6. Money Markets

8/14/2019 6. Money Markets

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Copyright 2006 Scott Bauguess

Part II: Security Markets

Topic 6Money Markets


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Money Markets

Short-term debt instruments

Maturity of < 1 year

Services immediate cash needs

Borrowers need short-term working capital Lenders need an interest-earning parking space for excess

funds

Instruments trade in an active secondary market Liquid market provides easy entry & exit for participants

Speed and efficiency of transactions allows cash to active even

for very short periods of time (over night).

Market size in 2004: $5.3 Trillion


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Money Markets

Large denominations Units of $1 - $10 million

Transactions costs low in relative terms

Individual investors do not participate in this market

Low default risk

Only high quality borrower participate

Low time maturities reduce the risk of changes in borrower

quality

Insensitive to interest rate changes Maturity (< 1 year) too short to be adversely affected, in general,

by changes in rates


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Money Market Securities

Treasury Bills

Federal Funds

Repurchase agreements

Commercial paper Negotiable Certificates of Deposit (CDs)

Bankers acceptances

All of these instruments are what comprise YOUR moneymarket investment account at your local bank


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Money Market Participants(excluding brokers/dealers)

Security Borrower (issuer) Lender (investor)

Treasury bills U.S. Treasury (FederalGovernment)

FED, Commercialbanks, Mutual Funds,Corporations, etc.

Federal Funds &Repurchase agreements Commercial banks,other FIs Commercial banks,other FIs

Commercial paper Corporations,Commercial banks

Corporations, Mutualfunds, other FIs

Negotiable CDs Commercial banks Corporations, Mutualfunds, other FIs

Bankers acceptances Commercial banks Corporations,Community banks


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Treasury securitiesIssued by Federal Government:

Finance annual deficits (budget shortfalls) Refinance maturing debt

Standard maturities: 4, 13, 26 or 52 weeks (1, 3, 6, 12 months)

Denominations: Face value $1,000 Round lots are sold as $5 million (new issues)

Risk:

Assumed risk/default free Ri= Rf+ beta*(RmRf)

Interest rate: No coupon payment T-bills sold at a discount to face value (implied rate of return)


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Treasury Auctions(Primary Market)

Auction cycle:

Weekly for 4, 13 & 26 week securities

Auction process: Single price auction (all winning bidders by the same)Competitive bids1. Requires $1 million minimum bid, generally made by dealers and large institutions2. Bidders submit a quantity and lowest yield (highest price) that they are willing to

accept3. No single bidder can win more than 35% of the issue.

Non-competitive bids:1. Purchasers seeking less than $1 million do not participate in the auction2. Indicate the quantity of securities desired to be purchased at the stop yield3. Get preferential allocation (all bids are met)

Non-public bids:1. The Federal Reserve Bank participates in this market (open market transactions)

and submits the quantity that they wish to purchase2. This quantity is guaranteed similar to non-competitive bids.



Treasury AuctionsWinning bid:

1. Competitive bids are sorted from lowest tohighest yield (highest to lowest price)

2. After non-competitive and non-publicpurchaser orders are filled, the Treasury

accepts the highest price (lowest yield) bidsuntil the issuance is completed

3. The highest yield accepted by the treasuryis the stop yield

4. Bidders above the stop yield are shut out

5. Bidders at the stop yield have their ordersfilled on a pro rata basis

yield (%)

3.50

3.52 > $7.5 Billion

3.54

3.573.60

3.61

3.62

3.63

3.64

3.65

stop yield



stop yield

Pro rated

percent

of face

value

Source: ww w.pub l icdebt . treas.gov



Treasury Auctions

Quantity of

T-bills

Bid Price(% of face) 1

2

3

4

5

6

7

competitive total

Noncompetitive Bids

$239 million

99.6633222%

Stop yield

$15,522 million

$15,761 million

winners losers



Secondary Treasury Market

Largest of any Money Market security:

Participants: Buy for their own account or on behalf of their customers1. Government approved dealers (approx 20, designated by the NYFRB)2. Secondary dealers (approx 500 trade in secondary market)3. Commercial banks, insurance companies, pension funds4. Federal reserve bank

Trading: takes place between1. Primary market dealers (fed wire transfers requiring no paper work)2. Dealers and their customers3. Volume greater than $100 billion daily (larger than NYSE)

Prices: determine the interest rate paid (T-bills are sold at discount)1. Dealers earn a bid-ask spread in secondary market

Regulation: Very little government oversight since traders are large institutions




Federal Reserve Bank of New York

Transfers $10m. In T-bills from

J.P. Morgan Chase to Lehman BrothersTransaction recorded in Feds Book-Entry System

J.P. Morgan Chasesells $10m. In T-bills

Lehman Brothersbuy $10m. In T-bills

Individualbuy $50,000

in T-bills

Local Bank

or Broker

J.P. MorganChase

sell $50,000

in T-bills

FRBNY

-$50,000 in T-billsfrom J.P. Morgan

Chases account

+ $50,000 T-bill

to IndividualSource: reprinted from Saunders Cornett Financial Markets and Institutions, 3rd

Edition, McGraw-Hill Irwin , 2006.

Purchase by individual

Between government security

dealers


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On-the-run: Trading in the most recent treasury market auction (most current issue)

Off-the-run: Once a new auction takes place, older issues of the same maturity arereferred to as off-the-run

Liquidity in off-the-run markets is far lower than new issues. A 6-month off-the-run T-bill with three months remaining is competing with an

newly issued 3-month T-bill that is on-the-run. Investors have substitutes intreasury securities that allows for more efficient pricing of new securities.

When-issued market: Treasury securities are traded prior to the time that they are issued.

This market extends from the day that the treasury auction is announced until theauction day.

This, too, increases pricing efficiency since dealers have an indication of what thestop yield will be before the auction takes place.

When-issued turn into an on-the-run secondary market once the auction iscompleted.


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Federal FundsShort term transactions between financial institutions:

1. Term is generally over night/week-end2. Not backed by collateral - unsecured loans3. Highly liquid market4. Depository institutions use this market to buy/sell excess deposits in order to

manage their liabilities.5. For banks, this is sometimes referred to as hot money

Federal Fund Yields:1. No coupon payment - sold at a discount2. Quoted rates assume a 360 day year, conversion ibond= iff(365/360)

Federal Funds Market:1. Trades take place between banks that buy/sell excess reserves held at their

federal reserve bank2. Banks or FIs that are not FRB members can use a correspondent bank (that is a

member) to conduct the transaction3. Transactions take place over the Fedwire


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Repurchase agreements

Definition: selling an asset with an explicit agreement to repurchase the assetafter a set period of time

Example:A bank has deficient reserves and needs to borrow overnight.1. BankAsells a treasury security to BankBat P02. BankAagrees to buy the treasury back at a higher pricePf> P0

3. Bank Bearns a rate of return implied by the difference in prices

4. Since the loan is backed by collateral, the rate is usually lower than therate available in the Federal Funds market

5. Fed conducts open market transactions through RAs, using transactionsthat are generally less than 15 days.

iRA =PfP0

P0

360

daysx


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Commercial Paper

Unsecured short-term promissory note:

1. Generally issued by corporations or financial institutions2. Sold directly to institutions or through dealers3. Is the largest (total $ value) of the money market securities4. Funds used to finance working capital requirements

Terms:1. Sold in denominations of $100k, $250k, $500k and $1 million.

2. Maturity less than 270 days (registration required otherwise)3. Common maturities are between 20 and 45 days4. Sold at discount and held to maturityno active secondary market5. Yields are quoted based on 360 day year

Issuers need good reputation to issue:1. Issuers must have excellent credit and be rated by a rating agency2. Low cost alternative to bank loans, but requires that lenders can tell your type

the adverse selection problem3. Firms in trouble are immediately cut off from this market in the same way that

troubled banks are quickly cut off from the federal funds market Tycos downgrade from tier 1 to tier 3 forced them out of the market


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Negotiable Certificates of Deposits (CDs)

A bank issued time deposit: Not a demand deposit1. Fixed interest rate and maturity2. Terms are negotiable (e.g. 6 month at 4.1% or 1 year at 5.2%)3. Common maturities are less than 12 months4. These funds are more certain to banks that demand deposits that can leave at

any time.

Terms and Trading:1. Most CDs are sold directly to investors who hold to maturity2. Investors receive both principal and interest3. Rates are quoted using a 360 day year4. A network of about 15 brokers/dealers make a secondary market

Risk:1. Small CDs are similar to demand deposits wrt insurance2. Large CDs (called Jumbo CDs) are not federally insured through FDIC3. Large banks, with perceived lower risk due to too-big-to-fail (TBTF) doctrine, often

have lower rates than smaller banks


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Bankers AcceptanceBanks act as intermediaries between trading partners:

1. Banks guarantee payments to secure orders of goods from manufacturers2. Are a type of letter of credit that guarantees a payment by the bank on a specific

date3. Particularly useful between foreign trading partners where there is a high level of

asymmetric informationBanks resolve this AI

Example:1. Lubbock Acme Enterprises orders 50,000 Red Raider flags from a Peruvian textile

manufacturer2. The Peruvian manufacturer pulls out a globe to figure out where Lubbock isthey

have no idea who the buyer is.3. Since the Peruvian manufacturer has to retool the factor to make the flags, they

want some guarantee that Lubbock Acme is actually going to pay

4. Lubbock Acme doesnt want to pay until they know that they are going to get thegoods delivered as promised.

5. Bank of America steps in as intermediary with a contract that provides a credibledelivery of payment once the goods are delivered.

6. Bank of America agrees to pay the amount of the BA if the Lubbock Acme fails topay


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Bankers Acceptance

Locality of BAs: San Francisco, New York and Chicago originate most BAs Only the largest banks engage in this market

Trading:1. Trading of BAs take place on secondary markets until such time that the payment is

delivered2. Maturity is typically 30 to 270 days

3. Denominations are bundled into $100,000 and $500,000 levels for trading4. If the manufacturer has an immediate need for cash, they can sell the BA prior to

delivery of the goods.

Risk: Default risk is low since both the bank and importer must default on payment, andresulting interest rates are low


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EurodollarsEurodollar: U.S. dollars held as deposits in foreign banks

Corporations often find it more convenient to hold deposits at foreign banks tofacilitate payments in their foreign operations

Can be held in U.S. bank branches or foreign banks Dollar denominated deposits are referred to as Eurodollars

Risk:

They are not subject to reserve requirements Nor are they eligible for FDIC depositor insurance (U.S. government is not interestedin protecting foreign depositors)

The resulting rates paid on Euro dollars are higher (higher risk)

Trading: Over night trading as in the Federal Funds market Eurodollars are traded in London, and the rates offered are referred to as LIBOR

(London Interbank Offered Rate) Rates are tied closely to the Fed Funds rate

Should the LIBOR rate drop relative to the Fed Funds rate, U.S. banks canbalance their reserves in the Eurodollar market (arbitrage)


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Money Market Rates

2002 2003 2004 2005

Federal Funds 1.67 1.13 1.35 3.26

Non fin CP 1.67 1.11 1.38 3.27

Fin CP 1.68 1.12 1.41 3.31

CD 1.72 1.15 1.45 3.38

Euro $ 1.72 1.15 1.45 3.55

T-bill 2 1.24 1.89 3.64

AAA Muni 4.87 4.52 4.5 4.18

AAA Corp 6.49 5.66 5.63 5.06

Documents

6. Money Markets