated by clearing banks, as they borrow to
  cover a shortfall of liquid funds and lend excess
  funds, establishing the inter-bank rate.
• Money markets used to manage short-term
  cashflows.
• Central banks provide liquidity to system and,
  through open market operations (repos), establish
  the level of short-term interest rate within the
  economy.

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Money Market

• A money market instrument is, in essence, a
  short-term loan (with a duration of year or less)
  from one large institution to another.
• They are unquoted securities, that is, not listed
  on a stock exchange.
• Often prices quoted on a discounted basis, i.e.,
  91 day Treasury Bill quoted at 98.5 means that in
  91 days it will be redeemed at par (100).
• Convention is that money market interest rates
  are simple interest. Also, when used, discount
  rates are simple discount rate.
• The number of days in a year is also by
  convention.
• In the UK, (Australia, etc) the convention in
  money market is that there are 365 days in a
  year.
• In the US and Euro money market, the convention
  is a 360 day year.

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Pricing Treasury Bills

• Price Quoted for UK Treasury Bill
  100(1-(n/365)(d/100))
• where n is no. of days outstanding
• where d is (annualised) discount rate
• Note the 365 convention
• According, the simple discount rate for the 91
  day Treasury Bill trading at 98.5 is
• 98.5100(1-(91/365)(d/100))
• So d 6.0 p.a.
• The above simple discount rate of 6.0 p.a.
  corresponds to a simple interest rate of 6.1
  p.a.

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Another Example

• A deposit of 5,000,000 is made for 30 days with
  a US bank at 4.0 p.a.. What are the maturity
  proceeds?
• Answer 5,016,666.67
• At what price should a Treasury bill, with 30
  days to maturity, trade at to offer a better
  investment than the deposit above?
• Answer 99.66 or less per nominal 100.

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Characteristics of Money Market Instruments as
a Class

• Security excellent overall but shade depends on
  borrower from the ultimate security of the US
  government to, say, a small Irish company.
• Excellent, because exposure time to credit
  worthiness of borrower is very limited and one
  can form a good assessment of risk of such a
  short period.
• Yield close to interest rate set by monetary
  authorities. Yield tends to incorporate
  short-term inflation expectations, so high when
  inflation is high.
• Term - Short-term, most within 91 days. Overnight
  common.
• Currency available in all currencies both
  within the legal jurisdiction of the issuing
  monetary authorities and without it (e.g.
  eurosterling, eurodollar, euroyen).
• Marketability high as near cash substitutes.
• Volatility low, as short term. A 1 change in
  interest rate on a 91 bill causes price to change
  by about ¼.
• Generally taxed as income, even if instrument is
  phrased as a capital only instrument.
• Expected returns comparatively low as closest
  approximation to risk-free asset.

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Money market instruments

• Generally quite similar as a class, within class
  categorise according to
• Term on investment overnight to 1 year
• Credit worthiness of borrower
• Marketability
• Fixed or variable interest rate over term
• Interest rate
• Remember SYSTEM T to help remember list of
  important attributes

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Different Types of Money Market Instruments

• Treasury Bills a bill issued on behalf of the
  government with a lifetime generally of 91 or 182
  days. Issued on a discounted basis (i.e.,
  maturity value is 100 and trades at a discount).
  Very liquid market. Important as comparison
  benchmark.
• Local Authority Bills as above but issuer now a
  local authority.
• Bills of Exchange a signed promise to pay a
  stated amount at a stated time by a company.
  These bills are made into Bank Bills when the
  promise is underwritten by a bank an eligible
  bank bill if the Central Bank discounts the
  bills of the underwriting bank (otherwise
  ineligible bank bill). Traded on a discounted
  basis. Tradable.
• Certificates of Deposits (CDs) Certificate of a
  deposit issued by banks, showing amount, time
  due, and rate of interest. Can be traded on
  liquid secondary market.

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Different Types of Money Market Instruments

• Commerical Paper Bearer notes for fixed sums
  payable at a given date issued by (large)
  companies at a discount. Tradable.
• Term deposits A bank deposit for a fixed period
  with either fixed or variable interest credited.
  Non-negotiable (i.e., not tradable). Rate close
  to LIBOR London interbank offered rate. For the
  euro we have EURIBOR.
• Call deposit immediate access to deposit,
  interest rate varies daily. Not tradable.
• Floating Rate Notes (FRNs) medium term
  instruments (generally about 5 year term) with
  variable interest paid quarterly, generally based
  on a spread above LIBOR. Tradable. Issuers are
  large companies, governments, and supranational
  organisations. These instruments can be listed on
  a stock exchange

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Repo

• A repo is a sale and repurchase agreement (of
  bill or gilt) and it is now the principal
  instrument that central banks use to control
  level of short-term interest rates.

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Why hold cash?

• To match known liabilities
• For known payments falling due
• For liquidity requirements.
• For uncertain payments
• Other reasons
• For its property of capital security for the
  especially risk averse.
• For opportunities because it is anticipated to
  fare better than other capital assets over the
  near future.
• ?? Because of very recent cash flow ??

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When is cash attractive as a speculative asset?

• When everything else is fallingwhich might be
• During a period of rising interest rates
• Before an unanticipated recession
• General rising economic uncertainty
• Foreign cash when local currency weakening

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Key Historical Statistics Irish Cash Returns
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Ends Description of Money Market