Tarheel Consultancy Services

1. Tarheel ConsultancyServices Manipal, Karnataka

2. Corporate Training and Consulting

3. Course on Fixed Income Securities For XIM -Bhubaneshwar

4. For PGP-II 2003-2005 Batch Term-V: September-December 2004

5. Module-I Part-V Basics of Money Market Securities

6. Introduction • There are fundamental differences between Money and Capital markets. • The same borrower may tap both markets to fulfill different needs. • For instance, a corporate borrower may issue long term bonds in the capital market to raise funds to build a factory. • The same borrower may issue commercial paper in the money market to finance his inventories.

7. Introduction (Cont…) • The purpose for which funds are borrowed therefore differs from borrower to borrower and often in the case of the same borrower from transaction to transaction. • The different motives for borrowing lead to the creation of different instruments with unique risk and return features.

8. Maturity • Money market securities by definition have an original maturity of one year or less. • The term original maturity refers to the maturity at the time of issue of the instrument. • The maturity of the instrument at a subsequent point of time is called its actual maturity.

9. Why Money Markets? • From the standpoint of both business entities as well as the government, inflows and outflows will rarely match. • Consequently at certain points in time, an enterprise may be in need of funds, while at other times, it may have a surplus.

10. Why? (Cont…) • Take the case of a government. • It will collect revenues primarily by way of taxes. • Such revenues tend to arrive in lumps during certain months of the year. • However the government has to incur expenses throughout the year, both on account of developmental works as well as on account of wages and salaries.

11. Why? (Cont…) • Consequently during most of the year the government will be a borrower, and will issue T-bills to meet its short-term needs. • However at certain points in time when it is flush with tax revenues, it may turn a net lender for short periods and may buy back T-bills.

12. Why? (Cont…) • The same it true for a business. • The balance in a current account will constantly fluctuate. • If surplus funds are available a business may temporarily park its funds in money market securities. • Else if there is a deficit it will issue instruments like commercial paper to raise short-term funds.

13. Perishable Money • Money is an extremely perishable commodity. • The longer money remains idle, the greater is the lost income. • And income that is lost can never be recovered. • We will give an illustration.

14. Illustration • Assume that a corporation has a surplus of 12 MM USD that can be invested at 12% per annum. • The year we will assume has 360 days, which is a standard assumption in money markets. • What will be the lost income if money remains idle for a day?

15. Illustration (Cont…) • Interest for a day: 12,000,000 x 0.12 x 1/360 = $ 4,000. • Loss of income if money lies idle for a week = $ 28,000

16. Borrowers & Lenders • It is a difficult task to characterize an entity as a borrower or a lender. • An enterprise that is a borrower at one point in time may turn a net lender subsequently. • Certain institutions tend to be on both sides of the market at the same time.

17. Borrowers & Lenders (Cont…) • Take an organization like a commercial bank. • It may borrow short term in the money market by issuing negotiable certificates of deposit. • It may at the same time extend working capital loans to its clients.

18. Borrowers & Lenders (Cont…) • Governments inevitably are borrowers. • At any point in time, the U.S. Treasury is the largest borrower in the global money market.

19. Characteristics • Investors are primarily concerned with safety and liquidity. • Liquidity is important because most investments are for very short periods of time. • The global money market has a lot of depth and can absorb large issues of securities as well as redemptions without a significant price impact.

20. Characteristics (Cont…) • The market is an OTC network of securities dealers, banks, and funds brokers, who are linked by telephones and computers. • The market as a whole is supervised by the Federal Reserve and other central banks.

21. Characteristics (Cont…) • Speed is of the essence. • Transactions are sealed and executed in a matter of minutes or even less. • Traders are constantly looking for arbitrage opportunities and will routinely move funds from one part of the globe to another.

22. Characteristics (Cont…) • National money markets may be securities dominated or bank dominated. • Securities dominated markets are characterized primarily by the buying and selling of marketable securities. • Examples include the U.S., U.K. and Canadian markets.

23. Characteristics (Cont…) • In bank dominated markets most of the activity is in the form of inter-bank and bank-client deals. • Examples include Japan, China, and Korea.

24. Features of The Market • It is a wholesale market. • Not for small investors. • However they can participate indirectly through MMMFs. • The money market facilitates large scale transfer of funds. • For most banks except the Bank of America, fund requirements usually exceed deposits. • For smaller state and local banks, deposits usually exceed fund requirements.

25. The Federal Reserve • The Federal Reserve is the central bank of the United States. • It is a key component of the money market. • It consists of 12 member banks located in the following cities.

26. Boston New York Philadelphia Cleveland Richmond Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco The Federal Reserve System

27. Open Market Operations • The money market is where the Federal Reserve carries out open-market operations. • The term refers to the buying and selling of Treasury securities by the FED in the secondary market. • This is done to regulate the money supply and influence interest rates.

28. Open Market Operations • In order to increase the money supply, the FED will buy Treasury securities. • To decrease the money supply, it will sell Treasury securities. • The decision to undertake such operations is taken by the Federal Open Market Committee (FOMC). • It is implemented by the Federal Reserve of New York.

29. Features of Trading • Because of the large volumes involved, skill and expertise in trading are of the utmost importance. • Most traders specialize in narrow segments of the market. • The market is bound by a strict code of honour. • Billions of dollars worth of business is conducted over the phone, and no one reneges. • The market is relatively unregulated and therefore highly innovative.

30. Types of Instruments • The most transactions in the global money markets take the form of: • T-bills • Federal agency securities • Dealer loans • Repurchase agreements • Bankers’ acceptances • Commercial paper • Eurocurrency deposits • Federal funds

31. Volumes • As of 1998 over 700 billion worth of T-bills were outstanding constituting about 13% of the Federal government’s debt. • Large (over $100,000) face value CDs were outstanding to the extent of about 500 billion.

32. Volumes (Cont…) • Agency securities and commercial paper were outstanding to the extent of over 1 trillion dollars. • Bankers’ acceptances totaled about 15 billion. • And Eurocurrency deposits exceeded 2 trillion dollars.

33. Benchmark Rates • The rates on various instruments revolve around the prevailing T-bill rates. • T-bills are devoid of default risk and have a deep and active secondary market. • Consequently they have the lowest yields.

34. Benchmark Rates (Cont…) • Federal agency securities are perceived to be virtually riskless since it is unlikely that the government will permit them to fail. • However the market for such securities is less liquid. • Consequently the rate on such securities will be slightly higher.

35. Benchmark Rates (Cont…) • Federal funds which are low risk inter-bank loans also have rates which are fairly close to T-bill rates. • For instance the average T-bill rate in 1999 was about 4.40% where the Fed Funds rate was fairly close to 5%.

36. Treasury Bills • These are a direct obligation of the U.S. government. • By law these must have an original maturity of one year or less. • Which explains why the Treasury does not issue zero coupon instruments with a maturity exceeding one year.

37. T-bills (Cont…) • The financial year for the U.S. government runs from 1 October till 30 September. • However most of its income by way of taxes arises in April. • Consequently even when the government is running a surplus budget, it tends to have a shortfall during most of the year. • These temporary deficits are bridged by issuing T-bills.

38. T-bills (Cont…) • The Treasury issues several types of T-bills. • Regular-series bills are issued at fixed intervals by way of competitive auctions. • 13 and 26 week bills are issued every week. • 52 week bills are issued once a month.

39. T-bills (Cont…) • Irregular series bills are issued only when a special need arises. • These take on two forms: • Strip bills • Cash management bills. • A strip bill is essentially a series of bills with different maturities. • Lenders have to buy the strip as a whole.

40. T-bills (Cont…) • Cash management bills are a re-opening of an existing issue. • What is a re-opening? • Consider a six month bill that was issued two months ago? • It will have four months to maturity today. • So if new four month bills are issued they will essentially add to the size of the existing issue. • This is the meaning of reopening a maturity.

41. Auctions • The Treasury sells T-bills via an auction procedure. • That is, the price is determined by the market based on competitive bidding, and is not set by the Treasury. • 13-week and 26-week bills are issued every week. • 52 week bills are issued once a month.

42. Auctions (Cont…) • In the case of 13-week and 26-week bills the auction is announced on Thursdays. • If Thursday were to be a holiday then it will be announced on the next business day. • Bidders have until 1 P.M. EST on the following Monday to submit their bids.

43. Auctions (Cont…) • An investor can submit multiple bids. • That is he can bid at different yields. • For instance an investor may bid for $500,000 worth of bids at a yield of 5.01% and for an additional $500,000 at a yield of 5%. • Bids have to be submitted at one of the 37 Federal Reserve banks and their branches or at the Treasury’s bureau of public debt.

44. Auctions (Cont…) • Bids may be submitted by person or by mail, or may be submitted electronically through a securities dealer. • Online bidding is also possible at www.publicdebt.treas.gov • Most dealers do not charge commissions for T-bills bought at auctions, but they may levy a processing fee.

45. Auctions (Cont…) • For bids that are filed directly with the Treasury or through Federal Reserve banks obviously no commissions are payable. • Investors may choose to hold a Treasury Direct account. • For such account holders interest payments and principal repayments can be credited directly to their bank accounts.

46. Auctions (Cont…) • Instructions can be given by such account holders to have the proceeds from maturing issues to be automatically reinvested in new issues. • There is no service charge for accounts with a face value of less than $100,000. • For higher balances there is a small maintenance fee.

47. Auctions (Cont…) • The Treasury permits both competitive as well as non-competitive bids. • Most individual bidders submit non-competitive bids. • Such bidders indicate only the quantity sought and agree to accept the yield that is determined by the auction process.

48. Auctions (Cont…) • Institutional investors however submit competitive bids by indicating both the quantity sought and the minimum yield that they are prepared to accept. • Non-competitive bids cannot be for more than $1,000,000 per bidder in the case of T-bills, and for $5,000,000 per bidder in the case of T-notes and bonds.

49. Auctions (Cont…) • The Treasury generally accepts all non-competitive bids. • Once the bids are received, the amount sought by non-competitive bidders is first subtracted from the total issue quantity. • All competitive bids are then ranked.

50. Auctions (Cont…) • In a price based auction bids will be ranked in descending order of price. • In a yield based auction they will be ranked in ascending order of yield. • All bids are required to be submitted to three decimal places. • In principle the Treasury can conduct a uniform price/yield auction or a discriminatory price/yield auction.