Chapter Five

Money Markets

5-1

2009, The McGraw-Hill Companies, All Rights

Money Markets
Liquid
Liquidfunds
fundsflow
flowbetween
betweenshort-term
short-termborrowers
borrowersand
and
lenders
lendersthrough
throughmoney
moneymarkets
markets
Money
Moneymarkets
marketsinvolve
involvedebt
debtinstruments
instrumentswith
withoriginal
original
maturities
maturitiesof
ofone
oneyear
yearor
orless
less
Money
Moneymarket
marketdebt
debt

issued
issuedby
byhigh-quality
high-quality(i.e.,
(i.e.,low
lowdefault
defaultrisk)
risk)economic
economicunits
unitsthat
that
require
requireshort-term
short-termfunds
funds
purchased
purchasedby
byeconomic
economicunits
unitsthat
thathave
haveexcess
excessshort-term
short-termfunds
funds

Money
Moneymarket
marketinstruments
instrumentshave
haveactive
activesecondary
secondary
markets
markets
5-2

2009, The McGraw-Hill Companies, All Rights

Money Market Yields

Some
Some money
money market
market instruments
instruments are
are bought
bought and
and
sold
sold on
on aa discount
discount basis
basis (e.g.,
(e.g.,Treasury
Treasury bills
bills and
and
commercial
commercial paper)
paper)
Discount
Discount yields
yields (i(idydy)) use
use aa 360-day
360-day year
year
( Pf P0 ) 360
idy

Pf
h

PPf f==the
theface
facevalue
valueof
ofthe
thesecurity
security
PP00==the
thediscount
discountprice
priceof
ofthe
thesecurity
security
hh==the
thenumber
numberof
ofdays
daysuntil
untilmaturity
maturity
5-3

2009, The McGraw-Hill Companies, All Rights

Money Market Yields

Compare
Compare discount
discount securities
securities to
to U.S.
U.S.Treasury
Treasury
bonds
)
bonds with
with bond
bond equivalent
equivalent yields
yields (i(ibey
bey)
( Pf P0 ) 365
idy

P0
h

Convert
Convert bond
bond equivalent
equivalent yields
yields into
into effective
effective
annual
annual returns
returns (EAR)
(EAR)

ibey
EAR 1

365 / h

5-4

365 / h

2009, The McGraw-Hill Companies, All Rights

Money Market Yields

Money
Moneymarket
marketsecurities
securitiesthat
thatpay
payinterest
interestonly
onlyatatmaturity
maturity
use
) (e.g., jumbo CDs and fed
usesingle-payment
single-paymentyields
yields(i(ispy
spy) (e.g., jumbo CDs and fed
funds)
funds)
since
sinceispy
ispyuses
usesaa360
360day
dayyear,
year,compare
comparetotobonds
bondsby
byconverting
convertingtotoaa
365
365day
dayyear
year

ibey ispy (365 / 360)

totoconvert
convertaasingle-payment
single-paymentyield
yieldtotoan
aneffective
effectiveannual
annualreturn
return

365 / 360

EAR 1 ispy

365
/
h

5-5

365 / h

2009, The McGraw-Hill Companies, All Rights

Money Market Instruments

Treasury
Treasury bills
bills (T-bills)
(T-bills)
Federal
Federal funds
funds (fed
(fed funds)
funds)
Repurchase
Repurchase agreements
agreements (repos
(repos or
or RP)
RP)
Commercial
Commercial paper
paper (CP)
(CP)
Negotiable
Negotiable certificates
certificates of
of deposit
deposit (CD)
(CD)
Banker
Banker acceptances
acceptances (BA)
(BA)
5-6

2009, The McGraw-Hill Companies, All Rights

Treasury Bills (T-Bills)

T-Bills
T-Bills are
are short-term
short-term debt
debt obligations
obligations
issued
issued by
by the
the U.S.
U.S. government
government
The
The Federal
Federal Reserve
Reserve buys
buys and
and sells
sells T-bills
T-bills
to
to implement
implement monetary
monetary policy
policy
T-bills
T-bills are
are virtually
virtually default
default risk
risk free,
free, are
are
highly
highly liquid,
liquid, and
and have
have little
little interest
interest rate
rate
risk
risk
5-7

2009, The McGraw-Hill Companies, All Rights

T-Bill Auctions

1313- and
and 26-week
26-weekT-bills
T-bills are
are auctioned
auctioned weekly
weekly
Bids
Bids are
are submitted
submitted by
by government
government securities
securities
dealers,
dealers, financial
financial and
and nonfinancial
nonfinancial corporations,
corporations,
and
and individuals
individuals
Bids
Bids can
can be
be competitive
competitive or
or noncompetitive
noncompetitive

competitive
competitivebids
bidsspecify
specifythe
thebid
bidprice
priceand
andthe
thedesired
desired
quantity
quantityof
ofT-bills
T-bills
noncompetitive
noncompetitivebidders
biddersget
getpreferential
preferentialallocation
allocationand
and
agree
agreeto
topay
paythe
thelowest
lowestprice
priceof
ofthe
thewinning
winning
competitive
competitivebids
bids
5-8

2009, The McGraw-Hill Companies, All Rights

T-Bill Auctions
Bid Price

Noncompetitive Bids

SC

ST

3
4
5
6

Stop-out
price (PNC)

Quantity of
T-bills

5-9

2009, The McGraw-Hill Companies, All Rights

The Secondary Market for T-Bills

The
The secondary
secondary market
market for
forT-bills
T-bills isis the
thelargest
largest of
of
any
any U.S.
U.S. money
money market
market instrument
instrument
22
22 primary
primary dealers
dealers make
make aa market
market in
inT-bills
T-bills by
by
buying
buying the
the majority
majority sold
sold at
at auction
auction and
and by
by
creating
creating an
an active
active secondary
secondary market
market
primary
primarydealers
dealerstrade
tradefor
forthemselves
themselvesand
andfor
forcustomers
customers
T-bill
T-billpurchases
purchasesand
andsales
salesare
arebook-entry
book-entrytransactions
transactions
conducted
conductedover
overFedwire
Fedwire

T-Bills
T-Bills are
are sold
sold on
on aa discount
discount basis
basis
5-10

2009, The McGraw-Hill Companies, All Rights

T-Bill Prices
T-Bill
T-Billprices
pricescan
canbe
becalculated
calculatedfrom
fromquotes
quotes(e.g.,
(e.g.,from
fromThe
The
Wall
WallStreet
StreetJournal)
Journal)by
byrearranging
rearrangingthe
thediscount
discountyield
yield
equation
equation
h

P0 Pf iT Bill (dy )
Pf
360

Or
Orby
byrearranging
rearrangingthe
thebond
bondequivalent
equivalentyield
yieldequation
equation
Pf

P0

365 / iT Bill (bey )

5-11

2009, The McGraw-Hill Companies, All Rights

Federal Funds
The
Thefederal
federalfunds
funds(fed
(fedfunds)
funds)rate
rate isisthe
thetarget
targetrate
rate
in
inthe
theconduct
conductof
ofmonetary
monetary policy
policy
Fed
Fedfund
fundtransactions
transactionsare
areshort-term
short-term(mostly
(mostly
overnight)
overnight)unsecured
unsecuredloans
loans
Banks
Bankswith
withexcess
excessreserves
reserveslend
lendfed
fedfunds,
funds,while
while
banks
bankswith
withdeficient
deficientreserves
reservesborrow
borrowfed
fedfunds
funds
Fed
Fedfunds
fundsare
aresingle-payment
single-paymentloans
loansand
andthus
thususe
use
single-payment
single-paymentyields
yields

5-12

2009, The McGraw-Hill Companies, All Rights

Repurchase Agreement
AArepurchase
repurchaseagreement
agreement(repo
(repoor
orRP)
RP)isisthe
thesale
saleof
of
aasecurity
security with
withan
anagreement
agreementto
tobuy
buy the
thesecurity
securityback
back
atataaset
setprice
pricein
inthe
thefuture
future
Repos
Reposare
areshort-term
short-termcollateralized
collateralizedloans
loans(typical
(typical
collateral
collateralisisU.S.
U.S.Treasury
Treasury securities)
securities)
AAreverse
reverserepurchase
repurchaseagreement
agreementisisthe
theopposite
oppositeside
side
of
ofaarepo
repo(i.e.,
(i.e.,ititisisthe
thepurchase
purchaseof
ofaasecurity
securitywith
withan
an
agreement
agreementto
tosell
sellititback
backin
inthe
thefuture)
future)

5-13

2009, The McGraw-Hill Companies, All Rights

Repurchase Agreement
The
) uses a
The yield
yield on
on repurchase
repurchase agreements
agreements (i(iRA
RA) uses a
360-day
360-day year
year like
like the
the discount
discount rate,
rate, but
but uses
uses the
the
current
current price
price in
in the
the denominator
denominator like
like the
the bond
bond
equivalent
equivalent yield
yield
( Pf P0 ) 360
iRA

P0
h

PPf f==the
therepurchase
repurchaseprice
priceof
ofthe
thesecurity
security
PP00==the
theselling
sellingprice
priceof
ofthe
thesecurity
security
hh==the
thenumber
numberof
ofdays
daysuntil
untilthe
therepo
repomatures
matures
5-14

2009, The McGraw-Hill Companies, All Rights

Commercial Paper
Commercial
Commercialpaper
paper(CP)
(CP)isisthe
thelargest
largestmoney
moneymarket
marketin
in
terms
termsof
ofdollars
dollarsoutstanding
outstanding
CP
CPisisunsecured
unsecuredshort-term
short-termcorporate
corporatedebt
debtissued
issuedto
toraise
raise
short-term
short-termfunds
funds(e.g.,
(e.g.,for
forworking
workingcapital)
capital)
Generally
Generallysold
soldin
inlarge
largedenominations
denominations(e.g.,
(e.g.,$100,000
$100,000to
to
$1
$1million)
million)with
withmaturities
maturitiesbetween
between11and
and270
270days
days
CP
CPisisusually
usuallysold
soldto
toinvestors
investorsindirectly
indirectlythrough
throughbrokers
brokers
and
anddealers
dealers(approximately
(approximately85%
85%of
ofthe
thetime)
time)
CP
CPisisusually
usuallyheld
heldby
byinvestors
investorsuntil
untilmaturity
maturityand
andhas
hasno
no
active
activesecondary
secondarymarket
market
Yields
Yieldsare
arequoted
quotedon
onaadiscount
discountbasis
basis(like
(likeT-bills)
T-bills)

5-15

2009, The McGraw-Hill Companies, All Rights

Negotiable Certificate of Deposit

A
Anegotiable
negotiable certificate
certificateof
of deposit
deposit (CD)
(CD) isis aa
bank-issued
bank-issued time
time deposit
deposit that
that specifies
specifies the
the interest
interest
rate
rate and
and the
the maturity
maturity date
date
CDs
CDs are
are bearer
bearerinstruments
instruments and
and thus
thus are
are salable
salable in
in
the
the secondary
secondary market
market
Denominations
Denominations range
range from
from$100,000
$100,000 to
to $10
$10
million;
million; $1
$1 million
million being
being the
themost
most common
common
Often
Often purchased
purchased by
by money
money market
market mutual
mutual funds
funds
with
with pools
pools of
of funds
funds from
fromindividual
individual investors
investors
5-16

2009, The McGraw-Hill Companies, All Rights

Bankers Acceptance
AABankers
BankersAcceptance
Acceptance(BA)
(BA)isisaatime
timedraft
draftpayable
payableto
to
aaseller
sellerof
ofgoods
goodswith
withpayment
paymentguaranteed
guaranteedby
byaabank
bank
Used
Usedin
ininternational
internationaltrade
tradetransactions
transactionsto
tofinance
financetrade
trade
in
ingoods
goodsthat
thathave
haveyet
yetto
tobe
beshipped
shippedfrom
fromaaforeign
foreign
exporter
exporter(seller)
(seller)to
toaadomestic
domesticimporter
importer(buyer)
(buyer)
Foreign
Foreignexporters
exportersprefer
preferthat
thatbanks
banksact
actas
aspayment
payment
guarantors
guarantorsbefore
beforesending
sendinggoods
goodsto
toimporters
importers
Bankers
Bankersacceptances
acceptancesare
arebearer
bearerinstruments
instrumentsand
andthus
thus
are
aresalable
salablein
insecondary
secondarymarkets
markets
5-17

2009, The McGraw-Hill Companies, All Rights

Money Market Participants

The
The U.S.
U.S.Treasury
Treasury
The
The Federal
Federal Reserve
Reserve
Commercial
Commercial banks
banks
Money
Money market
market mutual
mutual funds
funds
Brokers
Brokers and
and dealers
dealers
Corporations
Corporations
Other
Otherfinancial
financial institutions
institutions
Individuals
Individuals
5-18

2009, The McGraw-Hill Companies, All Rights

International Money Markets

U.S.
U.S.dollars
dollarsheld
heldoutside
outsidethe
theU.S.
U.S.are
aretracked
trackedamong
among
multinational
multinationalbanks
banksin
inthe
theEurodollar
Eurodollarmarket
market
The
Therate
rateoffered
offeredfor
forsale
saleon
onEurodollar
Eurodollarfunds
fundsisisthe
the
London
LondonInterbank
InterbankOffered
OfferedRate
Rate(LIBOR)
(LIBOR)
Eurodollar
EurodollarCertificates
Certificatesof
ofDeposits
Deposits are
areU.S.
U.S.dollar
dollar
denominated
denominatedCDs
CDsheld
heldin
inforeign
foreignbanks
banks
Eurocommercial
Eurocommercialpaper
paper(Euro-CP)
(Euro-CP)isisissued
issuedin
in
Europe
Europeand
andcan
canbe
bein
inlocal
localcurrencies
currenciesor
orU.S.
U.S.dollars
dollars

5-19

2009, The McGraw-Hill Companies, All Rights