The Money Market

Chapter 9

© 2003 South-Western/Thomson Learning

 Learning Objectives
 Primary participants and instruments of
money markets
 How money markets are used by various
participants
 Recent trends in money market instruments
 How money markets have become
international in scope
 What money market mutual funds are and
why they have become important
intermediaries
Slide 2
 Money Market

Short-term credit market:

where debt securities
having original maturities
of 1 year or less are
traded

Slide 3
 Money Market Characteristics
 Issued in large denominations
 Usually $1 million or more
 Money market instruments have short
maturities
 Less than 3 months
 Ranging from 1 day to 1 year
 Money market instruments characterized
by:
 Low liquidity
 Default risk
 Does not occupy one particular
geographic location or trading floor
Slide 4
 Money Market Benefits

 More efficient source of credit for

largest:
 Financial institutions
 Nonfinancial corporations
 Governmental bodies

Slide 5
 Money Market Benefits
 Advantages over bank borrowing
 Banks required to hold noninterest-
bearing required reserves:
 As vault cash
 On deposit at Fed
 only 90-97% of banks’ domestic transactions
deposits can be lent out
 Banks face regulatory constraints on:
 size of loan they can make to one particular
borrower
 Particular types of assets they are allowed
to hold on their balance sheet
Slide 6
 Money Market Participants

 Commercial banks and savings

associations
 GSEs
 The Federal Reserve
 Corporations and finance companies
 Pension funds and insurance
companies
 Brokers and dealers

Slide 7 MMMFs and individuals
 Commercial Banks and Savings
Associations
 Play five important roles:
 Borrow in money market:
 To meet their reserve needs
 To make loans to their commercial or
household customers
 Hold significant levels of Treasury
securities on asset side of their balance
sheets

Slide 8
 Commercial Banks and Savings
Associations

3. Assist other participants by:

 Providing credit enhancements for a fee to
those issuing commercial paper and bankers’
acceptances
4. Serve as agents and underwriters in
commercial paper market
5. Serve as primary dealers of U.S.
government securities
 Enables them to trade money market
securities on behalf of their corporate
customers
Slide 9
 GSEs
 Governments & Government-Sponsored
Enterprises (GSEs):
 U.S. Treasury is world’s single largest
borrower
 Issues U.S. Treasury bills (T-bills)
 Treasury notes and bonds that have longer maturities
 Privately owned GSEs:
 Federal National Mortgage Association (Fannie
Mae)
 Federal Farm Credit Banks Funding
Corporation (FFCBFC)
 Student Loan Marketing Association (Sallie
Mae)
Slide 10
 Privately-owned GSEs

 Engaged in assisting with finance of:

 Housing
 Agriculture
 Education
 State and municipal (local governments
and special districts) governments issue
short-term municipal notes to finance:
 Their own expenditures
 Expenditures of local schools, hospitals
and private firms

Slide 11
 The Federal Reserve

 Fed controls level of reserves

available to depository institutions
 open market purchase and sale of T-
bills
 repurchase agreements

Slide 12
 Corporations/Finance Companies

 Use money markets to

 raise funds
 store funds
 Issue large amounts of commercial
paper as primary source of funds
 which they lend to consumers and firms
 use to make up for temporary shortfalls of
cash

Slide 13
 Pension Funds and Insurance
Companies
 Both use money market for
 cash management
 to provide needed liquidity

Slide 14
 Brokers and Dealers
 Ensure the regular functioning of the
money market
 Market new issues of securities

 Repurchase securities

 Establish secondary market

 Act as intermediaries in the RP market

 Match buyers and sellers

Slide 15
The Broker’s Role in the Federal Funds Market

Slide 16
 Money Market Instruments
 Commercial paper
 Unsecured, short-term promissory notes
as alternative to:
 Short-term bank loans
 Other forms of borrowing
 Primary benefit to largest & most
creditworthy issuers is:
 Cost of borrowing is lower than at a
commercial bank

Slide 17
 Money Market Instruments
 Commercial paper
 Characteristics largely defined by
legislation and issuers’ attempt to avoid
costly disclosure requirements mandated
for other types of securities
 Expensive requirements avoided if these are
met:
 Paper issued must mature in less than 270 days
 Paper must be issued in large denomination so
that it is not typically purchased directly by
public
 Proceeds must be used to fund current
transactions
Slide 18
 Money Market Instruments
 Commercial paper
 Financial companies (specifically nonbank
financial companies responsible for
issuing majority:
 Domestic paper
 Foreign paper
 Companies choose to issue paper:
 Through a dealer
 Engage in direct placements

Slide 19
 Money Market Instruments
 Federal (Fed) Funds
 When institutions anticipate insufficient
reserves, they often turn to Federal (fed) funds
market.
 Here they can borrow reserves from other
institutions on an overnight basis.
 Institutions with excess reserves can turn to
the fed funds market to loan these reserves
and earn interest.

Slide 20
 Money Market Instruments
 Fed Funds
 Fed funds are lent:
 on an overnight basis
 in denominations of $5 million or more
 Fed Funds Rate:
 Interest rate charged on overnight loans of
reserves among commercial banks

Slide 21
 Money Market Instruments
 Repurchase Agreements
 Short-term contract in which seller agrees to:
 Sell government security to a buyer
 Buy it back on a later date at a higher price
 Reverse Repurchase Agreements or
Matched Sale-Purchase (MSP) Agreement
 Repurchase agreement viewed from
perspective of initial buyer
 Short-term agreements in which:
 Buyer buys a government security from seller
 Agrees to sell it back on a later date at a higher price

Slide 22
 Money Market Instruments

Most money market instruments

are sold at a discount.

 number of days 
Interest earned  funds invested  RP rate  
 360 

selling price - purchace price 360

PR rate  
purchace price number of days

Slide 23
 Money Market Instruments
 CERTIFICATES of DEPOSIT (CDs)
 Debt instruments issued by commercial banks with:
 Minimum denomination of $100,000
 Fixed interest rate
 Return the principal at maturity
 Debt instruments issued by commercial banks that
may be:
 Negotiable (tradable)
 Non-negotiable (not tradable)
 Thrift CDs
 Certificates of deposit issued by:
 Savings associations
 Credit unions

Slide 24
 Money Market Instruments
 CERTIFICATES of DEPOSIT (CDs)
 Interest rates on negotiable CDs tend to be higher
than T-bill rates:
 CD holders exposed to default risk - only a portion of
deposit is insured
 Unlike T-bills, earnings on CDs subject to state/local
income taxes
 Secondary market for CDs much thinner than T-bills,
making negotiable CDs less liquid than T-bills
 Euro CDs
 Certificates of deposit issued by foreign branches
of commercial banks but denominated in currency
of the branch’s home country

Slide 25
 Money Market Instruments
 Foreign CDs
 Certificates of deposit issued by the
foreign branches of commercial banks
but denominated in currency of the
branch’s host country
 Yankee CDs
 Certificate of deposit issued by a
foreign bank in a foreign currency, but
sold in the United States

Slide 26
 Money Market Instruments
 U.S. TREASURY BILLS
 Sold to a variety of different types of
buyers with:
 Low minimum denominations
 $10,000
 Short maturities
 Sold on a discount basis
 Sold at price below its face, or par, value
 Original issues are sold at regularly
scheduled auctions
Slide 27
 Money Market Instruments
 U.S. Treasury Bills – Auction Methods
 Multiple-Price Method
 Seller accepts bids prior to selling securities
 Sales awarded beginning with highest bidder
 Buyers end up paying different prices for same securities
based upon their respective bids
 Treasury discontinued this method in November 1998
 Stop-Out Yield
 Lowest accepted bid price or yield in securities auction
 Uniform Price Method
 Seller accepts bids prior to selling securities
 Sales awarded beginning with highest bidder
 Buyers pay same price for securities based on stop-out yield

Slide 28
 Money Market Instruments
 EURODOLLARS
 Dollar-denominated deposit liabilities exempt
from U.S. banking regulations
 International Banking Facilities (IBFs)
 Financial institutions in U.S.
 Cater to needs of foreign individuals, corporation,
and/or governments
 Allow non-U.S. residents to hold unregulated Eurodollar
deposits
 London Interbank Bid Rate (LIBID)
 Interest rate London banks are willing to borrow
Eurodollar balances
 London Interbank Offered Rate (LIBOR)
 Interest rate London banks are willing to loan Eurodollar
balances
Slide 29
The Anatomy of
Eurodollar
Borrowing

Slide 30
 Money Market Instruments
 BANKERS’ ACCEPTANCES (BAs)
 Allow bank to “accept” responsibility or
guarantee payment of one of its
customers
 Important in international trade when
export company may not know or easily
determine the credit-worthiness of
foreign company

Slide 31
 Money Market Instruments

 MONEY MARKET MUTUAL FUNDS

(MMMFs)
 Short-term investment pools use
proceeds they raise from selling shares to
invest in various money market
instruments
 Disintermediation
 Reversal of financial intermediation process
whereby funds are:
 Pulled from financial intermediaries
 Moved directly into open market instruments

Slide 32