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232 Money Markets and Financial Institutions

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Holding bids constant, single-price auctions raise less money ... Large investors willing to accept slightly more risk can buy CP or deposit money in Eurodollars ... – PowerPoint PPT presentation

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Title: 232 Money Markets and Financial Institutions


1
232Money Markets and Financial Institutions
  • Prof. Greg Duffee
  • Haas School of Business
  • Fall 2004

2
Money markets
  • Common features
  • Markets for borrowing and lending at short
    maturities (one year or less)
  • Very large wholesale markets (large
    transactions)
  • Near zero default risk
  • Our discussion will also introduce concepts of
  • Primary and secondary markets
  • Brokers and dealers
  • Money market yield conventions

3
The commercial paper market
  • CP is issued by major financial and non-financial
    corporations
  • For former, an important source of funding
  • Maturities average about 30 days max 270
  • Unsecured IOUs

4
CP
  • Two main uses
  • Long-term financing (rolling over maturing CP)
  • Matching fluctuating demands for cash
  • Purchasers
  • MM mutual funds, insurance companies, pension
    funds
  • Advantage as an investment vehicle is very low
    risk

5
CP markets
  • Two types of primary markets (initial issuance of
    IOUs)
  • Dealer market investment banks buy CP from
    issuer, market to investors
  • Direct placements issuer sells directly to
    investors (bilateral negotiation)
  • Roughly equal in size nonfinancial CP typically
    uses dealer
  • Minimal secondary market (subsequent trading of
    IOUs before maturity)

6
Economics of the CP market
  • Facts about the market
  • About 500 firms in US issue CP
  • All have their CP rated by credit rating agencies
  • Market effectively requires high rating to issue
    CP
  • At least medium investment-grade
  • For issuers, CP financing is cheaper than
    longer-term debt
  • Questions
  • Why cant lower-quality borrowers use the CP
    market (junk CP)?
  • Why is it so cheap for issuers?
  • How do issuers deal with rollover risk?

7
  • Answers
  • Moral hazard limits issuance of unrestricted IOUs
  • Covenants required for lower-quality firms
  • Short maturity of CP means that high-quality
    firms do not have enough time to get into
    trouble low credit risk
  • CP issuers have backup lines of credit from
    commercial banks (with covenants)

8
Recent trends in CP
  • Amount outstanding
  • Yield spread between two CP ratings

9
Themes to remember
  • Nature of the market is strongly affected by
  • Asymmetric information
  • Transaction costs
  • Temporary supply/demand fluctuations can produce
    sharp, short-run variations in rates
  • Not as obvious as simple economic principles
    might suggest financial instruments are
    typically highly substitutable

10
CP yield conventions
  • CP yields are quoted on a 360 day discount basis
  • Assumes a year is 360 days
  • Interest is figured as a fraction of amount paid
    back, not amount borrowed

11
  • GE issues CP with a face value of 100, payable
    in 30 days. It sells today for 99.85. What is
    the yield quoted in the CP market? What is the
    bond-equivalent yield?

12
Treasury bills
  • ZCB with maturities 1 year or less
  • Yield convention same as CP 360-day discount
  • 900 billion outstanding
  • About ΒΌ of Fed debt
  • Uses the same as CP Long-term financing by
    rolling over, matching fluctuating demands for
    cash

13
Treasury bills
  • Investors
  • Foreign central banks
  • The Fed (open market operations)
  • Wholesale investors MM mutual funds, insurance
    companies, pension funds, banks
  • Individuals
  • Lowest interest rates among all taxable
    investments
  • Strong demand for zero default risk, low
    interest-rate risk

14
Markets for Treasury bills
  • Originally sold at auction (primary market)
  • Secondary market
  • Inter-dealer market is a broker market
  • Brokers have computer systems on which dealers
    post prices, quantities to buy/sell with other
    dealers
  • Rest of market is a dealer market
  • Individuals, companies call a dealer to get
    price, make trade
  • Wholesale (inter-dealer) market is a broker
    market
  • Separate markets is a common feature of secondary
    trading in financial instruments

15
The primary market for Treasury bills
  • 60 billion auctioned each week
  • Currently, weekly auctions of 26-week, 13-week,
    and 4-week bills
  • Occasional cash management bills
  • Purchasers are
  • Dealers (competitive bidders)
  • Individual investors (competitive bidding
    through dealers or noncompetitive)
  • Foreign governments, the Fed (noncompetitive)
  • Amounts auctioned determined by Treasury based on
    funding requirements and perceived demand
  • Auctions are run by the Fed

16
Auction mechanics
  • The bidders
  • Competitive qualified dealers, on own account
    or for customers
  • Each can bid for up to 35 of entire amount
    auctioned
  • Small number of big players mostly major
    investment banks
  • Noncompetitive others
  • The bids
  • Competitive bids are pairs of quantity and yield
  • Example 10 million at 1.8
  • Noncompetitive bids are quantities only
  • Sealed-bid method used

17
Auction mechanics
  • Treasury announces amount a few days in advance
  • Example Thursday, June 24, announce 17 billion
    of 13-week bills and 15 billion of 26-week bills
    to be sold on Monday, June 28 (plus whatever the
    Fed buys)
  • Single-price (aka uniform-price) system is used
  • All winning bidders pay same price
  • All noncompetitive bids are added up and
    subtracted first
  • Bids at highest yield (stop-out yield) are
    prorated so total amount of bids equals issuance
    amount)
  • Stop-out yield determines the bonds price

18
Hypothetical bidding example
  • Auction of 11.5 billion in 182-day notes
  • 500 million in competitive bids

19
(No Transcript)
20
More about Treasury auctions
  • With slight modifications, same procedure is used
    to issue longer-term Treasury securities
  • Auctions used to be multiple-price auctions
  • Winning bidders paid the yield they bid
  • Why the change?
  • Holding bids constant, single-price auctions
    raise less money
  • But bidding patterns cannot be held constant
    winners curse
  • Single-price bids are more aggressive
  • Economic theory leans towards single-price
    empirical evidence is mixed

21
Secondary markets for Treasury bills
  • Trading activity is very heavy
  • Combined trades of most active participants is
    about 10 turnover/day
  • Reasons for trading
  • Continual rebalancing of portfolios
  • Nonfinancial corporations sweeping spare funds
    into treasuries
  • Mutual funds adjusting to redemptions or new
    funds
  • Speculation/hedging
  • Positions can be used to bet on direction of
    short-term rates
  • Common use hedge much interest-rate risk in
    other securities
  • More discussion when we consider longer-term
    Treasury securities

22
The Fed funds market
  • Used primarily by commercial banks to borrow and
    lend bank reserves
  • Banks keep funds on account at the Fed
  • Banks with excess funds lend to those with
    insufficient funds (based on withdrawals, reserve
    requirements)
  • Lending takes place in this market
  • Maturity primarily, same-day borrowing of
    reserves overnight
  • Term Fed funds exists
  • Trade size about 25MM, daily volume 100
    billion
  • Brokers usually arrange trades (thousands of
    banks)

23
Fed funds
  • No collateral
  • Interest rates vary from transaction to
    transaction (supply/demand, not credit risk,
    which is small)
  • Most commonly seen rate effective Fed funds
    rate
  • Volume-weighted average of daily rates
  • Rates can fluctuate dramatically because of
    market segmentation
  • Same-day funds are hard to come by
  • The Federal Reserve defines monetary policy in
    terms of a target effective Fed funds rate

24
Fed funds yield convention
  • Fed funds quoted on a 360-day add-on basis
  • Also called money market basis
  • Simple interest calculation, 360-day year
  • Example Borrow 10 million overnight at 2.
    What is paid back?

25
Yield conventions
  • For the same economic transaction, rank the
    following rates 360-day discount, 360-day
    add-on, simple interest with 365-day year
  • Lowest is 360-day discount Interest figured off
    of higher base amount
  • Middle is 360-day add-on
  • Highest is simple interest with 365-day year.
    The period over which you are borrowing is a
    larger fraction of a year when a 360-day year
    is used, so rate is smaller.

26
General principles of yield conventions
  • Money-market rates are used when the transaction
    is like a loan of X.
  • Discount rates are used when the transaction is
    like the sale of a security with face value of X.

27
Eurodollar deposits
  • Eurodollars are -denominated time deposits in
    banks outside of the US
  • Maturity from one day and up
  • Interest received is Eurodollar deposit rate
    (competitive depends on bank)
  • Eurocurrencies are deposits denominated in a
    currency that is not the home currency of the
    bank
  • Multinational corporations use Euro deposits to
    simplify payment systems

28
The market for Eurodollar deposits
  • Major banks use Euro deposit market heavily to
    borrow and lend funds (borrow and lend deposits)
  • Primary market is a broker/dealer market
  • Potential borrowers/lenders contact brokers or
    major banks in London (center of market) directly
  • Deposit rate is negotiated with dealer
  • Primary market is liquid for maturities ranging
    from day to year
  • No collateral for borrowed deposits
  • Small amount of credit risk, priced into the rate

29
The Eurodollar market
  • Secondary market is small (Eurodollar CDs)
  • Average rate of interest charged by London banks
    to lend deposits to other (A-rated) banks is
    called LIBOR London Interbank Offered Rate
  • Term structure of LIBOR

30
The importance of LIBOR
  • LIBOR is the baseline for pricing interest-rate
    instruments floating-rate debt, interest rate
    swaps, caps, floors. Priced at spread to LIBOR
  • Why?
  • LIBOR is less responsive to idiosyncratic
    supply/demand fluctuations that affect other
    markets
  • With issuers limited in number (Treasury), in
    ability to react quickly (Treasury, CP), or with
    institutional restrictions on trading (Fed
    funds), idiosyncratic demand shocks move rates
  • With Eurodollars, major financial institutions
    can be on either side, no institutional
    restrictions to slow their reaction

31
The RP (repo) market
  • A market for short-term collateralized borrowing
    and lending
  • Used by financial institutions, Gov
    organizations. Very large market (4 trillion
    outstanding/day)
  • Mechanics
  • Primary market only a dealer market
  • Funds usually borrowed for next-day delivery
  • Market liquid for maturities ranging from one day
    to many months (term repo)
  • Collateral is usually Treasury securities, but
    other publicly-traded securities can be used

32
The RP market
  • Legally, RP is a matched sale-repurchase
  • Buy security for 10MM today
  • Simultaneously agree to forward contractsell
    security back for 10MM one days interest
    tomorrow
  • Therefore for one day, lender of funds has
    unrestricted use of security (contrast with
    borrowing to buy car/house)
  • Can think of RP as borrowing money or borrowing a
    security
  • Terminology
  • To repo (borrow money), to do repo (lend money),
    to reverse in securities (borrow securities), to
    reverse out securities (lend securities)

33
Credit risk in repo
  • Low and two-way
  • Credit risk for party that reverses in the
    security is created by the possibility that the
    securitys price falls and the counterparty
    defaults
  • Haircuts apply to collateral (maybe 0.25 for
    100 in bills, 1 to 3 for longer-term bonds)
  • Haircuts reduce this risk
  • Credit risk for the party that reverses out the
    security is created by the possibility of a price
    increase coupled with a counterparty default
  • Haircuts raise this risk

34
The RP market
  • One-day RP rate closely tracks Fed funds rate
  • Funds rate typically higher credit risk
  • The Fed conducts monetary policy through the RP
    market
  • The RP market is used extensively by investment
    banks to fund positions they take in securities
    markets
  • Also popular with non-financial institutions that
    want to store funds in liquid, collateralized form

35
Financing Treasurys in the RP market
  • Speculating without much cash
  • To go long, buy, reverse out the security no
    money down
  • To go short, sell, and reverse in to deliver
  • Short example a CP dealer buys 50MM (face) of
    6-month CP on Wednesday, will sell entire amount
    to customers on Monday. Goal is to hedge general
    market interest rate risk of position
  • Desired hedge short-sell 50MM of 6-month
    T-bills at Wednesdays rate, close out short
    position at Mondays rate.
  • But short-selling Treasurys is equivalent to
    borrowing at the Treasury rateno one will lend
    to the CP dealer at that rate w/o collateral
  • More generally shorts must deliver!

36
RPs and shorts
  • The CP dealer can hedge using repos
  • Key intuition with repos, lender of cash
    (reversing in securities) has temporary ownership
    of securities but does not face price risk of
    securities
  • Hands securities back at future date at price
    fixed today
  • Application
  • Short-sell Treasury bills
  • Lend proceeds in RP market, taking same bills as
    collateral
  • Hand over bills to counterparty in short position
  • Close out RP position when hedge is no longer
    needed
  • Buy bills in cash market, hand over to close out
    RP position returned principal plus interest in
    repo loan pays for bills

37
RPs and shorts
  • Short-sellers demand for securities is a major
    reason for heavy use of repo market
  • We will return to this use of the repo market
    later in the semester

38
Observations on money markets (1)
  • Money market instruments impose no restrictions
    on borrowers (other than obligation to pay back
    the loan)
  • Borrowing without restrictions is limited to
    financially secure firms over short time horizons
  • If same firms want to borrow long term, or if
    lower-quality firms want to borrow short or long
    term, restrictions are always imposed on the
    borrower
  • Only default-free entities have easy access to
    long-term borrowing without restrictions

39
Observations on money markets (2)
  • Rates on mm instruments are linked because they
    are close substitutes for many investors and
    borrowers
  • Commercial banks can borrow unsecured funds in
    Fed funds, Eurodollar markets
  • Large investors who want extremely low risk
    investments can buy Treasury bills or lend in
    repo market
  • Large investors willing to accept slightly more
    risk can buy CP or deposit money in Eurodollars

40
Observations on money markets (3)
  • Primary markets are structured to minimize
    transaction costs in linking buyers and sellers
  • Methods include direct search, brokers, dealers,
    and auctionswe will deal with these more
    systematically later
  • Secondary markets range from extremely active to
    non-existent
  • No technological barriers to trading CP,
    Eurodollars in secondary markets, but too little
    demand to justify expense of market

41
Appendix Explicit example of short-selling and
RPs
  • CP dealer buys 50MM (face) of 6-month CP on
    Wednesday, will sell entire amount to customers
    on Monday. Goal is to hedge general market
    interest rate risk of position.

42
  • Wednesday
  • Sell 50MM (face) of newly-issued 6-month T-bills
    for delivery on Thursday at yield 1.75
  • Next-day overnight repo reverse out bills at
    1.75 (determines price), repo rate of 1.90
  • Thursday
  • Receive 50MM(1-0.0175)(182/360)49,557,639 for
    T-bills
  • Hand over cash to RP counterparty, receive the
    bills
  • Deliver the bills to counterpart of short
    position
  • Arrange another next-day overnight repo at
    (assumed unchanged) Treasury yield of 1.75, repo
    rate of 1.90

43
  • Friday
  • Close out original RP transaction
  • Receive principal plus interest of
    49,557,639(10.0190/360) 49,560,255
  • Return T-bills
  • Perform under 2nd RP transaction
  • Lend 50MM(1 0.0175(181/360))49,560,069
  • Receive T-bills as collateral
  • Pocket 186 from T-bill RP spread
  • Arrange another next-day overnight repo at
    (assumed unchanged) Treasury yield of 1.75, repo
    rate of 1.9

44
  • Monday
  • Close out 2nd RP transaction
  • Receive principal plus 3 days interest of
    49,560,069(1 0.0190(3/360))49,567,916
  • Return T-bills
  • Perform under 3rd RP transaction
  • Lend 50MM(1 0.0175(178/360))49,567,361
  • Receive T-bills as collateral
  • Pocket 555 from T-bill RP spread
  • Buy T-bills for next-day delivery at (assumed
    higher) yield of 2

45
  • Tuesday
  • Close out 3rd RP transaction
  • Receive principal plus interest of
    49,567,361(10.019)49,569,977
  • Deliver T-bills
  • Perform under cash transaction
  • Pocket difference of 59,644 as profit from short
    position in T-bills
  • Buy T-bills at 50MM(1 0.02(177/360))49,508,33
    3
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