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Chapter Five

Chapter Five. Money Markets. 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

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Chapter Five

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  1. Chapter Five Money Markets McGraw-Hill/Irwin

  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 nation’s supply of liquid funds among major short-term lenders and borrowers McGraw-Hill/Irwin

  3. Definition of Money Markets • Money market securities are generally fixed income securities that have an original issue maturity of one year or less, thus they have little price risk. • Money markets primarily exist to minimize the cost of maintaining liquidity for financial, non-financial and government institutions and to provide borrowers with low cost, short term sources of funds. • Money market securities should thus provide safety of principle, liquidity and a predictable, albeit typically modest, yield McGraw-Hill/Irwin

  4. Why Money markets • Money markets exist because rarely do required cash disbursements occur at the same time and in the same amounts as cash inflows for corporations and institutions. • At times units will have excess cash that is not immediately needed, and other economic units will need to borrow cash for a short period of time. • Thus, entities must maintain liquid sources of funds. • In addition, precautionary amounts of funds beyond planned liquidity needs must be maintained because expected cash inflows and required cash disbursements cannot be predicted with perfect accuracy McGraw-Hill/Irwin

  5. opportunity cost • The opportunity cost of keeping cash on hand can be quite high. The opportunity cost is the rate of return that could be earned in the highest valued alternative if liquidity balances did not have to be maintained. • Money markets have developed to provide corporations, governments and institutions with safe, liquid investments (or sources of funds for borrowers) that minimize the opportunity cost of maintaining liquidity. McGraw-Hill/Irwin

  6. Secondary markets • Secondary markets, or some other method of quickly recovering the investment at short notice, are of paramount importance for money market instruments because much of the funds invested in money markets may be needed by the lender for unexpected liquidity needs. • Money market securities also have little or no default risk. • With the focus on liquidity and safety, the rate of return on money market securities is expected to be significantly less than promised yields on capital market instruments. McGraw-Hill/Irwin

  7. Yields on Money Market Securities Many money market securities use special quoting conventions • Discount Yields • Single-Payment Yields • Equivalent Annual Return McGraw-Hill/Irwin

  8. Discount rates • Discount rates (or discount yields) quote the interest rate as an annualized percentage of the sale (redemption) price of the security assuming there are only 360 days in a year. Even if the security matures in 90 days, the rate quote is as if the security matured in one year. McGraw-Hill/Irwin

  9. Single payment securities • Single payment securities or loans (also called add ons) quote the rate as an annualized percentage of the purchase price of the security, assuming there are only 360 days in a year. McGraw-Hill/Irwin

  10. A calculation for restating semi-annual, quarterly, or monthly discount-bond or note yields into an annual yield. For a fixed income security with a par value of $1000, the calculation is as follows: ((1000- purchase price)/ purchase price)*365/days to maturity McGraw-Hill/Irwin

  11. The total amount of money market securities outstanding in 2004 in the major money markets was over $5,260 billion. • This represents a compound annual growth rate of 7% over the period 1990 to 2004. McGraw-Hill/Irwin

  12. Money Market Instruments • Treasury Bills • Federal Funds • Repurchase Agreements • Commercial Paper • Negotiable Certificates of Deposit • Banker Acceptances McGraw-Hill/Irwin

  13. Treasury Bills • T-bills are short term obligations of the U.S. government used to finance government spending needs. • At the end of 2004 there was $981.9 billion outstanding comprising about 19% of total money market securities. • Original issue maturities are 13 or 26 weeks. • The minimum denomination is $1,000 and a round lot is $5 million. • T-bills are thought to be free of default risk and the 1 year T-Bill rate is often used as a measure of the short term ‘risk free rate.’ McGraw-Hill/Irwin

  14. T-Bills Auction • Each week new 13 and 26 week T-bills are offered for sale at competitive auction. • T-bills are sold to the highest bidder at auction, but no one bidder can purchase more than 35% of the total amount in any one auction. • Noncompetitive bids of up to $1 million can be made. • The Treasury is now using a single price auction. • In the past Treasury securities were sold at a discriminating auction where high bidders paid higher prices, and lower bidders paid lower prices. Noncompetitive bidders paid the average price of the accepted bids McGraw-Hill/Irwin

  15. Treasury Auction Results Nov 18,2004 Bid Price 99.4975% Noncompetitive Bids 1 SC ST 2 3 4 99.48875% (PNC) stop-out price (low bid accepted) 5 6 7 Quantity of T-bills $19,254.8m $17,509.5m McGraw-Hill/Irwin

  16. Why single price auction • In the Treasury single price auction the lowest bid price accepted becomes the price that all winning bidders pay. There are two purported advantages of a single price auction over a discriminating auction: • 1. A greater number of bidders have their bids filled and • 2. More aggressive bidding occurs under the single price format resulting in a higher average price paid by investors. McGraw-Hill/Irwin

  17. The secondary market for T-bills • The secondary market for T-bills is the largest of any money market security. • There are 22 primary government security dealers who purchase the new issues and about 500 smaller dealers who actively participate in trading T-bills. • The FedWire is often used for trades between dealers and other institutions. McGraw-Hill/Irwin

  18. Secondary Market T-bill Transaction J.P. Morgan Chase sells $10m. In T-bills Lehman Brothers buy $10m. In T-bills Fedwire Transaction Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan Chase to Lehman Brothers Transaction recorded in Fed’s Book-Entry System Fedwire Transaction FRBNY -$50,000 in T-bills from J.P. Morgan Chase’s 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 McGraw-Hill/Irwin

  19. Case: Salomon Brothers • In violation of regulations, Salomon Brothers (Chase/Solomon) bought about 80% of one Treasury auction in an attempt to squeeze the market. Many T-bills are sold on a ‘when issued’ basis by dealers who anticipate obtaining them at auction (i.e. T-bills are often sold short before they are issued). Since Salomon obtained so much of the auction, other dealers could not meet their prior short sale obligations and had to pay a premium price to Salomon to obtain the bills which the dealers had already agreed to deliver to customers. The government forced Salomon to give up their profits from the squeeze and pay fines. The biggest loss was to Salomon’s reputation. McGraw-Hill/Irwin

  20. Discount instruments • T-bills are discount instruments. • T-bill prices (P0) are calculated as P0 = PF  (1 – (i*h/360)) where i is the discount quote, h is the maturity in days and PF is the face value of the bill. • One should calculate the bond equivalent yield in order to compare rate quotes on different instruments that use different quoting conventions. • The bond equivalent yield for a T–bill can be calculated as (PF–P0)/P0 * (365/h). McGraw-Hill/Irwin

  21. Treasury Bill Basics Summary • 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 McGraw-Hill/Irwin

  22. 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 FOMC’s instrument of choice for its open market operations McGraw-Hill/Irwin

  23. 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 a weighted-average of the rate on winning competitive bids; get preferential allocation McGraw-Hill/Irwin

  24. 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 • Asked • Spread McGraw-Hill/Irwin

  25. Calculating T-bill Yields from Discount Rates iT-bill(dy) = PF - PO 360 PF h Where: iT-bill= Annualized yield on the T-bill PF = Price (face value) paid to the T-bill holder PO = Purchase price of the T-bill h = Number of days until the T-bill matures Example: iT-bill(dy) = $10,000 - $9,905.71 360 = 2.19% $10,000 155 McGraw-Hill/Irwin

  26. Federal Funds • Fed funds, together with repurchase agreements, comprise about 30% of total money market securities. • Federal funds, or fed funds, are short term unsecured loans of deposits held at the Federal Reserve (i.e. loans of excess reserves. • These loans occur largely between institutions. • Small banks often make loans to their correspondent banks when local loan demand is insufficient McGraw-Hill/Irwin

  27. ‘bullet’ loans • The majority of fed funds are overnight loans, although many are made on ‘continuing contract.’(Continuing contract means that unless the borrower or lender notifies the other party the loan will automatically be renewed daily) • Fed funds are add on loan contracts (single payment or ‘bullet’ loans) and follow the convention of quoting all rates on an annual basis assuming a 360 day year. McGraw-Hill/Irwin

  28. equivalent yield • To convert a fed funds rate quote to a bond equivalent yield take the rate quote and multiplied it by 365/360. • Many fed fund loans are arranged through correspondent banks or through brokers such as Garban-Intercapital Ltd. and RMJ Securities Corp. • The typical brokerage fee may be as small as 50 cents per million dollars. McGraw-Hill/Irwin

  29. Funds transfers • Funds transfers occur over the FedWire and transactions can be completed very quickly (in a matter of minutes). • A FI is not required to hold reserves at the Fed to participate in the fed funds market; deposits at banks are often used in place of deposits at the Federal Reserve. • Typical transactions are $5 million and up. McGraw-Hill/Irwin

  30. Federal Funds Summary • 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 • Fed fund transactions take the form of short-term (mostly overnight) unsecured loans McGraw-Hill/Irwin

  31. 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 • Correspondent banks – banks with reciprocal accounts and agreements McGraw-Hill/Irwin

  32. Repurchase Agreements • A repurchase agreement (repo or RP) is an agreement where the seller of securities agrees to repurchase the securities at a preset price at a preset time (typically from 1 to 14 days). • Repos are in effect, collateralized loans similar to fed funds loans. • The seller is borrowing. • money and pledging the securities as collateral and the buyer (who is said to be engaging in a reverse repo) is lending money. • The interest rate is determined by setting the buy and sell price of the securities. McGraw-Hill/Irwin

  33. Repo interest rate • The rate of interest paid on the repo is not a function of the rate of return on the underlying securities. • If risky securities are pledged as collateral, the fund’s lender may require a larger ‘haircut,’ i.e. repos normally have to be slightly overcollateralized. • For instance, to borrow $100 the repo seller would have to sell securities currently worth $102, for a $2 haircut. • The repo is a ‘real’ sale in the sense that title to the securities passes to the lender of funds for the term of the agreement. McGraw-Hill/Irwin

  34. Repo Pricing and Transfers • Transfers may occur over the FedWire system. • Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations. • Repos are add on instruments (single payment loans) with yields that average about 25 basis points less than fed funds loans due to the repo collateral. • Repos take longer to arrange than fed funds and fed funds loans are more likely to be used when funds are needed immediately. McGraw-Hill/Irwin

  35. Repurchase Agreements (RPs or Repos) Summary • 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 McGraw-Hill/Irwin

  36. 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 McGraw-Hill/Irwin

  37. Commercial Paper • Commercial paper is a short term unsecured promissory note issued by creditworthy corporations and financial institutions. • Because the notes are unsecured and are not very liquid, commercial paper is rated by ratings agencies. • The paper rating strongly affects the cost of financing with commercial paper. • Low quality paper is often secured by bank lines of credit to obtain a better rating. • The spread between prime grade and medium grade paper has averaged about 22 basis points per year McGraw-Hill/Irwin

  38. Maturity of CP • The maximum maturity is 270 days (most are less) because the SEC requires formal registration of securities with maturities greater than 270 days. • Commercial paper comprised about 25% of total money market securities in 2004, down from 2001 in absolute dollar amount and as a percentage of total money market securities. McGraw-Hill/Irwin

  39. Discount instrument • Commercial paper is a discount instrument and uses discount quotes similar to T–bills • Credit concerns coupled with some high profile downgrades of major paper issuers such as GM, Ford and Tyco have reduced the amount of commercial paper in the past several years. McGraw-Hill/Irwin

  40. History • The commercial paper market has developed to provide corporations with an alternative to short term bank loans. • Commercial paper outstanding grew tremendously in the 1990s because large, creditworthy paper issuers were able to obtain lower cost financing by issuing paper rather than borrowing from banks. McGraw-Hill/Irwin

  41. no active secondary market • Commercial paper is issued in denominations ranging from $100,000 to $1 million, with the most common maturities in the 20 to 45 day range. • About 15% of issuers directly market their own paper, but the bulk is sold through brokers and dealers. • There is no active secondary market for commercial paper, partly because commercial paper dealers will redeem paper from the buyers if the buyer needs the money prior to maturity. McGraw-Hill/Irwin

  42. Commercial Paper Summary • 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 McGraw-Hill/Irwin

  43. 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 McGraw-Hill/Irwin

  44. Negotiable Certificates of Deposit • A negotiable certificate of deposit is a bearer certificate indicating that a time deposit has been made at the issuing bank which the bearer (holder) can collect at maturity. • Large CDs are negotiable instruments. Negotiable CDs have a minimum denomination of $100,000, but denominations of $1 million are the most common. • Maturities range from 1, 2, 3 and 6 months out to 1 year McGraw-Hill/Irwin

  45. CD rates • Negotiable CD rates are add on rates (single-payment loans) quoted using the 360 day convention.(CDs with maturity greater than one year area not bullet loans, rather they usually pay interest semiannually) • They comprised about 26% of money market securities in 2004. McGraw-Hill/Irwin

  46. CD draw funds that would be invested in non-bank money market securities. • Large well known banks, particularly New York banks, often can pay lower interest rates on their CDs than other lesser well known institutions. • About 15 dealers make a secondary market in CDs, although it is not very active. • CDs are required to have ‘substantial interest penalties for early withdrawal.’ • The secondary market eliminates the problem of the interest penalty, and has increased bank’s ability to draw funds that would otherwise be invested in non-bank money market securities. McGraw-Hill/Irwin

  47. 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 CD’s rather than new issues McGraw-Hill/Irwin

  48. Negotiable Certificates of Deposits Summary • A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market • Bearer Instrument • 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 McGraw-Hill/Irwin

  49. Banker’s Acceptances (BAs) • Drafts are often used to facilitate international trade in goods and services. • The seller of the goods writes either a time draft or a sight draft payable by the buyer of the goods or services. • A sight draft is a claim that becomes due and payable upon presentation to the buyer. • A time draft is a claim that becomes due and payable at a certain future date specified on the draft. McGraw-Hill/Irwin

  50. Because the seller normally will not know the creditworthiness of the buyer (and credit investigation costs can be quite high), the seller may be reluctant to ship the goods unless payment can be guaranteed by a third party. Banker’s acceptances are a certain kind of time draft where a bank has agreed to pay the seller of the goods the amount owed if the buyer cannot or will not pay on the date due. The draft is backed by a letter of credit drawn on the buyer’s bank, ensuring that the bank will “accept” the draft drawn up by the seller. Once the seller can prove that the goods have been shipped in accordance with the contract and the proper paperwork has been presented to the buyer, the time draft can be sold as a discount instrument McGraw-Hill/Irwin

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