Chapter 5 The Money Market

1
Chapter 5The Money Market

• What characterizes money market securities?
• What kinds of money market instruments exist?
• How are Treasury bills sold?
• How do yield calculations differ from other
  markets?

2
Chapter 5The Money Market

• Money market securities are debt instruments that
  have a maturity of less than one year
• There is an amazing diversity of instruments in
  the money market
• Looking at different instruments may discover
  yield enhancement opportunities
• Savings accounts pay 2 to 3 per year
• T-bills now pay about 5.5

3
Characteristics of Money Market

• Short term - less than one year, many less than
  120 days
• Low risk - usually only good credits have access
  to issuing in the money market
• High liquidity - ability to convert quickly to
  cash
• In addition, most transactions are large
• Quick conversion to cash (high liquidity) gives
  money market its name

4
A brief history

• Money market began taking off in early 1980s
• Interest rates spiked
• Regulations limited interest rate paid on
  deposits
• Innovations in money market instruments led to
  withdrawal of cash from banks into the new
  instruments

5
Payment of Interest Varies

• Interest bearing debt pays periodic coupons
• Interest bearing at maturity debt pays the stated
  interest at maturity
• e.g. most bank loans
• Discount notes have no explicit interest but
  rather sell at price below the face amount
• The interest (face amount - price paid)
• Most money market instruments have no coupons

6
Treasury Bills (T-bills)

• Issued by the US Treasury and backed by the US
  Government
• Recall bid and ask?
• Bid is the highest price a buyer will pay
• Ask is the lowest price a seller will accept
• T-bills are discount notes

7
Bankers Discount

• T-bills are quoted on a bankers discount basis
• The discount rate is the quote
• The discount rate is based on a 360-day year
• To convert the discount rate to a price

8
Example

• A 6 ask quote on a 100,000 T-bill that matures
  in 60 days means that you can buy a T-bill at

9
Money Market Yields

• T-bills are quoted on a bankers discount but
  this is not the yield on our investment
• To find the yield on a T-bill, we use the holding
  period rate of return and annualize to a
  360-day year
• Money market yields are based on a 360-day year

10
Converting bank discount to MM yield
In our example,
11
Straight yield basis

• Years have more than 360 days
• The straight yield basis converts the bank
  discount basis to a 365 day holding period

12
Converting bank discount to straight yield
In our example,
13
Ask yield

• To compare T-bills with bonds, the financial
  press reports the ask yield
• If T-bill is less than 182 days (½ year), then
  the straight yield is the ask yield
• If T-bill is longer than 182 days, we must
  account for semi-annual compounding of bond yields

14
Primary market for T-bills

• The US Treasury issues new T-bills via an auction
• Every Monday, 13 week and 26 week T-bills are
  auctioned
• Once per quarter, 52 week T-bills are auctioned
• Others determined as needed

15
The T-bill auction

• Bids can be placed in two ways
• Competitively (state bankers discount rate)
• Non-competitively (state only amount desired)
• The Treasury first allocates the quantity of the
  issue to cover quantity bids and bids by the
  Federal Reserve
• Then the Treasury begins to allocate the issue to
  the higher price bidder (lowest bank discount
  rate)
• But everyone pays the same price

16
T-bill auction p.2

• Example p.192
• Stop bid is the highest competitive bid that is
  filled (only partially filled)
• Each bidder at the stop receives only a portion
  of their bid

17
Commercial Paper (CP)

• CP is unsecured debt of the issuer
• No specific assets support the debt
• CP is available to issuers who are strong,
  reliable credits with good reputations
• Can escape SEC registration and prospectus
  requirements if less than 270 days and proceeds
  fund current transactions
• Most CP has very short maturities (20-45 days)
• CP is quoted on a bankers discount basis

18
Primary Market for CP

• Directly placed paper is sold directly from the
  issuer to the public
• Many times, the buyer is a large investor
• Dealer placed paper is underwritten like other
  securities
• Little or no secondary market
• Bank lines of credit default guarantee
• Rollover and run

19
Bankers Acceptances (BA)

• Similar to a check, it is a promise of payment of
  the issuer that is guaranteed (or accepted) by a
  bank
• Created in the course of international trade
• It is used so that firms do not have to worry
  about health of foreign companies that they are
  unfamiliar with
• BA can be resold in secondary market

20
Certificates of Deposit (CDs)

• They are slightly different from time deposits
  available to small investors at banks
• Penalties apply if funds are withdrawn early
• Here, we are interested in negotiable CDs that
  can be resold in a secondary market
• Large (1 Million) issues

21
CDs p.2

• Debt instruments issued by banks
• Buyers earn a stated interest rate for a given
  maturity
• Term CDs have maturities of greater than one year
• Variable rate or floating rate CDs reset the
  interest rate periodically

22
Federal Reserve System

• Depository institutions are members of the
  Federal Reserve System
• Banks are required to keep reserves on deposit
  with the Federal Reserve Banks
• Federal Reserve sets size of reserve depending on
  amount/type of deposits in member banks
• Ratio is higher for liquid accounts
• Amount available for banks to lend equal to
  deposits less required reserve

23
Banks with a reserve shorfall

• There are several options available to banks who
  have not deposited adequate reserves
• The discount window is where banks can borrow
  funds from the Federal Reserve at a low discount
  rate
• This option is limited because of Fed oversight
• Member banks may also borrow and lend to each
  other through the Federal Funds market
• Finally, a bank could use a repurchase agreement
  (see later)

24
Federal Funds Market (or Fed Funds)

• Banks with excess reserves loan to banks with too
  few reserves at the fed funds rate
• Borrowing is called buying fed funds and lending
  is called selling fed funds
• Essentially buying and selling excess reserves
• Most activity is on an overnight basis

25
Example of fed funds transaction

• A bank has a 10 million shortfall in reserves
  can buy 10 million in the fed funds market at an
  overnight rate of 3
• The bank gets 10 million today. Tomorrow it
  pays back

26
Repurchase agreement (repo)

• A repo is a simultaneous purchase and sale of a
  security at specified times and prices
• A repo amounts to a short term loan where the
  interest rate is based on the difference in the
  purchase and sale prices
• Collateral for loan is the underlying security
• Developed as an alternative to fed funds market
  for non-banks

27
Quick example

• Orange Computers may have 100 million excess
  cash on its books that it can lend to Macrosoft
  on a short-term basis
• Macrosoft sells some T-bills to Orange for 100
  million and agrees to buy them back a week later
  at a slightly higher price
• If Macrosoft does not later buy back T-bills
  (i.e. defaults), Orange still has T-bills

28
Other repo market terminology

• The T-bill value in the prior example must exceed
  100 million
• The margin or haircut is the excess value of the
  securities over the loan amount
• It protects the lender from default and the
  volatility of T-bill prices
• Open repos leave the term unspecified
• Can be terminated by either side
• Borrower can substitute collateral, if needed

29
Summary of Chapter 5

• There are many different types of short-term,
  liquid money market instruments
• Instead of holding cash, firms may want to
  consider alternative interest bearing securities
• WSJ money rates