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Money Markets PowerPoint PPT Presentation


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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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Money Markets

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6

Money

Markets


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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

  • 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


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Money Market Securities

  • Treasury Bills

  • Commercial paper

  • Negotiable certificates of deposits

  • Repurchase agreements

  • Federal funds

  • Banker’s acceptances


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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


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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


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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


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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


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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)


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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


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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


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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


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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


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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)


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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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