Financial Market Analysis
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U NI T 1 – M O NE Y M A R K E T S
Financial Market Analysis ACCT3602
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Money Markets
Money market refers to all instruments and procedures that provide for transactions in short-term debt instruments generally issued by borrowers with very high credit ratings.
By financial convention, short-term means maturity periods of one year or less although most mature in less than 120 days.
Money market is an intangible market. It is primarily a telephone and computer market rather than a physical
structure.
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Why Do We Need Money Markets?
In theory, the banking industry should handle the needs for short- term loans and accept short-term deposits.
Banks also have an information advantage on the credit- worthiness of participants.
Banks do mediate between savers and borrowers; however, they are heavily regulated.
This creates a distinct cost advantage for money markets over banks.
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Why Do We Need Money Markets? 4
Reserve requirements create additional expense for banks that money markets do not have.
Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets, especially in the 1970s and 1980s. When interest rates rose, depositors moved their money from banks to money markets.
The cost structure of banks limits their competitiveness to situations where their informational advantages outweighs their regulatory costs.
Limits on interest banks could offer was not relevant until the 1950s. In the decades that followed, the problem became apparent. Commercial bank
interest-rate ceilings were removed in March of 1986, but by then the retail money markets were well established.
The Purpose of Money Markets 5
The purpose of money markets is to facilitate the transfer of short-term funds from agents with excess funds (corporations, financial institutions, individuals, government) to those market participants who lack funds for short-term needs.
They play a central role in the country’s financial system, by influencing it through the country’s monetary authority.
Money markets serve public policy objectives, i.e. financing public sector deficits and managing the accumulated government deficits. Government public debt policy is an important determinant of the money markets
operations, since government debt typically forms a key part of the country's money markets (as well as debt markets).
The Purpose of Money Markets
Investors in money markets:
Provides a place for warehousing surplus funds for short periods of time
Borrowers in money markets:
Provided with low-cost source of temporary funds
Corporations and governments use these markets because the timing of cash inflows and outflows are not well synchronized.
Money markets provide a way to solve these cash-timing problems.
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Characteristics of Money Markets
In a money market, money or currency is not actually traded.
The securities in the money market are short term with high liquidity; therefore, they are close to being money.
Money market securities are usually sold in large denominations ($1,000,000 or more)
They have low default risk because only the most creditworthy institutions can participate in the money markets.
Money markets consist of tradable instruments as well as non-tradable instruments.
Traditional money markets instruments, which included mostly dealing of market participants with central bank, have decreased their importance during the recent years, followed by an increasing trend to finance short-term needs by issuing new types of securities such as REPOs, commercial papers or certificates of deposit.
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Characteristics of Money Markets
In terms of risk two specific money-market segments are: unsecured debt instruments markets
(e.g. deposits with various maturities, ranging from overnight to one year);
secured debt instruments markets (e.g. REPOs) with maturities also ranging from overnight to one year.
Differences in amount of risk are characteristic to the secured and the unsecured segments of the money markets. Credit risk is minimized by limiting access to only high-quality counter-parties.
When providing unsecured interbank deposits, a bank transfers funds to another bank for a specified period of time during which it assumes full counterparty credit risk.
In the secured REPO markets, this counterparty credit risk is mitigated as the bank that provides liquidity receives collateral (e.g., bonds) in return.
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Money Market Segments
Interbank market- where banks and non-deposit financial institutions settle contracts with each other and with central bank, involving temporary liquidity surpluses and deficits.
Primary market which is absorbing the new issues and enabling borrowers to raise new funds.
Secondary market for different short-term securities, which redistributes the ownership, ensures liquidity, and as a result, increases the supply of lending and reduces its price.
Derivatives market – market for financial contracts whose values are derived from the underlying money market instruments.
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Money Market Segments
Interbank market is defined mainly in terms of participants, while other markets are defined in terms of instruments issued and traded. As the prefix suggests, the interbank market is “between banks,” with each trade representing
an agreement between the banks to exchange the agreed amounts of currency at the specified rate on a fixed date. The interbank market is alternately referred to as the cash market or the spot market to differentiate it from the currency futures market, which is the only other organized market for currency trading.
Therefore, there is a considerable overlap between these segments.
Interbank market is referred mainly as the market for very short deposits and loans, e.g. overnight or up to two weeks.
Nearly all types of money market instruments can be traded in interbank market.
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Money Market Participants 11
Money Market Participants 12
Money market participants include mainly credit institutions and other financial intermediaries, governments, as well as individuals (households).
Ultimate lenders in the money markets are households and companies with a financial surplus which they want to lend, while ultimate borrowers are companies and government with a financial deficit which need to borrow. Ultimate lenders and borrowers usually do not participate directly in the markets. As a rule
they deal through an intermediary, who performs functions of broker, dealer or investment banker.
An important role is played by government, which issue money market securities and use the proceeds to finance budget deficits. The government debt is often refinanced by issuing new securities to pay off old debt, which
matures. Thus it manages to finance long-term needs through money market securities with short-term maturities.
Money Market Participants 13
Central bank employs money markets to execute monetary policy. Through monetary intervention means and by fixing the terms at which banks are provided with money, central banks ensure economy’s supply with liquidity.
Credit institutions (i.e., banks) account for the largest share of the money market. They issue money market securities to finance loans to households and corporations,
thus supporting household purchases and investments of corporations.
Besides, these institutions rely on the money market for the management of their short-term liquidity positions and for the fulfillment of their minimum reserve requirements.
Money Market Participants 14
Other important market participants are other financial intermediaries, such as money market funds, investment funds other than money- market funds, insurance companies and pension funds.
Large non-financial corporation’s issue money market securities and use the proceeds to support their current operations or to expand their activities through investments.
In general issuance of money market securities allow market participants to increase their expenditures and finance economic growth.
Money Market Instruments 15
Treasury bills and other short-term government securities (up to one year);
Interbank loans, deposits and other bank liabilities;
Repurchase agreements and similar collateralized short-term loans;
Commercial papers, issued by non-deposit entities (non-finance companies, finance companies, local government, etc. ;
Certificates of deposit;
Eurocurrency instruments;
Interest rate and currency derivative instruments
Slide 16
Money Market Instruments: T-Bills
TREASURY BILLS
These are the best known and most popular short-term investment vehicle; issued by and backed by the government to finance budget deficits.
Sold to a variety of different types of buyers with denominations of $1,000 and up to a maximum of $5 million.
They have original maturities of either four weeks, three months, or six months.
T-bills carry no stated interest - sold on a discount basis at price below its face, or par, value.
For example, a Treasury bill with a par value of $10,000 may be sold for $9,500. Upon maturity, the government will pay the investor $10,000, resulting in a profit of $500. The amount of profit earned from the payment is considered the interest earned on the T-bill.
Money Market Instruments: T-Bills 17
Original issues are sold at regularly scheduled auctions
Upon treasury’s announcement of the size of the upcoming auction, tenders or sealed bids are being solicited from competitive and noncompetitive bidders. A competitive bidder specifies both the amount of the security that the bidder wants to buy,
as well as the price that the bidder wants to pay. The price of the securities in the auction is set based on the prices offered in competitive bids, taking the average of all accepted competitive prices.
Competitive bidders are the largest financial institutions that generally purchase largest amounts of Treasury securities. In general 80- 90% Treasury securities are sold to them.
A non- competitive bidder specifies only the amount of the security that the bidder wants to buy, without providing the price, and automatically pay the defined price.
Noncompetitive bidders are retail customers, who purchase low volumes of the issues, and are not sophisticated enough to submit a bid price. Direct purchases of Treasury securities by individuals are limited in many countries. In such cases they use the services of dealers.
Slide 18
Money Market Instruments
Treasury Bills – Auction Methods (Primary Market)
There are two main types of auctions - multiple price and uniform price. In multiple-price auctions, the issuer orders the bids by price – from highest to lowest -
and accepts the higher bids until the issue is exhausted. Each winning bidder pays the price it bid.
In uniform-price auctions, the issuer orders bids in descending order and accepts those that allow full absorption of the amount up for issue. However, all successful bidders pay the price of the lowest successful bid.
In both techniques, the lowest accepted price is the cut-off price.
Multiple-price auctions have advantages for the issuer. They maximize revenue for a given demand curve, as the issuer obtains the maximum price
each participant is willing to pay, and the issuer thereby obtains the consumers’ surplus.
In a uniform-price auction, by contrast, since successful bidders pay only the lowest (marginal) price regardless of what they were initially prepared to pay, the consumers’ surplus is shared between the issuer and the bidders.
Money Market Instruments 19
The lowest rejected bid yield (or the highest accepted bid yield) is called stop yield.
The corresponding price is called the stop-out price.
That is, the lowest auction price at which T-bills are sold.
The average yield is the average of all accepted competitive bids, weighted by the amounts allocated at each yield.
All noncompetitive bidders pay the average yield.
A cover is the ratio between the total amount competitive and non-competitive bids tendered and the total issue (i.e. the total amount of accepted bids).
A large cover indicates active market participation in an auction.
Money Market Instruments: Treasury Bill Auctions Example
The Treasury is offering $11 billion of the security.
Let us assume that noncompetitive bids totaled $1 billion. Thus, $10 billion in T-Bills will be issued to competitive bidders.
The Treasury works its way down this chart, in ascending order of yield.
Bidder 1’s bid is accepted ($6.5 billion is left). Then Bidder 2’s bid is accepted ($4 billion is
left). Bidder 3 and Bidder 4 both bid the same price
(and thus the same discount or yield). There is not enough security left to satisfy each of their $3 billion bids, but the Treasury wants to sell the remaining $4 billion. The remainder is split proportionately: Bidder 3 and Bidder 4 will both receive $2 billion.
Every bidder buys the security at $987.11 (a yield or discount of 5.10%).
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NAME BID PRICE (DISCOUNT)
YIELD AMOUNT
Bidder 1 $987.16 (5.08%)5.22% $3.5 billion
Bidder 2 $987.13 (5.09%)5.23% $2.5 billion
Bidder 3 $987.11 (5.10%)5.24% $3.0 billion
Bidder 4 $987.11 (5.10%)5.24% $3.0 billion
Bidder 5 $987.08 (5.11%)5.25% $2.0 billion
Bidder 6 $987.06 (5.12%)5.26% $1.0 billion
Money Market Instruments: Treasury Bills Discounting Example
You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate?
(1)
n x
F
PF i discount
360
%20.4 28
360
000,1
73.996000,1
xi
discount
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Money Market Instruments: Treasury Bills Discounting Example
You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its annualized yield?
i yt F P
P 365
n (1)
%28.4 28
365
37.996
73.996000,1
xi
yt
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Money Market Instruments: T-Bills 23
Treasury Bills in the Secondary Market
Typically the Treasury securities have an active and liquid secondary market.
The most actively traded issues, which are usually the ones sold through an auction most recently, are called on-the-run issues.
They have narrower bid-ask spreads than older, off-the-run issues.
Bid price is the amount of money a buyer is willing to pay for a security.
Ask price is the amount the seller is willing to sell a security for.
The difference between these two prices is referred to as the bid-ask spread
The role of brokers and dealers is performed by financial institutions.
Sample Treasury Bill 24
Money Market Instruments: T-Bills 25
Since the Treasury bill does not generate interest payments, the value of it is the present value of par value. Therefore, since the Treasury bill does not pay interest, investors will pay a price for a one-year security that will ensure that the amount they receive one year later will generate the desired return.
Example: Assume investor requires a 5 percent annualized return on a one-year Treasury bill with a $100,000 par value. He will be willing to pay the price P = $100,000/ 1.05 = $95,238.00. If investor requires a return higher than 5 percent, he will discount the par value at a
higher return rate. This will result in a lower price to be paid today.
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Money Market Instruments: Interbank Market
Interbank Market Loans or Federal (Fed) Funds - Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day to 14 days.
When institutions anticipate insufficient reserves, they often turn to Federal
Reserve Bank (FED) funds market.
Here they can borrow reserves from other institutions on an overnight basis.
Used by banks to meet short-term needs or to meet reserve requirements.
Institutions with excess reserves can turn to the fed funds market to loan these
reserves and earn interest.
Money Market Instruments: Interbank Market 27
The interbank interest rates and interest rates in the traditional market are interconnected. If banks are short of liquidity they will lend less to both markets and will cause
interest rates to rise.
When Central bank provides funds to the discount market, less attractive terms are offered by banks. Thus they may choose other markets to invest and will cause the drop in interest rates.
The major characteristics of the interbank markets are: The transfer of immediately available funds
Short time horizons
Unsecured transfers
Slide 28
Money Market Instruments: Commercial Paper
Commercial Paper - unsecured promissory notes, issued by well-known,
creditworthy corporations, that mature in no more than 270 days.
Though unsecured, it is usually backed by a line of credit at a commercial bank.
The aim of its issuance is to provide liquidity or finance company’s investments, e.g. in inventory and accounts receivable.
The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.
These short-term promissory notes are alternatives to:
Short-term bank loans
Other forms of borrowing
The primary benefit to largest and most creditworthy issuers is that the cost
of borrowing is lower than at a commercial bank.
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Money Market Instruments: Commercial Paper
Commercial Paper Characteristics largely defined by legislation and issuers’ attempt to avoid costly disclosure requirements
mandated for other types of securities
Expensive requirements avoided if these are met: Paper issued must mature in less than 270 days otherwise it must register with
Securities Exchange Commission (SEC)
Paper must be issued in large denomination so that it is not typically purchased directly by public
Proceeds must be used to fund current transactions, e.g. inventory and accounts receivables
CPs can be sold directly by the issuer, or may be sold to dealers who charge a placement fee (e.g. 1/8 percent). Since issues of CPs vary in terms of issuers, amounts, maturity dates, there is no active secondary market for commercial papers. However, dealers may repurchase CPs for a fee.
Money Market Instruments: CD’s 30
Certificate of Deposit (CD) states that a deposit has been made with a bank for a fixed period of time At the end of which it will be repaid with interest.
An institution is said to ‘issue’ a CD when it accepts a deposit and to ‘hold’ a CD when it itself makes a deposit or buys a certificate in the secondary market. From an institution’s point of view, issued CDs are liabilities; held CDs are assets.
The advantage to the depositor is that the certificate can be tradable. Thus though the deposit is made for a fixed period, the depositor can use funds earlier
by selling the certificate to a third party at a price which will reflect the period to maturity and the current level of interest rates.
The advantage to the bank is that it has the use of a deposit for a fixed period but, because of the flexibility given to the lender, at a slightly lower price than it would have had to pay for a normal time deposit.
Money Market Instruments: CD’s 31
The minimum denomination can be $100 000, although the issue can be as large as $1 million.
Maturities usually range from two weeks to one year for negotiable CDs. Three- and six-month maturities are common. Some CDs are issued for one year and even
for two years but the market for these is comparatively thin. This has led to the practice of
banks issuing ‘roll-over’ CDs, i.e. six-month CDs with a guarantee of further renewal on specified terms.
Though negotiable CD denominations are typically too large for individual investors, money market funds allow individuals to be indirect investors
There is also a secondary market for these securities; however its liquidity is very low.
Money Market Instruments: CD’s 32
Negotiable CD’s must be priced offering a premium above government securities (e.g. Treasury bills) to compensate for less liquidity and safety.
The premiums are generally higher during the recessionary periods.
The premiums reflect also the money market participants’ understanding about the safety of the financial system.
The interest rate paid on CDs is often linked to interbank rate. If London Interbank Offered Rate (LIBOR) is 4.75 per cent, for example, the CD
described above might be paying 5 percent because it is quoted as paying LIBOR plus 25 basis points.
Money Market Instruments: REPO 33
A Repurchase Agreement (REPO) is an agreement to buy any securities
from a seller with the agreement that they will be repurchased at some specified date and price in the future.
REPO is a fully collateralize loan in which the collateral consists of marketable securities such as bonds.
In essence the REPO transaction represents a loan backed by securities.
If the borrower defaults on the loan, the lender has a claim on the securities.
Most REPO transactions use government securities, though some can involve such short- term securities as commercial papers and negotiable Certificates of Deposit.
Repurchase agreement is short-term
one to 15 days and for one, three, or six months.
There is no secondary market for REPOs
Money Market Instruments: REPO 34
The repurchase price is higher than the initial sale price, and the difference in price constitutes the return to the lender.
The amount of REPO loan is determined in the following way: REPO principal = Securities market value x ( 1 – Haircut )
Securities market value = PAR x ( 1 – (d x n / 360 )) where the securities market value is determined as the current market value of these
securities
d is the rate of discount of the securities
n is term of the securities
PAR is the par value of the securities.
Money Market Instruments: REPO 35
The deduction from current market value of the securities collateral required to do the REPO transaction is call a haircut or a margin. The haircut is stated in terms of basis points. A standard haircut can be, e.g. 25 basis
points (or 0.0025%).
Thus a REPO loan is over-collateralized loan meaning that the amount of the collateral exceeds the loan principal and the haircut.
In a REPO transaction, the securities market value is equal to the value of collateral, against which the borrowing takes place.
Since the value of the securities may be fluctuating during the term of the REPO, the amount of the loan (the principal) is less than the current market value of the securities.
Money Market Instruments: REPO 36
Haircut – the function of a broker/ dealer’s securities portfolio, that cannot be traded, but instead must be held as capital to act as a cushion against loss. The haircut or margin offers some protection to the lender in case the borrower goes
bankrupt or defaults for some other reason.
Repurchase of the securities is made by repaying REPO loan and interest: REPO principal + Interest = REPO principal ( 1 + (y x t / 360 ))
where y is the yield or rate of the REPO transaction, t is the term of the REPO transaction.
Money Market Instruments: REPO 37
Open REPO A REPO agreement with no set maturity date, but renewed each day upon agreement
of both counterparties.
Term REPO A REPO with a maturity of more than one day.
A reverse REPO A purchase of securities by one party from another with the agreement to sell them.
A REPO and a reverse REPO can refer to the same transaction but from different perspectives and is used to borrow securities and to lend cash.
The participants of REPO transactions are banks, money market funds, and non-financial institutions.
Money Market Instruments: Eurocurrency 38
In recent years some of the fastest growing markets have been the so- called euro-currency markets. These are markets in which the borrowing and lending denominated in a currency of
some other country takes place.
Eurocurrency instrument is any instrument denominated in a currency which differs from that of the country in which it is traded. When such instruments are denominated in some other currency, they are identified
as ‘euro-’, though it can be any currency (e.g. US dollars, or Japanese yen).
The trading can also take place anywhere (in European countries or in New York or Tokyo or Hong Kong).
Money Market Instruments: Eurocurrency
The deposit and loan transactions are of large denominations
e.g. exceeding 1 million USD. Therefore only governments and largest corporations can participate in the market.
The Eurodollar market has continued to grow rapidly because depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market.
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Money Market Instruments: Eurocurrency 40
Eurocurrency liabilities of financial institutions are the following:
Euro Certificates of deposits negotiable deposits with a fixed time to maturity.
Interbank placements short-term, often overnight, interbank loans of Eurocurrency time deposits.
Time deposits non-negotiable deposits with a fixed time to maturity.
Due to illiquidity their yields tend to be higher than the yields on equivalent maturity of negotiable Euro certificates of deposits.
Call money Call money are non-negotiable deposits with a fixed maturity that can be withdrawn at any
time.
Money Market Instruments: Eurocurrency 41
Eurocurrency assets of financial institutions are the following: Euro Commercial Papers (Euro CPs)
short-term bearer notes, with maturities from 7 to 365 days, issued by large, well-known private corporations with the aim to provide short-term investments with a broad currency choice for international investors. It can be resold in a highly liquid secondary market. The issuers should be highly rated as Euro CPs are unsecured.
Syndicated Euro-loans the lending of Eurocurrency deposits to nonfinancial companies with the need for funds. Since they
are non-negotiable, banks used to hold the syndicated loans in their portfolios until they mature. Due to their illiquidity, the loans are often made jointly by a group of lending banks, which is called a syndicate. The role of syndication is to share loan risks among the banks that are members of the syndicate.
Euro-notes un-securitized debt instruments, substitutes for non-negotiable Euro-loans. They are short-term,
most often up to one year. Floating rate notes (FRNs) offer a variable interest rate that is reset periodically, usually semi-annually or quarterly, according to some predetermined market interest rate (e.g. LIBOR). For a high rated issuer the interest rate can be set lower than LIBOR.
Money Market Securities and Their Depth
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