Economics 434 Theory of Financial Markets

Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

The Money Markets • Treasury bills • Commercial paper • Includes ABCP • Not more than 270 days to maturity in order to avoid SEC filing • Repo market

The Repo Market • “Repo” means repurchase agreement (seller of security agrees to repurchase it at a later date at a fixed price) • In reality • Doing a repo is a loan (investment) of cash receiving treasury collateral • The other side of the trade is a “reverse repo”

A Repo A Does a Repo Sends $ 100 million in cash to A B B Sends $ 105 million in treasury bills to A B is doing a reverse repo

Other interpretations of the same transaction • A Does a repo • A might be borrowing a security and providing cash collateral • B would then be lending a security and receiving cash collateral

Implication of Repo Market for Fed Reserve Funds Target • Reserves can be augmented or reduced by acting in the federal funds market or the repo market (or in other markets) • Repo market is far, far larger than funds market • It is more likely that Repo rate sets Funds rate than the other way around • Hence, Fed cannot control Fed Funds rate, as is commonly believed

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Economics 434 Theory of Financial Markets