FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 8
• The Money Markets

2
The Money Markets Definitions and
Characteristics

• The money market is the financial market for
  short-term borrowing and short term lending (1
  year or less).
• Money market instruments can be as short as
  overnight.
• Includes short-term debt securities, such as
  banker's acceptances, commercial paper,
  repurchase agreements, negotiable certificates of
  deposit, and Treasury Bills.
• Money market securities are generally very safe
  investments which return a relatively low
  interest rate that is most appropriate for
  short-term time horizons.
• Many, but not all, have well developed secondary
  markets, and thus are regarded as highly liquid
  financial assets.
• Financial asset bid and ask spreads (i.e., the
  buying and selling spread) are relatively small
  due to the large size of the market.
• Money market securities generally have
  (relatively) low default and price (i.e.,
  interest rate) risk, but (relatively) high
  reinvestment risk.

3
Purpose of Money Markets

• Satisfying Needs of Investors
• Provides investors a place for investing surplus
  funds for short periods of time.
• Can be as short as overnight (e.g., Fed funds
  market or the repurchase agreement market) or out
  to a year.
• Offers highly liquid assets (as measured by
  relative price stability and good secondary
  markets).
• Satisfying Needs Borrowers
• Provides borrowers source of short-term funds.
• For example, financing the working capital needs
  of businesses.
• Commercial paper market
• Important to both investors and borrowers because
  the timing of their short term cash inflows and
  outflows may not be well synchronized.
• Money markets provide a way to manage cash-timing
  problems.

4
Participants in U.S. Money Markets

• U.S. Treasury Department
• Financing its internal (domestic) deficit (when
  government expenditures exceed tax receipts), or
• Refinancing operations as national debt
  maturities.
• Foreign Governments (and Central Banks)
• Recycling their U.S. dollar (external) trade
  surpluses back into U.S. financial markets.
• Involves many Asian countries today (China,
  Japan, South Korea).
• Federal Reserve System (U.S. Central Bank)
• Federal Reserve Bank of New York conducts Open
  Market Operations in the money markets (buying
  and selling U.S. T-Bills) to meet the fed funds
  target.

5
Participants in U.S. Money Markets

• Commercial Banks and Other Depository
  Institutions (e.g., savings banks)
• Source of funds to these institutions
• Also hold their secondary reserves in the form
  of liquid U.S. Treasury bills (these are part of
  their investment portfolio).
• Essential for meeting unexpected deposit
  withdrawals and increases in loan demands.
• Non Depository Financial Firms (e.g., finance
  companies, leasing companies)
• Securing funds in the money markets to lend to
  potential customers
• Non-financial Businesses Firms
• Financing short term working capital needs (cash
  shortfalls)
• Important for financing foreign trade (financing
  export sales is done through bankers acceptances)
• Investing their short term surplus funds

6
Participants in U.S. Money Markets

• Contractual Financial Firms (e.g., property and
  casualty insurance companies)
• Holding liquid assets to meet unpredictable and
  unanticipated claims from policy holders.
• Investment firms (brokerage firms, asset
  managers mutual funds pension funds)
• They offer money market portfolios to investors.
• Encourages investors with limited funds (and
  limited investor knowledge) to participate in the
  money markets.
• Individuals (Households)
• Are investors primarily through money market
  mutual funds.
• But individuals can invest directly (e.g.,
  commercial paper).

7
Key Money Market Instruments

• Treasury Bills
• Federal Funds
• Repurchase Agreements (repos)
• Negotiable Certificates of Deposit (CDs)
• Commercial Paper
• Prime Loans
• Bankers Acceptance
• Eurocurrencies Accounts (Offshore Accounts)

8
Money Market Instruments and Rates

• Instrument Interest Rate (p.a.)
• Oct 25, 04 Nov 7, 06 Oct 29, 07
• Prime rate 4.75 8.25 7.75
• Fed funds (overnight) 1.75 5.25
  4.75
• 1 month T-bills 1.57 5.105 3.915
• 1 month Commercial paper 1.78 5.27
  4.78
• 1 month CDs 1.90 5.29 4.81
• 1 month bankers acceptances 1.90 5.27
  4.68
• 1 month London euros 1.92 5.28
  4.70
• Repurchase Agreements n.a. 5.25 4.73
• Auction results
• Dealer placed
• Dealer financing rate for overnight sale and
  repurchase of Treasury securities.
• Source http//online.wsj.com/page/mdc/2_0500-rate
  s-10.html?mod2_0031

9
Money Market Instruments and Rates

• Instrument Interest Rate (p.a.)
• Oct 29, 07 Mar 19, 08
• Prime rate 7.75 5.25
• Fed funds (overnight) 4.75 2.25
• 1 month T-bills 3.915 0.52
• 1 month Commercial paper 4.78 2.53
• 1 month CDs 4.81 2.55
• 1 month bankers acceptances 4.68 2.55
• 1 month London euros 4.70 2.50
• Repurchase Agreements 4.73 1.13
• Auction results
• Dealer placed
• Dealer financing rate for overnight sale and
  repurchase of Treasury securities.
• Source http//online.wsj.com/page/mdc/2_0500-rate
  s-10.html?mod2_0031

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Money Market Rates Move Together
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T-Bills Importance to Investors

• Money Market Assets generally safe and highly
  liquid
• Safe Assume no (to very little) risk of default.
• Liquidity Good secondary market (can be sold
  quickly) and with (relative) principal value
  stability (little price risk).
• Purchased by commercial banks for
• Secondary reserves.
• Needed to meet cash withdrawals and loan demands.
• Purchased by investment firms
• For their money market mutual fund offerings.
• Money market instruments are also importance
  because investors and borrowers can manage cash
  inflow and outflow imbalances.

12
Marketable U.S. Government Debt December 2007

• Security Amount Percent of Total
• T-Bills 1,000 billion 22
• T-Notes 2,487 billion 55
• T-Bonds 559 billion 12
• Other (TIPs) 471 billion
• Total 4,517 billion
• Note 10 of the marketable debt is held by the
  Federal Reserve. About half the marketable debt
  is held by foreigners (private and public
  holdings), with Japan the largest at 680 billion
  and China second at around 400 billion.
• Source http//www.fms.treas.gov/bulletin/index.ht
  ml (federal debt link).

13
The Real Rate of Interest
Notice that the inflation rate exceeds the rate
on T-bills in several of the years. This
indicates a negative real return for T-bill
investors during these periods.
14
Current U.S. Real T-Bill Rates

• 3 month T-Bill rate 0.88 (March 18, 2008)
• CPI core (annual rate) 2.30 (February 2008)
• Real rate -1.42
• What does this current real rate tell you?
• What is the incentive to invest?
• Positive or negative?
• What is the incentive to borrow?
• Positive or negative?
• Is Fed policy easy or tight?
• In October 2007 the real rate was 1.18
• How have the incentives and Fed policy changed?

15
Federal Funds

• Short-term funds transferred (i.e., loaned or
  borrowed) between financial institutions through
  the Federal Reserve System, usually for a period
  of one day (overnight).
• These funds are the excess reserves of banks.
• Federal funds rate is currently the key U.S.
  monetary policy operating target.
• Open market operations affects this rate by
  varying the supply of financial institutions
  reserves.
• Important to commercial banks
• Lending institutions earn money on excess
  reserves.
• Borrowing institutions balance their reserve
  requirement account.
• Very important as a base (or benchmark) rate
  for other money market rates in the economy.
• Current rate is 2.25

16
Repurchase Agreement (Repos)

• In a repurchase agreement, or repo, a customer
  provides cash to a government securities dealer
  in exchange for a Treasury bill, note or bond.
  The exchange is reversed the next day, with the
  customer receiving interest on the overnight
  loan.
• Essentially a short-term collateralized loan.
• Party selling securities receives immediate cash.
• Party buying securities will receive interest.
• Under these agreements, one can invest or borrow
  money for periods ranging from 1 to 365 days.
• Major participants are primary government
  securities dealers.
• Banks and dealers authorized to participate in
  auctions of U.S. Treasury securities through the
  New York Federal Reserve Bank and the Federal
  Open Market Committee.

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Use of Repurchase Agreements

• Financial institutions enter into repo
  transactions in order to cover cash short
  positions or to earn a return on idle cash.
• Borrow or lend funds for short periods of time.
• Most typical time frame 3 to 14 days.
• Central banks use repurchase agreements for
  temporary or defensive open market
  operations.
• Central bank buying securities from government
  securities dealers to temporarily increase funds
  in market (these are called repurchase
  agreements) seller agrees to buy back.
• Central bank selling securities to government
  securities dealers to temporarily remove funds
  from market (these are called reverse repurchase
  agreements, or matched sale-purchase
  transactions) buyer agrees to sell back.
• The United States has the largest repo market in
  the world, followed by France.

18
Negotiable Certificates of Deposit

• A bank-issued security that documents a bank
  deposit and specifies an interest rate and a
  maturity date.
• Used by banks to raise funds.
• Negotiable means holder can sell CD in secondary
  markets before maturity date.
• Denominations range from 100,000 to 10
  million.
• Investors include individuals, asset managers.
• Negotiable important to investors because it
  provides early exit strategy if needed.

19
Commercial Paper

• Short term, promissory notes, issued by financial
  and non-financial corporations as a way of
  raising money
• U.S. market About 1.7 trillion outstanding
  commercial paper offered by approximately 2,000
  companies.
• Non-financial companies (25) and financial (75)
• U.S. Commercial paper maturities are less than
  270 days.
• This does not require SEC registration for a
  public placement.
• In practice, most commercial paper has a maturity
  of between 5 and 45 days, with 30-35 days being
  the average maturity. Many issuers continuously
  roll over their commercial paper, financing a
  more-or-less constant amount of their assets
  using commercial paper.
• Small secondary market, thus generally held until
  maturity.
• Thus, not nearly as liquid as T-Bills.
• Commercial paper is viewed as an alternative to
  short term borrowing from commercial banks (prime
  loans).
• Spread between the two usually produces a lower
  nominal return (or cost) on commercial paper than
  on prime loans.
• Difference is about 200 to 300 basis points (See
  next slide)

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Prime Rate and Commercial Paper Rate
Notice that difference between the two ranges
from 200 to 300 basis points.
21
Explaining the Cost Difference Commercial
Paper Backup Requirements

• What accounts for the interest rate differential?
• In 1970, Penn Central Transportation Co.
  defaulted on 82 million worth of commercial
  paper.
• Since that time, investors have required that
  almost all commercial paper be rated by a rating
  service.
• Rating services require evidence of short-term
  liquidity (a backup) and will not issue a
  commercial paper rating without it.
• Thus, commercial paper issuers need to have
  access to funds that can be used to pay off all
  or some of their maturing commercial paper.
• These back up funds are either in the form of
  their own cash reserves or bank lines of credit,
  with most commercial paper issuers maintain
  backup liquidity through bank lines of credit.
• Banks charge a fee for these lines of credit (a
  percentage of the credit line) whether or not the
  line is activated.

22
Placement of Commercial Paper

• Commercial paper can be placed either through
  commercial paper dealers or directly by the
  issuer.
• Dealer placed paper
• Most issuing firms place their paper through
  dealers (as opposed to directly).
• Dealers include investment banks, such as Merrill
  Lynch, Goldman Sachs, and Shearson Lehman and
  commercial banks such as Citigroup, and Bank of
  America.
• These dealers purchase commercial paper from
  issuers and resell it to the investing public.
• The difference between what a dealer pays the
  issuer for commercial paper and what the dealer
  sells it for (called the "dealer spread) is
  around 10 basis points.

23
Direct Placement of Commercial Paper

• A few companies (approximately 125) use their own
  organization to sell their commercial paper.
• Most of these direct issuers are finance
  companies or bank holding companies.
• General Motors Acceptance Corporation (GMAC)
  offers its commercial paper directly to
  institutional and commercial investors in the
  United States.
• GMAC paper can be purchased directly by calling
  their trading floor line at 1-800-338-4622.
  Orders may also be placed electronically via the
  companys issuer website.
• http//www.gmacfs.com/us/en/business/investing/com
  mercial_paper/index.html

24
Investors in Commercial Paper

• Major investors in the commercial paper market
  are institutions, and include
• Money market mutual funds and commercial bank
  trust (private banking) departments
• Money market mutual funds hold about 33 of
  outstanding commercial paper, while bank trust
  departments hold up to 25 percent.
• Other important investors include non-financial
  corporations, life insurance companies, and
  pension funds.
• Individuals hold little commercial paper
  directly.
• However, individuals are large indirect investors
  in commercial paper through their investment in
  money market mutual funds.

25
Foreign Commercial Paper Markets

• While the U.S. market is by far the largest, a
  variety of foreign commercial paper markets began
  operating in the 1980s and early 1990s. These
  other major (foreign) markets include
• Japan (denominated in yen)
• Canada (in Canadian dollars)
• Eurodollar market (in U.S. dollars)
• U.S. dollar-denominated commercial paper issued
  in other than the U.S. financial market
  (offshore).
• Market located primarily in Europe (London).

26
Bankers Acceptances Background

• Assume an exporter and importer agree on the
  terms of a particular sale
• What are the issues that remain for both?
• The exporter usually wants to maintain legal
  title to the goods until they are paid for (or at
  least until payment is assured),
• While the importer typically is reluctant to pay
  for the goods before they are shipped
  (additionally, the importer wants to make sure
  that the goods ordered are indeed the goods
  shipped).
• Commercial banks have developed procedures to
  bridge this gap between the concerns of exporters
  and importers.
• In the process, banks provide external financing
  needed by the trading partners (specifically the
  importing firm).
• Critical to this process is a letter of credit.

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Letter of Credit

• Defined A Letter of Credit is a document which
  acknowledges a banks promise to pay a
  beneficiary (exporter) for merchandise sold to a
  buyer (importer) if specified conditions are met.
• Thus, a letter of credit substitutes the bank's
  credit for the credit of another party (i.e., the
  buyer of the goods).
• Letters of credit are used to ensure that payment
  will be received and that the goods ordered will
  be shipped.
• The use of letters of credit has become a very
  important aspect of international trade due to
  the nature of international dealings including
  factors such as distance, differing laws in each
  country and the potential difficulty in knowing
  each party personally,
• The bank acts on behalf of the buyer (i.e.,
  importer) by ensuring that the supplier (i.e.,
  exporter) will not be paid until the bank
  receives a confirmation that the goods which have
  been ordered have been shipped.
• A letter of credit is a tool to reduce payment
  risk.

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Letter of Credit and Bankers Acceptances

• Letter of credit arrangement will be requested by
  the exporter (seller) and will required the
  importer (buyer) to initiate a formal letter of
  credit with his/her bank.
• The letter of credit will detail the conditions
  surrounding the transaction between an exporter
  and importer.
• What is being purchased, how shipped, when
  shipped, etc.
• When these conditions have been met, the bank
  will issue a draft (i.e., promise to pay or
  promissory note) which is presented to the
  exporter.
• Draft can either be a sight draft (on demand) or
  a time draft.
• When this draft is guaranteed by the importers
  bank it becomes a bankers acceptance.
• Through the letter of credit, the exporter has
  the promise of a bank to pay, rather than a
  promise of the importer.
• The bankers acceptance can be sold by the
  exporter before its maturity date in secondary
  markets.
• It is sold at a discount at the existing bankers
  acceptance rate.
• Bankers acceptances are a popular investment for
  money market funds.

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14 Steps in Trade Transaction
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Eurodollars (aka Offshore Market)

• U.S. Dollar denominated time-deposits deposited
  in banks located outside of the United States.
• These banks can be either foreign banks or U.S.
  banks.
• What is important is location banks must be
  offshore from the U.S.
• Largest euro-dollar market by location is in
  London, England.
• Today, other major currencies can also be
  deposited in these offshore markets.
• Yen, pounds, Swiss francs, European euros.
• These deposits are also offshore from their
  legal tender countries and are designed by the
  prefix Euro (e.g., euro-yen, euro-pounds, etc.)
• Large global banks attract these deposits by
  offering interest rates on offshore time
  deposits (with maturities ranging from overnight
  deposits out to one year.
• These banks then lend these offshore deposits to
  global business who are in need of foreign
  currencies (e.g., needing dollars to pay for
  trade related activities).

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Understanding the Euro-Currency Market An Example

• Assume a German company sells a product to a U.S.
  company and charges 1,000,000 for the sale.
• The U.S. company pays by instructing its bank in
  New York to transfer 1,000,000 into the account
  of the German company (assume the German company
  has an account at a New York bank).
• The German company then instructs its U.S. bank
  to transfer the dollar deposit to a U.S. dollar
  time deposit account at its bank in London.
• The London bank can now lend out these dollars to
  its corporate clients and/or can lend out these
  deposits to other banks in the London Interbank
  Market.

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Brief History of the Eurocurrency Market

• Market originated in 1956, at the time of the
  Hungarian revolt when communist governments
  (mainly the Soviet Union) concerned about the
  potential freeze of their dollar accounts in U.S.
  banks and needing dollars for international trade
  and, shifted their deposits to London.
• The first bank in the London which accepting
  these U.S. dollar deposits was the Soviet-owned
  Banque Commerciale pour I'Europe du Nord.
• This bank was known by its cable code, EURBANK.
• From this cable code the term euromarket
  originated.
• By the 1960s, the practice of euro-deposits was
  extended to regular business customers.
• As the economies of Europe and Asia grew, the
  market was extended to additional currencies
  other than the US dollar.

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Money Market Mutual Funds

• Investment funds that invest only in short-term
  securities.
• Money market fund investments can include U.S.
  Treasury securities, federal agency notes,
  certificates of deposit, repurchase agreements,
  bankers acceptances, and commercial paper (see
  next slide).
• Open end funds (also called mutual funds)
  unlimited capitalization (number of shares)
  offered to the public.
• Purchase and sale of mutual fund share is through
  the investment funds themselves (e.g., Vanguard
  and T. Rowe Price money market funds)
• Closed end funds fixed (limited) number of
  shares offered to the public
• Purchase and sale of shares is done through
  financial markets such as OTC or organized
  exchanges like the NYSE (e.g., John Hancock,
  Money Market Fund JHMXX on NASDAQ)
• Combined these funds totaled 3.1 trillion at the
  end of 2007 (up from 2.4 trillion at the end of
  2006).
• Market consists of retail market (sold to
  individuals) and Institutional market (sold to
  pension funds and businesses)

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Assets of Money Market Mutual Funds

• Corporate notes Debt instruments with
  maturities of 9 month out to a few years.

35
Retail and Institutional Funds

• Tax-exempt refer to tax deferred accounts.

36
Household Money Market Mutual Fund Holdings
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Returns and Retail Money Market Mutual Fund Cash
Flows

• Cash Flow 6 month moving average
• Interest Rate Spread Money market mutual fund
  return minus commercial bank deposit rate

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Comparing Major Money Market Securities