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6. Money Markets. Chapter Objectives. Provide a background on money market securities Explain how institutional investors use money markets Explain the globalization of money markets. Money Market Securities. Maturity of a year or less

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6

Money

Markets

chapter objectives
Chapter Objectives
  • Provide a background on money market securities
  • Explain how institutional investors use money markets
  • Explain the globalization of money markets
money market securities
Money Market Securities
  • Maturity of a year or less
  • Debt securities issued by corporations and governments that need short-term funds
  • Large primary market focus
  • Purchased by corporations and financial institutions
  • Secondary market for securities
money market securities4
Money Market Securities
  • Treasury Bills
  • Commercial paper
  • Negotiable certificates of deposits
  • Repurchase agreements
  • Federal funds
  • Banker’s acceptances
money market securities5
Money Market Securities
  • Treasury bills
    • Issued to meet the short-term needs of the U.S. government
    • Attractive to investors
      • Minimal default risk—backed by Federal Government
      • Excellent liquidity for investors
        • Short-term maturity
        • Very good secondary market
money market securities6
Money Market Securities
  • Treasury bill auction (fill bids in amount determined by Treasury borrowing needs)
    • Bid process used to sell T-bills
    • Bids submitted to Federal Reserve banks by the deadline
    • Bid process
      • Accepts highest bids
      • Accepts bids until Treasury needs generated

Competitive Bidding

money market securities7
Money Market Securities
  • Treasury bill auction—noncompetitive bids

($1 million limit)

    • May be used to make sure bid is accepted
    • Price is the weighted average of the accepted competitive bids
    • Investors do not know the price in advance so they submit check for full par value
    • After the auction, investor receives check from the Treasury covering the difference between par and the actual price

Noncompetitive Bidding

money market securities8
Money Market Securities
  • Estimating T-bill yield
    • No coupon payments
    • Par or face value received at maturity
    • Yield at issue is the difference between the selling price and par or face value adjusted for time
    • If sold prior to maturity in secondary market
      • Yield based on the difference between price paid for T-bill and selling price adjusted for time
money market securities9
Money Market Securities
  • Calculating T-Bill Annualized Yield

365

SP – PP

YT

=

PP

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)

money market securities10
Money Market Securities
  • T-bill yield for a newly issued security

360

Par – PP

T-bill discount

=

PP

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

money market securities11
Money Market Securities
  • Short-term debt instrument
  • Alternative to bank loan
  • Dealer placed vs. directly placed
  • Used only by well-known and creditworthy firms
  • Unsecured
  • Minimum denominations of $100,000
  • Not a large secondary market

Commercial Paper

money market securities12
Money Market Securities
  • Commercial paper backed by bank lines of credit
    • Bank line used if company loses credit rating
    • Bank lends to pay off commercial paper
    • Bank charges fees for guaranteed line of credit
money market securities13
Money Market Securities
  • Estimating commercial paper yields (same as t-bill)

Par – PP

360

YCP

=

PP

n

YCP= Commercial paper yield

Par = Face value at maturity

PP = Purchase price

n = number of days to maturity

money market securities14
Money Market Securities
  • Issued by large commercial banks
  • Minimum denomination of $100,000 but $1 million more common
  • Purchased by nonfinancial corporations or money market funds
  • Secondary markets supported by dealers in security

Negotiable Certificates of Deposit (NCD)

money market securities15
Money Market Securities
  • NCD placement
    • Direct placement
    • Use a correspondent institution specializing in placement
    • Sell to securities dealers who resell
    • Sell direct to investors at a higher price
  • NCD premiums
    • Rate above T-bill rate to compensate for lower liquidity and safety
money market securities16
Money Market Securities
  • Sell a security with the agreement to repurchase it at a specified date and price
  • Borrower defaults, lender has security
  • Reverse repo name for transaction from lender
  • Negotiated over telecommunications network
  • Dealers and brokers used or direct placement
  • No secondary market

Repurchase Agreements

money market securities17
Money Market Securities
  • Estimating repurchase agreement yields

SP – PP

360

Repo Rate

=

PP

n

Repo Rate= Yield on the repurchase agreement

SP = Selling price

PP = Purchase price

n = number of days to maturity

exhibit 6 5

1

Purchase Order

Importer

Exporter

5

Shipment of Goods

L/C (Letter of Credit) Application

Shipping Documents & Time Draft

L/C Notification

2

4

6

3

L/C

Japanese Bank

American Bank

Shipping Documents &

T

ime Draft

7

(Exporter’s Bank)

(Importer’s Bank)

Draft

Accepted (B/A

Created)

Exhibit 6.5

a

money market securities19
Money Market Securities
  • A bank takes responsibility for a future payment of trade bill of exchange
  • Used mostly in international transactions
  • Exporters send goods to a foreign destination and want payment assurance before sending
  • Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time

Bankers Acceptance

money market securities20
Money Market Securities
  • Exporter 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 total
  • Return is based on calculations for other discount securities
  • Similar to the commercial paper example

Bankers Acceptance

major participants in money market
Major Participants in Money Market
  • Participants
    • Commercial banks
    • Finance, industrial, and service companies
    • Federal and state governments
    • Money market mutual funds
    • All other financial institutions (investing)
  • Short-term investing for income and liquidity
  • Short-term financing for short and permanent needs
  • Large transaction size and telecommunication network
valuation of money market securities
Valuation of Money Market Securities
  • Present value of future cash flows at maturity (zero coupon)
  • Value (price) inversely related to discount rate or yield
  • Money market security prices more stable than longer term bonds
  • Yields = risk-free rate + default risk premium
exhibit 6 7

International

U.S.

U.S.

U.S.

Issuer’s

Issuer’s

Economic

Fiscal

Monetary

Economic

Industry

Unique

Conditions

Policy

Policy

Conditions

Conditions

Conditions

Short-T

erm

Risk-Free

Risk

Interest

Premium

Rate

of Issuer

(T

-bill Rate)

Required Return

on the Money

Market Security

Price of the

Money Market

Security

Exhibit 6.7

a

interaction among money market yields
Interaction Among Money Market Yields
  • Securities are close investment substitutes
  • Investors trade to maintain yield differentials
  • T-Bill is the benchmark yield in money market
  • Yield changes in T-bills quickly impacts other securities via dealer trading
  • Yield differentials determined by risk differences between securities
  • Default risk premiums vary inversely with economic conditions
globalization of money markets
Globalization of Money Markets
  • Money market rates vary by country
    • Segmented markets
    • Tax differences
    • Estimated exchange rates
    • Government barriers to capital flows
  • Deregulation Improves Financial Integration
  • Capital Flows To Highest Rate of Return
globalization of money markets26
Globalization of Money Markets
  • Performance of international securities
  • Effective yield for international securities has two components
    • The yield earned on the investment denominated in the currency of the investment
    • The exchange rate effect
globalization of money markets27
Globalization of Money Markets
  • Performance of international securities
  • Yield for an international investment

SPf – PPf

Yf

=

PPf

Yf= Foreign investment’s yield

SPf = Investment’s foreign currency selling price

PPf = Investment’s foreign currency purchase

globalization of money markets28
Globalization of Money Markets
  • The exchange rate effect (%ΔS) measures the percentage change in the spot during the investment period
    • % ΔS measures the expected percent change in the currency
      • Currency appreciated, % ΔS is positive and adds to net yield
      • Currency depreciated, % ΔS is negative and reduces net yield
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