MODULE 2

Cash Money Markets

Minimum Correct Answers for this module: 6/12

Overall Objective:

To understand the function of the money market, the differences and similarities between the major
types of cash money market instrument and how they satisfy the requirements of different types of
borrower and lender. To know how each type of instrument is quoted, the quotation, value date,
maturity and payment conventions that apply and how to perform standard calculations using
quoted prices. Given the greater inherent complexity of repo, a good working knowledge is required
of its nature and mechanics.

At the end of this section, candidates will be able to:

• Define the money market

• Describe the main features of the basic types of cash money market instruments
 interbank deposits,
 bank bills or bankers’ acceptances,
 treasury or central bank bills,
 commercial paper,
 certificates of deposit and repos
In terms of whether or not they are securitised, transferable or secured; in which form they
pay return (i.e. Discount, interest or yield); how they are quoted; their method of issuance;
minimum and maximum terms; and the typical borrowers/issuers and lenders/investors that
use each type
• Use generally-accepted terminology to describe the cash flows of each type of instrument
• Understand basic dealing terminology as explained in the model code
• Distinguish between and define what is meant by domestic, foreign and euro- (offshore)
money markets, and describe the principal advantages of Euromarket money instruments
• Describe the differences and similarities of classic repos and sell/buy-backs in terms of their
legal, economic and operational characteristics
• Define initial margin and margin maintenance
• List and outline the main types of custody arrangements in repo
• Calculate the value of each type of instrument using quoted prices, including the secondary
market value of transferable instruments
• Calculate the present and future cash flows of a repo given the value of the collateral and an
agreed initial margin
• Define general collateral (gc) and specials
• Describe what happens in a repo when income is paid on collateral during the term of the
repo, in an event of default and in the event of a failure by one party to deliver collateral.

Source: www.aciforex.org

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Cash Money Markets
The money market refers to the market in which large borrowers and investors fund themselves or
invest for periods typically less than one year. These activities include the trading of money market
instruments, often referred to as “paper”, such as T-Bills and CD’s which will be explored in this
module. Although some institutions offer retail money market solutions, the money market is
typically a wholesale one, with minimum amounts of $1 million traded between the participants.
The money market plays a vital part of an efficient financial system and its smooth functioning is
essential to a country’s economy.

Maturities
Cash money markets have maturities that range between one day and 1 year and can be further
distinguished by the terms “Call” or “Term” money.

Term money describes a deposit that has a set maturity date, payment schedule and a fixed interest
rate associated to it, for example a 6 months fixed deposit that pays 10% p.a.

Call money can be left on deposit for an unspecified length of time but must be repaid on demand.
For example an overnight call account will earn a floating rate based on the daily overnight interest
rate which can be placed on the account for 6 months but it can be withdrawn immediately without
incurring penalties.

Domestic and International Markets

A domestic money market transaction is one that is traded within its country of origin in the relevant
domestic currency. For example, a Rand deposit transacted and held in South Africa.

An international money market transaction takes place outside of the domestic jurisdiction. These
types of transactions are usually referred to as “Euro” transactions although they are not specific to
those money market transactions denominated in the euro currency. For this reason and to avoid
confusion they are now also referenced as international transactions. An example of such a
transaction is a US$ 3 month deposit placed and held in a bank account in Japan and is called a 3m
Eurodollar deposit, JPY held by a Frankfurt based bank is EuroYen.

Most domestic money markets will trade from today (T0), (although some domestic markets
conventions do trade value tomorrow)
For example an overnight deposit that starts today and matures tomorrow or a 3 month term
deposit will start today and mature on the same date in three months’ time (assuming it’s a business
day).

“Eurocurrency” deposits work for value spot (T2)

For example a Eurodollar overnight transaction that is agreed today will start in two business days’
time and terminate one day later. A 3month Eurodollar deposit will only commence from spot date
and run for a further 3 months from the spot date. (See Module 1 Day and Date Conventions)

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Money market instruments
Interbank deposits
This is one of the most active segments of the money market and involves the unsecured borrowing
and lending between banks and financial institutions. The distinction of it being an unsecured
transactions indicates that no collateral is taken by the leading counterparty and therefore reflects
the willingness of the lender to take on the credit risk of the borrowing bank.

The size of this market indicates the preference of banks to fund their deficits or manage their cash
surpluses through interbank loans rather than other unsecured lending alternatives and this has
been further enforced from a capital adequacy perspective via Basel directives which assign a more
favourable risk weighting to such transactions.

Interbank deposits are not only unsecured wholesale transactions but also non-transferable which
means that a term interbank transaction cannot by unwound without doing an offsetting borrowing
or loan as they only terminate at maturity.

Quotation and pricing

Interbank loans accrue interest in arrears so upon maturity the principal+ interest is paid to the
lender.

d
Interest Amount  Principal x i x
D
Bids and Offers
Money market instruments accrue interest and therefore their prices are quoted as interest rates
expressed as annual percentages. As in all financial markets these prices are expressed as two way
prices in the form of bids and offers as below:

Bid Offer

4.25 4.40

Market conventions do differ as to whether a price is quoted bid/offer (low/high) or offer/bid

(high/low) but either way the offer is the rate at which market maker is prepared to offer or place
funds (lend) and the bid is the rate at which the market maker is prepared to take or receive
funds(borrow) . The difference between the bid and the offer is the market makers spread.

Bid: Market maker is prepared to borrow at this rate

Offer: Market maker is prepared to lend at this rate

Certificates of Deposit (CD’s)

The non-transferable nature of fixed deposits led to the development of the Certificates of Deposit
market. CD’s are negotiable in nature and which means that they can be transferred to another
party by selling them in the secondary market. This may be preferable to the investor who needs
liquidity before the original maturity date compared to a fixed deposit which would result in
penalties through lost interest.

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CD’s are issued by banks as proof of funds held on deposit on behalf of the customer. They are
interest bearing instruments which promise to pay the holder principal plus interest at maturity and
can be issued as bearer instruments or registered form.

Scripless: Ownership and settlement managed on an electronic registry

Scrip: Issued as a physical certificate

Bearer: The counterparty that holds a bearer certificate is considered the owner

Registered: Registered in the holder’s name which is printed on the certificate (if it is in scrip
form)

Although most CD’s have maturities of less than a year and offer fixed interest which is payable at
maturity, longer dated CD’s may also be issued which pay interest at regular intervals (e.g. every 6
months) or even pay a floating rate referenced to a benchmark. Such floating rate notes usually have
maturities between 3 and 5 years.

Quotation and pricing

CD’s are issued with a face value equal to the amount borrowed and a fixed interest rate for the life
of the loan, therefore they are (like fixed deposits) redeemed for principal plus interest at maturity.
They are referred to as yield instruments and the interest rate is referred to as the coupon. CD’s are
quoted from the securities perspective.

They are quoted as follows:

Bid Offer

5.55 5.40

The market maker is prepared to buy “paper” at 5.55% (which where they are prepared to lend
funds)
The market maker is prepared to sell “paper” at 5.40 (which is where they are prepared to borrow
funds)

A buyer of a CD that holds it to maturity will earn a return equal to the coupon rate paid, its true
yield- this is true for all yield instruments.

( )

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Trading CD’s in the secondary market

The sale of a CD in the secondary market is the same as transferring a loan to the new buyer. This
new buyer of the CD now assumes the credit risk of the bank that issued the paper which they hold.

In other words on transfer the new buyer of the CD does not have credit risk to the counterparty
from which they bought the instrument as it is the issuer from who they will claim their funds.

When a CD is sold before its maturity, the return achieved needs to be calculated. The interest rates
may well have changed and the sale price of the CD must be calculated based on the current market
prices. The proceeds from a sale of a CD before maturity is calculated by applying the present value
formula (using current interest rates for the instrument) to the future value (the original principal +
interest) of the CD at maturity.

( ( ))

To calculate your holding period return, consider the purchase price, sale proceeds and the period of
holding the instrument. The formula is as follows:

( )

Example 1:

A dealer buys a 3 month (91 day) USD CD at 4.75% for $5 million.

31 days later the now 60 day CD is priced at 4.55/4.50 and the dealer decides to sell it.
How much will the dealer receive for the CD and how much return was made?

The dealer will sell the CD at the market makers bid = 4.50

The sale proceeds are calculated as follows:

( ( ))

1. Calculate proceeds at maturity

Original Coupon rate used

( ) Original CD maturity used

= $5,060,034.72

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 2. Calculate sale proceeds
Proceeds at maturity

Remaining days to maturity

( ( ))
Current market coupon for
= $5,022,366.97 60day CD

3. Holding period return

31 day holding period
( ) Note that all equations use the
360 day base convention
=5.19%

In this instance the dealer earned a better return than the original purchase coupon. Why?

Let’s examine:

The dealer bought paper (CD) at 4.75% and sold paper (CD) at 4.50%, although this seems like they
bought high and sold low, which intuitively suggests that they should have lost on the deal, this is
not the whole story.

The dealer bought a CD and 4.75% was used to calculate the FV:
=5,060,034.72

Later the dealer sold the CD, and 4.50% was used to present value these maturity proceeds:

( )
=5,022.366.97

If in fact the dealer had sold at a higher rate, such as 5% they would have been using that rate to
present value their maturity proceeds which would have resulted in relatively lower sales proceeds.
Now you should better understand why the illustrated transaction example resulted in a profit.

The golden rule to remember when referring to instruments in terms of yield is therefore:

BUY HIGH and SELL LOW

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Discount Instruments
Discount instruments are those that don’t pay interest at maturity but instead pay it upfront. The
face value is re-paid at maturity but the initial consideration is the face value reduced by the
discount amount. Discount instruments can be further classified into two categories, straight
discount products and discount-to-yield products.

Straight discount products are quoted and traded at discount rates.

Discount-to-yield products are traded as discount products but the interest rate is quoted as a yield
instead.

A discount rate can be readily converted to be expressed as a yield, or vice versa, so be mindful of
which rate is quoted (for example on a discount-to-yield product) and then apply the correct formula
to calculate the initial consideration or price.

Treasury Bills
T-bills are short-term debt instruments issued by the government to raise funds for both fiscal and
monetary tool purposes. The term “bills” is used to reference their short term nature of less than a
year. As they are issued by government and have short maturities they are considered almost “risk-
free” and will therefore generally carry lower returns than other investments. Most governments
have a regular primary issuance program through which bills are auctioned usually via their central
bank. These are highly liquid instruments with much of their demand being driven by banks due to
their capital reserve requirements which require them to hold these type of low risk short term
assets.

Quotation and pricing

T-bills are discount instruments which are redeemed at face value and issued at a price discounted
from their face value. The markets have different conventions as to whether they are quoted at a
straight discount or a discount to yield.

For example:
US and UK T-bills are quoted as a straight discount rate
Euroland T-bills are quoted as a yield

Bid Offer Remember in all markets where

“paper” is exchanged for funds
2.94% 2.84%
the bid price refers to where
the market maker is bid for
paper and the offer where they
are willing to sell paper. This is
the opposite to the bid and
offer of funds.

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Example 2:

A US T-bill with a face value of $20million matures in 91 days. It is quoted at 2.84%. What price
would you pay for this bill now?

Discount amount = $143,577.78

Use 360 day base (B)

[ ( )]

( )

=$19,856,422.00

Example 3:

A French T-bill with a face value of $20million matures in 91 days. It is quoted at 2.84%. What price
would you pay for this bill now?

Quoted as discount-to-yield
[ ( )]
2.84% is expressed as a yield

Therefore apply PV formula to

[ ( )] Face Value
=$19,857,445.60

Bankers Acceptances (BA’s)

BA’s are also known as bills of exchange or trade bills and they were borne from the need to finance
trade related transactions. Exporters were reluctant to ship goods to their buyers without any form
of promise of payment so importers issued notes promising (promissory notes) to pay for the goods
upon their arrival to enable the trade transactions. The exporter now had promise of payment but
this income was still only due sometime in the future. In order to realise the payment before
delivery took place these notes were sold to a bank nominated by the importer, at a discount. These
promissory notes were usually endorsed by the importer’s bank (e.g. by a letter of credit) to provide
assurance that the importer was in good standing to pay the debt. Banker’ acceptances make a
transaction between two parties who don’t know each other much safer because it enables a bank’s
credit worthiness to be substituted for that of the importer’s. Once the note has been “accepted”
by a bank it becomes a tradeable instrument with relatively low credit risk as it guaranteed by the
accepting bank, the importer’s bank as well as potential recourse to a physical transaction of
underlying goods.

Quotation and pricing

Like T-Bills, BA’s are discount instruments and are similarly quoted as a straight discount in the US
and UK and as a discount-to-yield in Europe

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Commercial Paper (CP)
Commercial paper are the products issued by non-banking institutions to finance their short-term
working capital needs and are usually a cheaper source of funding for them compared to a bank
loan. They are unsecured debt instruments and although they are negotiable in nature although
their secondary market is not as liquid as the T-bills for instance, as most investors tend to hold them
to maturity. Typically CP’s are issued for less than 9 months with maturities between 1 and 3 months
fairly common. Investors in this market prefer issuances with a credit rating and therefore only large
corporations usually issue CP and they get their paper rated from agencies such as Moody’s or
Standard & Poor’s.

Commercial Paper can be issued in the domestic market (CP) or in the “Euromarket” (ECP) and each
has their own convention for quotation.

Quotation and pricing

Euro-commercial paper (ECP) adopts a ‘discount-to-yield’ approach which means it trades at a
discount but it is quoted as a yield. Domestic CP is quoted at a straight discount in the US and UK,
although some domestic markets do apply the yield convention. See Summary below

COUNTRY INSTRUMENT DAY/YEAR BASIS YIELD OR DISCOUNT

CONVENTION
US CD ACT/360 Yield
T-Bill ACT/360 Discount
EUROLAND Money market ACT/360 Yield
UK CD ACT/365 Yield
T-Bill ACT/365 Discount
JAPAN Money market ACT/365 Yield
SOUTH AFRICA CD ACT/365 Yield
T-Bill ACT/365 Discount
EUROMARKET Money Market ACT/360 Yield
(INTERNATIONAL)
Exceptions:
GBP, ZAR ACT/365 Yield

Repurchase agreements (Repo’s)

A repurchase agreement is a transaction between two parties where the one party lends money and
the other lends securities, usually government securities. From a cash point of view it can looked at
as one party borrowing money and simultaneously pledging securities against this loan and for this
reason it can be considered as a form of collateralised
lending.

The transaction involves two legs, whereby the Open Repo’s can be transacted
counterparties agree to exchange cash and securities and which have no fixed date
simultaneously agree to reverse the position on an agreed
date at an agreed price.

Maturities of repos range from 1 day to one year.

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First leg - Sale of the bond
sells 100 worth of bonds

A B
pays 100 cash for bonds

Second leg - Repurchase at the same price

Bank A Bank B
pays 100 cash plus Repo rate

A B
sells 100 worth of bonds

Counterparty A is the initial seller of securities (Borrower of cash)

Counterparty B is the initial buyer of securities and is known as the Reverse Repo (Lender of cash)

Central banks use repo’s extensively to manage liquidity in their banking system. They are also used
by bond traders to fund their positions and by investors such as pension funds and money market
fund managers looking for assets with reduced risk.

There are several ways of structuring a repo agreement, the two main types are the all in (classic)
repo), and the sell/buy back repo

The principal difference between these two types of repo stems from the fact that a repurchase
agreement is always evidenced by a written contract, whereas a sell/buy-back may or may not be
documented.

All in (classic) Repo

This transaction, although economically the same as a secured loan of cash, is legally a sale and
repurchase of securities and it is governed by a standard legal agreement which has been prepared
by The Bond Market Association (TBMA) and the International Capital Markets Association (ICMA).

The repo rate is the return earned on the repo transaction, expressed as an interest rate.

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As legal title to the collateral changes hands, albeit temporarily, if the seller defaults during the life
of the repo, the buyer (as the new owner) can sell the asset to a third party to offset his loss. The
asset therefore acts as collateral and mitigates the credit risk that the buyer has on the seller.

Even though legal title passes to the new holder they do not earn rights to any benefits of coupon
payments paid during the repo period. If a coupon is paid during the repo period, the buyer (new
holder) must pay this back to the seller (reverse repo) immediately.

The legal documentation of this transaction allows the lender of cash (repo buyer) to take collateral
which exceeds the value of the loan amount. This additional collateral (margin) will protect the
buyer against the collateral value falling and being worth less than the cash lent out. During the life
of the repo margin calls can be made to compensate for significant fluctuations in the value of the
collateral compared to the cash. Further to this, the agreement gives the right of substitution which
means that the borrower of cash (securities seller) can call back the collateral and replace it with
another security. In a general collateral repo the lender of cash (securities buyer) may also have
rights to substitution if for example the underlying securities issuer is in default.

General collateral (GC)

If a general collateral repo has been traded the collateral returned on maturity of the second leg
does not have to be identical to what was received upfront. Rather a broad class of assets are
accepted which are high quality and liquid in nature and the users accept that they have the rights to
deliver any of the issues in the GC basket. General collateral baskets are often made up of
government securities.

Special Collateral
There are times when specific issues are in particular demand either due to specific views taken by
market participants or to fulfil obligations on futures and the government bond has become the
cheapest to deliver. In these situations competition will force buyers to offer cheap cash in exchange
for the bond and the repo rate will fall below the GC rate, the security will be said to have “gone on
special”.

Hold in custody repo (HIC)

This repo is where the security remains with the custodian who is arranging the repo on behalf of
the owner of the collateral.

Sell/Buy-back
This transaction comprises two finite deals compared to the classic repo which is one deal with two
legs, and it is not governed by the TBMA/ICMA agreement. Further differences include how a
coupon is handled if paid during the life of the sell/buyback and the exclusion of margin provisions.

In the sell/buy-back, the first deal is a sale of a bond and the second deal is a buy back of the same
bond at a pre-determined price for delivery at the maturity of the repo. The repo rate is implicit in
the forward buy-back price. The bond is therefore bought and sold at different prices whereas the
bond is exchanged at the same price in the classic repo with repo interest paid separately. Sell/buy
backs have to have a fixed maturity so that the forward bond price can be calculated. If a coupon is
paid during the life of this transaction it is paid to the holder of the collateral and it is not necessary

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for it to be repaid immediately as adjustments are made to reflect this payment in the forward price.
As a sell/buy-back is handled as two separate bond transactions variation margin is not possible
although initial margin can be agreed.

Classic repo Sell/Buy-back

Sale and repurchase Outright sale: forward Buy-back

Concluded under one contract Two legally independent contracts

Same price for initial and final bond Different prices for initial and final transaction
exchange: repo interest paid separately

Initial and variation margin allowed Variation margin is not possible

Bond coupon received during trade is Coupon returned with compensation in

returned to seller forward price

Collateral may be substituted No provision for substitution

Quotation and pricing

Classic repos are quoted as interest rates with bids and offers (either Bid/Offer or Offer/Bid), for
instance:

Bid Offer

4.65 4.60

The market maker is prepared to buy bonds at 4.65% (lend funds in exchange for securities).
The market maker is prepared to sell bonds at 4.60% (borrow funds in exchange for securities).

Repo prices are slightly below deposit prices for the same maturities due to their collateralised
nature.

Example 4:

You agree to reverse repo in EUR100m face value of bonds which are trading at a dirty price of EUR
102.75%. How much cash must you provide if a 2% haircut is
agreed?
Collateral value must be 102% of
1. The collateral market value is cash value:
EUR 100m x 102.75% = EUR 102,750,000
Collateral value =Cash x 102%
2. Initial cash consideration is Cash Value = Collateral ÷ 102%
EUR 102,750,000 / 102% =EUR 100,735,294.12

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 The repo is agreed for 7 days at a 5% repo rate:

Repo:
Bond Dirty Price 102.75% Bond nominal to nearest million
Bond Nominal EUR100m
Bond Value 102,750,000 Dirty price X Nominal (face Value)
Initial cash 100,735,294.12
Cash Value = Bond value ÷ 102%
Repo interest rate 5%
Final cash 100,833,231.21 Initial cash x repo rate x d/B

Example 5:

You enter into a repo for EUR100m cash for bonds with a dirty price of EUR 102.75%. Calculate the
terms of the 5% repo for 7 days if a 2% haircut is agreed?

*Eur100m calls for a market value of Eur102 m of bonds as collateral. At a dirty price of 102.75% the
face value of bonds needs to be Eur99,270,072.99. Round this to the nearest million and re-calculate
values based on this amount

Repo:
Bond Dirty Price 102.75% Bond nominal to nearest million
*Bond Nominal EUR99m
Bond Value 101,722,500.00 Dirty price X Nominal (face Value)
Initial cash 99,727,941.00
Cash Value = Bond value ÷ 102%
Repo interest rate 5%
Final cash 99,824,897.72 Initial cash x repo rate x d/B

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Module 2: Review Questions
1. You are looking to buy USD2million of 90 day US T-bills and a dealer has quoted 0.75% / 0.80%.
What would you pay for these bills?
2. You are shown the following. Which are Eurocurrency deposits?
a) A USD deposit held by a bank based in the US
b) A USD deposit held by a bank based in Singapore
c) A EUR deposit held by a bank based in the UK
d) A GBP deposit held by a bank based in the UK

3. 90 day ECP is traded at 2.753% for a face value of USD 10million, how much is paid for the
instrument?

4. 60 days ago you bought a 90day USD10million CD at 2.5% on issue date, now you sell it back at
2.25%. What is the true yield that you have achieved?

5. You buy a secondary USD CD (with an original life of 90 days) for 30 days when the price is
quoted 4.15/ 4.25. The face value of the CD is USD10, 000,000 and the coupon is 4.75%.If you
hold the CD to maturity, what would be your return on investment?

6. Which of the following money market instruments typically pays return in the form of a discount
to face value?
a) USCP
b) Classic repo
c) CD
d) Euro CD

7. Which one of the following instruments has a maximum maturity of 5 years?

a) Euro Commercial Paper
b) US Treasury bill
c) London CD
d) Unsecured USCP

8. A GBP deposit traded in Luxembourg between two Swiss banks is cleared:

a) wherever the parties agree
b) in Zürich
c) in Luxembourg
d) in London

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9. Which counterparty in a classic repo usually takes an initial margin?
a) The seller
b) The buyer
c) Both
d) Neither

10. What happens when a coupon is paid on bond collateral during the term of a sell/buy-back?
a) A margin call is triggered on the seller
b) The equivalent value plus reinvestment income is deducted from the buy-back price
c) Nothing
d) A manufactured payment is made to the seller

11. If the dirty price of a bond is 102.15 and a classic repo for bond with a face value of $10 mio is
done at a rate of 4.75% for 7 days, what is the initial consideration and the final consideration
money if a 2% margin is called for?

12. In a classic repo, who receives the coupon?

13. What is the secondary market value of a GBP200m 4% CD originally issued for 91 days,that is
trading at 3.65% after 60 days?
a. GBP200,789,781.86
b. GBP200,800,684.72
c. GBP201,370,272.70
d. GBP201,389,244.64

14. What market value of collateral does a dealer need against USD50million in cash in a 3 day
reverse repo at a rate of 2.10% if initial margin of 2% is taken?
a. USD52,000,000
b. USD51,000,000
c. USD50,000,000
d. USD49,000,000

15. In a sell/buy back repo, if the collateral falls in value the lender of cash can:
a. Call for additional collateral
b. Substitute the collateral
c. Cancel the transaction
d. None of the above

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