1Anthony Santomero (1998) and S. Christoffersen (1999)

10. Understanding the Money Market

Firms can acquire money either directly in capital markets or indirectly through financial institutions. There are five main markets firms use directly:

• Money Markets -- Liquidity Needs

• Bond Markets--Issuing Debt

• Mortgage Markets--Secondary Markets that exist extensively in the US but not in Canada. Banks use them to securitize their mortgages. Some firms with heavy exposure to real estate may use these markets or simply for speculation.

• Equity Markets--Public companies are traded in secondary markets. Primary markets raise capital for new companies.

• Derivative Markets--Hedging needs or speculation.

Each of these markets have a primary and secondary market.

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10.1 Overview of the Money Market

• Money market instruments are low risk, highly liquid, and of short duration.

• In the primary market, short term funds are obtained quickly and easily. Agreements vary by credit standing of the borrower, type of instrument, and source of funds.

• In the secondary market, claims whose maturities have not yet expired are traded. The return reflects supply and demand.

• Unlike other markets, the money market is decentralized.

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10.2 Instruments of the Money Market

• Money market instruments are debt obligations with maturities from one day to a full year. Their principal is generally very secure. Issuers are of high credit standing. Instruments tend to be highly liquid and are usually issued in large denominations.

10.2.1 Treasury Bills• Treasury bills are debt obligations of the U.S./ Canadian Govt.• Treasury bills have no coupons and are issued at a discount from face

value. The price is determined in an auction under the oversight of the Federal Reserve Bank of New York and the Bank of Canada.

• Denominations begin at $10,000 and increase in $5,000 units.• Smaller denominations can be purchased on secondary markets.• T-bills are exempt from state and local taxes in the U.S.• Millions of dollars of T-bills are held by the Fed and the Bank of

Canada as a method of controlling the money supply.• Canadian and US debt are financed using T-bills.• No contract in the primary market, just accounting transactions.• Published at YDB

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10.2.2 Primary Market and Auctions of Treasury bills, notes, and bonds.

• The primary market is an auction. In the US, 3- and 6-month T-bills are auctioned weekly, and 1-year bills are auctioned every four weeks. In Canada, a package of 3 mo, 6mo, and 1 yr T-bills are auctioned every two weeks.

• Two types of bids: competitive and non-competitive. Non-competitive bids pay the weighted average of winning bids.

• Sealed-bid auctions are used for both treasury bills, notes, and bonds.

• Sealed-bids are submitted on a YDB with an amount of desired funds attached to the bid. Lowest bid (YDB) wins.

• A multiple price auction implies that the available amounts are auctioned to the bidders offering the lowest to highest bid. The winner of the auction is cursed (Winner’s curse) with paying the highest price although their order is completed.

• For notes and bonds, coupons are decided based on yield determined in the auction.

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10.2.3 Federal Agency Discount Notes (US)• Federally Sponsored Agencies raise funds in the open market to

support targeted activities. At one time, GSEs (government sponsored enterprises) or FSAs were removed from US govt debt balance sheet. Now on the balance sheet.

• Agency notes are not guaranteed but investors implicitly expect government support.

• These notes are issued the Federal Finance Bank or by six privately owned, federally sponsored credit agencies:

– Federal Home Loan Banks (not taxed)

– Federal Home Loan Mortgage Corp. (taxed)

– Federal National Mortgage Assn. (taxed)

– Student Loan Marketing Assn.

– Farm Credit Banks (not taxed)

– The World Bank• Agency discount notes are similar to Treasury bills but traded less

actively and of smaller issue size.• Agency discount notes have yields that are typically 10 to 30 b.p.

above T-bills because of lack of liquidity and explicit backing.• No formal contract, accounting transaction

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10.2.4 Short Term Municipal Securities • Temporary needs for cash by state and local governments are met

through municipal securities.• Canadian provinces and districts also raise cash in the money

markets as do US states and local governments. • These can be either the discount variety or coupon bearing (typically

variable). • Interest earnings are exempt from federal income taxes and

oftentimes, state and local taxes. The interest earnings in Canada are subject to taxes.

• General obligation (G.O.) securities are backed by the taxing power of the issuer. (ie. BC, Quebec, etc)

• Revenue securities are backed by the revenue arising from the specific projects funded. (ie. Transportation, schools, health, utilities, water, waste management)

• Municipal offerings often carry credit ratings provided by private credit rating agencies. Moody’s grades the bonds offered by provinces.

• Minimum amount in US munis is $5000 or sometimes $1000 if interest bearing. Market for individuals seeking to avoid taxes.

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10.2.4 Fed Funds (US) or the Bank Rate (Canada)• U.S. depository institutions trade funds on account at the Fed.

Similarly, Canadian banks trade on an account with the Bank of Canada.

• Law requires banks to hold a portion of their liabilities in reserve earning no interest. Bank for International Settlements (BIS) uses 8% of liabilities as a guideline.

• The reserve requirement “taxes” banks since some of their money cannot be put into interest bearing loans. Therefore, the banks want to make sure they are not holding too much or too little in reserves.

• Those institutions with excess funds can make overnight loans (term fed funds may last for several days) to those with deficits.

• Although the funds are essentially transferred between banks, everything is cleared through the Fed or the Bank of Canada.

• No contract, just an accounting transaction.

• Loans are often made between close to opening of the business day.

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10.2.4 Fed Fund Rate (US) or Bank Rate (Canada)

• It is influenced by market forces and by actions of the Fed or the Bank of Canada.

• The Fed and the Bank of Canada often use this rate as a policy variable. For instance, in the 1970s targeting low interest rates was often the goal of these central agencies. Inflation caused them to abandon these policies. The announcement is a surprise to banks and dealers in both the US and Canada.

• Many other money market instruments are priced using the Fed rate.

• The first sign of distress of an institution is the rate it pays for Fed funds. Any default risk will be reflected in a slightly higher rate.

• During times of crisis, many banks experience difficulties in accessing fed funds. This means their cost of borrowing increases substantially and often puts them at risk of default.

• Not a rate available to firms.

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10.2.5 Negotiable Certificates of Deposit (GICs in Canada)• Negotiable certificates of deposit (NCDs) are tradable time deposits

which are issued for $100,000 or higher ($1 mil).• Most NCDs have a fixed interest rate to maturity, unlike Tbills and

Commercial Paper. • Some have variable interest rates changed each specified subperiod.

The rate is usually expressed as a percent over the LIBOR• Maturity 7 days to 12 mos.• The four general classes of NCDs are characterized by their differing

rates, risk, and liquidity:

– Domestic CDs (issued by US banks like GICs in Canada)

– Eurodollar CDs (issued in London by offshore banks)

– Yankee CDs (issued in the US by foreign banks)

– Thrift CDs (issued by Savings and Loans)• The credit risk of NCDs is rated by several private rating agencies.• Receive a physical certificate for the CD• Other types of instruments issued by banks:

– Deposit Notes (interest bearing)

– Bank Notes (not on the balance sheet so do not pay FDIC)• Published using YDB

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10.2.6 Commercial Paper• Commercial paper is a short term unsecured promissory notes issued

by both financial and nonfinancial firms. • Sold through dealers and by the issuer directly• In terms of outstanding debt, this is the second largest money market

instrument after T-bills.• Commercial paper is typically issued at a discount with maturities of 30

days or less.• Higher risk. Yields reflect credit risk.• Minimum denomination $25,000• Issues are rated by credit agencies and most are backed by lines of

credit issued by banks.• Published YDB

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10.2.7 Bankers Acceptances

• A bankers acceptance (BA) is a draft that orders payment of a specified amount on a future date.

• The bank on which the BA is drawn guarantees payment. The bank is given trade documents, title to goods, and a commission.

• BAs are sold at a discount from face value, with maturities of one to six months.

• BAs facilitate international trade. An exporter may not trust that the importer will pay when he receives the shipment. In essence, the BA is a postdated check with a bank’s backing.

• One of the first roles of banks in Europe.• Published as YDB.• Rates are lower than CP because of the promise to pay and the

collateral of goods

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10.2.8 Repurchase Agreements• A repurchase agreement (REPO) is the purchase and repurchase of a

security at a price at the initial trade date.• The purchaser receives title. This is returned upon repurchase of the

securities. The purchaser then receives interest at the repo rate.• The repo rate depends upon the nature of the collateral and

creditworthiness of the borrower.• Most repos are for less than three months.

Purchaser Seller Today

Title to Assets

Cash

Purchaser SellerTitle to Assets

Cash + Repo Rate

Future Date

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10.3 Comparing Instruments

Instrument Borrowers InvestorsCP Firms and Banks Money Market Funds, firmsTreasury Bill Government Individuals, firms, banks, money

market funds, foreign governmentsFed Funds Banks BanksMunis State and local Governments

(Provinces)Individuals, Insurance Companies

CDs Banks Firms, Money Markets,Individuals

Repos Banks, Dealers, Firms and BanksBAs Firms and banks Firms, banks, money markets

funds, governmentsAgency Notes World Bank, Fannie Mae, Freddie

Mac, Sally MaeIndividuals, money market funds,governments

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10.4 Price Quotation and Yield Conventions

• Bond Equivalent Yields — a YTM calculation using a semiannual yield convention.

• Yield on a Discount Basis- the face value is reduced by the discount (prorated in relation to a 360-day year) to get the price.

• A more accurate measure is the effective annual interest rate which gives the true annualized rate of return over the period.

• To calculate the effective annual interest rate you must know the price and redemption value.

• Effective Annual Yield (EAY) —assumes that the investment can be rolled over at the same interest rate in order to get the annual yield.

EAY = Face Value

Price

365

1T

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10.5 Yield Convention for Interest bearing Instruments

With interest bearing instruments (ie. CDs), the price paid is simply the amount of the loan.

The stated interest rate (SIR) is simply the interest rate over the given period multiplied by 360/T. The interest rate reported in most publications is the SIR in terms of yield on a discount basis.

Redemption

Value =

Loan

Amount SIR

1360

T

EAY =Redemption Value

Loan Amount

365

1T

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10.6 Yield conventions if an interest bearing bond is sold before maturity

SIR is the market rate of interest on the instrument when it is initially sold

where R is the market rate of interest given for this instrument with only T days remaining to maturity.

Redemption

Value = Principal

initial maturity lengthSIR

1360

Purchase Price = Redemption Value

1360

TR

EAY = Redemption Value

Purchase Price

365

1T

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10.7 Summary

• The money market has grown in importance as the demand for short term funds has increased.

• The investor must be careful in this market due to the myriad of instruments and idiosyncrasies.

• Varied pricing conventions complicate the picture. A return to the basics, in the form of effective annual yield, can cut through the confusion

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11. Understanding the Bond Market

11.1 Overview of the Bond Market

• The bond market brings together borrowers and lenders with long term time horizons.

• It is comprised of two sectors: government and corporate bonds.

• The government sector includes national sovereign, foreign sovereign, agency, and state and local debt issues.

• Features of bonds, such as call provisions, seniority, and credit rating, greatly affect their value.

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11.2 Instruments of the Bond Market

11.2.1 Treasury Debt

• Treasury debt can be classified by its maturity. Bills are one year or less. Notes are ten years or less. Bonds are greater than 10 years in length.

• Treasury debt is auctioned on a yield basis. (Discussed in money market section)

• The most recently issued notes and bonds within a maturity class are referred to as on-the-run issues.

• Primary Dealers participate in auctions

• Stripping is the process of splitting off the coupons from the principal. There are n+1 strips available for a bond paying n coupons.

• Call provisions on treasury debt have been abondoned.

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11.2.2 Agency Debt

• Like the money market, federal agencies borrow in the bond market for longer maturities.

• In contrast to the money market, more agencies borrow long-term and the backing varies from 100% to 0% US government support.

Agencies

– Farm Credit System, Farm Credit System Financial Assistance Corporation, Federal Home Loan Banks, Federal National Mortgage Association, Financing Corporation, Maritime Administration, Resolution Funding Corporation, Student Loan Marketing Association

International Organizations

– Asian Development Bank, Inter-American Development Bank, World Bank

Mortgage-Backed Debt

– Federal Home Loan Mortgage Corporation, Federal National Mortgage Association, Government National Mortgage Association, Federal Agricultural Mortgage Corporation

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11.2.3 Municipal Bonds• Long term capital needs of state and local governments are met through the

issuance of municipal bonds.

• Municipal bonds are exempt from federal taxes and interest payments are exempt from local taxes.

• Typically, long-term municipal debt is sold as serial bonds rather than term bonds.

• The majority of municipal bonds are revenue bonds, as opposed to general obligation debt.

• Call provisions exist on these bonds.

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11.2.4 Corporate Bonds

• Private firms obtain their long term debt capital in the corporate bond market.

• Investors in the corporate bond market generally hold securities until maturity.

• Most corporate bonds contain call provisions which allow the issuer to retire the bonds beyond some specific call date, but prior to maturity.

• Corporate bond backing comes in the following forms:

– debentures (no collateral)

– equipment obligations (backed by rolling stock/inventories)

– subordinated debentures (2nd claimant to underlying assets)

– collateral trust bonds (backed by marketable security)

– mortgage bonds (backed by mortgaged collateral)

• The bond indenture details the type of backing and other legal technicalities associated with the bond.

• A sinking fund provision requires the corporation to retire a certain percentage of outstanding debt each year.

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11.3 Default Risk and Bond Ratings

Corporate Bond Ratings

– Rating agencies use elaborate systems of financial ratio analysis in the assessment of a firm’s ability to repay its debt. Examples of ratios:

Coverage RatiosProfitability RatiosFinancial Leverage RatiosRate of Return On Total AssetsLiquidity RatiosCurrent Ratio

Quick Ratio

11.4 Summary

• Bond and money markets are similar because they both offer debt. Bond markets tend to be less liquid, riskier, and longer in maturity.