Money Markets

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CHAPTER 7

• Money Markets

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Overview of the Money Market

• Short-term debt market -- most under 120 days.
• A few high quality borrowers.
• Many diverse investors.
• Informal market centered in New York City.
• Standardized securities -- one security is a
  close substitute for another.

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Overview of the Money Market(concluded)

• Good marketability -- secondary market.
• Large, wholesale open-market transactions.
• Many brokers and dealers are competitively
  involved in the money market.
• Payment in Federal Funds -- immediately available
  funds.
• Physical possession of securities seldom made --
  centralized safekeeping.
• Book-Entry Securities

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Economic Role ofMoney Market (MM)

• The money market is a market for liquidity
• Liquidity is stored in MM by investing in MM
  securities.
• Liquidity is bought in MM by issuing securities
  (borrowing).
• There are few high-quality borrowers and many
  diverse MM investors.

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Characteristics of MoneyMarket Instruments

• Low default risk
• Short-term maturity
• High marketability and liquidity
• Typically Large denominations
• Low transaction costs
• Wholesale market

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Money Market Participants

• Commercial Banks
• Federal Reserve System
• U.S. Treasury and Treasury Security Dealers
• Corporations
• Money Market Funds

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Money Market Balance SheetPosition of Major
Participants
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Commercial Banks -- MostImportant Participant in
the MM

• Bank assets or investments
• Treasury bills.
• Agency securities.
• Bankers' acceptances (from other banks).
• Federal Funds sold.
• Repurchase agreements (securities purchased under
  agreements to resell).

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Commercial Banks,cont.

• Bank liabilities or borrowing
• Negotiable CDs.
• Commercial paper.
• Bankers' acceptances.
• Federal Funds purchased.
• Repurchase agreements (securities sold under
  agreements to repurchase).
• MM securities provides sources and uses of
  liquidity due to wide fluctuations in loans and
  deposits.

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The Federal Reservein the Money Markets

• Money market securities is the major asset
  category of the Fed.
• Open-market operations (buying and selling of MM
  securities by Fed) is the primary tool for
  implementing monetary policy.
• Purchase -- increases member bank reserves.
• Sale -- decreases member bank reserves.

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Dealers in U.S. Securities --

• Involved in both primary and secondary markets.
• Purchases new treasury debt and resells it
  (primary).
• "Makes a market" by buying/selling (dealer)
  securities (bid/ask).
• Purchases are financed by repurchase agreements
  or fed funds.

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U.S. Treasury Bills

• Characteristics
• Sold on discount basis.
• Maturities up to one year - 91, 182, 364 days.
• Denominations are in multiples of 1000.

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U.S. Treasury Bills

• Pricing Treasury Bills
• Treasury bills are priced on a discount yield
  basis, a traditional yield calculation.
• The discount yield, yd, is

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Discount Yield
yd Pf P0 360 days Pf
n
x
X 100
yd the discount yield on an annualized basis Pf
the face value of the Treasury bill P0 the
purchase price of the T-bill n the number of
days until maturity
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Discounted Price of Treasury Bill Using the
Discount Yield
n P0 Pf -
360
Pf
x
x
yd
For definitions, please see previous slide.
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Bond Equivalent Yield
ybe Pf Po 365
Po n
X 100
x
ybe Bond Equivalent Yield For other
definitions, please see Slide 14.
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Discounted Price of Treasury Bill Using the Bond
Equivalent Yield
P0 Pf 1 (ybe
x n ) 365
Ybe Bond Equivalent Yield For other
definitions, please see Slide 14.
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U.S. Treasury Bills

• The Wall Journal lists T-Bill yields on a bond
  equivalent basis where the discounted price is
  the denominator and 365 days is used as the
  annualizer.
• The effective annual yield assuming compounding a
  year isEffective Yield (Face
  Value/Price)365/D -1 x 100.

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Auctioning New Bills

• Weekly sale by U. S. Treasury of three- and
  six-month maturities longer-term bills, monthly
  or quarterly.
• Competitive vs. noncompetitive bid states both
  the quantity of bills and bid price. Large bids.
  Multiple bids.
• Noncompetitive bid states only the quantity of
  bills requested at weighted average price.
  Smaller bids (1mm or less.)

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Book-entry Securities

• No physical securities only record entries.
• Book-entry record keeping
• Most of marketable Treasury debt is now in book-
  entry form.

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Types of Federal Agencies

• Farm credit agencies -- loans to farmers.
• Housing credit agencies -- loans and secondary
  market support for mortgage market.
• Other agencies -- special purposes.
• Federal financing bank -- purchases securities of
  agencies and issues its own obligations.

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Characteristics of Agency Debt

• Most are not guaranteed by federal government
  federal guarantee implied, not explicit.
• Marketability varies with the development of the
  secondary market.
• Yields are higher than T-Bills.
• Slightly greater default risk.
• Slightly lower marketability.

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Types of short-term debt issued by federally
sponsored credit agencies

• Bonds
• Carry a coupon
• Discount notes
• Sold at a discount below par

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Negotiable Certificates of Deposit

• Characteristics of Negotiable CDs
• Large denomination time deposit, less than six
  month's maturity.
• Negotiable -- may be sold and traded before
  maturity.
• Issued at face value with coupon rate.
• Development of the CD Market
• Issued by Citibank in 1961.
• Offset declining demand deposits as a source of
  funds.

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Negotiable Certificates of Deposit(concluded)

• The CD Market
• Rate negotiated between buyer and seller.
• Market is sensitive to rates above or below the
  market rates.
• Rates are lower for money center banks and are
  tiered upward for regional banks.
• Purchased mainly by corporate businesses.

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Commercial Paper

• Short term -- one to 270 days.
• Usually Unsecured.
• Large denominations -- 100,000 and up.
• Issued by high-quality borrowers.
• A wholesale money market instrument -- few
  personal investors.
• Sold at a discount from par.
• Directly or dealer sold.
• Backed by bank lines of credit.

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The Commercial Paper Market

• Major investors
• Commercial banks.
• Insurance companies.
• Nonfinancial business firms.
• Bank trust departments.
• State and local pension funds.
• Banks are involved
• Backup lines of credit.
• Act as agents in issuance.
• Hold notes in safekeeping.
• Facilitate payment in Federal Funds.

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The Commercial Paper Market(concluded)

• Credit ratings important for commercial paper
  issuance.
• Backup lines of credit from banks support or
  guarantee quality.
• Placement
• Directly by a sales force of the borrowing firm.
• Indirectly through dealers.

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Bankers Acceptance

• A bankers acceptance is a time draft drawn on
  and accepted by a commercial bank. Time drafts
  are orders to pay a specified amount of money to
  the bearer on a specific day

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Bankers' Acceptances

• Time draft -- order to pay in future.
• Drafts are drawn on and/or accepted by commercial
  bank.
• Direct liability of bank.
• Mostly relate to international trade.
• Secondary market -- dealer market.
• Discounted in market to reflect yield.
• Standard maturities of 30, 60, or 90 days -- max
  of 180.

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Creating a Banker's Acceptance

• Importer initiates purchase from foreign
  exporter, payable in future.
• Importer needs financing exporter needs
  assurance of payment in future.
• Importer's bank writes irrevocable letter of
  credit for exporter
• Specifies purchase order.
• Authorizes exporter to draw time draft on bank.

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Creating a Banker's Acceptance (concluded)

• Importer's bank accepts draft (liability to pay)
  and creates a banker's acceptance.
• Advantage of a banker's acceptance (BA)
• Exporter receives funds by selling BA in the
  market.
• Exporter eliminates foreign exchange risk.
• Importer's bank guarantees payment of draft in
  future.

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The Sequence of a Bankers Acceptance Transaction
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Federal Funds

• Characteristics of Federal Funds
• Market for depository institutions.
• Most liquid of all financial assets.
• Related to monetary policy implementation.
• Yields related to the level of excess bank
  reserves.
• Originally a market for excess reserves -- Now a
  source of investment (federal funds sold) and
  continued financing (federal funds purchased).

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Federal Funds (concluded)

• Most Are One-day (Overnight), Unsecured Loans
• Bookkeeping Entry, Interest Paid Separately
• Traded in Fed Funds or Immediately Available
  Funds
• Unit of trade is 1 mm or more
• Now, a wide array of financial institutions
  provide Federal Funds.

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Fed Funds Calculations
Ybe yff(365/360)
Yff quoted yield on Fed Funds
Ybe Bond Equivalent Yield
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Repurchase Agreements (Repo)

• Bank financing -- source of funds
• Security sold under agreement to repurchase at
  given price in future.
• Way to include corporate business in federal
  funds market.
• Negotiated market rate.
• Bank investment reverse Repo
• Security purchased under agreement to resell at
  given price in future.
• Smaller banks are able to invest excess liquidity
  in a secured investment.

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Repurchase Agreements (Repo) (concluded)

• Used by dealers to finance security inventories
• Repos are used by the Federal Reserve in open
  market operations.
• Yields are quoted as follows Prepo -
  P0 360

Yrepo

x
n
P0
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Recent Money Market RatesFebruary 8, 2005
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Interrelationship of Money Market Interest Rates

• Various MM instruments are close substitutes in
  investment portfolios.
• Interest rates move together over time.
• Deviations from traditional spreads are quickly
  eliminated by interest rate arbitrage.

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Conclusion

• Characteristics of Money Market Instruments
• Low Default Risk
• Short-Term Maturity
• High Marketability
• Typically High Denominations
• Money Market
• Instruments
• Participants
• Discount Yield
• Bond Equivalent Yield