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Chapter Five

Money Markets

5-2

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

little or no chance of principal loss

low rates of return

Most money market instruments have active secondary markets to provide liquidity

5-3

Money Market Yields

Money market securities use special rate quoting conventions:

Discount yields (id): 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 (isp): 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 (ibe) for comparison with bonds

Note that ibey is an APR.

5-4

Money Market Yields

Treasury bills and commercial paper rates are quoted as discount yields

Discount yields (id) use a 360-day year

Pf = the face value of the security

P0 = the discount price of the security

n = the number of days until maturity

5-5

Money Market Yields

Compare discount securities to bonds with bond equivalent yields (ibe)

Convert bond equivalent yields into effective annual returns (EAR)

5-6

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 (isp)

to convert a single-payment yield to a bond equivalent yield:

to directly convert a single payment yield to an EAR:

5-7

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%

5-8

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%

5-9

Sample Calculations of Money Market Yields

What is the commercial paper’s EAR?

5-10

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)

5-11

Treasury Bills (T-Bills)

T-Bills are short-term debt obligations issued by the U.S. government

T-bills are virtually default risk free, are highly liquid, and have little interest rate risk

5-12

Treasury Bills (T-Bills)

The Federal Reserve buys and sells T-bills to implement monetary policy

Strong international demand for T-bills as safe haven investment

5-13

T-Bill Auctions

13- and 26-week T-bills are auctioned weekly, other maturities available

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

5-14

Quantity of

T-bills

Bid Price

Noncompetitive Bids

Stop-out

price (PNC)

T-Bill Auctions

5-15

The Secondary Market for T-Bills

The secondary market for T-bills is the largest of any U.S. money market instrument

21 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

5-16

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

5-17

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

Multimillion dollar loans may be arranged in a matter of minutes

Fed funds are single-payment loans and thus use single-payment yields

5-18

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’

5-19

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 purchase of a security with an agreement to sell it back in the future

5-20

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

n = the number of days until the repo matures

5-21

Commercial Paper

Commercial Paper (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 78% 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)

5-22

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

5-23

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

5-24

Banker’s Acceptance

A Banker’s 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

Banker’s acceptances are bearer instruments and thus are salable in secondary markets

5-25

Diagram of a Banker’s Acceptance

5-26

2014 Money Market Yields

Data from the Wall Street Journal Online Money Rates Section except CD rate which is in a separate section from May 2014. Rates are for 3 month maturities except as noted.

* Overnight; ** 13 week, *** Year over year, all items as measured by the CPI

5-27

Money Market Securities Outstanding

5-28

Money Market Participants

The U.S. Treasury

The Federal Reserve

Commercial banks

Money market mutual funds

Brokers and dealers

Corporations

Other financial institutions

Individuals

5-29

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

5-30

International Money Markets

5-31

International Money Markets

5-32

International Money Markets

5-33

International Money Markets

The London Interbank Offer Rate (LIBOR) is the rate on interbank loans between British banks

LIBOR is the base rate on trillions of dollars of derivatives and is the base rate for many loans

Large banks manipulated LIBOR to profit on derivatives positions and/or to appear less risky during the crisis.

Bank profits from misquoting LIBOR may have exceeded $75 billion

Many banks fined, changed LIBOR reporting process

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U.S. buyer

(importer)

Chinese seller

(exporter)

U.S. bank

(importer’s bank)

Chinese bank

(exporter’s bank)

2299 55

1010

1. Purchase order sent by U.S. buye r to Chinese seller

2. Chinese seller requests a letter of credit

3. Notification of letter of credit and draft authorization

4. Order shipped

5. Time draft and shipping papers sent to Chinese seller’s bank

6. Time draft and shipping papers sent to U.S. bank; banker’s

acceptance created

7. Payments sent to foreign bank (immediately if Chinese seller

wishes to discount the draft and collect immediately, at

maturity if not)

8. Payments sent to Chinese seller (see #7)

9. Payment to U.S. bank by U.S. buyer at maturity, paid in full

10. Shipping papers delivered

Instrument

Federal

Funds*

Commercial

Paper Jumbo CDs+ Euro CP

Rate 0.10% 0.11% 0.10% 0.23%

Instrument LIBOR

Banker’s

Acceptances Euro$ Repo*

Rate 0.2274% 0.23% 0.15% 0.14%

Instrument

Treasury

Bills** Inflation***

Rate 0.030 2.0%

Money market securities outstanding i n 1990, 2004, 2007, 2010 and 2013

Billions $

Instrument 1990 2004 2007 2010 2013

Treasury Bills $ 527 $ 982 $1,010 $1,856 $1,607

Fed funds & Repos 372 1,585 2,731 1,656 1,097

Commercial Paper 538 1,310 2,109 1.083 1,001

Negotiable CDs 547 1,379 2,149 1,822 1,491

Banker's Acceptances 52 4 1 1 0

Total $2,036 $5,260 $8,000 $6,418 $5,196

% of Total in Given Year

Instrument 1990 2004 2007 2010 2013

Treasury Bills 26% 19% 13% 29% 31%

Fed funds & Repos 18% 30% 34% 26% 21%

Commercial Paper 26% 25% 26% 17% 19%

Negotiable CDs 27% 26% 27% 28% 29%

Banker's Acceptances 3% 0.1% 0.0% 0.0% 0%

100% 100% 100% 100% 100%

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