money markets ch. 9 (uts)

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Chapter 6

Money Markets

Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline

Money market securities Institutional use of money markets Valuation of money market securities Risk of money market securities Interaction among money market yields

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Money Market Securities

Money market securities:Have maturities within one yearAre issued by corporations and governments

to obtain short-term fundsAre commonly purchased by corporations and

government agencies that have funds available for a short-term period

Provide liquidity to investors

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Money Market Securities (cont’d)

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

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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

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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

nm kP )1/(Par

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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?

259,9$

)08.1/(000,10$

)1/(Par

nm kP

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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

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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

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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

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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:

nPP

PPSPYT

365

n

PP 360

Par

Pardiscount bill-T

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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?

%94.8

91

365

782,9

782,9000,10

365

nPP

PPSPYT

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Estimating the T-Bill Discount

Using the information from the previous example, what is the T-bill discount?

%62.8

91

360

000,10

782,9000,10

360

Par

Pardiscount bill-T

n

PP

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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 Has no active secondary market Is typically not purchased directly by individual investors

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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

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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 Some firms (such as finance companies) create in-house

departments to place commercial paper

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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

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Estimating the Commercial Paper YieldAn 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?

%42.11

120

360

289,000

289,000- 300,000

cpY

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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 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

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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

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Negotiable certificates of deposit (NCDs) (cont’d)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

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Negotiable certificates of deposit (NCDs) (cont’d)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

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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

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Repurchase agreements (cont’d) 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

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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?

%50.3

90

360

9,913,314

314,913,9000,000,10

360rate Repo

nPP

PPSP

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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

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Federal funds (cont’d) 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

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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

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Banker’s acceptances (cont’d) 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

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Sequence of Steps in the Creation of A Banker’s Acceptance

Importer Exporter

American Bank(Importer’s Bank)

Japanese Bank(Exporter’s Bank)

1 Purchase Order

5 Shipment of Goods

2 L/C Application

3 L/C

7Shipping Documents& Time Draft Accepted

4 L/C Notification

6 Shipping Documents & Time Draft

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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

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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

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Valuation of Money Market Securities For money market securities making no

interest payments, the value reflects the present value of a future lump-sum paymentThe discount rate is the required rate of return

by investors

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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:

nm kP )1/(Par

),( and )( RPRfkkfP fm

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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

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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

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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

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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

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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

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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

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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

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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

1)%1()1( SYY fe

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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?

%94.8

10087.108.1

1)%1()1(

SYY fe

money markets ch. 9 (uts)

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