5-1McGraw-Hill/Irwin

Chapter FiveMoney Markets

5-2

Money Markets

• Liquid funds flow between short-term borrowers and lenders through money markets

• Money markets involve debt instruments with original maturities of one year or less

• Money market debt– issued by high-quality (i.e., low default risk) economic units that

require short-term funds– purchased by economic units that have excess short-term funds– low rates of return

• Money market instruments have active secondary markets which provides liquidity

• Liquid funds flow between short-term borrowers and lenders through money markets

• Money markets involve debt instruments with original maturities of one year or less

• Money market debt– issued by high-quality (i.e., low default risk) economic units that

require short-term funds– purchased by economic units that have excess short-term funds– low rates of return

• Money market instruments have active secondary markets which provides liquidity

Money Market Yields Money Market Yields

• Money market securities use special rate quoting conventions:– Discount yields (idy): Interest rate is quoted on an annual basis

assuming a 360 day year as a percent of redemption price or face value– Single payment yields (ispy): Interest rate is quoted on an annual basis

assuming a 360 day year as a percent of purchase price

• Both may be converted to a bond equivalent yield (ibey) for comparison with bonds

• Money market securities use special rate quoting conventions:– Discount yields (idy): Interest rate is quoted on an annual basis

assuming a 360 day year as a percent of redemption price or face value– Single payment yields (ispy): Interest rate is quoted on an annual basis

assuming a 360 day year as a percent of purchase price

• Both may be converted to a bond equivalent yield (ibey) for comparison with bonds

5-4

Money Market Yields

• Treasury bills and commercial paper are bought and sold on a discount basis

• Discount yields (idy) use a 360-day year

Pf = the face value of the security

P0 = the discount price of the securityh = the number of days until maturity

• Treasury bills and commercial paper are bought and sold on a discount basis

• Discount yields (idy) use a 360-day year

Pf = the face value of the security

P0 = the discount price of the securityh = the number of days until maturity

hP

PPi

f

f

dy

360)( 0

5-5

Money Market Yields

• Compare discount securities to U.S. Treasury bonds with bond equivalent yields (ibey)

• Convert bond equivalent yields into effective annual returns (EAR)

• Compare discount securities to U.S. Treasury bonds with bond equivalent yields (ibey)

• Convert bond equivalent yields into effective annual returns (EAR)

hP

PPi fbey

365)(

0

0

1365

1/365

h

bey

hiEAR

Example: T-Bill

Face value = $10,000; Maturity = 73 days; Sells for $9,800• Discount yield:

Period yield = (10,000-9,800)/10,000 = 2%

Annualized = 2% x 360/73 = 9.863%• Bond Equivalent Yield:

Period yield = (10,000 – 9,800)/9,800 = 2.0408%

Annualized = 2.0408% x 365/73 = 10.2041%• Effective Annual Yield:

= (1 + 2.0408%)365/73 - 1 = 10.6292%

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5-7

Money Market Yields

• Money market securities (Negotiable or jumbo)CDs and fed funds that pay interest only at maturity use single-payment yields (ispy) (e.g., jumbo CDs and fed funds)

– since ispy uses a 360 day year, compare to bonds by converting to a 365 day year

– to directly convert a single-payment yield to an effective annual return

• Money market securities (Negotiable or jumbo)CDs and fed funds that pay interest only at maturity use single-payment yields (ispy) (e.g., jumbo CDs and fed funds)

– since ispy uses a 360 day year, compare to bonds by converting to a 365 day year

– to directly convert a single-payment yield to an effective annual return

)360/365(spybey ii

1360

1/365

h

spy

hiEAR

Example: CD Yield

• Face: 10,000; maturity 73 days; pays 6% • Interest for the period = 6%x73/360=1.22% or $

21.67 • Bond Equivalent Yield:

= 6% x 365/360 = 6.0833%• Effective Annual Yield

Note: no of periods/year = 365/73 = 5

= (1 + 1.22%)5 - 1 = 6.2332%

5-8

Money Market YieldsMoney Market Yields

• Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (ispy)

– to convert a single-payment yield to a bond equivalent yield:

– to directly convert a single payment yield to an EAR:

• Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (ispy)

– to convert a single-payment yield to a bond equivalent yield:

– to directly convert a single payment yield to an EAR:

)360/365(spybey ii

1/365

360/3651

/365

h

spy hiEAR

hP

PPi fspy

360)(

0

0

Sample Calculations of Money Sample Calculations of Money Market YieldsMarket Yields

• A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the commercial paper:

• The bond equivalent yield for the commercial paper is 2.038%

• A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the commercial paper:

• The bond equivalent yield for the commercial paper is 2.038%

hP

PPi

f

f

dy

360)( 0

$995,000P;90

360

$1M

)P($1M0.02 0

0

hP

PPi fbey

365)(

0

0

2.038%90

365

$995,000

$995,000)($1Mibey

Sample Calculations of Money Sample Calculations of Money Market YieldsMarket Yields

• A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the CD:

• The bond equivalent yield for the CD is 2.0278%

• The commercial paper has the better return since its bond equivalent yield is 2.038%

• A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the CD:

• The bond equivalent yield for the CD is 2.0278%

• The commercial paper has the better return since its bond equivalent yield is 2.038%

)360/365(spybey ii %.)/(.ibey 02782360365020

5-12

Money Market Instruments

• Treasury bills (T-bills)

• Federal funds (fed funds)

• Repurchase agreements (repos or RP)

• Commercial paper (CP)

• Negotiable certificates of deposit (CD)

• Banker acceptances (BA)

• Treasury bills (T-bills)

• Federal funds (fed funds)

• Repurchase agreements (repos or RP)

• Commercial paper (CP)

• Negotiable certificates of deposit (CD)

• Banker acceptances (BA)

5-13

Treasury Bills (T-Bills)

• T-Bills are short-term debt obligations issued by the U.S. government

• The Federal Reserve buys and sells T-bills to implement monetary policy

• T-bills are virtually default risk free, are highly liquid, and have little interest rate risk

• Strong international demand for T-bills as safe haven investment

• T-Bills are short-term debt obligations issued by the U.S. government

• The Federal Reserve buys and sells T-bills to implement monetary policy

• T-bills are virtually default risk free, are highly liquid, and have little interest rate risk

• Strong international demand for T-bills as safe haven investment

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T-Bill Auctions

• 13- and 26-week T-bills are auctioned weekly• Bids are submitted by government securities

dealers, financial and nonfinancial corporations, and individuals

• Bids can be competitive or noncompetitive– competitive bids specify the bid price and the desired

quantity of T-bills– noncompetitive bidders get preferential allocation and

agree to pay the lowest price of the winning competitive bids

• 13- and 26-week T-bills are auctioned weekly• Bids are submitted by government securities

dealers, financial and nonfinancial corporations, and individuals

• Bids can be competitive or noncompetitive– competitive bids specify the bid price and the desired

quantity of T-bills– noncompetitive bidders get preferential allocation and

agree to pay the lowest price of the winning competitive bids

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Quantity ofT-bills

Bid Price 1

2

3

4

5

6

7

SC ST

Noncompetitive Bids

Stop-outprice (PNC)

T-Bill AuctionsT-Bill Auctions

5-16

5-17

The Secondary Market for T-Bills

• The secondary market for T-bills is the largest of any U.S. money market instrument

• 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market– primary dealers trade for themselves and for customers

– T-bill purchases and sales are book-entry transactions conducted over Fedwire

• T-Bills are sold on a discount basis

• The secondary market for T-bills is the largest of any U.S. money market instrument

• 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market– primary dealers trade for themselves and for customers

– T-bill purchases and sales are book-entry transactions conducted over Fedwire

• T-Bills are sold on a discount basis

Transaction Between Primary Dealers

5-18

J.P. Morgan Chase Sell $10 million in T-Bills

Lehman Brothers Buy $10 million in T-Bills

Federal Reserve Bank of NYTransfers $10 million from Chase to Lehman

Transaction Recorded in Fed’s Book Entry System

Fedwire

Interbank Transaction

Fedwire

Purchase by Individual

5-19

Individual Buy $50,000 in T-Bills

Local Bank or Broker

Primary DealerJP Morgan ChaseSells $50,000 in T-Bills

FRBNY-$50,000 in T-Bills from JP Morgan+ $50,000 in T-Bills to Individual

Fedwire

Wire Transfer

Engraved T-Bill

Engraved T-Bill

5-20

T-Bill Prices

• T-Bill prices can be calculated from quotes (e.g., from The Wall Street Journal) by rearranging the discount yield equation

• Or by rearranging the bond equivalent yield equation

• T-Bill prices can be calculated from quotes (e.g., from The Wall Street Journal) by rearranging the discount yield equation

• Or by rearranging the bond equivalent yield equation

fdyf P

hiPP

3600

3651

0 hi

PP

bey

f

Example: T-Bill Prices

• 30 days TB, Face value=$10,000, sells at 6%

• Price?

= $10,000 - $10,000 x 6% (30/360)

= $9,950

5-21

5-22

Federal Funds

• The federal funds (fed funds) rate is the target rate in the conduct of monetary policy

• Fed fund transactions are short-term (mostly overnight) unsecured loans

• Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds

• Fed funds are single-payment loans and thus use single-payment yields

• Multimillion dollar loans may be arranged in a matter of minutes

• The federal funds (fed funds) rate is the target rate in the conduct of monetary policy

• Fed fund transactions are short-term (mostly overnight) unsecured loans

• Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds

• Fed funds are single-payment loans and thus use single-payment yields

• Multimillion dollar loans may be arranged in a matter of minutes

FEDERAL FUNDS TRANSACTIONS

5-23

J.P. Morgan ChaseLends (Sell) $75 million in Federal Funds

Bank of AmericaBorrows (Buy) $75 million in Federal Funds

Fedwire

FRBNYToday:Takes $75 mil. From reserve account of JPM------------------------------Tomorrow:Adds $75 mil. plus one day’s interest to JPM account

FRB of San FranciscoToday:Adds $75 mil. To reserve account of BOA------------------------------Tomorrow:Takes $75 mil. plus one day’s interest from BOA account

Fedwire

5-24

Repurchase Agreement

• A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future

• Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities)– Similar to a fed fund loan, but collateralized

– Funds may be transferred over FedWire system

– If collateralized by risky assets, the repo may involve a ‘haircut’

• A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future

• Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities)– Similar to a fed fund loan, but collateralized

– Funds may be transferred over FedWire system

– If collateralized by risky assets, the repo may involve a ‘haircut’

Repurchase AgreementRepurchase Agreement

• Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations

• A reverse repurchase agreement is the opposite side of a repo (i.e., it is the purchase of a security with an agreement to sell it back in the future)

• Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations

• A reverse repurchase agreement is the opposite side of a repo (i.e., it is the purchase of a security with an agreement to sell it back in the future)

5-26

Repurchase Agreement

• The yield on repurchase agreements (iRA) uses a 360-day year like the discount rate, but uses the current price in the denominator like the bond equivalent yield

Pf = the repurchase price of the security

P0 = the selling price of the securityh = the number of days until the repo matures

• The yield on repurchase agreements (iRA) uses a 360-day year like the discount rate, but uses the current price in the denominator like the bond equivalent yield

Pf = the repurchase price of the security

P0 = the selling price of the securityh = the number of days until the repo matures

hP

PPi f

RA

360)(

0

0

Repurchase Agreement

5-27

J.P. Morgan ChaseBuys $75 million Repo

Bank of AmericaSells $75 million Repo

Fedwire

FRBNYToday:-$75 mil. reserve account of JPM+ $75 mil to T-Bill account of JPM------------------------------Tomorrow:+ $75 mil. plus one day’s interest to JPM reserve a/c- $75 mil to T-Bill account of JPM

FRB of San FranciscoToday:+$75 mil. reserve account of BOA- $75 mil to T-Bill account of BOA------------------------------Tomorrow:- $75 mil. plus one day’s interest to BOA reserve a/c+ $75 mil to T-Bill account of BOA

Fedwire

5-28

Commercial Paper

• Commercial paper (CP) is the largest money market in terms of dollars outstanding

• CP is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital)

• Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days

• CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time)

• CP is usually held by investors until maturity and has no active secondary market

• Yields are quoted on a discount basis (like T-bills)

• Commercial paper (CP) is the largest money market in terms of dollars outstanding

• CP is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital)

• Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days

• CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time)

• CP is usually held by investors until maturity and has no active secondary market

• Yields are quoted on a discount basis (like T-bills)

Asset-Backed Commercial PaperAsset-Backed Commercial Paper

• A type of commercial paper that is backed by assets of the issuing firm

• Grew very rapidly prior to the financial crisis peaking at $2.16 trillion, much of it was backed by mortgage investments

• The market collapsed during the financial crisis

• A type of commercial paper that is backed by assets of the issuing firm

• Grew very rapidly prior to the financial crisis peaking at $2.16 trillion, much of it was backed by mortgage investments

• The market collapsed during the financial crisis

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Negotiable Certificate of Deposit

• A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date

• CDs are bearer instruments and thus are salable in the secondary market

• 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

• A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date

• CDs are bearer instruments and thus are salable in the secondary market

• 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

5-31

Banker’s Acceptance

• A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank

• Used in international trade transactions 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 payment guarantors before sending goods to importers

• Banker’s acceptances are bearer instruments and thus are salable in secondary markets

• A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank

• Used in international trade transactions 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 payment guarantors before sending goods to importers

• Banker’s acceptances are bearer instruments and thus are salable in secondary markets

5-32

U.S. buyer (importer)

Chinese seller(exporter)

U.S. bank (importer’s bank)

Chinese bank (exporter’s bank)

1

7

6

4

22 99 55 88331010

1 Purchase order sent by U.S. buyer to Chinese seller2 Chinese seller requests a letter of credit3 Notification of letter of credit and draft authorization4 Order shipped5 Time draft and shipping papers sent to Chinese seller’s bank6 Time draft and shipping papers sent to U.S. bank; banker’s acceptance created7 Payments sent to foreign bank (immediately if Chinese seller wishes to discount the draft and collect immediately, at maturity if not)8 Payments sent to Chinese seller (see #7)9 Payment to U.S. bank by U.S. buyer at maturity, paid in full10 Shipping papers delivered

Creation of a Banker’s Acceptance

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Money Market Participants

• The U.S. Treasury• The Federal Reserve• Commercial banks• Money market mutual funds• Brokers and dealers• Corporations• Other financial institutions• Individuals

• The U.S. Treasury• The Federal Reserve• Commercial banks• Money market mutual funds• Brokers and dealers• Corporations• Other financial institutions• Individuals

2011 Money Market Yields2011 Money Market Yields

InstrumentFederal Funds*

CommercialPaper CDs Euro CP

Rate 0.11% 0.17% 0.23% 1.18%

Instrument LIBORBanker’s

AcceptancesEuro$ Repo*

Rate 0.27375% 0.22% 0.25% 0.08%

InstrumentTreasury

Bills**Inflation***    

Rate 0.060 2.7%    

Data from the Wall Street Journal Online Money Rates Section April 2011. Rates are for 3 month maturities except as noted.* Overnight; ** 13 week, *** Year over year, all items as measured by the CPI

Rates for maturities of 3 months - November 2004

5-37

InstrumentFederal Funds*

CommercialPaper CDs Euro CP

Rate 2.06% 2.38% 3.03% 4.69%

Instrument LIBORBanker’s

Acceptances Euro$ T–bill**Rate 2.71875% 2.75% 2.70% 1.80%

Money Market Securities OutstandingMoney Market Securities Outstanding

  Billions $Instrument 1990 2004 2007 2010Treasury Bills $ 527 $ 982 $1,010 $1,856Fed funds & Repos 372 1,585 2,731 1,656Commercial Paper 538 1,310 2,109 1.083Negotiable CDs 547 1,379 2,149 1,822Banker's Acceptances 52 4 1 1 Total $2,036 $5,260 $8,000 $6,418           % of Total in Given YearInstrument 1990 2004 2007 2010Treasury Bills 26% 19% 13% 29%Fed funds & Repos 18% 30% 34% 26%Commercial Paper 26% 25% 26% 17%Negotiable CDs 27% 26% 27% 28%Banker's Acceptances 3% 0.1% 0.0% 0.0%  100% 100% 100% 100%Source: Text

International Money MarketsInternational Money Markets

• U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market

• The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR)

• Eurodollar Certificates of Deposit are U.S. dollar-denominated CDs held in foreign banks

• Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

• U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market

• The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR)

• Eurodollar Certificates of Deposit are U.S. dollar-denominated CDs held in foreign banks

• Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

International Money MarketsInternational Money Markets

PROBLEMS

5-41

5-42

Discount yield: idy = (($1m. - $973,750)/$1m.)(360/65) = 14.538%

Bond equivalent yield: ibey = (($1m. - $973,750)/$973,750)(365/65) = 15.138%

EAR: EAR = (1 + .15138/(365/65))365/65 - 1 = 16.111%

5-43

• The nominal bond equivalent yield is calculated as

ibey = 6.56%(365/360) = 6.651%

• The EAR on the CD is calculated as

EAR = (1 + (.06651)/(365/115))365/115 - 1 = 6.804%

5-44

a. The yield on this repo to the bank is calculated as follows

iRA = $25,000,000 - $24,950,000 x 360 = 10.31%

$24,950,000 7b. The yield on this repo to the bank is calculated as follows

iRA = $25,000,000 - $24,950,000 x 360 = 3.44%

$24,950,000 21

5-45

The return on the commercial paper is calculated as

icp(dy) = $500,000 - $495,000 360 = 8.00%

$500,000 45And

icp(bey) = $500,000 - $495,000 365 = 8.19%

$495,000

45

5-46

a. Before the rate change, the CD holder will receive FV = $500,000 (1 + .055/3) = $509,167in four months in exchange for $500,000 deposited in the bank today.

Immediately after the market rate on the CD rises to 6 percent, the CD value decreases to PV = 509,167/(1 + .06/3) = $499,183.33

b. Immediately after the market rate on the CD falls to 5.25 percent, the CD value decreases to PV = 509,167/(1 + .0525/3) = $500,409.83

5-47

5-48