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Chapter Outline Money market securities  Institutional use of money markets  Valuation of money market securities  Risk of money market securities  Interaction among money market yi

Chapter 6

Money Markets

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning All rights reserved.

Chapter Outline

 Money market securities

 Institutional use of money markets

 Valuation of money market securities

 Risk of money market securities

 Interaction among money market yields

 Globalization of money markets

Money Market Securities

to obtain short-term funds

government agencies that have funds

available for a short-term period

Money Market Securities (cont’d)

 Treasury bills:

the federal government and are free of default risk

government security dealers

Money Market Securities (cont’d)

 Investors in Treasury bills

 Depository institutions because T-bills can be easily liquidated

 Other financial institutions in case cash outflows exceed cash inflows

 Individuals with substantial savings for liquidity purposes

 Corporations to have easy access to funding for unanticipated(dung truoc, huong truoc) expenses

Money Market Securities (cont’d)

 Pricing Treasury bills

 The price is dependent on the investor’s required rate of return:

 Treasury bills do not pay interest

 To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested

n

P  Par /( 1  )

Computing the Price of a

Treasury Bill

A one-year Treasury bill has a par value of

$10,000 Investors require a return of 8 percent

on the T-bill What is the price investors would

be willing to pay for this T-bill

?

259 ,

9

$

) 08 1 /(

000 ,

10

$

) 1

Money Market Securities (cont’d)

 Treasury bill auction

 Investors submit bids on T-bill applications for the maturity of their choice

 Applications can be obtained from a Federal Reserve district

or branch bank

 Financial institutions can submit their bids using the Treasury

Automated Auction Processing System (TAAPS-Link)

 Institutions must set up an account with the Treasury

 Payments to the Treasury are withdrawn electronically from the account

 Payments received from the Treasury are deposited into the account

Money Market Securities (cont’d)

 Treasury bill auction (cont’d)

 Weekly auctions include 13-week and 26-week T-bills

 4-week T-bills are offered when the Treasury anticipates a short-term cash deficiency

 Cash management bills are also occasionally offered

 Investors can submit competitive or noncompetitive bids

 The bids of noncompetitive bidders are accepted

 The highest competitive bids are accepted

 Any bids below the cutoff are not accepted

 Since 1998, the lowest competitive bid is the price applied to all competitive and noncompetitive bids

Money Market Securities (cont’d)

 Treasury bills (cont’d)

 T-bills are sold at a discount from par value

 The yield is influenced by the difference between the selling price and the purchase price

 If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price

Money Market Securities (cont’d)

 Estimating the yield (cont’d)

 The annualized yield is:

 Estimating the T-bill discount

 The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:

n PP

PP SP

Y T   365

n

PP 360 Par

Par discount

bill -

Computing the Yield of a

91

365 782

, 9

782 ,

9 000 ,

PP SP

YT

Estimating the T-Bill Discount

Using the information from the previous example, what is the T-bill discount

?

% 62 8

91

360 000

, 10

782 ,

9 000

, 10

360 Par

Par discount

bill - T

Money Market Securities (cont’d)

 Commercial paper:

 Is a short-term debt instrument issued by well-known,

creditworthy firms

 Is typically unsecured

 Is issued to provide liquidity to finance a firm’s investment in

inventory and accounts receivable

 Is an alternative to short-term bank loans

 Has a minimum denomination of $100,000

 Has a typical maturity between 20 and 270 days

 Is issued by financial institutions such as finance companies and bank holding companies

 Has no active secondary market

 Is typically not purchased directly by individual investors

Money Market Securities (cont’d)

Money Market Securities (cont’d)

 Volume of commercial paper:

 Has increased substantially over time

 Is commonly reduced during recessionary periods

 Placement

 Some firms place commercial paper directly with investors

 Most firms rely on commercial paper dealers to sell it

 Some firms (such as finance companies) create in-house departments to place commercial paper

Money Market Securities (cont’d)

 Backing commercial paper

 Issuers typically maintain a backup line of credit

 Allows the company the right to borrow a specified maximum amount of funds over a specified period of time

 Involves a fee in the form of a direct percentage or in the form

of required compensating balances

 Estimating the yield

 The yield on commercial paper is slightly higher than on a bill

T- The nominal return is the difference between the price paid and the par value

Estimating the Commercial

120

360 289,000

289,000 -

Money Market Securities (cont’d)

 The commercial paper yield curve:

 Illustrates the yield offered on commercial paper at various maturities

 Is typically established for a maturity range from 0 to 90 days

 Is important because it may influence the maturity that is used by firms that issue CP

 Is similar to the short-term range of the Treasury yield curve

 Is affected by short-term interest rate expectations

 Is similar to the yield curve on other money market instruments

Money Market Securities (cont’d)

 Negotiable certificates of deposit (NCDs):

depository institutions as a short-term source of funds

year

Money Market Securities (cont’d)

(cont’d)

 Placement

 Directly

 Through a correspondent institution

 Through securities dealers

Money Market Securities (cont’d)

 Negotiable certificates of deposit (NCDs) (cont’d)

 NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price

 If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate

Money Market Securities (cont’d)

 Repurchase agreements

 One party sells securities to another with an agreement to

repurchase them at a specified date and price

 Essentially a loan backed by securities

 A reverse repo refers to the purchase of securities by one party

from another with an agreement to sell them

 Bank, S&Ls, and money market funds often participate in repos

 Transactions amounts are usually for $10 million or more

 Common maturities are from 1 day to 15 days and for one,

three, and six months

 There is no secondary market for repos

Money Market Securities (cont’d)

 Some companies use in-house departments

 Estimating the yield

 The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with

a 360-day year

Estimating the Repo Yield

An investor initially purchased securities at a price

of $9,913,314, with an agreement to sell them

back at a price of $10,000,000 at the end of a

90-day period What is the repo rate

?

% 50 3

90

360 9,913,314

314 ,

913 ,

9 000

, 000 ,

10

360 rate

PP SP

Money Market Securities (cont’d)

 The federal funds market allows depository

institutions to lend or borrow short-term funds from

each other at the federal funds rate

 The rate is influenced by the supply and demand for funds in the federal funds market

 The Fed adjusts the amount of funds in depository institutions to influence the rate

 All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions

 The fed funds rate is typically slightly higher than the T-bill rate

Money Market Securities (cont’d)

 Two depository institutions communicate directly

through a communications network or through a

federal funds broker

 The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institution’s reserve account by the amount of the loan

 Commercial banks are the most active participants in the federal funds market

 Most loan transactions are or $5 million or more and usually have one- to seven-day maturities

Money Market Securities (cont’d)

 Banker’s acceptances:

 Indicate that a bank accepts responsibility for a future payments

 Are commonly used for international trade transactions

 An unknown importer’s bank may serve as the guarantor

 Exporters frequently sell an acceptance before the payment date

 Have a return equal to the difference between the discounted price paid and the amount to be received in the future

 Have an active secondary market facilitated by dealers

Money Market Securities (cont’d)

 Steps involved in banker’s acceptances

 First, the U.S importer places a purchase order for goods

 The importer asks its bank to issue a letter of credit (L/C)

on its behalf

 Represents a commitment by that bank to back the payment owed to the foreign exporter

 The L/C is presented to the exporter’s bank

 The exporter sends the goods to the importer and the shipping documents to its bank

 The shipping documents are passed along to the importer’s bank

Sequence of Steps in the Creation

1 Purchase Order

5 Shipment of Goods

2 L/C Application

3 L/C 7

Institutional Use of Money Markets

 Financial institutions purchase money market securities

to earn a return and maintain adequate liquidity

 Institutions issue money market securities when

experiencing a temporary shortage of cash

 Money market securities enhance liquidity:

 Newly-issued securities generate cash

 Institutions that previously purchased securities will generate cash upon liquidation

 Most institutions hold either securities that have very active

secondary markets or securities with short-term maturities

Institutional Use of Money Markets (cont’d)

outflows maintain additional money market

securities

creditor to the initial issuer

instruments to obtain cash

financial institutions

Valuation of Money Market

Securities

 For money market securities making no

interest payments, the value reflects the

present value of a future lump-sum

payment

by investors

Valuation of Money Market

Securities (cont’d)

 The price of a noninterest-paying money market

( and

Valuation of Money Market

Valuation of Money Market

Securities (cont’d)

 Indicators of future money market security prices

 Economic growth is monitored since it signals changes in

short-term interest rates and the required return from

investing in money market securities

Risk of Money Market Securities

 Because of the short maturity, money market

securities are generally not subject to interest rate

risk, but they are subject to default risk

 Investors commonly invest in securities that offer a slightly

higher yield than T-bills and are very unlikely to default

 Although investors can assess economic and firm-specific

conditions to determine credit risk, information about the

issuer’s financial condition is limited

 Measuring risk

 Money market participants can use sensitivity analysis to

determine how the value of money market securities may

change in response to a change in interest rates

Interaction Among Money Market

Yields

each other

 Market forces will correct disparities in yield and

the yields among securities tend to be similar

investors tend to shift from risky money

market securities to Treasuries

 Flight to quality

 Creates a greater differential between yields

Globalization of Money Markets

 Interest rate differentials occur because geographic

markets are somewhat segmented

 Interest rates have become more highly correlated:

 Conversion to the euro

 The flow of funds between countries has increased because

of:

 Tax differences

 Speculation on exchange rate movements

 A reduction in government barriers

 Eurodollar deposits, Euronotes, and Euro-commercial paper

are widely traded in international money markets

Globalization of Money Markets

(cont’d)

 Eurodollar deposits and Euronotes

 Eurodollar certificates of deposit are U.S dollar deposits

in non-U.S banks

 Have increased because of increasing international trade and historical U.S interest rate ceilings

 In the Eurodollar market, banks channel deposited funds to

other firms that need to borrow them in the form of

Eurodollar loans

 Typical transactions are $1 million or more

 Eurodollar CDs are not subject to reserve requirements

 Interest rates are attractive for both depositors and borrowers

 Rates offered on Eurodollar deposits are slightly higher than NCD rates

Globalization of Money Markets

(cont’d)

 Eurodollar deposits and Euronotes (cont’d)

 Investors in fixed-rate Eurodollar CDs are adversely affected

by rising market rates

 Issuers of fixed-rate Eurodollar CDs are adversely affected

by declining rates

 Eurodollar-floating-rate CDs (FRCDs) periodically adjust to

LIBOR

 The Eurocurrency market is made up of Eurobanks that

accept large deposits and provide large loans in foreign

currencies

 Loans in the Eurocredit market have longer maturities than

loans in the Eurocurrency market

 Short-term Euronotes are issued in bearer form with

maturities of one, three, and six months

Globalization of Money Markets

(cont’d)

 Is issued without the backing of a banking

syndicate

 Has maturities tailored to satisfy investors

 Has a secondary market run by CP dealers

 Has a rate 50 to 100 basis points above LIBOR

 Is sold by dealers at a transaction cost between 5

and 10 basis points of the face value

Globalization of Money Markets

% 1

( ) 1

(     

Computing the Effective Yield

A U.S investor buys euros for $1.15 and invests in

a one-year European security with a yield of 8

percent After one year, the investor converts

the proceeds from the investment back to

dollars at the spot rate of $1.16 per euro What

is the effective yield earned by the investor

?

1 0087

1 08

1

1 )

% 1

( ) 1