1 / 48

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term. Lecture 3: Money markets. LEARNING OUTCOMES. At the end of the topic the student should understand: Building blocks

sylvia
Download Presentation

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 3: Money markets

  2. LEARNING OUTCOMES At the end of the topic the student should understand: • Building blocks • What the money markets are, how they are used, and the various money market instruments • Key benchmark interest rates, e.g. LIBOR • Interest rates and discount pricing • Repurchase agreements, ‘repos’ • The role of the central bank in the money markets • Analysis: Money markets in the financial crisis of 2007-09 • Main events of the crisis • How a ‘dealer bank’ fails • Impact of loss of money market liquidity

  3. MONEY MARKET • What are money markets? • Markets for short term lending and borrowing • Usually for less than one year • Wholesale rather than retail market • Participants are corporations, financial institutions, governments • Short term liquidity transactions, e.g. • Corporation needs cash for 2 months until a payment arrives • Government needs to meet payroll while facing big seasonal fluctuations in tax receipts • Bank wants to invest money that depositors may withdraw at any moment • C.f. bonds: longer term contracts, usually to finance investment

  4. Money market (cont.) • Money markets bring together these borrowers and investors without intermediation by banks • Webs of borrowers and lenders linked by telephones and computers • Not in a particular place, nor with a single set of rules • Each currency has its own money markets • Interest rates vary between currencies • Foreign currency instruments involve risk from exchange rate fluctuations • Central bank’s (e.g. Bank of England’s) policies determine short-run interest rates for that currency (£)

  5. How money markets operate • Domestic money market • Instruments (securities) denominated in country’s home currency • Overseen by that country’s regulators • International or ‘Euro’ money markets (nothing to do with the €) • Instrument denominated in a foreign currency • Outside jurisdiction of the foreign country’s authorities • Trading • Deals arranged by telephone, then completed electronically • Lots worth tens of millions of £ or $ • Brokers / dealers bring together buyers and sellers • Operate from large banks and specialist trading houses • Some act as market makers: quote buy and sell prices • Enforcement • Private trades: private enforcement only • Clearing house trades: clearing house holds the security on behalf of the buyer; reduces counterparty risk (risk of other side reneging)

  6. MONEY MARKET FUNDS • Individuals and corporations usually invest via money market funds, rather than buying individual securities directly • Diversification • Funds pool money market securities to provide diversification • Savers buy ‘shares’ in the money market fund • Return is a dividend, but in effect an interest rate • Securities equivalent to cash • Usually required by law to invest only in cash equivalents: safety and liquidity similar to cash • Cheaper intermediation than banks • No branch network, no small investors or wider banking services • Spread of a few 1/10ths of 1%; banks’ spread around 2-4%

  7. Money market funds are supposed to be very safe… • 2008 crisis in financial markets • Reserve Primary Fund (a money market fund) had invested in Lehman Brothers short-term debt • Lehman Brothers (investment bank) went bust in Sept 2008 • Reserve Primary Fund was unable to return its investors’ funds • ‘Broke the buck’: Reserve lowered its share price below $1 • Followed by freezing up of money markets • Money markets no longer seen as safe • Hard to find buyers for securities; investors wanted to take their money out • Markets became illiquid: investors could no longer withdraw funds at short notice • Tightening of rules governing money market funds • Greater liquidity; higher credit quality

  8. THE INTERBANK MARKET • Originally, market where banks lent to each other • Participants now include other large institutions: corporations, other financial institutions, international organisations • No secondary trading • Loans are ‘non-negotiable’: lender cannot sell the entitlement to interest to a third party, instead has to wait to recover its money • No collateral • Borrowers are respectable, safe banks

  9. LIBOR: London Interbank Offered Rate • A ‘reference rate’ • (3-month) LIBOR is used as the base rate for many financial transactions • Based on ‘offers’ rather than actual trades • Actual trades may not be sufficiently frequent • British Banking Association (BBA) asks a panel of 16 banks, each day, at what interest rates they could borrow money at various maturities, from overnight to 12 months, for 10 currencies • This is open to manipulation, as demonstrated by recent cases: link • A number of banks and brokers have been prosecuted by competition authorities and financial regulators in the UK, EU, US and elsewhere, for operating cartels that manipulated benchmark rates • Core LIBOR, Euribor, Yen Libor, Swiss Franc Libor • Total penalties for benchmark manipulation stand at $5.8 billion (at 4 Dec 2013, according to the FT) and likely to rise higher: link • LIBOR is now being reformed …

  10. LIBOR rates Exhibit 5.2 LIBOR Rates for 31 December 2010 (expressed as annual equivalent percentages)Source: www.bbalibor.com

  11. LIBOR and Central Bank rates

  12. LIBOR premium over base rate

  13. Other interbank rates • SONIA (Sterling Overnight Interbank Average) • Actual sterling overnight rates • Eurozone • EURIBOR (Euro Interbank Offered Rate): offered rate between banks for periods of one week to one year • EONIA (Euro OverNight Index Average): overnight rate for the € • EURONIA (Euro Overnight Index Average): UK equivalent of EONIA, overnight rates on € deposits in London • USA • Federal Funds Rate (fed funds): overnight interbank rate • Prime rate: interest rate charged to best corporate customers • Others • Japan: TIBOR (Tokyo Interbank Offered Rate) • Singapore: SIBOR • Hong Kong: HIBOR

  14. EUROCURRENCY • Currency is deposited and lent outside the jurisdiction of the country that issued the currency • Nothing to do with the Euro (€) • Eurodollar: $ held in e.g. a Swiss bank (though the term ‘Eurodollar’ is often used generally to mean any Eurocurrency) • Eurocurrency markets grew in 1950s & 1960s • Other countries wary of depositing dollars in US banks: US regulations & tax; fear of seizure for political reasons • Eurocurrency: short-term (< one year) deposits and loans • Eurocredit: market in medium- and long-term loans • Interest rates usually linked to LIBOR • e.g. 3-month LIBOR + 150 basis points (1/100th of 1%) • Floating interest rate

  15. Benefits of Eurosecurities • Lower cost, in both transaction costs and rates of return • Less regulation • Ability to hedge foreign currency movements • National markets may not be able to provide the same volume of finance

  16. INTEREST RATES AND PRICES • Given their short maturities, most money market instruments do not pay interest during their lifetimes • Interest usually comes from discount pricing • Borrower sells an instrument which carries the promise to pay, e.g. £10 million in 30 days’ time • Investor pays say £9.9 million for this: i.e. less than face value • Discount = face value – purchase price • Yield (to maturity) = rate of interest gained by holder when instrument reaches maturity and pays its face value • Prices move inversely to changes in short-term interest rates • A higher interest rate is reflected in larger discount to face value, i.e. lower price paid for the instrument

  17. Secondary markets • Many money market instruments may be sold on to another investor: they are ‘negotiable’ • E.g. after 20 days, the original lender could sell this promise to pay £10 million in a further 10 days for £9.96 million • If it sells this for £9.87 million then it makes a £30,000 loss • Secondary markets make money market instruments liquid

  18. TYPES OF MONEY MARKET INSTRUMENTS • Treasury bills • Government agency notes • Local government notes • International agency paper • Commercial paper • Bills of exchange / bankers’ acceptances • Certificates of deposit (‘Note’ = short-term debt instrument)

  19. Treasury bills • Securities with maturities of one year or less issued by national governments • Often called T-billsor Treasury notes • Maturities of one month (28 days), three months (91 days), six months (182 days) or twelve months • Issued at weekly tenders by Debt Management Office (DMO) • Sold by competitive tender to banks • Negotiable securities: can be (and are) sold on to other investors • Sold at a discount to par value • Par value of £100 • Competitive tender determines price paid (typically < £100) • Governments choose mix of maturities • Short term borrowing may be necessary if country has history of high inflation and investors are wary of its long term bonds

  20. Exhibit 5.4 DMO Treasury bill tender results, February 2011Source: www.dmo.gov.uk

  21. Government-related issues • Government agency notes • Short term debt issued by national government agencies and government-sponsored corporations • E.g. development banks, housing finance corporations, education lending agencies, publicly-owned utilities • Local government notes • Issued by state, provincial or local governments & their agencies (e.g. schools authorities, transport commissions) • Ability to issue money market securities varies across countries • Widely used in the US, Brazil and Canada, not common in the UK • Commonly used to manage highly seasonal tax receipts • International agency paper • Short-term debt issued by international agencies, e.g. World Bank, Inter-American Development Bank, owned by member governments

  22. Commercial paper • Unsecured short-term instrument of debt • Issued primarily by corporations (private and government) • Buyers include other corporations, insurance companies, pension funds, governments and banks • Promissory note (an IOU): promises to the holder a sum of money to be paid in a set number of days • Average maturity of about 40 days • Normal range is 30–90 days, but can be as long as 270 days • Normally issued at a discount • Available only to the most respected corporations • Secondary market is weak or non-existent

  23. US commercial paper (USCP) • Largest commercial paper market in the world • February 2011: $1,041 billion • Down from pre-crisis peak of $2,200 billion (in Aug 2007) • Of this, $355.8 billion was US asset-backed commercial paper (ABCP) • Secured on the collateral of assets such as receivables, e.g. mortgage, credit card, vehicle loan payments • Because its maturity is less than 270 days, commercial paper does not have to be registered with the Securities and Exchange Commission (SEC) • Largest US-based issuers: General Electric Co., Citigroup Inc., Bank of America Corp. and Morgan Stanley

  24. Bills of exchange and bankers’ acceptances • Bills of exchange / bankers’ acceptances • Used to make payments in international trade • Company wishes to export goods to buyer in another country: how can it be guaranteed payment? • Bills of exchange • Exporter draws up bill of exchange (or trade bill) showing amount owed by the buyer and the due date • Buyer (importer) accepts this, signing a promise to pay • Exporter may either hold this to maturity, or sell it (at a discount) to a bank • Bankers’ acceptance • Promise to pay is made by the importer’s bank rather than the importer itself

  25. Certificates of deposit (CDs) • Also known as time deposits • Used by corporations, governments and money market funds to invest cash for short periods • Bank issues a certificate stating that a (time) deposit has been made, and that the bank will pay a higher amount on the maturity date • Maturities of between a week and a year (typically 1–4 months) • Term securities: penalty on saver withdrawing before the maturity date • CD may be negotiable or non-negotiable • Negotiable CD can be traded in a secondary market: liquidity • CDs issued in lots of £50,000 to £500,000 in the UK, or $100,000 to $1 million in the US

  26. CREDIT RATINGS (more in Lecture 5) • Credit-worthiness of borrowers is important in money markets • Credit rating agencies evaluate borrowers and individual securities, and issue a rating indicating risk of default • 3 major CRAs: Moody’s, Standard & Poor’s (S&P), Fitch • Ratings usually paid for by the borrower • Ratings given to governments, agencies, corporations • Investment grade • Long-term bonds: AAA (‘triple A’) to BBB- ; Aaa to Baa3 • Short-term instruments: P-1 to P-3; A-1+ to A-3; F1+ to F3 • Many institutional investors permitted to invest only in investment-grade instruments • High-yield or ‘junk’ bonds: below investment grade • Long-term: BB+ to D; Ba1 to C • Short-term: B to D; not prime; medium or low grade

  27. Exhibit 5.9 Credit rating systems

  28. REPOS • Repurchase agreement, ‘repo’ • A form of securitised borrowing for a few days • Combination of two transactions: sale and repurchase • Dealer sells securities it owns to an investor, for cash • Also promises to buy back the securities at a specified (higher) price at a future date • Reverse repo: dealer buys securities from an investor and promises to sell them back at a later date at an agreed price • ‘Haircut’ • Difference between initial and repurchase prices • Gives the investor some protection in case the securities (collateral) fall in value before repurchase • Regularly used by banks and other financial institutions to borrow money from each other • Term is usually between 1 and 14 days

  29. Use of repos • Interest rate is lower than for unsecured loans • Collateralised with government-backed securities, e.g. T-bills • Allows banks & financial institutions to gain liquiditywhile holding large inventories of money market securities • Reverse repo: borrowing the security • May be used to cover a short position • May be used as part of a deal to profit from interest rate changes • e.g. take out repo in one security and reverse repo in another, in expectation that the relative prices of the two will change • Since 2007-08 financial crisis, investors reluctant to accept non-government securities as collateral for repos • Decline in repo activity has limited banks’ ability to lend, affecting the real economy

  30. Exhibit 5.10 Repo rates in February 2011Source: www.bbalibor.com

  31. ROLE OF CENTRAL BANKS • The central bank plays important roles in the money markets • Open market operations • The central bank sells and purchases government debt • This adds money to or removes money from the banking system, which encourages or inhibits banks’ lending • Often now done through repo arrangements • Central bank interest rates • Central bank lends directly to financial institutions at posted rates • UK: base rate • US, Japan: discount rate • Provides liquidity (lender of last resort) • Often less attractive than private loans

  32. COMPARING INTEREST RATES • Observations can be made about the interest rate on different money market instruments • Investors generally require higher return for longer lending periods • The credit rating of the borrowing institution has a strong influence on the rate of interest charged • When expectations about future inflation rise, interest rates rise accordingly, which leads to a decrease in the market price of money market instruments • Money market interest rates with similar terms to maturity stay close together and move up or down with quite a high degree of correlation over time • Short-term interest rates can be lowered by central bank interventionin the markets

  33. Exhibit 5.15 UK average interest rates 1981–2011, per cent annualised rateSource: www.bank of England.co.uk

  34. Exhibit 5.16 US average interest rates 1981–2011, per cent annualised rateSource: www.federalreserve.gov

  35. MONEY MARKETS IN THE FINANCIAL CRISIS Read Gorton & Metrick (JEL 2012): Getting Up to Speed on the Financial Crisis • During 2000s: credit boom, steep rises in house prices (US, UK & elsewhere), global imbalances in foreign trade • Early 2007: problems emerging in US sub-prime mortgagemarket, failures of several subprime mortgage originators • August 2007: runs in several short-term money markets previously considered ‘safe’ • Start of a sequence of runs and failures [next] • Subprime mortgage losses triggered the crisis, but these do not account for its magnitude or the widespread effects • Amplification of prospective subprime losses into financial crisis • Disruptions to financial markets & institutions were far more damaging than the subprime losses themselves

  36. Major events • Jan-July 2007: • Bankruptcies of several subprime mortgage underwriters • Downgrades of mortgage-backed securities by rating agencies • August 2007: Problems start to affect money markets • Haircuts on repo collateral rise, issuers of ABCP struggle to roll over outstanding paper; large investment funds in France freeze redemptions • Aug 17, 2007: run on US subprime originator Countrywide • Sept 9, 2007: run on UK bank Northern Rock; nationalised in March 2008 • March 11, 2008: Fed creates Term Securities Lending Facility to promote liquidity • March 16, 2008: Bear Stearns fails, Fed brokers takeover by JPMorgan Chase • Sept 7, 2008: US govt takes over Fannie Mae & Freddie Mac (mortgage securitisers) • Sept 15, 2008: Lehman Brothers files for bankruptcy; problems escalate into global crisis • Sept 16, 2008: • Reserve Primary Fund ‘breaks the buck’, causing run on money market funds • Fed Reserve bails out AIG, an insurer • Sept 19, 2008: US govt & Fed act to guarantee money market funds and provide liquidity • Oct 3, 2008: US govt approves Troubled Asset Relief Program, with $700bn of funding • Oct 8, 2008: Central banks in US, UK, the ECB & others cut interest rates • Oct 13, 2008: European govts announce bank recapitalisation plans

  37. Vulnerabilities • According to Ben Bernanke (cited by Gorton & Metrick) • Systemic vulnerabilities due to changes in the financial sector • Financial crisis was a bank run, but in money markets, where • bank-like debt products • provided to institutional investors • by financial institutions who were mostly ‘shadow banks’, not regulated deposit-taking institutions • Problems affected mainly short-term debt • repo agreements • commercial paper • These markets had grown enormously in the 4-5 years before 2007, were now large, and unregulated • IMF estimates outstanding repo in US at 20-30% of US GDP in each of the years 2002-2007 • Higher still in EU: low of 30%, peak >50% of EU GDP, in same period

  38. Runs on dealer banksDuffie (JEP 2010): The Failure Mechanics of Dealer Banks • Dealer bank: intermediary in markets for securities and derivatives, e.g. • JPMorgan • Goldman Sachs • UBS • BNP Paribas • Citigroup • Barclays Capital • HSBC Group • Royal Bank of Scotland • Failures of dealer banks in 2008 • Bear Stearns • Lehman Brothers

  39. What do dealer banks do?(1) Securities dealing, underwriting and trading • Dealer bank acts as intermediary in securities markets • between issuers and investors in securities in primary markets • between investors in secondary markets • Sets ‘bid’ and ‘offer’ prices at which it will trade • Makes a profit from difference between bid and offer prices • Intermediate large block trades in exchange-traded markets • Intermediate repo markets • May also trade on its own account: proprietary (‘prop’) trading • To settle their trades, dealer banks have clearing accounts with other banks, e.g. JPMorgan Chase, Bank of New York Mellon • Counterparty risk may be mitigated by involving a third party • Usually a clearing bank that holds the collateral and is responsible for returning cash to the creditor (e.g. ‘tri-party repos’)

  40. (2) Over-the-counter derivatives • OTC trades are • Privately negotiated, not on an exchange • Counterparty is usually a dealer bank • Dealer usually covers most/all of the risk of its derivatives positions by running a ‘matched book’, i.e. offsetting trades • Makes a profit from bid-offer spread • Two main forms of risk • Contingent payments: derivatives contract passes money from one party to the other, contingent on some event (e.g. movement in a stock price or interest rate) • Counterparty risk: other party may fail to pay up (default) • This risk may be reduced by collateral, e.g. an amount of cash or safe securities that is posted • During the 2007-08 financial crisis both the amount and quality of collateral demanded went up

  41. (3) Prime brokerage & asset management • Prime brokerage • A range of services provided to hedge funds and other large investors, in return for fees • e.g. clearing, cash management, securities lending, management of securities holdings, financing, reporting (e.g. accounting) • May act as derivatives counterparty to prime-brokerage clients • At end-2007 most prime brokerage provided by 3 large players: Morgan Stanley, Goldman Sachs and Bear Stearns • Asset management • Manage investments of institutions (e.g. pension funds) and wealthy individuals • e.g. holding securities, cash management, brokerage • Management of its own investment vehicles: internal hedge funds and private-equity partnerships

  42. (4) Off-balance sheet financing • Dealer bank sets up a ‘special purpose entity’ to finance a scheme • E.g. originate or purchase mortgages & other loans by selling these to a financial corporation set up for this purpose • SPE pays the sponsoring bank for these assets by issuing debt to third-party investors • Principal and interest on this debt is paid out of cash flows from the assets bought from the sponsoring bank • ‘Off-balance sheet’ • debt obligations of SPE are contractually remote from sponsoring bank • bank may not be required to treat SPE’s assets & obligations as its own for accounting and regulatory purposes (e.g. capital requirements) • ‘Structured investment vehicle’ • A particular form of SPE used to finance mortgages & other loans with short-term debt sold to e.g. money-market funds • Hit by solvency concerns when US house prices fell in 2007-08 and subprime mortgage defaults rose

  43. How does a dealer bank fail? • Similar to a depositor run at a commercial bank • Fears over a dealer bank’s solvency cause other parties to try to reduce their potential losses if it defaults • Flight of short-term creditors • Loss of prime-brokerage clients • Cash-draining actions by derivatives counterparties • Loss of clearing-bank privileges • The following explain how these actions by other parties contribute to the failure of a dealer bank

  44. (1) Flight of short-term creditors • Dealer banks finance their assets using short-term funds • Issuing bonds and commercial paper; short-term repo agreements • normal operation: daily renewal of overnight repos, av. haircut <2% • Counterparties: money-market funds, securities borrowers, other dealers • If there are concerns over bank’s solvency • Little incentive for repo creditors to renew these contracts • while collateral gives some security, some creditors may have to sell this immediately if regulation prevents holding this type of asset • If many repo creditors fail to renew, bank may be unable to finance its assets and be forced to sell them • ‘fire sale’: forced selling in a hurry, buyers know this and prices fall • lower prices may produce a ‘death spiral’, e.g. lower market value of securities still held by the bank, reducing the amount it may raise against these in repo agreements • In a general financial crisis, haircuts on repos increase • Following Lehman’s failure, haircuts rose from <5% to around 20% even on investment-grade corporate bonds

  45. (2) Loss of prime-brokerage clients • Dealer bank may be able to use cash and securities in prime-brokerage accounts for its own business purposes • Regulations may or may not prevent commingling of bank’s own assets and its clients’ accounts • if not, bank may use clients’ assets for e.g. secured borrowing • Even if clients’ cash is segregated, it may be aggregated across many clients in a single pool • one client’s cash may be used to meet cash demand of another • Imperfect protection of prime-brokerage accounts may cause clients to move elsewhere is a bank’s position is weak • Loss of prime brokerage clients causes several problems • Loss of client assets to use as collateral for securities lending • Loss of flexibility in meeting clients’ cash demands • Even if clients remain with the bank, loss of confidence might undermine the bank’s ability to obtain cash (using client assets as collateral), making it difficult to meet clients’ cash demands

  46. (3) Actions of derivatives counterparties • Counterparties to OTC derivatives may try to reduce their exposure to a potential bank failure by • Borrowing from the bank • Entering new trades that force the bank to pay out cash for a derivatives position • Cashing in derivatives positions that are in their favour • These actions reduce the bank’s cash position • Failure to accept these trades would signal the bank’s weakness • Ask another dealer for a ‘novation’ • The other dealer takes on the risk of the bank’s default • This may spread alarm, causing others to take defensive actions • Increased collateral on OTC derivatives contracts • Derivatives agreements allow counterparties to request more collateral if bank’s credit rating is downgraded below a certain level

  47. (4) Loss of clearing-bank privileges • The dealer bank’s clearing bank may refuse to process its transactions • Usually, clearing bank grants ‘daylight overdraft privileges’ to its creditworthy clearing customers • e.g. cash could be wired to settle a securities trade before the cash actually appears in the dealer bank’s clearing account on that day • If a dealer bank’s liquidity becomes uncertain, the clearing bank has a ‘right of offset’ • this allows it to discontinue cash payments that would reduce the account holder’s cash balance below zero during the day • E.g. Lehman’s default • Lehman’s clearing bank, JPMorgan Chase, reportedly invoked its right of offset, refusing to wire cash to settle Lehman’s trades with its counterparties, triggering its bankruptcy

  48. IMPACT OF LOSS OF MONEY MARKET LIQUIDITY • Loss of money market liquidity hit financial institutions that relied on short-term funding from the money markets • E.g. Northern Rock, a retail bank in the UK • Hit by loss of money market liquidity in August 2007 • Northern Rock had an unusually high reliance on wholesale funding (rather than deposits) to fund its mortgage and other lending • Much of this funding was short-term • Experienced a (retail) bank run in September 2007 • triggered by BoE’s announcement on 14 Sept of central bank support • Performance of its mortgage book was above industry average • NR had virtually no subprime lending • Nationalised by UK government in March 2008 • See Hyun Song Shin (JEP 2009): Reflections on Northern Rock

More Related