final report
menmen03
Lecture8-MoneyMarket-Jun29.pptx
Financial Institutions & markets
FIN 353 – Summer 2020
Snow Han
SFSU
Agenda
Money Market
Why money market is important
Different bond instruments traded in Money Markets
Time value of money/discount of cash flow for one period
How to compute investment returns in money market bonds (investment rate vs. discount rate)
Examples
Cash (Cash Equivalent) & Short Term Securities Apple Inc.
- 2013 Annual report
$18 billion in short-term securities + $11 billion in cash & cash equivalents
(TA=207 billion)
- 2014 Annual report
12 billion in short term securities + 14 billion in actual cash & cash equivalent (TA=232 billion)
- 2015 Annual report
20 billion in short term securities + 21 billion in actual cash & cash equivalent (TA=290 billion)
Microsoft
- “ we consider all highly liquid interest-earning investments with a maturity of 3 months or less at the date of purchase to be cash equivalents”
Money Market Definition
The securities in the money market are short term with high liquidity; therefore, close to being money *– cash equivalent (m<3 months)
Major Characteristics
Mature in 1 year or less from their issue date, most mature in less than 120 days
Low default risk (short term, and high quality issuer) – safe, anything else???
Sold in large denominations (wholesale market) - Usually ($1,000,000 or more)
Usually transactions don’t happen in an exchanges (location), but over the phone (OTC)
Usually there are regular buyers, and it is easy to match buyers with sellers
Very flexible for firms to storage their money, or find money to finance their short term investment, usually financing their working capital
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Purpose of Money Markets - Flexibility
“warehouse” surplus fund till they need it (short period of time)
Low cost borrowing for government, firms, & intermediaries who need immediate infusion of fund for a short period of time (temporary)
Good tool for firms to “storage” or “warehouse” their money when there is no investment opportunities. Also flexible enough for firms to fill their short term financial need
What’s the reason behind all these?
Cash inflows and outflows are not synchronized…
https://www.youtube.com/watch?v=Wgcv_wJOLcA
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Development of Money market
Short term loans vs. Money Market securities
1. Banks have lower interest rates for deposits
Glass-Steagall Act of 1933
Forbid interest payments on corporate checking accounts
And limit the interest payment on time deposits (set a ceiling rate for deposits)
When market interest rates rose, depositors moved their money from banks to money markets
2. Banks are heavily regulated – more legal costs
The bank usually don’t want to make short-term loans. – unprofitable – try to concentrate their asset in the area that provides higher profit margin.
From 1933 until 1986 it also imposed maximum rates of interest on various other types of bank deposits, such as savings accounts and NOW accounts. Incorprated in to regD
The motivation for the deposit interest restrictions was the perception that the bank failures of the early 1930s, during the first part of the Great Depression, had been caused in part by excessive bank competition for deposit funds, driving down the margin between lending rates and borrowing rates and encouraging overly speculative investment behavior on the part of large banks
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COST ADVANTAGEs
Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets,
especially in the 1970s and 1980s.
They removed the ceiling in 1986 March, but by then the money market has already well established
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What securities are traded on the market?
Treasury Bills (<1 yr federal government bonds)
Federal Funds (=reserves) for banks
Certificate of Deposits (CDs)- Large denomination
Commercial Papers
*Euro Dollars
*Banker’s Acceptances
Money Market Instrument 1- T-Bills
Sold with 28, 91, and 182 day maturities (1, 3, or 6 months)
Usually dominated in $1,000 (after 2008, some are dominated $100)
After 1976, “Book Entry”
After 1998, individuals can directly purchase t-bills online
NO INTEREST PAYMENT
Sell at Discount of face value (price < face value/ par value)
A credit market instrument that pays the owner only the face value of the security at the maturity date and nothing prior to then is called a discount bond
ownership is recorded electronically. Book-entry securities eliminate the need to issue paper certificates of ownership. Ownership of securities is never physically transferred when they are bought or sold; accounting entries are merely changed in the books of the commercial financial institutions where investors maintain accounts.
When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks
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Risk & Return
The interest rate for T-bills is one of the lowest
T-bills has such a low return, mainly because they are close to risk-free
High liquidity – Deep secondary market
The federal government can hardly go bankruptcy. They can always issue t-bills to make up for their deficit. They can even print out money.
Why they move together?
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Money Market Instrument 2 – Federal Funds
Short-term funds transferred (loaned or borrowed) b/w financial institutions (banks), usually for a period of one day (overnight)
Why called federal funds? –reserve saved in the federal reserve banks
0.3 trillion everyday
Unsecured
Same as T-Bills, highly liquid, and extremely low risk
Which means the interest rate for T-bills and federal funds should follow each other closely.
Federal Funds Rate
Money Market Instrument 3 -Repurchase Agreements (Repos)
Pretty similar to Federal Funds, but non-bank can participate
-Agreement A firm sells (usu. Treasury) securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price.
This is similar to use the (usu. Treasury) securities as collateral for a short term loan
*Fed purchases/sells Treasury securities in the repo market –open market tool
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Money Market Instrument 4- Negotiable Certificates of Deposit (CD)
A bank-issued certificate that documents a deposit and specifies the interest rate and the maturity date
Not a demand deposit (with maturity)
Usually mature in 1-4 months, or 6 month
Denomination ranges from $100,000 to $10 million
CD itself can be bought and sold until maturity
The second most popular money market instrument, behind only T-bills
It appeared first since bank try to counter the declining demand for deposit, invented by Citibank in 1960..
Larger savers were saving their money in other money market securities , they tried to attract their customer back, so they pay a higher interest rate. – Still bank deposit, the interest they can be are still be regulated by regulation
Later they try to offer CDs overseas, where they can circumpass the regulation
Until 1970s, regulation release the constraints on the interest rate. And the CD markets began to grow rapidly
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Negotiable CD Rates
What does this mean??????
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Money Market Instrument 5 – Commercial Papers
Unsecured promissory notes, issued by corporations, that mature in no more than 270 days.
Only the largest, most creditworthy corporations issue commercial papers (non-bank)
Backed by line of credit at the banks
Like T-bills, most commercial papers is issued on a discount basis
However, commercial papers doesn’t have a strong secondary market. Most of the time, commercial papers are sold directly by the issuers to the buyers.
In cases that buyers has a need for cash, the issuer can redeem the commercial paper
Mainly issued by finance companies
Hold by commercial banks, insurance companies, pension fund….
It started due to the tight economy in 1960s. Banks have to issue Commercial paper to get money and issue loan. However, the Fed try to control money supply by adding reserve requirement on this commercial papers in 1970 s– so now, banks stopped issue commercial papers.
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Commercial Paper Rate
Commercial Paper Volume
Banker’s Acceptances
These are often used when buyers / sellers of expensive goods live in different countries.
Bank intervene
An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods.
Before the maturity, Banker’s acceptances could be trade for immediate cash at a discount
Active secondary market
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Who Participates in the Money Markets?
Treasury Department
Federal Reserve System (FOMC)
Commercial Banks
Businesses/firms (e.g: Apple Inc., Microsoft…etc.)
Finance Companies (eg. GMAC, Chrysler Capital…etc.)
Insurance Companies
Investment companies (Brokerage)
Pension Fund
Mutual Fund
Individuals
Individual can participate through the development of Mmmutual fund, introduced in the 1970s.
It is hard to differentiate or to list who are the buyer/sellers. Because most of these will be buyers and sellers at the same time. They operate on both sides of the market
Except one – the treasury, who is always a demander of money – largest money market borrower around the world!
To ad just their tax revenue
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T-bill – Discount Bond
When an investor pays less for the security than it will be worth when it matures (par value/face value), the bond is called a discount bond.
Below are some T-bill price quotes in 2013 May.
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What is the rate of returns for T-bills?
cost of borrowing money, profit for people who lending money
We have two ways to measure the returns on T-bills
Discount Rate - Annualized
Investment Rate - Annualized
Example
How much do you pay – Price – 99.999222*10 = 999.99222
How much is your face value/par value –F =100*10=1000
What is your Discount rate?
= 0.00010 =0.01%
What is your investment rate?
= 0.00010 =0.01%
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Exercise
Q: Why investment rate is always higher than discount rate?
The denominator is smaller (you use price (P) for investment rate instead of face value)
You multiply the actual number of days in the year(365 or 366 for leap year instead of 360…)
Q: which is a better measure for your return?
The two rates follow each other closely, but investment rate is more accurate measure for investment return.
Treasury Bill Auctions
Every Thursday, the Treasury announce how many treasury bills it will offer for sale, and the maturities of each
The Treasury may accept both competitive and noncompetitive bids
In a competitive bid, the bidder specify the price they would like to pay, and the amount they would like to buy (no buying responsibility)
In a noncompetitive bid, the bidder doesn’t specify price, only the amount! (buying responsibility)
The treasury accept competitive bids in ascending order of yield (or descending order of price) until it reach the offering amount-noncompetitive bid amount
The price is set by the highest yield in the competitive bid (the last one get offered)!
https://www.youtube.com/watch?v=Wgcv_wJOLcA
Submit their bid by next Monday. And the results will be announced on The next morning
To ensure proper level of competition, no one dealer is allowed to purchase more than 35% of any one issue.
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Auction Example
| Bidder | Bid Amount | Price |
| 1 | $500 million | $0.9940 |
| 2 | $750 million | $0.9901 |
| 3 | $1.5 billion | $0.9925 |
| 4 | $1 billion | $0.9936 |
| 5 | $600 million | $0.9939 |
In a Treasury auction of $2.1 billion par value 91-day T-bills, the following bids were submitted:
These are all competitive bids!
Auction Example
| Bidder | Bid Amount | Price |
| 1 | $500 million | $0.9940 |
| 2 | $750 million | $0.9901 |
| 3 | $1.5 billion | $0.9925 |
| 4 | $1 billion | $0.9936 |
| 5 | $600 million | $0.9939 |
What will be the price ? And interest rate?
The price will still be the lowest price among all accepted competitive bids
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Auction Example
What if there are also $750 million in non-competitive bids?
All noncompetitive bids will be received, first
The rest of the amount goes to competitive bid
(2.1 bil- 750 mil=1.35 bil)
| Bidder | Bid Amount | Price |
| 1 | $500 million | $0.9940 |
| 2 | $750 million | $0.9901 |
| 3 | $1.5 billion | $0.9925 |
| 4 | $1 billion | $0.9936 |
| 5 | $600 million | $0.9939 |
The price will still be the lowest price among all accepted competitive bids
Then why not everybody submit non competitive bid – because it is limited to 5 million
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Another Auction
https://www.youtube.com/watch?v=Wgcv_wJOLcA
The T-bill Auction is pretty competitive to ensure the low interest rate, thus no one dealer is allowed to hold more than 35% of the entire issue.
Then why not everybody submit non competitive bid – because it is limited to 5 million
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Why interest rates move together?
These instruments share similar characteristics: short term, and low risk
They are substitute for each other
If one interest rate deviate from the other, the demand-supply movement in the market will soon correct the differences
Liquidity! – Secondary market
For commercial papers, with limited secondary market, the rates are bit high…T-bills are the most liquid, and lowest rate
T-Bill Rate
Real vs. Nominal Interest Rates
Nominal interest rate – no allowance for inflation
Real Interest rate - adjusted for expected changes in inflation
(ex ante)Real interest rate=nominal interest rate – (expected) changes in the price level
ir = i – pe (Fisher Equation)
=> more accurately reflects true cost of borrowing
(ex post)Real interest rate=nominal interest rate – (actual) changes in the price level
When real rate is low, there are greater incentives to borrow and less to lend
Example
If i = 5% and pe = 0% then
If i = 10% and pe = 20% then
Three-Month T-Bills
TIPS
Treasury Inflation-Protected Securities, or TIPS
Semi-Annual coupon at fixed rate
The coupon rate will not change.
However, the principal increases with inflation as measured by the Consumer Price Index (CPI).
vice versa, the principal decreases with deflation
At maturity, you are paid the greater of adjusted principal or original principal
Summary
What are the disadvantages of money market?
The disadvantages of money market shows up when you try to finance a long-term project.
How?
Think about you have a project that will last for 10 years, and you have to provide consistent funding for that project until it is completed after 10 years.
If you use money market to finance the project, you have to renew your contract every year. When market interest rate goes up, your interest goes up – you have more cost borrowing money! - This is INTEREST RATE RISK! (Refinancing risk)
But if you use capital market, you are locked in the interest rate at today. The fluctuation of market interest rates doesn’t affect your borrowing.
The bottom line here is : MONEY MARKET HAVE LOWER DEFAULT RISK, BUT HIGHER INTEREST RATE RISK.
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