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Chapter Five Money Markets Mc. Graw-Hill/Irwin 1 © 2007, The Mc. Graw-Hill Companies, All Chapter Five Money Markets Mc. Graw-Hill/Irwin 1 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Definition and Purpose of Money Markets • The Money Markets are associated with the Definition and Purpose of Money Markets • The Money Markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations, FIs and governments • Only High-Quality Entities can borrow in the Money Markets and individual issues are large Mc. Graw-Hill/Irwin 2 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Definition and Purpose of Money Markets • Investors in Money Market Instruments include corporations Definition and Purpose of Money Markets • Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon • The Money Markets essentially serve to allocate the nation’s supply of liquid funds among major short-term lenders and borrowers Mc. Graw-Hill/Irwin 3 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Money Market Instruments • • • Treasury Bills (TBs) Federal Funds (FFs) Repurchase Agreements Money Market Instruments • • • Treasury Bills (TBs) Federal Funds (FFs) Repurchase Agreements (RAs) Commercial Papers (CP) Negotiable Certificates of Deposit (CD) Banker Acceptance (BA) Mc. Graw-Hill/Irwin 4 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Money Market Participants Instrument Principal Issuer Principal Investor Treasury bills U. S. Treasury Federal Money Market Participants Instrument Principal Issuer Principal Investor Treasury bills U. S. Treasury Federal funds Repurchase agreement Negotiable CDs Commercial banks FRS; Comm banks; Brokers and dealers; Other FIs Comm banks Other FIs; Corps Commercial banks Banker’s acceptances Commercial banks FRS; Comm banks; MF’s Brokers and dealers; Other FIs; Corp’s Commercial banks FRS, Comm banks; MF’s Brokers and dealers Other FIs, Corp’s Brokers and dealers; MF’s Corporations Brokers and dealers; MF’s Corps; Other FIs Comm banks; Corp’s; Brokers and dealers Commercial Paper Mc. Graw-Hill/Irwin 5 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Money Market Instruments Outstanding, December 1990 and 2004 (in billions of dollars) Amount Outstanding Money Market Instruments Outstanding, December 1990 and 2004 (in billions of dollars) Amount Outstanding Rate of Return 1990 2004 981. 9 6. 68% 2. 15% 1, 585. 1 1, 309. 7 7. 31 8. 14 1. 83 1. 89 1, 379. 4 4. 4 8. 13 7. 95 2. 28 2. 04 Treasury bills $527. 0 Federal funds and repurchase agreements 372. 3 Commercial paper 537. 8 Negotiable certificates of deposit 546. 9 Banker’s acceptance 52. 1 Mc. Graw-Hill/Irwin $ 6 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Treasury Bill Basics • Issued by the Treasury – to cover government budget deficits Treasury Bill Basics • Issued by the Treasury – to cover government budget deficits and – to refinance maturing debt • Standard Original Maturities of 13 weeks, 26 weeks, or 52 weeks • Denominations are $1, 000 but typical round lot is $5 million • Virtually default risk free Mc. Graw-Hill/Irwin 7 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

The Auction Process for T-bills • Amount of new 13 -week and 26 -week The Auction Process for T-bills • Amount of new 13 -week and 26 -week T-bills offered weekly • Bids submitted by government securities dealers, financial and non-financial corporations and individuals Mc. Graw-Hill/Irwin 8 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

The Auction Process for T-bills • Individual competitive bidders – limited to 35% total The Auction Process for T-bills • Individual competitive bidders – limited to 35% total issue size, – can submit more than one bid, – allocations made beginning with highest bidder • Noncompetitive bidders – indicate quantity desired and agree to pay a weightedaverage of the rate on winning competitive bids; – get preferential allocation Mc. Graw-Hill/Irwin 9 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Treasury Auction Results Nov 18, 2004 Bid Price Noncompetitive Bids 99. 4975% 1 SC Treasury Auction Results Nov 18, 2004 Bid Price Noncompetitive Bids 99. 4975% 1 SC 2 ST 3 99. 48875% (PNC) stop-out price (low bid accepted) 4 5 6 7 $19, 254. 8 m $17, 509. 5 m Mc. Graw-Hill/Irwin 10 Quantity of T-bills © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

The Secondary Market for T-bills • The largest of any U. S. money market The Secondary Market for T-bills • The largest of any U. S. money market security • Approximately 30 financial institutions “make” a market in T-bills by buying and selling securities for their own accounts and by trading for their customers, including depository institutions, insurance companies, pensions funds, etc. • T-bills are the FOMC’s instrument of choice for its open market operations Mc. Graw-Hill/Irwin 11 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Secondary Market T-bill Transaction J. P. Morgan Chase sells $10 m. In T-bills Fed Secondary Market T-bill Transaction J. P. Morgan Chase sells $10 m. In T-bills Fed Tra wire nsa ctio n Individual buy $50, 000 in T-bills Mc. Graw-Hill/Irwin Lehman Brothers buy $10 m. In T-bills Federal Reserve Bank of New York Transfers $10 m. In T-bills from J. P. Morgan Chase to Lehman Brothers Transaction recorded in Fed’s Book-Entry System J. P. Morgan Chase (dealer) sell $50, 000 in T-bills Local Bank or Broker 12 e wir on Fed acti ns Tra FRBNY -$50, 000 in T-bills from J. P. Morgan Chase’s account + $50, 000 T-bill to Individual © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

T-bill Rates and Yields • No interest paid on T-bills (coupon rate is zero), T-bill Rates and Yields • No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value • T-bill rates are quoted in Wall Street Journal • Discount Yield • Asked • Spread Mc. Graw-Hill/Irwin 13 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Bid and Ask Prices • Bid price is the price at which TBs are Bid and Ask Prices • Bid price is the price at which TBs are purchased by the dealers. • Ask price is the price at which TBs are sold by the dealers. • Dealer’s profit is the bid-ask spread. • Normally, the ask price exceeds the bid price. Mc. Graw-Hill/Irwin 14 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Calculating T-bill Yields from Discount Rates i. T-bill(dy) = PF - PO PF Where: Calculating T-bill Yields from Discount Rates i. T-bill(dy) = PF - PO PF Where: 360 h i. T-bill= Annualized yield on the T-bill PF = Price (face value) paid to the T-bill holder PO = Purchase price of the T-bill h = Number of days until the T-bill matures Example: i. T-bill(dy) = $10, 000 - $9, 905. 71 360 = 2. 19% $10, 000 155 Mc. Graw-Hill/Irwin 15 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Federal Funds • Short-term funds transferred between FIs, usually for a period of one Federal Funds • Short-term funds transferred between FIs, usually for a period of one day • Federal Funds rate – the interest rate for borrowing fed funds – a focus or target rate in the conduct of monetary policy • Federal Funds Yields – single-payment loans – Fed fund transactions take the form of shortterm (mostly overnight) unsecured loans Mc. Graw-Hill/Irwin 16 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Trading in the Fed Funds Market • Commercial banks conduct the majority of transactions Trading in the Fed Funds Market • Commercial banks conduct the majority of transactions in the fed funds market • Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds • Fed funds transactions can be initiated by either the lending or borrowing institution or handled through a broker Mc. Graw-Hill/Irwin 17 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Repurchase Agreements (RPs or Repos) • An agreement involving the sale of securities by Repurchase Agreements (RPs or Repos) • An agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price on a specified date • For example, open market transactions in which the Trading Desk purchases government securities with an agreement that the seller will repurchase them within a stated period of time. Mc. Graw-Hill/Irwin 18 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Repurchase Agreements (RPs or Repos) • Essentially a collateralized funds loan with collateral in Repurchase Agreements (RPs or Repos) • Essentially a collateralized funds loan with collateral in the form of securities (e. g. T-bills and Fannie Mae securities) Mc. Graw-Hill/Irwin 19 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Repurchase Agreements (RPs or Repos) Reverse repurchase agreement • An agreement involving the purchase Repurchase Agreements (RPs or Repos) Reverse repurchase agreement • An agreement involving the purchase of securities by one party from another with the promise to sell them back. Mc. Graw-Hill/Irwin 20 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Trading Process for Repurchase Agreements • Arranged either directly between two parties or with Trading Process for Repurchase Agreements • Arranged either directly between two parties or with the help of brokers and dealers • The repo buyer arranges to purchase T-bills from the repo seller with an agreement that the seller will repurchase the T-bills within a stated period of time Mc. Graw-Hill/Irwin 21 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Paper • An unsecured short-term promissory note issued by a corporation to raise Commercial Paper • An unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements • The largest (in terms of dollar value) of the money market instruments Mc. Graw-Hill/Irwin 22 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Paper • Generally sold in denominations of $100, 000, $250, 000, $500, 000 Commercial Paper • Generally sold in denominations of $100, 000, $250, 000, $500, 000 and $1 million • Maturities of 1 -270 days (if maturity is greater than 270 days, SEC requires registration) • Generally held until maturity so there is not an active secondary market Mc. Graw-Hill/Irwin 23 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Trading Process for Commercial Paper • CPs are sold either directly to investors or Trading Process for Commercial Paper • CPs are sold either directly to investors or indirectly through brokers and dealers such as investment banks or major bank subsidiaries • Selling through brokers more expensive for issuer due to underwriting costs Mc. Graw-Hill/Irwin 24 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Negotiable Certificates of Deposits • A bank-issued time deposit that specifies an interest rate Negotiable Certificates of Deposits • A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market • Bearer Instrument Mc. Graw-Hill/Irwin 25 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Negotiable Certificates of Deposits • Denominations range from $100, 000 to $10 million; $1 Negotiable Certificates of Deposits • 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 Mc. Graw-Hill/Irwin 26 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Trading Process for NCDs • Banks issuing NCDs post daily rates for the more Trading Process for NCDs • Banks issuing NCDs post daily rates for the more popular maturities and subject to funding needs, try to sell to investors who are likely to hold them as investments rather than sell them to the secondary market • In some cases, the bank and investor negotiate the size, rate and maturity Mc. Graw-Hill/Irwin 27 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Trading Process for NCDs • Secondary market consists of a linked network of approximately Trading Process for NCDs • Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues Mc. Graw-Hill/Irwin 28 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Banker’s Acceptances • A time draft payable to a seller of goods with payment Banker’s Acceptances • A time draft payable to a seller of goods with payment guaranteed by a bank • Arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) Mc. Graw-Hill/Irwin 29 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Banker’s Acceptances • Foreign exporters prefer that banks act as guarantors for payment before Banker’s Acceptances • Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer Mc. Graw-Hill/Irwin 30 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Bankers Acceptances • An order to pay a specified amount on a specified date Bankers Acceptances • An order to pay a specified amount on a specified date in the future. • Facilitates commercial trade transactions. • Sold on a discounted basis prior to maturity. © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Creation of Bankers Acceptances • Importing of goods into the U. S. • Exporting Creation of Bankers Acceptances • Importing of goods into the U. S. • Exporting of goods from the U. S. to foreign entities • Storing and shipping of goods between two foreign countries where neither the importer nor the exporter is a U. S. firm • Storing and shipping of goods between two entities in the U. S. Mc. Graw-Hill/Irwin 32 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Accepting Banks • Created by all four groups of banks – money center banks Accepting Banks • Created by all four groups of banks – money center banks – regional banks – Japanese banks – Yankee banks • Eligible BAs can serve as collateral for discount window loans of the Fed. • BA rate is determined in open market. Mc. Graw-Hill/Irwin 33 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Dealers in Bankers Acceptances • Banks may sell bankers acceptances – directly to investors Dealers in Bankers Acceptances • Banks may sell bankers acceptances – directly to investors – directly to dealers Mc. Graw-Hill/Irwin 34 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Risks in Bankers Acceptances • Credit Risk – risk that neither borrower nor accepting Risks in Bankers Acceptances • Credit Risk – risk that neither borrower nor accepting bank will be able to pay the principal at maturity • Yield includes premium for: – credit risk – liquidity risk Mc. Graw-Hill/Irwin 35 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Example • 1. An exporter receives a letter of credit from the importer's bank. Example • 1. An exporter receives a letter of credit from the importer's bank. He ships goods and presents documentation (a draft, an invoice, and a copy of the bill of lading) to his own bank. • 2. The exporter's bank pays the exporter cash by discounting the draft, which it in turn presents for payment to the importer's bank. Mc. Graw-Hill/Irwin 36 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Example • 3. The importer's bank Example • 3. The importer's bank "accepts the draft, " thereby creating a BA. It stipulates its willingness to pay at some specified time in the future. • 4. The exporter's bank can either hold the BA until maturity or, more likely it will sell it immediately to the importer's bank. Mc. Graw-Hill/Irwin 37 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Example • 5. Once the importer's bank has purchased back its BA, it can Example • 5. Once the importer's bank has purchased back its BA, it can either hold it till maturity or sell it on the open market at a discount. • 6. At maturity the importer's bank will collect from the importer and use those funds to pay the holder of the bankers acceptance. Mc. Graw-Hill/Irwin 38 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Mc. Graw-Hill/Irwin 39 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved Mc. Graw-Hill/Irwin 39 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

International Aspects of Money Markets • While U. S. money markets are the largest, International Aspects of Money Markets • While U. S. money markets are the largest, the international market is growing – U. S. securities bought/sold by foreign investors – foreign money market securities • Euro money market instruments – Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP • London Interbank Offered Rate (LIBOR) – the rate paid on Eurodollars Mc. Graw-Hill/Irwin 40 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved