Money markets

1
Money markets

• Dr.Guru. Raghavan

2
Introduction

• In a global context, the term money market refers
  to the net work of corporations, financial
  institutions, investors and governments which
  deal with flow of short term capital.
• The money markets have expanded significantly in
  recent years as a result of the general outflow
  of money from the banking industry, a process
  referred to as disintermediation.
• Financial deregulation has caused banks to lose
  market share in both deposit gathering and
  lending.
• There is an identifiable money market for each
  currency, because interest rates vary from one
  currency to another.

3
Introduction..

• These markets are not independent, and both
  investors and borrowers will shift from one
  currency to another depending upon relative
  interest rates.
• However, regulations limit the ability of some
  money markets investors to hold foreign currency
  instruments and most money market investors are
  concerned to minimize any risk of loss as a
  result of exchange rate fluctuations.
• For these reasons, most money market transactions
  occur in the investors home currency
• The money markets do not exist in a particular
  place or operate according to a single set of
  rules. Nor do they offer a single set of posted
  prices.

4
Introduction..

• The Bank for International Settlements, which
  compiles statistics gathered by national central
  banks, estimates that the total amount of money
  market instruments in circulation worldwide at
  December 2004 was 8.2 trillion, compared with 6
  trillion in 2001 and 4 trillion at the end of
  1995

5
What money markets do

• There is no precise definition of the money
  markets but the phrase is usually applied to the
  buying and selling of debt instruments maturing
  in a year or less. The money markets are thus
  related to the bond markets, in which the
  corporations and governments borrow and lend
  based on longer term contracts.
• Similar to bond investors, money market
  investors are extending credit, without taking
  any ownership in the borrowing entity or any
  control over management

6
What money markets do..

• However, bond issuers typically raise money to
  finance investments that will generate profits
  or in the case government issuers, public
  benefits for many years in to the future.
  Issuers of money market instruments are usually
  more concerned with cash management or with
  financing their portfolios of financial assets.
• A well functioning money market facilitates the
  development of market for longer term securities.
  Money markets attach a price to liquidity, the
  availability of money for immediate investment.
  The interest rates for extremely short term use
  of money serve as benchmarks for longer term
  financial instruments.

7
What money markets do..

• If the money markets are active, or liquid,
  borrowers and investors always have the option of
  engaging in a series of short term transactions
  rather than in longer term transactions and this
  usually hold down longer term rates.
• In the absence of active money markets to set
  short term rates, issuers and investors may have
  less confidence that longer term rates are
  reasonable and greater concern about being able
  to sell their securities they choose.
• For this reason, countries with less active money
  markets, on balance, also tend to have less
  active bond markets

8
Investing in money markets

• Short term instruments are often unattractive to
  investors, because the high cost of learning
  about the financial status of a borrower can
  outweigh the benefits of acquiring a security
  with a life span of say six months. For this
  reason, investors typically purchase money market
  instruments through funds, rather than buying
  individual securities directly

9
Money market funds

• The expansion of money markets has been fuelled
  by a special type of entity, the money market
  fund, which pools money market securities,
  allowing investors to diversify risk among the
  various company securities in the fund
• Retail money market funds cater for individuals
  and institutional money market funds serve
  corporations, foundations, government agencies
  and other large investors. The funds are normally
  required by law or regulation to invest only in
  cash equivalents, securities whose safety and
  liquidity make them almost as good as cash

10
Money market funds..

• Money market funds are a comparatively recent
  innovation. They reduce investors search costs
  and risks. They are also able to perform the role
  of intermediation at much lower cost than banks,
  because money market funds do not need to
  maintain branch offices, accept accounts with
  small balances and otherwise deal with the
  diverse demands of bank customers.
• The spread between the rate money market funds
  pay investors and the rate at which they lend out
  these investors money is normally a few tenths
  of a percentage point, rather than the 2 to 4
  percentage point spread between what banks pay
  depositors and charge borrowers.

11
Money market funds..

• The shift of short term capital into investment
  funds rather than banks is most advanced in the
  United States, which began deregulating its
  financial sector earlier than most other
  countries
• The flow of assets into money market funds is
  related to the gap between short term and long
  term interest rates.

12
Individual sweep accounts

• The investment companies that operate equity
  funds and bond funds usually provide money market
  funds to house the cash that investors wish to
  keep available for immediate investment. People
  with large amounts of assets often invest in
  money market instruments through such sweep
  accounts. These are multi purpose accounts at
  banks or stockbrokerage firms, with the assets
  used for paying current bills, investing in
  shares, and buying mutual funds. Any uncommitted
  cash is automatically swept in to money market
  funds or overnight investments at the end of each
  day, in order to earn the highest possible return

13
Institutional investors

• Money market funds are by no means the only
  investors in money market instruments. All
  sizeable banks maintain trading departments that
  actively speculate in short term securities.
  Investment trusts that mainly hold bonds or
  equities normally keep a small proportion of
  their assets in money market instruments to
  provide flexibility, in part to meet investors
  requests to redeem shares in the trust without
  having to dispose of long term holdings
• Pension funds and insurers, which typically
  invest with extremely long time horizons, also
  invest a proportion of their assets in money
  market instruments in order to have access to
  cash at any time without liquidating long term
  positions.

14
Interest rates and prices

• Borrowers in the money markets pay interest for
  the use of the money they have borrowed. Most
  money market securities pay interest at a fixed
  rate, which is determined by market conditions at
  the time they are issued. Some issuers prefer to
  offer adjustable rate instruments, on which the
  rate will change from time to time according to
  procedures laid down at the time the instruments
  are sold.

15
Interest rates and prices..

• Because of their short maturities, most money
  market instruments do not pay periodic interest
  during their lifetimes but rather are sold to
  investors at a discount to their face value. The
  investor can redeem them at face value when they
  mature, with the profit on the redemption serving
  in the place of interest payments

16
Interest rates and prices..

• The value of money market securities changes
  inversely to changes in short term interest
  rates. Because money market instruments by nature
  are short term, their prices are much less
  volatile than the prices of longer term
  instruments and any loss or gain from holding the
  security in the short time until maturity rather
  than investing at current yields is small.

17
Types of instruments

• The best known money market instruments are
• commercial paper
• bankers acceptance
• treasury bills
• government agency notes
• local government notes
• inter bank loans
• time deposits
• paper issued by international organizations
• It is pertinent to remind ourselves that the
  amount issued during the course of a year is much
  greater than the amount outstanding at any one
  time, as many money market securities are
  outstanding for only short periods of time

18
Commercial paper

• Commercial paper is a short term debt obligation
  of a private sector firm or a government
  sponsored corporation.
• In most cases it has a life time or maturity
  greater than 90 days but less than 9 months. This
  maturity is dictated by regulations.
• Commercial paper is usually unsecured, although a
  particular commercial paper issue may be secured
  by a specific asset of the issuer or may be
  guaranteed by a bank
• The main advantage is that it allows financially
  sound companies to meet their short term
  financing needs at lower rates than could be
  obtained by borrowing directly from banks.

19
Commercial paper..

• Many large companies have continued commercial
  paper programmes, bringing in new short term debt
  on to the market every few weeks or months. It is
  common for issuers to roll over their paper
  (where regulations permit) using the proceeds of
  a new issue to repay the principal or a previous
  issue. In effect this allows issuers to borrow
  money for long periods of time at short term
  interest rates, which may be significantly lower
  than long term rates. (The short term nature of
  the obligation lowers the risk perceived by the
  investors)
• These continual borrowing programmes are not
  riskless. If market conditions or a change in the
  firms financial circumstances preclude a new
  commercial paper issue, the borrower faces
  default if it lacks the cash to redeem the paper
  that is maturing.

20
Commercial paper..

• The use of commercial paper also creates a risk
  that if interest rates should rise, the total
  cost of successive short term borrowings may be
  greater than had the firm undertaken longer term
  borrowing when rates were low

21
Bankers acceptances

• An acceptance is a promissory note issued by a
  non financial firm to a bank in return for a
  loan. The bank resells the note in the money
  market at a discount and guarantees payment.
  Acceptances usually have a maturity of less than
  six months

22
Bankers acceptances..

• Bankers acceptances differ from commercial
  paper in significant ways
• They are usually tied to the sale or storage of
  specific goods, such as an export order for which
  the proceeds will be received in two or three
  months
• They are not issued at all by financial industry
  firms.
• They do not bear interest instead an investor
  purchases the acceptance at a discount from face
  value and then redeems it for face value at
  maturity
• Investors rely on the strength of the guarantor
  bank, rather than of the issuing company, for
  their security

23
Bankers acceptances..

• In an era when banks were able to borrow at
  lower cost than other types of firms, bankers
  acceptances allowed manufacturers to take
  advantage of banks superior credit standing.
  This advantage has largely disappeared, as many
  other big corporate borrowers are considered at
  least as creditworthy as banks. Although bankers
  acceptances are still a significant source of
  financing for some companies, their importance
  has diminished considerably as a result of
  greater flexibility and lower cost of commercial
  papers.

24
Treasury bills

• Treasury bills, often referred to as T-bills, are
  securities with a maturity of one year or less,
  issued by national governments.
• Treasury bills issued by a government in its own
  currency are generally considered the safest of
  all possible investments in that currency.
• Such securities account for a larger share of
  money market trading than any other type of
  instrument
• The mix of money market and longer term debt
  issuance varies considerably from government to
  government and time to time.

25
Treasury bills..

• In cases where a government is unable to convince
  investors to buy its longer term obligations,
  treasury bills may be its principal source of
  financing. This is the main reason for the steep
  growth in treasury bills issuance by the
  governments of emerging market countries during
  the 1980s. Many of these countries have histories
  of inflation or political instability that have
  made investors vary of long term bonds, forcing
  governments as well as non government borrowers
  to use short term instruments.

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Treasury bills..

• As countries develop reputations for better
  economic and fiscal management, they are often
  able to borrow for long terms rather than relying
  exclusively on short term instruments
• Some emerging market countries have issued
  treasury bills denominated in foreign currencies,
  mainly dollars, in order to borrow at lower rates
  than prevail in their home currency. This
  strategy requires frequent refinancing of short
  term foreign currency debt.

27
Treasury bills..

• The overall size of the treasury bill market
  changes considerably from year to year, depending
  upon the status of governments fiscal policies.
  The market shrank in the late 1990s as a result
  of the shift from budget deficits to budget
  surpluses, which reduced government debt
  outstanding in the US, Canada and most EU
  countries and some emerging markets, but then
  expanded after 2000 as many governments increased
  their budget deficits to combat recession

28
Government bonds/notes/papers/securities

• National government agencies and government
  sponsored corporations are heavy borrowers in the
  money markets in many countries. These include
  entities such as development banks, housing
  finance corporations, education lending agencies
  and agricultural finance agencies.

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Local government bonds/notes/papers/securities

• Local government notes are issued by state,
  provincial or local governments, and by agencies
  of these governments such as electricity boards
  and transport commissions. The ability of
  governments at this level to issue money market
  securities varies greatly from country to
  country. In some cases, the approval of national
  authorities is required in others local agencies
  are allowed to borrow only from banks and cannot
  enter the money markets.

30
Local government bonds/notes/papers/securities..

• One common use for short term local government
  securities is to deal with highly seasonal tax
  receipts. Such securities, called tax
  anticipation notes, are issued to finance general
  government operations during a period when tax
  receipts are expected to be low, and are redeemed
  after a tax payment deadline. Local governments
  and their agencies may also issue short term
  instruments in anticipation of transfers from a
  higher level of government. This allows them to
  proceed with spending plans even though the
  transfer from higher authorities has not yet been
  received.

31
Interbank loans

• Loans extended from one bank to another with
  which it has no affiliation are called inter bank
  loans. Many of these loans are across
  international boundaries and are used by the
  borrowing institution to re lend to its own
  customers.
• Banks lend far greater sums to other institutions
  in their own country. Over night loans are short
  term unsecured loans from one bank to another.
  They may be used to help the borrowing bank
  finance loans to customers, but often the
  borrowing bank adds the money to its reserves in
  order to meet regulatory requirements and to
  balance assets and liabilities

32
Interbank loans..

• The interest rates at which banks extend short
  term loans to one another have assumed
  international importance. (LIBOR in UK, EURIBOR
  in Europe and FED FUNDS RATE in US)
• Each of these rates is applied only to loans to
  healthy, creditworthy institution. A bank that
  believes another bank to be in danger of failing
  will charge sharply higher interest rates or may
  refuse to lend at all, even overnight, lest the
  unsecured loan be lost if the borrower fails

33
Time deposits

• Time deposits another name for certificates of
  deposit or CDs, are interest bearing bank
  deposits that cannot be withdrawn without penalty
  before a specified date. Although time deposits
  may last for as along as five years, those with
  terms of less than one year compete with other
  money market instruments. Deposits with terms as
  brief as 30 days are common. Large time deposits
  are often used by corporations, governments and
  money market funds to invest cash for brief
  periods.

34
International agency papers

• IAP is issued by World Bank, the Inter American
  Development Bank and other organizations owned by
  member governments. These organizations often
  borrow in many different currencies, depending
  upon interest and exchange rates

35
Repos

• Repurchase agreements, known as Repos, play a
  critical role in the money markets. They serve to
  keep the markets highly liquid, which in turn
  ensures that there will be a constant supply of
  buyers for new money market instruments
• A repo is a combination of two transactions. In
  the first, a securities dealer, such as a bank,
  sells securities it owns to an investor, agreeing
  to repurchase the securities at a specified
  higher price at a future date. In the second
  transaction, days or months later, the repo is
  unwound as the dealer buys back the securities
  from the investor.
• The amount the investor lends is less than the
  market value of the securities, a difference
  called the haircut, to ensure that it still has
  sufficient collateral if the value of the
  securities should fall before the dealer
  repurchases them

36
Repos..

• For the investor, the repo offers a profitable
  short term use for unneeded cash. A large
  investor whose investment is greather than the
  amount covered by bank insurance may deem repos
  safer than bank deposits, as there is no risk of
  loss if the bank fails. The investor profits in
  two different ways. First s/he receives more for
  reselling the securities than s/he paid to
  purchase them. In effect s/he is collecting
  interest on the money s/he advanced to the dealer
  at a rate known as the repo rate. Second, if s/he
  believes the price of securities will fall, the
  investor can sell them and later purchase
  equivalent securities to return to the dealer
  just before the repo must be unwound. The dealer
  meanwhile has obtained a loan in the cheapest
  possible way, and can use the proceeds to
  purchase yet more securities

37
Repos..

• In a reverse repo the roles are switched, with an
  investor selling securities to a dealer and
  subsequently repurchasing them. The benefit to
  the investor is the use of cash at an interest
  rate below that of other instruments
• Repos and reverse repos allow dealers, such as
  banks and investment banks, to maintain large
  inventories of money market securities, while
  preserving their liquidity by lending out the
  securities in their portfolio. They have
  therefore become an important source of financing
  for dealers in money market instruments.

38
How trading occurs

• Trading in money market instruments occurs almost
  entirely over telephone links and computer
  systems. The banks and non bank dealers in money
  market instruments sign contracts, either with
  one another or with a central clearing house,
  committing themselves to completing transactions
  on the terms agreed. Because of the large amounts
  of money involved, the collapse of an important
  bank or securities dealers with many unsettled
  trades could pose a threat to other banks and
  dealers as well. For this reason, clearing houses
  have been striving to achieve a real time
  settlement, in which funds and securities are
  transferred as quickly as possible after the
  transaction has been reported

39
Credit ratings and the money market

• Ratings agencies are private firms that offer
  opinions about the credit worthiness of borrowers
  in the financial markets. The issuers of treasury
  bills, agency notes, local government notes, and
  international agency paper usually obtain ratings
  before bringing their issues to market.
• Some commercial paper issues are rated, although
  in many cases the ratings agency expresses its
  view of an issuers multi year commercial paper
  programme rather than judging each issue
  separately. Participants in inter bank lending
  and buyers of bankers acceptances look for a
  rating not of a particular deal, but of the
  financial institutions involved

40
Credit ratings and the money market..

• Three firms, Moodys Investor Services, Standard
  Poors (SP) and Fitch IBCA, rate money market
  issuers around the world. Some of these agencies
  maintain separate scales for rating short term
  government debt, commercial paper and banks
  strength. Many other ratings agencies specialize
  in individual industries or countries

41
Short term credit ratings
Moodys SP Fitch IBCA
Very strong capacity to pay Prime 1 SP 1 F 1, F 1
Strong capacity to pay Prime 2 SP 1 F 2
Adequate ability to pay Prime 3 SP 2 F 3
Speculative ability to pay Not prime SP 3 B, C
In default D
42
Tier importance

• These ratings have a great impact on the market.
  In the US, money market funds invest
  overwhelmingly in Tier 1 commercial paper,
  defined as paper having the highest short term
  ratings from at least two rating agencies. Funds
  are prohibited from investing more than 5 of
  their assets in Tier 2 paper, defined as paper
  that does not qualify for Tier 1. As a result,
  comparatively little commercial paper is issued
  by firms that cannot qualify for Tier 1 and there
  is almost no below investment grade paper
  available in the market.

43
Tier importance..

• Similarly, banks that do not have high financial
  strength ratings will have difficulty attracting
  certificates of deposit, and the lowering of a
  banks rating by any of the ratings agencies will
  cause depositors to demand higher interest rates
  or to flee altogether

44
Money markets and monetary policy

• The money markets play a central role in the
  execution of central banks monetary policy in
  many countries. The job of national central banks
  which indirectly seek to regulate the amount of
  credit in the economy in order to manage economic
  growth and inflation involve mainly purchasing
  and selling government debt to government
  securities dealers in open market operations.
  These operations involve adding money to or
  draining money out of the banking system, which
  encourages or constrains banks lending and
  thereby affects spending and demand in the economy

45
Money markets and monetary policy..

• These days, however, central banks in countries
  with well developed financial systems often
  manage monetary policy through the repo market
  rather than with direct purchases and sale of
  securities. Under this system, the central bank
  enters into a repurchase agreement with a dealer.
  The money it pays the dealer passes to the
  dealers bank, adding reserves to the banking
  system. When the repo matures the dealer returns
  the money to the central bank, draining the
  banking system of reserves unless the central
  bank enters into new repo transactions to keep
  the reserves level unchanged
• If the central bank wishes to drain reserves from
  the system, it engages in a matched sale-purchase
  transaction, selling securities from its
  portfolio to dealers with agreements to
  repurchase them at future dates

46
Central bank interest rates

• In many countries, central banks can also lend
  directly to the money markets by providing credit
  to financial institutions at posted rates. Such
  loans are mainly for the purpose of helping
  institutions that have experienced sudden
  withdrawals of funds or otherwise face a lack of
  liquidity. Central bank loan rates are often less
  attractive than those available in the private
  sector, so as to encourage financial institutions
  to borrow in the money markets before turning to
  the central bank.

47
Watching short term interest rates

• Spreads
• Overnight rates
• Prime rates
• Mortgage rates

48
Spreads

• The differences in interest rates on different
  instruments are highly sensitive indicators of
  market participants expectations
• One important set of spreads is that between un
  collateralised loans and repos
• As repos are fully collateralised there is almost
  no risk that repayment will be disrupted.
• Uncollateralised loans among banks, however, are
  at risk if a bank should fail
• The spread between these two types of lendings in
  various countries is instructive.
• A widening spread may indicate the investors
  worry and deteriorating economy

49
Overnight rates

• Rates on overnight bank deposits receive close
  attention. In some countries this is known as the
  call rate
• In the eurozone countries this is called EONIA
  (Euro Overnight Index Average)
• Differences in rates for money market
  instruments of different maturities are among the
  most sensitive economic indicators

50
The prime rates

• The prime rate was established decades ago as the
  interest rate charged by banks in US to their
  best corporate borrowers and it receives a great
  deal of attention in the market
• Although big corporate borrowers are no longer
  affected by the prime rate, it is the basis for a
  large proportion of variable rate consumer
  credit, including credit card loans and home
  equity loans.
• Thus a rise in the prime rate often curtails
  consumer spending

51
Mortgage rates

• Changes in the variable mortgage rates in
  countries like UK are passed on to homeowners
  within a matter of weeks and therefore have an
  almost immediate impact on the economy
• These rates usually change in increments of 0.25
  and lenders are free to alter them, along with
  the mortgage payments they govern, as often as
  desired.
• This has made mortgage rates as one of the most
  sensitive economic indicators

52

• End