Money Markets

GD 20503Financial Markets and Institutions

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Outlines:Types of Money Market SecuritiesInstitutional Use of Money MarketsValuation of Money Market SecuritiesGlobalization of Money Markets

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Types of Money Market SecuritiesTreasury BillsCommercial PaperNegotiable Certificates of Deposit (NCDs)Repurchase AgreementsFederal FundsBanker’s Acceptance

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Exhibit 6.1 How Money Markets Facilitate the Flow of Funds

Treasury BillsWho is the issuer?; Common investors; Common maturities; andSecondary market activityT-bills are attractive to investors because:i. They are backed by the federal government

and they are virtually free of credit (default) risk

ii. Liquidity – short maturity and strong secondary market

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See Exhibit 6.4

Treasury BillsPricing T-bills:T-bills do not pay interest. They are priced at

a discount from their pay valueExample (p.127): if investors require a 7%

annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is

P = $10,000/1.07 = $9,345.79

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Treasury BillsEstimating the Yield:Their yield is influenced by the difference

between the selling price and the purchase price

The annualized yield from investing in a T-bill ():

where SP = selling price, PP = purchase price and n = number of days of the investment (holding period)

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Treasury BillsExample (p.128): An investor purchase a T-

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

= 8.36%

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Exhibit 6.4 Survey of Commonly Issued Money Market Securities

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Securities Issued by Common investors

Common Maturities

Secondary Market Activity

T-bills Federal government Households, firm and financial institutions

13 weeks, 26 weeks, 1 year

High

NCDs Large banks and saving institutions

Firms 2 week to 1 year Moderate

Commercial paper

Bank holding companies, finance companies and other companies

Firms 1 day to 270 days Low

Banker’s acceptance

Banks Firms 30 days to 270 days

High

Federal funds

Depository institutions

Depository institutions

1 day to 7 days Nonexistent

Repurchase agreements

Firms and financial institutions

Firms and financial institutions

1 day to 15 days Nonexistent

Commercial PaperWho is the issuer?; Common investors; Common maturities; andSecondary market activity

Ratings:Since commercial paper is issued by corporations

that are susceptible to business failure, the commercial paper could possibly default

Thus, the rating serves as an indicator of the potential risk of default.

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See Exhibit 6.4

Commercial PaperCredit Risk during the Credit Crisis:Historically the percentage of issues that

have defaulted is very rare, as most issuers of commercial paper are very strong financially.

However, during the credit crisis in 2008, Lehman Brothers (a large securities firm) defaulted.

Yield Curve:The curve is typically established for a

maturity range from 0 to 90 days.11

Commercial PaperEstimating the Yield:Like T-bills, commercial paper does not pay

interest, but is priced at a discount from par value.

Example (p.130): If an investor purchase 30-day commercial paper with a par value of $1,000,000 for a price of $990,000, the yield ( is

= 12.12%

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Negotiable Certificates of Deposits (NCDs)Who is the issuer?; Common investors; Common maturities; andSecondary market activityEstimating the Yield:NCDs provide a return in the form of interest

along with the difference between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase price.

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See Exhibit 6.4

Negotiable Certificates of Deposits (NCDs)Example (p.131): An investor purchased an

NCD a year ago in the secondary market for $970,000. He redeems it today upon maturity and receives $1,000,000. He also receives interest of $40,000. His annualized yield is:

=

= 7.22%

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Repurchase AgreementsWith a repurchase agreements (or repo), one

party sells securities to another with an agreement to repurchase the securities at a specified date and price

The repo transaction represents a loan backed by the securities.

If the borrower defaults on the loan, lender has claim to the securities.

Most repo transactions use government securities.

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

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Repurchase AgreementsWho is the issuer?; Common investors; Common maturities; andSecondary market activity

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See Exhibit 6.4

Federal FundsWho is the issuer?; Common investors; Common maturities; andSecondary market activityThe federal funds market allows

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

The federal funds rate is normally slightly higher than the T-bill rate.

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See Exhibit 6.4

Banker’s AcceptanceA banker’s acceptance indicates that a bank

accept responsibility for a future payment (the bank acts as a guarantor).

It is commonly used for international trade transactions

Who is the issuer?; Common investors; Common maturities; andSecondary market activity

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See Exhibit 6.4

Exhibit 6.3 Sequence of Steps in the Creation of Banker’s Acceptance

The Japanese exporter is unfamiliar with the imported

The bank acts as a guarantor.

Institutional Use of Money MarketsTypes of Financial Institutions:i. Commercial Banksii. Finance companiesiii. Money market mutual fundsiv. Insurance companiesv. Pension fundsFinancial institutions purchase money market

securities in order to simultaneously earn a return and maintain adequate liquidity.

They issue money market securities when experiencing a temporary shortage of cash

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Exhibit 6.5 Institutional Use of Money Markets

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Valuation of Money Market SecuritiesMarket Price of Money Market Security (Pm)

Pm = Par / (1 + k)n

where: Par = par value or principal amount at maturity

k = required rate of return by investorsn = time to maturity

A change in Pm

where: Rf = risk free interest rate

RP = risk premium

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),( RPRfP fm

Exhibit 6.6 Framework for Pricing Money Market Securities

Valuation of Money Market SecuritiesImpact of Changes in Credit Risk:Lehman Brothers’ Default:Lehman Brothers filed for bankruptcy in Sept

2008 – it shocked the commercial paper market – investors were unwilling to invest in commercial paper – many firms were no longer able to rely on commercial paper market for short-term funding.

Risk Premium among Money Market Securities:

During periods of heightened uncertainty about the economy, investors tend to shift from risky money market securities to Treasury securities.

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Exhibit 6.7 Money Market Yields (3-Month Maturity)

Valuation of Money Market SecuritiesInterest Rate Risk:If short-term interest rates increase, the

required rate of return on money market securities will increase and the price of the money market securities will decrease (see the valuation formula).

Although money market securities values are sensitive to interest rate movements in the same direction as bonds, they are not as sensitive as bond values to interest rate movements.

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Exhibit 6.9 International Money Market Rates over Time

Globalization of Money Markets