The Money MarketThe Money Market

Chapter 9

© 2003 South-Western/Thomson Learning

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Learning ObjectivesLearning Objectives Primary participants and instruments of

money markets

How money markets are used by various

participants

Recent trends in money market instruments

How money markets have become

international in scope

What money market mutual funds are and

why they have become important

intermediaries

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Money MarketMoney Market

Short-term credit market: where debt securities having original maturities of 1 year or less are traded

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Money Market CharacteristicsMoney Market Characteristics Issued in large denominations

Usually $1 million or more Money market instruments have short

maturities Less than 3 months Ranging from 1 day to 1 year

Money market instruments characterized by: Low liquidity Default risk

Does not occupy one particular geographic location or trading floor

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Money Market BenefitsMoney Market Benefits

More efficient source of credit for largest: Financial institutions Nonfinancial corporations Governmental bodies

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Money Market BenefitsMoney Market Benefits

Advantages over bank borrowing Banks required to hold noninterest-

bearing required reserves: As vault cash On deposit at Fed

only 90-97% of banks’ domestic transactions deposits can be lent out

Banks face regulatory constraints on: size of loan they can make to one particular

borrower Particular types of assets they are allowed

to hold on their balance sheet

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Money Market ParticipantsMoney Market Participants

Commercial banks and savings associations

GSEs The Federal Reserve Corporations and finance companies Pension funds and insurance

companies Brokers and dealers MMMFs and individuals

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Commercial Banks and Savings AssociationsCommercial Banks and Savings Associations

Play five important roles: Borrow in money market:

To meet their reserve needs To make loans to their commercial or

household customers

Hold significant levels of Treasury securities on asset side of their balance sheets

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Commercial Banks and Savings AssociationsCommercial Banks and Savings Associations

3. Assist other participants by: Providing credit enhancements for a fee to

those issuing commercial paper and bankers’ acceptances

5. Serve as agents and underwriters in commercial paper market

6. Serve as primary dealers of U.S. government securities Enables them to trade money market

securities on behalf of their corporate customers

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GSEsGSEs Governments & Government-Sponsored

Enterprises (GSEs): U.S. Treasury is world’s single largest

borrower Issues U.S. Treasury bills (T-bills) Treasury notes and bonds that have longer maturities

Privately owned GSEs: Federal National Mortgage Association (Fannie

Mae) Federal Farm Credit Banks Funding

Corporation (FFCBFC) Student Loan Marketing Association (Sallie

Mae)

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Privately-owned GSEsPrivately-owned GSEs

Engaged in assisting with finance of: Housing Agriculture Education

State and municipal (local governments and special districts) governments issue short-term municipal notes to finance: Their own expenditures Expenditures of local schools, hospitals

and private firms

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The Federal ReserveThe Federal Reserve

Fed controls level of reserves available to depository institutions open market purchase and sale of T-

bills repurchase agreements

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Corporations/Finance CompaniesCorporations/Finance Companies

Use money markets to raise funds store funds

Issue large amounts of commercial paper as primary source of funds which they lend to consumers and firms use to make up for temporary shortfalls of

cash

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Pension Funds and Insurance CompaniesPension Funds and Insurance Companies

Both use money market for cash management to provide needed liquidity

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Brokers and DealersBrokers and Dealers

Ensure the regular functioning of the money market

Market new issues of securities Repurchase securities Establish secondary market Act as intermediaries in the RP market Match buyers and sellers

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The Broker’s Role in the Federal Funds Market

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Money Market InstrumentsMoney Market Instruments

Commercial paper Unsecured, short-term promissory notes

as alternative to: Short-term bank loans Other forms of borrowing

Primary benefit to largest & most creditworthy issuers is: Cost of borrowing is lower than at a

commercial bank

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Money Market InstrumentsMoney Market Instruments Commercial paper

Characteristics largely defined by legislation and issuers’ attempt to avoid costly disclosure requirements mandated for other types of securities

Expensive requirements avoided if these are met: Paper issued must mature in less than 270 days Paper must be issued in large denomination so

that it is not typically purchased directly by public

Proceeds must be used to fund current transactions

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Money Market InstrumentsMoney Market Instruments

Commercial paper Financial companies (specifically nonbank

financial companies responsible for issuing majority: Domestic paper Foreign paper

Companies choose to issue paper: Through a dealer Engage in direct placements

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Money Market InstrumentsMoney Market Instruments Federal (Fed) Funds

When institutions anticipate insufficient reserves, they often turn to Federal (fed) funds market.

Here they can borrow reserves from other institutions on an overnight basis.

Institutions with excess reserves can turn to the fed funds market to loan these reserves and earn interest.

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Money Market InstrumentsMoney Market Instruments

Fed Funds Fed funds are lent:

on an overnight basis in denominations of $5 million or more

Fed Funds Rate: Interest rate charged on overnight loans of

reserves among commercial banks

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Money Market InstrumentsMoney Market Instruments

Repurchase Agreements Short-term contract in which seller agrees to:

Sell government security to a buyer Buy it back on a later date at a higher price

Reverse Repurchase Agreements or

Matched Sale-Purchase (MSP) Agreement Repurchase agreement viewed from

perspective of initial buyer Short-term agreements in which:

Buyer buys a government security from seller Agrees to sell it back on a later date at a higher price

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Money Market InstrumentsMoney Market Instruments

Most money market instruments are sold at a discount.

days of number360

price purchace

price purchace - price selling ratePR

360

days of number rate RP invested funds earnedInterest

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Money Market InstrumentsMoney Market Instruments CERTIFICATES of DEPOSIT (CDs)

Debt instruments issued by commercial banks with: Minimum denomination of $100,000 Fixed interest rate Return the principal at maturity

Debt instruments issued by commercial banks that may be: Negotiable (tradable) Non-negotiable (not tradable)

Thrift CDs Certificates of deposit issued by:

Savings associations Credit unions

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Money Market InstrumentsMoney Market Instruments CERTIFICATES of DEPOSIT (CDs)

Interest rates on negotiable CDs tend to be higher than T-bill rates: CD holders exposed to default risk - only a portion of

deposit is insured Unlike T-bills, earnings on CDs subject to state/local

income taxes Secondary market for CDs much thinner than T-bills,

making negotiable CDs less liquid than T-bills

Euro CDs Certificates of deposit issued by foreign branches

of commercial banks but denominated in currency of the branch’s home country

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Money Market InstrumentsMoney Market Instruments

Foreign CDs Certificates of deposit issued by the

foreign branches of commercial banks but denominated in currency of the branch’s host country

Yankee CDs Certificate of deposit issued by a

foreign bank in a foreign currency, but sold in the United States

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Money Market InstrumentsMoney Market Instruments

U.S. TREASURY BILLS Sold to a variety of different types of

buyers with: Low minimum denominations

$10,000

Short maturities

Sold on a discount basis Sold at price below its face, or par, value Original issues are sold at regularly

scheduled auctions

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Money Market InstrumentsMoney Market Instruments U.S. Treasury Bills – Auction Methods

Multiple-Price Method Seller accepts bids prior to selling securities

Sales awarded beginning with highest bidder Buyers end up paying different prices for same securities

based upon their respective bids

Treasury discontinued this method in November 1998

Stop-Out Yield Lowest accepted bid price or yield in securities auction

Uniform Price Method Seller accepts bids prior to selling securities

Sales awarded beginning with highest bidder Buyers pay same price for securities based on stop-out yield

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Money Market InstrumentsMoney Market Instruments EURODOLLARS

Dollar-denominated deposit liabilities exempt from U.S. banking regulations

International Banking Facilities (IBFs) Financial institutions in U.S. Cater to needs of foreign individuals, corporation,

and/or governments Allow non-U.S. residents to hold unregulated Eurodollar

deposits London Interbank Bid Rate (LIBID)

Interest rate London banks are willing to borrow Eurodollar balances

London Interbank Offered Rate (LIBOR) Interest rate London banks are willing to loan Eurodollar

balances

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The Anatomy of Eurodollar Borrowing

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Money Market InstrumentsMoney Market Instruments

BANKERS’ ACCEPTANCES (BAs) Allow bank to “accept” responsibility or

guarantee payment of one of its customers

Important in international trade when export company may not know or easily determine the credit-worthiness of foreign company

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Money Market InstrumentsMoney Market Instruments

MONEY MARKET MUTUAL FUNDS (MMMFs) Short-term investment pools use

proceeds they raise from selling shares to invest in various money market instruments

Disintermediation Reversal of financial intermediation process

whereby funds are: Pulled from financial intermediaries Moved directly into open market instruments