Chapter Five

Money Markets

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 Definition and Purpose of Money
Markets
• The Money Markets are associated with the issuance and
trading of short-term (less than 1 year) debt obligations
of large corporations, FIs and governments
• 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

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 Money Market Instruments

• Treasury Bills
• Federal Funds
• Repurchase Agreements
• Commercial Paper
• Negotiable Certificates of Deposit
• Banker Acceptances

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 Money Market Instruments Outstanding,
December 1990 and 2004 (in billions of
dollars)

Amount Outstanding Rate of Return

1990 2004 1990 2004

Treasury bills $527.0 $ 981.9 6.68% 2.15%
Federal funds and
repurchase agreements 372.3 1,585.1 7.31 1.83
Commercial paper 537.8 1,309.7 8.14 1.89
Negotiable certificates
of deposit 546.9 1,379.4 8.13 2.28
Banker’s acceptance 52.1 4.4 7.95 2.04

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 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
• Virtually default risk free
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 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
• Individual competitive bidders 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 a weighted-average of the rate on winning
competitive bids; get preferential allocation

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 Treasury Auction Results Nov 18,2004
Bid Price
Noncompetitive Bids
99.4975% 1
SC ST
2
3
4
99.48875%
(PNC) 5
stop-out 6
price (low
7
bid
accepted)

$17,509.5m $19,254.8m Quantity of

T-bills

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 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

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 Secondary Market T-bill Transaction
J.P. Morgan Chase Lehman Brothers
sells $10m. In T-bills buy $10m. In T-bills

Federal Reserve Bank of New York

Transfers $10m. In T-bills from

J.P. Morgan Chase to Lehman Brothers
Transaction recorded in Fed’s Book-Entry System

FRBNY
Individual J.P. Morgan -$50,000 in T-bills
Local Bank
buy $50,000 Chase from J.P. Morgan
or Broker
in T-bills sell $50,000 Chase’s account
in T-bills + $50,000 T-bill
to Individual

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 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
• Asked
• Spread
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 Calculating T-bill Yields from Discount
Rates
iT-bill(dy) = PF - PO  360
PF h

Where: iT-bill= Annualized yield on the T-bill

PF = Price (face value) paid to the T-bill holder
PO = Purchase price of the T-bill
h = Number of days until the T-bill matures

Example: iT-bill(dy) = $10,000 - $9,905.71  360 = 2.19%

$10,000 155
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 Federal Funds

• Short-term funds transferred between FIs,

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
• Federal Funds Yields
– single-payment loans
– Fed fund transactions take the form of short-
term (mostly overnight) unsecured loans
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 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
• Correspondent banks – banks with reciprocal
accounts and agreements

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 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 securities)
• Reverse repurchase agreement

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 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

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 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

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 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

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 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
• Denominations 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

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 Trading Process for NCDs

• Banks issuing NCDs 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

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 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
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 Money Market Participants
Instrument Principal Issuer
Treasury bills U.S. Treasury
Federal funds Commercial banks
Repurchase agreement FRS; Comm banks;
Brokers and dealers;
Other FIs
Commercial Paper Comm banks
Other FIs; Corps
Negotiable CDs Commercial banks
Banker’s acceptances Commercial banks
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Principal Investor
FRS; Comm banks; MF’s
Brokers and dealers;
Other FIs; Corp’s
Commercial banks
FRS, Comm banks; MF’s
Brokers and dealers
Other FIs, Corp’s
Brokers and dealers;MF’s
Corporations
Brokers and dealers;MF’s
Corps; Other FIs
Comm banks; Corp’s;
Brokers 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 (LIBOR)
– the rate paid on Eurodollars
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