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The Money Market
1Copyright 2013 Diane Scott Docking
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Copyright 2013 Diane Scott Docking 2
The Money Markets Defined
The term “money market” is a misnomer. Money (currency) is not actually traded in the money markets. The securities in the money market are short term with high liquidity; therefore, they are close to being money.
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Copyright 2013 Diane Scott Docking 3
Money Market Securities’ Characteristics
Maturity of ______________ from their ________ date.
Large primary market focus Secondary market for securities
Money market securities are usually sold in ________ denominations.
They have ______ default risk.
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Money Market Instruments
1. Treasury Bills
2. Federal Funds
3. Repurchase Agreements
4. Commercial Paper
5. Negotiable Certificates of Deposit
6. Banker’s Acceptance
7. Eurodollars
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Treasury Bills
Issued to meet the short-term needs of the
_____________________ Standard Original Maturities of 4 weeks, 13 weeks
(three month), 26 weeks (six month), or 52 weeks Denominations are $1,000; typical round lot is $5
million Virtually default risk free Interest earned is at state and local
government level.
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Treasury Bills (continued)
______________ security do not make periodic interest payments. Instead, the security holder receives interest at the maturity date, the interest being the difference between face value (maturity value or par value) and the purchase price
6
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T-Bill Quote Example:
As of July 29, 2013:
Maturity Bid Asked Chg Asked Yield
02/06/2014 0.055 0.050 -0.005 0.051
Quote is end of day 07/29/2013, assume 2 days to settle (this can vary) so day 1 = 7/31/2013…02/06/2014 is last trading day. So 191 days to maturity.
http://online.wsj.com/mdc/public/page/2_3020-treasury.html?mod=mdc_bnd_pglnk
Discount Rate Bond Equivalent Yield
Change from yesterday’s closing Ask Yield
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Treasury Bills Facts
- what dealers will pay for security (or what investors can sell it for)
- what dealers will sell security for (or what investors can buy it for)
- is the dealers profit or markup Bid price Ask price Spread is _____ in T-Bill market because market is so deep
Bid-ask quotes for T-bills are bid yields and ask yields- Bid yields Ask yields- As yields , prices
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Calculating Yields/Prices on U.S. Treasury Bills
Treasury bills are priced on a discount rate basis, idy or DR, is:
maturity todays PriceFaceDiscount : where
360
Face
DiscountDR
n
ndyi
360 FaceDiscount :where
Discount FacePrice
nidy
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Calculating Yields/Prices on U.S. Treasury Bills The Wall Journal lists T-Bill yields on a bond equivalent basis (asked yield)
The effective annual return
Relationship between DR and Asked Yield (ibey):
nibey
365
Price
Discount yield Asked
1Price
Face1
3651
365365
nnbey
eff n
iiEAR
nDR
DRibey
360
365
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Copyright 2013 Diane Scott Docking 11
Wall Street Journal Example:
Cost to buy $1,000,000 of T-bills:
Ask Yield calculation:
Effective Return calculation:
2$999,734.7
28.265 000,000,1Price
28.265$360
1910005. $1,000,000Discount
0.051%% 0507083.0000507083.191
365
999,734.72
265.28bey
%0507144.01999,734.72
1,000,000 191365
EAR%0507144.01191365
000507083.1
191365
EAR
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Problem: T-bill
You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? Ask Yield? Effective Annual Return?
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Solution to Problem: T-bill
What is its discount rate?
nx
F
PFidiscount
360
__________28
360
000,1
37.996000,1
xidiscount
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Solution to Problem: T-bill
What is its ask yield (or bond equivalent yield)?
iyt F P
P
365
n
_____________28
365
37.996
37.996000,1
xiyt
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Solution to Problem: T-bill
What is its effective annual return?
1Price
Face365
n
effiEAR
__________1996.37
1,000 28365
effiEAR
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T-Bill Auction
All non-competitive bids accepted. Specify quantity only. Maximum bid . Price is the competitive auction yield price.
Investors do not know the price in advance so they submit check for full par value
After the auction, investor receives check from the Treasury covering the difference between par and the actual price
Noncompetitive Bidding
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T-Bill Auction
Specify price (as a yield %) and quantity desired. Minimum purchase $1,000 Single price auction used since 1998 Treasury accepts highest bids prices (lowest bid yields) Maximum amount sold to any one buyer is 35% of
offering amount
Competitive Bidding
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http://www.treasurydirect.gov/instit/annceresult/press/preanre/2012/R_20120730_2.pdf
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Treasury Bill Auction Results (M&E 7ed, Ch.11)
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Treasury Bills Rates (M&E, 7ed Ch. 11)
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Example of a T-Bill Auction
The Treasury is auctioning off $120 million in 13-week (91 day)
T-bills. The following bids are received:
Noncompetitive bids: $10 million
Competitive bids:
Alpha Institution $42 mill. 4.000% bid yield
Delta Institution $10 mill. 4.200% bid yield
Gamma Fund $20 mill. 4.250% bid yield
Beta Fund $18 mill. 4.110% bid yield
Epsilon Fund $40 mill. 4.200% bid yield
Chi Institution $10 mill. 4.125% bid yield
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Example of a T-Bill Auction (cont.)
1. Which institutions will have their bids filled? By how much?
2. What is the “stopout rate” or “stop yield” or “high yield”? 3. What was the price paid by the winning bidders?4. What is the $ amount of the funds received by the
Treasury?5. What is the bank equivalent yield (i.e. ask yield)?6. What is the Treasury’s annualized interest cost from this
auction (i.e., effective yield)?
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Example of a T-Bill Auction (cont.)
1. Maximum bid amount = 35% x $120 million = $42 million
Amount available after non-competitive bids of $10 mill. filled = $110 million
2.
3.
Bidder Bid Price $ Amount Bid Running Balance
Alpha 4.000%
Beta 4.110%
Chi 4.125%
Delta 4.200%
Epsilon 4.200%
Gamma 4.250%
______1.061667 001Price 1.061667360
910420. 100Discount
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Example of a T-Bill Auction (cont.)
4. Treasury receives:
5. Ask Yield:
6. Effective Yield:
or
______________$1.274mill. $120Price
mill. 1.274$360
910420. mill. $120Discount
____________91
365
118.726
1.274beyi
4.374%
1
mill. 118.726
mill. 120 91365
EAR______191365
0430.1
91365
EAR
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Copyright 2013 Diane Scott Docking 25
Federal Funds
Interbank lending and borrowing Fed district bank debits and credits accounts for purchase
(borrowing) and sale (lending)• Fed Funds __________________ - this is a bank liability. • Fed Funds _________ - this is a bank asset.
Usually $5 million or more Federal funds rate usually slightly higher than T-bill rate Fed Funds target vs. Actual FF rate Current FF target: http://www.frbdiscountwindow.org/
Effective FF rates: http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm
360365
ffbey ii
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Fed Funds Rates (M&E, ed. 7, Ch. 11)
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Repurchase Agreements (Repo)
Repo Bank Financing – Source of funds – a bank liability “Security sold under agreement to repurchase” at given
price in future.
Reverse Repo Bank Investment/Loan – Use of funds – a bank asset “Security purchased under agreement to resell” at given
price in future.
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Repurchase Agreements (cont.)
Negotiated market rate. Over telecommunications network Dealers and brokers used or direct placement No secondary market Rate is lower than the fed funds rate, since it is backed up by a
security.
Used by: Federal Reserve in open market operations. Government securities dealers to secure funds to invest in new
Treasury issues. Banks to secure funds to meet temporary liquidity needs as well as
lend funds when they have excess reserves.
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Estimating Repo Rate
For Repurchase agreements:
Prepo= Repurchase price of security, which equals selling price plus interest
P0= Sales price of the security N=number of days to maturity
nx
P
PPrepo 360rateRepo
0
0
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Reverse Repurchase Agreement (Aka: Securities Purchased Under Agreement to Resell)
Bank buys a security from a customer with the agreement to sell it back to customer within so many days (say 90 days). Bank takes possession and title of security In effect, a loan with collateral
Bank accounting entries:Dr) Reverse Repurchase Agreements $100,000
Cr) Cash $100,000
. . .
Dr) Cash $101,000
Cr) Reverse Repurchase Agreements $100,000
Cr) Interest Revenue 1,000 Repo Rate:
4%90
360x
100,000
100,000101,000
n
360x
P
PPrateRepo
0
0repo
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Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase)
Bank sold its own security to a dealer/bank with the agreement to repurchase it within so many days (say 90 days). Bank releases possession and title of security In effect, a bank debt with security used collateral
Bank accounting entries:Dr) Cash $100,000
Cr) Repurchase Agreement $100,000
Dr) Securities Sold Under Repo $120,000
Cr) AFS Securities $120,000
…..
Dr) Repurchase Agreement $100,000
Dr) Interest Expense 1,000
Cr) Cash $101,000
Dr) AFS Securities $120,000
Cr) Securities Sold Under Repo $120,000
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Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase)
Bank sold its own security to a dealer/bank with the agreement to repurchase it within so many days (say 90 days).
Repo Rate:
4%90
360x
100,000
100,000101,000
n
360x
P
PPrateRepo
0
0Repo
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Commercial Paper Alternative to bank loan Short-term debt instrument
• Initial maturities days • Usually days.
Used only by well-known and creditworthy firms• ______________• Credit ratings important
Minimum denominations of $100,000 Placement
• Directly by a sales force of the borrowing firm.• Indirectly through dealers.
Not a large secondary market (generally held to maturity) Sold at a discount from par – just like T-bills.
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Commercial Paper Rates (M&E, 7 ed., Ch. 11)
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Commercial Paper Volume (M&E, 7 ed., Ch. 11)
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Commercial Paper (continued)
Directly-Placed Versus Dealer-Placed Paper Commercial paper is classified as either
directly placed paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary
dealer-placed instruments are when the issuer uses the services of a security firm to sell its paper
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Copyright 2013 Diane Scott Docking 37
Negotiable Certificates of Deposit
Development of the CD Market Issued by Citibank in 1961. Offset declining demand deposits as a source of funds.
CD Issuers Money center banks and large regional banks are the
primary issuers of domestic CDs
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Negotiable Certificates of Deposit Characteristics of Negotiable CDs
Large denomination time deposit, less than six month's maturity.• minimum is ____days• most are less than l year
Negotiable - may be sold and traded before maturity.• Primary market - denominations of at least $100,000. • Secondary market - $1 million or more.
Issued at face value with coupon rate.• Interest computed on a 360 day year.• Rate negotiated between buyer and seller.• Rates higher than on T-Bills
o higher credit risk, lower marketability and higher taxability.
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Example 5-9 in text: Negotiable Certificates of Deposit
Q1: A bank has issued a 6-month (182 day), $1 million NCD with a 0.72% annual interest rate. How much will the NCD holder receive at maturity?
A:
maturity todays where
,360
n
niFaceFaceFV
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Example 5-9 in text: Negotiable Certificates of Deposit
A:
640,003,1$
640,3000,000,1$
360
1820072.0000,000,1$000,000,1$
FV
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Example 5-9 in text: Negotiable Certificates of Deposit
Q2: Immediately after the CD is issued, the secondary market price falls to $999,651. What is the new yield on the CD?
A: = 0.7893%
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Example 5-9 in text: Negotiable Certificates of Deposit
Q3: After the price drop, what is the EAR on the NCD?
A:
%7909.01182365
007893.1
1365
1
182365
365
nbey
eff n
iiEAR
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Negotiable CD Rates (M&E, 7ed., Ch. 11)
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Comparing Money Market Securities : A comparison of rates
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Copyright 2013 Diane Scott Docking 46
Bankers' Acceptances
1. Time draft1. Drafts are drawn on and/or accepted by commercial
bank.
2. Direct liability of bank.
2. Mostly relate to international trade.
3. Secondary market - dealer market.
4. Discounted in market to reflect yield.
5. Standard maturities of 30, 60, 90 days –270 days max.
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Exhibit: Bankers Acceptance (see chart next page)
1) Importer (U.S.) places P.O. for goods.
2) Exporter (Japan) demands payment before shipment. So, Importer asks American Bank to issue a Letter of Credit.
3) American Bank presents LC to Japanese Bank.
4) Japanese Bank notifies Exporter that they have a LC and okay to ship.
5) Exporter ships goods.
6) Exporter sends shipping documents to Japanese Bank.
7) Japanese Bank sends shipping documents and Time Draft (like an invoice) to American Bank.
8) American Bank “stamps” Draft as “accepted” and a BA is created. American Bank will pay owner of BA (i.e. the Draft) so many $ in n-days.
9) American Bank returns BA to Japanese Bank who gives it to Exporter.
10) Exporter can sell BA at its current discounted PV or hold it until maturity.
11) At maturity of BA, Importer pays American Bank, who pays holder of BA.
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Copyright 2013 Diane Scott Docking 48
Exhibit: (Bankers Acceptance)
1 Purchase Order
Shipment of Goods5
L/C3
Shipping Documents & Time DraftDraft Accepted (B/A Created)
7 Japanese Bank(Exporter’s Bank)
American Bank(Importer’s Bank)
Importer Exporter
2
L/C
(Le
tter
of C
redi
t) A
pplic
atio
n
4
L/C
Not
ifica
tion
6
Shi
ppin
g D
ocum
ents
& T
ime
Dra
ft
B/A sent to Japanese Bank9
10
B/A
sen
t to
Exp
orte
r w
ho k
eeps
or
sells
it
AB pays holderof B/A at maturity
11B/A created8
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Banker’s Acceptance
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Copyright 2013 Diane Scott Docking 50
Eurodollars
Deposits of U.S. dollars in banks located outside the U.S. London interbank bid rate (LIBID)
• The rate paid by banks buying funds
London interbank offer rate (LIBOR)• The rate offered for sale of the funds (rate paid on ED)
Time deposits with fixed maturities Largest short term security market in the
world No reserve requirements at banks outside U.S.
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Comparing Money Market Securities: Money Market Securities and Their Depth
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