6Money Markets

Chapter ObjectivesProvide a background on money market securitiesExplain how institutional investors use money marketsExplain the globalization of money markets

Money Market SecuritiesMaturity of a year or lessDebt securities issued by corporations and governments that need short-term fundsLarge primary market focusPurchased by corporations and financial institutionsSecondary market for securities

Money Market SecuritiesTreasury BillsCommercial paperNegotiable certificates of depositsRepurchase agreementsFederal fundsBankers acceptances

Money Market SecuritiesTreasury billsIssued to meet the short-term needs of the U.S. governmentAttractive to investors Minimal default riskbacked by Federal GovernmentExcellent liquidity for investorsShort-term maturityVery good secondary market

Money Market Securities

Treasury bill auction (fill bids in amount determined by Treasury borrowing needs)Bid process used to sell T-billsBids submitted to Federal Reserve banks by the deadlineBid processAccepts highest bidsAccepts bids until Treasury needs generatedCompetitive Bidding

Money Market Securities

Treasury bill auctionnoncompetitive bids($1 million limit)May be used to make sure bid is acceptedPrice is the weighted average of the accepted competitive bidsInvestors do not know the price in advance so they submit check for full par valueAfter the auction, investor receives check from the Treasury covering the difference between par and the actual priceNoncompetitive Bidding

Money Market SecuritiesEstimating T-bill yieldNo coupon paymentsPar or face value received at maturityYield at issue is the difference between the selling price and par or face value adjusted for timeIf sold prior to maturity in secondary marketYield based on the difference between price paid for T-bill and selling price adjusted for time

Money Market SecuritiesCalculating T-Bill Annualized Yield

YTSP PP PP365 nYT = The annualized yield from investing in a T-bill SP = Selling pricePP = Purchase price n = number of days of the investment (holding period)=

Money Market SecuritiesT-bill yield for a newly issued security

Par PP PP360 nT-bill discount = percent discount of the purchase price from parPar = Face value of the T-bills at maturityPP = Purchase price n = number of days to maturityT-bill discount=

Money Market Securities

Short-term debt instrumentAlternative to bank loanDealer placed vs. directly placedUsed only by well-known and creditworthy firmsUnsecuredMinimum denominations of $100,000Not a large secondary marketCommercial Paper

Money Market SecuritiesCommercial paper backed by bank lines of creditBank line used if company loses credit ratingBank lends to pay off commercial paperBank charges fees for guaranteed line of credit

Money Market SecuritiesEstimating commercial paper yields (same as t-bill)YCPPar PP PP360 nYCP = Commercial paper yieldPar = Face value at maturityPP = Purchase price n = number of days to maturity=

Money Market Securities

Issued by large commercial banksMinimum denomination of $100,000 but $1 million more commonPurchased by nonfinancial corporations or money market fundsSecondary markets supported by dealers in securityNegotiable Certificates of Deposit (NCD)

Money Market SecuritiesNCD placementDirect placementUse a correspondent institution specializing in placementSell to securities dealers who resellSell direct to investors at a higher priceNCD premiumsRate above T-bill rate to compensate for lower liquidity and safety

Money Market Securities

Sell a security with the agreement to repurchase it at a specified date and priceBorrower defaults, lender has securityReverse repo name for transaction from lenderNegotiated over telecommunications networkDealers and brokers used or direct placementNo secondary marketRepurchase Agreements

Money Market SecuritiesEstimating repurchase agreement yieldsRepo RateSP PP PP360 nRepo Rate = Yield on the repurchase agreementSP = Selling pricePP = Purchase price n = number of days to maturity=

Exhibit 6.5a

Money Market Securities

A bank takes responsibility for a future payment of trade bill of exchangeUsed mostly in international transactionsExporters send goods to a foreign destination and want payment assurance before sendingBank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific timeBankers Acceptance

Money Market Securities

Exporter can hold until the date or sell before maturityIf sold to get the cash before maturity, price received is a discount from drafts totalReturn is based on calculations for other discount securities Similar to the commercial paper exampleBankers Acceptance

Major Participants in Money MarketParticipantsCommercial banksFinance, industrial, and service companiesFederal and state governmentsMoney market mutual fundsAll other financial institutions (investing)Short-term investing for income and liquidityShort-term financing for short and permanent needsLarge transaction size and telecommunication network

Valuation of Money Market SecuritiesPresent value of future cash flows at maturity (zero coupon)Value (price) inversely related to discount rate or yieldMoney market security prices more stable than longer term bondsYields = risk-free rate + default risk premium

Exhibit 6.7a

Interaction Among Money Market YieldsSecurities are close investment substitutesInvestors trade to maintain yield differentialsT-Bill is the benchmark yield in money marketYield changes in T-bills quickly impacts other securities via dealer tradingYield differentials determined by risk differences between securitiesDefault risk premiums vary inversely with economic conditions

Globalization of Money MarketsMoney market rates vary by countrySegmented marketsTax differencesEstimated exchange ratesGovernment barriers to capital flowsDeregulation Improves Financial IntegrationCapital Flows To Highest Rate of Return

Globalization of Money MarketsPerformance of international securitiesEffective yield for international securities has two componentsThe yield earned on the investment denominated in the currency of the investmentThe exchange rate effect

Globalization of Money MarketsPerformance of international securitiesYield for an international investment YfSPf PPf PPfYf = Foreign investments yieldSPf = Investments foreign currency selling pricePPf = Investments foreign currency purchase=

Globalization of Money MarketsThe exchange rate effect (%S) measures the percentage change in the spot during the investment period

% S measures the expected percent change in the currencyCurrency appreciated, % S is positive and adds to net yieldCurrency depreciated, % S is negative and reduces net yield