CHAPTER

Money Markets

2003 South-Western/Thomson Learning

Chapter Objectives
Provide a background on money market securities s Explain how institutional investors use money markets s Explain the globalization of money markets
s

Money Market Securities

Maturity of a year or less s Debt securities issued by corporations and governments that need short-term funds s Large primary market focus s Purchased by corporations and financial institutions s Secondary market for securities
s

Money Market Securities

Treasury Bills s Commercial paper s Negotiable certificates of deposits s Repurchase agreements s Federal funds s Bankers acceptances
s

Money Market Securities

s

Treasury bills
q Issued

to meet the short-term needs of the U.S. government q Attractive to investors

x Minimal
s s

default riskbacked by Federal Government x Excellent liquidity for investors

Short-term maturity Very good secondary market

Money Market Securities Competitive Bidding

s

Treasury bill auction (fill bids in amount determined by Treasury borrowing needs)
q Bid

process used to sell T-bills q Bids submitted to Federal Reserve banks by the deadline q Bid process
x Accepts

highest bids x Accepts bids until Treasury needs generated

Money Market Securities

Noncompetitive Bidding
s

Treasury bill auctionnoncompetitive bids ($1 million limit)

q q q q

May be used to make sure bid is accepted Price is the weighted average of the accepted competitive bids Investors do not know the price in advance so they submit check for full par value After the auction, investor receives check from the Treasury covering the difference between par and the actual price

Money Market Securities

s

Estimating T-bill yield

q No

coupon payments q Par or face value received at maturity q Yield at issue is the difference between the selling price and par or face value adjusted for time q If sold prior to maturity in secondary market
x Yield

based on the difference between price paid for T-bill and selling price adjusted for time

Money Market Securities

s

Calculating T-Bill Annualized Yield

YT =

SP PP PP

365 n

YT = The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period)

Money Market Securities

s

T-bill yield for a newly issued security

T-bill discount =

Par PP PP

360 n

T-bill discount = percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity

Money Market Securities

Commercial Paper
q Short-term

debt instrument q Alternative to bank loan q Dealer placed vs. directly placed q Used only by well-known and creditworthy firms q Unsecured q Minimum denominations of $100,000 q Not a large secondary market

Money Market Securities

s

Commercial paper backed by bank lines of credit

q Bank

line used if company loses credit rating q Bank lends to pay off commercial paper q Bank charges fees for guaranteed line of credit

Money Market Securities

s

Estimating commercial paper yields

Par PP PP

YCP =

360 n

YCP = Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity

Money Market Securities

Negotiable Certificates of Deposit (NCD)

q Issued

by large commercial banks q Minimum denomination of $100,000 but $1 million more common q Purchased by nonfinancial corporations or money market funds q Secondary markets supported by dealers in security

Money Market Securities

s

NCD placement
q Direct

placement q Use a correspondent institution specializing in placement q Sell to securities dealers who resell q Sell direct to investors at a higher price
s

NCD premiums
q Rate

above T-bill rate to compensate for lower liquidity and safety

Money Market Securities

Repurchase Agreements
q Sell

a security with the agreement to repurchase it at a specified date and price q Borrower defaults, lender has security q Reverse repo name for transaction from lender q Negotiated over telecommunications network q Dealers and brokers used or direct placement q No secondary market

Money Market Securities

s

Estimating repurchase agreement yields

SP PP PP

Repo Rate =

360 n

Repo Rate = Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity

Money Market Securities

Federal Funds
q Interbank

lending and borrowing q Federal funds rate usually slightly higher than Tbill rate q Fed district bank debits and credits accounts for purchase (borrowing) and sale (lending) q Federal funds brokers may match up buyers and sellers using telecommunications network q Usually $5 million or more

Exhibit 6.5
1 Purchase Order Shipment of Goods

Importer

Exporter

L/C (Letter of Credit) Application

L/C

American Bank (Importers Bank)

Shipping Documents &T ime Draft Draft Accepted (B/ACreated)

Japanese Bank (Exporters Bank)

Shipping Documents & Time Draft

6

L/C Notification

Money Market Securities

Bankers Acceptance
qA

bank takes responsibility for a future payment of trade bill of exchange q Used mostly in international transactions q Exporters send goods to a foreign destination and want payment assurance before sending q Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time

Money Market Securities

Bankers Acceptance
q Exporter

can hold until the date or sell before

maturity q If sold to get the cash before maturity, price received is a discount from drafts total q Return is based on calculations for other discount securities q Similar to the commercial paper example

Major Participants in Money Market

s

Participants
q q q q q

Commercial banks Finance, industrial, and service companies Federal and state governments Money market mutual funds All other financial institutions (investing)

s s s

Short-term investing for income and liquidity Short-term financing for short and permanent needs Large transaction size and telecommunication network

Valuation of Money Market Securities

Present value of future cash flows at maturity (zero coupon) s Value (price) inversely related to discount rate or yield s Money market security prices more stable than longer term bonds s Yields = risk-free rate + default risk premium
s

Exhibit 6.7
International Economic Conditions U.S. Fiscal Policy U.S. Monetary Policy U.S. Economic Conditions Issuers Industry Conditions Issuers Unique Conditions

Short-Term Risk-Free Interest Rate (T -bill Rate)

Risk Premium of Issuer

Required Return on the Money Market Security

Price of the Money Market Security

Interaction Among Money Market Yields

Securities are close investment substitutes s Investors trade to maintain yield differentials s T-Bill is the benchmark yield in money market s Yield changes in T-bills quickly impacts other securities via dealer trading s Yield differentials determined by risk differences between securities s Default risk premiums vary inversely with economic conditions
s

Globalization of Money Markets

s

Money market rates vary by country

q Segmented

markets q Tax differences q Estimated exchange rates q Government barriers to capital flows

Deregulation Improves Financial Integration s Capital Flows To Highest Rate of Return

s

Globalization of Money Markets

s

Eurodollar deposits and Euronotes

q Dollar

deposits in banks outside the U.S. q Increased because of international trade growth and U.S. trade deficits over time q No reserve requirements at banks outside U.S.
s

Eurodollar Loans
q Channel

funds to other multinationals that need short-term financing

Globalization of Money Markets

s

Euro-commercial paper
q Issued

without the backing of a banking syndicate q Maturity tailored to investors q Dealers that place paper create a secondary market q Rates range between 50 and 100 basis points above the LIBOR rate

Globalization of Money Markets

Performance of international securities s Effective yield for international securities has two components
s
q The

yield earned on the investment denominated in the currency of the investment q The exchange rate effect

Globalization of Money Markets

Performance of international securities s Yield for an international investment
s Yf PPf Yf = Foreign investments yield SPf = Investments foreign currency selling price PPf = Investments foreign currency purchase = SPf PPf

Globalization of Money Markets

s

The exchange rate effect (%S) measures the percentage change in the spot during the investment period

Ye = (1 + Yf ) (1 + %S ) 1
q%

S measures the expected percent change in the currency

x Currency

yield x Currency depreciated, % S is negative and reduces net yield

appreciated, % S is positive and adds to net

Chapter Concepts Summary

Surplus units channel investments to securities issued by deficit units s Debt securities markets
s
q Money

Market q Capital Market

s

Money market securities

q Short-term q High

quality q Very good liquidity