Money Market Instruments

Money Market Instruments

• Treasury bills• Commercial paper• Negotiable certificates of deposits• Repurchase agreements• Federal funds• Bankers acceptances• Euro Dollar deposits

Treasury bills

• Treasury bills are issued by federal government in order to borrow money on short term basis.

• One year T-Bills are issued on a monthly basis.

• The par value of T-Bills is a maximum of $10,000 in multiples of $5000 thereafter.

• T-Bills are attractive to investors because :– Backed by the federal government and are free of default

risk.– Another attractive features is their liquidity, due to their

short maturity and strong secondary market.

Treasury Bills• Investors in Treasury

Bills:• Depository institutions• Individuals• Corporations• Money market funds

• Pricing Treasury Bills:• The price of a T-bill

depends on the required return of an investor.

• Since it does not pay any coupon payments. Its price is the present value of a par value.

• P = Par value /(1 + K )n

• P = 10,000 / (1 +0.07)• = $9,345.7

Treasury bill Auction

• The primary Treasury bill market is an auction by mail.

• Investors have an option of bidding:– Competitively – Non competitively

Treasury bill Auction

• To assure that their bid will be accepted, investors can use a non-competitive bid.

• Since non-competitive bidders do not know this amount in advance, they write a check for the par value of the treasury bills they have requested.

• Non-competitive bidders are limited to purchasing treasury bills with a maximum par value $1 million per auction.

• Once the auction results are completed, the treasury sends a check back to them that represents the difference between par value and the final price.

• After accounting for non competitive bidding, Treasury accepts the highest competitive bid and works it way down till it has generated its required amount.

• Since 1998, Treasury now applies the lowest price to all competitive and non competitive bidders.

• Competitive bidders can purchase more treasury bills than the maximum purchased through non competitive bidding.

Estimating the Yield

• Treasury bills do not offer coupon payments and are always sold at discount from par value.

• The annualized yield from investing in a T-bill can be determined as:

• YT = S – P * 3 65 P n• S = Selling price• P = purchase price• N = number of days of the

investment

• Example:• If an investor purchases a T-bill

with a six month (182 days) maturity and $10,000 par value for $9,600. if this T-bill is held to maturity, its yield is

• YT = $10,000 - $9,600 * 365 $9,600 182

= 8.36%• If an investor holds this T-bill only

for 120 days and sells in secondary market for $9,820

• YT = $9,820 - $9,600 * 365

$9,600 120 = 6.97%

T – BILL DISCOUNT• Business periodicals frequently quote the T-bill discount

along with the T-bill yield. The T-bill discount represents the percent discount of the purchase price from par value for newly issued T-bills and is computed as

• DT = par – P * 360

par n • DT = $10,000 – $9,600 * 360 =

7.91% $10,000 182

Commercial paper• Commercial paper is used only by

well known credit worthy firms and is typically unsecured.

• It is normally issued to provide liquidity or finance a firm’s investment in inventory and accounts receivable.

• Collateralized commercial paper reduces the risk to investors and thus is easier to sell.

• Some commercial paper is backed by standby letter of credit from banks.

• The minimum denomination of commercial paper is $25,000, although denominations of $100,000 or more are common.

• Maturities are normally between 20 and 45 days but can be as short as one day or as long as 270 days.

• Ratings:• Commercial papers face default

risk and risk is influenced by the issuer’s financial conditions.

• The focus is on issuer’s ability to pay over short term. The ratings serve as an indicator of the potential risk of default.

Commercial paperPlacement • Some firms place commercial paper

directly with investors. Others use commercial paper dealers, at a cost of usually one-eighth of one percent of the face value.

• Most of non-financial companies prefer to use commercial paper dealers rather than in-house resources to place their commercial paper.

• Finance companies typically maintain an in-house department, since they frequently do borrowing in this manner regardless of the business cycle.

Backing Commercial Paper • Issuers of commercial paper typically

maintain backup lines of credit in case they for some reason cannot roll over commercial paper at a reasonable rate.

Commercial paper• The yield on commercial paper is slightly

higher then the yield on a T-bill with the same maturity, since commercial paper carries some default risk and is less liquid.

• Like T-bills commercial paper is sold on a par

value at a discount.

• For example, if an investor purchases 30-day commercial paper with a par value of $1,000,000 for a price of $990,000, the yield is

• Y = $1,000,000 - $990,000 * 360$990,000

30

= 12.12%

• Consider the case of a firm that plans to issue 90-day commercial paper with a par value of $5,000,000.

• It expects to sell the commercial paper for $4,850,000. The yield it expects to pay investors is estimated to be

Y = par – P * 360

P n = $5,000,000 - 4,850,000 * 360

4,850,000 90

= 12.37%

Negotiable certificates of Deposits

• The negotiable certificates of deposits are issued by large commercial banks and other depository institutions as a short term source of funds.

• Its minimum denomination is $100,000, although a $1 million denomination is more common.

• Maturities on NCD’s normally range from two weeks to one year. A secondary market for NCDS exists, providing investors with some liquidity.

Negotiable certificates of Deposits

• Placement • Some issuers place their NCDs

directly; others use a correspondent institution that specializes in placing NCDs.

• Another alternative is to sell NCDs to securities dealers, who in turn resell them.

• NCDs can normally be sold to investors directly at a higher price.

• Measurement of the Premium • NCDs must offer a premium

above the Treasury bill yield to compensate for less liquidity and safety. The premiums are generally higher during recessionary periods.

Negotiable certificates of Deposits

Yield:• NCDs provide return in the form of interest along with the

difference in price at which it is redeemed (or sold in secondary market) and the purchase price.

• Yield for an investor who buys it at par value and holds till maturity is the interest rate.

• While yield for an investor buying or selling in a secondary market is:

• Y = Selling price - Purchase price + InterestPurchase price

Repurchase Agreements

• A repurchase agreement represents the sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price.

• In essence, a repo transaction represents a loan backed by the securities.

• A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them.

• Repo transactions are negotiated through a telecommunications network.

Repurchase Agreements

• Dealers and repo brokers act as financial intermediaries to create repos for firms with deficient and excess funds, receiving a commission for their services.

• Some companies that commonly engage in repo transactions have an in-house department for finding counterparties and executing the transactions.

• The most common maturities are from one day to fifteen days and for one, three and six months. Because of the short maturities, a secondary market for repos does not exist.

Federal Funds

• The federal funds market allows depository institutions

to effectively lend or borrow short term funds from each other at the so called federal funds rate.

• The federal funds rate is slightly higher than the

Treasury bill rate at any point in time. • Commercial banks are the most active participants in

the federal funds market.

Banker’s Acceptances

• A banker’s acceptance represents a bank accepting responsibility for a future payment. It is commonly used for international trade transactions.

• Exporters can hold the bankers acceptance until the date at which payment is to be made, yet they frequently sell the acceptance before then at a discount to obtain cash immediately.

• The investor who purchases the acceptance then receives the payment guaranteed by the bank in the future.

• The investors return on a banker’s acceptance, like that of commercial paper, is derived from the difference between the discounted price paid for the acceptance and the amount to be received in the future.

• Maturities of bank’s acceptance often range from 30 to 270 days.

Eurodollar Deposits • As corporations outside the United States increased

international trade transactions in US dollars, the US dollar deposits in non US banks grew.

• In Eurodollar market, banks channel the deposited

funds to other firms that need to borrow them in the form of Eurodollar loans.

• The deposit and loan transactions in Eurodollars are typically $1 million or more per transaction. So only governments are large corporations participate in this market.

Eurodollar Deposits and Euro notes

• Eurodollar CDs are not subject to reverse requirements, which means that banks can lend out 100 percent of the deposits that arrive.

• The rates offered to Eurodollar deposits are slightly higher than rates offered on negotiable certificates of deposit.

• Unlike, other CDs Eurodollar transactions represent a loan from one commercial bank to another.

Eurodollar Deposits and Euro notes • A secondary market for Eurodollar

CDs exists.

• Investors in Eurodollar transactions are adversely affected by rising market interest rates, while issuers of these CDs are adversely affected by decreasing rates.

• Short term euro notes are issued on bearer form, with common maturities of one, three and six months.

Euro-Commercial Paper • Euro-commercial paper is issued

without the backing of the banking syndicate. Maturities can be tailored to satisfy investors.

• The Euro CP market is used by large

corporations that wish to hedge future cash inflows in a particular foreign currency.

• The Euro CP rate is typically between 50 and 100 basis points above LIBOR. Euro CP is sold by dealers, at a transaction cost ranging between 5 and 10 basis points of the face value.

Performance of Foreign Money Market Securities

• Performance of an investment in foreign money market security is measured by the Effective yield.

• • Effective yield is dependent on:• Yield earned on money market security in foreign currency• The exchange rate• • The yield earned on the money market security :• • Yf = Selleing price - Purchase price• Purchase price

Performance of Foreign Money Market Securities

• Exchange rate effect is measured by the percentage change in the spot exchange rate from the time of investment until the security was sold and the foreign currency was converted into investor’s home currency.

• • EFFECTIVE YIELD :

• Yc = (1 + Yf) x (1+ %∆S) - 1

• A U.S investor invests in a one year Mexican money market security when the exchange rate is $0.12 for a Peso. The security earns 22 percent return. After one year the investor converts his investment in to U.S dollar at an exchange rate of $0.13 per perso.

• Yc = .(1 + Yf) x (1+ %∆S) - 1• = (1.22) x (1.0833) - 1• = 32.16% • Effective yield is higher than the

yield on foreign currency security when ever the foreign currency value increases over investment horizon

Valuation of Money Market Securities

• The price of most of money market securities

depends on the required return of an investor. Since they do not pay any coupon payments, Price is the present value of a par value.

P = Par value / (1 + K)n

• P = $10,000 / 1.07• = $9,345.7

Money Market Price Movements

• Sine maturity is less than or equal to one year, n is measured as a fraction of a year.

• A change in price:• ∆P = f (∆k) where ∆k = f(∆ Rf , ∆RP)

Factors affecting price of Money Market Securities

• International Economic conditions• Fiscal Policy• Monetary Policy• Economic Conditions• Issuer’s Industry conditions• Issuer’s Unique conditions