Money and Fixed-Income Market

1. Money and Fixed-Income Market Fed Funds Treasury Bills Rates and Yields Repos and Reverses Fixed-Income Securities

2. Introduction • Money Market • Cash equivalents, short-term (maturity  1 year), liquid (marketable), low-risk debt securities • Instruments • Federal funds • Treasury bills (T-bills) • Certificate of deposit • Commercial paper • Bankers’ acceptances • Eurodollars • Repurchase agreements (repos) and reverses • Brokers’ calls

3. Federal Funds • Rate charged for Federal Funds among the banks • Most widely quoted “Fed” rate • Is it set really set by the Fed? Effective Rate vs. Target Rate(Aug 27, 2008)

4. Treasury Bills • Definition • Short-term Gov. security issued at discount • e.g., pay $900 today for 1yr T-bill of $1000 par value • Characteristics • Highly liquid • Extremely safe (virtually risk free) • Exempt of state and local taxes • Initial maturity at 4, 13, and 26 weeks Pay $900 Receive $1000 face (par) value Today Maturity

5. Treasury Bills • Quotation • Market convention is to use rate rather than price for T-bill quote • Bank Discount Rate (BD) • rBD: bank discount rate • F: face value (par) • P: price • n: days to maturity

6. Treasury Bills • Example • A 90-day T-Bill of par $10,000 trades at $9,600. What’s the bank discount rate? • n = 90, F = $10,000, P = $9,600 • Annualized return on the investment? • rBEY: bond equivalent yield (APR)

7. Treasury Bills • Bond Equivalent Yield (BEY) • Measures (simple) annualized return on T-bill investment • Facilitates comparison of yields between T-bill and T-bond • Bank discount rate is NOT a true interest rate • Bank discount rates are converted to yields • Bonds quoted in yields • Converted Yields = Bond Equivalent Yield

8. Treasury Bills • Sample quotes from WSJ (Sep 1 2005) Actual # days – 2 Bank discount rate Bond Equivalent yield

9. Treasury Bills • What about price? • 9/1/05, on WSJ you see 12/1/05 T-bill is quoted at 3.43% (ask). How much does it cost to buy $1,000 par of that T-bill? • F = $1,000, rBD = 3.43%, n = 91, P = ? • Bond equivalent yield

10. Certificates of Deposit (CD) Issued by Denomination Maturity Liquidity Default risk Interest type Taxation Depository Institutions Any, $100,000 or more are marketable Varies, typically 14 day minimum 3 months or less are liquid, if negotiable First $100,000 ($250,000) is insured Add on Interest income is fully taxable

11. Commercial Paper Issued by Maturity Denomination Liquidity Default risk Interest type Taxation Large creditworthy corporations and financial institutions Maximum 270 days, usually 1 to 2 months Minimum $100,000 3 months or less are liquid if marketable Unsecured, Rated, Mostly high quality Discount Interest income is fully taxable New Innovation: Asset backed commercial paper is backed by a loan or security. In summer 2007 asset backed CP market collapsed when subprime collateral values fell.

12. Repos and Reverses • Repo screen from Bloomberg: 8/19/99

13. Repos and Reverses • Repurchase Agreement (Repo) • Sale of high grade security with agreement to buy it back at higher prices • Repo rate: • Repo dealer’s borrowing rate implied in the repo price differentials. • Convention: 360 day Treasury Security Lender Repo Dealer Day 0: Cash (P ) Treasury Security Lender Repo Dealer Day n: Cash (F )

14. Repos and Reverses • Reverse Repo • Purchase of high grade security with agreement to sell it back at higher prices • Rev/Repo rate: repo dealers’ lending rate implied in the price differentials Treasury Security Borrower Repo Dealer Day 0: Cash (P ) Treasury Security Borrower Repo Dealer Day n: Cash (F )

15. Repos and Reverse • Example • You have $2M worth of 26 weeks T-bill you’d like to hold to maturity. However, you need $2M cash urgently for a week. What to do? • (Term) Reverse/Repo • Day 0: Get $2M from a repo dealer by giving him T-bill • Look at the reverse/repo rate to determine the amount of money to pay back • Day 7: get the T-bill back by paying $2,001,925 to the repo dealer

16. Money Market Instrument Yields Yields on money market instruments are not always directly comparable! Factors influencing “quoted” yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Simple vs. Compound Interest

17. Major Components of the Money Market

18. MMMF and the Credit Crisis of 2008 Between 2005 and 2008 money market mutual funds (MMMFs) grew by 88%. MMMFs had their own crisis in 2008 when Lehman Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehman’s commercial paper. On Sept. 16, Reserve Primary fund “broke the buck.” What does this mean? A run on money market funds ensued, and unsecured money market rates jumped up. The U.S. Treasury temporarily offered to insure all money funds (close to $3.4 trillion) to stop the run.

19. Spreads on CDs and Treasury Bills

20. Fixed-Income Securities • Publicly Issued • Treasury Notes and Bonds • Agency Issues (Federal Government) • Municipal Bonds • Federal tax exemption • Local and state tax exemption for state residents • Privately Issued • Corporate Bonds • Mortgage-Backed Securities

21. Fixed-Income Securities • What are they? • A security promising full payment of coupon and principal according to a fixed time schedule • E.g., A 10 year $10,000 T-note with 6¼% coupon • Three Prominent Characteristics • Principal • Face value of a bond • Interest • Coupon of a bond • Maturity • Life span of a bond