Financial Transaction

6 Money Markets

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the features of the most popular money market securities,

· ▪ explain how money markets are used by institutional investors,

· ▪ explain the valuation and risk of money market securities, and

· ▪ explain how money markets have become globally integrated.

Money markets are used to facilitate the transfer of short-term funds from individuals, corporations, or governments with excess funds to those with deficient funds. Even investors who focus on long-term securities tend to hold some money market securities. Money markets enable financial market participants to maintain liquidity.

6-1 MONEY MARKET SECURITIES

Money market securities  are debt securities with a maturity of one year or less. They are issued in the primary market through a telecommunications network by the Treasury, corporations, and financial intermediaries that wish to obtain short-term financing. The means by which money markets facilitate the flow of funds are illustrated in Exhibit 6.1. The U.S. Treasury issues money market securities (Treasury bills) and uses the proceeds to finance the budget deficit. Corporations issue money market securities and use the proceeds to support their existing operations or to expand their operations. Financial institutions issue money market securities and bundle the proceeds to make loans to households or corporations. Thus, the funds are channeled to support household purchases, such as cars and homes, and to support corporate investment in buildings and machinery. The Treasury and some corporations commonly pay off their debt from maturing money market securities with the proceeds from issuing new money market securities. In this way, they are able to finance expenditures for long periods of time even though money market securities have short-term maturities. Overall, money markets allow households, corporations, and the U.S. government to increase their expenditures; thus the markets finance economic growth.

   Money market securities are commonly purchased by households, corporations (including financial institutions), and government agencies that have funds available for a short-term period. Because money market securities have a short-term maturity and can typically be sold in the secondary market, they provide liquidity to investors. Most firms and financial institutions maintain some holdings of money market securities for this reason.

   The more popular money market securities are:

· ▪ Treasury bills (T-bills)

· ▪ Commercial paper

· ▪ Negotiable certificates of deposit

· ▪ Repurchase agreements

· ▪ Federal funds

· ▪ Banker's acceptances

Each of these instruments is described in turn.

Exhibit 6-1 How Money Markets Facilitate the Flow of Funds

6-1a Treasury Bills

When the U.S. government needs to borrow funds, the U.S. Treasury frequently issues short-term securities known as Treasury bills. The Treasury issues T-bills with 4-week, 13-week, and 26-week maturities on a weekly basis. It periodically issues T-bills with terms shorter than four weeks, which are called cash management bills. It also issues T-bills with a one-year maturity on a monthly basis. Treasury bills were formerly issued in paper form but are now maintained electronically.

Investors in Treasury Bills  Depository institutions commonly invest in T-bills so that they can retain a portion of their funds in assets that can easily be liquidated if they suddenly need to accommodate deposit withdrawals. Other financial institutions also invest in T-bills in the event that they need cash because cash outflows exceed cash inflows. Individuals with substantial savings invest in T-bills for liquidity purposes. Many individuals invest in T-bills indirectly by investing in money market funds, which in turn purchase large amounts of T-bills. Corporations invest in T-bills so that they have easy access to funding if they suddenly incur unanticipated expenses.

Credit Risk  Treasury bills are attractive to investors because they are backed by the federal government and are therefore virtually free of credit (default) risk. This is a very desirable feature, because investors do not have to use their time to assess the risk of the issuer, as they do with other issuers of debt securities.

Liquidity  Another attractive feature of T-bills is their liquidity, which is due to their short maturity and strong secondary market. At any given time, many institutional investors are participating in the secondary market by purchasing or selling existing T-bills. Thus, investors can easily obtain cash by selling their T-bills in the secondary market. Government securities dealers serve as intermediaries in the secondary market by buying existing T-bills from investors who want to sell them, or selling them to investors who want to buy them. These dealers profit by purchasing the bills at a slightly lower price than the price at which they sell them.

Pricing Treasury Bills  The par value (amount received by investors at maturity) of T-bills is $1,000 and multiples of $1,000. Since T-bills do not pay interest, they are sold at a discount from par value, and the gain to the investor holding a T-bill until maturity is the difference between par value and the price paid.

   The price that an investor will pay for a T-bill with a particular maturity depends on the investor's required rate of return on that T-bill. That price is determined as the present value of the future cash flows to be received. The value of a T-bill is the present value of the par value. Thus, investors are willing to pay a price for a one-year T-bill that ensures that the amount they receive a year later will generate their desired return.

EXAMPLE

If investors require a 4 percent annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is

P = $10,000/1.04

= $9.615.38

   if the investors require a higher return, they will discount the $10,000 at that higher rate of return, which will result in a lower price that they are willing to pay today. You can verify this by estimating the price based on a required return of 5 percent and then on a required return of 6 percent.

   To price a T-bill with a maturity shorter than one year, the annualized return can be reduced by the fraction of the year in which funds will be invested.

EXAMPLE

If investors require a 4 percent annualized return on a six-month T-bill, this reflects a 2 percent unannualized return over six months. The price that they will be willing to pay for a T-bill with a par value of $10,000 is therefore

P = $10,000 1.02

 = $9,803.92

Estimating the Yield  Because T-bills do not offer coupon payments and are sold at a discount from par value, their yield is influenced by the difference between the selling price and the purchase price. If an investor purchases a newly issued T-bill and hold-sit until maturity, the return is based on the difference between the par value and the purchase price. If the T-bill is sold prior to maturity, the return is based on the difference between the price for which the bill was sold in the secondary market and the purchase price. The annualized yield from investing in a T-bill (YT) can be determined as

where

YT = 

SP  −  PP

PP

 × 

365
n
SP =	selling price
PP =	purchase price
n =	number of days of the investment (holding period)

EXAMPLE

An investor purchases a T-bill with a six-month (182-day) maturity and $10,000 par value for $9,800. If this T-bill is held until maturity, its yield is:

WEB

www.federalreserve.gov/econresdata

Go to the section on interest rates to review Treasury bill rates over time.

   Suppose the investor plans to sell the T-bill after 120 days and forecasts a selling price of $9,900 at that time. The expected annualized yield based on this forecast is

The higher the forecasted selling price, the higher the expected annualized yield.

Estimating the Treasury Bill Discount  Some business periodicals quote the T-bill discount along with the T-bill yield. The T-bill discount represents the percentage discount of the purchase price from par value (Par) for newly issued T-bills, and is computed as follows:

   T-bill discount = 

Par −  PP

Par

 × 

360

n

EXAMPLE

If a newly issued 6-month (182-day) T-bill with a par value of $10,000 is purchased for $9,800, the T-bill discount is

   For a newly issued T-bill that is held to maturity, the T-bill yield will always be higher than the discount. The difference occurs because the purchase price is the denominator of the yield equation whereas the par value is the denominator of the T-bill discount equation, and the par value will always exceed the purchase price of a newly issued T-bill. In addition, the yield formula uses a 365-day year versus the 360-day year used for the discount computation.

6-1b Treasury Bill Auction

The primary T-bill market is an auction. Individual investors can submit bids online for newly issued T-bills at  www.treasurydirect.gov .

   Financial institutions can submit their bids for T-bills (and other Treasury securities) online using the Treasury Automated Auction Processing System (TAAPS). Individuals and financial institutions can set up an account with the Treasury. Then they can select the specific maturity and face value that they desire and submit their bids electronically. Payments to the Treasury are withdrawn electronically from the account, and payments received from the Treasury when the securities mature are deposited electronically into the account.

   At the auctions, investors have the option of bidding competitively or noncompetitively. The Treasury has a specified amount of funds that it plans to borrow, which dictates the amount of T-bill bids that it will accept for that maturity. Investors who wish to ensure that their bids will be accepted can use noncompetitive bids. Noncompetitive bidders are limited to purchasing T-bills with a maximum par value of $5 million per auction, however. Consequently, large corporations typically make competitive bids so that they can purchase larger amounts.

   After accounting for noncompetitive bids, the Treasury accepts the highest competitive bids first and then works its way down until it has generated the amount of funds from competitive bids that it needs. Any bids below that cutoff point are not accepted. The Treasury applies the lowest accepted bid price to all competitive bids that are accepted and to all noncompetitive bids. Thus, the price paid by competitive and noncompetitive bidders reflects the lowest price of the competitive bids. Competitive bids are still submitted because, as noted before, many bidders want to purchase more T-bills than the maximum that can be purchased on a noncompetitive basis.

   At each auction, the prices paid for six-month T-bills are significantly lower than the prices paid for three-month T-bills, because the investment term is longer. The lower price results in a higher unannualized yield that compensates investors for their longer-term investment.

WEB

www.treasurydirect.gov

Results of recent Treasury bill auctions.

   The results of the weekly auction of 13-week and 26-week T-bills are summarized in the financial media each Tuesday and are also provided online at the Treasury Direct website. Some of the more commonly reported statistics are the dollar amount of applications and Treasury securities sold, the average price of the accepted competitive bids, and the coupon equivalent (annualized yield) for investors who paid the average price.

6-1c Commercial Paper

Commercial paper is a short-term debt instrument issued only by well-known, creditworthy firms that is typically unsecured. It is normally issued to provide liquidity or to finance a firm's investment in inventory and accounts receivable. The issuance of commercial paper is an alternative to short-term bank loans. Some large firms prefer to issue commercial paper rather than borrow from a bank because it is usually a cheaper source of funds. Nevertheless, even the large creditworthy firms that are able to issue commercial paper normally obtain some short-term loans from commercial banks in order to maintain a business relationship with them. Financial institutions such as finance companies and bank holding companies are major issuers of commercial paper.

Denomination  The minimum denomination of commercial paper is usually $100,000, and typical denominations are in multiples of $1 million. Maturities are normally between 20 and 45 days but can be as short as 1 day or as long as 270 days. The 270-day maximum is due to a Securities and Exchange Commission ruling that paper with a maturity exceeding 270 days must be registered.

   Because of the high minimum denomination, individual investors rarely purchase commercial paper directly, although they may invest in it indirectly by investing in money market funds that have pooled the funds of many individuals. Money market funds are major investors in commercial paper. Although the secondary market for commercial paper is very limited, it is sometimes possible to sell the paper back to the dealer who initially helped to place it. However, in most cases, investors hold commercial paper until maturity.

Credit Risk  Because commercial paper is issued by corporations that are susceptible to business failure, commercial paper is subject to credit risk. The risk of default is affected by the issuer's financial condition and cash flow. Investors can attempt to assess the probability that commercial paper will default by monitoring the issuer's financial condition. The focus is on the issuer's ability to repay its debt over the short term because the payments must be completed within a short-term period.

   Although issuers of commercial paper are subject to possible default, historically the percentage of issues that have defaulted is very low, as most issuers of commercial paper are very strong financially. In addition, the short time period of the credit reduces the chance that an issuer will suffer financial problems before repaying the funds borrowed. However, during the credit crisis in 2008, Lehman Brothers (a large securities firm) failed. This made investors more cautious before purchasing securities, as discussed later in the chapter.

Exhibit 6.2 Possible Ratings Assigned to Commercial Paper

	MOODY'S	STANDARD & POOR'S	FITCH
Highest	P1	A1	F1
High	P2	A2	F2
Medium	P3	A3	F3
Low	NP	B or C	F4
Default	NP	D	F5

Credit Risk Ratings  Commercial paper is commonly rated by rating agencies such as Moody's Investors Service, Standard & Poor's Corporation, and Fitch Investor Service. The possible ratings assigned to commercial paper are shown in  Exhibit 6.2 . The rating serves as an indicator of the potential risk of default. Some investors rely heavily on the rating to assess credit risk, rather than assess the risk of the issuer themselves.

WEB

www.federalreserve.gov/releases/cp/about.htm

Provides valuable information about commercial paper.

   A money market fund can invest only in commercial paper that has a top-tier or second-tier rating, and second-tier paper cannot represent more than 5 percent of the fund's assets. Thus, corporations can more easily place commercial paper that is assigned a top-tier rating. Some commercial paper (called  junk commercial paper ) is rated low or not rated at all.

Placement  Some firms place commercial paper directly with investors. Other firms rely on commercial paper dealers to sell their commercial paper at a transaction cost of about one-eighth of 1 percent of the face value. This transaction cost is generally less than it would cost to establish a department within the firm to place commercial paper directly. However, companies that frequently issue commercial paper may reduce expenses by creating such an in-house department. Most nonfinancial companies use commercial paper dealers rather than in-house resources to place their commercial paper. Their liquidity needs, and therefore their commercial paper issues, are cyclical, so they would use an in-house, direct placement department only a few times during the year. Finance companies typically maintain an in-house department because they frequently borrow in this manner.

Backing Commercial Paper  Some commercial paper is backed by assets of the issuer. Commercial paper that is backed by assets should offer a lower yield than if it were not secured by assets. However, the issuers of asset-backed commercial paper tend to have more risk of default than the well-known firms that can successfully issue unsecured commercial paper, and the value of assets used as collateral may be questionable. Thus yields offered on asset-backed commercial paper are often higher than the yields offered on unsecured commercial paper.

   Some issuers of asset-backed commercial paper obtain credit guarantees from a sponsoring institution in the event that they cannot cover their payments on commercial paper. This allows them to more easily sell their commercial paper to investors.

   Issuers of commercial paper typically maintain backup lines of credit in case they cannot roll over (reissue) commercial paper at a reasonable rate because, for example, their assigned rating has been lowered. A backup line of credit provided by a commercial bank gives the company the right (but not the obligation) to borrow a specified maximum amount of funds over a specified period of time. The fee for the credit line can either be a direct percentage (e.g., 0.5 percent) of the total accessible credit or be in the form of required compensating balances (e.g., 10 percent of the credit line).

Estimating the Yield  Like T-bills, commercial paper does not pay interest and is priced at a discount from par value. At a given point in time, the yield on commercial paper is slightly higher than the yield on a T-bill with the same maturity because commercial paper carries some credit risk and is less liquid. The nominal return to investors who retain the paper until maturity is the difference between the price paid for the paper and the par value. Thus the yield received by a commercial paper investor can be determined in a manner similar to the T-bill yield, although a 360-day year is usually used.

EXAMPLE

If an investor purchases 30-day commercial paper with a par value of $1,000,000 for a price of $995,000, and holds the commercial paper until maturity, the yield (Yep) is

WEB

www.federalreserve.gov/releases/cp

Provides information on current commercial paper rates as well as a database of commercial paper rates over time.

   When a firm plans to issue commercial paper, the price (and hence the yield) to investors is uncertain. Thus the cost of borrowing funds is uncertain until the paper is issued.

   When firms sell their commercial paper at a lower (higher) price than projected, their cost of raising funds will be higher (lower) than they initially anticipated.

   Ignoring transaction costs, the cost of borrowing with commercial paper is equal to the yield earned by investors holding the paper until maturity. The cost of borrowing can be adjusted for transaction costs (charged by the commercial paper dealers) by subtracting the nominal transaction fees from the price received.

Commercial Paper Yield Curve  The commercial paper yield curve represents the yield offered on commercial paper at various maturities, based on the assumption that the paper is held to maturity. The curve is typically established for a maturity range from 0 to 90 days because most commercial paper has a maturity within that range. This yield curve is important because it may influence the maturity that is used by firms that issue commercial paper and by the institutional investors that purchase commercial paper. The shape of this yield curve could be roughly drawn from the short-term range of the traditional Treasury yield curve. However, that curve is graphed over a long time period, so it is difficult to derive the precise shape of a yield curve over a three-month range from that graph.

   The same factors that affect the Treasury yield curve affect the commercial paper yield curve, but they are applied to very short-term horizons. In particular, expectations regarding the interest rate over the next few months can influence the commercial paper yield curve.

Commercial Paper Rate over Time  Therate (or yield) offered on newly issued commercial paper over time is provided in  Exhibit 6.3 . The movements in the commercial paper rate are highly correlated with the T-bill rate with the same maturity. The annualized commercial paper rate commonly contains a very small premium (such as 0.3 percent or smaller) above the T-bill rate to reflect a slight degree of default risk.

Exhibit 6.3 Commercial Paper Rate over Time

6-1d Negotiable Certificates of Deposit

Negotiable certificates of deposit (NCDs)  are certificates issued by large commercial banks and other depository institutions as a short-term source of funds. The minimum denomination is $100,000, although a $1 million denomination is more common. Nonfinancial corporations often purchase NCDs. Although NCD denominations are typically too large for individual investors, they are sometimes purchased by money market funds that have pooled individual investors' funds. Thus, money market funds allow individuals to be indirect investors in NCDs, creating a more active NCD market.

   Maturities on NCDs normally range from two weeks to one year. A secondary market for NCDs exists, providing investors with some liquidity. However, institutions prefer not to have their newly issued NCDs compete with their previously issued NCDs being resold in the secondary market. An oversupply of NCDs for sale could force institutions to sell their newly issued NCDs at a lower price.

Placement  Some issuers place their NCDs directly; others use a correspondent institution that specializes in placing NCDs. Another alternative is to sell NCDs to securities dealers who in turn resell them. A portion of unusually large issues is commonly sold to NCD dealers. Normally, however, NCDs can be sold to investors directly at a higher price.

Yield  Negotiable certificates of deposit provide a return in the form of interest along with the difference between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase price. Given that an institution issues an NCD at par value, the annualized yield that it will pay is the annualized interest rate on the NCD. If investors purchase this NCD and hold it until maturity, their annualized yield is the interest rate. However, the annualized yield can differ from the annualized interest rate for investors who either purchase or sell the NCD in the secondary market instead of holding it from inception until maturity.

   Negotiable certificates of deposit must offer a slightly higher yield above the T-bill yield with the same maturity in order to compensate for less liquidity and safety. The premiums are generally higher during recessionary periods, and they reflect the market's perception of the financial system's safety.

EXAMPLE

An investor purchased an NCO a year ago in the secondary market for $990,000. He redeems it today upon maturity and receives $1,000,000. He also receives interest of $40,000. His annualized yield (YNCD) on this investment is

6-1e Repurchase Agreements

With a repurchase agreement (or repo), one party sells securities to another with an agreement to repurchase the securities at a specified date and price. In essence, the repo transaction represents a loan backed by the securities. If the borrower defaults on the loan, the lender has claim to the securities. Most repo transactions use government securities, although some involve other securities such as commercial paper or NCDs. A  reverse repo  refers to the purchase of securities by one party from another with an agreement to sell them. Thus, a repo and a reverse repo refer to the same transaction but from different perspectives. These two terms are sometimes used interchangeably, so a transaction described as a repo may actually be a reverse repo.

   Financial institutions such as banks, savings and loan associations, and money market funds often participate in repurchase agreements. Many nonfinancial institutions are also active participants. The size of the repo market is about $4.5 trillion, and transaction amounts are usually for $10 million or more. The most common maturities are from 1 to 15 days and for one, three, and six months. A secondary market for repos does not exist. Some firms in need of funds will set the maturity on a repo to be the minimum time period for which they need temporary financing. If they still need funds when the repo is about to mature, they will borrow additional funds through new repos and use these funds to fulfill their obligation on maturing repos.

Placement  Repo transactions are negotiated through a telecommunications network. Dealers and repo brokers act as financial intermediaries to create repos for firms with deficient or excess funds, receiving a commission for their services.

   When the borrowing firm can find a counterparty to the repo transaction, it avoids the transaction fee involved in having a government securities dealer find the counterparty. Some companies that commonly engage in repo transactions have an in-house department for finding counterparties and executing the transactions. A company that borrows through repos may, from time to time, serve as the lender. That is, it may purchase the government securities and agree to sell them back in the near future. Because the cash flow of any large company changes on a daily basis, it is not unusual for a firm to act as an investor one day (when it has excess funds) and a borrower the next (when it has a cash shortage).

Impact of the Credit Crisis  During the credit crisis in 2008, the values of mortgage securities declined and so financial institutions participating in the housing market were exposed to more risk. Consequently, many financial institutions that relied on the repo market for funding were not able to obtain funds. Investors became more concerned about the securities that were posted as collateral. Bear Stearns, a large securities firm, relied heavily on repos for funding and used mortgage securities as collateral. But the valuation of these types of securities was subject to much uncertainty because of the credit crisis. Consequently, investors were unwilling to provide funding, and Bear Stearns could not obtain sufficient financing. It avoided bankruptcy only with the aid of the federal government. The lesson of this example is that repo market funding requires collateral that is trusted by investors. When economic conditions are weak, some securities may not serve as adequate collateral to obtain funding.

 USING THE WALL STREET JOURNAL: Key Interest Rates

The Wall Street Journal discloses quoted interest rates for commercial paper, CDs, Treasury bills, and other securities, as shown here. Notice that the rate quoted for commercial paper or CDs is slightly higher than the rate quoted for Treasury securities with the same maturity. Issuers of these securities and investors in these securities closely monitor the prevailing rates.

Source: Republished with permission of Dow Jones & Company, Inc., from the Wall Street Journal, January 25, 2011, p. C11.

Estimating the Yield  The repo rate is determined as the difference between the initial selling price of the securities and the agreed-on repurchase price, annualized to a 360-day year.

EXAMPLE

An investor initially purchased securities at a price (PP) of $992,000 while agreeing to sell them back at a price (SP) of $1,000,000 at the end of a 60-day period. The yield (or repo rate) on this repurchase agreement is

6-1f Federal Funds

The federal funds market enables depository institutions to lend or borrow short-term funds from each other at the so-called  federal funds rate . This rate is charged on federal funds transactions, and it is influenced by the supply of and demand for funds in the federal funds market. The Federal Reserve adjusts the amount of funds in depository institutions in order to influence the federal funds rate (as explained in  Chapter 4 ) and several other short-term interest rates. All types of firms closely monitor the federal funds rate because the Federal Reserve manipulates it to affect general economic conditions. For this reason, many market participants view changes in the federal funds rate as an indicator of potential changes in other money market rates.

   The federal funds rate is normally slightly higher than the T-bill rate at any given time. A lender in the federal funds market is subject to credit risk, since it is possible that the financial institution borrowing the funds could default on the loan. Once a loan transaction is agreed upon, the lending institution can instruct its Federal Reserve district bank to debit its reserve account and to credit the borrowing institution's reserve account by the amount of the loan. If the loan is for just one day, it will likely be based on an oral agreement between the parties, especially if the institutions commonly do business with each other.

   Commercial banks are the most active participants in the federal funds market. Federal funds brokers serve as financial intermediaries in the market, matching up institutions that wish to sell (lend) funds with those that wish to purchase (borrow) them. The brokers receive a commission for their service. The transactions are negotiated through a telecommunications network that links federal funds brokers with participating institutions. Most loan transactions are for $5 million or more and usually have a maturity of one to seven days (although the loans may often be extended by the lender if the borrower requests more time).

   The volume of interbank loans on commercial bank balance sheets over time is an indication of the importance of lending between depository institutions. The interbank loan volume outstanding now exceeds $200 billion.

6-1g Banker's Acceptances

WEB

www.federalreserve.gov/fomc/fundsrate.htm

Provides an excellent summary of the Fed's adjustment in the federal funds rate over time.

A  banker's acceptance  indicates that a bank accepts responsibility for a future payment. Banker's acceptances are commonly used for international trade transactions. An exporter that is sending goods to an importer whose credit rating is not known will often prefer that a bank act as a guarantor. The bank therefore facilitates the transaction by stamping ACCEPTED on a draft, which obligates payment at a specified point in time. In turn, the importer will pay the bank what is owed to the exporter along with a fee to the bank for guaranteeing the payment.

   Exporters can hold a banker's acceptance until the date at which payment is to be made, but they frequently sell the acceptance before then at a discount to obtain cash immediately. The investor who purchases the acceptance then receives the payment guaranteed by the bank in the future. The investor's return on a banker's acceptance, like that on commercial paper, is derived from the difference between the discounted price paid for the acceptance and the amount to be received in the future. Maturities on banker's acceptances typically range from 30 to 270 days. Because there is a possibility that a bank will default on payment, investors are exposed to a slight degree of credit risk. Thus, they deserve a return above the T-bill yield in compensation.

   Because acceptances are often discounted and sold by the exporting firm prior to maturity, an active secondary market exists. Dealers match up companies that wish to sell acceptances with other companies that wish to purchase them. A dealer's bid price is less than its ask price, and this creates the spread (or the dealer's reward for doing business). The spread is normally between one-eighth and seven-eighths of 1 percent.

Steps Involved in Banker's Acceptances  The sequence of steps involved in a banker's acceptance is illustrated in  Exhibit 6.4 . To understand these steps, consider the example of a U.S. importer of Japanese goods. First, the importer places a purchase order for the goods (Step 1). If the Japanese exporter is unfamiliar with the U.S. importer, it may demand payment before delivery of goods, which the U.S. importer may be unwilling to make. A compromise can be reached by creating a banker's acceptance. The importer asks its bank to issue a  letter of credit (L/C)  on its behalf (Step 2). The L/C represents a commitment by that bank to back the payment owed to the Japanese exporter. Then the L/C is presented to the exporter's bank (Step 3), which informs the exporter that the L/C has been received (Step 4). The exporter then sends the goods to the importer (Step 5) and sends the shipping documents to its bank (Step 6), which passes them along to the importer's bank (Step 7). At this point, the banker's acceptance (B/A) is created, which obligates the importer's bank to make payment to the holder of the banker's acceptance at a specified future date. The banker's acceptance may be sold to a money market investor at a discount. Potential purchasers of acceptances are short-term investors. When the acceptance matures, the importer pays its bank, which in turn pays the money market investor who presents the acceptance.

   The creation of a banker's acceptance allows the importer to receive goods from an exporter without sending immediate payment. The selling of the acceptance creates financing for the exporter. Even though banker's acceptances are often created to facilitate international transactions, they are not limited to money market investors with international experience. Investors who purchase acceptances are more concerned with the credit of the bank that guarantees payment than with the credit of the exporter or importer. For this reason, the credit risk on a banker's acceptance is somewhat similar to that of NCDs issued by commercial banks. Yet because it has the backing not only of the bank but also of the importing firm, a banker's acceptance may be perceived as having slightly less credit risk than an NCD.

Exhibit 6.4 Sequence of Steps in the Creation of a Banker's Acceptance

   The types of money market securities are summarized in  Exhibit 6.5 . When money market securities are issued to obtain funds, the type of securities issued depends on whether the issuer is the Treasury, a depository institution, or a corporation. When investors decide which type of money market securities to invest in, their choice depends on the desired return and liquidity characteristics.

6-2 INSTITUTIONAL USE OF MONEY MARKETS

The institutional use of money market securities is summarized in  Exhibit 6.6 . Financial institutions purchase money market securities in order to earn a return while maintaining adequate liquidity. They issue money market securities when experiencing a temporary shortage of cash. Because money markets serve businesses, the average transaction is very large and is typically executed through a telecommunications network.

   Money market securities can be used to enhance liquidity in two ways. First, newly issued securities generate cash. The institutions that issue new securities have created a short-term liability in order to boost their cash balance. Second, institutions that previously purchased money market securities will generate cash upon liquidation of the securities. In this case, one type of asset (the security) is replaced by another (cash).

   Most financial institutions maintain sufficient liquidity by holding either securities that have very active secondary markets or securities with short-term maturities. T-bills are the most popular money market instrument because of their marketability, safety, and short-term maturity. Although T-bills are purchased through an auction, other money market instruments are commonly purchased through dealers or specialized brokers. For example, commercial paper is purchased through commercial paper dealers or directly from the issuer, NCDs are usually purchased through brokers specializing in NCDs, federal funds are purchased (borrowed) through federal funds brokers, and repurchase agreements are purchased through repo dealers.

Exhibit 6.5 Summary of Commonly Issued Money Market Securities

SECURITIES	ISSUED BY	COMMON INVESTORS	COMMON MATURITIES	SECONDARY MARKET ACTIVITY
Treasury bills	Federal government	Households, firms, and financial institutions	13 weeks, 26 weeks, 1 year	High
Negotiable certificates of deposit (NCDs)	Large banks and savings institutions	Firms	2 weeks to 1 year	Moderate
Commercial paper	Bank holding companies, finance companies, and other companies	Firms	1 day to 270 days	Low
Banker's acceptances	Banks (exporting firms can sell the acceptances at a discount to obtain funds)	Firms	30 days to 270 days	High
Federal funds	Depository institutions	Depository institutions	1 day to 7 days	Nonexistent
Repurchase agreements	Firms and financial institutions	Firms and financial institutions	1 day to 15 days	Nonexistent

Exhibit 6.6 Institutional Use of Money Markets

TYPE OF FINANCIAL INSTITUTION	PARTICIPATION IN THE MONEY MARKETS
Commercial banks and savings institutions	· • Bank holding companies issue commercial paper. · • Some banks and savings institutions issue NCDs, borrow or lend funds in the federal funds market, engage in repurchase agreements, and purchase T-bills. · • Commercial banks create banker's acceptances. · • Commercial banks provide backup lines of credit to corporations that issue commercial paper.
Finance companies	· • Issue large amounts of commercial paper.
Money market mutual funds	· • Use proceeds from shares sold to invest in T-bills, commercial paper, NCDs, repurchase agreements, and banker's acceptances.
Insurance companies	· • May maintain a portion of their investment portfolio as money market securities for liquidity.
Pension funds	· • May maintain a portion of their investment portfolio as money market securities that may be liquidated when portfolio managers desire to increase their investment in bonds or stocks.

   Financial institutions whose future cash inflows and outflows are more uncertain will generally maintain additional money market instruments for liquidity. For this reason, depository institutions such as commercial banks allocate a greater portion of their asset portfolio to money market instruments than pension funds usually do.

   Financial institutions that purchase money market securities are acting as creditors to the initial issuer of the securities. For example, when they hold T-bills, they are creditors to the Treasury. The T-bill transactions in the secondary market commonly reflect a flow of funds between two nongovernment institutions. Treasury bills represent a source of funds for those financial institutions that liquidate some of their T-bill holdings. In fact, this is the main reason that financial institutions hold T-bills. Liquidity is also the reason financial institutions purchase other money market instruments, including federal funds (purchased by depository institutions) and repurchase agreements (purchased by depository institutions and money market funds) as well as banker's acceptances and NCDs (purchased by money market funds).

   Some financial institutions issue their own money market instruments to obtain cash. For example, depository institutions issue NCDs, and bank holding companies and finance companies issue commercial paper. Depository institutions also obtain funds through the use of repurchase agreements or in the federal funds market.

   Many money market transactions involve two financial institutions. For example, a federal funds transaction involves two depository institutions. Money market funds commonly purchase NCDs from banks and savings institutions. Repurchase agreements are frequently negotiated between two commercial banks.

6-3 VALUATION OF MONEY MARKET SECURITIES

The market price of money market securities (Pm) should equal the present value of their future cash flows. Since money market securities normally do not make periodic interest payments, their cash flows are in the form of one lump-sum payment of principal. Therefore, the market price of a money market security can be determined as

Pm  = 

Par

(1 + k)n

where

Par =	par value or principal amount to be provided at maturity
k =	required rate of return by investors
n =	time to maturity

Since money market securities have maturities of one year or less, n is measured as a fraction of one year.

   A change in Pm can be modeled as

Δ Pm  = f(Δk ) and (Δk) =  f  (Δ Rf , ΔRP)

where

Rf =	risk-free interest rate
RP =	risk premium

Therefore,

ΔPm  =  f  (ΔRf , ΔRP)

   This illustrates how the prices of money market securities would change in response to a change in the required rate of return, which itself is influenced by the risk-free interest rate and the perceived credit risk over time.  Exhibit 6.7  identifies the underlying forces that can affect the short-term risk-free interest rate (the T-bill rate) and the risk premium and therefore affect the required return and prices of money market securities over time.

Exhibit 6.7 Framework for Pricing Money Market Securities

   In general, the money markets are widely perceived to be efficient in that the prices reflect all available public information. Investors closely monitor economic indicators that may signal future changes in the strength of the economy, which can affect short-term interest rates and hence the required return from investing in money market securities. Some of the more closely monitored indicators of economic growth include employment, gross domestic product, retail sales, industrial production, and consumer confidence. A favorable movement in these indicators tends to create expectations of increased economic growth, which could place upward pressure on market interest rates (including the risk-free rate for short-term maturities) and downward pressure on prices of money market securities.

   Investors also closely monitor indicators of inflation, such as the consumer price index and the producer price index. An increase in these indexes may create expectations of higher interest rates and places downward pressure on money market prices.

   In addition to the indicators, investors also assess the financial condition of the firms that are issuing commercial paper. Their intent is to ensure that the issuing firm is financially healthy and therefore capable of paying off the debt at maturity.

6-3a Impact of Changes in Credit Risk

If investors want to avoid credit risk, they can purchase T-bills. When investing in other money market securities, they must weigh the higher potential return against the exposure to credit risk. Investors commonly invest in money market securities such as commercial paper and NCDs that offer a slightly higher yield than T-bills and are very unlikely to default. The perception of credit risk can change over time, which affects the required return and therefore the price of money market securities.

Credit Risk Following Lehman's Default  The credit crisis of 2008 had a major impact on the perceived risk of money market securities. Lehman Brothers relied on commercial paper as a permanent source of financing. As its outstanding issues of commercial paper came due, it would issue more and use the proceeds to pay off the paper that was due. It was heavily invested in mortgage-backed securities, and used these securities as collateral when issuing commercial paper to borrow funds. However, as the value of mortgage-backed securities declined, institutional investors were no longer willing to purchase Lehman's commercial paper because they questioned the value of the collateral. Since it could not obtain new funding, it was unable to pay off its existing debt. As Lehman Brothers filed for bankruptcy in September 2008, it defaulted on hundreds of millions of dollars of commercial paper that it had issued. This shocked the commercial paper market. As a result of the Lehman Brothers failure, investors became more concerned that commercial paper issued by other financial institutions might also be backed by assets with questionable quality.

   Some issuers of asset-backed commercial paper obtained credit guarantees from a sponsoring institution in the event that they could not cover their payments on commercial paper. Normally, the credit guarantees might calm investors. Yet, during the credit crisis, the financial institutions providing credit guarantees for issuers of commercial paper were highly exposed to mortgages and other risky assets. The credit guarantee is only as good as the credit of the guarantor. Suddenly, institutional investors began to realize their exposure to default risk when investing in asset-backed commercial paper. As these investors cut back on their investments in commercial paper in order to avoid risk, the financial institutions that relied on commercial paper for their financing could no longer obtain the funds that they needed.

   In the two months following the bankruptcy of Lehman Brothers, the volume of commercial paper declined by about $370 billion. Those firms that were still able to sell commercial paper had to pay higher risk premiums to compensate for the higher credit risk perceived by investors.

   The credit crisis illustrates how problems in one debt security market (e.g., mortgage-backed securities) can be contagious to other debt markets (the commercial paper market). This is one reason why the federal government was concerned about systemic risk, whereby the adverse effects triggered in the market for mortgage-backed securities might spread to affect all types of financial markets and financial institutions. Furthermore, many financial institutions were heavily invested in mortgages and therefore exposed to the same type of risk. The failures of some financial institutions could expose others that provided credit guarantees on commercial paper.

   Due to concerns about systemic risk, the U.S. government took action to stabilize the money markets. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act) was enacted, whereby the Treasury injected $700 billion into the financial system. This allowed the Treasury to invest in the large commercial banks as a means of providing the banks with capital to cushion their losses and therefore reduce their risk. Since financial institutions are major participants in the money markets, the liquidity of the money markets increased after the Treasury took action.

   In November 2008, the Federal Reserve began to purchase commercial paper issued by highly rated firms. The Fed normally does not participate as an investor in the commercial paper market, but this new form of participation was intended to restore activity and therefore increase liquidity in the commercial paper market.

Exhibit 6.8 Value of Commercial Paper Outstanding over Time

   However, the commercial paper market has not completely recovered.  Exhibit 6.8  shows how the amount of commercial paper outstanding reached a high of about $2.2 trillion in 2007, but has declined to about $1 trillion. Furthermore, investors are requiring that the asset-backed commercial paper be secured with safer securities (such as Treasury securities) rather than mortgage-backed securities.

Risk Premiums Following Lehman's Default  During periods of heightened uncertainty about the economy, investors tend to shift from risky money market securities to Treasury securities. This so-called flight to quality creates a greater differential between yields, since risky money market securities must provide a larger risk premium to attract investors. During the credit crisis in 2008, the failure of Lehman Brothers increased the risk premium that some financial institutions had to pay when issuing commercial paper or NCDs, as shown in  Exhibit 6.9 . In the period shortly after Lehman's collapse, institutional investors were willing to purchase these money market securities only if the yield was sufficiently high to compensate for possible default risk. Months later, the rates on most money market securities declined as the credit risk declined, resulting in a reduction in the credit risk premium. In addition, as the Fed implemented a stimulative monetary policy in 2009 by pumping more money into the banking system, the rates on T-bills declined, and rates on other money market securities declined as well.

Exhibit 6.9 Money Market Yields over Time (Annualized Yields, One-Month Maturity)

6-3b Interest Rate Risk

If short-term interest rates increase, the required rate of return on money market securities will increase and the prices of money market securities will decrease. Although money market security values are sensitive to interest rate movements in the same direction as bonds, they are not as sensitive as bond values to interest rate movements. This lower degree of sensitivity is due primarily to the shorter term to maturity. With money market securities, the principal payment will occur in the next year, whereas the principal payment on bonds may be 10 or 20 years away. In other words, an increase in interest rates is not as harmful to a money market security because it will mature soon anyway, and the investor can reinvest the proceeds at the prevailing rate at that time.

Measuring Interest Rate Risk  Participants in the money markets can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates.

EXAMPLE

Assume that Long Island Bank has money market securities with a par value of $100 million that will mature in nine months. Since the bank will need a substantial amount of funds in three months, it wants to know how much cash it will receive from selling these securities three months from now. Assume that it expects the unannualized required rate of return on those securities for the remaining six months to be 3 percent, 3.5 percent, or 3.8 percent, with a 33.3 percent (i.e., equal) chance for each of these three scenarios.

    Exhibit 6.10  shows the probability distribution of the proceeds that Long Island Bank will receive from selling the money market securities three months later in terms of the possible scenarios for the required rate of return at that time. As this exhibit shows, the bank expects that it will receive at least $96,339,113, but it could receive more if interest rates (and therefore the required rate of return) are relatively low in three months. By deriving a probability distribution of outcomes, the bank can anticipate whether the proceeds to be received will be sufficient to cover the amount of funds that it will need in three months.

Exhibit 6.10 Probability Distribution of Proceeds from Selling Money Market Securities

6-4 GLOBALIZATION OF MONEY MARKETS

As international trade and financing have grown, money markets have developed in Europe, Asia, and South America. Corporations commonly accept foreign currencies as revenue if they will need those currencies to pay for imports in the future. Since a corporation may not need to use funds at the time it receives them, it deposits the funds to earn interest until they are needed. Meanwhile, other corporations may need funds denominated in foreign currencies and therefore may wish to borrow those funds from a bank. International banks facilitate the international money markets by accepting deposits and providing loans in a wide variety of currencies.

   The flow of funds between countries has increased as a result of tax differences among countries, speculation on exchange rate movements, and a reduction in government barriers that were previously imposed on foreign investment in securities. Consequently, international markets are integrated.

   The money market interest rates in each country are influenced by the demand for short-term funds by borrowers, relative to the supply of available short-term funds that are provided by savers. If the demand for short-term funds denominated in a particular currency is high relative to the short-term funds that are available in that currency, the money market interest rates will be relatively high in that country. Conversely, if the demand for short-term funds in that currency is low relative to the supply of short-term funds available, the money market interest rates in that country will be relatively low.

   The money market interest rate paid by corporations who borrow short-term funds in a particular country is slightly higher than the rate paid by the federal government in the same country, which reflects the premium to compensate for credit risk of corporate borrowers. There may also be an additional premium to compensate for less liquidity of short-term securities issued by corporations.

   Market interest rates vary among countries, as shown in  Exhibit 6.11 . Notice in the exhibit how money market rates are correlated among countries. Money market rates among several countries increased during the 2005–2006 period, when many economies were growing. However, money market rates declined during the 2008–2013 period, when most countries experienced weak economies. The interest rates of several European countries are the same as a result of the conversion of their currencies to the euro.

Exhibit 6.11 International Money Market Rates over Time

6-4a Eurodollar Securities

As corporations outside the United States (especially in Europe) increasingly engaged in international trade transactions in U.S. dollars, U.S. dollar deposits in non-U.S. banks grew. Furthermore, because interest rate ceilings were historically imposed on dollar deposits in U.S. banks, corporations with large dollar balances often deposited their funds in Europe to receive a higher yield. These dollar deposits in Europe were referred to as  Eurodollars . Several types of money market securities utilize Eurodollars.

Eurodollar CDs   Eurodollar certificates of deposit  are large, dollar-denominated deposits (such as $1 million) accepted by banks in Europe. Eurodollar CD volume has grown substantially over time, since the U.S. dollar is used as a medium of exchange in a significant portion of international trade and investment transactions. Some firms overseas receive U.S. dollars as payment for exports and invest in Eurodollar CDs. Because these firms may need dollars to pay for future imports, they retain dollar-denominated deposits rather than convert dollars to their home currency.

   In the so-called  Eurodollar market , banks channel the deposited funds to other firms that need to borrow them in the form of Eurodollar loans. The deposit and loan transactions in Eurodollars are typically $1 million or more per transaction, so only governments and large corporations participate in this market. Because transaction amounts are large, investors in the market avoid some costs associated with the continuous small transactions that occur in retail-oriented markets. In addition, Eurodollar CDs are not subject to reserve requirements, which means that banks can lend out 100 percent of the deposits that arrive. For these reasons, the spread between the rate banks pay on large Eurodollar deposits and what they charge on Eurodollar loans is relatively small. Consequently, interest rates in the Eurodollar market are attractive for both depositors and borrowers. The rates offered on Eurodollar deposits are slightly higher than the rates offered on NCDs.

   A secondary market for Eurodollar CDs exists, allowing the initial investors to liquidate their investment if necessary. The growth in Eurodollar volume has made the secondary market more active.

   Investors in fixed-rate Eurodollar CDs are adversely affected by rising market interest rates, whereas issuers of these CDs are adversely affected by declining rates. To deal with this interest rate risk,  Eurodollar floating-rate CDs  (called FRCDs) have been used in recent years. The rate adjusts periodically to the London Interbank Offer Rate (LIBOR), which is the interest rate charged on international interbank loans. As with other floating-rate instruments, the rate on FRCDs ensures that the borrower's cost and the investor's return reflect prevailing market interest rates.

    Euronotes  Short-term  Euronotes  are short-term securities issued in bearer form with common maturities of one, three, and six months. Typical investors in Euronotes often include the Eurobanks (banks that accept large deposits and make large loans in foreign currencies) that are hired to place the paper. These Euronotes are sometimes underwritten in a manner that guarantees the issuer a specific price.

Euro-Commercial Paper   Euro-commercial paper (Euro-CP)  is issued without the backing of a banking syndicate. Maturities can be tailored to satisfy investors. Dealers that place commercial paper have created a secondary market by being willing to purchase existing Euro-CP before maturity.

   The Euro-CP rate is typically between 50 and 100 basis points above LIBOR. Euro-CP is sold by dealers at a transaction cost ranging from 5 to 10 basis points of the face value. This market is tiny compared to the U.S. commercial paper market. Nevertheless, some European companies that want short-term funding in dollars can more easily place their paper here, where they have a household name.

6-4b International Interbank Market

Some international banks periodically have an excess of funds beyond the amount that other corporations want to borrow. Other international banks may be short of funds because their client corporations want to borrow more funds than the banks have available. An international interbank market facilitates the transfer of funds from banks with excess funds to those with deficient funds. This market is similar to the federal funds market in the United States, but it is worldwide and conducts transactions in a wide variety of currencies. Some of the transactions are direct from one bank to another, while others are channeled through large banks that serve as intermediaries between the lending bank and the borrowing bank. Historically, international banks in London carried out many of these transactions.

   The rate charged for a loan from one bank to another in the international interbank market is the LIBOR, which is similar to the federal funds rate in the United States. Several banks report the interest rate that they offer in the interbank market and their rates may vary slightly. The LIBOR is the average of the reported rates at a given point in time. The LIBOR varies among currencies and is usually in line with the prevailing money market rates in the currency. It varies over time in response to changes in money market rates in a particular currency, which are driven by changes in the demand and supply conditions for short-term money in that currency. The term LIBOR is still frequently used, even though many international interbank transactions do not pass through London.

LIBOR Scandal  In 2012, some banks that periodically report the interest rate they offer in the interbank market falsely reported their rates. These banks have some investment or loan positions whose performance is dependent on the prevailing LIBOR. For example, some banks provide loans with rates that adjust periodically in accordance with LIBOR, and therefore would benefit from inflating the reported rate they charge on interbank loans in order to push LIBOR higher. Some banks were charged with colluding to manipulate LIBOR in order to boost their trading profits. In particular, many banks have large positions in derivative securities (such as interest rate swaps, described in  Chapter 15 ), and manipulating LIBOR by just 0.1 percent could generate millions of dollars in profits from their positions.

6-4c Performance of Foreign Money Market Securities

The performance of an investment in a foreign money market security is measured by the  effective yield  (yield adjusted for the exchange rate), which is a function of (1) the yield earned on the money market security in the foreign currency and (2) the exchange rate effect. The yield earned on the foreign money market security (Yf) is

Yf  = 

SPf  − PPf

PPf

where

SPf  = selling price of the foreign money market security in the foreign currency

PPf  = purchase price of the foreign money market security in the foreign currency

   The exchange rate effect (denoted as %ΔS) measures the percentage change in the spot exchange rate (in dollars) from the time the foreign currency was obtained to invest in the foreign money market security until the time the security was sold and the foreign currency was converted into the investor's home currency. Thus, the effective yield is

Ye  = (1 + Yt) × (1 + %ΔS) − 1

EXAMPLE

A U.S. investor obtains Mexican pesos when the peso is worth $0.12 and invests in a one-year money market security that provides a yield (in pesos) of 22 percent. At the end of one year, the investor converts the proceeds from the investment back to dollars at the prevailing spot rate of $0.13 per peso. In this example, the peso increased in value by 8.33 percent, or 0.0833. The effective yield earned by the investor is

   The effective yield exceeds the yield quoted on the foreign currency whenever the currency denominating the foreign investment increases in value over the investment horizon. Conversely, it is lower than the yield quoted on the foreign currency whenever the currency denominating the foreign investment decreases in value over the investment horizon. In fact, U.S. investors have sometimes experienced a negative effective yield in periods when the foreign currency denominating their investment depreciated substantially.

SUMMARY

· ▪ The main money market securities are Treasury bills, commercial paper, NCDs, repurchase agreements, federal funds, and banker's acceptances. These securities vary according to the issuer. Consequently, their perceived degree of credit risk can vary. They also have different degrees of liquidity. Therefore, the quoted yields at any given point in time vary among money market securities.

· ▪ Financial institutions manage their liquidity by participating in money markets. They may issue money market securities when they experience cash shortages and need to boost liquidity. They can also sell holdings of money market securities to obtain cash. The value of a money market security represents the present value of the future cash flows generated by that security. Since money market securities represent debt, their expected cash flows are typically known. However, the pricing of money market securities changes in response to a shift in the required rate of return by investors. The required rate of return changes in response to interest rate movements or to a shift in the security's credit risk.

· ▪ Interest rates vary among countries. Some investors are attracted to high interest rates in foreign countries, which cause funds to flow to those countries. Consequently, money markets have become globally integrated. Investments in foreign money market securities are subject to exchange rate risk because the foreign currency denominating the securities could depreciate over time.

POINT COUNTER-POINT

Should Firms Invest in Money Market Securities?

Point  No. Firms are supposed to use money in a manner that generates an adequate return to shareholders. Money market securities provide a return that is less than that required by shareholders. Thus, firms should not be using shareholder funds to invest in money market securities. If firms need liquidity, they can rely on the money markets for short-term borrowing.

Counter-Point  Yes. Firms need money markets for liquidity. If they do not hold any money market securities, they will frequently be forced to borrow to cover unanticipated cash needs. The lenders may charge higher risk premiums when lending so frequently to these firms.

Who Is Correct?  Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Primary Market Explain how the Treasury uses the primary market to obtain adequate funding.

· 2. T-Bill Auction How can investors using the primary T-bill market be assured that their bid will be accepted? Why do large corporations typically make competitive bids rather than noncompetitive bids for T-bills?

· 3. Secondary Market for T-Bills Describe the activity in the secondary T-bill market. How can this degree of activity benefit investors in T-bills? Why might a financial institution sometimes consider T-bills as a potential source of funds?

· 4. Commercial Paper Who issues commercial paper? What types of financial institutions issue commercial paper? Why do some firms create a department that can directly place commercial paper? What criteria affect the decision to create such a department?

· 5. Commercial Paper Ratings Why do ratings agencies assign ratings to commercial paper?

· 6. Commercial Paper Rates Explain how investors' preferences for commercial paper change during a recession. How should this reaction affect the difference between commercial paper rates and T-bill rates during recessionary periods?

· 7. Negotiable CDs How can small investors participate in investments in negotiable certificates of deposits (NCDs)?

· 8. Repurchase Agreements Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Why?

· 9. Banker's Acceptances Explain how each of the following would use banker's acceptances: (a) exporting firms, (b) importing firms, (c) commercial banks, and (d) investors.

· 10. Foreign Money Market Yield Explain how the yield on a foreign money market security would be affected if the foreign currency denominating that security declined to a greater degree.

· 11. Motive to Issue Commercial Paper The maximum maturity of commercial paper is 270 days. Why would a firm issue commercial paper instead of longerterm securities, even if it needs funds for a long period of time?

· 12. Risk and Return of Commercial Paper You have the choice of investing in top-rated commercial paper or commercial paper that has a lower risk rating. How do you think the risk and return performances of the two investments differ?

· 13. Commercial Paper Yield Curve How do you think the shape of the yield curve for commercial paper and other money market instruments compares to the yield curve for Treasury securities? Explain your logic.

Advanced Questions

· 14. Influence of Money Market Activity on Working Capital Assume that interest rates for most maturities are unusually high. Also, assume that the net working capital (defined as current assets minus current liabilities) levels of many corporations are relatively low in this period. Explain how the money markets play a role in the relationship between the interest rates and the level of net working capital.

· 15. Applying Term Structure Theories to Commercial Paper Apply the term structure of interest rate theories that were discussed in Chapter 3 to explain the shape of the existing commercial paper yield curve.

· 16. How Money Market Rates May Respond to Prevailing Conditions How have money market rates changed since the beginning of the semester? Consider the current economic conditions. Do you think money market rates will increase or decrease during the semester? Offer some logic to support your answer.

· 17. Impact of Lehman Brothers Failure Explain how the bankruptcy of Lehman Brothers (a large securities firm) reduced the liquidity of the commercial paper market.

· 18. Bear Stearns and the Repo Market Explain the lesson to be learned about the repo market based on the experience of Bear Stearns.

· 19. Impact of Credit Crisis on Liquidity Explain why the credit crisis affected the ability of financial institutions to access short-term financing in the money markets.

· 20. Impact of Credit Crisis on Risk Premiums Explain how the credit crisis affected the credit risk premium in the commercial paper market.

· 21. Systematic Risk Explain how systemic risk is related to the commercial paper market. That is, why did problems in the market for mortgage-backed securities affect the commercial paper market?

· 22. Commercial Paper Credit Guarantees Explain why investors that provided guarantees on commercial paper were exposed to much risk during the credit crisis.

Interpreting Financial News

Interpret the following statements made by Wall Street analysts and portfolio managers.

· a. “Money markets are not used to get rich, but to avoid being poor.”

· b. “Until conditions are more favorable, investors are staying on the sidelines.”

· c. “My portfolio is overinvested in stocks because of the low money market rates.”

Managing in Financial Markets

Money Market Portfolio Dillema As the treasurer of a corporation, one of your jobs is to maintain investments in liquid securities such as Treasury securities and commercial paper. Your goal is to earn as high a return as possible but without taking much of a risk.

· a. The yield curve is currently upward sloping, such that 10-year Treasury bonds have an annualized yield 3 percentage points above the annualized yield of three-month T-bills. Should you consider using some of your funds to invest in 10-year Treasury securities?

· b. Assume that you have substantially more cash than you would possibly need for any liquidity problems. Your boss suggests that you consider investing the excess funds in some money market securities that have a higher return than short-term Treasury securities, such as negotiable certificates of deposit (NCDs). Even though NCDs are less liquid, this would not cause a problem if you have more funds than you need. Given the situation, what use of the excess funds would benefit the firm the most?

· c. Assume that commercial paper is currently offering an annualized yield of 7.5 percent, while Treasury securities are offering an annualized yield of 7 percent. Economic conditions have been stable, and you expect conditions to be very favorable over the next six months. Given this situation, would you prefer to hold T-bills or a diversified portfolio of commercial paper issued by various corporations?

· d. Assume that commercial paper typically offers a premium of 0.5 percent above the T-bill rate. Given that your firm typically maintains about $10 million in liquid funds, how much extra will you generate per year by investing in commercial paper versus T-bills? Is this extra return worth the risk that the commercial paper could default?

PROBLEMS

· 1. T-Bill Yield Assume an investor purchased a six-month T-bill with a $10,000 par value for $9,000 and sold it 90 days later for $9,100. What is the yield?

· 2. T-Bill Discount Newly issued three-month T-bills with a par value of $10,000 sold for $9,700. Compute the T-bill discount.

· 3. Commercial Paper Yield Assume an investor purchased six-month commercial paper with a face value of $1 million for $940,000. What is the yield?

· 4. Repurchase Agreement Stanford Corporation arranged a repurchase agreement in which it purchased securities for $4.9 million and will sell the securities back for $5 million in 40 days. What is the yield (or repo rate) to Stanford Corporation?

· 5. T-Bill Yield You paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until maturity, what is the T-bill yield? What is the T-bill discount?

· 6. T-Bill Yield The Treasury is selling 91-day T-bills with a face value of $10,000 for $9,900. If the investor holds them until maturity, calculate the yield.

· 7. Required Rate of Return A money market security that has a par value of $10,000 sells for $8,816.60. Given that the security has a maturity of two years, what is the investor's required rate of return?

· 8. Effective Yield A U.S. investor obtains British pounds when the pound is worth $1.50 and invests in a one-year money market security that provides a yield of 5 percent (in pounds). At the end of one year, the investor converts the proceeds from the investment back to dollars at the prevailing spot rate of $1.52 per pound. Calculate the effective yield.

· 9. T-Bill Yield

· a. Determine how the annualized yield of a T-bill would be affected if the purchase price were lower. Explain the logic of this relationship.

· b. Determine how the annualized yield of a T-bill would be affected if the selling price were lower. Explain the logic of this relationship.

· c. Determine how the annualized yield of a T-bill would be affected if the number of days were reduced, holding the purchase price and selling price constant. Explain the logic of this relationship.

· 10. Return on NCDs Phil purchased an NCD a year ago in the secondary market for $980,000. The NCD matures today at a price of $1million, and Phil received $45,000 in interest. What is Phil's return on the NCD?

· 11. Return on T-Bills Current T-bill yields are approximately 2 percent. Assume an investor considering the purchase of a newly issued three-month T-bill expects interest rates to increase within the next three months and has a required rate of return of 2.5 percent. Based on this information, how much is this investor willing to pay for a three-month T-bill?

FLOW OF FUNDS EXERCISE

Financing in the Money Markets

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Carson has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It previously purchased Treasury securities that it could sell if it experiences any liquidity problems. If the economy continues to be strong, Carson may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering issuing stock or bonds to raise funds in the next year.

· a. The prevailing commercial paper rate on paper issued by large publicly traded firms is lower than the rate Carson would pay when using a line of credit. Do you think that Carson could issue commercial paper at this prevailing market rate?

· b. Should Carson obtain funds to cover payments for supplies by selling its holdings of Treasury securities or by using its credit line? Which alternative has a lower cost? Explain.

INTERNET/EXCEL EXERCISES

· 1. Go to  http://research.stlouisfed.org/fred2 . Under “Categories,” select “Interest rates.” Compare the yield offered on a T-bill with the yield offered by another money market security with a similar maturity. What is the difference in yields? Why do you think the yields differ?

· 2. How has the risk premium on a specific risky money market security (versus the T-bill) changed since one year ago? Is the change due to a change in economic conditions? Explain.

· 3. Using the same website, retrieve interest rate data at the beginning of the last 20 quarters for the three-month T-bill and another money market security and place the data in two columns of an Excel spreadsheet. Derive the change in interest rates for both money market securities on a quarterly basis. Apply regression analysis in which the quarterly change in the interest rate of the risky money market security is the dependent variable and the quarterly change in the T-bill rate is the independent variable (see Appendix B for more information about using regression analysis). Is there a positive and significant relationship between the interest rate movements? Explain.

WSJ EXERCISE

Assessing Yield Differentials of Money Market Securities

Use the “Money Rates” section of the Wall Street Journal to determine the 30-day yield (annualized) of commercial paper, certificates of deposit, banker's acceptances, and T-bills. Which of these securities has the highest yield? Why? Which of these securities has the lowest yield? Why?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter. If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. Treasury bill auction

· 2. commercial paper AND offering

· 3. commercial paper AND rating

· 4. repurchase agreement AND financing

· 5. money market AND yield

· 6. commercial paper AND risk

· 7. institutional investors AND money market

· 8. banker's acceptance AND yield

· 9. [name of a specific financial institution] AND repurchase agreement

· 10. [name of a specific financial institution] AND commercial paper