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Fixed Income Markets

Fixed Income Markets. I. Money Markets. A. Money Market Instruments Definition Money market securities are financial instruments with maturity of one year or less. Instruments and Participants Domestic Money Market Instruments Principal Borrowers Treasury bills U.S. Government

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Fixed Income Markets

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  1. Fixed Income Markets

  2. I. Money Markets A. Money Market Instruments • Definition Money market securities are financial instruments with maturity of one year or less.

  3. Instruments and Participants • Domestic Money Market Instruments Principal Borrowers Treasury bills U.S. Government Commercial paper Non-financial and financial businesses Negotiable CDs Banks Repurchase agreements Securities dealers, banks, non- financial corporations, governments

  4. Instruments Principal Borrowers Federal funds Banks Banker’s acceptances Non-financial and financial businesses Discount window Banks Municipal Notes State and local governments Government sponsored Farm Credit System, Federal Enterprise securities Home Loan Bank System, Federal National Mortgage Association

  5. Instruments Principal Borrowers Shares in money market Money market funds, local instruments government investment pools, short-term investment funds Futures contracts Dealers, banks (principal users) Futures options Dealers, banks (principal users) Swaps Banks (principal dealers)

  6. International Money Market Instruments Instruments Principal Borrowers Eurodollars Banks Eurodollar CDs Banks Euronotes Euro-commercial paper Non-financial and financial businesses

  7. Characteristics • High degree of safety • Active secondary market • Telephone network

  8. B. Treasury Bills • Maturity • Regular issues 91-day bills Issued weekly 182-day bills Issued weekly 51-week bills Issued monthly • Irregular issues

  9. Denominations $10,000 $15,000 $50,000 $100,000 $500,000 $1,000,000 round lot: $5,000,000

  10. Auction • Non-competitive Bidding ($1,000,000 or less)  Direct purchase from Federal Reserve Banks  Indirect purchase through brokers

  11. Competitive Bidding Amount (in bil.)Bid Remark $0.20 7.55% lowest yield,/highest price 0.26 7.56 0.33 7.57 0.57 7.58 average yield/ average price 0.79 7.59 0.96 7.60 1.25 7.61 1.52 7.62 stop yield/ stop price

  12. Dearlers • Reporting Dealers Securities firms which are on the Federal Reserve’s regular reporting list. • Primary Dealers (Recognized Dealers) Securities firms and commercial banks that the Federal Reserve will deal with in implementing its open market operations.

  13. Government Brokers Brokers used by primary dealers trading Treasury securities with each other. • Other Dealers and Brokers

  14. T-Bill Rate (T-Bill Discount, or Yield on a Bank Discount Basis) T-bill Rate = [(par - PP) / par]  (360 / n) = [dollar discount/ par]  (360 / n), where par = par value, PP = purchase price, and n = holding period in days.

  15. Example: par = $100,000, PP = $97,569, and n = 100 days. Yield = [($100,000- $97,569)/ $100,000]  (360 / 100) = 8.75%.

  16. Dollar Discount Dollar Discount = T-bill Rate  par (n /360)

  17. Example: T-bill Rate = 8.75%, par = $100,000, and n = 100 days. Dollar Discount = 0.0875$100,000(100/360) = $2,431. Purchase price = par value - dollar discount = $100,000 - $2,431 = $97,569.

  18. Yield T-bill Yield = [(SP - PP) / PP]  (365 / n), where SP = selling price, PP = purchase price, and n = holding period in days.

  19. Example: SP = $10,000, PP = $9,600, and n = 182 days. Yield = [($10,000 - $9,600)/ $9,600](365 / 182) = 8.36%

  20. C. Commercial Paper • Issuers Finance companies Bank holding companies Industrial companies Foreign corporations (Yankee commercial paper)

  21. Maturity • Not Registered One day to 270 days, normally between 20 and 45 days. • Registered Over 270 days

  22. Denominations Minimum $25,000 Minimum round lot $100,000 Typical multiples of $1 million

  23. Rating McCarthy, Crisanti & Category Duff & Phelps Fitch Moody’s S&P Maffei Investment Duff 1+ F-1+ A-1+ Grade Duff 1 F-1 P-1 A-1 MCM 1 Duff 1- Duff 2 F-2 P-2 A-2 MCM 2 Duff 3 F-3 P-3 A-3 MCM 3 Non-invest. Grade Duff 4 F-S NP(Not B MCM 4 Prime) C MCM 5 In default Duff 5 D D MCM 6

  24. Placement • Directly Placed Commercial Paper • Dealer-Placed Commercial Paper

  25. Backing • Reasons Credit enhancement Rollover risk • Types of Credit-Supported commercial paper Credit-Supported commercial paper (line of credit paper) Fee (0.5%) Compensating balances  Asset-backed commercial paper

  26. Yield Yield = [(par - PP) / PP]  (360 / n), where par = par value, PP = purchase price, and n = holding period in days.

  27. Example: par = $5,000,000, PP = $4,850,000, and n = 90 days. Yield = [($5,000,000 - $4,850,000) / $4,850,000]  (360 / 90) = 12.37%

  28. D. Negotiable Certificates of Deposits (NCDs) • Issuers • Domestic market Commercial banks Thrift institutions (thrift CDs) U.S. branches of foreign banks (Yankee CDs) • Foreign markets (Euro CDs)

  29. Maturity Short-term: two weeks to one year Long-term: term CDs • Denominations Minimum $100,000 Typical $1,000,000

  30. Placement • Directly placed NCDs • Dealer placed NCDs

  31. Yield on a Bank Discount Basis • Risk premium  Higher premium during recessionary years  Higher premium during financial crises  Higher premium for high-risk issuers • Liquidity premium • Fixed rate vs floating rate

  32. E. Repurchase Agreements (RPs) • Issuers • Financial institutions Commercial banks Thrifts Money market funds Securities dealers • Non-financial institutions Municipalities Businesses

  33. Maturity • Overnight repos • Term repos Two to fifteen days One, three and six months • Denominations Typical $10 million or higher

  34. Yield or Repo Rate Repo Rate = [(SP - PP) / PP]  (360 / n), where SP = selling price collected by an investor, PP = purchase price paid by an investor, and n = holding period in days.

  35. Example: SP = $10,000,000, PP = $9,852,217, and n = 60 days. Yield = [($ 10,000,000-$ 9,852,217)/$ 9,852,217]  (360 / 60) = 9%

  36. Determinants of repo rates: • Creditworthiness of the issuer • Type of collateral • Federal funds rate The repo rate is usually 25 basis points below the funds rate because a repo has collateral, while a federal funds transaction is unsecured.

  37. F. Federal Funds • Participants Depository institutions Brokers • Characteristics • Short-term borrowing of immediate availability • Borrowed only by depository institutions • Exempted from reserve requirements

  38. Maturity • Overnight federal funds (3/4 of the total federal funds) • Continuing contract federal funds (automatically renewed overnight federal funds) • Term federal funds: few days to six months

  39. Denominations Typical $5,000,000 • Placement • Directly placed • Broker-placed

  40. Security • Unsecured federal funds • Secured federal funds • Federal Funds Transfer • Adjusting reserve accounts through Fedwire • Reclassifying the demand deposits of a respondent bank

  41. Federal Funds Rate • Higher than repo rate and Treasury bill rate. • Higher volatility than other money market rates because it is affected by changes in monetary policy.

  42. G. Banker’s Acceptances • Issuers Exporters Importers Commercial banks

  43. 1. Purchase order Importer Exporter 5. Shipment of goods 6. Shipping 2. L/C 4. L/C documents application notification & time draft 3. L/C Importer’s bank Exporter’s bank 7. Shipping documents & draft acceptance

  44. Acceptance financing The use of banker’s acceptances to finance commercial transaction. • Importing goods into the U.S. • Exporting goods from the U.S. • Storing and shipping goods between foreign countries (third country acceptances)

  45. Maturity • 30 to 270 days • Federal Reserve eligibility requirement A Banker’s acceptance with maturity longer than six months do not meet the eligibility requirement as collateral at the discount window.

  46. Placement • Directly placed by Accepting banks An accepting bank is a bank which creates banker’s acceptances. • Dealer placed • Unsold acceptances created by large accepting banks • Acceptances created by smaller accepting banks • Acceptances created by Yankee banks (U.S. branches of foreign banks)

  47. Rates • Higher than T-bill rate • Risk premium - Higher default risk than T-bills. • Liquidity premium- Less developed secondary market. • Commission charged by accepting banks • U.S. banks - 25 to 30 basis points • Japanese banks - 10 to 15 basis points • Dealer’s Spread - 12.5 to 87.5 basis points

  48. H. Eurocurrency • Participants Governments Large financial institutions Commercial banks (Eurobanks) Organized exchanges Institutional investors Large corporations

  49. Related Markets • Foreign exchange market • Eurocurrency market • Eurocredit market • Euro CD market • Euronote market • Currency forward market • Currency Futures market • Currency options market • Currency swap market

  50. Euro CDs • Types • Fixed -rate CDs • Floating-rate CDs (FRCDs) The rate adjusts periodically to the London Interbank Offer Rate (LIBOR).

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