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Money Market Risk ManagementBlackwell, Griffiths and Winters, Chapter 12, and other material

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Introduction to MM Risk Management

Managing risk in the money markets is very different from managing risk in the other financial markets

• Why? The unique role of the money markets as markets for trading liquidity.

• Result: most of the risk management in money markets occurring before the investment is made instead of during ownership.

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Trading Liquidity

Market for liquidity creates a unique environment for managing risk.

• Short-term investment where safety outweighs return

• Invested funds is at risk over the life of the investment

Result: investors analyze the borrowers and the market mechanisms before the investmentWhy? to ensure that the risk exposure of their cash is at a minimum.

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Risks and MM Investors

Investors storing a temporary cash surplus

Focus is on the protection of their cash

Leads to concerns about two types of risk:

• liquidity risk and

• default risk.

Liquidity Risk

Background on LiquidityLiquidity is the degree that a asset can

be converted into cash or another asset

An asset is considered highly liquid if it can be quickly converted to cash without a major price concession.

Money market investors are concerned about liquidity because they are storing temporary cash surpluses

Result: money market investors require high degree of liquidity.

Components to liquidity managementBorrower has a contractual obligation

to return the investor’s cash a specific point in time

Investors may need their cash sooner than expected

• Needs a highly liquid secondary market

• Needs a market where money market investors can quickly sell their securities without a price concession.

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Liquidity Risk Secondary Market

A dealer market

• Dealers stand ready to trade (‘make a market’) at their quoted bid and ask prices.

May not need large trading volume IF dealers stand ready to trade.

Dealers stand ready to trade by quoting bid and ask prices for

• T-bills • Negotiable CDs• Bankers’ acceptance• Short-term agency debt.Only very limited trading in

commercial paper

In repurchase agreements (repos) and Fed funds the nature of the transactions precludes a secondary market

• The need for liquidity is addressed by having the majority of the instruments have a maturity of one day

• Investors get their cash back each day and can decide each day whether to loan the cash or hold the cash.

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Default Risk

The general definition of default is when a borrower fails to meet any part of the debt contract. In long-term debt default often occurs because of the violation of a contract covenant.

The short-term nature of the money markets precludes the need for covenants, so default in the money market is associated with failure to make the scheduled payment.

Default Risk

Government and Agency Default Risk

Treasury bills are considered default-free because they are backed by the full faith and credit of the U.S. government.

Federally-owned agency debt is also default-free because these agency are part of the federal government.

Federally-sponsored agency debt is not default-free because these agencies are privately owned

BUT: investors tend to view this debt

as having an implicit guarantee.

Commercial Paper, Negotiable CDs and Bankers’ Acceptances

These securities are different forms of corporate debt

Money market investors limit their exposure to default risk in these securities by

• Only lending to the highest quality borrowers

(This is this is how investors manage risk before the investment)

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Default Risk and Commercial Paper, Negotiable CDs

and Bankers’ Acceptances

To assess credit quality, the credit rating agencies providing rating for companies wanting to issue commercial papers and banks wanting to issue tradable short-term debt.

As an example of only lending to the highest quality borrowers, over 97% of all commercial paper is issued by borrowers in the two lowest default risk rating categories.

Default Risk and Federal Funds

The Fed funds market is for trading of reserve deposits held at a Federal Reserve Bank

• Done to manage a bank’s reserves for settlement.

Fed funds trades are loans of reserve deposits between banks

Managing default risk:• Each loan be made under a pre-

existing line of credit between the borrowing and lending bank.

To borrow Fed funds from a bank, the borrowing bank requests a credit relationship with the lending bank.

The lending bank does a credit analysis of the borrower, which results in a two step decision:

• Step 1: Yes or No on extending a line of credit to the borrower.

• Step 2: If Yes, then set the borrowing limit on the line of credit.

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Default Risk and Federal Funds

Pre-existing line of credit for borrowers in the Fed funds market facilitates transactions

• Because the decision to provide credit has already been made

(Text uses term facilitates trading but there is no secondary market so no trading)

When a request for Fed funds comes into a bank, the person that processes the request simply checks for the existence of a line of credit for the borrower and the amount of funds available under the line.

Default Risk and REPOs

A repo is an agreement to sell securities with a simultaneous agreement to buy them back at a future date

• Note: this is legally a security transaction

• But has the cash flow characteristics of a collateralized loan

• Because the lender of cash in a repo is secured by the securities in the repo.

Market convention designed to minimizes investor’s exposure to default risk using 3 rules to govern the collateral.

• The market value of the collateral must exceed the market value of the loan.

• If the value of collateral falls below the amount of the loan, then the lender requests either additional collateral or repayment of a portion of the loan.

• The collateral is held by a third-party trustee, which prevents the collateral from being pledged against more than one loan.

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Interest Rate Risk

All debt securities are exposed to interest rate risk because their values change with market rates.

Investors are concerned about having to sell a security at an unfavorable price because of an increase in interest rates.

Interest rate risk is not a primary concern to money market investors because all have as short duration

If it is a concern, derivatives can be used to hedge interest rate risk in money market securities.

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Default and Liquidity Risk and Money Market Mutual Funds

Background

A mutual fund is a portfolio of securities.

A money market mutual fund is a portfolio of money market securities.

Unique among mutual funds: its value is held at $1.00 per share

Requires carefully asset management to meet the conditions necessary to keep share price at a “buck”

Stable NAV and Breaking the Buck

Under Rule 2a-7, money market funds are able to use a stable NAV of $1.00 per share

MMF value portfolio securities at their acquisition cost adjusted for amortization of premium or accretion of discount. This is known as amortized cost accounting.

Money market funds must calculate a separate NAV (called the “mark-to-market” or “shadow” NAV)

This is based on market quotations the funds assets plus undistributed realized gains and losses

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Stable NAV and Breaking the Buck

As long as the shadow NAV does not fall more than have a cent from the amortized cost basis, the share price can be set at $1.00

Shadow NAV varies due to

• Policy driven interest rate changes

• Effects of credit quality changes on asset values

Losses on Lehman commercial paper in 2008 led to the Reserve Fund “breaking the buck” and the fear that there could be a run on MMFs

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SEC 2010 Money Market Reforms

Washington, D.C., Jan. 27, 2010 - The Securities and Exchange Commission today adopted new rules designed to significantly strengthen the regulatory requirements governing money market funds and better protect investors.

That is, the new rules were designed to limit the likelihood of breaking a buck and to protect the MMFs from a run on the fund

Highlights follow on Liquidity and Credit Risks

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Further Enhancement of Liquidity

The rules would further restrict the ability of money market funds to purchase illiquid securities by:

Restricting money market funds from purchasing illiquid securities if, after the purchase, more than 5 percent of the fund's portfolio will be illiquid securities (rather than the current limit of 10 percent).

Redefining as "illiquid" any security that cannot be sold or disposed of within seven days at carrying value.

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2010 Liquidity Requirements

Improved Liquidity: The new rules require money market funds to have a minimum percentage of their assets in highly liquid securities

Daily Requirement: For all taxable money market funds, at least 10 percent of assets must be in cash, U.S. Treasury securities, or securities that convert into cash (e.g., mature) within one day.

Weekly Requirement: For all money market funds, at least 30 percent of assets must be in cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, or securities that convert into cash within one week.

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2010 Credit Quality Requirements

Higher Credit Quality: The new rules limits lower quality (Second Tier) securities:

• Restricting a fund from investing more than 3 percent of its assets in Second Tier securities (rather than the current limit of 5 percent).

• Restricting a fund from investing more than ½ of 1 percent of its assets in Second Tier securities issued by any single issuer (rather than the current limit of the greater of 1 percent or $1 million).

• Restricting a fund from buying Second Tier securities that mature in more than 45 days (rather than the current limit of 397 days).

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Latest Reform

The SEC recently (August 2014) adopted amendments to the rules governing MMFs; among the more important:

• Require institutional prime and institutional MMFs to use a floating net asset value as opposed to allowing such MMFs to maintain a stable $1.00 share price through use of the amortized cost method of valuation

• Government (fund that invests in only government securities)and retail (fund owned by natural persons) MMF are exempt from the floating NAV requirement

• Introduce mechanisms for MMF boards of directors to impose liquidity fees and/or temporarily suspend redemptions

• Require further diversification of MMF portfolios, amend existing MMF stress testing requirements, and require additional reporting and disclosures from MMFs

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