Chapter 6: Money Markets Chapter Outline: • Money Market Securities. • Institutional Use of Money Markets. • Valuation of Money Market Securities. • Risk of Money Market Securities. • Globalization of Money Market.
Money Market Securities • Treasury Bills. • Commercial Papers. • Negotiable Certificate of Deposit. • Repurchase Agreements. • Federal Funds. • Banker’s Acceptances.
Money Market Securities • Money market securities: • Have maturities within one year • Are issued by corporations and governments to obtain short-term funds • Are commonly purchased by corporations and government agencies that have funds available for a short-term period • Provide liquidity to investors
Treasury Bills • Are issued by the U.S. Treasury • Are sold weekly through an auction • Have a par value of $1,000 • Are attractive to investors because they are backed by the federal government and are free of default risk • Are liquid • Can be sold in the secondary market through government security dealers
Treasury Bills (cont’d) Investors in Treasury bills: • Depository institutions because T-bills can be easily liquidated • Other financial institutions in case cash outflows exceed cash inflows • Individuals with substantial savings for liquidity purposes • Corporations to have easy access to funding for unanticipated expenses
Treasury Bills (cont’d) • Pricing Treasury bills • The price is dependent on the investor’s required rate of return: • Treasury bills do not pay interest • To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested
Computing the Price of a Treasury Bill A one-year Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill?
Treasury Bills (cont’d) Treasury bill auction • Investors submit bids on T-bill applications for the maturity of their choice • Applications can be obtained from a Federal Reserve district or branch bank • Financial institutions can submit their bids using the Treasury Automated Auction Processing System (TAAPS-Link) • Institutions must set up an account with the Treasury • Payments to the Treasury are withdrawn electronically from the account • Payments received from the Treasury are deposited into the account
Treasury Bills (cont’d) Treasury bill auction (cont’d) • Weekly auctions include 13-week and 26-week T-bills • 4-week T-bills are offered when the Treasury anticipates a short-term cash deficiency • Cash management bills are also occasionally offered • Investors can submit competitive or noncompetitive bids • The bids of noncompetitive bidders are accepted • The highest competitive bids are accepted • Any bids below the cutoff are not accepted • Since 1998, the lowest competitive bid is the price applied to all competitive and noncompetitive bids
Treasury Bills (cont’d) Estimating the yield • T-bills are sold at a discount from par value • The yield is influenced by the difference between the selling price and the purchase price • If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price
Treasury Bills (cont’d) Estimating the yield (cont’d) • The annualized yield is: • Estimating the T-bill discount • The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:
Computing the Yield of a Treasury Bill An investor purchases a 91-day T-bill for $9,782. If the T-bill is held to maturity, what is the yield the investor would earn?
Estimating the T-Bill Discount Using the information from the previous example, what is the T-bill discount?
Commercial Paper • Is a short-term debt instrument issued by well-known, creditworthy firms • Is typically unsecured • Is issued to provide liquidity to finance a firm’s investment in inventory and accounts receivable • Is an alternative to short-term bank loans • Has a minimum denomination of $100,000 • Has a typical maturity between 20 and 270 days • Is issued by financial institutions such as finance companies and bank holding companies • Has no active secondary market • Is typically not purchased directly by individual investors
Commercial Paper (cont’d) Ratings • The risk of default depends on the issuer’s financial condition and cash flow • Commercial paper rating serves as an indicator of the potential risk of default • Corporations can more easily place commercial paper that is assigned a top-tier rating • Junk commercial paper is rated low or not rated at all
Commercial Paper (cont’d) • Volume of Commercial paper: • Has increased substantially over time • Is commonly reduced during recessionary periods • Placement: • Some firms place commercial paper directly with investors • Most firms rely on commercial paper dealers to sell it • Some firms (such as finance companies) create in-house departments to place commercial paper
Commercial Paper (cont’d) • Backing Commercial Paper: • Issuers typically maintain a backup line of credit • Allows the company the right to borrow a specified maximum amount of funds over a specified period of time • Involves a fee in the form of a direct percentage or in the form of required compensating balances • Estimating the yield • The yield on commercial paper is slightly higher than on a T-bill • The nominal return is the difference between the price paid and the par value
Estimating the Commercial Paper Yield An investor purchases 120-day commercial paper with a par value of $300,000 for a price of $289,000. What is the annualized commercial paper yield?
Commercial Paper (cont’d) • The commercial paper yield curve: • Illustrates the yield offered on commercial paper at various maturities • Is typically established for a maturity range from 0 to 90 days • Is important because it may influence the maturity that is used by firms that issue CP • Is similar to the short-term range of the Treasury yield curve • Is affected by short-term interest rate expectations • Is similar to the yield curve on other money market instruments
Negotiable Certificates of Deposit (NCDs): • Are issued by large commercial banks and other depository institutions as a short-term source of funds • Have a minimum denomination of $100,000 • Are often purchased by nonfinancial corporations • Are sometimes purchased by money market funds • Have a typical maturity between two weeks and one year • Have a secondary market
Negotiable Certificates of Deposit (NCDs): • Placement • Directly • Through a correspondent institution • Through securities dealers • Premium • NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety • Premiums are generally higher during recessionary periods
Negotiable Certificates of Deposit (NCDs): • Yield • NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price • If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate
Repurchase Agreements • One party sells securities to another with an agreement to repurchase them at a specified date and price • Essentially a loan backed by securities • A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them • Bank, S&Ls, and money market funds often participate in repos • Transactions amounts are usually for $10 million or more • Common maturities are from 1 day to 15 days and for one, three, and six months • There is no secondary market for repos
Repurchase Agreements • Placement • Repo transactions are negotiated through a telecommunications network with dealers and repo brokers • When a borrowing firm can find a counterparty to a repo transaction, it avoids the transaction fee • Some companies use in-house departments • Estimating the yield • The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with a 360-day year
Estimating the Repo Yield An investor initially purchased securities at a price of $9,913,314, with an agreement to sell them back at a price of $10,000,000 at the end of a 90-day period. What is the repo rate?
Federal Funds • The federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate • The rate is influenced by the supply and demand for funds in the federal funds market • The Fed adjusts the amount of funds in depository institutions to influence the rate • All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions • The fed funds rate is typically slightly higher than the T-bill rate
Federal Funds • Two depository institutions communicate directly through a communications network or through a federal funds broker • The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institution’s reserve account by the amount of the loan • Commercial banks are the most active participants in the federal funds market • Most loan transactions are or $5 million or more and usually have one- to seven-day maturities
Banker’s Acceptances • Indicate that a bank accepts responsibility for a future payments • Are commonly used for international trade transactions • An unknown importer’s bank may serve as the guarantor • Exporters frequently sell an acceptance before the payment date • Have a return equal to the difference between the discounted price paid and the amount to be received in the future • Have an active secondary market facilitated by dealers
Banker’s Acceptances • Steps involved in banker’s acceptances • First, the U.S. importer places a purchase order for goods • The importer asks its bank to issue a letter of credit (L/C) on its behalf • Represents a commitment by that bank to back the payment owed to the foreign exporter • The L/C is presented to the exporter’s bank • The exporter sends the goods to the importer and the shipping documents to its bank • The shipping documents are passed along to the importer’s bank
Sequence of Steps in the Creation of A Banker’s Acceptance Purchase Order 1 Importer Exporter Shipment of Goods 5 4 L/C Notification 2 L/C Application 6 Shipping Documents & Time Draft L/C 3 Japanese Bank (Exporter’s Bank) American Bank (Importer’s Bank) Shipping Documents & Time Draft Accepted 7
Institutional Use of Money Markets • Financial institutions purchase money market securities to earn a return and maintain adequate liquidity • Institutions issue money market securities when experiencing a temporary shortage of cash • Money market securities enhance liquidity: • Newly-issued securities generate cash • Institutions that previously purchased securities will generate cash upon liquidation • Most institutions hold either securities that have very active secondary markets or securities with short-term maturities
Institutional Use of Money Markets (cont’d) • Financial institutions with uncertain cash in- and outflows maintain additional money market securities • Institutions that purchase securities act as a creditor to the initial issuer • Some institutions issue their own money market instruments to obtain cash • Many money market transaction involve two financial institutions
Valuation of Money Market Securities • For money market securities making no interest payments, the value reflects the present value of a future lump-sum payment • The discount rate is the required rate of return by investors
Valuation of Money Market Securities (cont’d) • Explaining money market price movements • The price of a noninterest-paying money market security is: • A change in the price can be modeled as:
Valuation of Money Market Securities (cont’d) • Explaining money market price movements (cont’d) • Impact of September 11 • The weak economy combined with this event caused investors to transfer funds into money market securities • The additional demand placed upward pressure on their price and downward pressure on their yields • The Fed added liquidity to the banking system and reduced the federal funds rate
Valuation of Money Market Securities (cont’d) • Indicators of future money market security prices • Economic growth is monitored since it signals changes in short-term interest rates and the required return from investing in money market securities • Employment • GDP • Retail sales • Industrial production • Consumer confidence • Indicators of inflation
Risk of Money Market Securities • Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk • Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default • Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuer’s financial condition is limited • Measuring risk • Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates
Interaction Among Money Market Yields • Money market instruments are substitutes for each other • Market forces will correct disparities in yield and the yields among securities tend to be similar • In periods of heightened uncertainty, investors tend to shift from risky money market securities to Treasuries • Flight to quality • Creates a greater differential between yields
Globalization of Money Markets • Interest rate differentials occur because geographic markets are somewhat segmented • Interest rates have become more highly correlated: • Conversion to the euro • The flow of funds between countries has increased because of: • Tax differences • Speculation on exchange rate movements • A reduction in government barriers • Eurodollar deposits, Euronotes, and Euro-commercial paper are widely traded in international money markets
Globalization of Money Markets (cont’d) • Eurodollar deposits and Euronotes • Eurodollar certificates of deposit are U.S. dollar deposits in non-U.S. banks • Have increased because of increasing international trade and historical U.S. interest rate ceilings • In the Eurodollar market, banks channel deposited funds to other firms that need to borrow them in the form of Eurodollar loans • Typical transactions are $1 million or more • Eurodollar CDs are not subject to reserve requirements • Interest rates are attractive for both depositors and borrowers • Rates offered on Eurodollar deposits are slightly higher than NCD rates
Globalization of Money Markets (cont’d) • Eurodollar deposits and Euronotes (cont’d) • Investors in fixed-rate Eurodollar CDs are adversely affected by rising market rates • Issuers of fixed-rate Eurodollar CDs are adversely affected by declining rates • Eurodollar-floating-rate CDs (FRCDs) periodically adjust to LIBOR • The Eurocurrency market is made up of Eurobanks that accept large deposits and provide large loans in foreign currencies • Loans in the Eurocredit market have longer maturities than loans in the Eurocurrency market • Short-term Euronotes are issued in bearer form with maturities of one, three, and six months
Globalization of Money Markets (cont’d) • Euro-commercial paper (Euro-CP): • Is issued without the backing of a banking syndicate • Has maturities tailored to satisfy investors • Has a secondary market run by CP dealers • Has a rate 50 to 100 basis points above LIBOR • Is sold by dealers at a transaction cost between 5 and 10 basis points of the face value
Globalization of Money Markets (cont’d) • Performance of foreign money market securities • Measured by the effective yield (adjusted for the exchange rate • Depends on: • The yield earned on the money market security in the foreign currency • The exchange rate effect
Computing the Effective Yield A U.S. investor buys euros for $1.15 and invests in a one-year European security with a yield of 8 percent. After one year, the investor converts the proceeds from the investment back to dollars at the spot rate of $1.16 per euro. What is the effective yield earned by the investor?