Part 4

Financial Markets

Chapter 9
The Money Markets
The Money Markets Defined
Why Do We Need Money Markets?
Cost Advantages
The Purpose of the Money Markets
Who Participates in the Money Markets?
U.S. Treasury Department
Federal Reserve System
Commercial Banks
Businesses
Investment and Securities Firms
Individuals
Money Market Instruments
Treasury Bills
Case: Discounting the Price of Treasury Securities to Pay the Interest
Mini Case: Treasury Bill Auctions Go Haywire
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Comparing Money Market Securities
Interest Rates
Liquidity
How Money Market Securities are Valued
Following the Financial News: Money Market Rates

T Overview and Teaching Tips

This chapter explores the institutional features of the money markets. The money market is the market for
debt securities issued with the original maturities of less than one year and a high degree of liquidity. They
are usually sold in large denominations and have low default risk. The chapter shows why money markets
are needed and their purpose to the government, firms, financial institutions, and individuals. The money
market is an interim investment that provides a higher return than holding cash or money in the bank but
less than what is usually expected from long term investments.

Chapter 9

The Money Markets

73

There are several players in the money market which include the U.S. Treasury Department, the Federal
Reserve, commercial banks, businesses, investment firms, and individuals. All participants work on both
sides of the market except for the U.S. Treasury Department, which is always a demander and never a
supplier of the money market. The participants use a variety of money market instruments to diversify
their needs. This section shows that most of these securities are short term and low risk. Point out to
students the international aspect of the use of Eurodollars so they get a broader view of securities around
the world. The securities also have several characteristics that are similar and different. Discuss with the
students the characteristics of interest rates, maturity, and liquidity.
The final section deals with money market securities are valued.

T Answers to End-of-Chapter Questions

1.

The money markets can be characterized as having securities that trade in one year or less, are of
large denomination, and are very liquid.

2.

Money market securities have an original maturity of less than one year, so the bond would not be
considered a money market security.

3.

Banks have higher costs than the money market owing to the need to maintain reserve requirements.
The lower cost structure of the money markets, coupled with the economies of scale resulting from
high volume and large-denomination securities, allows for higher interest rates.

4.

Term securities have a specific maturity date. Demand securities can be redeemed at any time. A six
month certificate of deposit is a term security. A checking account is a demand security.

5.

Following the Great Depression, regulators were primarily concerned with stopping banks from
failing. By removing interest-rate competition, bank risk was substantially reduced. The problem with
these regulations was that when market interest rates rose above the established interest-rate ceiling,
investors withdrew their funds from banks.

6.

The U.S. government sells large numbers of securities in the money markets to support government
spending. Over the past several decades, the government has spent more each year than it has
received in tax revenues. It makes up the difference by borrowing. Part of what it borrows comes
from the money markets.

7.

Businesses both invest and borrow in the money markets. They borrow to meet short-term cash flow
needs, often by issuing commercial paper. They invest in all types of money market securities as an
alternative to holding idle cash balances.

8.

Merrill Lynch initially felt that it could better service its regular customers by making it easier to buy
and sell securities from an account held at the brokerage house. The brokerage could offer a market
interest rate on these funds by investing them in the money markets.

9.

Life insurance companies can invest for the long term because the timing for their liabilities is known
with reasonable accuracy. Property and casualty insurance companies cannot predict the natural
disasters that cause large payouts on policies.

10. Treasury bills are usually viewed as the most liquid and least risky of securities because they are
backed by the strength of the U.S. government and trade in extremely large volumes.

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11. In competitive bidding for securities, buyers submit bids. A noncompetitive bidder accepts the
average of the rate paid by the competitive bidders.
12. Federal funds are sold by banks to other banks. They are used to invest excess reserves and to raise
reserves if a bank is short.
13. The Federal Reserve cannot directly set the federal funds rate of interest. It can influence the interest
rate by adding funds to or withdrawing reserves from the economy.
14. Large businesses with very good credit standings sell commercial paper to raise short-term funds.
The most common use of these funds it to extend short-term loans to customers for the purchase of
the firms products.
15. Bankers acceptances substitute the creditworthiness of a bank for that of a business. When a
company sells a product to a company it is unfamiliar with, it often prefers to have the promise of a
bank that payment will be made.

T Quantitative Problems
1.

What would be your annualized yield on the purchase of a 182-day Treasury-Bill for $4,925 that pays
$5,000 at maturity?
Solution:
i=

2.

$5,000 $4,925 365

= 3.05%
$4,925
182

What is the annualized yield on a Treasury bill that you purchase for $9,940 and will mature in
91 days for $10,000?
Solution: 2.42%

3.

If you want to earn an annualized yield of 3.5%, what is the most you can pay for a 91-day TreasuryBill $5,000 at maturity?
Solution:
$5,000 P 365

= 3.50%
P
91
P = $4,956.74

4.

What is the annualized yield on a Treasury bill that you purchase for $9,900 that will mature in 91
days for $10,000?
Solution: 4.05%

5.

The price of 182-day commercial paper is $7,840. If the annualized yield is 4.04%, what will the
paper pay at maturity?
Solution:
$F $7,840 365

= 4.04%
$7,840
182
P = $7997.93

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75

How much would you pay for a Treasury bill that matures in one year and pays $10,000 if you
require a 1.8% return?
Solution: $9,823.18

7.

The price of $8,000 face value commercial paper is $7,930. if the annualized yield is 4%, when will
the paper mature?
Solution:
$8,000 $7,930 365

= 4.00%
$7,930
X
X = 80 days

8.

How much would you pay for a Treasury bill that matures in one year and pays $10,000 if you
require a 3% return?
Solution: $9,708.74

9.

The annualized yield on a particular money market instrument is 3.75%. The face value is $200,000
and it matures in 51 days. What is its price? What would be the price if it had 71 days to maturity?
Solution:
$200,000 P 365

= 3.75%
P
51
P = $198,958
$200,000 P 365

= 3.75%
P
71
P = $198,552

10. The annualized yield is 3% for 91-day commercial paper and 3.5% for 182-days commercial paper.
What is the expected 91-day commercial paper rate 91 days from now?
Assuming the difference is just due to higher future interest rates, an investor should be able to earn
the same return over 182 days using either 182-day paper or a 91-day paper rollover strategy.
Assume that the 182-day paper has a $100,000 face value. The current price is:
$100,000 P
365

= 3.5%
P
182
P = $98,284.73
Now, invest the same amount in 91-day paper.
F 98,284.73 365

= 3.0%
98,284.73
91
F = $99,019.87. That is, such an investment should payoff $99,019.87 after 91 days.
Now, invest $99,019.87 in 91-day paper again. It is expected to give a final value of $100,000 (just
like the 182-day paper).
100,000 99,019.87 365

= 3.97%. The 91-day rate in 91-days is expected to be 3.97%.

99,019.87
91

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11. Assume that 45% of a Treasury Bill auction was sold for $998 per $1,000 per value, 35% was sold
for $997, and the last 20% was sold for $996. What would be the weighted average price paid by a
noncompetitive bid?
Solution: $998 0.45 + $997 0.35 + $996 0.20 = $997.25
Noncompetitive bidders pay $997.25 per $1,000 of Treasury Bills purchased.
12. In a Treasury auction of $2.5 billion par value 91-day T-bills, the following bids were submitted:
Bidder
1
2
3
4
5

Bid Amount
$500 million
$750 million
$1.5 billion
$1 billion
$600 million

Price
$0.9940
$0.9901
$0.9925
$0.9936
$0.9939

(a) If only these competitive bids are received, who will receive T-bills, what quantity, and at what
price?
(b) If the Treasury also received $750 million in noncompetitive bids, who will receive T-bills, what
quantity, and at what price?
Solution: (a) If only the competitive bids are received, the following bids, quantities, and prices
will be awarded:
Bidder
1
5
4
3

Bid Amount
$500 million
$600 million
$1 billion
$400 million

Price
$0.9940
$0.9939
$0.9936
$0.9925

Amount Paid
$497.00 million
$596.34 million
$993.60 million
$397.00 million

(b) If $750 million in noncompetitive bids are also received, the following bids,
quantities, and prices will be awarded:

Bidder
1
5
4

Competitive Bids
Bid Amount
Price
Amount Paid
$500 million $0.9940
$497.00 million
$600 million $0.9939
$596.34 million
$650 million $0.9936
$645.84 million
Noncompetitive Bids
*
$750 million $0.9938
$745.35 million
$0.9938 = (500 0.9940 + 600 0.9939 +
650 0.9936)/1,750