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Money Markets

Money Markets. Defined - The market in which debt (fixed income) instruments with maturities less than one year are traded

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Money Markets

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  1. Money Markets • Defined - The market in which debt (fixed income) instruments with maturities less than one year are traded • Function - They exist because, for most entities, revenues and expenditures do not occur simultaneously. Additionally, there is an opportunity cost associated with holding cash in the form of currency. • Example - Counties collect property taxes in November but they have expenditure needs throughout the year. • Result - They facilitate the transfer of short-term excess funds from suppliers to borrowers

  2. Money Market Securities • Key Characteristics • Maturities less than one year • Short duration of securities limits their potential for price volatility • Generally traded in large denominations • “Round-lot” is considered $1 million or more • Typically high credit quality (low default risk) • A short-term rating of A1 / P1 or better • Traded on an over- the-counter (OTC) market

  3. “Investment Grade” Ratings - S&P Long-Term Ratings Short-Term Ratings Rating Definition A-1+ Highest degree of safety. A-1 Very strong degree of safety. A-2 Strong degree of safety. A-3 Satisfactory degree of safety. Rating Definition AAA Highest rating; extremely strong security. AA Very strong security; differs from AAA in only a small degree. A Strong capacity but more susceptible to adverse economic effects than two above categories. BBB Adequate capacity but adverse economic conditions more likely to weaken capacity. Source: Wells Capital Management – Guideline development presentation

  4. AAA AA+ A-1+ AA AA- A+ A-1 A A- A-2 BBB+ BBB BBB- A-3 BB+ BB B BB- Correlation between Long-term & Short-term ratings - S&P Long-term rating Short-term rating Source: Wells Capital Management – Guideline development presentation

  5. Common money market instruments • Treasury Bills • Short-term obligations issued by the U.S. government • Issued via a weekly auction • The bid process has competitive and non-competitive components • Issued in 3 and 6 month maturities • Until recently there was issued a 1 year T-Bill • Considered to be “risk-free” • Quoted on a discount basis • Discount YieldT-Bill = ((PF - PO)/PF) X (360/days) • 6.92% = ((10,000 - 9,650)/10,000) X (360/182) • Translation to a bond equivalent yield (BEY) • BEYT-Bill = ((PF - PO)/PO) X (365/days) • 7.27% = ((10,000 - 9,650)/9,650) X (365/182)

  6. Treasury Market Snapshot - 02/09/04 Source: Bloomberg

  7. Common money market instruments • Federal Funds (Fed Funds) • Short-term funds transferred between financial institutions • Commercial banks are the primary participants in the Fed Funds market • Borrowing & lending excess reserves that they have at the Fed • Maturity is usually one to seven days • Pay interest once, at maturity • Quoted on a 360 day basis • Translation to a bond equiv yield is: FFbey = iFF (365/360) • A 6% fed funds interest rate equates to a 6.083% bond equivalent yield • Generally, the Fed Funds rate revolves around the “target” rate set by the Federal Reserve • Fed maintains the Fed Funds rate around the target rate through the open market operations discussed in previous lecture

  8. Source: Bloomberg

  9. Common money market instruments • Repurchase Agreements (Repo) • An agreement involving the sale of securities by one entity to another with a promise to repurchase the securities at a specified price and date • Reverse repurchase agreements (Reverse repo) • An agreement involving the purchase of securities by one entity from another with the promise to sell them back at a specified price and date • These are different sides of the same transaction • Title to the securities trades hands for the period of the transaction • Federal Reserve uses repo to conduct its open market operations • iRA = ((PF - PO)/PO) X (360/days) • 6.15% = ((10,008,548 - 10,000,000)/10,000,000) X (360/5) • 6.24% BEY = ((10,008,548 - 10,000,000)/10,000,000) X (365/5) • Repo less liquid than fed funds because collateral needs to be arranged

  10. Common money market instruments • Commercial Paper • Short-term unsecured promissory notes issued by corporations • Largest money market instrument in terms of $’s outstanding • Maturities range from 1 to 270 days • Corporate debt longer than 270 days requires SEC registration • Distributed directly from issuer to investor or through a dealer • Less expensive for the issuer to directly place but • Dealers provide “firm commitment underwriting” to place entire issue • Distribution via electronic interfaces is becoming more common • Issuers of CP and investors in CP are very sensitive to credit quality • Quoted on a discount basis • Discount YieldCP = ((PF - PO)/PF) X (360/days) • 6.92% = ((10,000 - 9,650)/10,000) X (360/182) • Translation to a bond equivalent yield (BEY) • 7.27% BEY = ((10,000 - 9,650)/9,650) X (365/182)

  11. Commercial Paper Distribution Dealer vs. Direct Placement 1991-1999 Source: Federal Reserve Board website

  12. Commercial Paper Yields CP vs. “Prime Rate” 1971 - 1999 Source: Federal Reserve Board website

  13. Goldman Sachs Commercial Paper Inventory - 2/3/03 Source: Bloomberg

  14. Common money market instruments • Asset-backed commercial paper • Fast growing sector of the commercial paper market • Instead of being unsecured, this type of commercial paper has various forms of collateral “backing it up” • Quoted on a discount basis • See notes on Treasury bills and commercial paper

  15. Common money market instruments • Negotiable Certificates of Deposit (NCD’s) • Bank-issued time deposit with a specified interest rate and maturity • NCD’s are bearer instruments • The holder at maturity receives the principal & interest • Became negotiable (“tradeable”) in the 1960’s • Yields are quoted on a 360 day basis • Yield calculation • $1 million, 6 month, 7 percent interest rate • FV = $1,000,000 x (1 + (.07 x (180/360))) = $1,035,000 • Immediately after purchase, yields drop to 6 percent for the same CD • PV = $1,035,000 / (1 + (.06 x (180/360))) = $1,004,854

  16. Common money market instruments • Bankers Acceptances (BA’s) • A time draft payable to a seller of goods, with payment guaranteed by a bank. • Exporter wants a guarantee it will be paid if it ships an order to an importer • US Bank writes letter of credit covering the importer • Exporter takes the credit risk of the bank, not the importer • Exporter can hold the BA for payment in full on the specified date or sell it for a discounted cash payment immediately • The buyer of the BA gets the par value at maturity • BA’s are bearer instruments • Majority of BA’s are originated in New York, Chicago, San Fran • Yields are quoted on a discount basis • See notes on Treasury bills or commercial paper

  17. Money Market Participants • Treasury • Issues treasury notes and bills to fund short-term expenditure needs • Federal Reserve • Buys/Sells treasuries and repos to conduct open market operations • Commercial Banks • Money market participation driven largely by reserve requirements • If a bank is short on reserves it issues money market securities • If a bank has excess reserves it invests in money market securities • Broker / Dealers • Link buyers and sellers of money market instruments • Corporations • Use money markets to raise cash for short-term operational needs • Other financial institutions • Invest in money market securities to maintain large, liquid cash pools

  18. International Aspects of Money Markets • London Interbank Offered Rate (LIBOR) • The rate paid on Eurodollars • Alternative to Fed Funds for short-term (overnight) funding • As a result, LIBOR and Fed Fund rate movements are closely correlated • Typical spread between LIBOR and Fed Funds is .125% • LIBOR typically higher than Fed Funds because of perceived credit risk • Other international money market securities • Euro CD’s • Euro Notes • Euro Commercial Paper

  19. Capital Markets revisited • Capital Markets • Securities with maturities longer than one year • Composed of: • Bond market • Asset-backed market • Equity market

  20. Bond Markets • Defined - The market in which debt (fixed income) instruments with maturities greater than one year are issued and traded • Result - They facilitate the transfer of excess funds from suppliers to borrowers • Traditionally categorized as follows: • Treasuries • Municipal bonds • Corporate bonds

  21. Bond Market Instruments • Treasury notes and bonds • Backed by the full faith and credit of the U.S. government • Note maturities range from 2 - 10 years • Bond maturities range from 10 - 30 years • Pay interest semi-annually • Primary issuance via an auction process • Competitive and noncompetitive bids (like T-bills) • Broker / Dealers maintain a very liquid secondary market • Minimum denomination is $1000 • Treasury STRIPS (Separate Trading of Registered Interest & Principal Securities) • Process whereby the coupon payments and the final principal payment of a bond are separated into individual securities • Dealers initiated this process in 1985 to better meet investors needs and to enrich themselves

  22. Present Value Example Source: Financial Markets & Institutions – Saunders/Cornett

  23. Bond Market Instruments • Municipal Bonds • Securities issued by state and local governments • General obligation bonds • Bonds backed by the full faith and credit of the issuing municipality • Revenue bonds • Bonds sold to finance a specific revenue-generating project and are backed by cashflows from that project • The majority of municipal issuance: • Is exempt from Federal taxes • Some bonds are also exempt from State taxes • Pays interest semi-annually • Taxable equivalent yield calculation • Tax Equiv Yield = Tax Exempt Yield / ( 1 - Tax Rate ) • 2.31% = 1.50% / ( 1 - .35 )

  24. Municipal Bond Example

  25. Municipal Bond Example

  26. Municipal Bond Yield Example 4.52% Yield if called on 6/1/03

  27. Bond Market Instruments • Corporate Bonds • Debt issued by corporations • Term bonds - a bond issue in which the entire issue matures on one date • Serial bonds - bonds that mature in a series of dates • Mortgage bonds - bonds issued to finance a specific project, the project gets pledged as collateral for the bond issue • Equipment Trust Certificates - bonds collaterized with tangible non-real estate property (e.g. - railcars, airplanes) • Debentures - unsecured debt • Subordinated debentures - unsecured debt that are junior in rights to mortgage bonds and debentures • Convertible bonds - bonds that may be exchanged for another security of the issuing firm at the discretion of the bond holder • Callable bonds - bonds that allow the issuer to force the bond holder to sell the bond back to the issuer at a specified price

  28. Present Value Example Source: Financial Markets & Institutions – Saunders/Cornett

  29. Valuation and Accruals • Bond valuation • Vb = PVdisc coups + PVdisc principal • Accrued interest calculation • Par x (Coup/2) x (Days since last coup / Days in coup period) • $1000 x (5%/2) x (21days / 181days) = $2.90

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