Fixed Income Markets

I. Money Markets

A. Money Market Instruments

• Definition

Money market securities are financial instruments with maturity of one year or less.

• Instruments and Participants– Domestic Money Market

Instruments Principal Borrowers

Treasury bills U.S. Government

Commercial paper Non-financial and financial

businesses

Negotiable CDs Banks

Repurchase agreements Securities dealers, banks, non- financial corporations,

governments

Instruments Principal Borrowers

Federal funds Banks

Banker’s acceptances Non-financial and financial businesses

Discount window Banks

Municipal Notes State and local governments

Government sponsored Farm Credit System, Federal

Enterprise securities Home Loan Bank System,

Federal National Mortgage Association

Instruments Principal Borrowers

Shares in money market Money market funds, local

instruments government investment pools,

short-term investment funds

Futures contracts Dealers, banks (principal users)

Futures options Dealers, banks (principal users)

Swaps Banks (principal dealers)

– International Money Market Instruments

Instruments Principal Borrowers

Eurodollars Banks

Eurodollar CDs Banks

Euronotes

Euro-commercial paper Non-financial and financial businesses

• Characteristics– High degree of safety– Active secondary market– Telephone network

B. Treasury Bills

• Maturity– Regular issues

91-day bills Issued weekly

182-day bills Issued weekly

51-week bills Issued monthly– Irregular issues

• Denominations$10,000

$15,000

$50,000

$100,000

$500,000

$1,000,000

round lot: $5,000,000

• Auction– Non-competitive Bidding ($1,000,000 or less)

Direct purchase from Federal Reserve Banks

Indirect purchase through brokers

– Competitive Bidding

Amount

(in bil.) Bid Remark

$0.20 7.55% lowest yield,/highest price

0.26 7.56

0.33 7.57

0.57 7.58 average yield/ average price

0.79 7.59

0.96 7.60

1.25 7.61

1.52 7.62 stop yield/ stop price

• Dearlers

– Reporting Dealers

Securities firms which are on the Federal Reserve’s regular reporting list.

– Primary Dealers (Recognized Dealers)

Securities firms and commercial banks that the Federal Reserve will deal with in implementing its open market operations.

– Government Brokers

Brokers used by primary dealers trading Treasury securities with each other.

– Other Dealers and Brokers

• T-Bill Rate (T-Bill Discount, or Yield on a Bank Discount Basis)

T-bill Rate = [(par - PP) / par] (360 / n)

= [dollar discount/ par] (360 / n),

where

par = par value,

PP = purchase price, and

n = holding period in days.

Example:

par = $100,000,

PP = $97,569, and

n = 100 days.

Yield = [($100,000- $97,569)/ $100,000]

(360 / 100)

= 8.75%.

• Dollar Discount

Dollar Discount = T-bill Rate par (n /360)

Example:

T-bill Rate = 8.75%,

par = $100,000, and

n = 100 days.

Dollar Discount = 0.0875$100,000(100/360)

= $2,431.

Purchase price = par value - dollar discount

= $100,000 - $2,431 = $97,569.

• Yield

T-bill Yield = [(SP - PP) / PP] (365 / n),

where

SP = selling price,

PP = purchase price, and

n = holding period in days.

Example:

SP = $10,000,

PP = $9,600, and

n = 182 days.

Yield = [($10,000 - $9,600)/ $9,600](365 / 182)

= 8.36%

C. Commercial Paper

• IssuersFinance companies

Bank holding companies

Industrial companies

Foreign corporations (Yankee commercial paper)

• Maturity

– Not Registered

One day to 270 days, normally between 20 and 45 days.

– Registered

Over 270 days

• Denominations

Minimum $25,000

Minimum round lot $100,000

Typical multiples of $1 million

• RatingMcCarthy,

Crisanti &

Category Duff & Phelps Fitch Moody’s S&P Maffei

Investment Duff 1+ F-1+ A-1+

Grade Duff 1 F-1 P-1 A-1 MCM 1

Duff 1-

Duff 2 F-2 P-2 A-2 MCM 2

Duff 3 F-3 P-3 A-3 MCM 3

Non-invest.

Grade Duff 4 F-S NP(Not B MCM 4

Prime)

C MCM 5

In default Duff 5 D D MCM 6

• Placement

– Directly Placed Commercial Paper

– Dealer-Placed Commercial Paper

• Backing

– Reasons

Credit enhancement

Rollover risk

– Types of Credit-Supported commercial paper

Credit-Supported commercial paper (line of credit paper)

Fee (0.5%)

Compensating balances

Asset-backed commercial paper

• Yield

Yield = [(par - PP) / PP] (360 / n),

where

par = par value,

PP = purchase price, and

n = holding period in days.

Example:

par = $5,000,000,

PP = $4,850,000, and

n = 90 days.

Yield = [($5,000,000 - $4,850,000) / $4,850,000] (360 / 90)

= 12.37%

D. Negotiable Certificates of Deposits (NCDs)

• Issuers– Domestic market

Commercial banks

Thrift institutions (thrift CDs)

U.S. branches of foreign banks (Yankee CDs)– Foreign markets (Euro CDs)

• Maturity

Short-term: two weeks to one year

Long-term: term CDs

• Denominations

Minimum $100,000

Typical $1,000,000

• Placement

– Directly placed NCDs – Dealer placed NCDs

• Yield on a Bank Discount Basis

– Risk premium

Higher premium during recessionary years

Higher premium during financial crises

Higher premium for high-risk issuers– Liquidity premium– Fixed rate vs floating rate

E. Repurchase Agreements (RPs)

• Issuers– Financial institutions

Commercial banks

Thrifts

Money market funds

Securities dealers– Non-financial institutions

Municipalities

Businesses

• Maturity

– Overnight repos– Term repos

Two to fifteen days

One, three and six months

• Denominations

Typical $10 million or higher

• Yield or Repo Rate

Repo Rate = [(SP - PP) / PP] (360 / n),

where

SP = selling price collected by an investor,

PP = purchase price paid by an investor, and

n = holding period in days.

Example:

SP = $10,000,000,

PP = $9,852,217, and

n = 60 days.

Yield = [($ 10,000,000-$ 9,852,217)/$ 9,852,217] (360 / 60)

= 9%

Determinants of repo rates:– Creditworthiness of the issuer– Type of collateral– Federal funds rate

The repo rate is usually 25 basis points below the funds rate because a repo has collateral, while a federal funds transaction is unsecured.

F. Federal Funds

• ParticipantsDepository institutions

Brokers

• Characteristics– Short-term borrowing of immediate availability– Borrowed only by depository institutions– Exempted from reserve requirements

• Maturity

– Overnight federal funds (3/4 of the total federal funds)

– Continuing contract federal funds (automatically renewed overnight federal funds)

– Term federal funds: few days to six months

• Denominations

Typical $5,000,000

• Placement

– Directly placed– Broker-placed

• Security

– Unsecured federal funds– Secured federal funds

• Federal Funds Transfer

– Adjusting reserve accounts through Fedwire– Reclassifying the demand deposits of a

respondent bank

• Federal Funds Rate

– Higher than repo rate and Treasury bill rate.– Higher volatility than other money market

rates because it is affected by changes in monetary policy.

G. Banker’s Acceptances

• Issuers

Exporters

Importers

Commercial banks

1. Purchase order

Importer Exporter

5. Shipment of goods

6. Shipping

2. L/C 4. L/C documents

application notification & time

draft

3. L/C

Importer’s bank Exporter’s bank

7. Shipping

documents & draft acceptance

Acceptance financing

The use of banker’s acceptances to finance commercial transaction.

– Importing goods into the U.S.– Exporting goods from the U.S.– Storing and shipping goods between foreign

countries (third country acceptances)

• Maturity

– 30 to 270 days – Federal Reserve eligibility requirement

A Banker’s acceptance with maturity longer than six months do not meet the eligibility requirement as collateral at the discount window.

• Placement– Directly placed by Accepting banks

An accepting bank is a bank which creates banker’s acceptances.

– Dealer placed* Unsold acceptances created by large

accepting banks* Acceptances created by smaller accepting

banks* Acceptances created by Yankee banks (U.S.

branches of foreign banks)

• Rates– Higher than T-bill rate

* Risk premium - Higher default risk than T-bills.

* Liquidity premium- Less developed secondary market.

– Commission charged by accepting banks* U.S. banks - 25 to 30 basis points* Japanese banks - 10 to 15 basis points

– Dealer’s Spread - 12.5 to 87.5 basis points

H. Eurocurrency

• ParticipantsGovernments

Large financial institutions

Commercial banks (Eurobanks)

Organized exchanges

Institutional investors

Large corporations

• Related Markets– Foreign exchange market– Eurocurrency market– Eurocredit market– Euro CD market– Euronote market– Currency forward market– Currency Futures market– Currency options market– Currency swap market

• Euro CDs– Types

* Fixed -rate CDs* Floating-rate CDs (FRCDs)

The rate adjusts periodically to the London Interbank Offer Rate (LIBOR).

– Yield

Euro CDs offer a higher yield than domestic CDs for three reasons:* Reserve requirements imposed on domestic

CDs * FDIC insurance premium for covering

domestic CDs* Sovereign risk

Euro CDs are obligations that are payable by an entity operating under a foreign jurisdiction, and their claim may not be enforced by the foreign government.

• Euronotes– Participants

Borrowers

Underwritten or committed note issuance facility (a syndicate formed by a group of

banks)

Investors

– Maturity

One month

Three months

Six months

I. Euro-Commercial Paper (Euro-CP)

• Participants

Borrowers

Dealers

Investors

• Maturity

Euro-commercial paper has longer maturity ( i.e., longer than 270 days) than that of U.S. commercial paper, and therefore has a more active secondary market.

• Placement

Euro-commercial paper is almost always dealer-placed. The commission ranges between 5 and 10 basis points of the face value.

• Yield

Euro-commercial paper is typically between 50 and 100 basis points above LIBOR.

J. Valuation of Money Market Instruments

• Market Value

P = Par / (1 + i)n,

where

P = price of the money market instrument,

Par = par value,

i = required annual rate of return, and

n = time to maturity (a fraction of one year).

Example:

Par = $10,000,

i = 7%, and

n = 1 year.

P = $10,000/ (1 + 0.07)1

= $9,345.79.

• Price Determinants

P = ƒ( i) = ƒ(Rf, DP, LP) ,

where

P = change in price,

i = change in required rate of return,

Rf = change in risk-free rate,

DP = change in default risk premium, and

LP = change in liquidity premium.

– Determinants of risk-free rate* Economic growth* Inflation* Money supply

– Determinants of default risk premium* Economic conditions* Conditions in the firm’s industry (degree of

competition, etc.)* Firm-specific conditions (debt level,

management, etc.)

II. Capital Markets

A. Treasury Bonds

• Types– Treasury Notes: Less than 10 years– Treasury Bonds: 10 years or more

• Minimum Denomination - $1,000

• Interest Payments– Coupon Bonds– Stripped Securities

• Coupon Stripping

Principal-only securities (Corpus)

Interest-only securities

• Examples

Merrill Lynch - Treasury Income Growth Receipts (TIGRs)

Salomon Brothers - Certificates of Accrual on Treasury Securities(CATS)

– Treasury Inflation-Protection Security (TIPS)– Brady Bonds

• Auction– Schedule

• Monthly Auction: Two- and five-year notes• Quarterly Auction:3-year, 10-year, and 30-year

auctioned in February, May, August and November.

– Bidding• Noncompetitive Tender: up to $1 million• Competitive Bidding

• Tax

Exempted from state and local taxes

• Fees

$40-$70 per $10,000

B. Federal Agency Securities

• Federal Farm Credit Bank System

• Farm Credit Financial Assistance Corp.

• Federal Home Loan Bank System

• Financing Corporation

• Resolution Trust Corporation

• Student Loan Marketing Association

C. Municipal Bonds

• Municipal Bonds– General Obligation Bonds (GOs)

• Full Faith and Credit Obligations

• Limited-Tax General Obligation Bonds

– Revenue Bonds

– Insured Bonds: Insured by insurance companies– Refunded Bonds (Prerefunded Bonds):Gos or

revenue bonds secured by an escrow fund consisting entirely of direct U. S. Government obligations.

• Municipal Notes (up to 3 years)– Tax Anticipation Notes (TANs)– Revenue Anticipation Notes (RANs)– Grant Anticipation Notes (GANs)– Bond Anticipation Notes (BANs)

• Minimum Denomination: $5,000

• Tax Exemption

D. Corporate Bonds

E. Duration

• Elasticity– Definition

Elasticity is defined as the percentage change in one variable with respect to a percentage change in another variable.

– Example % Q

Price elasticity of demand = .

% P

• Interest RiskInterest risk is the risk related to changes in

interest rates that cause a bond’s realized yield to differ from the promised yield.

– Price RiskPrice risk is the risk related to the change in capital

gain as a result of change in bond price.

– Reinvestment RiskReinvestment risk is the risk related to the change in

realized yield caused by changing reinvestment rates of future cash flows.

• Duration – Definition I– Duration is the bond price elasticity, or

Percentage change in bond price

D = - Percentage change in interest rate

= - [B/B] / [(1 + i)/(1 + i)],

where

D = duration of the bond,

B = bond price, and

i = market rate of interest.

• Duration – Definition II– Duration is a weighted average of the number

of periods until each of the cash flows is received.

nt=1[CFt / (1 + i)t](t)

D = ,

nt=1[CFt / (1 + i)t]

where

D = duration of the bond,

CFt = cash flow at time t,

t = time period in which cash flow is received,

n = number of periods to maturity, and

i = yield to maturity (or market rate).

Given the price of bond,

CF1 CF2 CFn

B = + + … + ,

(1+i)1 (1+i)2 (1+i)n

the first derivative of bond price with respect to (1 + i) becomes

dB/d(1+i) = – CF1(1+i)-2 – 2CF2(1+i)-3 – … – nCFn(1+i)-(n+1)

CF1 2CF2 nCFn

= – + + … + . (1+i)2 (1+i)3 (1+i)n+1

Dividing both sides by B and multiplying by (1+i), we obtain

dB/B CF1 2CF2 nCFn

=-(1/B) + + … +

d(1+i)/(1+i) (1+i)1 (1+i)2 (1+i)n

This can be restated as

nt=1[CFt / (1 + i)t](t)

D = .

nt=1[CFt / (1 + i)t]

Sum of time lengths, each component weighted by the present value of

its corresponding cash flow

D = ,

Price of the bond

– Example

Year Cash Flow

1 $ 80.00

2 80.00

3 80.00

1,000.00

Market rate = 10%

$80 $80 $1,080 (1) + (2) + (3)(1.1)1 (1.1)2 (1.1)3

D = $80 $80 $1,080 + + (1.1)1 (1.1)2 (1.1)3

= 2.78.

Market rate = 15%

$80 $80 $1,080

(1) + (2) + (3)

(1.15)1 (1.15)2 (1.15)3

D =

$80 $80 $1,080

+ +

(1.15)1 (1.15)2(1.15)3

= 2.76.

• Properties– Bonds with higher coupon rates have shorter

durations than bonds with smaller coupons of the same maturity.

– Term to maturity and duration are positively related. The longer the maturity of a bond, the higher the bond’s duration.

– For bonds with a single payment (principal with or without a coupon payment), duration is equal to term to maturity.

– The higher the market rate of interest, the shorter the duration of the bond.

– The longer a bond’s duration, the greater the bond price volatility.

• Bond Price VolatilityD = - [B/B] / [(1 + i)/(1 + i)],

[B/B] = - D [i/(1 + i)].

Bond Price

Pricing error

Tangent line at i

Yield to Maturity

nt=1{[t(t+1)CFt] / (1+i)t+2}

Convexity = .

Bond price

[B/B] = - D [i/(1 + i)] + (1/2)Convexity(i)2.

• Interest Rate Risk– Zero Coupon Approach– Maturity-Matching Approach– Duration-Matching Approach

III. Financial Guarantees

IV. Securitized Credit Instruments

V. Rating Agencies and Information Services

VI. Financial Market Regulators