11 Chapter Money Market Instruments Treasury Bills Repurchase

11 Chapter Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds, and Bank CDs Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose Mc. Graw Hill / Irwin Slides by Yee-Tien (Ted) Fu

11 - 2 Learning Objectives w To examine the characteristics of Treasury bills and the workings of the government securities market. w To learn how securities dealers operate and why they are so important to the functioning of the money market. w To understand how banks borrow and lend funds through Federal funds trading and the issuance of CDs. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 3 Learning Objectives w To see the impact that the managerial strategy known as liability management has on bank performance and practice in recent years. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 4 Introduction w The money market supplies the cash needs of short-term borrowers and provides savers who hold temporary cash surpluses with an interestbearing outlet for their funds. w In this chapter, we focus on securities dealers and banks, and explore in detail four popular money market instruments – Treasury bills, repurchase agreements, Federal funds, and bank CDs. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 5 U. S. Treasury Bills w U. S. Treasury bills (T-bills) are direct obligations of the U. S. government that have an original maturity of one year or less. w Tax revenues or any other source of government funds may be used to repay the holders of these financial instruments. w They carry great weight in the financial system due to their zero (or nearly zero) default risk, ready marketability, and high liquidity. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 6 Volume of U. S. Treasury Bills Outstanding End of Year Total Volume of Bills Outstanding ($ Billions) Marketable Public Debt of the U. S. ($ Billions) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2001 $ 39. 4 60. 2 87. 9 157. 5 216. 1 399. 9 527. 4 760. 7 646. 9 811. 2 $ 189. 0 214. 6 247. 7 263. 2 623. 2 1, 437. 7 2, 195. 8 3, 307. 2 2, 966. 9 2, 983. 0 T-bills as a % of the Total Marketable Public Debt 20. 8 % 28. 1 35. 5 43. 4 34. 7 27. 8 24. 0 23. 0 21. 8 27. 2 2003 Data Source: Board of Governors of the Federal Reserve System by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill / Irwin

11 - 7 Types of Treasury Bills w Regular-series bills are issued routinely every week or month in competitive auctions with original maturities of three months (13 weeks), six months (26 weeks), and one year (52 weeks). w Irregular-series bills are issued only when the Treasury has a special cash need. These instruments include strip bills and cash management bills. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 8 How Bills Are Sold Source: U. S. Bureau of the Public

11 - 9 How Bills Are Sold

11 - 10 Calculating the Yield on Bills w T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value. w Bill yields are determined by the bank discount method, which does not compound interest rates and uses a 360 -day year for simplicity. w The bank discount rate (DR) on T-bills 360 = Par value – Purchase price Par value Days to maturity Mc. Graw Hill / Irwin . 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 11 Calculating the Yield on Bills w Because the rates of return on most other debt instruments are not figured in the same way, comparisons with other securities cannot be made directly. w The investment yield or rate (IR) on T-bills 365 = Par value – Purchase price Days to maturity. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 12 Market Interest Rates on Treasury Bills % 3 -Month 12 -Month 2003 Data Source: Board of Governors of the Federal Reserve System by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill / Irwin

11 - 13 Investors in Treasury Bills w T-bills are held mainly by commercial banks, nonfinancial corporations, state and local governments, and the Federal Reserve banks. w Commercial banks and private corporations hold T-bills as a reserve of liquidity. w The Federal Reserve banks conduct part of their open market operations in T-bills because of the depth and volume of activity of the market. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 14 Primary Dealers w Primary dealers are dealer firms that are qualified to trade securities directly with the Federal Reserve Bank of New York. w Primary dealers agree to “meaningfully participate” in trading with the Federal Reserve at any time the Fed wishes, to make “realistic” bids, and to trade continuously in the full range of government securities. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 15 Primary Dealers w Primary dealers have a significant incentive to attempt to corner the government securities market and to collude and place common bids, so that all the dealers can get some share of the new securities to fill their customers’ orders and make a profit. w In the wake of a scandal involving Salomon Brothers in 1991, auction rules were tightened and a market-surveillance committee was created. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 16 Primary Dealers w Then in 1998, the U. S. Treasury abandoned its first-price sealed-bid, or English auction approach, in which each successful bidder paid the price that it had bid. w It adopted the uniform-price, or Dutch auction method, in which all successful bidders receive securities at the same price – the marketclearing or stop-out price. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 17 Dealers in the Money Market w The bulk of the dealers’ operating capital is obtained through borrowings from commercial banks and other institutions. w The two most heavily used sources of dealer funds are demand loans from the largest banks and repurchase agreements with banks and other lenders. w A demand loan may be called in at any time if the banks need cash urgently. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 18 Dealers in the Money Market w Under a repurchase agreement (RP), the dealer sells securities to a lender but makes a commitment to buy back the securities at a later date at a fixed price plus interest. w RPs are simply a temporary extension of credit collateralized by marketable securities. w Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months, …) while continuing contracts may be terminated by either party on short notice. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 19 Dealers in the Money Market w Interest income from RPs = Amount Current Number of days loaned of loan RP rate 360 days . w Periodically, RPs are marked to market. If the price of the pledged securities has dropped, the borrower may have to pledge additional collateral. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 20 Sources of Dealer Income w Dealers hope to earn a profit (the positive spread between the bid and ask prices) from their market-making activities. w By correctly anticipating interest rate movements, dealers may earn sizable position profits too. è If interest rates fall (and security prices rise), dealers will experience capital gains on a long position (but losses on a short position). Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 21 Sources of Dealer Income w Dealers also receive carry income, the difference between interest earned on the securities they hold and their cost of borrowing funds. w In addition, dealers receive miscellaneous service fees for their advice and assistance to customers. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 22 Dealer Positions in Securities w Dealer holdings of securities are both huge and subject to erratic fluctuations, due mainly to interest rate movements and expectations. w Today, dealers make heavy use of interest rate hedging tools to further protect their portfolios from losses due to changes in interest rates. è They are active participants in the financial futures markets and are also making increased use of forward commitments. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 23 Government Security Brokers w Government securities dealers usually trade among themselves through brokers. w Government security brokers do not take investment positions themselves, but try to match bids and offers placed with them by dealers and other investors. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 24 Banks in the Money Market Banks’ Money Market Roles Principal channel for payments for loans, securities & other transactions Custody agents for safekeeping securities owned by market participants and pledged as collateral for loans Agents in trust for property management on behalf of bank customers Direct lenders to money market borrowers Mc. Graw Hill / Irwin Guarantors of performance & payment Channel for government money & credit policy 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 25 Federal Funds w Federal funds are any monies available for immediate payment (i. e. same-day money). w They are generally transferred from one depository institution to another by simple bookkeeping entries requested via an on-line computer system, by wire, or by telephone. w Federal funds are the principal means of making payments in the money market. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 26 Federal Funds w The term federal funds came about because early in the development of the market, the principal source of immediately-available money was the reserve balance that each Federal Reserve System member bank had to keep at the Federal Reserve bank in its region. w Today, the federal funds market is broader in scope – some deposits with commercial banks are also available for immediate transfer. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 27 Federal Funds w Banks and other depository institutions must hold in a special reserve account liquid assets equal to a fraction of the funds deposited with them by the public. w The required legal reserves may be either vault cash or reserve balances with the regional Federal Reserve banks. w Since the reserves earn little or no income, most bankers try to lend out excess reserves. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 28 The Structure of the Federal Funds Market Banks & large depositors with excess reserves available (suppliers) Banks needing more legal reserves & other money market borrowers (demanders) Accommodating banks Funds brokers Absorbing excess funds Supplying additional funds The Central Bank Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 29 Federal Funds w Total federal funds borrowings by banks in the U. S. exceeded $600 billion as the 21 st century began. w Most federal funds loans are either overnight transactions or continuing contracts that have no specific maturity and that can be terminated without advance notice by either party. w One-day loans carry a fixed rate of interest, but continuing contracts often do not. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 30 Interest Rates on Federal Funds % Federal Funds 3 -Month T-Bill (secondary market) 2003 Data Source: Board of Governors of the Federal Reserve System by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill / Irwin

11 - 31 Federal Funds w Beginning 1989, the Federal Reserve has routinely set target levels for the federal funds rate, and raised or lowered those targets depending on whether it wishes to slow down borrowing and spending in the economy or speed them up. w Through daily open market operations (buying and selling securities), the Fed is able to push the funds rate in the desired direction. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 32 Intended Federal Funds Rate % Actual Federal Funds Rate Intended Federal Funds Rate 2003 Data Source: Board of Governors of the Federal Reserve System by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill / Irwin

11 - 33 Negotiable Certificates of Deposit w A certificate of deposit (CD) is an interestbearing receipt for funds left with a depository institution for a set period of time. w True money market CDs are negotiable CDs that may be sold any number of times before maturity and that carry a minimum denomination of $100, 000. w They were introduced in 1961 to attract lost deposits back into the banking system. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 34 Negotiable Certificates of Deposit w CD interest rates are computed as a yield to maturity (ytm) on a 360 -day basis. Interest = term in days deposit promised income 360 principal ytm w In secondary market trading, the bank discount rate (DR) is used as a measure of CD yields. DR = Par value – Purchase price Par value Mc. Graw Hill / Irwin 360 days to maturity . 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 35 Negotiable Certificates of Deposit w The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions. w Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 36 The Market Structure for Negotiable CDs Money center banks Large Issue primary market CDs depositors (corporations & other Funds raised to meet legal customers) reserve requirements and other bank cash needs Redemption of CDs at maturity Mc. Graw Hill / Irwin Sale of Immediately negotiable available CDs funds Buyers in the secondary CD market 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 37 Negotiable Certificates of Deposit w Bankers are becoming increasingly innovative in packaging CDs to meet the needs of customers. w New types of CDs include variable-rate CDs, rollover or rolypoly CDs, jumbo CDs, Yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising-rate CDs, and foreign index CDs. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 38 Bank Activity in the Money Market w In the 1960 s and 1970 s, competition forced major corporations to seek out alternative investments for their short-term funds. w Bankers thus turned to the money market for additional funds – negotiable CDs appeared and the federal funds market was broadened. w Then, as policies were tightened, many bankers turned to the Eurocurrency market, commercial paper, and RPs. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 39 Bank Activity in the Money Market w All the clever bank maneuvers form part of a technique called liability management. w By varying the daily interest rates offered on CDs and other funds sources, bankers can gain a measure of control over their liabilities. è If a bank needs more funds on a given day, the bank can simply offer a higher yield on the particular money market instrument that it desires to use. Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 40 Money and Capital Markets in Cyberspace w More information about the various money market instruments can be found at: http: //www. publicdebt. treas. gov è http: //www. treasurydirect. gov/ è http: //www. federalreserve. gov/fomc/ è http: //www. economagic. com/fedbog. htm è http: //www. toerien. com/neg_financial_instrument s/negotiable_financial_instuments. htm è Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 41 Chapter Review w Introduction w U. S. Treasury Bills Volume of Bills Outstanding è Types of Treasury Bills è How Bills Are Sold è Calculating the Yield on Bills è Market Interest Rates on Treasury Bills è Investors in Treasury Bills è Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 42 Chapter Review w Primary Dealers Scandal Rocks the Market for Government Securities è A New Way to Auction Government Securities è w Dealers in the Money Market è Reliance on Borrowed Funds • Demand Loans and Repurchase Agreements Sources of Dealer Income è Dealer Positions in Securities è Government Security Brokers è Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 43 Chapter Review w Banks in the Money Market w Federal Funds Nature of Federal Funds è Use of the Federal Funds Market to Meet Deposit Reserve Requirements è Mechanics of Federal Funds Trading è Volume of Borrowings in the Funds Market è Interest Rates on Federal Funds è Federal Funds and Government Economic Policy è Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 - 44 Chapter Review w Negotiable Certificates of Deposit Terms Attached to CDs è Buyers of CDs è New Types of CDs è w Bank Activity in the Money Market Mc. Graw Hill / Irwin 2003 by The Mc. Graw-Hill Companies, Inc. All rights reserved.