Chapter Five

Money Markets

5-1
 Money Markets
• Liquid funds flow between short-term borrowers and
lenders through money markets
• Money markets involve debt instruments with original
maturities of one year or less
• Money market debt
– issued by high-quality (i.e., low default risk) economic units that
require short-term funds
– purchased by economic units that have excess short-term funds
– low rates of return
• Money market instruments have active secondary
markets which provides liquidity

5-2
 Money Market Yields
• Money market securities use special rate quoting conventions:
– Discount yields (idy): Interest rate is quoted on an annual basis
assuming a 360 day year as a percent of redemption price or face value
– Single payment yields (ispy): Interest rate is quoted on an annual basis
assuming a 360 day year as a percent of purchase price

• Both may be converted to a bond equivalent yield (ibey) for

comparison with bonds
 Money Market Yields

• Treasury bills and commercial paper are bought

and sold on a discount basis
• Discount yields (idy) use a 360-day year
( Pf  P0 ) 360
idy  
Pf h
Pf = the face value of the security
P0 = the discount price of the security
h = the number of days until maturity

5-4
 EXAMPLE PROBLEM

• A 91-US T-bill (Treasury

bill) with a face value of USD 5
million at a discount rate of 2.5%
and a price of USD 4.9 million.
Assuming that a year has 360
days, Calculate the discount rate
assumed by the T-bill.
5-5
 Solution
• The information given in the
• Now using the formula
question is as follows:
• PV = 1,500,000
provide:
FV = 5,000,000 • DR=
Days = 91
Year = 360 • (5,000,000 − 4,900,000
DR =?
• / 5,000,000) × (360/91)
=0.07912
( Pf  P0 ) 360 • =7.912%
idy  
Pf h

5-6
 Money Market Yields

• Compare discount securities to U.S. Treasury

bonds with bond equivalent yields (ibey)
( Pf  P0 ) 365
ibey  
P0 h
• Convert bond equivalent yields into effective
annual returns (EAR)
365/ h
 h 
EAR  1  ibey  1
 365 

5-7
 Bond Equivalent Yields (ibey)

• A 91-day commercial • AOR=YearDays×(

is quoted at a discount FV−PV)PV
rate of 5.5% for a year
assumed to have 360
days. Calculate the
bond equivalent yield • AOR=YearDays×(
rate given the price of FV−PV)PV=36591
the instrument is paid ×(100−98.610)98.6
100 per face value.
10=5.655%
5-8
 Example: T-Bill

Face value = $10,000; Maturity = 73 days; Sells for $9,800

• Discount yield:
Period yield = (10,000-9,800)/10,000 = 2%
Annualized = 2% x 360/73 = 9.863%
• Bond Equivalent Yield:
Period yield = (10,000 – 9,800)/9,800 = 2.0408%
Annualized = 2.0408% x 365/73 = 10.2041%
• Effective Annual Yield:
= (1 + 2.0408%)365/73 - 1 = 10.6292%

5-9
 Money Market Yields

• Money market securities (Negotiable or jumbo)CDs and

fed funds that pay interest only at maturity use single-
payment yields (ispy) (e.g., jumbo CDs and fed funds)
– since ispy uses a 360 day year, compare to bonds by converting to a
365 day year
ibey  ispy (365 / 360)

– to directly convert a single-payment yield to an effective annual

return 365/ h
 h 
EAR  1  ispy  1
 360 

5-10
 Example: CD Yield

• Face: 10,000; maturity 73 days; pays 6%

• Interest for the period = 6%x73/360=1.22% or $
21.67
• Bond Equivalent Yield:
= 6% x 365/360 = 6.0833%
• Effective Annual Yield
Note: no of periods/year = 365/73 = 5
= (1 + 1.22%)5 - 1 = 6.2332%

5-11
 Money Market Yields

• Negotiable (or jumbo) CDs and fed funds are money market
securities that pay interest only at maturity. These use single-
payment yields (ispy)
(Pf  P0 ) 360
ispy  
P0 h
– to convert a single-payment yield to a bond equivalent yield:

ibey  ispy (365 / 360)

– to directly convert a single payment yield to an EAR:
365/ h
 365 / 360 
EAR  1  ispy  1
 365 / h 
 Sample Calculations of Money
Market Yields
• A $1M investment in 90 day commercial paper has a 2%
discount yield and an equivalent size and risk 90 day CD has a
2% single payment yield. Which security offers the better
return? For the commercial paper:
( Pf  P0 ) 360 ($1M  P0 ) 360
idy   0.02   ;P0  $995,000
Pf h $1M 90

(Pf  P0 ) 365 ($1M  $995,000) 365

i bey   ibey    2.038%
P0 h $995,000 90

• The bond equivalent yield for the commercial paper is 2.038%

 Sample Calculations of Money
Market Yields
• A $1M investment in 90 day commercial paper has a 2%
discount yield and an equivalent size and risk 90 day CD has a
2% single payment yield. Which security offers the better
return? For the CD:

ibey  ispy (365 / 360) i bey  0.02  ( 365 / 360 )  2.0278%

• The bond equivalent yield for the CD is 2.0278%

• The commercial paper has the better return since its bond
equivalent yield is 2.038%
 Money Market Instruments

• Treasury bills (T-bills)

• Federal funds (fed funds)
• Repurchase agreements (repos or RP)
• Commercial paper (CP)
• Negotiable certificates of deposit (CD)
• Banker acceptances (BA)

5-15
 Treasury Bills (T-Bills)

• T-Bills are short-term debt obligations issued by

the U.S. government
• The Federal Reserve buys and sells T-bills to
implement monetary policy
• T-bills are virtually default risk free, are highly
liquid, and have little interest rate risk
• Strong international demand for T-bills as safe
haven investment

5-16
 T-Bill Auctions

• 13- and 26-week T-bills are auctioned weekly

• Bids are submitted by government securities
dealers, financial and nonfinancial corporations,
and individuals
• Bids can be competitive or noncompetitive
– competitive bids specify the bid price and the desired
quantity of T-bills
– noncompetitive bidders get preferential allocation and
agree to pay the lowest price of the winning
competitive bids

5-17
 T-Bill Auctions

Noncompetitive Bids
Bid Price 1
SC ST
2
3
4
5
6
Stop-out
price (PNC) 7

Quantity of
T-bills

5-18
5-19
 The Secondary Market for T-Bills

• The secondary market for T-bills is the largest of

any U.S. money market instrument
• 22 primary dealers “make” a market in T-bills by
buying the majority sold at auction and by
creating an active secondary market
– primary dealers trade for themselves and for customers
– T-bill purchases and sales are book-entry transactions
conducted over Fedwire
• T-Bills are sold on a discount basis

5-20
 Transaction Between Primary Dealers
J.P. Morgan Chase Sell Lehman Brothers Buy
$10 million in T-Bills
Interbank Transaction $10 million in T-Bills

Fedwire Fedwire

Federal Reserve Bank of NY

Transfers $10 million from Chase to Lehman
Transaction Recorded in Fed’s Book Entry System

5-21
 Purchase by Individual
Wire
Individual Local Bank Transfer Primary Dealer
Buy $50,000 in Engraved or Broker JP Morgan Chase
T-Bills T-Bill Sells $50,000 in T-Bills

Engraved
T-Bill
Fedwire

FRBNY
-$50,000 in T-Bills from JP Morgan
+ $50,000 in T-Bills to Individual

5-22
 T-Bill Prices

• T-Bill prices can be calculated from quotes (e.g., from The

Wall Street Journal) by rearranging the discount yield
equation
 h 
P0  Pf  idy   Pf 
 360 
• Or by rearranging the bond equivalent yield equation
Pf
P0 
 h 
1  ibey  
 365 

5-23
 Example: T-Bill Prices

• 30 days TB, Face value=$10,000, sells at

6%
• Price?
= $10,000 - $10,000 x 6% (30/360)
= $9,950

5-24
 Federal Funds

• The federal funds (fed funds) rate is the target rate in the
conduct of monetary policy
• Fed fund transactions are short-term (mostly overnight)
unsecured loans
• Banks with excess reserves lend fed funds, while banks
with deficient reserves borrow fed funds
• Fed funds are single-payment loans and thus use single-
payment yields
• Multimillion dollar loans may be arranged in a matter of
minutes

5-25
 FEDERAL FUNDS TRANSACTIONS
J.P. Morgan Chase Bank of America
Lends (Sell) $75 Borrows (Buy) $75
million in Federal million in Federal
Funds Funds

FRBNY FRB of San Francisco

Today: Today:
Takes $75 mil. From reserve Fedwire Adds $75 mil. To reserve
account of JPM account of BOA
------------------------------ ------------------------------
Tomorrow: Tomorrow:
Adds $75 mil. plus one day’s Fedwire Takes $75 mil. plus one day’s
interest to JPM account interest from BOA account

5-26
 Repurchase Agreement

• A repurchase agreement (repo or RP) is the sale of

a security with an agreement to buy the security back
at a set price in the future
• Repos are short-term collateralized loans (typical
collateral is U.S. Treasury securities)
– Similar to a fed fund loan, but collateralized
– Funds may be transferred over FedWire system
– If collateralized by risky assets, the repo may involve a
‘haircut’

5-27
 Repurchase Agreement
• Typical denominations on repos of one week or less are $25
million and longer term repos usually have $10 million
denominations
• A reverse repurchase agreement is the opposite side of a repo
(i.e., it is the purchase of a security with an agreement to sell
it back in the future)
 Repurchase Agreement

• The yield on repurchase agreements (iRA) uses a

360-day year like the discount rate, but uses the
current price in the denominator like the bond
equivalent yield
( Pf  P0 ) 360
iRA  
P0 h
Pf = the repurchase price of the security
P0 = the selling price of the security
h = the number of days until the repo matures

5-29
 Repurchase Agreement
J.P. Morgan Chase Bank of America
Buys $75 million Repo Sells $75 million Repo

FRBNY FRB of San Francisco

Today: Today:
-$75 mil. reserve account of +$75 mil. reserve account of
JPM BOA
+ $75 mil to T-Bill account Fedwire
- $75 mil to T-Bill account of
of JPM BOA
------------------------------ ------------------------------
Tomorrow: Tomorrow:
+ $75 mil. plus one day’s - $75 mil. plus one day’s
Fedwire
interest to JPM reserve a/c interest to BOA reserve a/c
- $75 mil to T-Bill account + $75 mil to T-Bill account of
of JPM BOA

5-30
 Commercial Paper

• Commercial paper (CP) is the largest money market in

terms of dollars outstanding
• CP is unsecured short-term corporate debt issued to raise
short-term funds (e.g., for working capital)
• Generally sold in large denominations (e.g., $100,000 to
$1 million) with maturities between 1 and 270 days
• CP is usually sold to investors indirectly through brokers
and dealers (approximately 85% of the time)
• CP is usually held by investors until maturity and has no
active secondary market
• Yields are quoted on a discount basis (like T-bills)

5-31
 Asset-Backed Commercial Paper
• A type of commercial paper that is backed by assets of the
issuing firm

• Grew very rapidly prior to the financial crisis peaking at

$2.16 trillion, much of it was backed by mortgage
investments

• The market collapsed during the financial crisis

 Negotiable Certificate of Deposit

• A negotiable certificate of deposit (CD) is a

bank-issued time deposit that specifies the interest
rate and the maturity date
• CDs are bearer instruments and thus are salable in
the secondary market
• Denominations range from $100,000 to $10
million; $1 million being the most common
• Often purchased by money market mutual funds
with pools of funds from individual investors

5-33
 Banker’s Acceptance

• A Banker’s Acceptance (BA) is a time draft payable to

a seller of goods with payment guaranteed by a bank
• Used in international trade transactions to finance trade
in goods that have yet to be shipped from a foreign
exporter (seller) to a domestic importer (buyer)
• Foreign exporters prefer that banks act as payment
guarantors before sending goods to importers
• Banker’s acceptances are bearer instruments and thus
are salable in secondary markets

5-34
 Creation of a Banker’s Acceptance

U.S. buyer 1 Chinese seller

(importer) (exporter)
4

2 9 10 3 5 8

6
U.S. bank Chinese bank
(importer’s bank) 7 (exporter’s bank)

1 Purchase order sent by U.S. buyer to Chinese seller

2 Chinese seller requests a letter of credit
3 Notification of letter of credit and draft authorization
4 Order shipped
5 Time draft and shipping papers sent to Chinese seller’s bank
6 Time draft and shipping papers sent to U.S. bank; banker’s acceptance created
7 Payments sent to foreign bank (immediately if Chinese seller wishes to discount
the draft and collect immediately, at maturity if not)
8 Payments sent to Chinese seller (see #7)
9 Payment to U.S. bank by U.S. buyer at maturity, paid in full
10 Shipping papers delivered
5-35
5-36
 Money Market Participants

• The U.S. Treasury

• The Federal Reserve
• Commercial banks
• Money market mutual funds
• Brokers and dealers
• Corporations
• Other financial institutions
• Individuals

5-37
 2011 Money Market Yields
Federal Commercial
Instrument Funds* Paper CDs Euro CP
Rate 0.11% 0.17% 0.23% 1.18%
Banker’s
Instrument LIBOR Euro$ Repo*
Acceptances
Rate 0.27375% 0.22% 0.25% 0.08%
Treasury
Instrument Inflation***
Bills**
Rate 0.060 2.7%

Data from the Wall Street Journal Online Money Rates Section April 2011.
Rates are for 3 month maturities except as noted.
* Overnight; ** 13 week, *** Year over year, all items as measured by the CPI
 Rates for maturities of 3 months -
November 2004

Federal Commercial
Instrument Funds* Paper CDs Euro CP
Rate 2.06% 2.38% 3.03% 4.69%
Banker’s
Instrument LIBOR Acceptances Euro$ T–bill**
Rate 2.71875% 2.75% 2.70% 1.80%

5-40
 Money Market Securities Outstanding
Billions $
Instrument 1990 2004 2007 2010
Treasury Bills $ 527 $ 982 $1,010 $1,856
Fed funds & Repos 372 1,585 2,731 1,656
Commercial Paper 538 1,310 2,109 1.083
Negotiable CDs 547 1,379 2,149 1,822
Banker's Acceptances 52 4 1 1
Total $2,036 $5,260 $8,000 $6,418

% of Total in Given Year

Instrument 1990 2004 2007 2010
Treasury Bills 26% 19% 13% 29%
Fed funds & Repos 18% 30% 34% 26%
Commercial Paper 26% 25% 26% 17%
Negotiable CDs 27% 26% 27% 28%
Banker's Acceptances 3% 0.1% 0.0% 0.0%
Source: Text
100% 100% 100% 100%
 International Money Markets
• U.S. dollars held outside the U.S. are tracked among
multinational banks in the Eurodollar market
• The rate offered for sale on Eurodollar funds is the London
Interbank Offered Rate (LIBOR)
• Eurodollar Certificates of Deposit are U.S. dollar-denominated
CDs held in foreign banks
• Eurocommercial paper (Euro-CP) is issued in Europe and can
be in local currencies or U.S. dollars
International Money Markets
PROBLEMS

5-44
Discount yield: idy = (($1m. - $973,750)/$1m.)(360/65) = 14.538%

Bond equivalent yield: ibey = (($1m. - $973,750)/$973,750)(365/65)

= 15.138%

EAR: EAR = (1 + .15138/(365/65))365/65 - 1 = 16.111%

5-45
• The nominal bond equivalent yield is calculated as

ibey = 6.56%(365/360) = 6.651%

• The EAR on the CD is calculated as

EAR = (1 + (.06651)/(365/115))365/115 - 1 = 6.804%

5-46
a. The yield on this repo to the bank is calculated as follows

iRA = $25,000,000 - $24,950,000 x 360 = 10.31%

$24,950,000 7
b. The yield on this repo to the bank is calculated as follows

iRA = $25,000,000 - $24,950,000 x 360 = 3.44%

$24,950,000 21

5-47
The return on the commercial paper is calculated as

icp(dy) = $500,000 - $495,000 360 = 8.00%

$500,000 45
And

icp(bey) = $500,000 - $495,000 365 = 8.19%

$495,000 45

5-48
a. Before the rate change, the CD holder will receive
FV = $500,000 (1 + .055/3) = $509,167
in four months in exchange for $500,000 deposited in the bank today.

Immediately after the market rate on the CD rises to 6 percent, the CD

value decreases to
PV = 509,167/(1 + .06/3) = $499,183.33

b. Immediately after the market rate on the CD falls to 5.25 percent, the
CD value decreases to
PV = 509,167/(1 + .0525/3)5-49
= $500,409.83
5-50
5-51