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Chapter 11: Money Markets, Short-Term Investing and Borrowing
Outline: Global Money Markets Short-Term Money Markets in the U.S. Managing Short-Term Investments Pricing and Yields on Short-Term
Investments Managing Short-Term Financing
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 1
Issuers of money markets: Government entities, securities dealers,
commercial banks, corporations
Investors are lenders; issuers are borrowers Individuals who invest are lending
Broker-dealers As brokers, trade on behalf of customers As dealers, trade for their own account Place majority of new issues in primary market and
provide liquidity in secondary markets Take positions in securities (ask price/bid price)
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 2
Money Market Participants
Money Market InstrumentsCP ABCP
Bank Obligations
Government Paper
FRNs Repos
Maturity Overnight–270 days
Overnight–270 days
1 day–2 years
4–52 weeks Variable Wholly negotiable
Issued by Companies Companies Banks Government/public
Companies/FIs
Companies/FIs
Interest rate
Fixed Fixed Fixed Fixed Variable Negotiable
Interest paid
On maturity
On maturity During or maturity
On maturity During or maturity
On maturity
Issued Discount Discount Interest Discount Interest Discount
Secured No Yes No No Yes/no Yes
Access to capital before maturity
Sell on secondary market
Sell on secondary market
Negotiable CDs sell on secondary market
Sell on secondary market
Sell on secondary; periodic reset dates
Negotiable
Risks Credit, price
Credit, liquidity, price
Credit, liquidity
Price Credit, liquidity
Credit, liquidity
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 3
Standard and Asset-Backed CP
CP Overnight to 270 days, but
most issued < 45 days Can be sold on secondary
market, but most held to maturity
Unsecured CP tends to be highly liquid and have broad range of maturities
Diversifiable risk Europe and U.S. have highly
developed markets Disadvantage is it is not
asset-backed; could have credit enhancement
ABCP Secured against short-
term trade receivables Single seller Multi-seller
More security than CP and liquidity support (credit enhancement) facilitates timely repayment
More complex, requires specialist appraisal and credit monitoring; moderately higher return
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 4
Bank Obligations
Banks raise funds in money markets. Time deposits:
Savings accounts, certificates of deposit (CDs), negotiable CDs ($100,000 or more)
Active secondary market for negotiable CDs
Repurchase agreements (repos)
Eurodollar deposits
Banker’s acceptances (BAs) Time draft issued by
purchaser and accepted by bank
Unconditional promise to pay at maturity
Holder can hold to maturity or sell at discount
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 5
Discussion Question
Which of the following typically has longer maturities for money market instruments and is based on LIBOR or Euribor but also has a wider bid-offer spread so regular trading can erode its yield advantage quickly?a) Government paperb) Floating rate notes (FRNs)c) Retail CDs
Answer: b
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 6
Repurchase Agreements (Repos)
Bank or securities dealer sells government securities to an investor and agrees to repurchase them later at a slightly higher price. Reverse repo is opposite side of same transaction. Can be based on any agreed-upon security.
Types: Overnight Term (2 days or longer) Open (no maturity date, can be terminated by either party
on day-to-day basis) Ample room to tailor maturity and interest. Legal possession provides comfort because
underlying can be sold.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 7
Money Market Funds (MMFs) Commingled pools of
money market instruments in which investors have an ownership interest
Local or foreign currency (if allowed)
NAV set at one unit of the currency
Funds can differ in: Risk Maturity Return
Professionally managed, marketable securities portfolio at low cost
May be more cost-effective than managing short-term investment portfolio
Administratively easy Daily liquidity; pay
dividends Low minimum
investment When interest rates are
falling, can extend maturities to lock in yields
Large scale = competitive trading
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 8
Short-Duration Mutual Funds
Invest in securities with maturities that exceed most money market instruments Average maturity 1
to 3 years Instruments
include government issues, CDs, CP
Offer higher average returns but also a higher risk of fluctuating NAV: Not configured
to maintain a fixed unit NAV
May be used for matching strategy
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 9
Short-Term Money Markets in the U.S.: Commercial Book-Entry System Nearly all short-term
securities issued in book-entry form: Registered and
transferred electronically by U.S. Treasury (Treasury securities only) or Commercial Book-Entry System (CBES)
Simultaneous transfer of securities against settlement of funds
National Book-Entry
System (NBES)
Depository institutions—
hold book- entry accounts
Brokers, dealers, banks—maintain book-
entry accounts for individual customers
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 10
Depository Trust and Clearing Corporation (DTCC)
DTCC works through subsidiaries to provide:Clearing, settlement and information services for:
Equities Corporate and municipal
bonds Government and mortgage-
backed securities Money market instruments OTC derivatives
Legal depositoryCustody and asset servicingIndustry-ownedOperates on at-cost basisSEC-registered services
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 11
DTCC
Depository Trust Company
(DTC)
National Securities Clearing Corporation
(NSCC)
U.S. Treasury Bills (T-Bills) Exempt from state tax
for most U.S. investors May have franchise tax Money market
instruments Original maturities < 1
year (4, 13, 26, 52 weeks)
Multiple-price, sealed-bid auction
Competitive or non-competitive
Daily dealer bid and ask yield quotes
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 12
Commercial Paper (CP) and the U.S. Money Market
Unsecured promissory note Major issuers in the U.S. are corporations, bank
holding companies, and non-bank finance companies Public market: 270 days or less SEC code: Section 3[a]3 for public issue, Section 4[2]
for private issue
Among highest yields in money market Default risk Limited secondary market Evaluated by rating agencies (can be credit-enhanced)
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 13
U.S. Federal Agency and Government-Sponsored Enterprise (GSE) Securities
Guarantees backed by full faith and credit of U.S. government. Ginnie Mae (GNMA) provides liquidity through its MBS
program. Real estate mortgage investment conduits (REMICs) Interest rate related price and prepayment risks Pools of mortgages (tranches) allow risk control
VA guarantees REMICs issued through Vendee Mortgage Trust.
GSEs are private companies providing funds for loans in housing, education and agriculture. Strong implication government would intervene in crisis. Fannie Mae, Federal Farm Credit Banks Funding Corporation,
Freddie Mac, Federal Home Loan Banks Office of Finance.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 14
Municipal Notes, VRDOs and Tax-Exempt CP
Issued by state and local governments or their agencies (up to 270 days for CP).
Many are exempt from federal and/or state income taxes in state of issuance.
Provide interim financing for general obligation bond projects.
VRDOs issued as long-term bonds with a put.
Active secondary market for short-term municipal obligations.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 15
Short-Term Investment Policy Investment objectives Permissible and prohibited
investments Minimum/acceptable
security ratings Maximum maturity for
individual securities and maximum duration for portfolio
Maximum percentage amounts of portfolio that may be invested in individual securities, companies, instrument classes, geographic areas, industries
Specific responsibilities for implementing policy
Methods of monitoring compliance with policies, procedures, internal controls
Provisions for performance measurement, evaluation, reporting
Guidance for classification of investments per FASB and GASB rules
Responsibilities and reporting requirements for custodians and broker-dealers
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 16
Investment Strategies
Buy-and-hold-to-maturity: conservative investor Matching: Purchasing securities that mature when funds
are required to meet an expected obligation or obligations Actively managed: aggressive investor
Two strategies for buying highly liquid, marketable securities (T-bills) that mature on a different day from when the investor intends to sell
Normal yield curve: Purchase maturities past capital need, sell early Inverted yield curve: Purchase maturities shorter than capital need,
then reinvest
Tax-based: high-tax-bracket investor Tax-advantaged mutual funds Dividend capture
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 17
Discussion Question
Which of the following securities safekeeping and custody services methods is generally less costly but also more risky due to the higher risk of fraud?a) Engage a third party to provide custodial
services for an investor (corporate trust department of a commercial bank).
b) Keep securities at the institution (usually a brokerage firm) from which they were purchased.
Answer: b
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 18
Investment Risk Considerations: Credit or Default Risk
Risk that payments on a security will not be made under the original terms
Credit evaluation assesses default likelihood Credit ratings based on default risk,
seniority and any collateral by Nationally Recognized Statistical Rating Organizations (NRSROs): Moody’s Standard and Poor’s (S&P) Fitch Dominion (DBRS) and other 6
Credit enhancement
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 19
Discussion Question
What is the primary benefit of a borrower receiving credit support?
Answer:Because the borrower’s debt assumes the credit rating of the guarantor, the borrowing cost may be reduced or the marketability of the debt enhanced.
v3.0 © 2011 Association for Financial Professionals. All rights reserved.
Session 8: Module 5, Chapter 11 - 20
Investment Risk Considerations: Asset Liquidity Risk
Risk that a security cannot be sold quickly without an unacceptable loss
Marketability Existence of active secondary market? Unrated securities may not be liquid; must
perform credit analysis. Maturity
Date on which obligation is settled. Holding investments over longer time
periods increases price risk.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 21
Price/interest rate risk Risk that arises when interest rates for
securities that are identical or nearly identical to portfolio securities change
Longer maturities subject to more price risk Threat that interest rates may rise during
holding period of fixed-rate security Reinvestment risk
Foreign exchange (FX) risk Risk of change in FX rates between currency of
security and company’s local currency
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 22
Investment Risk Considerations: Other Risks
Yield Curves
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 23
Taxable Equivalent Yield (TEY)Example: Taxable security = 4.60% yield. Tax-exempt security (of similar risk and maturity) = 3.20%
yield. Firm’s marginal income tax rate is 35%.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 24
The tax-exempt security should be chosen because it has a higher effective after-tax yield. The after-tax yield of the taxable security is .046(1 – 0.35), or 2.99%.
Tax-exempt YieldTEY =
1 Investor's Marginal Tax Rate
0.032= = 0.0492 = 4.92%1 0.35
Holding Period Yield (HPY)
HPY example: 90-day $100,000 T-bill purchased for $98,800
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 25
Cash Received at Maturity Amount InvestedHPY =
Amount Invested
$100,000 $98,800 $1,200= = = 0.01215 = 1.215%$98,800 $98,800
Discussion Question
Which of the following is true of T-Bills, CP and BAs?a) They pay unregulated rates of interest
based on current market value.b) They do not pay interest; rather, they
are issued at less than par value (the discount) and pay par value at maturity.
c) They pay a semiannual coupon.
Answer: b. They are all discounted instruments.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 26
Dollar Discount and Discount Rate
Example: $1,000,000 par (or face) value 182-day T-bill is sold for $974,216
HPY = 0.0265 and 360-day basis yield = 5.24%
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 27
Dollar Discount 360Discount Rate = Par Value Days to Maturity
$25,784 360= = 0.0510 = 5.10%$1,000,000 182
Dollar Discount = Par Value Purchase Price = Cash Received at Maturity Amount Invested = $1,000,000 $974,216 = $25,784
Dollar Discount and Money Market Yield The dollar discount can be related to the discount
rate by rearranging the discount rate equation from the prior slide. Example from prior slide: 182-day $1,000,000 T-bill with a discount rate of 5.1% = $25,784 dollar discount.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 28
360Money Market Yield = Holding Period Yield ×
Days to Maturity
$1,000,000 $974,216 360= ×
$974,216 182
= 0.0265 x 1.978 = 0.0524 or 5.24%
The money market yield (360-day year):
Days to MaturityDollar Discount = Discount Rate × Par Value ×
360
Bond Equivalent Yield
Bond equivalent yield, or annual yield to an investor, using a 365-day-per-year follows.
Example from prior slides: 182-day $1,000,000 T-bill, $974,216 invested.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 29
Method 1
365Bond Equivalent Yield = Holding Period Yield ×
Days to Maturity
$1,000,000 $974,216 365= ×
$974,216 182
= 0.0265 × 2.0055 = 0.0531 or 5.31%
T-Bill Quotes Dealers buy and sell T-bills in a secondary market. Bid quote is the discount at which a dealer will buy a T-bill. Ask quote is the discount at which a dealer will sell a T-bill. Ask yield is the yield to an investor purchasing a T-bill at
the ask discount. Ask yield is quoted on a 365-day-per-year basis.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 30
Maturity Date
Days to Maturity
Bid Discount
Ask Discount
Ask Yield (%)
Feb 20 29 1.14 1.13 1.15
Feb 27 36 1.14 1.13 1.15
Mar 06 43 1.13 1.12 1.14
Short-Term Funding Alternatives
Trade credit Internal borrowing Selling of
receivables Commercial bank
credit Loan syndications
and participations Line of credit Revolving credit
agreement
Single payment notes
Repurchase agreement (repo)
Commercial paper (CP) issuance
Asset-based borrowing
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 31
Selling of Receivables
Factoring The sale or transfer of A/R to a third party, who charges a percentage commission to the borrower on the amount of A/R (depending on the quality of A/R, not company’s financial statements); with or without recourse.
Securitization Company issues debt securities backed by a pool of receivables; suitable assets usually have a predictable cash flow stream to retire the issue and a historical record of low losses.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 32
Commercial Bank Credit: Loan Syndication and Participation
Multiple financial institutions (syndicate) share a single credit facility.
An agent acts as an intermediary.
All syndicate members share documentation; each lender has a promissory note.
A financial institution purchases interest in another lender’s credit facility.
The purchaser is called the participant; the seller is the lead institution.
A participant does not have a separate note.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 33
Loan participationLoan syndication
Direct lending relationship Indirect lending relationship
Line of Credit Key Characteristics
Lender gives access to funds up to a maximum amount over a specified period.
May be committed or uncommitted line: Committed obligates
the buyer to provide funding as long as the buyer is not in default.
Uncommitted can be cancelled by the lender at any time.
Usually revolving. May be secured or
unsecured. Usually has a 30- to
60-day clean-up period.
Basic cost components: All-in rate of interest Commitment fees Compensating
balances
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 34
Commercial Paper (CP) Issuance
In practice, many CP issuers roll over outstanding balances at maturity to new CP issue. To do this: Maintain CP backup lines of credit. Issuer must carry strong credit rating or get
higher rating through credit enhancement (standby L/C).
Issued at discount + dealer fees, backup credit facility fees, rating agency charges and credit enhancement costs. Therefore rarely used for less than $50 million.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 35
Annual Cost for Commercial Paper (CP)
Example: A company issues $20 million of CP with a 20-day maturity at a discount of 5.40%.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 36
Part 1 of 4:
Days to MaturityDollar Discount = Discount Rate Par Value
36020= 0.054 $20,000,000 = $60,000360
Usable Funds= Par Value Discount= $20,000,000 $60,000= $19,940,000
Annual Cost for a Line of Credit
A line of credit lender charges interest and a commitment fee on the line.
Interest is charged on the used portion of the line. The commitment fee may be charged on the line
or its unused portion. The overall interest rate on the line is determined
by the total interest paid on the line’s used portion and the amount paid for the commitment fee relative to the average used portion of the credit line over the borrowing period.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 8: Module 5, Chapter 11 - 37