Professional Documents
Culture Documents
Part 11
Part 11
1
Introduction
2
Introductio
n
Introduction
All debt markets have a common feature
needs
3
Introductio
n
Purpose of borrowing
4
Introductio
n
Types of financial assets
short-term securities
5
Introductio
n
Term to maturity
Loans in the money market have an
original term to maturity of <1 year
Original term to Actual term to
maturity maturity
The original term to The actual term to
maturity of a security is maturity is the current
its term to maturity at the term to maturity of the
time of issue security
It cannot change once a It will obviously keep
security is issued declining with the
passage of time
6
Introductio
n
Money Markets
Money market securities have to be debt
securities
Since equity shares have no maturity date.
Money market consists of transactions to
meet short-term cash needs
Meant for current account, not for capital account
It is the mechanism through which holders of
‘temporary cash surpluses’ interact with
parties with ‘temporary cash deficits’
The nature of transactions range from overnight
to 1 year
7
Introductio
n
Why?
8
Example
Disbursements must be
made throughout the When tax revenues arrive
year to meet expenses the government will be
such as Wages, Salaries, temporarily flush with
Office supplies, Fuel funds
costs At such points in time it
will enter the money
market as a lender
9
Example
Example – Business
11
Example
Example – Business
12
Introductio
n
Why the attention?
Why are we so concerned about short-term
transactions?
Money is an extremely perishable commodity
When idle cash is not invested there is an opportunity
cost - interest income is foregone
Income that is lost is lost forever
When large amounts of funds are involved, the income
that is lost from not profitably investing idle funds for
even a day can be substantial
13
Introductio
n
Example
A firm has 12MM dollars available overnight.
Assume interest rate @ 12% p.a.
Assume the year has 360 days
A common assumption in money markets
If money is kept idle the lost income will be:
12,000,000 x 0.12 x (1/360) = $4,000
If the money were to remain idle for a week the
income foregone will be $28,000
14
Introductio
n
Borrowers & Lenders
It is very difficult to classify an economic entity
as a borrower or a lender.
The same institutions frequently operate on both
sides of the market
E.g. Citibank
Borrower Lender
It will borrow regularly in At the same time it will
the money market by be making short term
way of Certificates of loans to corporate
Deposit, borrowings of borrowers
Federal Funds etc.
15
Introductio
n
Borrowers & Lenders
Borrower Lender
Frequently a corporation will Only to come back into
borrow millions of dollars on a the market as a lender a
single day few days hence due to a
sudden upsurge in cash
receipts
Institutions that are present on both sides of the market
include Large banks, Finance companies, Non-financial
corporations, Central Banks of countries
One institution that is usually
always on the demand side is
the government. At any point
in time the U.S. Treasury is the
largest borrower in the world
16
Introductio
n
What do investors want?
17
Introductio
n
Liquidity
A liquid market is characterized by the
presence of a large number of buyers
and sellers at all time.
What would happen if the market were
to be illiquid?
If there is excess demand large buy orders
will send prices shooting up
If there is excess supply large sell orders
will send prices crashing down.
18
Introductio
n
Liquid market
In a liquid market large trades can be
executed without a major price impact
Liquid markets are characterized by low
bid-ask spreads
Since transactions are frequent dealers
can afford to operate with a smaller
profit per round trip transaction
Bid the price at which the dealer buys
from the public
Ask the price at which the dealer sells to
the public
Round trip a purchase followed by a
subsequent sale
19
Introductio
n
Safety
20
Introductio
n
Safety - Examples
1970: Penn Central Transportation
Company defaulted on its short-term
commercial notes.
The short-term commercial paper market
ground to a halt
Investors refused to buy even paper issued by
top grade companies
1980s: Continental Illinois Bank had to be
propped up by government loans.
Immediately rates on all short-term bank CDs
rose
There was a fear that all large bank CDs had
become risky 21
Introductio
n
Risks in the Market
Risks
Re-
Market Default Inflation Currency Political
investment
Risk Risk Risk Risk Risk
Risk
22
Introductio
n
Risks in the Market
23
Introductio
n
Risks…(Cont…)
4. Inflation risk - the risk that the purchasing power of cash
flows received from a security could erode.
5. Currency risk - the risk that the domestic currency may
appreciate with respect to a foreign currency.
This will lead to lower cash inflows in terms of domestic
currency when foreign currency is converted.
6. Political risk - the risk that changes in regulations may
result in reduced returns or even a total loss of invested
capital.
24
Introductio
n
Risks…(Cont…)
26
Introductio
n
Other Risks
28
Introductio
n
Features (Cont…)
29
Introductio
n
Central Banks
The market is overseen by the Federal
Reserve Bank in the U.S. and by the
central banks of other countries. These
are:
U.K. – Bank of England
Japan – Bank of Japan
Europe – European central bank
Germany – Bundesbank
Australia – Reserve Bank of Australia
30
Introductio
n
Features (Cont…)
31
Categories of Money Market
Instruments
32
Categories of
MMI
Categories
Money
Market
Instruments
Off-balance-sheet Derivative
Cash Instruments
Instruments Instruments
33
Categories of
MMI
Categories
Cash instruments - A contract for the
immediate borrowing or lending of funds
Off-balance-sheet instruments (OBS) -
Arrangements for borrowing or lending at
a future point in time
The price is fixed in advance
This cannot be recorded on the balance sheet
of the parties
Balance sheet can only reflect current
borrowing/lending
34
Categories of
MMI
Cash Instruments
Cash
Instru-
ments
Bank bills
Certifi- Re-
Deposits & Commer-
Treasury cates Euro purchase
& Bankers’ cial
Bills Of notes Agreee-
Loans Accept- Paper
Deposit ments
ances
35
Categories of
MMI
Illustration
% p.a.
36
Categories of
MMI
Derivative Securities
Some off-balance-sheet-instruments do
not involve future borrowing / lending
They are used for managing risk
Only a return is paid
Instruments
38
Categories of
MMI
Notional Principal
39
Key Dates in Cash Market
Instruments
40
Key Dates
Key Dates
Transaction date
Value date
Maturity Date
41
Key Dates
Transaction Date
42
Key Dates
Value Date
43
Key Dates
Value Date
44
Key Dates
Maturity Date
The date on which the instrument ceases to
accrue a return
Maturity date is often not a date
It is a term to maturity which is a whole number of
weeks/months after the value date
Date of maturity follows two conventions
The Modified Following Business Day Convention
The End/End Rule
45
The Modified Following Business Day
Convention
This convention consists of the following
three rules
1. Maturity is set for the same date as the
value date
If the value date is 21 March
The one month maturity will be 21 April
The two month maturity will be 21 May
2. If the maturity as per rule 1 is a non-
business day, then it is moved to the
following business day
46
Modified…(Cont…)
3. If the following business day according to
rule 2 falls in the next calendar month, then
the maturity date is moved back to the last
business day of the calendar month.
47
The End/End Rule
If the value date is the last business day
of the current calendar month, then the
maturity date will be the last business
day of the relevant calendar month.
Consider a one month deposit with a value
date of 31 May.
It will mature on 30 June if it is a business day.
Consider a one month deposit with a value
date of 30 June
It will mature on 31 July if it is a business day
48
The End/End Rule (Cont…)
Consider a one month deposit with a value
date of 31 January
It will mature on 28 or 29 February
Consider a one month deposit with a value
date of 28 or 29 February
It will mature on 31 March
If the maturity date as per this rule were
to be a holiday then the modified
following business day convention would
apply.
49
Fed Funds & Clearinghouse
Funds
50
Fed Funds
51
Fed Funds
Fed Funds…(Cont…)
When a dealer firm buys
securities from a trader…
53
Fed Funds
54
Fed Funds
Process
55
Fed Funds
Funds availability
Clearinghouse funds are not accepted in
money markets
For money market transactions these
transactions are far too slow and risky
57
Global Money Mkts
59
Types of National MoneyGlobal Money Mkts
Markets
Securities dominated market most
borrowing and lending is through open
market trading of financial instruments.
Western markets are largely securities dominated.
Bank dominated market bank borrowing
and lending is at the centre of most
transactions.
Asian markets tend to be largely bank dominated.
These markets have a potential weakness - they
yield more easily to government pressures
resulting in bad loans
60
Global Money Mkts
61
Securities & Relative Volumes
62
Sec & Rel vols
Growing Volumes
64
Sec & Rel vols
67
Interbank
Mkt
Interbank Market
It is a market for large or wholesale
loans and deposits
It is an arena for transactions between
commercial banks
Borrowing / lending is for periods <= 12
months
Participants
Commercial banks
Insurance companies
Pension funds
68
Interbank
Mkt
Need for Interbank Market
69
Interbank
Mkt
Features of Interbank Market
intermediary
70
Interbank
Mkt
Types of Loans
73
Interbank
Mkt
LIBOR
74
Interbank
Mkt
BBA LIBOR
BBA British Bankers’ Association
It is the most widely used benchmark
for short term interest rates
Rate is complied by BBA and Reuters
and released after 11 a.m. London time
BBA maintains a panel of 8 banks
It provides a reference panel which
reflects the balance of the market by
Country
Type of institution
75
Interbank
Mkt
LIBID
76
Interbank
Mkt
LIBID vs. LIBOR
LIBID LIBOR
Rate that banks with Rate that banks seeking
surplus funds might haveto borrow might have to
to accept on interbank pay
deposit
77
Interbank
Mkt
SONIA & EURONIA
SONIA EURONIA
(Sterling Overnight Index (Euro Overnight Index
average) average)
These indices track actual market overnight funding rates
79
Interbank
Mkt
Calculating
Interest payable on assumption of a 360
day year
P x (r/100) x (T/360)
P Principal
T No. of days
r Rate of interest
80
Interbank
Mkt
Illustration
Bank makes a loan = $7.5 MM
Period: 1 year (365 days)
Interest rate = 5.25% p.a.
81
Securities and Relative Interest
Rates
82
Sec & Rel. Int.
Rates
T-Bills
The foundation of the market’s structure is
the level of yields on T-bills
These securities have zero default risk
They carry minimal market risk
Secondary market for T-bills is the most active
and deep of all securities markets.
Due to combination of low risk and ready
marketability T-bills carry the lowest yields
83
Sec & Rel. Int.
Rates
84
Sec & Rel. Int.
Rates
Relative Rates (Cont…)
Instrument Yield Instrument Yield
Federal Funds 3.72 6-M CD 4.27
2-M Non- 3.83 1-M ED 3.87
financial CP
3-M Non- 3.86 3-M ED 4.07
financial CP
1-M Financial 3.82 6-M ED 4.25
CP
2-M Financial 3.91 Bank Prime 6.75
CP Rate
3-M Financial 4.02 4-week T-bills 3.31
CP
85
1-M CD 3.89 3-M T-bills 3.65
Treasury Bills
86
T-Bills
Treasury Bills
Purchases / Sales of T-bills often represent the
largest volume of daily transactions in the
money market.
Interest rates on such bills are the benchmark for all
other money market rates.
What are the important features of T-bills?
a. Zero default risk
b. Ready marketability
c. High liquidity
87
T-Bills
U.S. T-Bills
U.S T-bills are direct obligations of the U.S.
government
By law T-bills in the U.S must have an original
maturity of <1 year
The government’s fiscal year runs from 1 Oct to
30 Sep
market conditions
89
T-Bills
94
T-Bills
bids
The Treasury entertains 2 types of bids.
Competitive bids typically are submitted by
large investors including banks and securities
dealers.
They bid for several million dollars worth of
securities at a time.
Non-competitive bids submitted by small
investors who agree to accept the price set at
the auction.
The Treasury generally fills all non-competitive
bids.
96
T-Bills
At the auction
Bids are arranged in descending All competitive bids
order from the highest price or in must be submitted to
ascending order from the lowest three decimal places
yield
Illustration
98
T-Bills
Pricing at auctions
100
T-Bills -
Yields
Example 1
Assume that a T-bill with
Face value = $100
90 days to maturity
Selling price = $97.50
101
T-Bills -
Yields
Example (Cont…)
102
T-Bills -
Yields
Example – Investment Rate
Rate of return for an investor who buys a bill at a
discount rate of DR will always be higher than the
quoted yield
Investment rate
104
T-Bills -
Yields
Holding Period Return
One formula is:
HPR = P2 – P1 360
_______ x _______
100 Tm1 -Tm2
105
T-Bills -
Yields
HPR terms
106
T-Bills -
Yields
Example 2
Assume that an investor buys a
180 day bill at a discount of 6%
Sells it 30 days later at a discount of 5.80%
HPR is
(180x6.00) – (150x5.80)
_______________________ = 7%
180 - 150
107
T-Bills -
Yields
Yield to Maturity
Calculate the Yield to Maturity of a T-bill that
has more than 182 days to maturity
A coupon paying bond with a time to
maturity >182 days will make a coupon
payment before maturity
To facilitate a comparison between the yield for
a discount instrument with >182 days to
maturity & the YTM of a conventional bond, the
discount security must be treated as if it too
pays a semi-annual coupon.
108
T-Bills -
Yields
Yields (Cont…)
109
T-Bills -
Yields
Yields (Cont…)
110
T-Bills -
Yields
Example - BEY
111
T-Bills -
Yields
Yields (Cont…)
P = $959111.11
Therefore:
112
T-Bills
Primary Dealers
The money market depends heavily on
the buying and selling activities of
securities dealers.
Primary Dealer
A dealer firm which is qualified to trade
securities directly with the Federal Reserve
Bank of New York
The firm must agree to be available to trade
securities at all times and post a capital of
at least $50m
113
T-Bills
Exclusive Privileges
Until recently the primary dealers
possessed several exclusive privileges in
dealing with the U.S. government
1. They held exclusive membership on the
Treasury Borrowing Advisory Committee which
helps the government decide what kinds of
securities to sell at each auction
2. They were the only traders along with banks
who could place bids for new government
securities on behalf of themselves and their
customers without posting the normally required
5% cash deposit on each bid amount.
114
T-Bills
Exclusive Privileges
Why collude?
In a large and highly competitive
market there was the risk that:
a. Primary dealers could overbid thereby
eliminating potential profits
b. They could underbid which would mean
that they would receive no securities at all
Thus dealers had a strong incentive to
share information with each other on
the size of the orders they wished to place
the prices they hoped to bid
116
T-Bills
119
T-Bills
Winners’ Curse
Multiple price auctions encouraged dealers
to bid high in order to increase the
probability of winning.
The higher the price bid, the lower the expected
profit when securities were sold in the secondary
market
Dealers placing higher bids faced a ‘Winners’
Curse’
They incurred a greater probability of loss when
they attempted to resell the securities.
At best the winners’ curse reduced the
aggressiveness of bidding and probably
resulted in the Treasury getting a lower
price.
120
Funding of Dealer Positions
121
Dealer
Positions
Funding of Dealer Positions
Government security dealers supply a large
volume of securities to the market
They depend heavily on the money market for
borrowed funds
Most dealers invest very little of their own equity
Ratios of security portfolios held to owners’
capital of even 40:1 are common.
The bulk of their operating capital is borrowed
from banks and other financial institutions.
122
Dealer
Positions
Sources of Dealer Funds
123
Dealer
Positions
Demand Loans
Every major bank posts rates at which it is willing to
make short-term loans to dealers.
Generally two rates are quoted
One for new loans
A lower rate for the renewal of existing loans
A demand loan may be called at any time.
Such loans are virtually riskless because they are
usually collateralized by U.S. government securities.
124
Repurchase agreements
125
Repurchase
Agreements
Repos
Repurchase agreements are an increasingly
popular alternative to demand loans.
They represent a temporary extension of
credit collateralized by marketable securities
Providers
of Repos
Non- Foreign
Large State Local Insurance
Finance Financial
Banks Govts Govts Cos
Cos Institutions
128
Repurchase
Agreements
Custodial Account
Securities for the collateral are supposed to be
placed in a ‘custodial account’ at a bank.
When loan is repaid the dealer’s liability is canceled
and the securities are returned
There is evidence that this safety feature is not
scrupulously followed.
If a dealer goes out of business, lender may have
difficulty in recovering the securities
Dealer firms have collapsed and many S&Ls lost
money from inadequately collateralized loans.
Fed authorities have imposed strict reporting
guidelines on dealers
129
Repurchase
Agreements
Types of Repos
Term Repos Contracts for terms longer
than overnight e.g. contracts for periods
ranging from 1 - 3 months or even longer
Dollar repos They permit the borrower to
repurchase securities that are similar to but
not necessarily the same as the securities
originally sold
FLEX repos They permit lenders to
withdraw a part of the loan whenever cash is
needed.
130
Repurchase
Agreements
Value of Collateral
The interest rate of repos is closely linked to
other money market rates.
Usually the collateral is valued at the current
market price plus accrued interest less a small
discount called a Haircut to reduce the
lender’s exposure to market risk.
The longer the term of the repo, and the riskier and
less liquid the security that is pledged, the larger
will be the Haircut.
131
Repurchase
Agreements
Value of Collateral
market.
collateral.
132
Repurchase
Agreements
Example of Repo - 1
A party has made an overnight loan of
$100 MM to a dealer at 7.2%
Thus the interest payable the next day
is:
100,000,000 x 0.072 x 1
___ = $20,000
360
133
Repurchase
Agreements
Illustration - 2
Take the case of a dealer who is looking
for a 30 day loan and is willing to pledge
T-notes as collateral.
Assume accrued interest = $205,700
The quoted price per $100 of face value
is $100.9375
The repo is for 30 days
The rate of interest is 9% p.a.
The haircut is 0.005 price points
134
Repurchase
Agreements
Illustration - 2 (Cont…)
The amount that can be borrowed against the
securities is:
5,000,000 (1.009375 - 0.005) + 205,700
= $5,227,575
135
Repurchase
Agreements
Illustration - 2 (Cont…)
136
Repurchase
Agreements
Credit Risk
137
Repurchase
Agreements
Credit Risk
Interest rates rise Interest rates decline
139
Repurchase
Agreements
Margins (Cont…)
140
Repurchase
Agreements
Reverse Repo
Such transactions offer a convenient route for
lenders to park excess funds for short periods.
From the perspective of the lender such an
arrangement is called a reverse repurchase
agreement or a reverse repo.
Thus every repo must be matched by a reverse repo.
A dealer looking to borrow funds will do a repo.
A dealer looking to place funds will do a reverse repo.
141
Repurchase
Agreements
Matched Book
142
Repurchase
Agreements
Rates
General collateral rate Most
government securities can be bought at
a rate called the general collateral rate.
Thus most securities are close substitutes
for each other.
Special repo rates Sometimes a
security may be in high demand and the
lender may charge a lower rate.
Such rates are called special repo rates.
143
Repurchase
Agreements
Repos (Cont…)
144
Repurchase
Agreements
Repos (Cont…)
145
Repurchase
Agreements
Settlement
Parties will have accounts with the Central
Securities Depositories
Sale of securities will be transacted by
book entry
Payments will be made by an assured
payment system of the CSD
Settlement may take place 1-2 days after
the date of the repo transaction agreement
146
Repurchase
Agreements
Repo Rates
Bid price Rate that the dealer is willing to
accept in return for purchasing bonds and
agreeing to sell them back
Bid rate is the customer’s repo rate and the
dealer's reverse repo rate
Offer rate Rate that the dealer is willing
pay to sell and then repurchase the bonds
Offer rate is the customer’s reverse repo rate
and the dealer’s repo rate
The Bid will always be higher than the Ask
147
Federal Funds
148
Fed Funds
Federal Funds
149
Fed Funds
Federal Funds
History Today
The name federal funds Today the Fed funds market
came about because in the is far broader in scope than
earlier years the principal just reserves on deposit with
source of immediately Federal Reserve Banks
available money was the
reserve balance that each
bank held with the regional
Federal Reserve Bank
If a bank needed to transfer Virtually all banks maintain
funds to another it needed deposits with large
to only contact the regional correspondent banks in
FRB and funds would be major cities. These deposits
transferred in a matter of may be readily transferred
seconds by computers from the account of one 150
Fed Funds
financial institution.
151
Fed Funds
State &
Securities Corpora- Insurance Commercial
Local S & Ls
dealers tions Cos banks
Govts
Trading
153
Fed Funds
Illustration 1
Take for example two banks that are located in New York
This is payable
The borrower would be
immediately. Fed funds
handed a check drawn on the
would be transferred to the
lender’s reserve account at
borrower’s reserve account
the Federal Reserve Bank of
before the close of business
New York
155
Fed Funds
Illustration 2
If the institutions are not located within the same
district the transaction would proceed in the same
way except that two Federal Reserve banks would be
involved
The borrower and the lender agree on the
terms of the loan
Contact Mechanisms
b. Telephone
157
Fed Funds
Overnight transactions
158
Fed Funds
159
Negotiable CDs
160
Nego CDs
What is a CD?
It is an interest bearing receipt for funds left with a depository
institution for short periods of time.
161
Nego CDs
Negotiable CDs
163
Nego CDs
Non-negotiable Time Deposits vs.
Negotiable CDs
Time Deposits CDs
An investor will deposit a The depositor will be
sum of money with a issued a bearer security
bank for a stated period
of time
Calculations
Consider a CD with a face value of V.
The funds owed on maturity is given by:
V + Tm
____ x V x i
360
where:
Tm original term to maturity
i interest rate
165
Nego CDs
Example
166
Nego CDs
Calculations (Cont…)
To convert the yield to a true yield for a
365 day year, multiply the quoted rate
by 365/360.
Thus
YTMCD = i x 365
____
360
167
Nego CDs
Example
i = 0.075
168
Nego CDs
Yield on CDs
169
Nego CDs
Types of CDs
1. Variable or floating rate CDs
2. Rollover or Rolypoly CDs
3. Jumbo CDs
4. Yankee CDs
5. Brokered CDs
6. Deposit notes
7. Bear and Bull CDs
8. Installment CDs
9. Rising rate CDs
10.Foreign-index CDs
170
Nego CDs
171
Nego CDs
2. Rollover CDs
In the 1970s the Rollover or Rolypoly CD was
introduced.
6 month CDs are the maximum maturity traded in the
secondary markets.
Rollover CDs are longer term CDs with higher
rates but in packages composed of a series of 6
month CDs extending for at least 2 years.
This promised higher returns plus the ability to
retire some components of the package early to
meet cash needs.
The customer is however obligated to purchase
the remaining certificates on each 6 month
anniversary date till the contract expires.
172
Nego CDs
Other CDs
173
Nego CDs
6. Deposit notes
174
Nego CDs
Other CDs
Other CDs
176
Nego CDs
178
Nego CDs
179
Nego CDs
Yields on CDs
180
Nego CDs
Illustration
A bank is quoting 8% p.a. on a 3 month
deposit
Reserves @ 5% and are non-interest
bearing
Effectively $8 interest is being offered
on $95 of usable funds
Effective rate =
8
95 = 8.42%
181
Nego CDs
Illustration
Effective cost is
182
Commercial Paper
183
Comm
Paper
Commercial Paper
Unsecured promissory notes are known as
commercial paper
Large corporations borrow billions of dollars in
the money market through these
A study in U.S. found that 1000+ corporations were
regularly selling commercial paper to money market
investors
Such paper consists of short-term unsecured
promissory notes issued by well known
companies that are financially strong and carry
high credit ratings
184
Comm
Paper
Funds raised for
185
Comm
Paper
Bridge Financing
186
Comm
Paper
Buyers of Commercial Paper
Paper is generally issued in multiples of
$1,000 & in denominations designed to
meet the needs of the buyer.
It is traded mainly in the primary market.
Opportunities for resale in secondary market are
limited
Investors are careful to purchase those
issues whose maturity matches their
planned holding periods.
Resale has increased in recent years
187
Comm
Paper
Credit rating
Most issuers of paper enjoy a high credit
rating.
To reduce risk for investors, borrowers
usually secure a line of credit at a
commercial bank for a small fee or a
deposit.
The line of credit cannot be used to directly
guarantee payment if company goes bankrupt.
The lender may renege on the credit line if the
borrower has had a `material adverse change’ in
his condition.
188
Comm
Paper
Letters of Credit
Many issuers also take out irrevocable
letters of credit prepared by their banks.
Such a letter of credit makes a bank
unconditionally responsible for repayment if
the corporation defaults.
Banks usually charge 50 to 150 b.p. on
the amount of the guarantee that is
issued.
Insurance companies and parent
companies of paper issuers also
guarantee issues of commercial paper.
189
Comm
Paper
Types of Commercial Paper
190
Comm
Paper
Direct Paper
The main issuers of direct paper are
Large finance companies
Bank holding companies
Issuers deal directly with investors rather
than use securities dealers as
intermediaries.
Such companies announce the rates that
they are paying on various maturities
Investors select maturities that closely match
their expected holding periods and buy the
paper directly from the issuer.
Interest rates may be adjusted during the day
that the paper is sold to regulate the inflow of
investor funds
191
Comm
Paper
Direct Paper (Cont…)
Leading finance companies that borrow in the
direct paper market include
General Motors Acceptance Corporation (GMAC)
General Electric Capital Corporation (GE Capital)
Such firms have
An ongoing need for short-term money
Possess top credit ratings
Have established working relationships with major
institutional investors in order to place new issues
regularly.
192
Comm
Paper
Direct Paper (Cont…)
Directly placed paper must be sold in large
volume to cover the substantial costs of
distribution and marketing.
On an average each direct issuer in the U.S.
borrows at least $1bn per month
Issuers of direct paper do not have to pay
dealers’ commissions
They must maintain a marketing division to
maintain constant contact with active investors
Issuers like Citicorp sell paper in weekly
auctions in which buyers bid for securities
193
Comm
Paper
Funds used for
Sometimes direct issuers must sell their paper
even when they have no need for funds
They have to maintain a good working relationship
with active investor groups.
They also have to pay fees to banks for supporting
lines of credit.
They have to pay agencies that rate their issues
They have to pay agents like trust companies that
collect funds and disburse payments.
194
Comm
Paper
Industrial Paper
The other variety of commercial paper is
dealer paper that is issued by security
dealers on behalf of their corporate
customers.
Such paper is also known as Industrial Paper.
This is issued mainly by non-financial
companies, smaller bank holding companies
and financial companies
These borrow less frequently than companies
that issue direct paper.
195
Comm
Paper
Buyers of Industrial Paper
The issuing company may sell the paper
directly to the dealer who buys it less a
discount and commissions, and then
attempts to resell it at the highest possible
price in the market.
Alternatively the issuing company may
bear all the risk with the dealer only
agreeing to sell at the best price available
less commissions.
This is referred to as a best efforts transaction.
196
Comm
Paper
Value of Paper
198
Comm
Paper
Credit Enhancements
199
Comm
Paper
Documented notes
200
Comm
Paper
Yankee Paper
Yankee paper Foreigners also issue paper
in the U.S. market.
Issuers can often issue Yankee paper at a
cheaper rate than what it would cost them
to borrow outside the U.S.
Foreign issuers generally pay higher rates
than American issuers of comparable credit
quality.
This is to compensate American investors for the
difficulty of gathering information on foreign
issuers and the lack of name recognition.
201
Comm
Paper
International Paper - Yen
202
Comm
Paper
International Paper – Canada
Like in the U.S. paper issues in Canada must
be backed by a bank line of credit in order to
catch the attention of the market.
The Canadian market has a broader range of
maturities ranging from 24 hours to a year.
Paper in Canada tends to be issued in large
denominations usually $100,000+
Most Canadian paper is therefore purchased
by large institutions rather than individual
investors.
203
Comm
Paper
International Paper - Euro
207
Comm
Paper
Maturity of US Paper
Maturities of US paper range from 3
days (weekend paper) to 270 days
Most paper has an original maturity of
60 days or less with an average
maturity of 20 to 45 days
US paper is generally not issued with a
maturity exceeding 270 days
Because any security with a maturity in
excess of 270 days must be registered with
the SEC
208
Comm
Paper
Yield on Commercial Paper
209
Comm
Paper
Denomination for Paper
The minimum denomination for paper is
usually $25,000
Among institutional investors the
minimum denomination is usually
$1,000,000
Notes are typically issued in bearer form
to make resale easier.
On maturity, payment is made on
presentation to the bank which is
designated as the agent.
Settlement is made in Federal Funds on
the same day.
210
Comm
Paper
Advantages with paper market
211
Comm
Paper
Example
Take the case of a firm that borrows
$100MM @ 8% with a compensating
balance of 20%
212
Comm
Paper
Advantages with paper market
c. Another advantage of borrowing in the paper
market is that rates are often more flexible
than bank rates.
A company in need can quickly raise funds through
either dealer paper or direct paper.
Dealers maintain close contact with the market
and generally know where funds can be found.
Notes can be issued and funds raised on the same
day.
213
Comm
Paper
Lending money
Federal & state regulations limit the amount
of money that a bank can lend to a single
borrower
For nationally chartered banks the maximum
unsecured loan that can be granted to a borrower
is 15% of the bank’s capital and surplus.
Corporate needs frequently exceed an
individual bank’s loan limit.
A consortium of banks can be assembled - but this
takes time.
In the paper market it is much easier to arrive at
agreements for large issues.
214
Comm
Paper
Lending Money (Cont…)
215
Comm
Paper
Risk of Paper
216
Comm
Paper
Master Note
A recent innovation in the direct paper
market
This is frequently issued to bank trust
departments and other permanent
investors by finance companies.
Under such an arrangement the
investing firm agrees to take some paper
each day up to an agreed upon
maximum amount.
Interest is calculated on the daily
average balance of paper taken by the
investor.
217
Comm
Paper
Medium Term Note
An extension of the paper market is the
Medium Term Note.
Such notes have maturities ranging from 9
months to 10 years and are issued by
investment grade corporations.
They carry fixed rates of interest and are
generally non-callable unsecured obligations
marketed through dealers.
Particularly suited for companies with
substantial quantities of medium term assets
E.g. who wish to balance such assets with
liabilities that are longer in maturity than
conventional commercial paper.
218
Comm
Paper
Ratings and Rating Agencies
Depending on the credit standing of the
issuer paper is rated as:
Prime
Desirable or
Satisfactory
Firms issuing paper generally seek ratings
from multiple issuers.
It is extremely difficult to market unrated paper.
About 75% of the firms that currently sell paper
are prime rated.
Generally notes bearing ratings from at least two
agencies are preferred by investors.
219
Comm
Paper
Rating Agencies
Prominent rating agencies include:
Moody’s Investors Service
Standard & Poor’s Corporation
Fitch Investor’s Service
Canadian Bond Rating Service
Japanese Bond Rating Institute
Dominion Bond Rating Service
IBCA Ltd.
220
Comm
Paper
Summary of the Rating Systems
221
Comm
Paper
Credit Rating
222
Comm
Paper
Credit Rating
Agencies are paid by the issuers of paper.
A good rating makes it easier and cheaper to
borrow
However rating agencies always look at the
issue from the perspective of a potential
investor.
Their credibility is based on their track record
from the standpoint of accuracy.
223
Comm
Paper
Evaluation Criteria
224
Federal Agency Securities
225
Fed Agency
Sec
Agencies
US government attempts to aid
disadvantaged sectors e.g.
Agriculture
Housing
Small businesses
College students
Government has created special
agencies to make loans to these sectors
These agencies are large enough to
complete for funds in the open market
226
Fed Agency
Sec
Types of Federal Credit Agencies
Government sponsored True Federal Agencies
agencies
229
Fed Agency
Sec
Features of agency securities
They are subject to fed income taxes
Exempt from state and local taxes
They are short to medium term with
maximum maturity of 10 years
Longer term have denominations of as less
as $1,000
Shorter term are usually sold in
denominations of $50,000
230
Fed Agency
Sec
Solicitation Method
A fiscal agent in NY will
assemble a group of
bankers, dealers, brokers to This pricing information is
bring each issue to the conveyed to the fiscal agent
market
232
BAs
What is a bill?
It is an undertaking to pay a specified
amount of money at a future date – upto 12
months in the future
It is a form of short-term finance for the
debtor
Bills can be sold in the money market at
any time prior to their maturity date
Bills are classified on basis of the entity
which gives the undertaking to pay
T-Bills
Bank bills
Trade bills
233
BAs
Bills of Exchange
In international trade when goods are
exported the exporter will draw up a
Draft or a Bill of Exchange.
A Draft is an instrument that instructs
the importer to pay the amount
mentioned upon presentation.
A Draft may be a
Sight Draft
Time Draft
234
BAs
Sight Drafts
235
BAs
Time Drafts
These are also known as Usance Drafts.
The bank will release the shipping
documents in such cases as soon as the
importer accepts the draft by signing on it.
The importer need not pay immediately.
In other words the exporter is offering him
credit for a period.
When the importer accepts a draft it
becomes a ‘Trade Acceptance’.
236
BAs
LC Based Transactions
In the case of a sight draft the importer’s
bank will pay on presentation.
In the case of a time draft it will accept it by
signing on it.
A draft that is accepted by a bank is called a
Banker’s Acceptance
It is obviously more marketable than a trade
acceptance.
238
BAs
239
BAs
240
BAs
Trade Bills
These are issued by a commercial
enterprise
They are bills drawn by one non-bank
company on another demanding payment
for a trade debt
They may be used for domestic /
international trade transactions
Financial institutions will buy only the finest
trade bills in the market
241
BAs
Bank Bills
acceptance
242
BAs
243
BAs
market
244
BAs
Illustration
Illustration (Cont…)
Purchase price:
= $4,890,625
Sale price:
= $4,920,833.33
247
BAs
Illustration (Cont…)
Profit:
$4,920,833.33 - $ 4,890,625 = $
30,208.33
(30,208.33/4,890,625) * (360/30)
= 7.41%
248
Eurocurrency Deposits
249
Eurocurrency
Deposits
What is Eurocurrency?
250
Eurocurrency
Deposits
Illustration
A french exporter ships champagne to a
New York importer accompanied by a bill
for $10,000
The importing firm pays for the
champagne by issuing a cheque
denominated in dollars and deposits it in a
US bank – First American bank – where
the French firm has a checking account
251
Eurocurrency
Deposits
Illustration (Cont…)
After the check clears the results are:
French Exporter’s Account
Assets Liabilities
Assets Liabilities
Deposit owed to French Exporter
= $10,000
252
Eurocurrency
Deposits
Illustration (Cont…)
253
Eurocurrency
Deposits
Illustration (Cont…)
The 4 transactions will be:
French Exporter’s Account
Assets Liabilities
Assets Liabilities
Reserves transferred to Deposit owed to French Exporter
Correspondent Bank = - $10,000 = - $10,000
254
Eurocurrency
Deposits
Illustration (Cont…)
Assets Liabilities
Reserves transferred from Deposit owed to Paris Bank =
First American Bank = $10,000
$10,000
Paris Bank’s Account
Assets Liabilities
Deposit with US Correspondent Deposit owed to French Exporter
Bank = $10,000 = $10,000
255
Illustration (Cont…)
256
Eurocurrency
Deposits
Illustration (Cont…)
Assets Liabilities
Loan to British company = +
$10,000
Deposit in Correspondent
Bank = - $10,000
British Oil Company’s Account
Assets Liabilities
Deposit with US Correspondent Loan from Paris Bank = $10,000
Bank = $10,000
257
Eurocurrency
Deposits
Illustration (Cont…)
Assets Liabilities
Deposit owed to French
Amount owed by British Oil
Company = + $10,000
exporter = $10,000
258