Chapter Five

Money Markets

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Goals
 LG 5-1. Define money markets.
 LG 5-2. Identify the major types of money market
securities.
 LG 5-3. Examine the process used to issue
Treasury securities.
 LG 5-4. List the main participants in money markets.
 LG 5-5. Examine the extent to which foreign
investors participate in U.S. money markets.
 LG 5-6. Understand the major developments in Euro
money markets.
5-2
Money Markets

 Money
Moneymarkets
marketsinvolve
involvedebt
debtinstruments
instrumentswith
withoriginal
original
maturities
maturitiesof
ofone
oneyear
yearor
orless
less
 Money
Moneymarket
marketdebt
debt
 issued
issuedby byhigh-quality
high-quality(i.e.,
(i.e.,low
lowdefault
defaultrisk)
risk)economic
economicunits
unitsthat
that
require
requireshort-term
short-termfunds
funds
 purchased
purchasedby byeconomic
economicunitsunitsthat
thathave
haveexcess
excessshort-term
short-termfunds
funds
 little
littleor
orno
nochance
chanceof ofloss
lossofofprincipal
principal
 low
lowrates
ratesof
ofreturn
return
 Most
Mostmoney
moneymarket
marketinstruments
instrumentshave
haveactive
activesecondary
secondary
markets
marketsto
toprovide
provideliquidity
liquidity

5-3
Money Market Yields

 Money
Moneymarket
marketsecurities
securitiesuse
usespecial
specialrate
ratequoting
quoting
conventions:
conventions:
 Discount
Discountyields
yields(i(idydy):): Interest
Interestrate
rateisisquoted
quotedononan
anannual
annualbasis
basis
assuming
assumingaa360
360day dayyear yearasasaapercent
percentof ofredemption
redemptionprice
priceor
or
face
facevalue
value
 Single
Singlepayment
paymentyields
yields(i(ispy ): Interest rate is quoted on an annual
spy): Interest rate is quoted on an annual
basis
basisassuming
assumingaa360 360day dayyear
yearasasaapercent
percentof
ofpurchase
purchaseprice
price

 Both
Bothmay
maybebeconverted
convertedto
toaabond
bondequivalent
equivalentyield
yield(i(ibey) for
bey) for
comparison
comparisonwith
withbonds
bonds

5-4
Money Market Yields

 Treasury
Treasury bills
bills and
and commercial
commercial paper
paper rates
rates are
are
quoted
quoted as
as discount
discount yields
yields
 Discount yields (idy) use a 360-day year
Discount yields (idy) use a 360-day year
( Pf  P0 ) 360
idy  
Pf h
PPf f==the
theface
facevalue
valueofofthe
thesecurity
security
PP00==the
thediscount
discountprice
priceofofthe
thesecurity
security
hh==thethenumber
numberof ofdays
daysuntil
untilmaturity
maturity

5-5
Money Market Yields

 Compare
Compare discount
discount securities
securities to
to bonds
bonds with
with bond
bond
equivalent
equivalent yields
yields (i(ibey)
bey)
(Pf  P0 ) 365
i bey  
P0 h
 Convert
Convert bond
bond equivalent
equivalent yields
yields into
into effective
effective
annual
annual returns
returns (EAR)
(EAR)
365 / h
 ibey 
EAR  1   1
 365 / h 

5-6
5-7
Money Market Yields

 Negotiable
Negotiable(or
(orjumbo)
jumbo)CDs
CDsand
andfed fedfunds
fundsare
aremoney
money
market
marketsecurities
securitiesthat
thatpay
payinterest
interestonlyonlyat
atmaturity.
maturity. These
These
use
usesingle-payment
single-paymentyields
yields(i(ispy)
spy)
(Pf  P0 ) 360
i spy  
P0 h
 to
toconvert
convertaasingle-payment
single-paymentyield
yieldto
toaabond
bondequivalent
equivalentyield:
yield:

ibey  ispy (365 / 360)

 to
todirectly
directlyconvert
convertaasingle
singlepayment
paymentyield
yieldto
toan
anEAR:
EAR:
365 / h
 365 / 360 
EAR  1  ispy  1
 365 / h 

5-8
Sample Calculations of Money
Market Yields

 AA$1M
$1Minvestment
investmentinin90
90day
daycommercial
commercialpaper
paperhas
hasaa2%2%
discount
discountyield
yieldand
andananequivalent
equivalentsize
sizeand
andrisk
risk90
90day
dayCDCD
has
hasaa2%
2%single
singlepayment
paymentyield.
yield. Which
Whichsecurity
securityoffers
offersthe
the
better
betterreturn?
return? For
Forthe
thecommercial
commercialpaper:
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
Thebond
bondequivalent
equivalentyield
yieldfor
forthe
thecommercial
commercialpaper
paperisis
2.038%
2.038%

5-9
Sample Calculations of Money
Market Yields

 AA$1M
$1Minvestment
investmentinin90
90day
daycommercial
commercialpaper
paperhas
hasaa2%2%
discount
discountyield
yieldand
andananequivalent
equivalentsize
sizeand
andrisk
risk90
90day
dayCDCD
has
hasaa2%
2%single
singlepayment
paymentyield.
yield. Which
Whichsecurity
securityoffers
offersthe
the
better
betterreturn?
return? For
Forthe
theCD:
CD:

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

 The
Thebond
bondequivalent
equivalentyield
yieldfor
forthe
theCD
CDisis2.0278%
2.0278%
 The
Thecommercial
commercialpaperpaperhas
hasthe
thebetter
betterreturn
returnsince
sinceits
itsbond
bond
equivalent
equivalentyield
yieldisis2.038%
2.038%

5-10
Sample Calculations of Money
Market Yields

 What
Whatisisthe
thecommercial
commercialpaper’s
paper’sEAR?
EAR?
365 / h
 ibey 
EAR  1   1
 365 / h 
365 / 90
 0.02038 
EAR  1    1  2.0537%
 365 / 90 

5-11
5-12
5-13
Money Market Instruments

 Treasury bills (T-bills)

Treasury bills (T-bills)
 Federal funds (fed funds)
Federal funds (fed funds)
 Repurchase agreements (repos or RP)
Repurchase agreements (repos or RP)
 Commercial paper (CP)
Commercial paper (CP)
 Negotiable certificates of deposit (CD)
Negotiable certificates of deposit (CD)
 Banker acceptances (BA)
Banker acceptances (BA)

5-14
Treasury Bills (T-Bills)

 T-Bills are short-term debt obligations

T-Bills are short-term debt obligations
issued
issued by
by the
the U.S.
U.S. government
government

 T-bills are virtually default risk free, are

T-bills are virtually default risk free, are
highly
highly liquid,
liquid, and
and have
have little
little interest
interest rate
rate risk
risk

5-15
Treasury Bills (T-Bills)

 The Federal Reserve buys and sells T-bills

The Federal Reserve buys and sells T-bills
to
to implement
implement monetary
monetary policy
policy

 Strong international demand for T-bills as

Strong international demand for T-bills as
safe
safe haven
haven investment
investment

5-16
T-Bill Auctions

 13-
13- and
and 26-week
26-week T-bills
T-bills are
are auctioned
auctioned weekly
weekly
 Bids are submitted by government securities
Bids are submitted by government securities
dealers,
dealers, financial
financial and
and nonfinancial
nonfinancial corporations,
corporations,
and
and individuals
individuals
 Bids can be competitive or noncompetitive
Bids can be competitive or noncompetitive
 competitive
competitivebids
bidsspecify
specifythe
thebid
bidprice
priceand
andthethedesired
desired
quantity
quantityof
ofT-bills
T-bills
 noncompetitive
noncompetitivebidders
biddersget
getpreferential
preferentialallocation
allocationand
and
agree
agreeto
topay
paythe
thelowest
lowestprice
priceof
ofthe
thewinning
winningcompetitive
competitive
bids
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
The Secondary Market for T-Bills

 The
The secondary
secondary market
market for
for T-bills
T-bills isis the
the largest
largest of
of
any
any U.S.
U.S. money
money market
market instrument
instrument
 22 primary dealers “make” a market in T-bills by
22 primary dealers “make” a market in T-bills by
buying
buying the
the majority
majority sold
sold at
at auction
auction and and byby creating
creating
an
an active
active secondary
secondary market
market
 primary
primarydealers
dealerstrade
tradefor
forthemselves
themselvesand
andfor
forcustomers
customers
 T-bill
T-billpurchases
purchasesandandsales
salesare
arebook-entry
book-entrytransactions
transactions
conducted
conductedover
overFedwire
Fedwire
 T-Bills
T-Bills are
are sold
sold on
on aa discount
discount basis
basis

5-19
T-Bill Prices

 T-Bill
T-Billprices
pricescan
canbe
becalculated
calculatedfrom
fromquotes
quotes(e.g.,
(e.g.,from
fromThe
The
Wall
WallStreet
StreetJournal)
Journal)by
byrearranging
rearrangingthe
thediscount
discountyield
yield
equation
equation  h 
P0  Pf  iT  Bill (dy )   Pf 
 360 
 Or,
Or,by
byrearranging
rearrangingthe
thebond
bondequivalent
equivalentyield
yieldequation
equation

Pf
P0 
 h 
1   
 365 / iT  Bill (bey ) 

5-20
5-21
Federal Funds

 The
Thefederal
federalfunds
funds(fed
(fedfunds)
funds)rate
rateisisthe
thetarget
targetrate
ratein
inthe
the
conduct
conductof ofmonetary
monetarypolicy
policy
 Fed
Fedfund
fundtransactions
transactionsareareshort-term
short-term(mostly
(mostlyovernight)
overnight)
unsecured
unsecuredloans
loans
 Banks
Bankswith
withexcess
excessreserves
reserveslend
lendfed
fedfunds,
funds,while
whilebanks
bankswith
with
deficient
deficientreserves
reservesborrow
borrowfed
fedfunds
funds
 Multimillion
Multimilliondollar
dollarloans
loansmay
maybe bearranged
arrangedin inaamatter
matterof
of
minutes
minutes
 Fed
Fedfunds
fundsarearesingle-payment
single-paymentloansloansand
andthus
thususe
usesingle-
single-
payment
paymentyields
yields

5-22
Repurchase Agreement

 AArepurchase
repurchaseagreement
agreement(repo(repoororRP)
RP) isisthe
thesale
saleof
ofaa
security
securitywith
withan
anagreement
agreementto tobuy
buythe
thesecurity
securitybackbackatataa
set
setprice
pricein
inthe
thefuture
future
 Repos
Reposare areshort-term
short-termcollateralized
collateralizedloans
loans(typical
(typicalcollateral
collateral
isisU.S.
U.S.Treasury
Treasurysecurities)
securities)
 Similar to a fed fund loan, but collateralized
Similar to a fed fund loan, but collateralized
 Funds may be transferred over FedWire system
Funds may be transferred over FedWire system
 If collateralized by risky assets, the repo may involve a
If collateralized by risky assets, the repo may involve a
‘haircut’
‘haircut’

5-23
Repurchase Agreement

 Typical
Typicaldenominations
denominationsononrepos
reposof
ofone
oneweek
weekor
orless
lessare
are
$25
$25million
millionand
andlonger
longerterm
termrepos
reposusually
usuallyhave
have$10
$10million
million
denominations
denominations

 AAreverse
reverserepurchase
repurchaseagreement
agreementisisthethepurchase
purchaseofofaa
security
securitywith
withananagreement
agreementto
tosell
sellititback
backin
inthe
thefuture
future

5-24
Repurchase Agreement

 The
The yield
yield on
on repurchase
repurchase agreements
agreements (i(iRA ) uses a
RA) uses a
360-day
360-day year
year like
like the
the discount
discount rate,
rate, but
but uses
uses the
the
current
current price
price in
in the
the denominator
denominator likelike the
the bond
bond
equivalent
equivalent yield
yield
( Pf  P0 ) 360
iRA  
P0 h

PPf f==the
therepurchase
repurchaseprice
priceof
ofthe
thesecurity
security
PP00==the
theselling
sellingprice
priceofofthe
thesecurity
security
hh==thethenumber
numberof ofdays
daysuntil
untilthe
therepo
repomatures
matures

5-25
5-26
Commercial Paper

 Commercial
CommercialPaperPaper(CP)
(CP)isisunsecured
unsecuredshort-term
short-termcorporate
corporate
debt
debtissued
issuedtotoraise
raiseshort-term
short-termfunds
funds(e.g.,
(e.g.,for
forworking
working
capital)
capital)
 Generally
Generallysold
soldin
inlarge
largedenominations
denominations(e.g.,
(e.g.,$100,000
$100,000to to$1
$1
million)
million)with
withmaturities
maturitiesbetween
between11and
and270270days
days
 CP
CPisisusually
usuallysold
soldto
toinvestors
investorsindirectly
indirectlythrough
throughbrokers
brokersand
and
dealers
dealers(approximately
(approximately85% 85%of
ofthe
thetime)
time)
 CP
CPisisusually
usuallyheld
heldbybyinvestors
investorsuntil
untilmaturity
maturityand
andhashasno
no
active
activesecondary
secondarymarket
market
 Yields
Yieldsare
arequoted
quotedon onaadiscount
discountbasis
basis(like
(likeT-bills)
T-bills)

5-27
5-28
Asset-Backed Commercial Paper

 AA type
type ofof commercial
commercial paper
paper that
that isis backed
backed by
by assets
assets
of
of the
the issuing
issuing firm
firm

 Grew
Grew very
very rapidly
rapidly prior
prior to
to thethe financial
financial crisis
crisis peaking
peaking
at
at $2.16
$2.16 trillion,
trillion, much
much ofof itit was
was backed
backed byby mortgage
mortgage
investments
investments

 The
The market
market collapsed
collapsed during
during the
the financial
financial crisis
crisis

5-29
Negotiable Certificate of Deposit

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

5-30
Banker’s Acceptance

 AABanker’s
Banker’sAcceptance
Acceptance(BA)(BA) isisaatime
timedraft
draftpayable
payabletotoaa
seller
sellerof
ofgoods
goodswith
withpayment
paymentguaranteed
guaranteedby byaabank
bank
 Used
Usedin ininternational
internationaltrade
tradetransactions
transactionsto tofinance
financetrade
tradeinin
goods
goodsthat
thathave
haveyet
yetto
tobe
beshipped
shippedfromfromaaforeign
foreignexporter
exporter
(seller)
(seller)to
toaadomestic
domesticimporter
importer(buyer)
(buyer)
 Foreign
Foreignexporters
exportersprefer
preferthat
thatbanks
banksact actas
aspayment
payment
guarantors
guarantorsbefore
beforesending
sendinggoods
goodsto toimporters
importers
 Banker’s
Banker’sacceptances
acceptancesare arebearer
bearerinstruments
instrumentsandandthus
thusare
are
salable
salableininsecondary
secondarymarkets
markets

5-31
Diagram 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

5-32
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 Acceptances Euro$ Repo*
Rate 0.27375% 0.22% 0.25% 0.08%
Treasury
Instrument Bills**
Inflation***    
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

5-33
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%
  100% 100% 100% 100%

Source: Text

5-34
Money Market Participants

 The
The U.S.
U.S. Treasury
Treasury
 The Federal Reserve
The Federal Reserve
 Commercial banks
Commercial banks
 Money market mutual funds
Money market mutual funds
 Brokers and dealers
Brokers and dealers
 Corporations
Corporations
 Other financial institutions
Other financial institutions
 Individuals
Individuals

5-35
International Money Markets

 U.S.
U.S.dollars
dollarsheld
heldoutside
outsidethetheU.S.
U.S.are
aretracked
trackedamong
among
multinational
multinationalbanks
banksin inthe
the Eurodollar
Eurodollarmarket
market
 The
Therate
rateoffered
offeredfor
forsale
saleononEurodollar
Eurodollarfunds
fundsisisthe
the
London
LondonInterbank
InterbankOffered
OfferedRate Rate(LIBOR)
(LIBOR)
 Eurodollar
EurodollarCertificates
Certificatesof ofDeposit
Deposit are
areU.S.
U.S.dollar-
dollar-
denominated
denominatedCDs CDsheld
heldin inforeign
foreignbanks
banks
 Eurocommercial
Eurocommercialpaper paper(Euro-CP)
(Euro-CP) isisissued
issuedin inEurope
Europe
and
andcan
canbebein
inlocal
localcurrencies
currenciesor orU.S.
U.S.dollars
dollars

5-36
International Money Markets

5-37