Money and Fixed-Income Market

Fed Funds

Treasury Bills

Rates and Yields

CDs and Commercial Paper

Fixed-Income Securities

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Introduction Money Market

Cash equivalents, short-term (maturity 1 year), liquid (marketable), low-risk debt securities

Instruments Federal funds Treasury bills (T-bills) Certificate of deposit Commercial paper Bankers’ acceptances Eurodollars Repurchase agreements (repos) and reverses Brokers’ calls

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Federal Funds Rate charged for Federal Funds among

the banks Most widely quoted “Fed” rate

Is it set really set by the Fed?

Effective Rate vs. Target Rate (Aug 27, 2008)

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Treasury Bills Definition

Short-term Gov. security issued at discount e.g., pay $900 today for 1yr T-bill of $1000 par value

Characteristics Highly liquid Extremely safe (virtually risk free) Exempt of state and local taxes (but not

federal) Initial maturity at 4, 13, 26, and 52 weeks

Pay $900

Today Maturity

Receive $1000 face (par) value

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Treasury Bills Quotation

Market convention is to use rate rather than price for T-bill quote

Bank Discount Rate (BD)

rBD: bank discount rate F: face value (par) P: price n: days to maturity

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Treasury Bills Example

A 90-day T-Bill of par $10,000 trades at $9,600. What’s the bank discount rate?

n = 90, F = $10,000, P = $9,600

Annualized return on the investment?

rBEY: bond equivalent yield (APR)

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Treasury Bills

Bond Equivalent Yield (BEY) Measures (simple) annualized return on

T-bill investment Facilitates comparison of yields between

T-bill and T-bond Bank discount rate is NOT a true interest rate Bank discount rates are converted to yields Bonds quoted in yields Converted Yields = Bond Equivalent Yield

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Treasury Bills Sample quotes from WSJ (Sep 1 2005)

MaturityDays to

MatrurityBid Asked Chg Ask Yield

Nov 10 05 70 3.38 3.37 -0.04 3.44Nov 17 05 77 3.4 3.39 -0.03 3.46Nov 25 05 85 3.42 3.41 -0.05 3.49Dec 01 05 91 3.44 3.43 -0.05 3.51

Actual # days – 2 Bank discount rate Bond Equivalent yield

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Treasury Bills What about price?

9/1/05, on WSJ you see 12/1/05 T-bill is quoted at 3.43% (ask). How much does it cost to buy $1,000 par of that T-bill?

F = $1,000, rBD = 3.43%, n = 91, P = ?

Bond equivalent yield

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Certificates of Deposit (CD)

Issued by Denomination Maturity Liquidity Default risk Interest type Taxation

Depository Institutions

Any, $100,000 or more are marketable

Varies, typically 14 day minimum

3 months or less are liquid, if negotiable

First $100,000 ($250,000) is insured

Add on

Interest income is fully taxable

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Commercial Paper Issued by

Maturity Denomination Liquidity Default risk Interest type Taxation

Large creditworthy corporations and

financial institutions

Maximum 270 days, usually 1 to 2 months

Minimum $100,000

3 months or less are liquid if marketable

Unsecured, Rated, Mostly high quality

Discount

Interest income is fully taxable

New Innovation: Asset backed commercial paper is backed

by a loan or security. In summer 2007 asset backed CP

market collapsed when subprime collateral values fell.

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Money Market Instrument Yields

Yields on money market instruments are not always directly comparable!

Factors influencing “quoted” yields Par value vs. investment value 360 vs. 365 days assumed in a year

(366 leap year) Simple vs. Compound Interest

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Major Components of the Money Market

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MMMF and the Credit Crisis of 2008 Between 2005 and 2008 money market mutual funds

(MMMFs) grew by 88%. MMMFs had their own crisis in 2008 when Lehman

Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehman’s

commercial paper. On Sept. 16, Reserve Primary Fund “broke the buck.”

What does this mean? A run on money market funds ensued, and unsecured

money market rates jumped up. The U.S. Treasury temporarily offered to insure all

money funds (close to $3.4 trillion) to stop the run.

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Spreads on CDs and Treasury Bills

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Spreads on Commercial Paper and T-Bills

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Fixed-Income Securities Publicly Issued

Treasury Notes and Bonds Agency Issues (Federal Government) Municipal Bonds

Federal tax exemption Local and state tax exemption for state residents

Privately Issued Corporate Bonds Mortgage-Backed Securities

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Fixed-Income Securities What are they?

A security promising full payment of coupon and principal according to a fixed time schedule

E.g., A 10 year $10,000 T-note with 6¼% coupon

Three Prominent Characteristics Principal

Face value of a bond Interest

Coupon of a bond Maturity

Life span of a bond