money markets. i. money market securities definition money market securities are financial...
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Money Markets
I. Money Market Securities
• Definition
Money market securities are financial instruments with maturity of one year or less.
• Instruments and Participants– Domestic Money Market
Instruments Principal Borrowers
Treasury bills U.S. Government
Commercial paper Non-financial and financial
businesses
Negotiable CDs Banks
Repurchase agreements Securities dealers, banks, non- financial corporations,
governments
Instruments Principal Borrowers
Federal funds Banks
Banker’s acceptances Non-financial and financial businesses
Discount window Banks
Municipal Notes State and local governments
Government sponsored Farm Credit System, Federal
Enterprise securities Home Loan Bank System,
Federal National Mortgage Association
Instruments Principal Borrowers
Shares in money market Money market funds, local
instruments government investment pools,
short-term investment funds
Futures contracts Dealers, banks (principal users)
Futures options Dealers, banks (principal users)
Swaps Banks (principal dealers)
– International Money Market Instruments
Instruments Principal Borrowers
Eurodollars Banks
Eurodollar CDs Banks
Euronotes
Euro-commercial paper Non-financial and financial businesses
• Characteristics– High degree of safety– Active secondary market– Telephone network
II. Treasury Bills
• Maturity– Regular issues
91-day bills Issued weekly
182-day bills Issued weekly
51-week bills Issued monthly– Irregular issues
• Denominations$10,000
$15,000
$50,000
$100,000
$500,000
$1,000,000
round lot: $5,000,000
• Auction– Non-competitive Bidding ($1,000,000 or less)
Direct purchase from Federal Reserve Banks
Indirect purchase through brokers
– Competitive Bidding
Amount
(in bil.) Bid Remark
$0.20 7.55% lowest yield,/highest price
0.26 7.56
0.33 7.57
0.57 7.58 average yield/ average price
0.79 7.59
0.96 7.60
1.25 7.61
1.52 7.62 stop yield/ stop price
• Dearlers
– Reporting Dealers
Securities firms which are on the Federal Reserve’s regular reporting list.
– Primary Dealers (Recognized Dealers)
Securities firms and commercial banks that the Federal Reserve will deal with in implementing its open market operations.
– Government Brokers
Brokers used by primary dealers trading Treasury securities with each other.
– Other Dealers and Brokers
• T-Bill Rate (T-Bill Discount, or Yield on a Bank Discount Basis)
T-bill Rate = [(par - PP) / par] (360 / n)
= [dollar discount/ par] (360 / n),
where
par = par value,
PP = purchase price, and
n = holding period in days.
Example:
par = $100,000,
PP = $97,569, and
n = 100 days.
Yield = [($100,000- $97,569)/ $100,000]
(360 / 100)
= 8.75%.
• Dollar Discount
Dollar Discount = T-bill Rate par (n /360)
Example:
T-bill Rate = 8.75%,
par = $100,000, and
n = 100 days.
Dollar Discount = 0.0875$100,000(100/360)
= $2,431.
Purchase price = par value - dollar discount
= $100,000 - $2,431 = $97,569.
• Yield
T-bill Yield = [(SP - PP) / PP] (365 / n),
where
SP = selling price,
PP = purchase price, and
n = holding period in days.
Example:
SP = $10,000,
PP = $9,600, and
n = 182 days.
Yield = [($10,000 - $9,600)/ $9,600](365 / 182)
= 8.36%
III. Commercial Paper
• IssuersFinance companies
Bank holding companies
Industrial companies
Foreign corporations (Yankee commercial paper)
• Maturity
– Not Registered
One day to 270 days, normally between 20 and 45 days.
– Registered
Over 270 days
• Denominations
Minimum $25,000
Minimum round lot $100,000
Typical multiples of $1 million
• RatingMcCarthy,
Crisanti &
Category Duff & Phelps Fitch Moody’s S&P Maffei
Investment Duff 1+ F-1+ A-1+
Grade Duff 1 F-1 P-1 A-1 MCM 1
Duff 1-
Duff 2 F-2 P-2 A-2 MCM 2
Duff 3 F-3 P-3 A-3 MCM 3
Non-invest.
Grade Duff 4 F-S NP(Not B MCM 4
Prime)
C MCM 5
In default Duff 5 D D MCM 6
• Placement
– Directly Placed Commercial Paper
– Dealer-Placed Commercial Paper
• Backing
– Reasons
Credit enhancement
Rollover risk
– Types of Credit-Supported commercial paper
Credit-Supported commercial paper (line of credit paper)
Fee (0.5%)
Compensating balances
Asset-backed commercial paper
• Yield
Yield = [(par - PP) / PP] (360 / n),
where
par = par value,
PP = purchase price, and
n = holding period in days.
Example:
par = $5,000,000,
PP = $4,850,000, and
n = 90 days.
Yield = [($5,000,000 - $4,850,000) / $4,850,000] (360 / 90)
= 12.37%
IV. Negotiable Certificates of Deposit (NCDs)
• Issuers
– Domestic market
Commercial banks
Thrift institutions (thrift CDs)
U.S. branches of foreign banks (Yankee CDs)– Foreign markets (Euro CDs)
• Maturity
Short-term: two weeks to one year
Long-term: term CDs
• Denominations
Minimum $100,000
Typical $1,000,000
• Placement
– Directly placed NCDs – Dealer placed NCDs
• Yield on a Bank Discount Basis
– Risk premium
Higher premium during recessionary years
Higher premium during financial crises
Higher premium for high-risk issuers– Liquidity premium– Fixed rate vs floating rate
V. Repurchase Agreements (RPs)
• Issuers
– Financial institutions
Commercial banks
Thrifts
Money market funds
Securities dealers– Non-financial institutions
Municipalities
Businesses
• Maturity
– Overnight repos– Term repos
Two to fifteen days
One, three and six months
• Denominations
Typical $10 million or higher
• Yield or Repo Rate
Repo Rate = [(SP - PP) / PP] (360 / n),
where
SP = selling price collected by an investor,
PP = purchase price paid by an investor, and
n = holding period in days.
Example:
SP = $10,000,000,
PP = $9,852,217, and
n = 60 days.
Yield = [($ 10,000,000-$ 9,852,217)/$ 9,852,217] (360 / 60)
= 9%
Determinants of repo rates:– Creditworthiness of the issuer– Type of collateral– Federal funds rate
The repo rate is usually 25 basis points below the funds rate because a repo has collateral, while a federal funds transaction is unsecured.
VI. Federal Funds
• ParticipantsDepository institutions
Brokers
• Characteristics– Short-term borrowing of immediate availability– Borrowed only by depository institutions– Exempted from reserve requirements
• Maturity
– Overnight federal funds (3/4 of the total federal funds)
– Continuing contract federal funds (automatically renewed overnight federal funds)
– Term federal funds: few days to six months
• Denominations
Typical $5,000,000
• Placement
– Directly placed– Broker-placed
• Security
– Unsecured federal funds– Secured federal funds
• Federal Funds Transfer
– Adjusting reserve accounts through Fedwire– Reclassifying the demand deposits of a
respondent bank
• Federal Funds Rate
– Higher than repo rate and Treasury bill rate.– Higher volatility than other money market
rates because it is affected by changes in monetary policy.
VII. Banker’s Acceptances
• Issuers
Exporters
Importers
Commercial banks
1. Purchase order
Importer Exporter
5. Shipment of goods
6. Shipping
2. L/C 4. L/C documents
application notification & time
draft
3. L/C
Importer’s bank Exporter’s bank
7. Shipping
documents & draft acceptance
Acceptance financing
The use of banker’s acceptances to finance commercial transaction.
– Importing goods into the U.S.– Exporting goods from the U.S.– Storing and shipping goods between foreign
countries (third country acceptances)
• Maturity
– 30 to 270 days – Federal Reserve eligibility requirement
A Banker’s acceptance with maturity longer than six months do not meet the eligibility requirement as collateral at the discount window.
• Placement– Directly placed by Accepting banks
An accepting bank is a bank which creates banker’s acceptances.
– Dealer placed* Unsold acceptances created by large
accepting banks* Acceptances created by smaller accepting
banks* Acceptances created by Yankee banks (U.S.
branches of foreign banks)
• Rates– Higher than T-bill rate
* Risk premium - Higher default risk than T-bills.
* Liquidity premium- Less developed secondary market.
– Commission charged by accepting banks* U.S. banks - 25 to 30 basis points* Japanese banks - 10 to 15 basis points
– Dealer’s Spread - 12.5 to 87.5 basis points
VIII. Eurocurrency
• ParticipantsGovernments
Large financial institutions
Commercial banks (Eurobanks)
Organized exchanges
Institutional investors
Large corporations
• Related Markets– Foreign exchange market– Eurocurrency market– Eurocredit market– Euro CD market– Euronote market– Currency forward market– Currency Futures market– Currency options market– Currency swap market
• Euro CDs– Types
* Fixed -rate CDs* Floating-rate CDs (FRCDs)
The rate adjusts periodically to the London Interbank Offer Rate (LIBOR).
– Yield
Euro CDs offer a higher yield than domestic CDs for three reasons:* Reserve requirements imposed on domestic
CDs * FDIC insurance premium for covering
domestic CDs* Sovereign risk
Euro CDs are obligations that are payable by an entity operating under a foreign jurisdiction, and their claim may not be enforced by the foreign government.
• Euronotes– Participants
Borrowers
Underwritten or committed note issuance facility (a syndicate formed by a group of
banks)
Investors
– Maturity
One month
Three months
Six months
IX. Euro-Commercial Paper (Euro-CP)
• Participants
Borrowers
Dealers
Investors
• Maturity
Euro-commercial paper has longer maturity ( i.e., longer than 270 days) than that of U.S. commercial paper, and therefore has a more active secondary market.
• Placement
Euro-commercial paper is almost always dealer-placed. The commission ranges between 5 and 10 basis points of the face value.
• Yield
Euro-commercial paper is typically between 50 and 100 basis points above LIBOR.
VIII. Valuation of Money Market Instruments
• Market Value
P = Par / (1 + i)n,
where
P = price of the money market instrument,
Par = par value,
i = required annual rate of return, and
n = time to maturity (a fraction of one year).
Example:
Par = $10,000,
i = 7%, and
n = 1 year.
P = $10,000/ (1 + 0.07)1
= $9,345.79.
• Price Determinants
P = ƒ( i) = ƒ(Rf, DP, LP) ,
where
P = change in price,
i = change in required rate of return,
Rf = change in risk-free rate,
DP = change in default risk premium, and
LP = change in liquidity premium.
– Determinants of risk-free rate* Economic growth* Inflation* Money supply
– Determinants of default risk premium* Economic conditions* Conditions in the firm’s industry (degree of
competition, etc.)* Firm-specific conditions (debt level,
management, etc.)