FINANCIAL INSTITUTIONS

REPORT

MONEY MARKET INSTRUMENTS

SUBMITTED TO: SHARIQUE AYUBI SUBMITTED BY: ABDUL SAMAD MUNAF ID: 8905 DATE: 9TH DECEMBER 2009

LETTER OF AUTHORIZATION

TABLE OF CONTENTS
TABLES OF CONTENTS
Introduction------------------------------------------- History----------------------------------------------- Types of Mutual Fund----------------------------------- Advantages of Mutual Fund------------------------------Disadvantages of Mutual Fund ---------------------------4 4 5 7 9 11

History of Mutual Funds in Pakistan-------------------------

INTRODUCTION

The money market exists for the purpose of: Issuing and trading of short term instruments, that is, instruments where the term remaining form the date when trading takes place to the date of maturity, is of a short-term nature.

Characteristics of money market instruments Short term borrowing and lending Low credit risk High liquidity High volume of lending and borrowing

INSTRUMENTS IN PAKISTAN
TREASURY BILLS CERTIFICATE OF DEPOSITS COMMERCIAL PAPER REPURCHASE AGREEMENTS BANKERS ACCEPTANCE EURODOLLAR DEPOSITS FEDERAL FUNDS

TREASURY BILLS
T-BILLS are the government debt securities that matures in one year or less from their issue date. A treasury bill differs from other types of investments in that they do not pay investments in that they do not pay interest in the traditional way. When an investor wishes to purchase a treasury bill, he buys it at a discount rate. The return to the investor is the difference between the maturity value and issue price.

FEATURES OF TREASURY BILLS:

Issued through bidding process. Zero coupon bonds sold at a discount to their face values. Purchased by individual, institutions, and corporate bodies including banks irrespective of their residential status. Can be traded freely in the countrys secondary markets, physical delivery could be affected if required.

INVESTMENT CHARACTERISTICS OF TREASURY BILLS:

Default risk: T-bills are on the guarantee of government, sothey have minimum default risk. Liquidity: T-bills are highly liquid instrument of financial market. Securities can be liquidated whenever the holder wants. Minimum denomination: T-bills are trade on the face value of Rs: 100 in Pakistan and in denominations of multiples of 100.

TYPES OF TREASURY BILLS:

There are different types of Treasury bills based on the maturity period and utility of the issuance like, ad-hoc Treasury bills, 3 months, 12months Treasury bills etc.

12-months (one-year) 6-months (24Weeks) 3-months (12-Weeks)

HOW TO CALCULATE RETURN ON T-BILLS?

T-bills are sold at a discount from their par value. Yield is based on their appreciation in price between times of issue. Time they mature or are sold by the investor. Bill yield are determined by the discount method: Treats the par value as the investment base Uses a 360-day year for simplicity

Discount rate = (par value-purchase price)/par value *360/number of days to maturity

Suppose you buy a 12 Weeks T-bill at Rs.98 and keep it until maturity having face value of rs.100. Then the discount rate on this bill can be calculated as:

How T-Bills are traded in Pakistan?

At start
Treasury bills were issued on fixed rate. e.g.; six months at 6 percent per year

In April 1991
Introduce the American-style auction-based system. The role of primary market restrict to fortnightly auctions. Primary dealers were appointed.

State bank of Pakistan is using two method of trading TBILLS:

Auction system Open Market Operations (OMO)

AUCTION SYSTEM:
1. 2. 3. 4. 5. SBP announces the T-Bill auction. Primary dealers submit the bids. After the submission deadline, bids will open. MOF decides the cut off price. After one or two days of finalizing price, securities are issued.

OPEN MARKET OPERATION:

In OMO Government fix the discount rate before the announcing the new securities and can be issued when they need funds. Through OMO Government can sell as well as buy back securities.

Trading T-Bills in OMO is mainly to control the circulation of money in the market .

Certificates of Deposit (CODs)

A certificate of deposit is a time deposit issued by a bank that pays interest periodically or at a specific maturity date, as evidenced by a certificate. The bank, or other financial institution, issues a certificate which indicates a specific dollar amount has been deposited with that bank for a fixed period of time at a predetermined interest rate. The characteristics of CDs are listed below,

Interest calculations are mostly based upon a standard 360 days in a year called actual/360 but some are actual/365 Insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000

Because CDs are only insured by the FDIC for $100,000, and because the investment is dependent solely upon the credit worthiness of the bank deposits of amounts in excess of $100,000 should be secured in some way. Collateralization recommendations:

Obtain state collateralization law Obtain Federal Reserve Banks operating circular on public depositors collateral Ask the bank to pledge securities to secure deposits of public monies that are not otherwise insured by the FDIC Identify depository risk exposure how reliable is the bank Establish a written depository collateralization agreement that includes: (1) funds to be collateralized; (2) eligible collateral; (3) market value; and collateralization ratios. Establish effective safekeeping procedures Prepare financial reporting disclosures

Credit Risk:
High. The investor should monitor the financial condition of the bank.

Liquidity Risk:
High. CDs cannot be liquidated without paying penalty.

Market Risk:
Moderate. Monitor collateral value and require adequate margins.

Advantages:
Flexible rate structures for small and large denominations ease of investment transaction.

Disadvantages:
Not liquid. Dependent upon FDIC insurance under $100,000 and dependent solely upon the credit worthiness of the bank if not collateralized.

COMMERCIAL PAPER
Short-term, unsecured promissory notes issued by well-known companies carrying high credit rating Used to meet immediate cash needs Funds raised from commercial paper are commonly used for current transactions SBP and SECP started process of creating commercial paper market in Pakistan in 2003

Maturity period: Between 30 days and one year from the date of subscription.

Issuer of Commercial Paper:

Highly rated companies and financial institutions with minimum equity of Rs. 100 million Minimum current ratio of 1: 1 and debt/equity ratio of 60: 40. Minimum credit rating of the issuer shall be A- No overdue loan or defaults

Size and Denomination:

Minimum size of the issue of commercial paper shall not be less than Rs.10 million In case of private placement, CP would be denominated in Rs. 100,000 or in multiple thereof In case of offer to general public, CP may be denominated in Rs. 5,000 or in multiples thereof

Mode of Issue and Discount Rate:

In the form of a promissory note Discount to face value is determined by the issuer keeping in view the prevailing T-bill rates, KIBOR and issuers credit rating

Calculation of Rate of Return: DRcp = (Par Value Purchase Price) / Par Value X 360 / Days to Maturity Investor of Commercial Paper:
Can be issued by way of Public offer and/or to Scheduled Banks Large Institutions as the issue size is often too high for individual investors

Advantages for Investor:

Higher yields than time deposits Safe investment Specific maturity dates chosen by the purchaser within a range of 270 days, and rated by credit agencies for evaluation purposes.

Disadvantages:
Reduced liquidity. The lack of active secondary market reduces the liquidity of commercial paper; there also may be other associated market pricing difficulties.

REPURCHASE AGREEMENT
A repurchase agreement is an agreement between a seller and a buyer in which the seller agrees to repurchase the securities at an agreed upon rate. A holder of securities sells repurchase agreements to an investor with an agreement to repurchase them at a fixed price on a fixed date. The security buyer, in effect, lends the seller money for the period of the agreement. The terms of the agreement are structured to compensate the security buyer. Large amounts of money are needed for this type of investment. Types of repurchase agreements are listed below.

Overnight repurchase agreements, which mature the next day Open repurchase agreements, which have undefined maturities. The rates are variable or set daily, they roll or terminate at the request of either party Term repurchase agreements have a defined maturity date, a fixed rate, and are liquid

Repurchase agreements can help brokers finance their inventories. The safety of repurchase agreements is based on: (a) The counterpartys credit-worthiness, (b) A written and signed repurchase agreement, (c) A safekeeping location, and (d) Delivery versus payment.

Types of Repo (In Term of Maturity) 1. Overnight repos 2. Term repos 3. Open repo

Major Borrowers and Lenders:

Major borrowers include government bond dealers of Treasuries and federal agency securities, and large banks Active lenders include state and local governments, insurance companies, Large banks, non-financial corporations, and foreign financial institutions Government securities are the main collateral for most repos

Repo Interest Income:

The difference between the underlying securities current price and repurchase price is the amount of interest paid by the borrower to the lender

RP Interest income = Amount of loan x Current Repo Rate x (Repo Term in days/360 days)

Purpose of Repo:
To meet deposit reserve requirements In order to purchase interest bearing securities Companies lend to avoid losing even a single days interest.

Credit Risk:
Low if covered by a Master Repurchase Agreement, which is a written contract that covers all repurchase transactions between two parties with respect to the repurchase agreements that have established each partys rights in these transactions? A master repurchase agreement will often specify, among other things, the right of the buyer or lender to liquidate the underlying securities in the event of a default by the seller or borrower.

Liquidity Risk:
Not applicable if the repo is executed as an overnight trade. Liquidity risk is high if the repo is executed as a term trade (greater than one day). A repo is considered to be an investment agreement.

Market Risk:
Not applicable if the repo is executed as an overnight trade. Low, if the repo is executed as an open or term trade. Monitor collateral regularly

Advantages:
Repos allow for overnight investments to the penny. They also offer flexibility and market rates.

Disadvantages:
Rates are influenced by the fluctuating daily federal funds rate and the quality of available collateral, there is collateral risk if the collateral is not delivered DVP (delivery vs. payment).

Bankers Acceptance
Acceptance means a vow to pay a definite amount of money The person who will pay is called as the promissory while the one who will receive is the beneficiary

Requirements of the Time Draft:

Promissory Signature The word accepted on top of his signatures and The date on which the amount will be paid. If the time draft is formally accepted by a bank then it becomes a bankers acceptance The maturities of bankers acceptance mostly range from 30 to 180 days The promissory uses the banks credit worthiness instead of his own

Mechanism of Bankers Acceptance:

Importer

Importers Bank

Acceptance

Manufacturer

Letter of Credit

Time Draft

Accepted

Discounted

Secondary Market for the Bankers Acceptance:

The issuing bank can either keep it in his portfolio or sell the bankers acceptance in the money market. It is sold at a discount from the value which will be payable on maturity. The net proceeds after the sale = The face amount of the acceptance The discount rate (interest rate*days into maturity*face amount) - The banks acceptance commission The combination of these is called the all in rate.

Credit Risk:
Moderate to high. Ratings banks issuing the bankers acceptance should be monitored. The short term obligations of the bank must be rated not less than A1/P1.

Liquidity Risk:
Moderate. Monitor credit and stability of bank. A bankers acceptance may be somewhat difficult to sell.

Market Risk:
Low to moderate, due to the short-term nature of this security.

Advantages:
Higher yield, specific maturity dates are chosen by the purchaser within a range of 180 days.

Disadvantages:
Reduced liquidity. The lack of active secondary market reduces the liquidity of commercial paper; there also may be other associated market pricing difficulties.

Eurodollar Deposits
Eurodollars are the deposits of US dollars in banks which are located outside United States. Generally, the "euro" prefix can be used to indicate any currency held in a country where it is not the official currency. The Eurodollar deposits are always moving in the form of loans.

Mechanism of Eurodollar Deposits:

Dealer In Pakistan

Gets Shipment Amount in Dollars

Deposited in a Bank Situated in US

Amount in Dollars Transferred to a Bank Situated In Pakistan

Eurodollar Deposits:
The chain of Eurocurrency and Eurodollars will remain functioning until they are in demand. Many are held for one month that is the usual time period for the shipment of goods. There is no central location for the trading of the Eurocurrency deposits. They are volatile and sensitive to fluctuations in interest rates and currency values. Difference of Interest rate Changes in Currency Value Political Risk Daily Cost of Funds derived from Eurodollars: Amount to be loaned * interest rate * 1/360

Federal Funds
Federal funds refer to the overnight borrowings which are undertaken in order to meet the state banks reserve requirements. The funds are not physically transferred. Commercial banks are the principle borrowers Meet the Legal Reserve Ratio requirement. Interest rates highly fluctuate daily depending on the volume of funds which are surplus in the market and the volume of fund needed by the market. Borrowers need of funds is fulfilled while the lender earns interest income on his funds.