CHAPTER 11

The Money
Markets
 Chapter Preview
We review the money markets and the securities
that are traded there. In addition, we discuss why
the money markets are important in our financial
system. Topics include:
The Money Markets Defined
The Purpose of Money Markets
Who Participates in Money Markets?
Money Market Instruments
Comparing Money Market Securities

11-2
 The Money Markets Defined

The term money market is a misnomer.

Money (currency) is not actually traded in
the money markets. The securities in the
money market are short term with high
liquidity; therefore, they are close to
being money.

11-3
 The Money Markets Defined

Money Markets Defined

1. Money market securities are usually sold in
large denominations ($1,000,000 or more)
2. They have low default risk
3. They mature in one year or less from their
issue date, although most mature in less than
120 days

11-4
 Money Market Instruments:
Repurchase Agreements

These work similar to the market for fed

funds, but nonbanks can participate.
A firm sells Treasury securities, but agrees
to buy them back at a certain date (usually
314 days later) for a certain price.

11-5
 Money Market Instruments:
Repurchase Agreements
A repurchase agreement, also known as a repo, RP, or sale and
repurchase agreement, is the sale of securities together with an agreement
for the seller to buy back the securities at a later date. The repurchase price
should be greater than the original sale price, the difference effectively
representing interest, sometimes called the repo rate. The party that originally
buys the securities effectively acts as a lender. The original seller is effectively
acting as a borrower, using their security as collateral for a secured cash loan
at a fixed rate of interest.
A repo is equivalent to a spot sale combined with a forward contract. The spot
sale results in transfer of money to the borrower in exchange for legal transfer
of the security to the lender, while the forward contract ensures repayment of
the loan to the lender and return of the collateral of the borrower. The
difference between the forward price and the spot price is effectively the
interest on the loan, while the settlement date of the forward contract is the
maturity date of the loan.

11-6
 Money Market Instruments:
Repurchase Agreements
A repo is economically similar to a secured loan, with the buyer (effectively
the lender or investor) receiving securities as collateral to protect him against
default by the seller. The party who initially sells the securities is effectively
the borrower. Almost any security may be employed in a repo, though highly
liquid securities are preferred as they are more easily disposed of in the event
of a default and, more importantly, they can be easily obtained in the open
market where the buyer has created a short position in the repo security by a
reverse repo and market sale; by the same token, non liquid securities are
discouraged. Treasury or Government bills, corporate and
Treasury/Government bonds, and stocks may all be used as "collateral" in a
repo transaction. Unlike a secured loan, however, legal title to the securities
passes from the seller to the buyer.

11-7
 Money Market Instruments:
Repurchase Agreements
Although the transaction is similar to a loan, and its
economic effect is similar to a loan, the terminology differs
from that applying to loans: the seller legally repurchases
the securities from the buyer at the end of the loan term.
However, a key aspect of repos is that they are legally
recognized as a single transaction and not as a disposal
and a repurchase for tax purposes.

11-8
 Money Market Instruments:
Repurchase Agreements

This set-up makes a repo agreements

essentially a short-term collateralized loan.
This is one market the Fed may use to
conduct its monetary policy, whereby the
Fed purchases/sells Treasury securities in
the repo market.

11-9
 Money Market Instruments:
Repurchase Agreements
Government securities dealers frequently engage in repos. The dealer
may sell the securities to a bank with the promise to buy the securities
back the next day. This makes the repo essentially a short term
collateralized loan.
Securities dealers use the repo to manage their liquidity and to take
advantage of anticipated changes in interest rates.
The Federal Reserve also use repos in conducting monetary policy.
Conduct of monetary policy requires that the FED adjust bank
reserves on temporary basis. To accomplish this adjustment the Fed
will buy or sell Treasury securities in the repo market.

11-10
 Money Market Instruments:
Repurchase Agreements
Interest Rate on Repos: Because repos are collateralized with
Treasury securities, they are usually low-risk investments and
therefore have low interest rates.
For e.g in 1985 ESM Government Securities and Bevill, Bresler &
Schulman declared bankruptcy. These firms had used the same
securities as collateral for more than one loan.

11-11
 Money Market Instruments:
Negotiable Certificates of Deposit

A bank-issued security that documents a

deposit and specifies the interest rate and
the maturity date
Denominations range from $100,000
to $10 million

11-12
 Money Market Instruments:
Negotiable Certificates of Deposit

The next slide shows actual CD rates and

T-bill rates 1990 through 2010.
Again, notice that the two rates track fairly
closely. What does this suggest about the
market for T-bills and the market for CDs?

11-13
Money Market Instruments:
Negotiable CD Rates

11-14
 Money Market Instruments:
Commercial Paper

Unsecured promissory notes, issued by

corporations, that mature in no more than
270 days.
The use of commercial paper increased
significantly in the early 1980s because of
the rising cost of bank loans.

11-15
 Money Market Instruments:
Commercial Paper

The next slide shows actual commercial

paper rates and the prime rates 1990 through
2010.
Although the two track closely in terms of
movements, notice that difference between
the two remains roughly 200 basis points.

11-16
Money Market Instruments:
Commercial Paper Rates

11-17
 Money Market Instruments:
Commercial Paper

The next slide shows actual commercial

paper volume by year from 1990
through 2010.
Notice that the volume fell significantly during
the recent economic recession. Even so, the
annual market is still quite large, at well over
$1.5 trillion outstanding.

11-18
Money Market Instruments:
Commercial Paper Volume

11-19
 Money Market Instruments:
Commercial Paper

A special type of commercial paper, known

as asset-backed commercial paper (ABCP),
played a key role in the financial crisis in
2008. These were backed by securitized
mortgages, often difficult to understand. This
special part of the commercial paper market
accounted for about $1 trillion.

11-20
 Money Market Instruments:
Commercial Paper

When the poor quality of the underlying

assets was exposed, a run on ABCP began.
Because ABCP was held by many money
market mutual funds (MMMFs), these funds
also experienced a run. The government
eventually had to step in to prevent the
collapse of the MMMF market.

11-21
 Money Market Instruments:
Bankers Acceptances

An order to pay a specified amount to the

bearer on a given date if specified
conditions have been met, usually delivery
of promised goods.
These are often used when buyers / sellers
of expensive goods live in different
countries.

11-22
 Money Market Instruments:
Bankers Acceptances Advantages

1. Exporter paid immediately

2. Exporter shielded from foreign
exchange risk
3. Exporter does not have to assess the
financial security of the importer
4. Importers bank guarantees payment
5. Crucial to international trade
11-23
 Money Market Instruments:
Bankers Acceptances

As seen, bankers acceptances avoid the

need to establish the credit-worthiness of a
customer living abroad.
There is also an active secondary market
for bankers acceptances until they mature.
The terms of note indicate that the bearer,
whoever that is, will be paid upon maturity.

11-24
 Money Market Instruments:
Eurodollars
Eurodollars represent Dollar denominated
deposits held in foreign banks.
The market is essential since many foreign
contracts call for payment is U.S. dollars due
to the stability of the dollar, relative to other
currencies.

11-25
 Money Market Instruments:
Eurodollars
The Eurodollar market has continued to grow
rapidly because depositors receive a higher rate
of return on a dollar deposit in the Eurodollar
market than in the domestic market.
Multinational banks are not subject to the
same regulations restricting U.S. banks and
because they are willing to accept narrower
spreads between the interest paid on deposits
and the interest earned on loans.

11-26
 Money Market Instruments:
Eurodollars Rates

London interbank bid rate (LIBID)

The rate paid by banks buying funds

London interbank offer rate (LIBOR)

The rate offered for sale of the funds

Time deposits with fixed maturities

Largest short term security in the world

11-27
 Global: Birth of the Eurodollar
The Eurodollar market is one of the most
important financial markets, but oddly enough,
it was fathered by the Soviet Union.
In the 1950s, the USSR had accumulated
large dollar deposits, but all were in US banks.
They feared the US might seize them, but still
wanted dollars. So, the USSR transferred the
dollars to European banks, creating the
Eurodollar market.

11-28
 Comparing Money Market
Securities

The next slide shows a comparison of

various money market rates from 1990
through 2010.
Notice that no real pattern is present among
the rates, indicating that investor
preferences to the features on the
instruments fluctuates.

11-29
 Comparing Money Market
Securities : A comparison of rates

11-30
 Comparing Money Market
Securities

Liquidity is also an important feature, which

is closely tied to the depth of the secondary
market for the various instruments.
The next slide summarizes the types of
securities, issuers, buyers, maturity, and
secondary market characteristics.

11-31
 Comparing Money Market Securities:
Money Market Securities and Their Depth

11-32
 Chapter Summary

The Money Markets Defined

Short-term instruments
Most have a low default probability

The Purpose of Money Markets

Used to warehouse funds
Returns are low because of low risk and
high liquidity

11-33
 Chapter Summary (cont.)

Who Participates in Money Markets?

U.S. Treasury
Commercial banks
Businesses
Individuals (through mutual funds)

Money Market Instruments

Include T-bills, fed funds, etc.

11-34