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Money Markets

• Defined - The market in which debt (fixed income) instruments with maturities less than one year are traded

• Function - They exist because, for most entities, revenues and expenditures do not occur simultaneously. Additionally, there is an opportunity cost associated with holding cash in the form of currency.

• Example - Counties collect property taxes in November but they have expenditure needs throughout the year.

• Result - They facilitate the transfer of short-term excess funds from suppliers to borrowers

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Money Market Securities

• Key Characteristics

– Maturities less than one year• Short duration of securities limits their potential for price volatility

– Generally traded in large denominations• “Round-lot” is considered $1 million or more

– Typically high credit quality (low default risk)• A short-term rating of A1 / P1 or better

– Traded on an over- the-counter (OTC) market

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“Investment Grade” Ratings - S&P

Rating Definition

AAA Highest rating; extremely strong security.

AA Very strong security; differs from AAA in only a small degree.

A Strong capacity but more susceptible to adverse economic effects than two above categories.

BBB Adequate capacity but adverse economic conditions more likely to weaken capacity.

Long-Term Ratings

Rating Definition

A-1+ Highest degree of safety.

A-1 Very strong degree of safety.

A-2 Strong degree of safety.

A-3 Satisfactory degree of safety.

Short-Term Ratings

Source: Wells Capital Management – Guideline development presentation

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Correlation between Long-term & Short-term ratings - S&P

AAA

AA+

AA A-1+

AA-

A+ A-1

A

A-

BBB+ A-2

BBB

BBB- A-3

BB+

BB B

BB-

Long-term rating Short-term rating

Source: Wells Capital Management – Guideline development presentation

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Common money market instruments

• Treasury Bills

– Short-term obligations issued by the U.S. government

– Issued via a weekly auction• The bid process has competitive and non-competitive components

– Issued in 3 and 6 month maturities• Until recently there was issued a 1 year T-Bill

– Considered to be “risk-free”

– Quoted on a discount basis• Discount YieldT-Bill = ((PF - PO)/PF) X (360/days)

• 6.92% = ((10,000 - 9,650)/10,000) X (360/182)

– Translation to a bond equivalent yield (BEY)• BEYT-Bill = ((PF - PO)/PO) X (365/days)

• 7.27% = ((10,000 - 9,650)/9,650) X (365/182)

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Treasury Market Snapshot - 02/09/04

Source: Bloomberg

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Common money market instruments

• Federal Funds (Fed Funds)

– Short-term funds transferred between financial institutions• Commercial banks are the primary participants in the Fed Funds market

– Borrowing & lending excess reserves that they have at the Fed

– Maturity is usually one to seven days

– Pay interest once, at maturity

– Quoted on a 360 day basis• Translation to a bond equiv yield is: FFbey = iFF (365/360)

– A 6% fed funds interest rate equates to a 6.083% bond equivalent yield

– Generally, the Fed Funds rate revolves around the “target” rate set by the Federal Reserve

• Fed maintains the Fed Funds rate around the target rate through the open market operations discussed in previous lecture

8Source: Bloomberg

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Common money market instruments

• Repurchase Agreements (Repo)

– An agreement involving the sale of securities by one entity to another with a promise to repurchase the securities at a specified price and date

• Reverse repurchase agreements (Reverse repo)

– An agreement involving the purchase of securities by one entity from another with the promise to sell them back at a specified price and date

• These are different sides of the same transaction

– Title to the securities trades hands for the period of the transaction

– Federal Reserve uses repo to conduct its open market operations

– iRA = ((PF - PO)/PO) X (360/days)

– 6.15% = ((10,008,548 - 10,000,000)/10,000,000) X (360/5)

– 6.24% BEY = ((10,008,548 - 10,000,000)/10,000,000) X (365/5)

– Repo less liquid than fed funds because collateral needs to be arranged

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Common money market instruments

• Commercial Paper– Short-term unsecured promissory notes issued by corporations– Largest money market instrument in terms of $’s outstanding– Maturities range from 1 to 270 days

• Corporate debt longer than 270 days requires SEC registration

– Distributed directly from issuer to investor or through a dealer• Less expensive for the issuer to directly place but• Dealers provide “firm commitment underwriting” to place entire issue• Distribution via electronic interfaces is becoming more common

– Issuers of CP and investors in CP are very sensitive to credit quality– Quoted on a discount basis

• Discount YieldCP = ((PF - PO)/PF) X (360/days)• 6.92% = ((10,000 - 9,650)/10,000) X (360/182)

– Translation to a bond equivalent yield (BEY)• 7.27% BEY = ((10,000 - 9,650)/9,650) X (365/182)

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Commercial Paper Distribution

Source: Federal Reserve Board website

Dealer vs. Direct Placement1991-1999

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Commercial Paper Yields

Source: Federal Reserve Board website

CP vs. “Prime Rate”1971 - 1999

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Goldman Sachs Commercial Paper Inventory - 2/3/03

Source: Bloomberg

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Common money market instruments

• Asset-backed commercial paper

– Fast growing sector of the commercial paper market

– Instead of being unsecured, this type of commercial paper has various forms of collateral “backing it up”

– Quoted on a discount basis• See notes on Treasury bills and commercial paper

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Common money market instruments

• Negotiable Certificates of Deposit (NCD’s)

– Bank-issued time deposit with a specified interest rate and maturity

– NCD’s are bearer instruments• The holder at maturity receives the principal & interest

– Became negotiable (“tradeable”) in the 1960’s

– Yields are quoted on a 360 day basis

– Yield calculation• $1 million, 6 month, 7 percent interest rate

– FV = $1,000,000 x (1 + (.07 x (180/360))) = $1,035,000

• Immediately after purchase, yields drop to 6 percent for the same CD– PV = $1,035,000 / (1 + (.06 x (180/360))) = $1,004,854

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Common money market instruments

• Bankers Acceptances (BA’s)– A time draft payable to a seller of goods, with payment guaranteed by

a bank.• Exporter wants a guarantee it will be paid if it ships an order to an

importer• US Bank writes letter of credit covering the importer

– Exporter takes the credit risk of the bank, not the importer

• Exporter can hold the BA for payment in full on the specified date or sell it for a discounted cash payment immediately

• The buyer of the BA gets the par value at maturity– BA’s are bearer instruments

– Majority of BA’s are originated in New York, Chicago, San Fran– Yields are quoted on a discount basis

• See notes on Treasury bills or commercial paper

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Money Market Participants

• Treasury

– Issues treasury notes and bills to fund short-term expenditure needs

• Federal Reserve

– Buys/Sells treasuries and repos to conduct open market operations

• Commercial Banks

– Money market participation driven largely by reserve requirements• If a bank is short on reserves it issues money market securities• If a bank has excess reserves it invests in money market securities

• Broker / Dealers

– Link buyers and sellers of money market instruments

• Corporations

– Use money markets to raise cash for short-term operational needs

• Other financial institutions

– Invest in money market securities to maintain large, liquid cash pools

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International Aspects of Money Markets

• London Interbank Offered Rate (LIBOR)

– The rate paid on Eurodollars

– Alternative to Fed Funds for short-term (overnight) funding• As a result, LIBOR and Fed Fund rate movements are closely correlated

• Typical spread between LIBOR and Fed Funds is .125%

• LIBOR typically higher than Fed Funds because of perceived credit risk

• Other international money market securities

– Euro CD’s

– Euro Notes

– Euro Commercial Paper

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Capital Markets revisited

• Capital Markets

– Securities with maturities longer than one year

– Composed of:• Bond market

• Asset-backed market

• Equity market

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Bond Markets

• Defined - The market in which debt (fixed income) instruments with maturities greater than one year are issued and traded

• Result - They facilitate the transfer of excess funds from suppliers to borrowers

• Traditionally categorized as follows:

– Treasuries

– Municipal bonds

– Corporate bonds

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Bond Market Instruments

• Treasury notes and bonds

– Backed by the full faith and credit of the U.S. government

– Note maturities range from 2 - 10 years

– Bond maturities range from 10 - 30 years

– Pay interest semi-annually

– Primary issuance via an auction process• Competitive and noncompetitive bids (like T-bills)

– Broker / Dealers maintain a very liquid secondary market• Minimum denomination is $1000

• Treasury STRIPS (Separate Trading of Registered Interest & Principal Securities)

– Process whereby the coupon payments and the final principal payment of a bond are separated into individual securities

– Dealers initiated this process in 1985 to better meet investors needs and to enrich themselves

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Present Value Example

Source: Financial Markets & Institutions – Saunders/Cornett

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Bond Market Instruments

• Municipal Bonds

– Securities issued by state and local governments• General obligation bonds

– Bonds backed by the full faith and credit of the issuing municipality

• Revenue bonds– Bonds sold to finance a specific revenue-generating project and are backed

by cashflows from that project

– The majority of municipal issuance:• Is exempt from Federal taxes

– Some bonds are also exempt from State taxes

• Pays interest semi-annually

– Taxable equivalent yield calculation• Tax Equiv Yield = Tax Exempt Yield / ( 1 - Tax Rate )

• 2.31% = 1.50% / ( 1 - .35 )

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Municipal Bond Example

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Municipal Bond Example

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Municipal Bond Yield Example

4.52% Yield if called on 6/1/03

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Bond Market Instruments

• Corporate Bonds

– Debt issued by corporations• Term bonds - a bond issue in which the entire issue matures on one date

• Serial bonds - bonds that mature in a series of dates

• Mortgage bonds - bonds issued to finance a specific project, the project gets pledged as collateral for the bond issue

• Equipment Trust Certificates - bonds collaterized with tangible non-real estate property (e.g. - railcars, airplanes)

• Debentures - unsecured debt

• Subordinated debentures - unsecured debt that are junior in rights to mortgage bonds and debentures

• Convertible bonds - bonds that may be exchanged for another security of the issuing firm at the discretion of the bond holder

• Callable bonds - bonds that allow the issuer to force the bond holder to sell the bond back to the issuer at a specified price

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Present Value Example

Source: Financial Markets & Institutions – Saunders/Cornett

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Valuation and Accruals

• Bond valuation

– Vb = PVdisc coups + PVdisc principal

• Accrued interest calculation

– Par x (Coup/2) x (Days since last coup / Days in coup period)

– $1000 x (5%/2) x (21days / 181days) = $2.90