Money Market Instruments Blackwell, Griffiths and Winters, Chapter 4, and other material

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Definition of the Money Markets

The money markets are the markets for short-term debt with short-term being defined as an initial maturity of one year or less.

If a security has an initial maturity of more than one year, it is part of the Capital Markets (bonds, stocks and mortgages are the primary capital market securities).

The economic role of the money markets is to facilitate the trading of liquidity.

In the money markets, investors (lenders) with temporary cash surpluses make these surpluses available to borrowers with temporary cash shortages.

Since the investors (lenders) have the cash, they get to set the rules for the market

Since their cash surplus is only temporary, they want to ensure that their cash gets repaid to them when they need it.

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The Money MarketRecap

Financial characteristics:• Low default risk• Low price risk (relatively short duration• High marketability

Organizational characteristics:• Each instrument is distinct• Standardized contracts• No formal organization -- an OTC market• Wholesale markets• Activity focused in the dealer or trading rooms of financial

institutions

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Key Money Market Instruments

Treasury Bills

Negotiable CDs

Domestic

Yankee

Thrift

Bankers Acceptance

Domestic

Yankee

Short-Term Agency Paper

Discount Notes

Consolidated Discount Notes

Consolidated Systemwide Discount Notes

Short-Term Tax-Exempt Securities (Munis)

TANs

BANs

RANs

Repurchase Agreements (RPs)

Reverse Repurchase Agreements (REPOs)

Eurodollar Deposits (Euros)

Time Deposits

Negotiable CDs

Federal Funds4

Quotes

Money Market:• Yield

Capital Market• Price as a proportion of face value• 102:28 is a security price at 102 28/32 % of its face

value• For a $1000 security, its dollar price would be:

• $1028.75

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Yields for Money Market Instrument

Bank Discount Basis

Bond equivalent Basis

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Discount Versus Bond Equivalent Yields

Bank Discount Basis

Treasury Bills

Commercial Paper

Finance Paper

Bankers Acceptances

Agency securities

RPs/Repos

Bond equivalent basis

CDs

Eurodollars

Federal funds

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Bank Discount Yield: Terms

Face value (maturity value) F

Price P

Discount D

Yield on Discount Basis Yd (decimal basis)

Days to maturity t

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Calculating the Price and the Bond Equivalent Yield

Quote is on a bank discount basis. Investor needs to calculate • The security’s price• The yield on a bond equivalent basis

First step is to calculate the discount• D = Yd x F x (t/360)

Next Step is to calculate the price• P = F - D

Final step is the calculation of the bond equivalent yield• Y = (365 x Yd) / (360 - t x Yd) (decimal basis)• To convert to percentage basis, multiply by 100

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Resolving 365 versus 360 day years

Bank discount yield represents a discount yield over a 360 day year.

In effect, 360 days are used to calculate “daily interest payment” and daily interest pay is paid over 365

Hence the bond equivalent yield is larger than the discount yield for two reasons:

It is computed on the price , not the face value

It is paid over 365 days

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An Example

Bank Discount Quote for a bill maturing in 65 days

Days to maturity 65

Ask discount yield 5.36

D = 0.0536 x 100 (65/360) = 0.9678

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Continued

P = 100 - .9678 = 99.0322 per $100 of face value

For a Treasury Bill with a face value of $100,000, the price would be:

$99032.02 = $100,000 x .990322

Y = ( (365 x .0536) / (360 - (65 x .0536))) = 5.49%

Effective Annual Yield = (1 + .0541/(365/65))(365/65) = 1.0551 or 5.51% 12

Effective Annual Yield

Bond Equivalent Yield does not take into effect compounding of interest earned

Effective annual yield = (1 + Y/(365/t))365/t - 1

For this bill, effective annual yield is:

5.62% = ((1 + (.0549 / (365/65))365/65 - 1) x 100

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Review of Primary and Secondary Markets

Primary market:• The market where a security is sold for the first time

Secondary market:• The market where previously issued securities are

bought and sold• Role of Secondary market

• Provide Liquidity to a security• Offer guidance to the primary market as to the

proper price• Disseminates information

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Treasury Bills

Characteristics

Short-term debt instruments issued in huge volume by the US Treasury on a bank discount basis

Virtually no default risk, little price (interest rate) risk and extremely liquid

Extreme liquidity stems from the extent, depth and resiliency of the secondary market for these instruments

These instruments are considered the ideal money market instrument

Book entry

Markets

Primary market:• Auction basis conducted by the

Federal Reserve Bank of New York on behalf of the US Treasury

• Monthly auction of 4 week Treasury bill

Secondary market• OTC• All major banks act as dealers• Dealers are the market-markets

in the secondary market

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Primary Market

Competitive Bids• Specify price and quantity

desired.• Minimum $10,000 & in multiples

of $5,000 above $10,000.• Mostly professionals - dealers &

banks.• No more than 35 percent of an

issue is sold to one entity under the competitive bidding process in order to ensure a competitive secondary market.

Non-competitive Bids• All non-competitive bids

accepted.• Specify quantity only.• Minimum $1,000• Maximum $1,000,000.• Mostly individuals & small

investors.• Pays stop-out (highest) rate of

competitive auction

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Auction of Treasury Bills

Initial maturity

1. 13-weeks; often referred to as three-month or 91-days, but the Treasury uses weeks because they believe that provides the most accurate description.

2. 26-weeks (six-months)

3. 52-weeks (one-year)

4. 4 weeks

Two types of bids in T-bill auctions:

1. Competitive bids, which specifies quantity of T-bills sought and discount rate, and

2. Non-competitive bids, which specify only the quantity of T-bills sought.

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T-bill Auction Process (cont.)Steps in the Auction Process

1. Fill all non-competitive bids (up to the $5 million) and set aside to assign price later.

2. Sort the competitive bids on bid price (high to low) (same as discount rate low to high) and assign the remainder of the available bills to competitive bidders starting with the highest price and moving down the list of bid prices.

3. The last competitive bid price accepted is referred to as the stop-out price, which is the lowest price accepted for the auction.

4. Assign all (non-competitive and competitive) accepted bids the stop-out price. This is referred to as uniform-price auction. This is used to eliminate the ‘winner’s curse that occurs in multiple-price auctions.

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T-bill Default Risk

Treasury bills are backed by the full faith and credit of the U.S. government. The U.S. government has never failed to pay its debts, so T-bills are considered default free.

T-bills are often referred to as risk-free, but they are not because all debt instruments are exposed to interest rate risk.

Commercial and Finance PaperCharacteristics

Characteristics• Short-term unsecured debt • Initial maturity less than 270 days

Commercial paper: issued by nonfinancial firmsFinance paper: issued by financial institutions

• Captive• Independent

• Subsidiaries of parent firm• Separate corporation

• Bank-related

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Commercial and Finance PaperMarkets

Primary

Direct Placement• Sales force that sells the paper

directly to investors

Dealer placed• Paper placed with investors by

dealer• This is a form of underwriting

• Banks prohibited under Glass-Steagall from engaging in this activity

• But permitted under the Section 20 loop-hole of the Bank Holding Company Act

• Fully permiited under the FMA

Secondary

No formal secondary market, through there is limited trading in the secondary market

Paper is typically sold to investors that plan to hold it to maturity

Some issues have “programs” in which investors regularly role over maturing commercial paper for new commercial paper

Commercial paper dealers are expected to make a market in their clients’ commercial paper

as of June 2000, over 80% of outstanding commercial paper was dealer-placed.

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Commercial Paper

Commercial paper is unsecured corporate debt issued to finance short-term working capital.

Commercial paper is used as an alternative to bank loans.

• an attractive alternative because it carries a lower interest rate

• but it is only available to low default risk businesses

• Money market investors only loan their money to low default risk borrowers.

The credit rating agencies rate all commercial paper in a manner similar to the bond ratings discussed in Chapter 3.

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Commercial Paper Ratings (Figure 4-4)Rating Description

Moody’s

Prime-1 Superior ability to repay senior short-term debt

Prime-2 Strong ability to repay senior short-term debt

Prime-3 Acceptable ability to repay senior short-term debt

Not Prime Issuer not in Prime rating categories

Standard and Poor’s

A-1 Strong capacity to meet financial commitments

A-2 Satisfactory capacity to meet financial commitments

A-3 Adequate capacity to meet financial commitments

B Vulnerable and has significant speculative characteristics

C Currently vulnerable to nonpayment

Bankers Acceptances

Created by banks on behalf of companies engaged in trading and/or storage of goods

The are negotiated time drafts drawn on and accepted by a bank, discounted and sold to investors, and redeemed by the bank at maturity for the full face value

Used to finance the import, export, transfer and storage of goods

Draft is accepted when drawee bank agrees to pay at maturity. Generally purchased by investors through dealers

Obligation of drawee bank

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Large Negotiable CDsCharacteristics

Characteristics

Certificate of deposit (CDs) were first issued in the early 1900s to corporate customers but were not negotiable

Certificate is issued by a depository institution and states the principal, interest rate, and maturity date

The Federal Reserve considers large those CDs with a stated principal of $100,000 or more

Typically issued with principal of $1 million or more

Issuers: Domestic banks and US branches of foreign banks (Yankee CDs) and Thrifts

Background

Typical investors are large corporation and large institutional investors.

Until 1961, investors had no choice but to hold CDs to maturity

In 1961,Citibank negotiated an agreement with the primary dealers in Treasury securities to deal (maintain a secondary market) in negotiable CDs

Subject to Regulation Q until 1970, when deregulated in response to the commercial paper crisis

Importance to depository institutions rose progressively until deregulation of other deposit rates 25

Large Negotiable CDsPrimary Markets

Primary market

Directly to investors, but some small amount through dealers

• Issuers post rates by maturity• Posted rate is typically a bit below

the secondary market rate so that the issuer can offer higher rates to preferred customers

• Tiering emerged in 1980s in response to the bank crisis in Texas and other oil and agriculture states and the deepening thrift crisis

• Prime or top-tiered issuers• Less default risk• Greater marketability

• Nonprime issuers

Secondary market• Secondary market was very liquid

during 1960s and 1970s• Liquidity is marginal now since

only a few dealers make a market in negotiable CDs

• Large CDs are not as important today as they were in the 1960s and 1970s

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Maturity

Typically less than 1 year• Interest is paid at maturity and based on 360 day year

Some use of term CDs with maturity greater than 1 year• Interest on term CDs is paid semi-annually

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Large Negotiable CDs CD Quotes

Quotes are on a simple interest basis• These are known as “add-on” securities, where the interest earned over the life

of the instrument is added to the initial investment

Illustration:• Suppose that a new-issue CD with principal of $100,000 has a 90-day maturity

and a yield of 5.375%• Its maturity value would be

FV = 100000 x (1 + .05375*(90/360))

= 100000 x (1.013438)

= 101343.75

360

..1

maturityoriginalyieldissueprincipalFV

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Secondary Market Price

The secondary market price of a CD includes the accrued interest.

Take the CD in the previous slide and assume that • 60 days remain until maturity• The quoted secondary market yield is 5.50%

Its price is found by:

360

maturityremaining.kt.yieldsecndary.m1

360

aturityoriginal.mdissue.yiel1

principalPV

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Secondary Market PriceContinued

= 100000 x 1.0134375 /1.009167

= 100000 x 1.004232

= 100423.20

36060

055.1

36090

05375.1100000price

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Repurchase AgreementsCharacteristics

Temporary sale of a security with the agreement to buy it back at a specified date and at a specified price

A repurchase agreement amounts to a collaterialized loan. The seller of the security is the borrower the buyer of the security is the lender

From the buyers point of view, the transaction is a reverse repurchase agreement

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Repurchase Agreements (Repo)

Bank Financing - Source of funds• Security sold under agreement to

repurchase at given price in future.

• Way to include corporate business in Federal Funds market.

• Negotiated market rate.Bank Investment – Reverse Repo

• Security purchased under agreement to resell at given price in future.

• Smaller banks are able to invest excess liquidity in a secured investment.

The interest rate on a repo is lower than the fed funds rate, since it is backed up by a security.

Repos are used by the Federal Reserve in open market operations.

Government securities dealers use repos to secure funds to invest in new Treasury issues.

Banks participate in the repo market to secure funds to meet temporary liquidity needs as well as lend funds when they have excess reserves.

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Credit/Default Risk

If borrower defaults, the lender keeps the collateralLender is protected by

• Over collateralization• Value of the loan is less than the value of the

security sold• Collateral is market to market if the RP is for more than

one day• If value falls below value of the “loan”

• Margin call, i.e., more collateral is supplied

or• The RP is Repriced

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Collateral

Typically Treasury bills

But it can be almost any asset• Treasury coupon• Agency issues• Mortgage bank securities• Commercial paper

Amount of collateral is influenced by the risk inherent in the collateral

• The greater the price risk and credit risk of the collateral the more collateral must be held against the value of the “loan”

Who holds the collateral?• Buyer takes possession; this is often

impractical• Segregated account collateral place

in segregated account and managed by the seller

• Custodial account: collateral is held at the borrower’s (the seller’s) clearing bank

This provides strong protection against default losses.

• However, repo traders still advise that repos should only be conducted with parties that are known to be creditworthy

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Marketability of Repos

• There is no secondary market in repos.• A repo is a loan with specific collateral, which prevents

trading the claim in a secondary market.• The term of the a repo is set to match the timing desired by

the lender, but should the lender need the funds back early, the borrower typically accommodates this need.

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Federal Reserve’s Use of Repos

The Fed conducts open market operations to adjust the money supply. Open market operations are the buying or selling of securities. The Fed does two types of open market operations: (1) permanent and (2) temporary. It uses repos for temporary open market operations because repos automatically reverse itself and therefore are by definition temporary.

Eurodollar DepositsCharacteristics

Characteristics

Term deposits denominated in dollars in banks outside the US

Part of the Eurocurrency market• This is the market for deposits

denominated in a given currency in banks outside the currency’s home country

• Before the Euro, Euro-mark deposits are deposits denominate in marks in banks outside of Germany

• The primary market for Eurocurrencies is very active

Markets

Euro TDs: Eurodollar time deposits• Primary market: directly to

investors• No secondary market

Euro CDs: Eurodollar negotiable CDs• Primary market: directly to

investors or through dealers• Secondary market

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Yields on Eurodollar Deposits Versus Domestic Deposits

Reflect such factors as:

Sovereign risk of country in which the Eurodeposit is held

E,g., UK versus Switzerland

The bank business funded by the Eurodollar deposit compared with the business funded by domestic deposits

Credit risk

Sovereign risk of off-shore lending ventures

FDIC premiums are on domestic deposits, no premiums paid on foreign deposits of US banks

Liquidity of secondary market

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Short-term Government Agency Securities

Short-term debt issued by government agencies and sponsored government agencies on a bank discount basis

• Government agency: agency owned in whole or part by a department of the US Government

• Debt issued by government agencies is guaranteed by the full faith and credit of the US Government

• Sponsored government agency: firm that is publicly chartered (by Congress) but privately owned

• Debt issued by sponsored agencies is guaranteed by the sponsored agency; it is not guaranteed by the US Government

Primary market• Underwriting through investment

banks

Secondary Market• Liquidity varies among issuer• Well developed secondary markets

for short-term debt issued by Federal Land Banks, Federal Intermediary Banks, Banks for Cooperatives, FHLB, and FNMA

• Even with a well-developed secondary market, the rate on agency debt trades at a positive spread to Treasury’s

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Types of Federal Agencies

General types

Farm credit agencies - loans to farmers.

Housing credit agencies - loans and secondary market support for mortgage market.

Other agencies - special purposes.

Federal Financing Bank - purchases securities of agencies and issues its own obligations.

Background

Except for GNMA, marketable agency debt is issued by sponsored agencies

These are not guaranteed by federal government; implied federal guarantee is presumed by many investors

Marketability varies with the development of the secondary market.

Yields are higher than T-Bills.• Slightly greater default risk.• Slightly lower marketability.

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Federal FundsCharacteristics

Traditionally use: Short-term unsecured loans among depository institutions• Federal funds bought: a bank borrows Federal Funds from

another bank; this is a liability on the books of the borrowing banks

• Federal funds sold: a bank lends Federal Funds to another bank; this is an asset on the books of the lending bank

This is a highly liquid market; some see it as the most liquid money market market

The rate on Federal funds is closely related to the conduct of monetary policy

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Federal Funds

Characteristics of Federal Funds• Market for depository

institutions.• Most liquid of all financial assets.• Related to monetary policy

implementation.Yields related to the level of excess

bank reserves.Originally a market for excess reserves

- Now a source of investment (federal funds sold) and continued financing (federal funds purchased).

Most are one-day, unsecured Loans.Bookkeeping entry -interest paid

separately.Traded in Fed Funds or Immediately

Available Funds.

Bank Financing - Source of funds• Federal funds purchased• Short-term (usually overnight)

unsecured borrowing by one bank from another bank.

• A bank liabilityBank Investment – Use of Funds

• Federal funds sold• Short-term (usually overnight)

unsecured loan from one bank to another bank.

• A bank asset.

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Fed Funds Default Risk

• Fed funds trades are unsecured inter-bank loans.• Because the traded funds are part of the settlement process,

the lenders in this market will only accept low risk borrowers. This is accomplished through pre-screening each borrower for a line of credit and only allowing a borrower to acquire Fed funds in amounts available under the line of credit.

Marketability of Fed Funds

• Because Fed funds are interbank loans done under a line of credit for a specific borrower, there is no secondary market in Fed funds.

• Liquidity is achieved by having almost all Fed funds loans have a maturity of one day (often referred to as overnight loans).

Fed funds loans are referred to as overnight loans because historically funds borrowed during a day were repaid at the beginning of the next business day.

However, when the Fed implemented fees for daylight overdrafts, the Fed funds market moved to 24-hour loans where the loan is repaid 24 hours after it was made.

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Short-Term Muni Market

Types• Tax Anticipation Notes• Bond Anticipation Notes• Revenue Anticipation Notes

Primary market: underwritten by dealers or a syndication of dealers

No secondary market

Used to provide working capital or fill short-term funding need

Discount notes may be offered on a continuous basis, much the same as banks offer CDs

Short-term bonds require notification

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