Money Markets

1. 6 Money Markets

2. Chapter Objectives • Provide a background on money market securities • Explain how institutional investors use money markets • Explain the globalization of money markets

3. Money Market Securities • Maturity of a year or less • Debt securities issued by corporations and governments that need short-term funds • Large primary market focus • Purchased by corporations and financial institutions • Secondary market for securities

4. Money Market Securities • Treasury Bills • Commercial paper • Negotiable certificates of deposits • Repurchase agreements • Federal funds • Banker’s acceptances

5. Money Market Securities • Treasury bills • Issued to meet the short-term needs of the U.S. government • Attractive to investors • Minimal default risk—backed by Federal Government • Excellent liquidity for investors • Short-term maturity • Very good secondary market

6. Money Market Securities • Treasury bill auction (fill bids in amount determined by Treasury borrowing needs) • Bid process used to sell T-bills • Bids submitted to Federal Reserve banks by the deadline • Bid process • Accepts highest bids • Accepts bids until Treasury needs generated Competitive Bidding

7. Money Market Securities • Treasury bill auction—noncompetitive bids ($1 million limit) • May be used to make sure bid is accepted • Price is the weighted average of the accepted competitive bids • Investors do not know the price in advance so they submit check for full par value • After the auction, investor receives check from the Treasury covering the difference between par and the actual price Noncompetitive Bidding

8. Money Market Securities • Estimating T-bill yield • No coupon payments • Par or face value received at maturity • Yield at issue is the difference between the selling price and par or face value adjusted for time • If sold prior to maturity in secondary market • Yield based on the difference between price paid for T-bill and selling price adjusted for time

9. Money Market Securities • Calculating T-Bill Annualized Yield 365 SP – PP YT  = PP n YT= The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period)

10. Money Market Securities • T-bill yield for a newly issued security 360 Par – PP T-bill discount =  PP n T-bill discount= percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity

11. Money Market Securities • Short-term debt instrument • Alternative to bank loan • Dealer placed vs. directly placed • Used only by well-known and creditworthy firms • Unsecured • Minimum denominations of $100,000 • Not a large secondary market Commercial Paper

12. Money Market Securities • Commercial paper backed by bank lines of credit • Bank line used if company loses credit rating • Bank lends to pay off commercial paper • Bank charges fees for guaranteed line of credit

13. Money Market Securities • Estimating commercial paper yields (same as t-bill) Par – PP 360 YCP  = PP n YCP= Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity

14. Money Market Securities • Issued by large commercial banks • Minimum denomination of $100,000 but $1 million more common • Purchased by nonfinancial corporations or money market funds • Secondary markets supported by dealers in security Negotiable Certificates of Deposit (NCD)

15. Money Market Securities • NCD placement • Direct placement • Use a correspondent institution specializing in placement • Sell to securities dealers who resell • Sell direct to investors at a higher price • NCD premiums • Rate above T-bill rate to compensate for lower liquidity and safety

16. Money Market Securities • Sell a security with the agreement to repurchase it at a specified date and price • Borrower defaults, lender has security • Reverse repo name for transaction from lender • Negotiated over telecommunications network • Dealers and brokers used or direct placement • No secondary market Repurchase Agreements

17. Money Market Securities • Estimating repurchase agreement yields SP – PP 360 Repo Rate =  PP n Repo Rate= Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity

18. 1 Purchase Order Importer Exporter 5 Shipment of Goods L/C (Letter of Credit) Application Shipping Documents & Time Draft L/C Notification 2 4 6 3 L/C Japanese Bank American Bank Shipping Documents & T ime Draft 7 (Exporter’s Bank) (Importer’s Bank) Draft Accepted (B/A Created) Exhibit 6.5 a

19. Money Market Securities • A bank takes responsibility for a future payment of trade bill of exchange • Used mostly in international transactions • Exporters send goods to a foreign destination and want payment assurance before sending • Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time Bankers Acceptance

20. Money Market Securities • Exporter can hold until the date or sell before maturity • If sold to get the cash before maturity, price received is a discount from draft’s total • Return is based on calculations for other discount securities • Similar to the commercial paper example Bankers Acceptance

21. Major Participants in Money Market • Participants • Commercial banks • Finance, industrial, and service companies • Federal and state governments • Money market mutual funds • All other financial institutions (investing) • Short-term investing for income and liquidity • Short-term financing for short and permanent needs • Large transaction size and telecommunication network

22. Valuation of Money Market Securities • Present value of future cash flows at maturity (zero coupon) • Value (price) inversely related to discount rate or yield • Money market security prices more stable than longer term bonds • Yields = risk-free rate + default risk premium

23. International U.S. U.S. U.S. Issuer’s Issuer’s Economic Fiscal Monetary Economic Industry Unique Conditions Policy Policy Conditions Conditions Conditions Short-T erm Risk-Free Risk Interest Premium Rate of Issuer (T -bill Rate) Required Return on the Money Market Security Price of the Money Market Security Exhibit 6.7 a

24. Interaction Among Money Market Yields • Securities are close investment substitutes • Investors trade to maintain yield differentials • T-Bill is the benchmark yield in money market • Yield changes in T-bills quickly impacts other securities via dealer trading • Yield differentials determined by risk differences between securities • Default risk premiums vary inversely with economic conditions

25. Globalization of Money Markets • Money market rates vary by country • Segmented markets • Tax differences • Estimated exchange rates • Government barriers to capital flows • Deregulation Improves Financial Integration • Capital Flows To Highest Rate of Return

26. Globalization of Money Markets • Performance of international securities • Effective yield for international securities has two components • The yield earned on the investment denominated in the currency of the investment • The exchange rate effect

27. Globalization of Money Markets • Performance of international securities • Yield for an international investment SPf – PPf Yf = PPf Yf= Foreign investment’s yield SPf = Investment’s foreign currency selling price PPf = Investment’s foreign currency purchase

28. Globalization of Money Markets • The exchange rate effect (%ΔS) measures the percentage change in the spot during the investment period • % ΔS measures the expected percent change in the currency • Currency appreciated, % ΔS is positive and adds to net yield • Currency depreciated, % ΔS is negative and reduces net yield