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CHAPTER 7

CHAPTER 7. Money Markets. Overview of the Money Market. Short-term debt market -- most under 120 days. A few high quality borrowers. Many diverse investors. Informal market centered in New York City. Standardized securities -- one security is a close substitute for another.

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CHAPTER 7

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  1. CHAPTER 7 Money Markets

  2. Overview of the Money Market • Short-term debt market -- most under 120 days. • A few high quality borrowers. • Many diverse investors. • Informal market centered in New York City. • Standardized securities -- one security is a close substitute for another.

  3. Overview of the Money Market(concluded) • Good marketability -- secondary market. • Large, wholesale open-market transactions. • Many brokers and dealers are competitively involved in the money market. • Payment in Federal Funds -- immediately available funds. • Physical possession of securities seldom made -- centralized safekeeping.

  4. Economic Role ofMoney Market (MM) • The money market is a market for liquidity • Liquidity is stored in MM by investing in MM securities. • Liquidity is bought in MM by issuing securities (borrowing).

  5. Characteristics of MoneyMarket Instruments • Low default risk. • Short maturity. • High marketability.

  6. Money Market Balance SheetPosition of Major Participants

  7. Commercial Banks -- MostImportant Participant in the MM • Bank assets or investments • Treasury bills. • Agency securities. • Bankers' acceptances (from other banks). • Federal Funds sold. • Repurchase agreements (securities purchased under agreements to resell).

  8. Commercial Banks,cont. • Bank liabilities or borrowing • Negotiable CDs. • Commercial paper. • Bankers' acceptances. • Federal Funds purchased. • Repurchase agreements (securities sold under agreements to repurchase). • MM securities provides sources and uses of liquidity due to wide fluctuations in loans and deposits.

  9. The Federal Reservein the Money Markets • Money market securities is the major asset category of the Fed. • Open-market operations (buying and selling of MM securities by Fed) is the primary tool for implementing monetary policy. • Purchase -- increases member bank reserves. • Sale -- decreases member bank reserves.

  10. Dealers in U.S. Securities -- • Involved in both primary and secondary markets. • Purchases new treasury debt and resells it (primary). • "Makes a market" by buying/selling (dealer) securities (bid/ask). • Purchases are financed by repurchase agreements or fed funds.

  11. U.S. Treasury Bills • Characteristics • Sold on discount basis. • Maturities up to one year. • Denominations are in multiples of $1000.

  12. U.S. Treasury Bills • Pricing Treasury Bills • Treasury bills are priced on a bank discount rate basis, a traditional yield calculation. • The bank discount rate, rd, is:

  13. U.S. Treasury Bills • The Wall Street Journal lists T-Bill yields on a bond equivalent basis where the discounted price is the denominator and 365 days is used as the annualizer. • The effective annual yield assuming compounding at a year is:Effective Yield = [(Face Value/Price)365/D -1] x 100%.

  14. Auctioning New Bills • Weekly sale by U. S. Treasury of three- and six-month maturities; longer-term bills, monthly or quarterly. • Competitive vs. noncompetitive bid: states both the quantity of bills and bid price. Large bids. Multiple bids. • Noncompetitive bid: states only the quantity of bills requested at weighted average price. Smaller bids.

  15. Book-entry Securities • No physical securities: only record entries. • Book-entry record keeping • Most of marketable Treasury debt is now in book- entry form.

  16. Types of Federal Agencies • Farm credit agencies -- loans to farmers. • Housing credit agencies -- loans and secondary market support for mortgage market. • Other agencies -- special purposes. • Federal financing bank -- purchases securities of agencies and issues its own obligations.

  17. Characteristics of Agency Debt • Most are not guaranteed by federal government; federal guarantee implied, not explicit. • Marketability varies with the development of the secondary market. • Yields are higher than T-Bills. • Slightly greater default risk. • Slightly lower marketability.

  18. Negotiable Certificates of Deposit • Characteristics of Negotiable CDs • Large denomination time deposit, less than six month's maturity. • Negotiable -- may be sold and traded before maturity. • Issued at face value with coupon rate. • Development of the CD Market • Issued by Citibank in 1961. • Offset declining demand deposits as a source of funds.

  19. Negotiable Certificates of Deposit(concluded) • The CD Market • Rate negotiated between buyer and seller. • Market is sensitive to rates above or below the market rates. • Rates are lower for money center banks and are tiered upward for regional banks. • Purchased mainly by corporate businesses.

  20. Commercial Paper • Short term -- one to 270 days. • Unsecured. • Large denominations -- $100,000 and up. • Issued by high-quality borrowers. • A wholesale money market instrument -- few personal investors. • Sold at a discount from par. • Directly or dealer sold. • Backed by bank lines of credit.

  21. The Commercial Paper Market(concluded) • Credit ratings important for commercial paper issuance. • Backup lines of credit from banks support or guarantee quality. • Placement • Directly by a sales force of the borrowing firm. • Indirectly through dealers.

  22. Bankers' Acceptances • Time draft -- order to pay in future. • Drafts are drawn on and/or accepted by commercial bank. • Direct liability of bank. • Mostly relate to international trade. • Secondary market -- dealer market. • Discounted in market to reflect yield. • Standard maturities of 30, 60, or 90 days -- max of 180.

  23. Creating a Banker's Acceptance • Importer initiates purchase from foreign exporter, payable in future. • Importer needs financing; exporter needs assurance of payment in future. • Importer's bank writes irrevocable letter of credit for exporter • Specifies purchase order. • Authorizes exporter to draw time draft on bank.

  24. Federal Funds • Characteristics of Federal Funds • Market for depository institutions. • Most liquid of all financial assets. • Related to monetary policy implementation. • Yields related to the level of excess bank reserves. • Originally a market for excess reserves -- Now a source of investment (federal funds sold) and continued financing (federal funds purchased).

  25. Federal Funds (concluded) • Most Are One-day, Unsecured Loans. • Bookkeeping Entry, Interest Paid Separately. • Traded in Fed Funds or Immediately Available Funds.

  26. Repurchase Agreements (Repo) • Bank Financing -- Source of funds • Security sold under agreement to repurchase at given price in future. • Way to include corporate business in Federal Funds market. • Negotiated market rate. • Bank Investment – Reverse Repo • Security purchased under agreement to resell at given price in future. • Smaller banks are able to invest excess liquidity in a secured investment.

  27. Repurchase Agreements (Repo)(concluded) • Repos are used by the Federal Reserve in open market operations.

  28. Interrelationship of Money Market Interest Rates • Various MM instruments are close substitutes in investment portfolios. • Interest rates move together over time. • Deviations from traditional spreads are quickly eliminated by interest rate arbitrage.

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