Zohra 69 4325 1 M10 MISH1520 06 PPW C09

Chapter 9
The Money
Markets
The Money Markets Defined
The term “money market” is a misnomer.

Money (currency) is not actually traded in
the money markets. The securities in the
money market are short term with high
liquidity; therefore, they are close to
being money.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-2

The Money Markets Defined
• Money Market’s basic characteristics are:

1. Money market securities are usually sold in
large denominations ($1,000,000 or more)
2. They have low default risk
3. They mature in one year or less from their
issue date. Most instruments mature in less
than 120 days

The Money Markets Defined:
Why Do We Need Money Markets?
In theory, the money markets should not be needed and the banking
industry should handle the needs for short-term loans and accept
short-term deposits. Banks also have an information advantage
on the credit-worthiness of participants.
Due to continuing relationships with customers banks are more
likely to offer loans cheaply than diversified markets which must
evaluate each borrower a new security is offered.
Furthermore, short term securities offered for sale in the money
markets are neither as liquid nor as safe as deposits placed in
thrifts and banks.

• The banking industry exists primarily to mediate
the asymmetric information problem between
lender savers and borrower spenders and banks
can earn profits by capturing economies of scale
while providing this service.
• However, banking sector is subject to more
regulations and governmental costs than are the
money markets.
• In situations where the asymmetric information
problem is not severe the money markets have a
distinct cost advantage over banks in providing
short term funds.

Cost Advantages
• Reserve requirements create additional expense

for banks that money markets do not have.
• Regulations on the level of interest banks could
offer depositors lead to a significant growth in
money markets, especially in the 1970s and
1980s. When interest rates rose, depositors
moved their money from banks to money markets
to earn a higher interest rate.

Cost Advantages
• Even today, the cost structure of banks

limits their competitiveness to situations
where their informational advantages
outweighs their regulatory costs.
• Figure 1 shows that limits on interest banks
could offer was not relevant until the 1950s.
But in the decades that followed, the
problem became apparent.

The Purpose of Money Markets
• The well developed secondary market for

money market instruments provides an
ideal place for warehousing surplus funds
until they are needed.
• The money markets provide a low-cost
source of funds to firms, the government,
and intermediaries that need a short term
infusion of funds.

• Most investors in the money markets are not trying to
earn unusually high returns on their money market funds.
• Rather, they use the money market as an interim
investment that provides a higher return than holding cash
or money in banks.
• Investment advisers often hold some funds in the money
market so that they will be able to act quickly to take
advantage of investment opportunities they identify.
• Most investment funds and financial intermediaries also
hold money market securities to meet investment or
deposit outflows.
• The sellers of money market securities find that the
money market provides a low cost source of temporary
funds.

• Why do corporations and the US government
sometimes need to get their hands on funds
quickly?
• The primary reason is that cash inflows and
outflows are rarely synchronized.
• Govt. Revenues occur only at certain times
whereas, expenses are incurred all year long.
• The government can borrow short term funds that
it will pay back when it receives tax revenues.

Who Participates
in the Money Markets?
• We will discuss, in turn, each of the

major borrowers and lenders in the
money market.

Who Participates
in the Money Markets?
Money Market Instruments
• We will examine each of these in the

following slides:
– Treasury Bills
– Federal Funds
– Repurchase Agreements
– Negotiable Certificates of Deposit

Money Market Instruments (cont.)
• We will examine each of these in the

following slides (continued):
– Commercial Paper
– Banker’s Acceptance
– Eurodollars

Money Market Instruments:
Treasury Bills
• To finance the national debt, the US Treasury Department
issues a variety of debt securities.
• The most widely held liquid security is the Treasury bill.
• T bills are sold with 28, 91 and 182 day maturities.
• The Fed has set up a direct purchase option that
individuals may use to T bills over the internet.
• This method of buying securities represented an effort to
make Treasury securities more widely available.

Treasury Bills
• Discounting: When an investor pays less for the

security than it will be worth when it matures, and
the increase in price provides a return.
• Risk: T bills have virtually zero default risk
because even if the government ran out of money,
it could simply print more to redeem them when
they mature.
• The rise of unexpected changes in inflation is also
low because of short term to maturity.
• The market of T bills is extremely deep and liquid.
• A deep market is one with many buyers
and sellers.
• A liquid market is one in which securities
can be bought and sold quickly and with
low transaction costs.
• Thus, investors have little risk.

Treasury Bill Auctions
• T-bills are auctioned to the dealers

every Thursday.
• The Treasury may accept both
competitive and noncompetitive bids, and
the price everyone pays is the highest
yield paid to any accepted bid.

Treasury Bill Rates
Treasury bills are very close to being risk free.

As expected for a risk free security, the interest rate earned
on Treasury bill security is among the lowest in the
economy.
Investors in T bills have found that in some years, their
earnings did not even compensate them for changes in
purchasing power due to inflation.
Clearly, the T bill is not an investment to be used for
anything but temporary storage of excess funds,
because it barely keeps up with inflation.

Fed Funds
• Short-term funds transferred (loaned or

borrowed) between financial institutions, usually
for a period of one day.
• Used by banks to meet short-term needs to meet
reserve requirements.
• The interest rate charged for borrowing these
funds was close to the rate that the Federal
Reserve charged on discount loans.

Purpose of Fed Funds
• The Federal reserve has set minimum reserve requirements
that all banks must maintain.
• To meet these reserve requirements, banks must keep a
certain percentage of their total deposits with the Federal
reserve.
• Banks can directly borrow from Federal Reserve but the Fed
actively discourages banks from regularly borrowing from it.
• The reason that banks like to lend in the fed funds market is
that money held at the Federal Reserve in excess of what is
required does not earn any interest.
• So even though the interest rate on fed funds is low, it beats
the alternative.

Terms for Fed Funds
• Fed funds are usually overnight investments.
• Banks analyze their reserve position on a daily
basis and either borrow or invest in fed funds,
depending on whether they have deficit or excess
reserves.
• Most fed funds borrowings are unsecured.
• Typically, the entire agreement is established by
direct communication between buyer and seller.

Fed Funds Rates
• The forces of supply and demand set the fed funds
interest rate.
• This is a competitive market that analysts watch closely
for indications of what is happening to short term rates.
• The federal reserve cannot directly control fed funds
rates.
• It can and does indirectly influence them by adjusting the
level of reserves available to banks in the system.
• The Fed will announce its intention to raise or lower the
fed funds rate in advance.

Fed Funds Rates

Money Market Instruments: Repurchase
Agreements
• These work similar to the market for fed
funds, but nonbanks can participate.
• A firm sells Treasury securities, but agrees
to buy them back at a certain date (usually
3–14 days later) for a certain price.

Repurchase Agreements
• Government securities dealers frequently engage in repos.
• The dealers may sell the securities to a bank with the promise to buy
the securities back the next day.
• This makes the repo essentially a short term collateralized loan.
• Securities dealers use the repo to manage their liquidity and to take
advantage of anticipated changes in interest rates.
• The Federal Reserve also uses repos in conducting monetary policy.
• Recall that the conduct of monetary policy typically requires that the
Fed adjust bank reserves on a temporary basis.
• To accomplish this adjustment, the Fed will buy or sell Treasury
securities in the repo market.
• The maturities of Federal Reserve repos never exceed 15 days.

Interest Rate on Repos
• Because repos are collateralized with
Treasury securities, they are usually low
risk investments and therefore have low
interest rates.
• Though rare losses have occurred in these
markets.

Money Market Instruments: Negotiable
Certificates of Deposit
• A bank-issued security that documents a deposit

and specifies the interest rate and the maturity
date
• Because a maturity date is specified, a CD is a
term security as opposed to a demand deposit.
• It is also known as a bearer instrument. This
means that whoever holds the instrument at
maturity receives the principal and interest. The
CD can be bought and sold until maturity.

Terms of Negotiable Certificates of
Deposit
• The denominations of negotiable certificates of
deposit range from $100,000 to $10 million.
• Few negotiable CDs are denominated less than $1
million.
• The reason that these instruments are so large is
that dealers have established the round lot size to
be $1 million.
• Negotiable CDs typically have a maturity of one to
four months. Some have six month maturities, but
there is little demand for ones with longer
maturities.
History of the CD
• Citibank issued the first large certificates of deposit in 1961.
• The bank offered the CD to counter the long term trend of declining demand deposits at
large banks.
• Corporate treasurers were minimizing their cash balances and investing their excess
funds in safe income generating money market instruments.
• The attraction of CD was that it paid a market interest rate.
• There was a problem, however.
• The rate of interest that banks could pay on CDs was restricted by Regulation Q.
• As long as interest rates on most securities were low, this regulation did not affect
demand.
• But when interest rates rose above the level permitted by Regulation Q, the market for
these certificates of deposit evaporated.
• In 1970, Congress amended Regulation Q to exempt certificates of deposit over
$100,000.
• CD is the second most popular money market instrument behind only the T bill.

Interest Rate on CDs
• The rates paid on CDs are negotiated

between the bank and the customer.
• They are similar to the rate paid on other
money market instruments because the
level of risk is relatively low.

Money Market Instruments: Commercial
Paper
• Unsecured promissory notes, issued by

corporations, that mature in no more than
270 days.
• Because these instruments are unsecured
only the largest and most creditworthy
corporations issue commercial paper.
• The interest rate the corporation is charged
reflects the firm’s level of risk.
Terms and Issuance
• Commercial paper always has an original maturity of less than 270
days.
• This is to avoid the need to register the security issue with the
Securities and Exchange Commission.
• Like T bills it is issued on a discounted basis.
• About 60% is directly sold by the issuer to the buyer.
• The balance is sold by dealers in the commercial paper market.
• A strong secondary market for commercial paper does not exist.
• A dealer will redeem commercial paper when a purchaser has a dire
need of cash, though this generally is not necessary.

History of Commercial Paper
• Commercial paper has been used in various forms since the 1920s.
• In 1969, tight money environment caused bank holding companies to
issue commercial paper to finance new loans.
• In response, to keep control over the money supply, the Federal
Reserve imposed reserve requirements on bank issued commercial
paper in 1970.
• Bank holding companies still use commercial paper to finance leasing
and consumer finance.
• The use of commercial paper increased substantially in the early
1980s because of the rising cost of bank loans.

Market for Commercial Paper
• Non bank corporations use commercial paper extensively to
finance the loans that they extend to their customers.
• Total firms issuing commercial paper varies between 600 to
800, depending on the level of interest rates.
• Some of the largest issuers of commercial paper choose to
distribute their securities with direct placement.
• Most issuers of commercial paper back up their paper with a
line of credit at a bank.
• This means that in the event the issuer cannot payoff or roll
over the maturing paper, the bank will lend the firm funds for
this purpose.
• The line of credit reduces the risk to the purchaser of the
paper and so lowers the interest rate.
• The bank that provides the backup line of
credit agrees in advance to make a loan to
the issuer if needed to pay off the
outstanding paper.
• Issuers pay this fee because they are able
to save more than this in lowered interest
costs by having the line.
• Commercial banks were the original
purchasers of commercial paper.

Banker’s Acceptances
• An order to pay a specified amount

to the bearer on a given date if specified
conditions have been met, usually delivery
of promised goods.
• They are used to finance goods that have
not yet been transferred from the seller to
the buyer.

Using a Banker’s Acceptance
• The transaction would begin with importer
obtaining a letter of credit from its bank which
implies that bank will make payment in case of
default by the importer.
• It will allow an exporter to draw a time draft for
the amount of sale.
• A time draft is like a post dated cheque, it can
only be cashed after a certain date.
• Importer will send the order along with LC to the
exporter.

• When exporter receives the documents, it is
willing to ship the equipment because the bank’s
credit standing has been substituted for that of
the actual buyer.
• Once the equipment has been shipped the
exporter will present the LC and the shipping
documents to its own bank.
• This bank will create the time draft authorized by
the LC and sends it to the importer’s bank.
• The importer’s bank will stamp the time draft
accepted and return it to the exporter’s bank.

• This accepted time draft is now a banker’s acceptance as
it is backed by the credit of a bank, it can be traded on the
secondary market.
• The transaction is completed when importer deposits the
funds in its bank to cover the amount of the time draft.
• When a banker’s acceptance finally matures and is
presented for payment, the issuing bank withdraws funds
from importer’s account to make payment.
• Of course, if importer is unable to make the required
deposit, its bank would pay the acceptance anyway and
attempt to collect from importer later.

Banker’s Acceptances Advantages
1. Exporter paid immediately

2. Exporter shielded from foreign
exchange risk because the local bank pays in
domestic funds
3. Exporter does not have to assess the financial
security of the importer because the importer’s
bank guarantees payment
4. Crucial to international trade

Banker’s Acceptances
• As seen, banker’s acceptances avoid the

need to establish the credit-worthiness of a
customer living abroad.
• There is also an active secondary market
for banker’s acceptances until they mature.
The terms of note indicate that the bearer,
whoever that is, will be paid upon maturity.

Money Market Instruments: Eurodollars
• Eurodollars represent Dollar denominated

deposits held in foreign banks.
• The market is essential since many foreign
contracts call for payment in U.S. dollars
due to the stability of the dollar, relative to
other currencies.

• The Eurodollar market has continued to grow

rapidly because depositors receive a higher rate
of return on a dollar deposit in the Eurodollar
market than in the domestic market.
• Multinational banks are not subject to the same
regulations restricting U.S. banks and because
they are willing to accept narrower spreads
between the interest paid on deposits and the
interest earned on loans.

Rates
• London interbank bid rate (LIBID)

– The rate paid by banks buying funds
• London interbank offer rate (LIBOR)

– The rate offered for sale of the funds
• Time deposits with fixed maturities

– Largest short term security in the world

Global: Birth of the Eurodollar
• The Eurodollar market is one of the most

important financial markets, but oddly
enough, it was fathered by the Soviet Union.
• In the 1950s, the USSR had accumulated
large dollar deposits, but all were in US
banks. They feared the US might seize
them, but still wanted dollars. So, the USSR
transferred the dollars to European banks,
creating the Eurodollar market.
Comparing Money Market Securities
• The next slide shows a comparison of

various money market rates from 1990
through 2007.
• Notice that no real pattern is present
among the rates, indicating that investor
preferences to the features on the
instruments fluctuates.

Comparing Money Market Securities : A
comparison of rates

Comparing Money Market Securities
• The next slide summarizes the types of

securities, issuers, buyers, maturity, and
secondary market characteristics.

Comparing Money Market Securities: Money
Market Securities and Their Depth

Chapter Summary
• The Money Markets Defined

– Short-term instruments
– Most have a low default probability
• The Purpose of Money Markets
– Used to “warehouse” funds
– Returns are low because of low risk and
high liquidity

Chapter Summary (cont.)
• Who Participates in Money Markets?

– U.S. Treasury
– Commercial banks
– Businesses
– Individuals (through mutual funds)
• Money Market Instruments

– Include T-bills, fed funds, etc.

Chapter Summary (cont.)
• Comparing Money Market Securities

– Issuers range from the US government to
banks to large corporations
– Mature in as little as 1 day to as long as 1 year
– The secondary market liquidity
varies substantially

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Chapter 9

The term “money market” is a misnomer.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-2

• Money Market’s basic characteristics are:

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-3

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-4

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-5

• Reserve requirements create additional expense

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-6

• Even today, the cost structure of banks

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-7

• The well developed secondary market for

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-8

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-9

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-10

• We will discuss, in turn, each of the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-11

• We will examine each of these in the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-13

• We will examine each of these in the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-14

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-15

• Discounting: When an investor pays less for the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-17

• T-bills are auctioned to the dealers

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-18

Treasury bills are very close to being risk free.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-19

• Short-term funds transferred (loaned or

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-20

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-21

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-22

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-23

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-24

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-25

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-26

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-27

• A bank-issued security that documents a deposit

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-28

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-30

• The rates paid on CDs are negotiated

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-31

• Unsecured promissory notes, issued by

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-33

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-34

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-36

• An order to pay a specified amount

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-37

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-38

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-39

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-40

1. Exporter paid immediately

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-41

• As seen, banker’s acceptances avoid the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-42

• Eurodollars represent Dollar denominated

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-43

• The Eurodollar market has continued to grow

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-44

• London interbank bid rate (LIBID)

• London interbank offer rate (LIBOR)

• Time deposits with fixed maturities

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 9-45