Chapter Five

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill /Irwin

Chapter FiveMoney Markets


Definition and Purpose of Money Markets

• The Money Markets are associated with the issuance and trading of short-term debt obligations of large corporations, FIs and government

• 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

• The Money Markets are associated with the issuance and trading of short-term debt obligations of large corporations, FIs and government

• 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


Money Market Securities

• Treasury Bills - short-term obligations issued by the U.S. government

• Federal Funds - short-term funds transferred between financial institutions usually for no more than one day

• Repurchase Agreements - agreement involving the sale of securities between parties with a promise to repurchase the security at a specific date and price

• Commercial Paper - short-term unsecured promissory notes issued by a company to raise short-term cash

• Negotiable Certificates of Deposit - negotiable bank-issued time deposit with specific interest rate/maturity

• Banker Acceptances - time draft payable to seller of goods with payment guaranteed by a bank

• Treasury Bills - short-term obligations issued by the U.S. government

• Federal Funds - short-term funds transferred between financial institutions usually for no more than one day

• Repurchase Agreements - agreement involving the sale of securities between parties with a promise to repurchase the security at a specific date and price

• Commercial Paper - short-term unsecured promissory notes issued by a company to raise short-term cash

• Negotiable Certificates of Deposit - negotiable bank-issued time deposit with specific interest rate/maturity

• Banker Acceptances - time draft payable to seller of goods with payment guaranteed by a bank


Money Market Instruments Outstanding,December 1990 and 1999 (in billions of

dollars)

Amount Outstanding

1990 1999

Amount Outstanding

1990 1999

Rate of Return

1990 1999

Treasury bills $527.0 $ 674.8 7.85% 5.23% Federal funds and repurchase agreements 372.3 1,006.1 8.10 5.30 Commercial paper 537.8 1,284.5 8.06 5.87 Negotiable certificates of deposit 546.9 836.8 8.15 6.05 Banker’s acceptance 52.1 8.3 7.93 5.24


Treasury Bill Basics

• 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

• 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


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

• Competitive bids 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 weighted-average of the winning competitive bids, get preferential allocation

• 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

• Competitive bids 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 weighted-average of the winning competitive bids, get preferential allocation


Treasury Auction Results

Quantity ofT-bills

Bid Price

98.678% 1

2

3

4

5

6

7

SC ST

Noncompetitive Bids

98.648%(PNC)(stop-atprice lowbidaccepted)

$10,581.9m $11,778.1m


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

• 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


Secondary Market T-bill Transaction

Federal Reserve Bank of New York

Transfers $10m. In T-bills fromJ.P. Morgan to Lehman Brothers

Transaction recorded in Fed’s Book-Entry System

J.P. Morgansells $10m. In T-bills

Lehman Brothersbuy $10m. In T-bills

FedwireTransactionFedwire

Transaction

Individualbuy $50,000

in T-bills

Local Bank or Broker

J.P. Morgansell $50,000

in T-bills

FRBNY-$50,000 in T-billsfrom J.P. Morgan’saccount+ $50,000 T-billto Individual


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– the price dealers are willing to pay T-bill holders to purchase

their T-bills for them

• Asked– the discount yield based on the current purchase price set by

dealers that is available to investors

• Spread– the percentage difference in the ask and bid yield, part of

transaction cost, the profit for dealers

• 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– the price dealers are willing to pay T-bill holders to purchase

their T-bills for them

• Asked– the discount yield based on the current purchase price set by

dealers that is available to investors

• Spread– the percentage difference in the ask and bid yield, part of

transaction cost, the profit for dealers


Calculating T-bill Yields from Discount Rates

iT-bill(dy) = PF - PO 360 PF h

Where: PF = Annualized yield on the T-bill PO = Price (face value) paid to the T-bill holder h = Number of days until the T-bill matures

Example: iT-bill(dy) = $10,000 - $9,650 360 = 6.92% $10,000 182

iT-bill(dy) = PF - PO 360 PF h

Where: PF = Annualized yield on the T-bill PO = Price (face value) paid to the T-bill holder h = Number of days until the T-bill matures

Example: iT-bill(dy) = $10,000 - $9,650 360 = 6.92% $10,000 182


Federal Funds Basics

• Short-term funds transferred between financial institutions, 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

• Short-term funds transferred between financial institutions, 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


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

• 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


Repurchase Agreements (RPs or Repos)

• 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)

• Reverse repurchase agreement– involves the purchase of securities between parties with the

promise to sell them back at a given date in the future

• 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)

• Reverse repurchase agreement– involves the purchase of securities between parties with the

promise to sell them back at a given date in the future


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

• 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


Commercial Paper

• 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

• 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


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

• 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


Negotiable Certificates of Deposits

• A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market

• Bearer Instrument– whoever holds the CD when it matures receives the principal

and interest

• Denominations that 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

• A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market

• Bearer Instrument– whoever holds the CD when it matures receives the principal

and interest

• Denominations that 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


Trading Process for NCDs

• Banks issuing CDs 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

• Banks issuing CDs 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


Banker’s Acceptances

• A time draft payable to a seller of goods with payment guaranteed by a bank

• Arise from international trade transactions and are used 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 guarantors for payment before sending goods to importer

• A time draft payable to a seller of goods with payment guaranteed by a bank

• Arise from international trade transactions and are used 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 guarantors for payment before sending goods to importer


Trading Process for BAs

DomesticImporter

ForeignExporter

U.S.Bank

ForeignBank

1. Purchase order sent2. Letter of credit requested3. Notification of letter credit and draft authorization4. Order shipped5. Time draft and shipping papers sent to foreign bank

6. Time draft and shipping papers sent to U.S. bank; BA created 7. Payments sent to foreign bank 8. Payments sent foreign exporter 9. Payment to U.S. bank10. Shipping papers delivered

1

4

3

5

86

7

10

2 9


Money Market Participants

Instrument

Treasury bills

Federal fundsRepurchase agreement

Commercial Paper

Negotiable CDs

Banker’s acceptances

Principal Issuer

U.S. Treasury

Commercial banksFRS, Comm banksBrokers and dealersOther FisComm banksOther FIs, CorpsCommercial banks

Commercial banks

Principal Investor

FRS, Comm banksBrokers and dealersOther FIs, CorpsCommercial banksFRS, Comm banksBrokers and dealersOther FIs, CorpsBrokers and dealersCorporationsBrokers and dealersCorps, Other FIsComm banks, CorpsBrokers and dealers


International Aspects of Money Markets

• While U.S. money markets are the largest, the international market is growing– U.S. securities bought/sold by foreign investors– foreign money market securities

• Euro money market instruments– Eurodollar deposits, Eurodollar CDs, Euro notes,

Euro CP

• London Interbank Offered Rate (LIOR)– the rate paid on Eurodollars

• While U.S. money markets are the largest, the international market is growing– U.S. securities bought/sold by foreign investors– foreign money market securities

• Euro money market instruments– Eurodollar deposits, Eurodollar CDs, Euro notes,

Euro CP

• London Interbank Offered Rate (LIOR)– the rate paid on Eurodollars


Euronotes and Euro CPs

Type of instrument 1995 1999

Euronotes $45.5 $72.8Currency type U.S. dollar 27.9 30.6 Euro currencies 0.5 22.8 Japanese yen 0.4 1.5 Other 16.7 17.9Issuer type FIs 41.4 61.2 Gov/state agencies 0.4 10.5 International Inst 1.2 ---- Corporations 2.5 1.1

Type of instrument 1995 1999

Euro CPs $87.0 $170.9Currency type U.S. dollar 55.7 84.4 Euro currencies 9.1 52.3 Japanese yen 2.1 2.5 Other 20.0 31.7Issuer type FIs 40.5 107.4 Gov/state agencies 14.2 15.1 International inst 2.1 5.1 Corporate issuers 30.2 43.2

Amount outstanding Amount outstanding

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Chapter Five

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