Chapter 10 Introduction to the Money Market and

Chapter 10 • Introduction to the Money Market and the Roles Played by Governments and Security Dealers

10 - 3 Learning Objectives • To understand the many roles and functions performed by the money market. • To identify the key money market players. • To examine the roles that governments and security dealers play in the functioning of the money market. • To discover how Treasury bills and repurchase agreements (RPs) arise through borrowing and lending in the money market. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 4 Introduction • All the transactions carried out in the financial markets seem to be basically the same: borrowers issue securities that lenders buy. • However, the different purposes for which money is borrowed can result in the creation of different kinds of financial assets having different maturities, risks, etc. • For instance, the money market is the market for short-term (one year or less) credit. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 5 Characteristics of the Money Market • The money market is the mechanism through which holders of temporary cash surpluses meet holders of temporary cash deficits. • The money market arises because for most individuals and institutions, cash inflows and outflows are rarely in perfect harmony with each other, and the holding of idle surplus cash is expensive. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 6 Key Borrowers and Lenders in the Money Market Government Treasuries (borrowing and redeeming securities) Corporate Borrowers & Cash-Management Customers Needing to Invest Cash Surpluses Security Dealers & Brokers Nonbank Financial Institutions (mutual funds, insurers, etc. ) Money Center Banks Central Banks (supplying funds and information and promoting market stability) Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 7 Characteristics of the Money Market Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 8 Characteristics of the Money Market • Money market investors seek mainly safety and liquidity, plus the opportunity to earn some interest income. • Because funds invested in the money market represent only temporary cash surpluses and are usually needed in the near future, money market investors are especially sensitive to risk. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 9 Types of Investment Risk Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 10 Characteristics of the Money Market • Original maturities on money market instruments range from as short as one day on many loans to banks and security dealers to a full year on some bank deposits and T-bills. • But because there are so many money market securities outstanding, some of which reach maturity each day, investors have a wide menu of actual maturities from which to make their selections. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 11 Characteristics of the Money Market • The money market is extremely broad and deep. It can absorb a large volume of transactions with only small effects on security prices and interest rates. • The money market is also very efficient. Securities dealers, major banks, and funds brokers maintain constant contact with one another through a vast telephone and computer network and are hence alert to any bargains. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 12 Characteristics of the Money Market • Federal funds are mainly deposit balances of commercial banks held at regional Federal Reserve banks and at larger correspondent banks across the U. S. • Federal funds are often called immediately-available funds because of the speed with which money moves from one bank’s reserve account to that of another. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 13 Characteristics of the Money Market • In contrast, funds transferred by checks are known as clearinghouse funds. The clearinghouse is a location where checks and other cash items are delivered and passed from one depository institution to another. • Clearinghouse funds are an acceptable means of payment for most purposes, but not in the money market, where speed is of essence. Clearinghouse funds also have an element of risk. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 14 Characteristics of the Money Market • The money market is a wholesale market for funds – most trading occurs in multiples of a million dollars. • The market is dominated by a relatively small number of large financial institutions that account for the bulk of federal funds trading. • Securities also move readily from sellers to buyers through the market-making activities of major security dealers and brokers. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 15 Characteristics of the Money Market • And, of course, governments and central banks around the world play major roles in the money market as the largest borrowers and as regulators. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 16 Government Involvement in the Money Market • Governments set the rules of the money-market “game” through regulation, and they consistently rank among the top issuers of money market debt. • Moreover, working through central banks, they help to shape money market conditions and set the tone for daily borrowing and lending activities. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 17 Government Involvement in the Money Market • Governments are usually most visible in the money market when they borrow money. • One of the largest borrowers in the money market of the United States is the U. S. Treasury Department, which enters the market weekly to sell Treasury bills. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 18 U. S. Treasury Bills • U. S. Treasury bills (T-bills) are direct obligations of the U. S. government that have an original maturity of one year or less. • Tax revenues or any other source of government funds may be used to repay the holders of these financial instruments. • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 19 Volume of U. S. Treasury Bills Outstanding Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e Source: Board of Governors of the Federal Reserve System * 2004 figures are for© July 2006 31, The 2004 Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 20 Types of Treasury Bills • Regular-series bills are issued routinely every week or month in competitive auctions with original maturities of one month (4 weeks), three months (13 weeks), and six months (26 weeks). • Irregular-series bills are issued when the Treasury has an emergency need for cash. These instruments include strip bills and cash management bills. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 21 How Bills Are Sold Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e Source: U. S. Bureau of©the Debt 2006 Public The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 22 How Bills Are Sold Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 23 Results of a Recent Bill Auction Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 24 Calculating the Return on T-Bills • T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value. • Bill yields are determined by the bank discount method, which does not compound interest rates and uses a 360 -day year for simplicity. • The bank discount rate (DR) on T-bills = Par value – Purchase price Par value Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e 360 Days to maturity . © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 25 Calculating the Return on T-Bills • 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. • The investment yield or rate (IR) on T-bills = Par value – Purchase price Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e 365 Days to maturity . © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 26 Market Interest Rates on U. S. T-Bills Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e Source: Board of Governors of the Federal Reserve System * 2004 figures are averages January © 2006 for. The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 27 Investors in Treasury Bills • T-bills are held mainly by commercial banks, nonfinancial corporations, state and local governments, and the Federal Reserve banks. • Commercial banks and private corporations hold T-bills as a reserve of liquidity. • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 28 Primary Dealers in Government Securities • Primary dealers are dealer firms that are qualified to trade securities directly with the Federal Reserve Bank of New York. • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 29 Primary Dealers in Government Securities Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 30 Primary Dealers in Government Securities • 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. • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 31 Primary Dealers in Government Securities • 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. • It adopted the uniform-price, or Dutch auction method, in which all successful bidders receive securities at the same price – the market-clearing or stop-out price. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 32 Dealers’ Borrowing and Lending Activities In the Money Market • The bulk of the dealers’ operating capital is obtained through borrowings from commercial banks and other institutions. • The two most heavily used sources of dealer funds are demand loans from the largest banks and repurchase agreements with banks and other lenders. • A demand loan may be called in at any time if the banks need cash urgently. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 33 Dealers’ Borrowing and Lending Activities In the Money Market • Under a repurchase agreement (RP or Repo), 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. • RPs are simply a temporary extension of credit collateralized by marketable securities. • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 34 Dealers’ Borrowing and Lending Activities In the Money Market Example of a Typical RP Loan Transaction Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 35 Dealers’ Borrowing and Lending Activities In the Money Market • Interest income from RPs = Amount Current Number of days loaned of loan RP rate . 360 days • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 36 Dealers’ Borrowing and Lending Activities In the Money Market • Traditional RPs are somewhat inflexible and most costly than they need to be. • Hence, a General Collateral Finance (GCF) Repo was created in 1998. • Working through a central clearinghouse, the new GCF Repos dealers are given greater control over the pledged collateral. Each dealer can also settle just the net amount owed to and received from all other parties in the market. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 37 Sources of Dealer Income • Dealers hope to earn a profit (the positive spread between the bid and ask prices) from their market-making activities. • By correctly anticipating interest rate movements, dealers may earn sizable position profits too. - 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 38 Sources of Dealer Income • Dealers also receive carry income, the difference between interest earned on the securities they hold and their cost of borrowing funds. • In addition, dealers receive miscellaneous service fees for their advice and assistance to customers. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 39 Sources of Dealer Income • Some dealers try to stabilize their income by simultaneously borrowing and lending money through a technique known as matched book. - Funds are borrowed through low-cost short-term RPs and then loaned out through longer-term, higher-yielding RPs. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 40 Dealer Positions in Securities • Dealer holdings of securities are both huge and subject to erratic fluctuations, due mainly to interest rate movements and expectations. • Today, dealers make heavy use of interest rate hedging tools to further protect their portfolios from losses due to changes in interest rates. - They are active participants in the financial futures markets and are also making increased use of forward commitments. Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 41 Government Security Brokers • Government securities dealers usually trade among themselves through brokers. • 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 Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 42 Markets on the Net • Bond Market Association at www. bondmarket. com • Browse Data of the Federal Reserve Board at www. economagic. com/fedbog. htm • U. S. Treasury Department Bureau of the Public Debt at www. publicdebt. treas. gov • Treasury Direct at www. Treasurydirect. gov • Federal Reserve Bank of New York at www. ny. frb. org Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 43 Markets on the Net • Board of Governors of the Federal Reserve System at www. federalreserve. gov • Federal Deposit Insurance Corporation at www. fdic. gov • Primary Dealers - Federal Reserve Bank of New York at www. ny. frb. org/markets/pridealers-listing. htm Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 44 Chapter Review • Introduction: The Market for Short-Term Credit • Characteristics of the Money Market - What the Money Market Does The Need for a Money Market Key Borrowers and Lenders in the Money Market The Goals of Money Market Investors Types of Investment Risk that Investors Face Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 45 Chapter Review • Characteristics of the Money Market … continued - Money Market Maturities - Depth and Breadth of the Money Market - The Speed of Money Market Payments: Federal Funds versus Clearinghouse Funds - A Market for Large Borrowers and Lenders Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 46 Chapter Review • Government Involvement in the Money Market - The Roles that Governments Play in the Money Market - Selling Treasury Bills to Money Market Investors: The Anchor of the Money Market - Calculating the Return on T-Bills - Market Interest Rates on T-Bills - Investors in T-Bills • Primary Dealers in Government Securities Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 - 47 Chapter Review • Dealers’ Borrowing and Lending Activities in the Money Market - Demand Loans for Dealers - Repurchase Agreements (RPs or REPOs) for Dealers and Other Money Market Participants - A New Type of RP: The GCF REPO - Sources of Dealer Income - Dealer Positions in Securities - Dealer Transactions and Government Security Brokers Mc. Graw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.