Money Markets

1. 6 Money Markets

2. Money Market Securities • Individuals/businesses/govts may have excess funds to invest but only for a short-period of time • WWU temporarily invests its building funds. • Wal-Mart temporarily has excess operating cash • At the same time, some may need to borrow funds for the short-term • Seasonal cash demands for inventory, payroll, temporary operating cycle shortages, etc. • Factors for short-term investments • Maturity, Liquidity, Price Stability, Security • A return greater than your ordinary bank savings account

3. Money Market Securities (cont.) Money Market Securities (MMS) are debt (lending) securities with original maturities of one year or less. Examples: • Treasury Bills • Commercial paper • Negotiable certificates of deposits • Repurchase agreements • Federal funds • Banker’s acceptances

4. 1. Treasury Bills • Issued to meet the short-term needsof the U.S. government (i.e. the Federal debt) • Sold at a discount and mature at par value • Advantages • No default risk—backed by the Federal government • No liquidity risk --- excellent liquidity for investors • Short-term maturity (4, 13, 26 or 52 weeks) • Very good secondary market • Come in multiples of $1,000 • When economic downturns come, a “flight to safety” makes T-bills attractive..In Dec/08, investors were so desperate to park their funds in T-bills for safety they were willing to accept a zero or slightly negative interest rate • Disadvantages: low return

5. Treasury Bills (cont.) • Treasury determines total amount needed to borrow. • Treasury first accepts noncompetitive bids up to maximum of $5 million face value (see www.treasurydirect.gov ) • May be used to make sure bid is accepted • Investors do not know the price in advance so they submit funds for full par value • After the auction, investor receives refund for the difference between par and actual price Noncompetitive Bidding

6. Treasury Bills (cont.) Competitive bidding • Used by large investors because of $5m limit • Bids submitted to Treasury by the deadline • Treasury accepts highest bids until desired borrowed amount has been reached. • Price paid to non-competitive bidders is the lowest accepted competitive bids. • Very liquid secondary market assures investors that they can sell their investments before maturity if necessary. • For auction schedule, see http://www.treasurydirect.gov/RI/OFAnnce

7. Treasury Bills (cont.) See auction calendar at http://www.treasury.gov/resource-center/data-chart-center/quarterly-refunding/Documents/auctions.pdf

8. Treasury Bills (cont.) Pricing Treasury Bills • Priced at a discount from their par value • Price depends on the investor’s required rate of return • Value of a T-bill is the present value of the par value Example: If investors require a 7 percent annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is: P = $10,000 / (1.07) P = $9,345.79

9. Treasury Bills (cont.) Calculating T-Bill Annualized Yield 365 SP – PP YT  = PP n YT= The annualized yield from investing in a T-bill SP = Selling price (or par value if held to maturity) PP = Purchase price n = number of days of the investment (holding period)

10. Treasury Bills (cont.) T-bill discount for a newly issued security 360 Par – PP T-bill discount =  Par 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. Commercial Paper • S/T loans to large banks or corporations who have established solid credit records for operating or S/T needs only (not for fixed asset or L/T needs) • Borrowers are financial institutions (banks, finance co.) or non-financial organizations (Boeing, LLU, Wal-Mart, Hershey’s, etc.) • Financial institutions often use CP to fund the credit cards they offer and other S/T cash needs. • Non-financial business use CP to fund seasonal inventory and other S/T cash needs (retailers at Christmas; candy co. at Halloween or Easter, etc.) • Alternative to bank loan (usually cheaper than bank loan), although some bank loans are still used to maintain relationship with bank. • Usually unsecured (no collateral) but often backed by bank lines of credit • Default risk exists (Penn Central, Wang Labs, Lomas Financial, Drexel Burnham Lambert) so CP is rated by agencies (S&P, Moody’s, Fitch’s) • Maturities run from 1 to 270 days (usually about month). Why? Because SEC required all paper exceeding 270 days to be registered. • Minimum is $100,000 but usually sold in millions • Not an active secondary market (liquidity risk)

12. Commercial Paper (cont.) • Dealers can place CP but expensive to pay .05% commissions • If a firm issues a lot of CP, the firm can directly place itwith investors (e.g Ford Motor Credit). • With the failure of Lehman Bros. in Sept/08, the CP market came to an abrupt halt and rates spiked to levels unseen before. The funds that greased the wheels of commerce seized up. This situation is what scared Hank Paulson (U.S. Treasury Secr.) to first ask for a Federal bailout. • Lehman’s Bros. collapsed on 9/15/08. Many MMMFds held Lehman’s CP. The next day, Reserve Primary Fund (the oldest and one of the largest MMMF) had to write off $785m of LB CP, which caused it to break the buck (97 cents on the dollar). Breaking the buck means that the value of the fund per share dropped below $1.00. Other than a minor incident in 1994, this was the first time in history that MMMFd broke the buck. • Bruce Bent started the first MMMFd with his Reserve Primary Fund in 1971. On 9/15/08, 54% of the assets were in CP. Bent, 71-years-old, was vacationing in Europe, but had to cut his vacation short. Bruce Bent

13. Commercial Paper (cont.) CP Rates After Lehman Collapse To stabilize the money markets, the Fed began purchasing CP on Oct. 26, 2008. As can be seen on the graph, CP rates declined substantially as the Fed’s actions brought liquidity and confidence back to the CP market.

14. Commercial Paper (cont.) Estimating commercial paper yields Par – PP 360 YCP  = PP n YCP= Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity

15. Negotiable Certificates of Deposit (NCD) • Issued by large commercial banks • Minimum denomination of $100,000 but $1 million more common (no deposit insurance if over $250k at same bank) • Purchased by nonfinancial corporations or money market mutual funds • Good secondary markets supported by dealers • Can be placed directly or thru dealers. • Offers rate higher than T-Bill because more liquidity and default risk. • Yield:

16. Repurchase Agreements (Repos) • Borrower sells a security to investor with the agreement to repurchase it at a specified date and price • For example, Baker Boyer Bank sells a repo to WWU & will pay back the money plus a fee (interest) in two weeks. • Flexible maturity– 1 day to 1 year, often overnight or over weekend, with 1-15 days & 3 or 6 months most common • Backed by collateral (usually Treasury Securities) so if borrower defaults lender gets collateral (no default risk) • Usually minimum of $10m but can be much smaller • Dealers and brokers used or direct placement • No secondary market (some liquidity risk) • Reverse repo: buyer is lender, purchase with agreement to sell

17. Repos (cont.) 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. Federal Funds • Interbank lending and borrowing, often for reserve requirements, with common maturity 1-7 days • Federal funds rate usually slightly higher than T-bill rate because of slight default risk • Fed District Bank debits and credits accounts for purchase (borrowing) and sale (lending) • Federal funds brokers may match up buyers and sellers using telecommunications network • Usually $5 million or more

19. Bankers Acceptances • Exporters want payment assurance before sending to a foreign destination AND importers can receive goods without giving immediate payment because of bank guarantee • Bank stamps a time draft from the importer ACCEPTED and guarantees to make good on the payment at a specific time • Exporter can hold BA or sell before maturity at a discount (so no liquidity risk) • Maturities are usually 30-270 days • Banks may possibly default so a little bit of default risk

20. 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

21. Summary of Money Market Instruments

22. Money Market Yields over Time(Annualized Yields, One-Month Maturity)

24. International Rate Comparison Rates tend to be correlated over time. Flow of money between countries has increased, due to tax differences, anticipated exchange rate movements, and fewer gov’t barriers

25. Globalization of Money Markets • Eurodollar deposits and Euronotes • Dollar deposits in banks outside the U.S. (even Canada!) • BTW: It is estimated that about $1T exists in U.S. currency and coin, most of which is held outside the U.S. • Eurodollars have increased because of international trade growth and U.S. trade deficits over time • No reserve requirements at banks outside U.S. • Eurodollar Loans • Channel funds to other multinationals that need short-term financing

26. Globalization of Money Markets • Euro-commercial paper • Issued without the backing of a banking syndicate • Maturity tailored to investors • Dealers that place paper create a secondary market • Rates usually range between 50 and 100 basis points above the LIBOR rate