Chapter Two

1. Chapter Two MARKETS AND INSTRUMENTS The presentation has been amended/updated by Dr. Mounira Ben Arab

2. 2.1 THE MONEY MARKET • Treasury bills (T-bills) • Federal funds (fed funds) • Repurchase agreements (repos or RP) • Commercial paper (CP) • Negotiable certificates of deposit (CD) • Banker acceptances (BA)

3. T- bills: represent the simplest form of borrowing: The government raises money by selling bills to the public. • The Federal Reserve buys and sells T-bills to implement monetary policy • Are virtually default risk free, highly liquid, and have little interest rate risk. • T-bills sell in minimum denominations of only $10,000. • The income earned on T-bills is exempt from all state and local taxes, as a consequence there is a strong international demand for T-bills as safe haven investment.

4. T-bills with initial maturities of 91 days or 182 days are issued weekly. Offerings of 52-week bills are made monthly. Sales are conducted via auction, at which investors can submit competitive or noncompetitive bids. A competitive bid is an order for a given quantity of bills at a specific offered price. The order is filled only if the bid is high enough relative to other bids to be accepted. A noncompetitive bid is an unconditional offer to purchase bills at the average price of the successful competitive bids.

5. T-Bill Auctions Noncompetitive Bids 1 Bid Price SC ST 2 3 4 5 6 Stop-out price (PNC) 7 Quantity of T-bills

6. T- bills: T-bill yields in the financial pages are quoted using the bank discount method.

7. T-bills use special rate quoting conventions: • Discount yields (idy): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of redemption price or face value • Pf = the face value of the security • P0 = the discount price of the security • h = the number of days until maturity • This may be converted to a bond equivalent yield (ibey) for comparison with bonds

8. Compare discount securities to bonds with bond equivalent yields (ibey) • Convert bond equivalent yields into effective annual returns (EAR)

9. 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

10. The Secondary Market for T-Bills The secondary market for T-bills is the largest of any U.S. money market instrument 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market primary dealers trade for themselves and for customers T-bill purchases and sales are book-entry transactions conducted over Fedwire T-Bills are sold on a discount basis

11. Federal Funds The federal funds (fed funds) rate is the target rate in the conduct of monetary policy Fed fund transactions are short-term (mostly overnight) unsecured loans. Multimillion dollars loans may be arranged in a matter of minutes Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds.

12. Fed funds are single-payment loans and thus use single-payment yields (ispy) to convert a single-payment yield to a bond equivalent yield: to directly convert a single payment yield to an EAR:

13. Repurchase Agreement A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities) Similar to a fed fund loan, but collateralized Funds may be transferred over FedWire system If collateralized by risky assets, the repo may involve a ‘haircut’

14. Repurchase Agreement Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations A reverse repurchase agreement is the purchase of a security with an agreement to sell it back in the future

15. 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

16. Commercial Paper Commercial Paper (CP) is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital) Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days. CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time) CP is usually held by investors until maturity and has no active secondary market CP like Treasury bills are quoted on a discount basis

17. Example A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the commercial paper: The bond equivalent yield for the commercial paper is 2.038%

18. The bond equivalent yield for the CD is 2.0278% The commercial paper has the better return since its bond equivalent yield is 2.038%

19. Asset-Backed Commercial Paper A type of commercial paper that is backed by assets of the issuing firm Grew very rapidly prior to the financial crisis peaking at $2.16 trillion. Much of it was backed by mortgage investments The market collapsed during the financial crisis

20. Negotiable Certificate of Deposit A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date CDs are bearer instruments and thus are salable in the secondary market 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 Negotiable (or jumbo) CDs like fed funds are money market securities that pay interest only at maturity. These use single-payment yields (ispy)

21. Banker’s Acceptance A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank Used in international trade transactions 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 payment guarantors before sending goods to importers Banker’s acceptances are bearer instruments and thus are salable in secondary markets

22. Diagram of a Banker’s Acceptance

23. International Money Markets U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR) Eurodollar Certificates of Deposit are U.S. dollar-denominated CDs held in foreign banks Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

24. Bond and Bond Markets Capital markets involve equity and debt instruments with maturities of more than one year Bonds are long-term debt obligations issued by corporations and government units Bond markets are markets in which bonds are issued and traded Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis) Corporate bonds

25. Bond Market Instruments Outstanding, 1994-2010 Bond Market Instruments

26. Treasury Notes and Bonds Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures Default risk free: backed by the full faith and credit of the U.S. government Low returns: low interest rates (yields to maturity) reflect low default risk Interest rate risk: because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change Liquidity risk: older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes

27. Current & Projected Federal Debt Levels Data Source: CBO

28. Treasury Notes and Bonds T-notes have original maturities from over 1 to 10 years T-bonds have original maturities from over 10 years Issued in minimum denominations (multiples) of $1,000 May be either fixed principal or inflation-indexed inflation-indexed bonds are called Treasury Inflation Protection Securities (TIPS) the principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months Trade in very active secondary markets Prices are quoted as percentages of face value, in 32nds

29. Sample Treasury Bond Quote Maturity mo/yr: Month and year, the bond matures November 15, 2017. Coupon: Coupon rate of 4.250% or $42.50 per year but paid semiannually ($1,000 face). Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to the dealer. Prices are quoted in 32nds. In this case, 112:26 = 112 26/32% of $1,000 or $1,128.125.

30. Sample Treasury Bond Quote Asked: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer. In this case, 112:27 = 112 27/32% of $1,000 or $1,128.4375. Chg: The change from the prior closing ASKED price in 32nds. In this case, the ASKED price increased thirteen 32nds from the prior quoted closing ask price. Asked Yld = Promised compound yield rate if purchased at the Asked price. In this case, the yield is 2.3316%.

32. Treasury STRIPS Separate Trading of Registered Interest and Principal Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury zero-coupon bonds Financial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bonds STRIPS have the periodic interest payments separated from each other and from the principal payment one set of securities reflects interest payments one set of securities reflects principal payments STRIPS are used to immunize against interest rate risk

33. Accrued Interest and Prices Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates. The price of the bond with accrued interest is called the full price or the dirty price, the price without accounting for accrued interest is the clean price.

34. Accrued Interest and Prices “Clean” prices are calculated as: Vb = the present value of the bond M = the par value of the bond INT = annual interest payment (in dollars) N = the number of years until the bond matures m = the number of times per year interest is paid id = interest rate used to discount cash flows on the bond

35. Accrued Interest on Bonds Accrued interest on T-notes and T-bonds is calculated as: The full (or dirty) price of a T-note or T-bond is the sum of the clean price (Vb) and the accrued interest

36. Accrued Interest Example You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)? The clean price is 120:19 or 120 19/32% of $1,000 or $1,205.9375. Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.

37. Notes and Bonds Markets The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T-notes and T-bonds through competitive and noncompetitive single-bid auctions 2-year notes are auctioned monthly 3-, 5-, and 10-year notes are auctioned quarterly (Feb, May, Aug, and Nov) 30-year bonds are auctioned semi-annually (Feb and Aug) Most secondary trading occurs directly through brokers and dealers

38. Municipal Bonds Municipal bonds (Munis) are securities issued by state and local governments to fund imbalances between expenditures and receipts to finance long-term capital outlays Attractive to household investors because interest is exempt from federal and most local income taxes General obligation (GO) bonds are backed by the full faith and credit of the issuing municipality Revenue bonds aresold to finance specific revenue generating projects

39. Municipal Bonds Compare Muni returns with fully taxable corporate bonds by finding the after tax return for corporate bonds:ia= ib(1 – t) ia = after-tax rate of return on a taxable corporate bond ib = before-tax rate of return on a taxable bond t = marginal total income tax rate of the bond holder Alternately, convert Muni interest rates to tax equivalent rates of return: ib= ia/(1 – t)

40. Municipal Bond Rates & Taxes For a 28% tax bracket, what is the equivalent after tax rate of a 6% corporate yield? ia = 6%(1- 0.28) = 4.32% For a 28% tax bracket, what corporate taxable yield is equivalent to a 4.5% muni bond rate? ib= 4.5% / (1-0.28) = 6.25%

41. Municipal Bonds Primary markets firm commitment underwriting: a public offering of Munis made through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public best efforts offering: a public offering in which the investment bank does not guarantee a firm price private placement: bonds are sold on a semi-private basis to qualified investors (generally FIs) Secondary markets: Munis trade infrequently due mainly to a lack of information on bond issuers

42. Corporate Bonds Corporate bonds are long-term bonds issued by corporations A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders Bearer versus registeredbonds Term versus serialbonds Mortgage bonds are secured debt issues

43. Corporate Bonds Debentures and subordinated debentures Convertible bonds versus non-convertible bonds icvb = rate of return on a convertible bond incvb = rate of return on a nonconvertible bond opcvb = value of the conversion option Stock warrants give bondholders the opportunity to purchase common stock at a prespecified price

44. Corporate Bonds Callable bonds versus non-callable bonds incb = rate of return on a noncallable bond icb = rate of return on a callable bond opcb = value of the call option A sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity

45. Corporate Bonds Primary markets are identical to that of Munis Secondary markets the exchange market (e.g., bond division of the NYSE) the over-the-counter (OTC) market Bond ratings the three major bond rating agencies are Moody’s,Standard & Poor’s (S&P), and Fitch bonds are rated by perceived default risk bonds may be either investment or speculative (i.e., junk) grade

46. Bond Credit Ratings

47. Bond Yield Spreads

48. Corporate Bond Quotes Issuer name, ticker symbol and coupon Maturity month and year Bond rating by the three major ratings agencies High, Low, and Last prices in decimal form as a percent of par Daily high price was $1,084.80 Change is the change from the prior day’s last price Yield % is the promised yield to maturity using the last price

49. Bond Market Indexes Managed by major investment banks Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned Changes in values of bond indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities

50. Bond Market Participants The major issuers of debt market securities are federal, state and local governments, and corporations The major purchasers of capital market securities are households, businesses, government units, and foreign investors Businesses and financial firms (e.g., banks, insurance companies, and mutual funds) are the major suppliers of funds for Munis and corporate bonds Foreign investors and governments are the major suppliers of funds for T-notes and T-bonds