FINANCIAL MARKETS AND INSTITIUTIONS: A Modern Perspective

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Chapter Five
Money Markets
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Money Markets

• Liquid funds flow between short-term borrowers
  and lenders through money markets
• Money markets involve debt instruments with
  original maturities of one year or less
• Money market debt
• issued by high-quality (i.e., low default risk)
  economic units that require short-term funds
• purchased by economic units that have excess
  short-term funds
• low rates of return
• Money market instruments have active secondary
  markets which provides liquidity

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Money Market Yields

• Money market securities use special rate quoting
  conventions
• Discount yields (idy) Interest rate is quoted
  on an annual basis assuming a 360 day year as a
  percent of redemption price or face value
• Single payment yields (ispy) Interest rate is
  quoted on an annual basis assuming a 360 day year
  as a percent of purchase price
• Both may be converted to a bond equivalent yield
  (ibey) for comparison with bonds

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Money Market Yields

• Treasury bills and commercial paper are bought
  and sold on a discount basis
• Discount yields (idy) use a 360-day year
• Pf the face value of the security
• P0 the discount price of the security
• h the number of days until maturity

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Money Market Yields

• Compare discount securities to U.S. Treasury
  bonds with bond equivalent yields (ibey)
• Convert bond equivalent yields into effective
  annual returns (EAR)

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Example T-Bill

• Face value 10,000 Maturity 73 days Sells
  for 9,800
• Discount yield
• Period yield (10,000-9,800)/10,000 2
• Annualized 2 x 360/73 9.863
• Bond Equivalent Yield
• Period yield (10,000 9,800)/9,800 2.0408
• Annualized 2.0408 x 365/73 10.2041
• Effective Annual Yield
• (1 2.0408)365/73 - 1 10.6292

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Money Market Yields

• Money market securities (Negotiable or jumbo)CDs
  and fed funds that pay interest only at maturity
  use single-payment yields (ispy) (e.g., jumbo CDs
  and fed funds)
• since ispy uses a 360 day year, compare to bonds
  by converting to a 365 day year
• to directly convert a single-payment yield to an
  effective annual return

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Example CD Yield

• Face 10,000 maturity 73 days pays 6
• Interest for the period 6x73/3601.22 or
  21.67
• Bond Equivalent Yield
• 6 x 365/360 6.0833
• Effective Annual Yield
• Note no of periods/year 365/73 5
• (1 1.22)5 - 1 6.2332

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Money Market Yields

• Negotiable (or jumbo) CDs and fed funds are money
  market securities that pay interest only at
  maturity. These use single-payment yields (ispy)
  
• to convert a single-payment yield to a bond
  equivalent yield
• to directly convert a single payment yield to an
  EAR

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Sample Calculations of Money Market Yields

• A 1M investment in 90 day commercial paper has a
  2 discount yield and an equivalent size and risk
  90 day CD has a 2 single payment yield. Which
  security offers the better return? For the
  commercial paper
• The bond equivalent yield for the commercial
  paper is 2.038

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Sample Calculations of Money Market Yields

• A 1M investment in 90 day commercial paper has a
  2 discount yield and an equivalent size and risk
  90 day CD has a 2 single payment yield. Which
  security offers the better return? For the CD
• The bond equivalent yield for the CD is 2.0278
• The commercial paper has the better return since
  its bond equivalent yield is 2.038

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Money Market Instruments

• Treasury bills (T-bills)
• Federal funds (fed funds)
• Repurchase agreements (repos or RP)
• Commercial paper (CP)
• Negotiable certificates of deposit (CD)
• Banker acceptances (BA)

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Treasury Bills (T-Bills)

• T-Bills are short-term debt obligations issued by
  the U.S. government
• The Federal Reserve buys and sells T-bills to
  implement monetary policy
• T-bills are virtually default risk free, are
  highly liquid, and have little interest rate risk
• Strong international demand for T-bills as safe
  haven investment

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T-Bill Auctions

• 13- and 26-week T-bills are auctioned weekly
• Bids are submitted by government securities
  dealers, financial and nonfinancial corporations,
  and individuals
• Bids can be competitive or noncompetitive
• competitive bids specify the bid price and the
  desired quantity of T-bills
• noncompetitive bidders get preferential
  allocation and agree to pay the lowest price of
  the winning competitive bids

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T-Bill Auctions
T-Bill Auctions
Noncompetitive Bids
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Bid Price
SC
ST
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Stop-out price (PNC)
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Quantity of T-bills
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The Secondary Market for T-Bills

• The secondary market for T-bills is the largest
  of any U.S. money market instrument
• 22 primary dealers make a market in T-bills by
  buying the majority sold at auction and by
  creating an active secondary market
• primary dealers trade for themselves and for
  customers
• T-bill purchases and sales are book-entry
  transactions conducted over Fedwire
• T-Bills are sold on a discount basis

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Transaction Between Primary Dealers
J.P. Morgan Chase Sell 10 million in T-Bills
Lehman Brothers Buy 10 million in T-Bills
Interbank Transaction
Fedwire
Fedwire
Federal Reserve Bank of NY Transfers 10 million
from Chase to Lehman Transaction Recorded in
Feds Book Entry System
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Purchase by Individual
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T-Bill Prices

• T-Bill prices can be calculated from quotes
  (e.g., from The Wall Street Journal) by
  rearranging the discount yield equation
• Or by rearranging the bond equivalent yield
  equation

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Example T-Bill Prices

• 30 days TB, Face value10,000, sells at 6
• Price?
• 10,000 - 10,000 x 6 (30/360)
• 9,950

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Federal Funds

• The federal funds (fed funds) rate is the target
  rate in the conduct of monetary policy
• Fed fund transactions are short-term (mostly
  overnight) unsecured loans
• Banks with excess reserves lend fed funds, while
  banks with deficient reserves borrow fed funds
• Fed funds are single-payment loans and thus use
  single-payment yields
• Multimillion dollar loans may be arranged in a
  matter of minutes

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FEDERAL FUNDS TRANSACTIONS
J.P. Morgan Chase Lends (Sell) 75 million in
Federal Funds
Bank of America Borrows (Buy) 75 million in
Federal Funds
FRBNY Today Takes 75 mil. From reserve account
of JPM ------------------------------ Tomorrow Ad
ds 75 mil. plus one days interest to JPM account
FRB of San Francisco Today Adds 75 mil. To
reserve account of BOA ---------------------------
--- Tomorrow Takes 75 mil. plus one days
interest from BOA account
Fedwire
Fedwire
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Repurchase Agreement

• A repurchase agreement (repo or RP) is the sale
  of a security with an agreement to buy the
  security back at a set price in the future
• Repos are short-term collateralized loans
  (typical collateral is U.S. Treasury securities)
• Similar to a fed fund loan, but collateralized
• Funds may be transferred over FedWire system
• If collateralized by risky assets, the repo may
  involve a haircut

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Repurchase Agreement

• Typical denominations on repos of one week or
  less are 25 million and longer term repos
  usually have 10 million denominations
• A reverse repurchase agreement is the opposite
  side of a repo (i.e., it is the purchase of a
  security with an agreement to sell it back in the
  future)

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Repurchase Agreement

• The yield on repurchase agreements (iRA) uses a
  360-day year like the discount rate, but uses the
  current price in the denominator like the bond
  equivalent yield
• Pf the repurchase price of the security
• P0 the selling price of the security
• h the number of days until the repo matures

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Repurchase Agreement
Bank of America Sells 75 million Repo
J.P. Morgan Chase Buys 75 million Repo

• FRBNY
• Today
• 75 mil. reserve account of JPM
• 75 mil to T-Bill account of JPM
• ------------------------------
• Tomorrow
• 75 mil. plus one days interest to JPM reserve
  a/c
• - 75 mil to T-Bill account of JPM

FRB of San Francisco Today 75 mil. reserve
account of BOA - 75 mil to T-Bill account of
BOA ------------------------------ Tomorrow -
75 mil. plus one days interest to BOA reserve
a/c 75 mil to T-Bill account of BOA
Fedwire
Fedwire
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Commercial Paper

• Commercial paper (CP) is the largest money market
  in terms of dollars outstanding
• CP is unsecured short-term corporate debt issued
  to raise short-term funds (e.g., for working
  capital)
• Generally sold in large denominations (e.g.,
  100,000 to 1 million) with maturities between 1
  and 270 days
• CP is usually sold to investors indirectly
  through brokers and dealers (approximately 85 of
  the time)
• CP is usually held by investors until maturity
  and has no active secondary market
• Yields are quoted on a discount basis (like
  T-bills)

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Asset-Backed Commercial Paper

• A type of commercial paper that is backed by
  assets of the issuing firm
• Grew very rapidly prior to the financial crisis
  peaking at 2.16 trillion, much of it was backed
  by mortgage investments
• The market collapsed during the financial crisis

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Negotiable Certificate of Deposit

• A negotiable certificate of deposit (CD) is a
  bank-issued time deposit that specifies the
  interest rate and the maturity date
• CDs are bearer instruments and thus are salable
  in the secondary market
• Denominations range from 100,000 to 10 million
  1 million being the most common
• Often purchased by money market mutual funds with
  pools of funds from individual investors

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Bankers Acceptance

• A Bankers Acceptance (BA) is a time draft
  payable to a seller of goods with payment
  guaranteed by a bank
• Used in international trade transactions to
  finance trade in goods that have yet to be
  shipped from a foreign exporter (seller) to a
  domestic importer (buyer)
• Foreign exporters prefer that banks act as
  payment guarantors before sending goods to
  importers
• Bankers acceptances are bearer instruments and
  thus are salable in secondary markets

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Creation of a Bankers Acceptance

• Purchase order sent by U.S. buyer to Chinese
  seller
• Chinese seller requests a letter of credit
• Notification of letter of credit and draft
  authorization
• Order shipped
• Time draft and shipping papers sent to Chinese
  sellers bank
• Time draft and shipping papers sent to U.S.
  bank bankers acceptance created
• Payments sent to foreign bank (immediately if
  Chinese seller wishes to discount the draft and
  collect immediately, at maturity if not)
• Payments sent to Chinese seller (see 7)
• Payment to U.S. bank by U.S. buyer at maturity,
  paid in full
• 0 Shipping papers delivered

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Money Market Participants

• The U.S. Treasury
• The Federal Reserve
• Commercial banks
• Money market mutual funds
• Brokers and dealers
• Corporations
• Other financial institutions
• Individuals

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International Money Markets

• U.S. dollars held outside the U.S. are tracked
  among multinational banks in the Eurodollar
  market
• The rate offered for sale on Eurodollar funds is
  the London Interbank Offered Rate (LIBOR)
• Eurodollar Certificates of Deposits are U.S.
  dollar denominated CDs held in foreign banks
• Eurocommercial paper (Euro-CP) is issued in
  Europe and can be in local currencies or U.S.
  dollars

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2011 Money Market Yields
Instrument Federal Funds Commercial Paper CDs Euro CP
Rate 0.11 0.17 0.23 1.18
Instrument LIBOR Bankers Acceptances Euro Repo
Rate 0.27375 0.22 0.25 0.08
Instrument Treasury Bills Inflation    
Rate 0.060 2.7    
Data from the Wall Street Journal Online Money
Rates Section April 2011. Rates are for 3 month
maturities except as noted. Overnight 13
week, Year over year, all items as measured
by the CPI
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Rates for maturities of 3 months - November 2004
Instrument Federal Funds Commercial Paper CDs Euro CP
Rate 2.06 2.38 3.03 4.69
Instrument LIBOR Bankers Acceptances Euro Tbill
Rate 2.71875 2.75 2.70 1.80
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Money Market Securities Outstanding
  Billions Billions Billions Billions Billions
Instrument 1990 1990 2004 2007 2010
Treasury Bills 527 527 982 1,010 1,856
Fed funds Repos 372 372 1,585 2,731 1,656
Commercial Paper 538 538 1,310 2,109 1.083
Negotiable CDs 547 547 1,379 2,149 1,822
Banker's Acceptances 52 52 4 1 1
Total 2,036 2,036 5,260 8,000 6,418
           
  of Total in Given Year of Total in Given Year of Total in Given Year of Total in Given Year of Total in Given Year
Instrument 1990 2004 2004 2007 2010
Treasury Bills 26 19 19 13 29
Fed funds Repos 18 30 30 34 26
Commercial Paper 26 25 25 26 17
Negotiable CDs 27 26 26 27 28
Banker's Acceptances 3 0.1 0.1 0.0 0.0
  100 100 100 100 100
Source Text
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International Money Markets

• U.S. dollars held outside the U.S. are tracked
  among multinational banks in the Eurodollar
  market
• The rate offered for sale on Eurodollar funds is
  the London Interbank Offered Rate (LIBOR)
• Eurodollar Certificates of Deposit are U.S.
  dollar-denominated CDs held in foreign banks
• Eurocommercial paper (Euro-CP) is issued in
  Europe and can be in local currencies or U.S.
  dollars

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International Money Markets
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PROBLEMS
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Discount yield idy ((1m. -
973,750)/1m.)(360/65) 14.538 Bond
equivalent yield ibey ((1m. -
973,750)/973,750)(365/65)
15.138 EAR EAR (1 .15138/(365/65))365/65
- 1 16.111
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• The nominal bond equivalent yield is calculated
  as
• ibey 6.56(365/360) 6.651
• The EAR on the CD is calculated as
• EAR (1 (.06651)/(365/115))365/115 - 1
  6.804

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• The yield on this repo to the bank is calculated
  as follows
  
• iRA 25,000,000 - 24,950,000 x 360 10.31
  
• 24,950,000 7
• b. The yield on this repo to the bank is
  calculated as follows
• iRA 25,000,000 - 24,950,000 x 360
  3.44
• 24,950,000
  21

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The return on the commercial paper is calculated
as icp(dy) 500,000 - 495,000 360
8.00
500,000 45 And icp(bey)
500,000 - 495,000 365 8.19
495,000 45
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a. Before the rate change, the CD holder will
receive FV 500,000 (1 .055/3)
509,167 in four months in exchange for 500,000
deposited in the bank today. Immediately after
the market rate on the CD rises to 6 percent, the
CD value decreases to PV 509,167/(1
.06/3) 499,183.33 b. Immediately after the
market rate on the CD falls to 5.25 percent, the
CD value decreases to PV 509,167/(1
.0525/3) 500,409.83
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