Chapter 14 The Money Market

Copyright Copyright 2002 by South-Western, a division of Thomson Learning 2002 by South-Western, a division of Thomson Learning TMTM

Chapter 14Chapter 14The Money MarketThe Money Market


Learning ObjectivesLearning Objectives

To specify the important features of money To specify the important features of money markets.markets.

Define the money market instruments by category.Define the money market instruments by category. Calculate the taxable-equivalent yield, yield from Calculate the taxable-equivalent yield, yield from

dividend capture, discount yield, coupon-dividend capture, discount yield, coupon-equivalent yield, and effective annual yield.equivalent yield, and effective annual yield.

Specify types of investment risk and their effects Specify types of investment risk and their effects on yields.on yields.

To understand yield curves and the theories that To understand yield curves and the theories that explain them.explain them.


Nature of the Money MarketNature of the Money Market

Primary and secondary marketsPrimary and secondary markets Wholesale and retail marketsWholesale and retail markets Money market interest ratesMoney market interest rates Tax statusTax status Market mechanics and intermediariesMarket mechanics and intermediaries


Money Market InstrumentsMoney Market Instruments

Bank instrumentsBank instruments Corporate instrumentsCorporate instruments Federal Government instrumentsFederal Government instruments State and local instrumentsState and local instruments Mixed instrumentsMixed instruments


Bank InstrumentsBank Instruments

InstrumentInstrument DenominationDenomination MaturityMaturity RiskRisk

Certificates of DepositCertificates of Deposit Primary: $100,000 +Primary: $100,000 + 7 days to7 days to * FDIC * FDIC Secondary: $2-$5mSecondary: $2-$5m 8 years8 years * Fixed mat.* Fixed mat.

*Expro risk of*Expro risk ofTime depositsTime deposits Minimum set by Minimum set by 1 day to 31 day to 3 Eurodollar Eurodollar

bankbank monthsmonths deposits deposits

Bankers AcceptancesBankers Acceptances $500,000 to $1m$500,000 to $1m Up to 270Up to 270 * Bank secured* Bank secureddaysdays * 2ndary mkt* 2ndary mkt

Loan participations Loan participations VariesVaries 1 day to 1 day to * Most have* Most have

3 years3 years guarantor guarantor* Illiquid* Illiquid

Securitized assets suchSecuritized assets such VariesVaries 1 year to 1 year to * Diversified* Diversifiedas auto loans, etc.as auto loans, etc. 3 years3 years portfolio portfolio


Corporate InstrumentsCorporate Instruments


Commercial paperCommercial paper Primary: $100,000 +Primary: $100,000 + 1 to 270 days1 to 270 days * Usually low * Usually low Secondary: $5mSecondary: $5m * Backup line* Backup line

* Liquidity * Liquidity function of function of issuerissuer

Floating-rate notesFloating-rate notes Primary: $1,000-$100,000Primary: $1,000-$100,000 9 months to 9 months to * Function of * Function of Secondary: $5 millionSecondary: $5 million 30 years30 years issuer issuer

Common or Common or No typicalNo typical No maturityNo maturity *Function of *Function of preferred stockpreferred stock daysdays issuer issuer

* Function of * Function of marketmarket


Federal Government InstrumentsFederal Government Instruments


Treasury billsTreasury bills Primary: $10,000+Primary: $10,000+ 3,6,12 months3,6,12 months *No default*No default riskrisk*Some interest*Some interest rate riskrate risk

Treasury notes/bondsTreasury notes/bonds 2-yr notes: $5,0002-yr notes: $5,000 Notes:2-5,7,10 yrs Notes:2-5,7,10 yrs *No default*No default5-,7-,10-yr notes5-,7-,10-yr notes Bonds: >10 yrsBonds: >10 yrs *Interest rate*Interest rateand bonds: $1,000and bonds: $1,000 risk risk

Government agenciesGovernment agencies Primary: $1,000Primary: $1,000 VariesVaries * Low default* Low defaultSecondary: largerSecondary: larger * Sporadic liq.* Sporadic liq.

* Interest rate* Interest rate risk functionrisk function of maturityof maturity* Event risk* Event risk


State and Local Government State and Local Government InstrumentsInstruments


Anticipation notesAnticipation notes Primary: $5,000Primary: $5,000 Few weeks toFew weeks to * Low default * Low default Secondary: $100,000Secondary: $100,000several yearsseveral years risk risk

* Liq. depends* Liq. depends on dealeron dealer* Interest rate* Interest rate risk functionrisk function of maturityof maturity

VRDNsVRDNs Primary: $5,000-$100,000Primary: $5,000-$100,000 30 years with30 years with * Low default * Low default Secondary: $100,000Secondary: $100,000put. Interestput. Interest and liq. risk and liq. risk

rate resetrate reset * Low liquidity* Low liquidity risk due to risk due to rate resetrate reset

Tax-exempt CPTax-exempt CP Primary: $50,000-$100,000Primary: $50,000-$100,000 Few days to Few days to * Same risk as* Same risk asSecondary: $100,000Secondary: $100,000several yearsseveral years anticipationanticipation


Mixed InstrumentsMixed Instruments


MMMFsMMMFs $10,000 for institutions$10,000 for institutions 25-60 days25-60 days * No FDIC* No FDIC* No liquidity* No liquidity riskrisk* No interest* No interest rate riskrate risk

Repurchase AgreementsRepurchase Agreements Typical: $1 millionTypical: $1 million Mostly overniteMostly overnite * Depends on * Depends on Term RPsTerm RPs institution institutiongenerally 3 wksgenerally 3 wks * Linked to * Linked to

collateral collateral * Some liq risk* Some liq risk* Event risk* Event risk

Sweep accountsSweep accounts NoneNone OvernightOvernight * Depends on * Depends on institutioninstitution


Money Market Rate CalculationsMoney Market Rate Calculations

D 365D 365YYcapcap = ------ x ------ = ------ x ------ Dividend capture yieldDividend capture yield (14.2)(14.2)

P nP n

YYcapcap [1 - (.30 x T)] [1 - (.30 x T)]

YYcap-tecap-te = --------------------- = --------------------- Tax-equivalent yieldTax-equivalent yield (14.3)(14.3)

(1 -T)(1 -T)Where:Where: .30 is related to the dividend exclusion.30 is related to the dividend exclusion

T is the investors marginal tax rateT is the investors marginal tax rateD is the dividendD is the dividendP is the security priceP is the security pricen is the holding period n is the holding period

D 365D 365YYcapcap = ------ x ------ = ------ x ------ Dividend capture yieldDividend capture yield (14.2)(14.2)

P nP n

YYcapcap [1 - (.30 x T)] [1 - (.30 x T)]

YYcap-tecap-te = --------------------- = --------------------- Tax-equivalent yieldTax-equivalent yield (14.3)(14.3)

(1 -T)(1 -T)Where:Where: .30 is related to the dividend exclusion.30 is related to the dividend exclusion

T is the investors marginal tax rateT is the investors marginal tax rateD is the dividendD is the dividendP is the security priceP is the security pricen is the holding period n is the holding period


Money Market Rate CalculationsMoney Market Rate Calculations

FV - P FV - P 360360YYdd = ------------ x ------- = ------------ x ------- Discount yieldDiscount yield (14.4)(14.4)

FV FV n n

FV - P FV - P 365365YYcece = ----------- x ------- = ----------- x ------- Coupon-equivalent yieldCoupon-equivalent yield (14.5)(14.5)

PP n n

FV - P FV - P 360360YYdd = ------------ x ------- = ------------ x ------- Discount yieldDiscount yield (14.4)(14.4)

FV FV n n

FV - P FV - P 365365YYcece = ----------- x ------- = ----------- x ------- Coupon-equivalent yieldCoupon-equivalent yield (14.5)(14.5)

PP n n


Term Structure TheoriesTerm Structure Theories

What explains the shape of the yield curve?What explains the shape of the yield curve?

Time to MaturityTime to Maturity

Yield,%Yield,%


Term Structure: Unbiased Term Structure: Unbiased ExpectationsExpectations

The prevailing yield curve is derived from the present The prevailing yield curve is derived from the present short-term rate and expectations for rates that will exist short-term rate and expectations for rates that will exist in the future.in the future.

(1+(1+ttRRnn) = [(1+) = [(1+ttRR11)(1+)(1+t+1t+1rr1,t1,t)(1+)(1+t+2t+2rr1,t1,t)......] )......] 1/n1/n

Thus, long-term rates are higher than current short-Thus, long-term rates are higher than current short-term rates if future short-term rates are expected to be term rates if future short-term rates are expected to be higher than current short-term rates...and long-term higher than current short-term rates...and long-term rates fall below current short-term rates if future rates fall below current short-term rates if future expected short-term rates are expected to be less than expected short-term rates are expected to be less than the current level of short-term rates.the current level of short-term rates.


Term Structure: Liquidity Term Structure: Liquidity PreferencePreference

Preference for liquidity is thought to characterize Preference for liquidity is thought to characterize enough investors that the yield curve (in absence of enough investors that the yield curve (in absence of expectations or other influences) should slope expectations or other influences) should slope upward from left to right. The longer the upward from left to right. The longer the maturity, the higher the premium demanded by maturity, the higher the premium demanded by investors.investors.

Yield,%Yield,%

Time to MaturityTime to Maturity

Yield, %Yield, %LiquidityLiquidityPremiumPremium


Term Structure: Segmentation Term Structure: Segmentation hypothesishypothesis

Instead of being close substitutes, securities with Instead of being close substitutes, securities with short, medium, and long maturities are seen by short, medium, and long maturities are seen by investors (fund suppliers) and issuers (fund investors (fund suppliers) and issuers (fund demanders) as quite different.demanders) as quite different.

The markets are thus separated, or segmented, by The markets are thus separated, or segmented, by the self-limiting behavior of institutions staying the self-limiting behavior of institutions staying within their preferred habitats.within their preferred habitats.


Term Structure: Biased Term Structure: Biased expectationsexpectations

A combination of the unbiased expectations theory A combination of the unbiased expectations theory and the liquidity preference hypothesis.and the liquidity preference hypothesis.


Risk Structure of Interest RatesRisk Structure of Interest Rates

Default riskDefault risk Liquidity riskLiquidity risk Interest rate riskInterest rate risk Reinvestment rate riskReinvestment rate risk Event riskEvent risk Foreign exchange and political riskForeign exchange and political risk


Risk-Return Assessment in Risk-Return Assessment in PracticePractice

Yield spread analysisYield spread analysis Safety ratingsSafety ratings Assessing liquidity riskAssessing liquidity risk


SummarySummary

We surveyed the menu of short-term investment We surveyed the menu of short-term investment alternativesalternatives

Investment objectives: corporate investors rank Investment objectives: corporate investors rank safety first, followed by liquidity and then yield.safety first, followed by liquidity and then yield.

We learned how to calculate various money market We learned how to calculate various money market rates of returnrates of return

We studied possible explanations for the shape of We studied possible explanations for the shape of the yield curvethe yield curve

We concluded with a discussion of the risk We concluded with a discussion of the risk structure of interest ratesstructure of interest rates

Documents

Chapter 14 The Money Market