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11. Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds, and Bank CDs. C h a p t e r. Money and Capital Markets. Financial Institutions and Instruments in a Global Marketplace. Eighth Edition. Peter S. Rose. McGraw Hill / Irwin. Slides by Yee-Tien (Ted) Fu.

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money market instruments treasury bills repurchase agreements federal funds and bank cds


Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds, and Bank CDs

C h a p t e r

Money and Capital Markets

Financial Institutions and Instruments in a Global Marketplace

Eighth Edition

Peter S. Rose

McGraw Hill / Irwin

Slides by Yee-Tien (Ted) Fu

learning objectives
 Learning Objectives 
  • To examine the characteristics of Treasury bills and the workings of the government securities market.
  • To learn how securities dealers operate and why they are so important to the functioning of the money market.
  • To understand how banks borrow and lend funds through Federal funds trading and the issuance of CDs.
learning objectives1
 Learning Objectives 
  • To see the impact that the managerial strategy known as liability management has on bank performance and practice in recent years.
  • The money market supplies the cash needs of short-term borrowers and provides savers who hold temporary cash surpluses with an interest-bearing outlet for their funds.
  • In this chapter, we focus on securities dealers and banks, and explore in detail four popular money market instruments – Treasury bills, repurchase agreements, Federal funds, and bank CDs.
u s treasury bills
U.S. Treasury Bills
  • U.S.Treasury bills(T-bills) are direct obligations of the U.S. government that have an original maturity of one year or less.
  • Tax revenues or any other source of government funds may be used to repay the holders of these financial instruments.
  • They carry great weight in the financial system due to their zero (or nearly zero) default risk, ready marketability, and high liquidity.
volume of u s treasury bills outstanding

Total Volume of Bills Outstanding

($ Billions)

Marketable Public Debt of the U.S.

($ Billions)

T-bills as a % of the Total Marketable Public Debt

End of Year

1960 $ 39.4 $ 189.0 20.8 %

1965 60.2 214.6 28.1

1970 87.9 247.7 35.5

1975 157.5 263.2 43.4

1980 216.1 623.2 34.7

1985 399.9 1,437.7 27.8

1990 527.4 2,195.8 24.0

1995 760.7 3,307.2 23.0

2000 646.9 2,966.9 21.8

2001 811.2 2,983.0 27.2

Data Source: Board of Governors of the Federal Reserve System

Volume of U.S. Treasury Bills Outstanding
types of treasury bills
Types of Treasury Bills
  • Regular-series bills are issued routinely every week or month in competitive auctions with original maturities of three months (13 weeks), six months (26 weeks), and one year (52 weeks).
  • Irregular-series bills are issued only when the Treasury has a special cash need. These instruments include strip bills and cash management bills.
how bills are sold
How Bills Are Sold

Source: U.S. Bureau of the Public Debt

calculating the yield on bills
Calculating the Yield on Bills
  • T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value.
  • Bill yields are determined by the bank discount method, which does not compound interest rates and uses a 360-day year for simplicity.
  • The bank discount rate (DR) on T-bills

=Par value – Purchase price360.

Par value Days to maturity

calculating the yield on bills1
Calculating the Yield on Bills
  • Because the rates of return on most other debt instruments are not figured in the same way, comparisons with other securities cannot be made directly.
  • The investment yield or rate (IR) on T-bills

=Par value – Purchase price365.

Purchase price Days to maturity

market interest rates on treasury bills




Data Source: Board of Governors of the Federal Reserve System

Market Interest Rates on Treasury Bills
investors in treasury bills
Investors in Treasury Bills
  • T-bills are held mainly by commercial banks, nonfinancial corporations, state and local governments, and the Federal Reserve banks.
  • Commercial banks and private corporations hold T-bills as a reserve of liquidity.
  • The Federal Reserve banks conduct part of their open market operations in T-bills because of the depth and volume of activity of the market.
primary dealers
Primary Dealers
  • Primary dealers are dealer firms that are qualified to trade securities directly with the Federal Reserve Bank of New York.
  • Primary dealers agree to “meaningfully participate” in trading with the Federal Reserve at any time the Fed wishes, to make “realistic” bids, and to trade continuously in the full range of government securities.
primary dealers1
Primary Dealers
  • Primary dealers have a significant incentive to attempt to corner the government securities market and to collude and place common bids, so that all the dealers can get some share of the new securities to fill their customers’ orders and make a profit.
  • In the wake of a scandal involving Salomon Brothers in 1991, auction rules were tightened and a market-surveillance committee was created.
primary dealers2
Primary Dealers
  • Then in 1998, the U.S. Treasury abandoned its first-price sealed-bid, or English auction approach, in which each successful bidder paid the price that it had bid.
  • It adopted the uniform-price, or Dutch auction method, in which all successful bidders receive securities at the same price – the market-clearing or stop-out price.
dealers in the money market
Dealers in the Money Market
  • The bulk of the dealers’ operating capital is obtained through borrowings from commercial banks and other institutions.
  • The two most heavily used sources of dealer funds are demand loans from the largest banks and repurchase agreements with banks and other lenders.
  • A demand loan may be called in at any time if the banks need cash urgently.
dealers in the money market1
Dealers in the Money Market
  • Under a repurchase agreement (RP), the dealer sells securities to a lender but makes a commitment to buy back the securities at a later date at a fixed price plus interest.
  • RPs are simply a temporary extension of credit collateralized by marketable securities.
  • Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months, …) while continuing contracts may be terminated by either party on short notice.
dealers in the money market2
Dealers in the Money Market
  • Interest income from RPs

= Amount  Current Number of days loaned .

of loan RP rate 360 days

  • Periodically, RPs are marked to market. If the price of the pledged securities has dropped, the borrower may have to pledge additional collateral.
sources of dealer income
Sources of Dealer Income
  • Dealers hope to earn a profit (the positive spread between the bid and ask prices) from their market-making activities.
  • By correctly anticipating interest rate movements, dealers may earn sizable position profits too.
    • If interest rates fall (and security prices rise), dealers will experience capital gains on a long position (but losses on a short position).
sources of dealer income1
Sources of Dealer Income
  • Dealers also receive carry income, the difference between interest earned on the securities they hold and their cost of borrowing funds.
  • In addition, dealers receive miscellaneous service fees for their advice and assistance to customers.
dealer positions in securities
Dealer Positions in Securities
  • Dealer holdings of securities are both huge and subject to erratic fluctuations, due mainly to interest rate movements and expectations.
  • Today, dealers make heavy use of interest rate hedging tools to further protect their portfolios from losses due to changes in interest rates.
    • They are active participants in the financial futures markets and are also making increased use of forward commitments.
government security brokers
Government Security Brokers
  • Government securities dealers usually trade among themselves through brokers.
  • Government security brokers do not take investment positions themselves, but try to match bids and offers placed with them by dealers and other investors.
banks in the money market

Banks’ Money Market Roles

Principal channel for payments for loans, securities & other transactions

Custody agents for safekeeping securities owned by market participants and pledged as collateral for loans

Guarantors of performance & payment

Direct lenders to money market borrowers

Channel for government money & credit policy

Agents in trust for property management on behalf of bank customers

Banks in the Money Market
federal funds
Federal Funds
  • Federal funds are any monies available for immediate payment (i.e. same-day money).
  • They are generally transferred from one depository institution to another by simple bookkeeping entries requested via an on-line computer system, by wire, or by telephone.
  • Federal funds are the principal means of making payments in the money market.
federal funds1
Federal Funds
  • The term federal funds came about because early in the development of the market, the principal source of immediately-available money was the reserve balance that each Federal Reserve System member bank had to keep at the Federal Reserve bank in its region.
  • Today, the federal funds market is broader in scope – some deposits with commercial banks are also available for immediate transfer.
federal funds2
Federal Funds
  • Banks and other depository institutions must hold in a special reserve account liquid assets equal to a fraction of the funds deposited with them by the public.
  • The required legal reserves may be either vault cash or reserve balances with the regional Federal Reserve banks.
  • Since the reserves earn little or no income, most bankers try to lend out excess reserves.
the structure of the federal funds market

Accommodating banks

Funds brokers

Banks & large depositors with excess reserves available (suppliers)

Banks needing more legal reserves & other money market borrowers (demanders)

Supplying additional



excess funds

The Central Bank

The Structure of the Federal Funds Market
federal funds3
Federal Funds
  • Total federal funds borrowings by banks in the U.S. exceeded $600 billion as the 21st century began.
  • Most federal funds loans are either overnight transactions or continuing contracts that have no specific maturity and that can be terminated without advance notice by either party.
  • One-day loans carry a fixed rate of interest, but continuing contracts often do not.
interest rates on federal funds


Federal Funds

3-Month T-Bill

(secondary market)

Data Source: Board of Governors of the Federal Reserve System

Interest Rates on Federal Funds
federal funds4
Federal Funds
  • Beginning 1989, the Federal Reserve has routinely set target levels for the federal funds rate, and raised or lowered those targets depending on whether it wishes to slow down borrowing and spending in the economy or speed them up.
  • Through daily open market operations (buying and selling securities), the Fed is able to push the funds rate in the desired direction.
intended federal funds rate


Actual Federal Funds Rate

Intended Federal Funds Rate

Data Source: Board of Governors of the Federal Reserve System

Intended Federal Funds Rate
negotiable certificates of deposit
Negotiable Certificates of Deposit
  • A certificate of deposit (CD) is an interest-bearing receipt for funds left with a depository institution for a set period of time.
  • True money market CDs are negotiable CDs that may be sold any number of times before maturity and that carry a minimum denomination of $100,000.
  • They were introduced in 1961 to attract lost deposits back into the banking system.
negotiable certificates of deposit1
Negotiable Certificates of Deposit
  • CD interest rates are computed as a yield to maturity (ytm) on a 360-day basis.

Interest =term in daysdeposit  promised

income 360 principal ytm

  • In secondary market trading, the bank discount rate (DR) is used as a measure of CD yields.

DR=Par value – Purchase price360 .

Par value days to maturity

negotiable certificates of deposit2
Negotiable Certificates of Deposit
  • The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions.
  • Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market.
the market structure for negotiable cds







& other


Issue primary market CDs

Funds raised to meet legal reserve requirements and other bank cash needs

Sale of







of CDs at


Buyers in the


CD market

The Market Structure for Negotiable CDs
negotiable certificates of deposit3
Negotiable Certificates of Deposit
  • Bankers are becoming increasingly innovative in packaging CDs to meet the needs of customers.
  • New types of CDs include variable-rate CDs, rollover or rolypoly CDs, jumbo CDs, Yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising-rate CDs, and foreign index CDs.
bank activity in the money market
Bank Activity in the Money Market
  • In the 1960s and 1970s, competition forced major corporations to seek out alternative investments for their short-term funds.
  • Bankers thus turned to the money market for additional funds – negotiable CDs appeared and the federal funds market was broadened.
  • Then, as policies were tightened, many bankers turned to the Eurocurrency market, commercial paper, and RPs.
bank activity in the money market1
Bank Activity in the Money Market
  • All the clever bank maneuvers form part of a technique called liability management.
  • By varying the daily interest rates offered on CDs and other funds sources, bankers can gain a measure of control over their liabilities.
    • If a bank needs more funds on a given day, the bank can simply offer a higher yield on the particular money market instrument that it desires to use.
money and capital markets in cyberspace
Money and Capital Markets in Cyberspace
  • More information about the various money market instruments can be found at:
chapter review
Chapter Review
  • Introduction
  • U.S. Treasury Bills
    • Volume of Bills Outstanding
    • Types of Treasury Bills
    • How Bills Are Sold
    • Calculating the Yield on Bills
    • Market Interest Rates on Treasury Bills
    • Investors in Treasury Bills
chapter review1
Chapter Review
  • Primary Dealers
    • Scandal Rocks the Market for Government Securities
    • A New Way to Auction Government Securities
  • Dealers in the Money Market
    • Reliance on Borrowed Funds
      • Demand Loans and Repurchase Agreements
    • Sources of Dealer Income
    • Dealer Positions in Securities
    • Government Security Brokers
chapter review2
Chapter Review
  • Banks in the Money Market
  • Federal Funds
    • Nature of Federal Funds
    • Use of the Federal Funds Market to Meet Deposit Reserve Requirements
    • Mechanics of Federal Funds Trading
    • Volume of Borrowings in the Funds Market
    • Interest Rates on Federal Funds
    • Federal Funds and Government Economic Policy
chapter review3
Chapter Review
  • Negotiable Certificates of Deposit
    • Terms Attached to CDs
    • Buyers of CDs
    • New Types of CDs
  • Bank Activity in the Money Market