Tarheel Consultancy Services

1
Tarheel Consultancy Services

• Manipal, Karnataka

2
Corporate Training and Consulting
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Course on Fixed Income Securities

• For
• XIM -Bhubaneshwar

4
For

• PGP-II
• 2003-2005 Batch
• Term-V September-December 2004

5
Module-I

• Part-V
• Basics of Money Market Securities

6
Introduction

• There are fundamental differences between Money
  and Capital markets.
• The same borrower may tap both markets to fulfill
  different needs.
• For instance, a corporate borrower may issue long
  term bonds in the capital market to raise funds
  to build a factory.
• The same borrower may issue commercial paper in
  the money market to finance his inventories.

7
Introduction (Cont)

• The purpose for which funds are borrowed
  therefore differs from borrower to borrower and
  often in the case of the same borrower from
  transaction to transaction.
• The different motives for borrowing lead to the
  creation of different instruments with unique
  risk and return features.

8
Maturity

• Money market securities by definition have an
  original maturity of one year or less.
• The term original maturity refers to the maturity
  at the time of issue of the instrument.
• The maturity of the instrument at a subsequent
  point of time is called its actual maturity.

9
Why Money Markets?

• From the standpoint of both business entities as
  well as the government, inflows and outflows will
  rarely match.
• Consequently at certain points in time, an
  enterprise may be in need of funds, while at
  other times, it may have a surplus.

10
Why? (Cont)

• Take the case of a government.
• It will collect revenues primarily by way of
  taxes.
• Such revenues tend to arrive in lumps during
  certain months of the year.
• However the government has to incur expenses
  throughout the year, both on account of
  developmental works as well as on account of
  wages and salaries.

11
Why? (Cont)

• Consequently during most of the year the
  government will be a borrower, and will issue
  T-bills to meet its short-term needs.
• However at certain points in time when it is
  flush with tax revenues, it may turn a net lender
  for short periods and may buy back T-bills.

12
Why? (Cont)

• The same it true for a business.
• The balance in a current account will constantly
  fluctuate.
• If surplus funds are available a business may
  temporarily park its funds in money market
  securities.
• Else if there is a deficit it will issue
  instruments like commercial paper to raise
  short-term funds.

13
Perishable Money

• Money is an extremely perishable commodity.
• The longer money remains idle, the greater is the
  lost income.
• And income that is lost can never be recovered.
• We will give an illustration.

14
Illustration

• Assume that a corporation has a surplus of 12 MM
  USD that can be invested at 12 per annum.
• The year we will assume has 360 days, which is a
  standard assumption in money markets.
• What will be the lost income if money remains
  idle for a day?

15
Illustration (Cont)

• Interest for a day
• 12,000,000 x 0.12 x 1/360 4,000.
• Loss of income if money lies idle for a week
  28,000

16
Borrowers Lenders

• It is a difficult task to characterize an entity
  as a borrower or a lender.
• An enterprise that is a borrower at one point in
  time may turn a net lender subsequently.
• Certain institutions tend to be on both sides of
  the market at the same time.

17
Borrowers Lenders (Cont)

• Take an organization like a commercial bank.
• It may borrow short term in the money market by
  issuing negotiable certificates of deposit.
• It may at the same time extend working capital
  loans to its clients.

18
Borrowers Lenders (Cont)

• Governments inevitably are borrowers.
• At any point in time, the U.S. Treasury is the
  largest borrower in the global money market.

19
Characteristics

• Investors are primarily concerned with safety and
  liquidity.
• Liquidity is important because most investments
  are for very short periods of time.
• The global money market has a lot of depth and
  can absorb large issues of securities as well as
  redemptions without a significant price impact.

20
Characteristics (Cont)

• The market is an OTC network of securities
  dealers, banks, and funds brokers, who are linked
  by telephones and computers.
• The market as a whole is supervised by the
  Federal Reserve and other central banks.

21
Characteristics (Cont)

• Speed is of the essence.
• Transactions are sealed and executed in a matter
  of minutes or even less.
• Traders are constantly looking for arbitrage
  opportunities and will routinely move funds from
  one part of the globe to another.

22
Characteristics (Cont)

• National money markets may be securities
  dominated or bank dominated.
• Securities dominated markets are characterized
  primarily by the buying and selling of marketable
  securities.
• Examples include the U.S., U.K. and Canadian
  markets.

23
Characteristics (Cont)

• In bank dominated markets most of the activity is
  in the form of inter-bank and bank-client deals.
• Examples include Japan, China, and Korea.

24
Features of The Market

• It is a wholesale market.
• Not for small investors.
• However they can participate indirectly through
  MMMFs.
• The money market facilitates large scale transfer
  of funds.
• For most banks except the Bank of America, fund
  requirements usually exceed deposits.
• For smaller state and local banks, deposits
  usually exceed fund requirements.

25
The Federal Reserve

• The Federal Reserve is the central bank of the
  United States.
• It is a key component of the money market.
• It consists of 12 member banks located in the
  following cities.

26
The Federal Reserve System

• Boston
• New York
• Philadelphia
• Cleveland
• Richmond
• Atlanta

• Chicago
• St. Louis
• Minneapolis
• Kansas City
• Dallas
• San Francisco

27
Open Market Operations

• The money market is where the Federal Reserve
  carries out open-market operations.
• The term refers to the buying and selling of
  Treasury securities by the FED in the secondary
  market.
• This is done to regulate the money supply and
  influence interest rates.

28
Open Market Operations

• In order to increase the money supply, the FED
  will buy Treasury securities.
• To decrease the money supply, it will sell
  Treasury securities.
• The decision to undertake such operations is
  taken by the Federal Open Market Committee
  (FOMC).
• It is implemented by the Federal Reserve of New
  York.

29
Features of Trading

• Because of the large volumes involved, skill and
  expertise in trading are of the utmost
  importance.
• Most traders specialize in narrow segments of the
  market.
• The market is bound by a strict code of honour.
• Billions of dollars worth of business is
  conducted over the phone, and no one reneges.
• The market is relatively unregulated and
  therefore highly innovative.

30
Types of Instruments

• The most transactions in the global money markets
  take the form of
• T-bills
• Federal agency securities
• Dealer loans
• Repurchase agreements
• Bankers acceptances
• Commercial paper
• Eurocurrency deposits
• Federal funds

31
Volumes

• As of 1998 over 700 billion worth of T-bills were
  outstanding constituting about 13 of the Federal
  governments debt.
• Large (over 100,000) face value CDs were
  outstanding to the extent of about 500 billion.

32
Volumes (Cont)

• Agency securities and commercial paper were
  outstanding to the extent of over 1 trillion
  dollars.
• Bankers acceptances totaled about 15 billion.
• And Eurocurrency deposits exceeded 2 trillion
  dollars.

33
Benchmark Rates

• The rates on various instruments revolve around
  the prevailing T-bill rates.
• T-bills are devoid of default risk and have a
  deep and active secondary market.
• Consequently they have the lowest yields.

34
Benchmark Rates (Cont)

• Federal agency securities are perceived to be
  virtually riskless since it is unlikely that the
  government will permit them to fail.
• However the market for such securities is less
  liquid.
• Consequently the rate on such securities will be
  slightly higher.

35
Benchmark Rates (Cont)

• Federal funds which are low risk inter-bank loans
  also have rates which are fairly close to T-bill
  rates.
• For instance the average T-bill rate in 1999 was
  about 4.40 where the Fed Funds rate was fairly
  close to 5.

36
Treasury Bills

• These are a direct obligation of the U.S.
  government.
• By law these must have an original maturity of
  one year or less.
• Which explains why the Treasury does not issue
  zero coupon instruments with a maturity exceeding
  one year.

37
T-bills (Cont)

• The financial year for the U.S. government runs
  from 1 October till 30 September.
• However most of its income by way of taxes arises
  in April.
• Consequently even when the government is running
  a surplus budget, it tends to have a shortfall
  during most of the year.
• These temporary deficits are bridged by issuing
  T-bills.

38
T-bills (Cont)

• The Treasury issues several types of T-bills.
• Regular-series bills are issued at fixed
  intervals by way of competitive auctions.
• 13 and 26 week bills are issued every week.
• 52 week bills are issued once a month.

39
T-bills (Cont)

• Irregular series bills are issued only when a
  special need arises.
• These take on two forms
• Strip bills
• Cash management bills.
• A strip bill is essentially a series of bills
  with different maturities.
• Lenders have to buy the strip as a whole.

40
T-bills (Cont)

• Cash management bills are a re-opening of an
  existing issue.
• What is a re-opening?
• Consider a six month bill that was issued two
  months ago?
• It will have four months to maturity today.
• So if new four month bills are issued they will
  essentially add to the size of the existing
  issue.
• This is the meaning of reopening a maturity.

41
Auctions

• The Treasury sells T-bills via an auction
  procedure.
• That is, the price is determined by the market
  based on competitive bidding, and is not set by
  the Treasury.
• 13-week and 26-week bills are issued every week.
• 52 week bills are issued once a month.

42
Auctions (Cont)

• In the case of 13-week and 26-week bills the
  auction is announced on Thursdays.
• If Thursday were to be a holiday then it will be
  announced on the next business day.
• Bidders have until 1 P.M. EST on the following
  Monday to submit their bids.

43
Auctions (Cont)

• An investor can submit multiple bids.
• That is he can bid at different yields.
• For instance an investor may bid for 500,000
  worth of bids at a yield of 5.01 and for an
  additional 500,000 at a yield of 5.
• Bids have to be submitted at one of the 37
  Federal Reserve banks and their branches or at
  the Treasurys bureau of public debt.

44
Auctions (Cont)

• Bids may be submitted by person or by mail, or
  may be submitted electronically through a
  securities dealer.
• Online bidding is also possible at
  www.publicdebt.treas.gov
• Most dealers do not charge commissions for
  T-bills bought at auctions, but they may levy a
  processing fee.

45
Auctions (Cont)

• For bids that are filed directly with the
  Treasury or through Federal Reserve banks
  obviously no commissions are payable.
• Investors may choose to hold a Treasury Direct
  account.
• For such account holders interest payments and
  principal repayments can be credited directly to
  their bank accounts.

46
Auctions (Cont)

• Instructions can be given by such account holders
  to have the proceeds from maturing issues to be
  automatically reinvested in new issues.
• There is no service charge for accounts with a
  face value of less than 100,000.
• For higher balances there is a small maintenance
  fee.

47
Auctions (Cont)

• The Treasury permits both competitive as well as
  non-competitive bids.
• Most individual bidders submit non-competitive
  bids.
• Such bidders indicate only the quantity sought
  and agree to accept the yield that is determined
  by the auction process.

48
Auctions (Cont)

• Institutional investors however submit
  competitive bids by indicating both the quantity
  sought and the minimum yield that they are
  prepared to accept.
• Non-competitive bids cannot be for more than
  1,000,000 per bidder in the case of T-bills, and
  for 5,000,000 per bidder in the case of T-notes
  and bonds.

49
Auctions (Cont)

• The Treasury generally accepts all
  non-competitive bids.
• Once the bids are received, the amount sought by
  non-competitive bidders is first subtracted from
  the total issue quantity.
• All competitive bids are then ranked.

50
Auctions (Cont)

• In a price based auction bids will be ranked in
  descending order of price.
• In a yield based auction they will be ranked in
  ascending order of yield.
• All bids are required to be submitted to three
  decimal places.
• In principle the Treasury can conduct a uniform
  price/yield auction or a discriminatory
  price/yield auction.

51
Auctions (Cont)

• Of late the Treasury has been conducting only
  single yield auctions.
• In a uniform yield auction, all successful
  bidders get the bills at the market clearing
  yield.
• In a discriminatory yield auction, all successful
  bidders get the bids at the yield that they bid.

52
Example

• Assume that the Treasury has announced an issue
  of 500,000,000.
• Non-competitive bidders have bid 75 MM.
• So 425 MM will be offered to the competitive
  bidders.
• Assume that the following bids have been received.

53
Example (Cont)
Bidder Yield Quantity
ABC Investments 5.010 25,000,000
XYZ Investments 5.070 75,000,000
Merrill Lynch 5.035 150,000,000
GE 5.050 100,000,000
Morgan Stanley 5.035 200,000,000
Orange County 5.080 125,000,000
Bank of Japan 5.025 120,000,000
54
Example (Cont)

• The bids will be ranked in ascending order of
  yield, and the aggregate demand will be
  determined.

55
Example (Cont)
Bidder Yield Quantity Aggregate Quantity
ABC Investments 5.010 25,000,000 25,000,000
Bank of Japan 5.025 120,000,000 145,000,000
Merrill Lynch 5.035 150,000,000 295,000,000
Morgan Stanley 5.035 200,000,000 495,000,000
GE 5.050 100,000,000 595,000,000
XYZ Investments 5.070 75,000,000 670,000,000
Orange County 5.080 125,000,000 795,000,000
56
Example (Cont)

• Allocation will begin from the top.
• ABC Investments will receive 25 MM.
• That will leave 400 MM.
• Bank of Japan will get 120 MM.
• That will leave 280 MM.
• Both Merrill Lynch and Morgan Stanley have bid
  5.035.

57
Example (Cont)

• Their total bid is for 350 MM.
• Since only 280 MM is available, pro-rata
  allocation will take place.
• Merrill Lynch will get 3/7 of 280 MM, while
  Morgan Stanley will get 4/7.
• So Merrill Lynch will get 120 MM and Morgan
  Stanley will get 160 MM.

58
Example (Cont)

• The remaining bidders will get nothing.
• They are said to be shut-out.
• The market clearing yield of 5.035 is called the
  stop-out yield.
• All non-competitive bidders will get the
  quantities that they asked for at this yield.

59
Example (Cont)

• Although the remaining bidders have been shut-out
  they can always buy in the secondary market after
  the auction.

60
Discriminatory Yield Auction

• What if the above auction had been conducted on a
  discriminatory yield basis?
• ABC would get 25 MM at 5.010.
• Bank of Japan would get 120 MM at 5.025.
• Merrill Lynch and Morgan Stanley would get 120 MM
  and 160 MM respectively at 5.035.
• The remaining bidders would be shut-out.

61
Discriminatory (Cont)

• All non-competitive bidders would get the
  quantities sought by them at a weighted average
  of the successful bids.
• The average in this case would be
• 25 x 5.010120 x 5.025280 x 5.035
• ___ ___ ____
• 425 425 425
• 5.0307

62
T-bills

• These days all bills are issued in book entry
  form.
• The minimum denomination is 1,000.
• They trade in multiples of 1,000 thereafter.
• They are zero coupon instruments.
• The income for an investor is equal to the
  difference between the price and the face value.

63
T-bills

• As per Federal law the income is treated as
  ordinary income and not as capital gains.
• Income is subject to Federal taxes but is exempt
  from state and local taxes.

64
Calculation of The Discount

• For all calculations involving money market
  instruments the year is assumed to have 360 days.
• Let us use the following symbols
• V Face Value
• Tm Days to Maturity
• d Quoted Yield

65
Price Calculation

• Dollar Discount
• D d x V x

Price P V - D
66
Example

• A bill with a face value of 1,000,000 has 80
  days to maturity.
• The quoted yield is 8.
• D 1,000,000x.08 x

177,77.78 P 1,000,000 177,77.78 982,222.22
67
Rate of Return

• The rate of return if the bill is purchased at
  this price will be greater than the quoted yield.
• R.O.R
• .

8.1448
68
Primary Dealers

• Who is a primary dealer?
• A primary dealer is one who is authorized to deal
  directly with the Federal Reserve Bank of New
  York.
• To qualify as a Primary Dealer the dealer must
  agree to make a market in government securities
  at all times and is required to post a capital of
  50 MM USD.

69
Primary Dealers (Cont)

• More than one-third of all primary dealers are
  controlled by corporation outside the U.S in
  Canada, the U.K. Switzerland, Hong Kong, and
  Japan.
• By getting primary dealer status, these dealers
  get a solid foothold in the U.S.
• There are currently 30 primary dealers.

70
Primary Dealers (Cont)

• In addition to these dealers there are more than
  1500 other dealers who perform a variety of
  dealing and market making functions in the
  Treasury market.
• The primary dealer system was established by the
  Federal Reserve.

71
Primary Dealers (Cont)

• What is the advantage of having primary dealers?
• It enables the central bank to conduct its
  monetary policy efficiently with a small group of
  well capitalized dealers.
• These dealers are expected to participate in
  Treasury auctions, to distribute Treasury issues,
  and to make a market in them.

72
Repos

• A Repo or a repurchase agreement is an
  arrangement that facilitates the borrowing of
  funds by a dealer.
• Under this arrangement the dealer will sell the
  securities to another party with a simultaneous
  commitment to buy it back later at a fixed price
  plus interest.

73
Repos (Cont)

• Thus a repo is a temporary extension of credit
  that is collateralized by marketable securities.
• Dealers routinely take positions in debt
  securities.
• If a dealer anticipates that interest rates will
  fall he will take a long position.

74
Repos (Cont)

• He will either hold the security as an investment
  or else will wait for a client to come along.
• The question is, how will he finance this
  position.
• After all a dealers capital is limited and
  dealers often hold positions that are as high as
  40 times their capital in value.

75
Repos (Cont)

• This is where repos come in.
• Take the case of a dealer who is looking for a 30
  day loan and is willing to pledge T-notes as
  collateral.

76
Repos (Cont)

• Assume that the accrued interest is 205,700.
• The quoted price per 100 of face value is
  100.9375.
• The repo is for 30 days.
• The rate of interest is 9 per annum.
• The haircut is 0.005 price points.

77
Repos (Cont)

• What is this haircut?
• The lender has to protect himself against the
  risk that the market value of the collateral may
  decline.
• Hence he will not lend the full value of the
  collateral but will apply a discount.
• This discount is called a haircut.

78
Repos (Cont)

• The amount that can be borrowed against the
  securities is
• 5,000,000(1.009375 - .005) 205,700
• 5,227,575
• The amount due at maturity is this principal plus
  interest.
• Interest 5,227,575x.09x

39,206.81
79
Repos (Cont)

• Notice that the haircut is applied to the clean
  price and not to the accrued interest.
• This is because the accrued interest is not a
  function of yield.
• During these 30 days there will be fluctuations
  in the value of the collateral.
• These must be regularly monitored to ensure
  adequate collateralization.

80
Types of Repos

• Most repos are done on an overnight basis.
• Typically a dealer will locate a corporation or
  MMMF which has funds to invest overnight.
• Some dealers may also undertake long term
  speculative positions, which consequently need to
  be financed for longer periods.
• Such repos are called Term Repos and carry a
  higher rate of interest.

81
Types of Repos (Cont)

• Some Repos are known as Continuing Contracts.
• They have no explicit maturity date but may be
  terminated at short notice by either party.
• These days repos with bells and whistles are
  available.

82
Types of Repos (Cont)

• In the case of a Dollar repo the borrower can ask
  for a security that is similar to what was sold a
  the outset, but is not necessarily the same.
• In a Flex repo the lender can take back a part of
  the loan whenever required.
• Thus it is like a bank account.

83
Collateral for Repos

• Most repos are collateralized by government
  securities.
• Sometimes other money market instruments like
  commercial paper and BAs may be used.

84
Credit Risk

• In practice both the borrower and the lender are
  subject to credit risk.
• If interest rates rise sharply, the value of the
  collateral will decline and the lender will be
  vulnerable.
• In this case, if the borrower were to go
  bankrupt, the lender will be left with assets
  which may be worth less than the loan amount.

85
Credit Risk

• If interest rates decline the value of the
  collateral will rise.
• Now if the lender goes bankrupt, the borrower
  will be left with an amount that is less than the
  market value of the securities.
• There is no strategy which will reduce the risk
  for both the parties.
• Increasing protection for one means enhanced risk
  for the other.

86
Credit Risk

• The lender can ask for margin.
• What this means is that he can lend less than the
  market value of the assets.
• But this will increase the risk for the borrower.
• The borrower can ask for reverse margin.
• That is, he can ask the lender to lend more than
  the market value of the securities.
• But this will increase the risk for the lender.

87
Credit Risk

• In practice it is the lenders who receive
  margins.
• This is because they are parting with cash which
  is the more liquid of the two assets.
• Thus the market value of the collateral will
  exceed the loan amount.
• The excess is called a Haircut.

88
Haircuts

• The size of the haircut would depend on
• The maturity of the collateral.
• Its liquidity.
• Its price volatility.
• The term to maturity of the repo,
• Creditworthiness of the borrower.

89
Market Risk and Marking to Market

• Market risk is the risk that the value of the
  collateral may decline.
• To reduce market risk, the collateral must be
  periodically marked to market.
• That is the market value of the security should
  be checked to see if it is adequately in excess
  of the loan amount.
• If not more collateral should be asked for.
• Or else a partial return of cash must be demanded.

90
Repos (Cont)

• In the case of an ordinary repo there will be a
  single interest rate that is applicable for the
  duration of the loan.
• In the case of a continuing contract the rate
  will change from day to day.
• The interest will be calculated on a daily basis
  but will be collected at the end.

91
Repos (Cont)

• Such transactions offer a convenient route for
  lenders to park excess funds for short periods.
• From the perspective of the lender such an
  arrangement is called a reverse repurchase
  agreement or a reverse repo.

92
Repos (Cont)

• Thus every repo must be matched by a reverse
  repo.
• Thus a dealer looking to borrow funds will do a
  repo.
• A dealer looking to place funds will do a reverse
  repo.

93
Repos (Cont)

• Who will do a reverse repo?
• A repo will be done by a person who wants to
  finance a long position.
• That is he will buy the security and do a repo
  thereby getting the funds to pay for the long
  position.
• He will have to pay interest on the funds
  borrowed.

94
Repos (Cont)

• However he will be entitled to any coupons and
  accrued interest from the underlying security.
• A dealer who wishes to go short in a debt
  security will borrow and sell it, and will pledge
  the cash proceeds as collateral.
• This will be an example of a reverse repo
  transaction.

95
Repos (Cont)

• In this case the short seller will earn the
  reverse repo rate on the cash proceeds.
• But will be eligible to pay any coupon or accrued
  interest for the period for which he is short.

96
Matched Book

• Some dealers will do a repo for one maturity with
  a party and a reverse repo for another maturity
  with another party.
• They hope to profit from the interest rate
  differential.
• Such dealers are said to be maintaining a matched
  book.

97
Repos (Cont)

• Most government securities can be bought at a
  rate called the general collateral rate.
• Thus most securities are close substitutes for
  each other.
• But sometimes a security may be in high demand.
• If so the lender may charge a lower rate.
• Such rates are called special repo rates.

98
Bankers Acceptances (BAs)

• In international trade when goods are exported
  the exporter will draw up a Draft or a Bill of
  Exchange.
• A Draft is an instrument that instructs the
  importer to pay the amount mentioned upon
  presentation.
• A Draft may be a Sight Draft or a Time Draft.

99
Sight Drafts

• In such cases the importer has to pay for the
  goods on sight of the draft.
• His bank will not release the shipping document
  until he pays.
• Such transactions are known as Documents Against
  Payment transactions.

100
Time Drafts

• These are also known as Usance Drafts.
• The bank will release the shipping documents in
  such cases as soon as the importer accepts the
  draft by signing on it.
• The importer need not pay immediately.
• In other words the exporter is offering him
  credit for a period.
• When the importer accepts a draft it becomes a
  Trade Acceptance.

101
Letters of Credit (LCs)

• Most international transactions are backed by
  LCs.
• An LC is a written guarantee given by the
  importers bank to honour any drafts or claims
  for payment presented by the exporter.
• LC based transactions are more secure.
• Shipments under an LC can be on the basis of a
  sight draft or a time draft.

102
LC Based Transactions

• In the case of a sight draft the importers bank
  will pay on presentation.
• In the case of a time draft it will accept it by
  signing on it.
• A draft that is accepted by a bank is called a
  Bankers Acceptance.
• It is obviously more marketable than a trade
  acceptance.

103
The Market for BAs

• In the U.S. there is an active secondary market
  for BAs.
• They are short term zero coupon assets which are
  redeemed at the face value on maturity
• BAs with a face value of 5MM USD are considered
  to constitute a round lot.

104
The Market for BAs

• Once a BA is issued the exporter can get it
  discounted by the accepting bank.
• That is he can sell it for its discounted value.
• Or he can sell it to someone else in the
  secondary market.

105
The Market for BAs

• The credit risk involved in holding a BA is
  minimal.
• This is because it represents an obligation on
  the part of the accepting bank.
• In addition it is also a contingent obligation on
  the part of the exporter.
• That is if the bank fails to pay, the holder has
  recourse to the exporter who is the drawer of the
  draft

106
Negotiable Certificates of Deposit

• A CD is an instrument issued by a bank in return
  for a time deposit.
• The term negotiable indicates that there is an
  active secondary market where these deposit
  receipts can be bought and sold.
• As per Federal law a CD must have a minimum
  maturity of 7days. There is no ceiling on the
  maturity.
• Most CDs have maturities ranging from one to
  three months.

107
CDs (Cont)

• A CD must be issued at par.
• In practice banks issue many types of CDs.
• A true money market CD must be negotiable, and
  have a denomination of 100,000.
• CDs usually trade in market lots of 1 MM dollars.

108
CDs (Cont)

• Rates are set by negotiations between borrowers
  and lenders and are a reflection of prevailing
  market conditions.
• The concept started in 1961 when Citibank started
  offering this to large corporate customers and
  organized a group of dealers to make a secondary
  market.

109
CDs (Cont)

• The motivation was the following.
• Over a period of time, corporate Treasury
  managers had found that instruments like T-bills
  and repos were excellent short term investments.
• Thus banks which were losing business came up
  with this innovative instrument.

110
CDs

• CDs may be issued in registered form or bearer
  form.
• Those issued in bearer form are more easily
  tradeable.
• Denominations range from 25,000 to
• 10 MM. Most traded CDs have denominations of
  1,000,000.

111
CDs (Cont)

• Maturities can be as long as 18 months.
• Most traded CDs have a maturity of 6 months or
  less.
• CDs with maturities in excess of one year are
  called Term CDs.

112
CDs (Cont)

• CDs issued by large, financially sound banks are
  called Prime CDs.
• Those issued by smaller and less sound banks are
  called Non Prime CDs.
• CDs are insured up to 100,000.
• Buyers include banks, corporations, foreign
  central banks and governments, HNIs and
  institutions.

113
CDs

• Insurance companies. Pensions funds, insurance
  companies, and MMMFs are large buyers.
• They find CDs to be attractive because they are
  liquid, carry low risk and can be issued for any
  desired maturity.

114
CDs (Cont)

• These days floating rate CDs with up to 5 years
  to maturity are available.
• Interest is reset every 30, 90 or 180 days.
• The gap between reset rates is called the leg or
  roll period.

115
CDs

• CDs are interest bearing instruments and not
  discount instruments.
• So to get a certificate with a face value of
  100,000 one has to actually deposit 100,000.
• CDs pay interest on an Actual/360 basis.

116
Example

• Assume that you deposit 1MM USD for 270 days at a
  rate of 10 per annum.
• At maturity you will receive the principal
  plus interest equal to
• 1,000,000x.10x 270
• ------- 75,000
• 360

117
Yields on CDs

• These are a function of demand and supply.
• CDs are not riskless because the issuing bank
  could fail.
• For the issuing bank, the effective cost of the
  CD is greater than the quoted rate of interest
  because of reserve requirements and insurance
  premia.

118
Illustration

• A bank is quoting 8 per annum on a 3 month
  deposit.
• Reserves are 5 and are non-interest bearing.
• So effectively 8 of interest is being offered on
  95 of usable funds.
• Effective rate

8.42
119
Illustration

• The insurance premium is 8.33b.p.
• So the effective cost is
• 8.42 .0833 8.5033

120
Commercial Paper (CP)

• Commercial Paper is a short term unsecured
  promissory note.
• Unsecured means that the loan is not not backed
  by a pledge of assets.
• Thus it is backed only by the liquidity and
  earning power of the borrower.
• CP markets are wholesale because the
  denominations are large.

121
Commercial Paper

• For a large credit worthy issuer CP issues offer
  low cost alternatives to a bank loan.
• Unlike T-Bills CPs carry a risk of default.
• Consequently investors demand higher yields.

122
Sale of Paper

• Most paper is sold through dealers who buy it
  from the issuer and resell it mainly to banks.
• They get a fee for this.
• Dealers also provide advice on what rate to offer
  on newly issued paper.
• Dealers also undertake to buy unsold paper.
• Large and regular issuers of paper often employ
  their own sales force.

123
Rating of Commercial Paper

• Paper is rated by one or more of the following
  main rating agencies in the U.S.
• Moodys
• Standard and Poor
• Duff and Phelps
• Fitch

124
Summary of the Rating Systems
Company Higher A/ Prime Lower A/ Prime Speculative Below Prime Defaulted
Moodys P-1 P-2,P-3 NP NP
SP A-1, A-1 A-2, A-3 B, C D
Duff Phelps Duff-1, Duff-1, Duff-1- Duff-2, Duff-3 Duff-4 Duff-5
Fitch F-1,F-1 F-2,F-3 F-5 D
125
Credit Rating

• We will illustrate using SPs rating scale.
• A-1 strong degree of safety for timely repayment
• A-2 satisfactory degree of safety
• A-3 adequate safety
• B,C risky or speculative
• D default history

126
Credit Rating

• Agencies are paid by the issuers of paper.
• A good rating makes it easier and cheaper to
  borrow
• However rating agencies always look at the issue
  from the perspective of a potential investor.
• This is because their credibility is based on
  their track record from the standpoint of
  accuracy.

127
Evaluation Criteria

• Rating agencies use the following criteria.
• Strong management.
• Good position for the company in a well
  established industry.
• Good earnings record.
• Adequate liquidity.
• Ability to borrow to meet both anticipated and
  unanticipated needs.