chapter six money markets © 2001 south-western college publishing company

Chapter Six

Money Markets

© 2001 South-Western College Publishing Company

2

Chapter Objectives

Provide a background on money market securities

Explain how institutional investors use money markets

Explain the globalization of money markets

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Money Market Securities

Maturity of a year or less Issued by corporations and governments that

need short-term funds Investors find out about new issues in the

primary market via a telecommunications network

Purchased by corporations and financial institutions

Secondary market for securities exists

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Treasury bills Issued to meet the short term needs of the

U.S. governmentAttractive to investors

• Liquidity

• Fairly safe from default risk due to government backing

• Strong secondary market exists

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Treasury bill auction competitive bids (Fill bids in amount determined by Treasury borrowing needs)Bid process used to sell T-billsBids submitted to Federal Reserve banks by

the deadlineBid process

• Accepts highest bids

• Accepts bids until generates total needed

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Estimating T-bill yieldNo coupon paymentsPar or face value received at maturityYield at issue is the difference between the

selling price and par or face value If sold prior to maturity in secondary market

• Yield based on the difference between price you paid to buy T-bill and price you sold it for

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Calculating T-bill yields Annualized yield

YT SP - PP

PP

365

n

YT = The annualized yield from investing in a T-bill

SP = Selling price

PP = Purchase price

n = number of days of the investment (holding period)

=

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Calculating T-bill yields T-bill discount for a newly issued security

Par - PP

PP

360

n

T-bill discount = percent discount of the purchase price from par

Par = Face value of the T-bills at maturity

PP = Purchase price

n = number of days to maturity

T-bill discount =

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Commercial paperShort-term debt instrumentUsed only by well-known and creditworthy

firmsUnsecuredMinimum denominations of $100,000Not an active secondary market

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Commercial paper ratingsPast defaults means a rating for default risk

helps investors evaluate risks and issuers sell the securities

Ratings agencies assign a grade based on credit risk

Commercial paper placement choicesDirect placementCommercial paper dealers

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Backing commercial paper with a line of creditUsed in case they can’t roll over or reissue

new debt at a reasonable rateRating change would affect costBank gives issuer right but not obligation to

borrow a certain amount for a specified period of time

Bank charges fees

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Estimating commercial paper yields

YCP

Par - PP

PP

360

n

YCP = Commercial paper yield

Par = Face value at maturity

PP = Purchase price


=

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Negotiable certificates of deposit NCDs Issued by large commercial banksMinimum denomination of $100,000 but $1

million more commonPurchased by nonfinancial corporations or

money market fundsSecondary market exists but issuers don’t like

new issues to compete with previous issues in the secondary market

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NCD placementDirect placementUse a correspondent institution specializing in

placementSell to securities dealers who resellSell direct to investors at a higher price

NCD premiumsRate above T-bill rate to compensate for less

liquidity and safety

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Repurchase agreementsSell a security with the agreement to

repurchase it at a specified date and priceBorrower defaults, lender has securityReverse repo name for transaction from

lenderNegotiated over telecommunications networkDealers and brokers used or direct placementNo secondary market

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Estimating repurchase agreement yields

Repo RateSP - PP

PP

360

n

Repo Rate = Yield on the repurchase agreement

SP = Selling price

PP = Purchase price


=

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Federal fundsDepository institutions use to borrow and lend

short-term funds with each otherFederal funds rate usually slightly higher than

T-bill rateFed district bank debits and credits accountsFederal funds brokers may match up buyers

and sellers using telecommunications networkUsually $5 million or more

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Banker’s acceptancesA bank takes responsibility for a future

paymentUsually result from international transactionsExporters send goods to a foreign destination

and want payment assurance before sendingBank stamps a draft from the importer

ACCEPTED and obligates the bank to make good on the payment at a specific time

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Banker’s acceptancesExporter can hold until the date or sell before

maturity If sold to get the cash before maturity, price

received is a discount from draft’s totalReturn is based on calculations for other

discount securities Similar to the commercial paper example

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Institutional use of Money Markets

Used by many kinds of institutional investors both to invest and borrow

Money market securities enhance liquidityNewly issued securities raise cashBuyers of securities generate cash when

they liquidate they holdings Active secondary market helps liquidity Short-term maturity enhances liquidity

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Valuation of Market Securities

Many money market securities do not make interest payments

Value is the present value of the security at maturity

Par or face value is the future value of a lump sum

Discount rate is rate investors require Like bonds, an inverse relationship between

price and yield

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Interaction Among Money Market Yields

Securities in the money market have interrelated yields Investors can substitute among securities Investors trade if a price and yield disparity

occurs among securities Economic uncertainty causes an investor shift to

securities with lower possible risk of default

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Globalization of Money Markets

Some segmentation remains in the global money market

Rates among countries have become more interrelated over time

Increase in the flow of fundsTax differences among countriesSpeculation on exchange rate changesReduced government barriers

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Eurodollar deposits and EuronotesDollar deposits in banks outside the U.S. Increased because of international trade

growthNo reserve requirements at banks outside

U.S. Eurodollar Loans

Channel funds to other multinationals that need short-term financing

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Eurodollar deposits and Euronotes Eurocurrency market consists of several banks

that with loans and deposits denominated in Eurocurrencies

Eurodollar CDsSecondary marketSome have floating rates tied to LIBOR or

London Interbank Offer Rate Eurocredit market offers longer maturity loans

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Euro-commercial paper Issued without the backing of a banking

syndicateMaturity tailored to investorsDealers that place paper created a secondary

market

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Performance of international securities Effective yield for international securities has

two componentsThe yield earned on the investment

denominated in the currency of the investment

The exchange rate effect

chapter six money markets © 2001 south-western college publishing company

Documents

primary market

money market securitiesexplain

purchase price n

selling price

money marketsexplain

commercial paper yieldpar

maturitytbill discount

number of days