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Chapter Five. Money Markets. Definition and Purpose of Money Markets. The Money Markets are associated with the issuance and trading of short-term debt obligations of large corporations, FIs and government

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Chapter Five

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  1. Chapter Five Money Markets

  2. Definition and Purpose of Money Markets • The Money Markets are associated with the issuance and trading of short-term debt obligations of large corporations, FIs and government • Only High-Quality Entities can borrow in the Money Markets and individual issues are large • Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon • The Money Markets essentially serve to allocate the nation’s supply of liquid funds among major short-term lenders and borrowers

  3. Money Market Securities • Treasury Bills - short-term obligations issued by the U.S. government • Federal Funds - short-term funds transferred between financial institutions usually for no more than one day • Repurchase Agreements - agreement involving the sale of securities between parties with a promise to repurchase the security at a specific date and price • Commercial Paper - short-term unsecured promissory notes issued by a company to raise short-term cash • Negotiable Certificates of Deposit - negotiable bank-issued time deposit with specific interest rate/maturity • Banker Acceptances - time draft payable to seller of goods with payment guaranteed by a bank

  4. Money Market Instruments Outstanding,December 1990 and 1999 (in billions of dollars) Rate of Return 1990 1999 Amount Outstanding 1990 1999 Treasury bills $527.0 $ 674.8 7.85% 5.23% Federal funds and repurchase agreements 372.3 1,006.1 8.10 5.30 Commercial paper 537.8 1,284.5 8.06 5.87 Negotiable certificates of deposit 546.9 836.8 8.15 6.05 Banker’s acceptance 52.1 8.3 7.93 5.24

  5. Treasury Bill Basics • Issued by the U.S. Treasury to cover government budget deficits and to refinance maturing debt • Standard Original Maturities of 13 weeks, 26 weeks, or 52 weeks • Denominations are $1,000 but typical round lot is $5 million

  6. The Auction Process for T-bills • Amount of new 13-week and 26-week T-bills offered announced weekly • Bids submitted by government securities dealers, financial and nonfinancial corporations and individuals • Competitive bids limited to 35% total issue size, can submit more than one bid, allocations made beginning with highest bidder • Noncompetitive bidders indicate quantity desired and agree to pay weighted-average of the winning competitive bids, get preferential allocation

  7. Treasury Auction Results Bid Price 98.678% Noncompetitive Bids 1 SC ST 2 3 4 98.648% (PNC) (stop-at price low bid accepted) 5 6 7 Quantity of T-bills $11,778.1m $10,581.9m

  8. The Secondary Market for T-bills • The largest of any U.S. money market security • Approximately 30 financial institutions “make” a market in T-bills by buying and selling securities for their own accounts and by trading for their customers, including depository institutions, insurance companies, pensions funds, etc • T-bills are the FOMC’s instrument of choice for its open market operations

  9. Secondary Market T-bill Transaction J.P. Morgan sells $10m. In T-bills Lehman Brothers buy $10m. In T-bills Fedwire Transaction Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan to Lehman Brothers Transaction recorded in Fed’s Book-Entry System Fedwire Transaction FRBNY -$50,000 in T-bills from J.P. Morgan’s account + $50,000 T-bill to Individual Individual buy $50,000 in T-bills J.P. Morgan sell $50,000 in T-bills Local Bank or Broker

  10. T-bill Rates and Yields • No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value • T-bill rates are quoted in Wall Street Journal • Discount Yield • the price dealers are willing to pay T-bill holders to purchase their T-bills for them • Asked • the discount yield based on the current purchase price set by dealers that is available to investors • Spread • the percentage difference in the ask and bid yield, part of transaction cost, the profit for dealers

  11. Calculating T-bill Yields from Discount Rates iT-bill(dy) = PF - PO 360 PF h Where: PF = Annualized yield on the T-bill PO = Price (face value) paid to the T-bill holder h = Number of days until the T-bill matures Example: iT-bill(dy) = $10,000 - $9,650 360 = 6.92% $10,000 182

  12. Federal Funds Basics • Short-term funds transferred between financial institutions, usually for a period of one day • Federal Funds rate • the interest rate for borrowing fed funds • a focus or target rate in the conduct of monetary policy

  13. Trading in the Fed Funds Market • Commercial banks conduct the majority of transactions in the fed funds market • Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds • Fed funds transactions can be initiated by either the lending or borrowing institution or handled through a broker

  14. Repurchase Agreements (RPs or Repos) • An agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price on a specified date • Essentially a collateralized fed funds loan with collateral in the form of securities (e.g. T-bills and Fannie Mae) • Reverse repurchase agreement • involves the purchase of securities between parties with the promise to sell them back at a given date in the future

  15. Trading Process for Repurchase Agreements • Arranged either directly between two parties or with the help of brokers and dealers • The repo buyer arranges to purchase T-bills from the repo seller with an agreement that the seller will repurchase the T-bills within a stated period of time

  16. Commercial Paper • An unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements • The largest (in terms of dollar value) of the money market instruments • Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million with maturities of 1-270 days (if maturity is greater than 270 days, SEC requires registration) • Generally held until maturity so there is not an active secondary market

  17. Trading Process for Commercial Paper • CPs are sold either directly to investors (25%) or indirectly through brokers and dealers such as investment banks or major bank subsidiaries • Selling through brokers more expensive for issuer due to underwriting costs

  18. Negotiable Certificates of Deposits • A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market • Bearer Instrument • whoever holds the CD when it matures receives the principal and interest • Denominations that range from $100,000 to $10 million, $1 million being the most common • Often purchased by money market mutual funds with pools of funds from individual investors

  19. Trading Process for NCDs • Banks issuing CDs post daily rates for the more popular maturities and subject to funding needs, tries to sell to investors who are likely to hold them as investments rather than sell them to the secondary market • In some cases, the bank and investor negotiate the size, rate and maturity • Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues

  20. Banker’s Acceptances • A time draft payable to a seller of goods with payment guaranteed by a bank • Arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) • Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer

  21. Trading Process for BAs 1 Domestic Importer Foreign Exporter 4 9 5 2 10 8 3 6 U.S. Bank Foreign Bank 7 1. Purchase order sent 2. Letter of credit requested 3. Notification of letter credit and draft authorization 4. Order shipped 5. Time draft and shipping papers sent to foreign bank 6. Time draft and shipping papers sent to U.S. bank; BA created 7. Payments sent to foreign bank 8. Payments sent foreign exporter 9. Payment to U.S. bank 10. Shipping papers delivered

  22. Money Market Participants Instrument Treasury bills Federal funds Repurchase agreement Commercial Paper Negotiable CDs Banker’s acceptances Principal Issuer U.S. Treasury Commercial banks FRS, Comm banks Brokers and dealers Other Fis Comm banks Other FIs, Corps Commercial banks Commercial banks Principal Investor FRS, Comm banks Brokers and dealers Other FIs, Corps Commercial banks FRS, Comm banks Brokers and dealers Other FIs, Corps Brokers and dealers Corporations Brokers and dealers Corps, Other FIs Comm banks, Corps Brokers and dealers

  23. International Aspects of Money Markets • While U.S. money markets are the largest, the international market is growing • U.S. securities bought/sold by foreign investors • foreign money market securities • Euro money market instruments • Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP • London Interbank Offered Rate (LIOR) • the rate paid on Eurodollars

  24. Euronotes and Euro CPs Amount outstanding Amount outstanding Type of instrument 1995 1999 Euronotes $45.5 $72.8 Currency type U.S. dollar 27.9 30.6 Euro currencies 0.5 22.8 Japanese yen 0.4 1.5 Other 16.7 17.9 Issuer type FIs 41.4 61.2 Gov/state agencies 0.4 10.5 International Inst 1.2 ---- Corporations 2.5 1.1 Type of instrument 1995 1999 Euro CPs $87.0 $170.9 Currency type U.S. dollar 55.7 84.4 Euro currencies 9.1 52.3 Japanese yen 2.1 2.5 Other 20.0 31.7 Issuer type FIs 40.5 107.4 Gov/state agencies 14.2 15.1 International inst 2.1 5.1 Corporate issuers 30.2 43.2