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Chapter 10

Money Market and Instruments

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
To understand the many roles and
functions performed by the money market.

To identify the key money market players.

Money Market Instruments

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Introduction
All the transactions in the financial markets may
appear to be the same: borrowers issue
securities that lenders buy

However, the different purposes for which money


is borrowed can result in the creation of different
kinds of financial assets having different
maturities, etc.

For instance, the money market is the market for


short-term (one year or less) credit and is
designed to provide needs for working capital
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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

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Key Borrowers and Lenders
in the Money Market
Corporate Borrowers
& Cash-Management
Customers Needing to
Government Invest Cash Surpluses Nonbank
Treasuries Financial
(borrowing and Institutions
redeeming
securities)

Security Money
Dealers & Center
Brokers Banks

Central Banks
(supplying funds and information
and promoting market stability)
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Characteristics of the
Money Market

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Characteristics of the
Money Market
Funds invested in the money market
represent temporary cash surpluses

Usually surpluses needed in the near future


Investors are especially sensitive to risk

Investors seek mainly safety and liquidity

Ensure surpluses are accessible when needed


Opportunity to earn interest income is secondary

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Types of Risk Confronting Investors

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Characteristics of the
Money Market
Original maturity is the interval of time between
the issue date of a security and its promised
redemption date
It can extend up to one year
It can be as short as overnight

Actual maturity is the interval of time between


the current date and the promised redemption
date of a security
Thousands of money market instruments
outstanding
Some reach maturity every day
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Characteristics of the
Money Market
Money market is extremely broad and deep
It can absorb a large volume of transactions
Transactions have only small effects on
security prices and interest rates

The money market is also very efficient


Securities dealers, major banks, and funds
brokers maintain constant contact
Telephone
Computer network
Hence alert to any bargains 10-11
Characteristics of the
Money Market
Federal funds are mainly deposit
balances of commercial banks held at
the central bank and at larger
correspondent banks across a country.

Federal funds are often called


immediately-available funds because of
the speed with which money moves
from one banks reserve account to
that of another.
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Characteristics of the
Money Market
Clearinghouse funds
Alternate structure to the federal funds
The clearinghouse is a location where
checks and other cash items are delivered
and passed from one financial
organization to another
Clearinghouse funds are an acceptable
means of payment for most purposes
Too slow for the money market
Clearinghouse funds also have an element
of risk
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Characteristics of the
Money Market
The money market is a wholesale
market for funds
Most trading occurs in multiples of a
million dollars
Dominated by a relatively small number of
large financial institutions Securities also
move readily from sellers to buyers
through the market-makers
Major security dealers
Brokers
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Characteristics of the
Money Market

Governments and central banks around


the world play major roles in the money
market as the largest borrowers and as
regulators.

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Treasury Bills
Treasury bills (T-bills)
Direct obligations of the government
Have an original maturity of one year or less

Tax revenues or any other source of government


funds may be used to repay the debt

They carry great weight in the financial system


Zero (or nearly zero) default risk
Ready marketability
High liquidity
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Types of Treasury Bills

Regular-series bills are issued routinely


every week or month
In competitive auctions
Various original maturities
One month (4 weeks)
Three months (13 weeks)
Six months (26 weeks)
Most revenues from the six month maturity

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Types of Treasury Bills

Irregular-series bills are issued when the


Treasury has an emergency cash need
Strip bills
Package of offered bills
Investor bids for a package of different
maturities
Cash management bills
Reopening an issue of bills that were sold
in a prior week
Issued at the actual maturity of the original
issue
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U.S. Treasury Bills:
Total Amount Outstanding

Source: Board of Governors of the Federal Reserve System


* 2006 figures are for the third quarter of 2006
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How U.S. T-Bills are Sold

T-bills sold using an auction


Marketplace sets the bill prices and yields
New regular bill issues announced by
Treasury
On Thursday of every week except
holidays
Bids due the following Monday before 1
p.m. EST
Must be filed with one of the regional
Federal Reserve banks or branches, or the
Treasury
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How Bills are Sold

Accepts two types of offers


Competitive tender
Submitted by large investors
Typically millions of dollars
Bid a discount rate of interest (DR)
Compete for limited supply
Noncompetitive tender
Normally under $1 million
Small investors accept price
determined by the auction
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Investors in Treasury Bills
T-bills are held mainly by commercial banks,
nonfinancial corporations, state and local
governments, and the central banks

Commercial banks and private corporations


hold T-bills as a reserve of liquidity

The central 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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Dealers Borrowing and Lending
Activities In the Money Market
The bulk of the dealers operating capital is
obtained through borrowings from commercial
banks and other institutions
Heavily used two sources of funds

Demand loans from the largest banks


May be called at any time if bank needs funds
Virtually riskless since collateralized

Repurchase agreements with banks and other


lenders
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Dealers Borrowing and Lending
Activities In the Money Market
Repurchase agreements (RP or Repo)
Dealer sells securities to a lender
Makes a commitment to buy back the
At a later date
At a fixed price plus interest
RPs are simply a temporary extension of credit
collateralized by marketable securities
Term RPs are for a set length of time
(overnight, a few days, 1 month, 3 months, )
Continuing contracts may be terminated by
either party on short notice.
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Dealers Borrowing and Lending
Activities In the Money Market
Interest income from RPs
= Amount Current Number of days
loaned ___ RP rate
. 360 days
Amt of loan

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Commercial Paper

In the global money market, commercial paper is an unsecured


promissory note with a fixed maturity of 1 to 270 days.
Commercial Paper is a money-market security issued (sold) by
large banks and corporations to get money to meet short term
debt obligations (for example, payroll), and is only backed by
an issuing bank or corporation's promise to pay the face
amount on the maturity date specified on the note.

Since it is not backed by collateral, only firms with excellent


credit ratings from a recognized rating agency will be able to
sell their commercial paper at a reasonable price. Commercial
paper is usually sold at a discount from face value, and carries
higher interest repayment dates than bonds.
Bankers Acceptance

A banker's acceptance, or BA, is a negotiable instrument


or time draft drawn on and accepted by a bank. It is an
order by the drawer to the bank to pay a specified sum of
money on a specified date to a named person or to the
bearer of the draft. Upon acceptance, which occurs when
an authorized bank accepts and signs it, the draft
becomes a primary and unconditional liability of the bank.

The accepted draft may be readily sold in an active


market. A banker's acceptance is also a money market
instrument a short-term discount instrument that
usually arises in the course of international trade.
Eurocurrency Deposit

A short-term certificate of deposit with a


fixed interest rate made in a currency
outside the jurisdiction of the issuing central
bank. For example, one may purchase a CD
in U.S. dollars and deposit it in a bank in
Great Britain. Eurocurrency deposits help
persons and businesses hedge against
short-term fluctuations in exchange rates.
Markets on the Net

Board of Governors of the Federal Reserve


System at www.federalreserve.gov
Browse Data of the Federal Reserve Board at
www.economagic.com/fedbog.htm
European Central Bank at www.ecb.eu
Federal Reserve Bank of New York at
www.ny.frb.org
Investopedia at www.investopedia.com

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Markets on the Net
Federal Deposit Insurance Corporation at
www.fdic.gov
Primary Dealers - Federal Reserve Bank of
New York at
www.ny.frb.org/markets/pridealers-
listing.htm
U.S. Treasury Department Bureau of the
Public Debt at www.publicdebt.treas.gov
Treasury Direct at www.Treasurydirect.gov

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Chapter Review

Introduction: The market for short-term


credit
Characteristics of the money market
What the money market does
The Need for a money market
Key borrowers and lenders in the money
market
The goals of money market investors
Types of Investment risk that investors
face
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Chapter Review

Characteristics of the money market


continued
Money market maturities
Depth and breadth of the money market
The speed of money market payments:
federal funds versus clearinghouse funds
A market for large borrowers and lenders

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Chapter Review

Dealers borrowing and lending


activities in the money market
Demand loans for dealers
Repurchase agreements (RPs or REPOs)
for dealers and other money market
participants
A New type of RP: The GCF REPO
Sources of dealer income
Dealer positions in securities
Dealer transactions and government
security brokers
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Calculating the Return on T-Bills

T-bills do not carry a promised interest


rate. Instead, they are sold at a
discount from their par or face value.
Bill yields are determined by the bank
discount method, which does not
compound interest rates and uses a
360-day year for simplicity.
The bank discount rate (DR) on T-bills
= Par value Purchase price 360 .

Par value Days to maturity


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Calculating the Return on T-Bills

Because the rates of return on most


other debt instruments are not figured
in the same way, comparisons with
other securities cannot be made
directly.
The investment yield or rate (IR) on T-
bills
= Par value Purchase price 365 .

Purchase price Days to maturity

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