Learning Outcomes
• Define the money market
Cash Money Markets
Learning Outcomes (Continued)
• 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 Euromarkets money instruments
Learning Outcomes (continued)
• 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
• Describe the main features of the basic types of cash money market
instrument
− 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
Learning Outcomes (continued)
• 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
Source: www.aciforex.org
Money Markets & Capital Markets
Cost Of Funds
• Pricing: Interest bearing instruments
− NACQ: Nominal Annual Compounded Quarterly
− NACM: Nominal Annual Compounded Monthly
• There really are only two overarching types of ways in
which the cost of funds are expressed:
− Fixed Rate - the same rate charged over the life of the transaction
on a pre-determined basis for example 10% NACQ (act/365)
− Floating Rate - the interest rate is reset periodically, linked to a
reference rate such as Jibar or Libor
Nature of interest rates
• An interest rate is the price a borrower pays
• The return a lender receives for deferring consumption, by
lending to the borrower.
• Interest rates are normally expressed as a percentage over
the period of one year.
• Interest rates are also a vital tool of monetary policy and are
used to control variables like investment, inflation, and
unemployment.

Influences on interest rates What determines the market rate?

• Deferred consumption • The risk-free cost of capital

• Inflationary expectations • Inflationary expectations

• Alternative investments • The level of risk in the investment

• Risks of investment • The costs of the transaction

• Liquidity preference

• Taxes

Types of interest rate instruments Classification of interest rate instruments

• Both assets and liabilities follow similar market observations
• Securities are usually classified into two broad areas
− Money market instruments/securities
− Capital market instruments/securities
• Both classifications are largely based on the amount of time for which
the funds will be used (referred to as tenor)
• One can further distinguish funds via the following
classification:
– Call funding / deposits
– Term funding / deposits
• The cost of money thus logically follows
– Liquid funds (in terms of notice) will pay/cost less
– Longer maturities typically pay/cost more (normal yield curve)

• Money market are all instruments with a maturity within 12 months

• Capital markets follow for maturities past 12 months

Cost of funds Why do rates float?
• There really are only two overarching types of ways in which • The Interest Rate Market is a dynamic market where
the cost of funds are expressed suppliers and users of funds meet

• Fixed Rate • The price of money (interest rate) therefore can never be
– The same rate charged over the life of the transaction on a pre- static given that numerous factors influence the cost of
determined basis for example 10% NACQ (act/365)
money, such as:
– Availability
• Floating Rate – Type of security provided
– The interest rate is reset periodically, linked to a reference rate such – The liquidity of the instruments once entered into
as Libor – The economic conditions prevailing in the country

Why fix? Question

• Though the price of money (interest rate) floats it does not • Which of the following rates represents the highest
imply that one has to remain floating investment yield in the market?

• View dependence may drive one side of the coin to prefer a a. Semi-annual bond yield of 3.75%
b. Annual bond yield of 3.75%
fixed rate of return over the ability to float c. Semi-annual money market yield of 3.75%
– E.g. an investor expecting rates to fall may opt for a fixed rate d. Annual money market rate of 3.75%
– Similarly, a borrower expecting rates to go up, may also prefer to fix
the interest rate

How do we answer this one? Answer – Step 1 (MM to Bond)

STEP 1 : CONVERT MONEY MARKET RATES TO BOND RATES
Formula Sheet: 365
Rate (bond) = Rate (mm) x 360
STEP 2 : ONCE ALL IN BOND RATES – THEN CONVERT TO THE
SAME NACA OR NACS a. Semi-annual bond yield of 3.75% NOTHING TO DO
b. Annual bond yield of 3.75% WITH THESE

a. Semi-annual bond yield of 3.75% c. Semi-annual money market yield of 3.75%

b. Annual bond yield of 3.75% Rate(bond) = 0.0375 x 365/360 = 0.0380 or 3.80%
Convert these to
c. Semi-annual money market yield of 3.75% Annual effective
d. Annual money market rate of 3.75% rates …
d. Annual money market rate of 3.75%
OR Rate(bond) = 0.0375 x 365/360 = 0.0380 or 3.80%
Convert these to
Semi-annual rates
 Answer – Step 2 (NACS to NACA) Answer
2
Formula Sheet: Rate (semi) • Which of the following rates represents the highest
So – Back to the original
Rate (annual) = 1 + 2
Answers
-1 investment yield in the Euromarket?
a. Semi-annual bond yield of 3.75% a. Semi-annual bond yield of 3.75%
Annual Equivalent = [1+(0.0375/2)]^2 – 1 = 0.037852 or 3.7852% b. Annual bond yield of 3.75%
c. Semi-annual money market yield of 3.75%
b. Annual bond yield of 3.75% d. Annual money market rate of 3.75%
c. Semi-annual money market yield of 3.75% 3.80%
Annual Equivalent = [1+(0.0380/2)]^2 – 1 = 0.0384 or 3.84%

d. Annual money market rate of 3.75% 3.80%

Money Market Instruments

• Treasury Bills

• Interbank Deposits

• Certificates of Deposits

• Commercial Papers

• Bills of Exchange
Money Market Instruments

Euromoney Markets Treasury Bills

• Domestic Market vs. Eurocurrency Market • T-Bills are issued, and backed by, by the US government

• Seen to be ‘risk free’

A eurocurrency deposit is a term used for
deposits in a currency that is held outside the
country of domicile (issue) of the currency • Maturities up to 1 year, in varying maturities

• Discount instruments (i.e. no interest payments) quoted to 2

• e.g. USD deposit held by a London based bank is decimal places
Eurodollars
• Redeemed at Face Value
• e.g. JPY deposit held by Paris based bank is Euroyen
Treasury BILLS (contd.) Treasury Bills (continued)
Pricing T-Bills: YIELD QUOTATION Pricing T-Bills: DISCOUNT RATE QUOTATION
Price = Face Value, discounted at the prevailing market rate • In some markets (e.g. the US and UK), quotations are in the
form of a Discount rate
• Discount rate (i) is used to calculate the Discount amount

d
Face Value (known as PAR) Disc Amt  Face Value x i x
P D
1  (i x d/D) • Where:
– d = days
– D = Day Basis

• Price = Face Value – Discount Amount

Converting A Discount Rate To A Yield Interbank Deposits

• In the exam, you may be asked to convert a Discount Rate • Lending and borrowing of funds (unsecured) between banks and
to a Yield Rate financial institutions

• Seen as more advantageous (capital adequacy calc) than unsecured

• Formula sheet: simply plug in the numbers! lending to non-financial institution

d • Interbank deposits quoted to 2 decimal places, with a bid & offer

True Yield  Discount rate / 1 - (discount rate x ) • BID: rate at which a borrower is willing to borrow (the lower rate)
D
• OFFER: rate at which a lender is willing to lend (the higher rate)
• Where:
d
– d = days
Interest Amt  Principal x i x
– D = Day Basis D
• At Maturity, Principal + Interest is repaid to the Lender

Certificates Of Deposit Certificates Of Deposit (continued)

• Also referred to as CDs • Price on the secondary market = PV of all future cash flows,
discounted at the prevailing market rate (i)
• Fixed or floating rate

• Between banks and their customers, maturity can exceed one year
(would then expect to receive periodic interest payments)
Proceeds at Maturity
• CD is issued by the bank as proof of funds held on behalf of the P
customer
1  (i x d/D)
• Funds can only be accessed on predetermined date; otherwise subject
to early termination charges
• REMEMBER: the yield (i) is in decimal form (e.g. 3.50% =
• At Maturity, Principal + Interest is repaid to the Lender 0.035)
• Can be sold in the secondary market; interest up to point of sale will
accrue to the seller
Bills Of Exchange Commercial Paper
• Also referred to as Bankers Acceptances, or BAs • Unsecured short-term note issued by a non-bank corporation

• Arose out of international trade requirements • Used to finance working capital needs, thus generally short maturities

• Importer issues promissory note, e.g. LC, endorsed by his bank • Importer issues promissory note, e.g. LC, endorsed by his bank

• Exporter takes this to his bank (who ‘ accepts’ the note) to obtain • Cheaper source of short term funding than bank loans
finance; sold into the secondary market at a discount to FV
• Credit risk: Generally issued by large corporations with a credit rating
• Credit risk is low: Backed by accepting bank, with recourse to the
importer’s bank • Pricing is the same as that of Treasury bills – Yield or Discount
approach, depending on place of issue
• Price = Face Value – Discount Amount

(WHERE HAVE WE SEEN THIS BEFORE??)

Question Answer - Calculations

Method 1 Weighted Average
• You have taken 3-month (92 days) deposits of 92 DAY MONEY MARKET INSTRUMENTS
− USD 12,000,000.00 at 1.10% and Weighted
− USD 6,000,000.00 at 1.04%. DEPOSIT RATE Rate LENDING RATE
-12 000 000.00 1.10% 0.73% 18 000 000.00 1.14%
• Minutes later, you quote 3-month USD 1.09-14% to
-6 000 000.00 1.04% 0.35%
another bank. -18 000 000.00 1.08% 1.08% 18 000 000.00 1.14%
• The other dealer takes the USD 18,000,000.00 at your Difference 0.06%
quoted price. Effective Interest Earned $ 2 760.00

• What is your profit or loss on this deal?

Method 2 Interest Earned per trade
a. USD 2,722.19 92 DAY MONEY MARKET INSTRUMENTS
b. USD 460.00 DEPOSIT RATE Interest LENDING RATE Interest
c. USD 3,220.00 -12 000 000.00 1.10% -33 733.33 18 000 000.00 1.14% 52 440.00
d. USD 2,760.00 -6 000 000.00 1.04% -15 946.67
-18 000 000.00 1.08% -49 680.00 18 000 000.00 1.14% 52 440.00
Difference $ 2 760.00

Question Question
• You have taken 3-month (92 days) deposits of • A 3-month (91 Day) US T-Bill is quoted at a rate of discount
− USD 12,000,000.00 at 1.10% and of 4.25%. What is the true Yield?
− USD 6,000,000.00 at 1.04%.
• Minutes later, you quote 3-month USD 1.09-14% to
a. 4.19%
another bank.
b. 4.25%
• The other dealer takes the USD 18,000,000.00 at your c. 4.30%
quoted price. d. 4.31%
• What is your profit or loss on this deal?

a. USD 2,722.19
b. USD 460.00
c. USD 3,220.00
d. USD 2,760.00
 Answer - Calculations PV and FV
What did we calculate?
d
True Yield  Discount rate / 1 - (discount rate x
First
) the discount from 100 = 4.25%, thus making the price 98.93
D (calculated as 100-(100 x 4.25% x 91/360)
= 0.0425 / 1- (0.0425 x 91/360)
= 0.0430 or 4.30%
PV 100 discounted at 4.25% for 91 days FV
98.93 100
98.93 grows to 100 at a yield of 4.30%

Second
What yield is required to take 98.93 back up to 100
(calculated as 100-98.93 = 1.07 thus (1.07/91 x 360 / 98.93) = 4.30%

SO – YIELD AND DISCOUNT

depends on where you start from

Answer Question
• A 3-month (91 Day) US T-Bill is quoted at a rate of discount • A 30-day 2% CD with a face value of GBP 20,000,000.00
of 4.25%. What is the true Yield? is trading in the secondary market with 20 days remaining
to maturity at 2.05%.
a. 4.19% • What would be your holding period yield if you bought the
b. 4.25% CD now and held it to maturity?
c. 4.30%
d. 4.31% a. 2.00%
b. 2.05%
c. 2.891%
d. 2.838%

Answer - Calculations Question

• A 30-day 2% CD with a face value of GBP 20,000,000.00
Proceeds at Maturity
P is trading in the secondary market with 20 days remaining

1  (i x d/D)
to maturity at 2.05%.
• What would be your holding period yield if you bought the
CD now and held it to maturity?
Step 1 = Work out how much you need to invest today
20,032,876.71 / [1 + (0.0205 x 20/365)] = 20,010,399.28 a. 2.00%
b. 2.05%
c. 2.891%
Step 2 – Work out the effective interest rate implied in the d. 2.838%
investment made today
20,032,876.71 – 20,010,399.28 = 22,477.43
22477.43/20x365/20,032,876.71 = 0.0205 or 2.05%
 Definition Of A Repo
• The term “Repo” is from “Sale and Repurchase
Agreement”

• Repo is a money market instrument. There are two usually

two parties to a repo transaction.
– One party “sells” securities (e.g. bonds) to the other while
simultaneously agreeing to repurchase them or receive them back
at a specified future date
– One party requires either the cash or the bonds and provides
collateral to the other as well as compensation for the temporary
Repurchase Agreements use of the desired asset
(REPO)

Repo Definition (Continued) Classic Repo

• Repo is therefore a secured loan
– Legally : a sale and repurchase of securities
– Economically : a secured loan of cash
• The cash investor (lender of cash or ‘reverse repo’) has
security against his loan and receives the repo rate
(‘interest’) as compensation
• Loan amount < Collateral value: Initial margin or ‘haircut’
• Two types: Classic (all-in) repo & Sell/buy-back repo
• Subject to a standardised regulatory contract, prepared by
TBMA and ISMA
• Fixed maturity or open-ended
• Collateral is exchanged and title passes to the new holder
(Lender of cash); collateral either delivered or held in
custody by custodian
• Lender receives agreed rate of interest (repo rate)

Classic Repo (continued) Classic Repo (One Deal With Two Legs)

First leg - Sale of the bond

• Benefit of coupon payments remain with Borrower of cash sells 100 worth of bonds
and are paid over by the Lender

• Risk (e.g. price fluctuation or default) and return on the

pays 100 cash for bonds
Securities remain with the seller of the Securities

• Lender of cash may take Initial Margin, as well as make Second leg - Repurchase at the same price

margin call (Variation Margin) if the value of collateral falls. Bank A Bank B
Collateral may even be substituted pays 100 cash plus Repo rate

sells 100 worth of bonds

Sell/Buy Back Repo Sell/Buy Back Repo (continued)
• Non-standardised agreement; TBMA and ISMA rules do • Risk (e.g. price fluctuation or default) and return on the
not apply Securities pass to the Cash Lender

• Must have Fixed maturity • The Forward Price will this reflect the coupon received and
collateral quality
• Outright sale; Collateral is exchanged and title passes to
the new holder (Lender of cash) • Rare for Initial Margin to be take. No Variation Margin

• At maturity, Cash Lender will receive the Forward Price

which was agreed at inception

• Coupon payments will be received by the Cash Lender

(holder of Collateral)

Sell/Buy-back Repo (two deals) REPO

First deal - Outright Sale
sells 100 worth of bonds • Repo rate is quoted as Bid/Offer or Offer/Bid: Always
borrow at HIGH and lend out funds at LOW

pays 100 cash for bonds
Second Deal - Forward buy-back
Bank A Bank B
pays pre-determined price
• Advantages for the cash investor :
− secured investment
− repo rate competitive with bank deposits
− diversification away from bank risk

sells ??? worth of bonds

Question Answer
• What are the primary reasons for taking an initial margin in • What are the primary reasons for taking an initial margin in
a classic repo? a classic repo?

a. Counterparty risk and operational risk a. Counterparty risk and operational risk
b. Counterparty risk and legal risk b. Counterparty risk and legal risk
c. Collateral illiquidity and counterparty risk c. Collateral illiquidity and counterparty risk
d. Collateral illiquidity and legal risk d. Collateral illiquidity and legal risk
Question Answer
• What happens when a coupon is paid on bond collateral • What happens when a coupon is paid on bond collateral
during the term of a classic repo? during the term of a classic repo?

a. Nothing a. Nothing
b. A margin call is triggered on the seller b. A margin call is triggered on the seller
c. A manufactured payment is made to the seller c. A manufactured payment is made to the seller
d. Equivalent value plus reinvestment income is deducted from the d. Equivalent value plus reinvestment income is deducted from the
repurchase price repurchase price

Question Answer - Calculations

• The two-week repo rate for the 5.25% Bund 2014 is quoted What do we know?
to you at 3.33-38%. Repo will be for 2 weeks i.e. 14 days
It’s a Reverse Repo – thus we EARN interest
• You agree to reverse in bonds worth EUR 266,125,000.00 On a quote of 3.33 – 38 which rate will apply to you?
with no initial margin.
You would earn interest at 3.33%
• You would earn repo interest of: Nominal of EUR 266,125,000.00
NO Margin – i.e. no additional interest calculations to
a. EUR 349,806 consider
b. EUR 344,632
c. EUR 319,315
d. EUR 324,110 266,125,000 x 0.0333 / 360 x 14
= 344, 631.88

Answer Summary
• The two-week repo rate for the 5.25% Bund 2014 is quoted • The price of near everything in finance can be estimated or calculated as
the present value of all future cash flows.
to you at 3.33-38%.
• Hence the importance on knowing exactly:
• You agree to reverse in bonds worth EUR 266,125,000.00 − When the flow will occur
with no initial margin. − How frequent it will occur
− The values of each
− What the interest rate expectation over time will be
• You would earn repo interest of:
• The pricing relationship (“Rule of one price”) binds security values
a. EUR 349,806
b. EUR 344,632 together in cases where any pay-off or profile in one, can be replicated in
c. EUR 319,315 another.
d. EUR 324,110
• The market compensates for risk (no free lunches)