CHAPTER 5: MONEY MARKETS

University of San Carlos Department of Accountancy M. M. Mancelita

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DEFINITION AND PURPOSE OF MONEY MARKETS

The Money Markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations, FIs and governments 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 nations supply of liquid funds among major short-term lenders and borrowers
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MONEY MARKET INSTRUMENTS

Treasury Bills

Federal Funds
Repurchase Agreements Commercial Paper Negotiable Certificates of Deposit

Banker Acceptances

Advantage: provides an investment opportunity that generates a higher rate of interest than holding cash, but it is also very liquid and has relatively low default risk.

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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 Virtually default risk free
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CALCULATING T-BILL YIELDS FROM DISCOUNT RATES

iT-bill(dy) = PF - PO PF
Where:

360 h

iT-bill= Annualized yield on the T-bill PF = Price (face value) paid to the T-bill holder PO = Purchase price of the T-bill h = Number of days until the T-bill matures

Example: iT-bill(dy) = $10,000 - $9,905.71 360 = 2.19% $10,000 155

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FEDERAL FUNDS
Short-term funds transferred between FIs, usually for a period of one day Federal Funds rate

the overnight or one day interest rate for borrowing fed funds a focus or target rate in the conduct of monetary policy
Federal Funds Yields

single-payment loans (pay interest only once) Fed fund transactions take the form of short-term (mostly overnight) unsecured loans benchmark interest rate of fed funds among banks
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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 Correspondent banks banks with reciprocal accounts and agreements
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CONVERSION OF FED FUNDS RATE OF I N T E R E S T T O A B O N D E Q U I VA L E N T RATE

ibey = iff (365/360)

The overnight fed funds rate on September 20, 2007, was 4.77 percent the conversion of the fed funds rate to a bond equivalent rate is?

ibey = iff (365/360) ibey = .0477 (365/360)= 4.836%

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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 securities) Reverse repurchase agreement- an agreement involving

the purchase of securities by one party from another with the

promise to sell them bank at a given date in the future.
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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

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REPO TRADING
J.P. Morgan (Repo buyer/ LENDER) Bank of America (Repo Seller/ BORROWER) T- bills

Repurchase of T-bills + interest

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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

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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 The better the credit rating on a commercial paper issue, the lower the interest rate on the issue.

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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 Denominations 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

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TRADING PROCESS FOR NCDS

Banks issuing NCDs 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 CDs rather than new issues
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BANKERS 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

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MONEY MARKET PARTICIPANTS

Instrument Principal Issuer Principal Investor

Treasury bills

U.S. Treasury

Federal funds Repurchase agreement

Commercial Paper Negotiable CDs Bankers acceptances

Commercial banks FRS; Comm banks; Brokers and dealers; Other FIs Comm banks Other FIs; Corps Commercial banks Commercial banks

FRS; Comm banks; MFs Brokers and dealers; Other FIs; Corps Commercial banks FRS, Comm banks; MFs Brokers and dealers Other FIs, Corps Brokers and dealers;MFs Corporations Brokers and dealers;MFs Corps; Other FIs Comm banks; Corps; Brokers and dealers

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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 (LIBOR)

the rate paid on Eurodollars

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COMPUTATIONS
DISCOUNT YIELD for DISCOUNT SECURITIES

idy= [( Pf

Po )/Pf ]x 360/h

BOND EQUIVALENT YIELD for NONDISCOUNT SECURTIES

ibey=[( Pf

Po )/P0 ]x 365/h

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COMPUTATIONS
Effective Annual Return
EAR= ( 1 + i/m) ^ m 1

EAR = (1 + ibey / 365/h) ^ 365/h - 1

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