Chapter 6 Money Markets Financial Markets and Institutions

Chapter 6 Money Markets Financial Markets and Institutions, 7 e, Jeff Madura Copyright © 2006 by South-Western, a division of Thomson Learning. All rights reserved. 1

Chapter Outline Money market securities n Institutional use of money markets n Valuation of money market securities n Risk of money market securities n Interaction among money market yields n Globalization of money markets n 2

Money Market Securities n Money market securities: ¨ Have maturities within one year ¨ Are issued by corporations and governments to obtain short-term funds ¨ Are commonly purchased by corporations and government agencies that have funds available for a short-term period ¨ Provide liquidity to investors 3

Money Market Securities (cont’d) n Treasury bills: ¨ Are issued by the U. S. Treasury ¨ Are sold weekly through an auction ¨ Have a par value of $1, 000 ¨ Are attractive to investors because they are backed by the federal government and are free of default risk ¨ Are liquid ¨ Can be sold in the secondary market through government security dealers 4

Money Market Securities (cont’d) n Treasury bills (cont’d) ¨ Investors n n in Treasury bills Depository institutions because T-bills can be easily liquidated Other financial institutions in case cash outflows exceed cash inflows Individuals with substantial savings for liquidity purposes Corporations to have easy access to funding for unanticipated expenses 5

Money Market Securities (cont’d) n Treasury bills (cont’d) ¨ Pricing Treasury bills n The price is dependent on the investor’s required rate of return: n Treasury bills do not pay interest To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested n 6

Computing the Price of a Treasury Bill A one-year Treasury bill has a par value of $10, 000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill? 7

Money Market Securities (cont’d) n Treasury bills (cont’d) ¨ Treasury bill auction n Investors submit bids on T-bill applications for the maturity of their choice n Applications can be obtained from a Federal Reserve district or branch bank n Financial institutions can submit their bids using the Treasury Automated Auction Processing System (TAAPS-Link) ¨ ¨ ¨ Institutions must set up an account with the Treasury Payments to the Treasury are withdrawn electronically from the account Payments received from the Treasury are deposited into the account 8

Money Market Securities (cont’d) n Treasury bills (cont’d) ¨ Treasury bill auction (cont’d) n Weekly auctions include 13 -week and 26 -week T-bills n 4 -week T-bills are offered when the Treasury anticipates a short-term cash deficiency n Cash management bills are also occasionally offered n Investors can submit competitive or noncompetitive bids n The bids of noncompetitive bidders are accepted n The highest competitive bids are accepted n Any bids below the cutoff are not accepted n Since 1998, the lowest competitive bid is the price applied to all competitive and noncompetitive bids 9

Money Market Securities (cont’d) n Treasury bills (cont’d) ¨ Estimating n the yield T-bills are sold at a discount from par value The yield is influenced by the difference between the selling price and the purchase price ¨ If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price ¨ 10

Money Market Securities (cont’d) n Treasury bills (cont’d) ¨ Estimating n The annualized yield is: ¨ Estimating n the yield (cont’d) the T-bill discount The discount represents the percent discount of the purchase price from par value for newly-issued T-bills: 11

Computing the Yield of a Treasury Bill An investor purchases a 91 -day T-bill for $9, 782. If the T-bill is held to maturity, what is the yield the investor would earn? 12

Estimating the T-Bill Discount Using the information from the previous example, what is the T-bill discount? 13

Money Market Securities (cont’d) n Commercial paper: ¨ ¨ ¨ ¨ ¨ Is a short-term debt instrument issued by well-known, creditworthy firms Is typically unsecured Is issued to provide liquidity to finance a firm’s investment in inventory and accounts receivable Is an alternative to short-term bank loans Has a minimum denomination of $100, 000 Has a typical maturity between 20 and 270 days Is issued by financial institutions such as finance companies and bank holding companies Has no active secondary market Is typically not purchased directly by individual investors 14

Money Market Securities (cont’d) n Commercial paper (cont’d) ¨ Ratings n n The risk of default depends on the issuer’s financial condition and cash flow Commercial paper rating serves as an indicator of the potential risk of default Corporations can more easily place commercial paper that is assigned a top-tier rating Junk commercial paper is rated low or not rated at all 15

Money Market Securities (cont’d) n Commercial paper (cont’d) ¨ Volume n n of commercial paper: Has increased substantially over time Is commonly reduced during recessionary periods ¨ Placement n n n Some firms place commercial paper directly with investors Most firms rely on commercial paper dealers to sell it Some firms (such as finance companies) create in-house departments to place commercial paper 16

Money Market Securities (cont’d) n Commercial paper (cont’d) ¨ Backing commercial paper n Issuers typically maintain a backup line of credit ¨ ¨ Allows the company the right to borrow a specified maximum amount of funds over a specified period of time Involves a fee in the form of a direct percentage or in the form of required compensating balances ¨ Estimating the yield n The yield on commercial paper is slightly higher than on a Tbill n The nominal return is the difference between the price paid and the par value 17

Estimating the Commercial Paper Yield An investor purchases 120 -day commercial paper with a par value of $300, 000 for a price of $289, 000. What is the annualized commercial paper yield? 18

Money Market Securities (cont’d) n Commercial paper (cont’d) ¨ The commercial paper yield curve: n Illustrates the yield offered on commercial paper at various maturities n Is typically established for a maturity range from 0 to 90 days n Is important because it may influence the maturity that is used by firms that issue CP n Is similar to the short-term range of the Treasury yield curve n Is affected by short-term interest rate expectations n Is similar to the yield curve on other money market instruments 19

Money Market Securities (cont’d) n Negotiable certificates of deposit (NCDs): ¨ Are issued by large commercial banks and other depository institutions as a short-term source of funds ¨ Have a minimum denomination of $100, 000 ¨ Are often purchased by nonfinancial corporations ¨ Are sometimes purchased by money market funds ¨ Have a typical maturity between two weeks and one year ¨ Have a secondary market 20

Money Market Securities (cont’d) n Negotiable certificates of deposit (NCDs) (cont’d) ¨ Placement n Directly n Through a correspondent institution n Through securities dealers ¨ Premium n NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety n Premiums are generally higher during recessionary periods 21

Money Market Securities (cont’d) n Negotiable certificates of deposit (NCDs) (cont’d) ¨ Yield NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price n If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate n 22

Money Market Securities (cont’d) n Repurchase agreements ¨ One party sells securities to another with an agreement to repurchase them at a specified date and price n ¨ ¨ ¨ Essentially a loan backed by securities A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them Bank, S&Ls, and money market funds often participate in repos Transactions amounts are usually for $10 million or more Common maturities are from 1 day to 15 days and for one, three, and six months There is no secondary market for repos 23

Money Market Securities (cont’d) n Repurchase agreements (cont’d) ¨ Placement n Repo transactions are negotiated through a telecommunications network with dealers and repo brokers n When a borrowing firm can find a counterparty to a repo transaction, it avoids the transaction fee ¨ Some companies use in-house departments ¨ Estimating the yield n The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with a 360 -day year 24

Estimating the Repo Yield An investor initially purchased securities at a price of $9, 913, 314, with an agreement to sell them back at a price of $10, 000 at the end of a 90 -day period. What is the repo rate? 25

Money Market Securities (cont’d) n Federal funds ¨ The federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate n n The rate is influenced by the supply and demand for funds in the federal funds market The Fed adjusts the amount of funds in depository institutions to influence the rate All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions The fed funds rate is typically slightly higher than the T-bill rate 26

Money Market Securities (cont’d) n Federal funds (cont’d) ¨ Two depository institutions communicate directly through a communications network or through a federal funds broker ¨ The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institution’s reserve account by the amount of the loan ¨ Commercial banks are the most active participants in the federal funds market ¨ Most loan transactions are or $5 million or more and usually have one- to seven-day maturities 27

Money Market Securities (cont’d) n Banker’s acceptances: Indicate that a bank accepts responsibility for a future payments ¨ Are commonly used for international trade transactions ¨ n n An unknown importer’s bank may serve as the guarantor Exporters frequently sell an acceptance before the payment date Have a return equal to the difference between the discounted price paid and the amount to be received in the future ¨ Have an active secondary market facilitated by dealers ¨ 28

Money Market Securities (cont’d) n Banker’s acceptances (cont’d) ¨ Steps involved in banker’s acceptances n First, the U. S. importer places a purchase order for goods n The importer asks its bank to issue a letter of credit (L/C) on its behalf ¨ n n n Represents a commitment by that bank to back the payment owed to the foreign exporter The L/C is presented to the exporter’s bank The exporter sends the goods to the importer and the shipping documents to its bank The shipping documents are passed along to the importer’s bank 29

Sequence of Steps in the Creation of A Banker’s Acceptance Purchase Order 1 Importer Shipment of Goods 5 2 Exporter 4 L/C Notification 6 Shipping Documents & Time Draft L/C Application 3 American Bank (Importer’s Bank) L/C Shipping Documents 7 & Time Draft Accepted Japanese Bank (Exporter’s Bank) 30

Institutional Use of Money Markets n n n Financial institutions purchase money market securities to earn a return and maintain adequate liquidity Institutions issue money market securities when experiencing a temporary shortage of cash Money market securities enhance liquidity: Newly-issued securities generate cash ¨ Institutions that previously purchased securities will generate cash upon liquidation ¨ Most institutions hold either securities that have very active secondary markets or securities with short-term maturities ¨ 31

Institutional Use of Money Markets (cont’d) n n Financial institutions with uncertain cash in- and outflows maintain additional money market securities Institutions that purchase securities act as a creditor to the initial issuer Some institutions issue their own money market instruments to obtain cash Many money market transaction involve two financial institutions 32

Valuation of Money Market Securities n For money market securities making no interest payments, the value reflects the present value of a future lump-sum payment ¨ The discount rate is the required rate of return by investors 33

Valuation of Money Market Securities (cont’d) n Explaining money market price movements ¨ The price of a noninterest-paying money market security is: ¨A change in the price can be modeled as: 34

Valuation of Money Market Securities (cont’d) n Explaining money market price movements (cont’d) ¨ Impact n n n of September 11 The weak economy combined with this event caused investors to transfer funds into money market securities The additional demand placed upward pressure on their price and downward pressure on their yields The Fed added liquidity to the banking system and reduced the federal funds rate 35

Valuation of Money Market Securities (cont’d) n Indicators of future money market security prices ¨ Economic growth is monitored since it signals changes in short-term interest rates and the required return from investing in money market securities n n n Employment GDP Retail sales Industrial production Consumer confidence Indicators of inflation 36

Risk of Money Market Securities n Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default ¨ Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuer’s financial condition is limited ¨ n Measuring risk ¨ Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates 37

Interaction Among Money Market Yields n Money market instruments are substitutes for each other ¨ Market forces will correct disparities in yield and the yields among securities tend to be similar n In periods of heightened uncertainty, investors tend to shift from risky money market securities to Treasuries ¨ Flight to quality ¨ Creates a greater differential between yields 38

Globalization of Money Markets n n Interest rate differentials occur because geographic markets are somewhat segmented Interest rates have become more highly correlated: Conversion to the euro ¨ The flow of funds between countries has increased because of: ¨ n n n ¨ Tax differences Speculation on exchange rate movements A reduction in government barriers Eurodollar deposits, Euronotes, and Euro-commercial paper are widely traded in international money markets 39

Globalization of Money Markets (cont’d) n Eurodollar deposits and Euronotes ¨ Eurodollar certificates of deposit are U. S. dollar deposits in non-U. S. banks n ¨ Have increased because of increasing international trade and historical U. S. interest rate ceilings In the Eurodollar market, banks channel deposited funds to other firms that need to borrow them in the form of Eurodollar loans n n Typical transactions are $1 million or more Eurodollar CDs are not subject to reserve requirements Interest rates are attractive for both depositors and borrowers Rates offered on Eurodollar deposits are slightly higher than NCD rates 40

Globalization of Money Markets (cont’d) n Eurodollar deposits and Euronotes (cont’d) Investors in fixed-rate Eurodollar CDs are adversely affected by rising market rates ¨ Issuers of fixed-rate Eurodollar CDs are adversely affected by declining rates ¨ n Eurodollar-floating-rate CDs (FRCDs) periodically adjust to LIBOR The Eurocurrency market is made up of Eurobanks that accept large deposits and provide large loans in foreign currencies ¨ Loans in the Eurocredit market have longer maturities than loans in the Eurocurrency market ¨ Short-term Euronotes are issued in bearer form with maturities of one, three, and six months ¨ 41

Globalization of Money Markets (cont’d) n Euro-commercial paper (Euro-CP): ¨ Is issued without the backing of a banking syndicate ¨ Has maturities tailored to satisfy investors ¨ Has a secondary market run by CP dealers ¨ Has a rate 50 to 100 basis points above LIBOR ¨ Is sold by dealers at a transaction cost between 5 and 10 basis points of the face value 42

Globalization of Money Markets (cont’d) n Performance of foreign money market securities ¨ Measured by the effective yield (adjusted for the exchange rate ¨ Depends n n on: The yield earned on the money market security in the foreign currency The exchange rate effect 43

Computing the Effective Yield A U. S. investor buys euros for $1. 15 and invests in a one-year European security with a yield of 8 percent. After one year, the investor converts the proceeds from the investment back to dollars at the spot rate of $1. 16 per euro. What is the effective yield earned by the investor? 44