Chapter 3: Money Markets

Instruments

Financial Markets and

Chapter Objectives
To understand the many roles and functions
performed by the money market.
To identify the key money market players.
To see how money market loans and securities
differ from other financial services and
instruments in the financial system.
To appreciate the importance of speed and
efficiency to money market participants and to
learn how risk is handled.
Financial Markets and

Money markets background

The term money markets is used to refer to
the markets where large denomination, low
risk, short-term financial securities are traded.
Money market instruments are forms of debt
that mature in less than one year and are very
liquid.
These instruments are generally
characterized by a high degree of safety of
principal and are most commonly issued in
units of $1 mln or more.
Financial Markets and

Characteristics of the Money Market

The money market is the mechanism
through which holders of temporary cash
surpluses meet holders of temporary cash
deficits.
The money market arises because for
most individuals and institutions, cash
inflows and outflows are rarely in perfect
harmony with each other, and the holding
of idle surplus cash is expensive.
Financial Markets and

The problem of liquidity

Supply of
cash flows

Short-term credits
and loans

Investing of surplus
funds

Money markets

Spending of
cash funds

Financial Markets and

Characteristics of the Money Market

The money market is a wholesale market for
funds most trading occurs in multiples of a
million dollars.
The market is dominated by a relatively small
number of large financial institutions that
account for the bulk of federal funds trading.
Securities also move readily from sellers to
buyers through the market-making activities
of major security dealers and brokers.
Financial Markets and

Characteristics of the Money

Market
Money market investors seek mainly
safety and liquidity, plus the opportunity to
earn some interest income.
Because funds invested in the money
market represent only temporary cash
surpluses and are usually needed in the
near future, money market investors are
especially sensitive to risk.
Financial Markets and

Institutional use of Money

Markets
Used by many kinds of institutional
investors both to invest and borrow
Money market securities enhance liquidity
Newly issued securities raise cash
Buyers of securities generate cash when they
liquidate they holdings

Active secondary market helps liquidity

Short-term maturity enhances liquidity
Financial Markets and

Borrowers and Lenders in the Money

Market

Government
Treasuries
(borrowing and
redeeming
securities)

Corporate Borrowers
& Cash-Management
Customers Needing to
Invest Cash Surpluses

Security
Dealers &
Brokers

Nonbank
Financial
Institutions
(mutual funds,
insurers, etc.)

Money
Center
Banks

Central Banks
(supplying funds and information
and promoting market stability)
Financial Markets and

Money Market Securities

Maturity of a year or less
Issued by corporations and governments
that need short-term funds
Investors find out about new issues in the
primary market via a telecommunications
network
Purchased by corporations and financial
institutions
Secondary market for securities exists
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Financial Markets and

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Money market participants

Commercial banks
Federal funds
Negotiable certificates of deposits
Repurchase agreements

Federal Reserve System key participant

Treasury bills
Discount window

Government (U.S.Treasury) always borrower

Treasury bills
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Money market participants

Businesses
Commercial paper
T-bills
Negotiable certificates of deposits

Investment Companies
Finance Companies
Pension Funds
Individuals through money market mutual
funds
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Banks in the Money Market

Banks Money Market Roles
Principal channel
for payments for
loans, securities &
other transactions
Agents in trust for
property management
on behalf of bank
customers
Direct lenders to Guarantors of
money market
performance
borrowers
& payment
Financial Markets and

Custody agents
for safekeeping
securities owned
by market
participants and
pledged as
collateral for
loans
Channel for
government
money & credit
policy
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Money Market Securities

Treasury bills (most marketable of all market
instruments)
Issued to meet the short term needs of the
U.S. government
Attractive to investors
Liquidity
Fairly safe from default risk due to government
backing
Strong secondary market exists
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Money Market Securities

Treasury bill auction competitive bids (Fill
bids in amount determined by Treasury borrowing
needs)
Bid process used to sell T-bills
Bids submitted to Federal Reserve banks by
the deadline
Bid process
Accepts highest bids
Accepts bids until generates total needed
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Money Market Securities

Treasury bill auction noncompetitive bids
($1 million limit)
Private persons, small commercial banks
Price is the weighted average of the accepted
competitive bids
Do not know the price in advance so submit
check for full par value
After the auction, get a check back from the
Treasury covering the difference between par
and the actual price
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Money Market Securities

Estimating T-bill yield
No coupon payments
Par or face value received at maturity
Yield at issue is the difference between the
selling price and par or face value
If sold prior to maturity in secondary market
Yield based on the difference between price you
paid to buy T-bill and price you sold it for

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Bank discount rate

Traditionally, the rate of return on Treasury bills is
expressed as a simple rate of discount.
T-bills and other money-market yields are not quoted in
the financial pages as effective annual rates of return.
Instead, the bank discount yield is used.
Consider a $10,000 par value T-bills sold at $9,600 with
maturity of 182 days (half year).
The $9,600 investment provides $400 in earnings. The
rate of return on investment is defined as dollars earned
per dollar invested
$400/$9600=0.0417 per six month period or 4,17%
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Money Market Securities

Calculating T-bill yields
T-bill discount for a newly issued security

T-bill discount =

Par - PP
Par

360
n

T-bill discount = percent discount of the purchase price from par

Par = Face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
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Money Market Securities

Calculating T-bill annualized yields (bond equivalent yield)
Return on the bill over the period corresponding to its remaining
maturity multiplied by the number of such periods in a year

SP - PP
YT =

365

PP
n
YT = The annualized yield from investing in a T-bill
SP = Selling price
PP = Purchase price
n = number of days of the investment (holding period)
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Example
If T-bill face value is $10,000, discount rate is
6.02% and maturity 86 days, so purchase price
of T-bill will be could be found by using the
formula :
PP=FV-(FV*Rd*days/360)
or PP=FV*[1-Rd*(days/360)]
$10,000*[1-0.0602*(86/360)]=$9,856.2
bond equivalent yield=
($10,000-$9,856.2)/$9,856.2*86/365=0.619 or
6.19%
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PROBLEMS
1. A U.S. Treasury bill has 180 days to maturity and
price of $9,600 per $10,000 face value. Calculate
the bank discount yield of the bill. Calculate the
bond equivalent yield for the T-bill
2. Face value 10,000 Treasury bill with 90-day
maturity sells at a bank discount yield of 3%. What
is the price of the bill? What is the bond equivalent
yield for the T-bill
3. Find the price of six-month (182 days) U.S.
Treasury bill with a par value of $100,000 and bank
discount yield of 9.18%
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Investors in Treasury Bills

T-bills are held mainly by commercial banks,
nonfinancial corporations, state and local
governments, and the Federal Reserve
banks.
Commercial banks and private corporations
hold T-bills as a reserve of liquidity.
The Federal Reserve banks conduct part of
their open market operations in T-bills
because of the depth and volume of activity of
the market.
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Money Market Securities

Commercial paper (earliest financial instrument)
Short-term debt instrument
Used only by well-known and creditworthy
firms (industry, communal, finance)
Unsecured
Minimum denominations of $100,000
Not an active secondary market (98% of holders
keep CP until maturity)

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Structure activity of CP issuers

Activity
Industry
Communal
Finance
Banking
Mortgage
Insurance
Transport

% of total
42,0
21,9
17,6
13,6
1,0
2,8
1,1
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Money Market Securities

Commercial paper ratings
Past defaults means a rating for default risk helps
investors evaluate risks and issuers sell the securities
Ratings agencies assign a grade based on credit risk
(Moody`s Inv Serv, S&p)

Commercial paper placement choices

Direct paper is issued mainly by large finance
companies and bank holding companies directly to the
investor (80 firms, 60% of total volume)
Dealer paper, or industrial paper, is issued by security
dealers on behalf of their corporate customers (mainly
nonfinancial companies and smaller financial
companies).
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Structure of the Commercial Paper

Market
Supply Side

Issuers of
commercial paper
Direct or finance
Finance
paper
companies
Bank holding
companies
Paper
Nonfinancial
dealer
firms
Dealer or houses
industrial
paper
Financial Markets and

Demand Side
Investors in
commercial paper
Money market
funds
Banks
Insurance
companies
Pension funds
Industrial
companies
Other investors
28

Money Market Securities

Backing commercial paper with a line of
credit
Used in case they cant roll over or reissue
new debt at a reasonable rate
Rating change would affect cost
Bank gives issuer right but not obligation to
borrow a certain amount for a specified period
of time
Bank charges fees
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Money Market Securities

Estimating commercial paper yields
YCP =

Par - PP
PP

360
n

YCP = Commercial paper yield

Par = Face value at maturity
PP = Purchase price
n = number of days to maturity
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Commercial Paper
Disadvantages
Advantages
Risk of alienating banks
Relatively low interest
whose loans may be
rates
needed when an
Flexible interest rates emergency develops
choice of dealer or direct
May be difficult to raise
paper
funds in the paper market
Large amounts may be
at times
Commercial paper must
borrowed conveniently
generally remain
The ability to issue paper
outstanding until maturity gives considerable
does not permit early
leverage when negotiating
retirement without penalty
with banks
Financial Markets and
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Money Market Securities

Negotiable certificates of deposit NCDs
Issued by large commercial banks
Minimum denomination of $100,000 but $1
million more common
Purchased by nonfinancial corporations or
money market funds
Secondary market exists but issuers dont like
new issues to compete with previous issues in
the secondary market
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Money Market Securities

NCD placement
Direct placement
Use a correspondent institution specializing in
placement
Sell to securities dealers who resell
Sell direct to investors at a higher price

NCD premiums
Rate above T-bill rate to compensate for less
liquidity and safety
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Money Market Securities

Repurchase agreements
Sell a security with the agreement to
repurchase it at a specified date and price
Borrower defaults, lender has security
Reverse repo name for transaction from
lender
Negotiated over telecommunications network
Dealers and brokers used or direct placement
No secondary market (very short-term period)
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Dealers in the Money Market

Interest income from RPs
= Amount Current Number of days loaned

of loan

RP rate

360 days

Periodically, RPs are marked to market. If

the price of the pledged securities has
dropped, the borrower may have to pledge
additional collateral.

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Money Market Securities

Estimating repurchase agreement yields
Repo Rate =

SP - PP
PP

360
n

Repo Rate = Yield on the repurchase agreement

SP = Selling price
PP = Purchase price
n = number of days to maturity
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Money Market Securities

Federal funds
Depository institutions use to borrow and lend
short-term funds with each other
Federal funds rate usually slightly higher than
T-bill rate
Fed district bank debits and credits accounts
Federal funds brokers may match up buyers
and sellers using telecommunications network
Usually $5 million or more
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Federal Funds
Banks and other depository institutions must
hold in a special reserve account liquid
assets equal to a fraction of the funds
deposited with them by the public.
The required legal reserves may be either
vault cash or reserve balances with the
regional Federal Reserve banks.
Since the reserves earn little or no income,
most bankers try to lend out excess reserves.
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The Structure of the Federal Funds

Market
Banks & large
depositors with
excess reserves
available
(suppliers)

Banks needing
more legal
reserves & other
money market
borrowers
(demanders)

Accommodating
banks
Funds brokers

Absorbing
excess funds

Supplying
additional
funds

The Central Bank

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Interest Rates on Federal Funds

%

Federal Funds

16
14
12
10
8
6
4

3-Month T-Bill
(secondary market)

2
0
1961

1966

1971

1976

1981

1986

Financial Markets and

1991

Data Source: Board of Governors of the Federal Reserve System

1996

2001

40

Money Market Securities

Bankers acceptances (first use in Europe in
XII century)
A bank takes responsibility for a future
payment
Usually result from international transactions
Exporters send goods to a foreign destination
and want payment assurance before sending
Bank stamps a draft from the importer
ACCEPTED and obligates the bank to make
good on the payment at a specific time
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Settlement with Bankers

acceptance

Bank in USA

4. Money

L/
.
2

d
an

co
t
af
r
D

irm
f
n

io
t
a

FOREIGN
COFFEE
EXPORTER

3.Draft accepted

7. Money

1. Claim on letter of credit

IMPORTER
IN USA

5. Draft and bill of lading it

6. Money

Financial Markets and

FOREIGN
BANK

42

How Acceptances Arise

Importer applies for line of credit
Importers bank issues letter of credit in favor of exporter
Letter of credit authorizes the drawing of a time draft
Importers bank accepts time draft from exporters bank
Importers bank pays exporters bank discounted value of
bankers acceptance, and then holds or sells it
Bankers acceptance is redeemed at maturity
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Money Market Securities

Bankers acceptances
Exporter can hold until the date or sell before
maturity
If sold to get the cash before maturity, price
received is a discount from drafts total
Return is based on calculations for other
discount securities
Similar to the commercial paper example
Maturity 30, 60, 90 days
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Volume of Selected Money Market

Instruments
($ Billions at Year-End)
Financial Instruments

1990

1992

1994

U.S. Treasury bills

$527 $658 $734
Federal agency securities 435
484
742
Commercial paper
561
549
595
Bankers acceptances
55
38
30
Federal funds
borrowings & REPOs 409
448
482
Net Euro$ borrowings
by domestic banks from
their own branches
37
71
76
Certificates of deposit
($100,000 or more)
432
367
364
Financial Markets and

1996

1998

2000

$777 $ 691 $ 647

926 1296 1852
775 1163 1624
26
14
10
610

572

618

114

152

191

413

576

720
45

Data Source: Board of Governors of the Federal Reserve System

The Pattern of Money Market

Interest Rates
The foundation of the markets structure is
the level of yields on Treasury bills.
Most other yields in the money market are
scaled upward from Treasury bill rates.
The key price and yield determinants are
safety, liquidity, marketability, and
taxability.

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10 - 47

The Pattern of Money Market

Interest Rates

Financial Markets and

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10 - 48

The Pattern of Money Market Interest

Rates

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Valuation of Market Securities

Many money market securities do not make
interest payments
Value is the present value of the security at
maturity
Par or face value is the future value of a
lump sum
Discount rate is rate investors require
Like bonds, an inverse relationship
between price and yield
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Types of Investment Risk

Market risk The risk that the market value
of an asset will decline, resulting in a capital
loss when sold. Also called interest rate risk.
Reinvestment risk The risk that an investor
will be forced to place earnings from a
security into a lower-yielding investment
because interest rates have fallen.
Default risk The probability that a borrower
fails to meet one or more promised principal
or interest payments on a security.
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Types of Investment Risk

Inflation risk The risk that increases in the
general price level will reduce the purchasing
power of earnings from the investment.
Currency risk The risk that adverse
movements in the price of a currency will
reduce the net rate of return from a foreign
investment. Also called exchange rate risk.
Political risk The probability that changes in
government laws or regulations will reduce
the expected return from an investment.
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Risk of Money Market Securities

Measuring risk
Use sensitivity analysis to see how price
might change as interest rates change
Derive probability distributions for outcomes
Consider the range or outcomes before
making a decision

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Interaction Among Money Market

Yields
Securities in the money market have
interrelated yields
Investors can substitute among securities
Investors trade if a price and yield disparity
occurs among securities

Economic uncertainty causes an investor

shift to securities with lower possible risk
of default
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Globalization of Money Markets

Some segmentation remains in the global
money market
Rates among countries have become
more interrelated over time
Increase in the flow of funds
Tax differences among countries
Speculation on exchange rate changes
Reduced government barriers
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Globalization of Money Markets

Eurodollar deposits and Euronotes
Dollar deposits in banks outside the U.S.
Increased because of international trade
growth
No reserve requirements at banks outside U.S.

Eurodollar Loans
Channel funds to other multinationals that
need short-term financing
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Eurocurrency Deposits
The Eurocurrency market has arisen
because of the tremendous need
worldwide for funds denominated in
dollars, Euros, pounds, and other
relatively stable currencies.
The Eurocurrency market represents
the largest of all money markets
worldwide, with total funds probably in
excess of $4 trillion.
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Eurocurrency Deposits
Eurodollars and other Eurocurrency
deposits are continually on the move in the
form of loans.
They are employed to finance the import
and export of goods, to supplement
government tax revenues, to provide
working capital for the foreign operations of
multinational corporations, and to provide
liquid reserves for the largest banks.
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Eurocurrency Maturities and

Risks
Most Eurocurrency deposits are shortterm deposits ranging from overnight to
one year, although a small percentage are
long-term time deposits.
Eurocurrency deposits are known to be
volatile and highly sensitive to fluctuations
in interest rates and currency prices. They
also carry political risk and default risk.
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The Supply of Eurocurrency Deposits

Eurocurrency deposits come from
foreign investment
tourism
balance of payments (trade) settlements
interbank funds
government funds
large corporations cash balances
central banks supplying or absorbing funds
from the banking system
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Globalization of Money Markets

Eurodollar deposits and Euronotes
Eurocurrency market consists of several
banks that with loans and deposits
denominated in Eurocurrencies
Eurodollar CDs
Secondary market
Some have floating rates tied to LIBOR or
London Interbank Offer Rate

Eurocredit market offers longer maturity loans

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Globalization of Money Markets

Euro-commercial paper
Issued without the backing of a banking
syndicate
Maturity tailored to investors
Dealers that place paper created a secondary
market

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Benefits and Costs of the

Eurocurrency Markets
Benefits
Makes possible an efficient mobilization of
funds around the globe.
Encourages international cooperation
among nations.
Creates a cash-management source to
aid the financial operations of corporations
and governments around the globe.
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Benefits and Costs of the

Eurocurrency Markets
Costs
The capacity to mobilize massive amounts
of funds may contribute to instability in
currency values.
Monetary and fiscal policies designed to
cure domestic economic problems may
not achieve their desired impact.

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Globalization of Money Markets

Performance of international securities
Effective yield for international securities
has two components
The yield earned on the investment
denominated in the currency of the
investment
The exchange rate effect

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Globalization of Money Markets

Performance of international securities
Yield for an international investment
Yf =

SPf - PPf
PPf

Yf = Foreign investments yield

SPf = Investments foreign currency selling price
PPf = Investments foreign currency purchase

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Money and Capital Markets in

Cyberspace
As the money market grows in size, it
attracts great attention on the world wide
web. Websites that are related to the
money market include:
http://homepage.swissonline.net/FinCalc/
http://www.enth.com/ask.asp
http://www.economagic.com/fedbog.htm

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