Power Point Slides for Financial Markets and Institutions

Power. Point Slides for: Financial Markets and Institutions 6 th Edition By Jeff Madura Prepared by David R. Durst The University of Akron

CHAPTER 6 Money Markets

Chapter Objectives Provide a background on money market securities n Explain how institutional investors use money markets n Explain the globalization of money markets n Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Maturity of a year or less n Debt securities issued by corporations and governments that need short-term funds n Large primary market focus n Purchased by corporations and financial institutions n Secondary market for securities n Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Treasury Bills n Commercial paper n Negotiable certificates of deposits n Repurchase agreements n Federal funds n Banker’s acceptances n Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n Treasury bills Issued to meet the short-term needs of the U. S. government l Attractive to investors l u. Minimal default risk—backed by Federal Government u. Excellent liquidity for investors n n Short-term maturity Very good secondary market Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Competitive Bidding n Treasury bill auction (fill bids in amount determined by Treasury borrowing needs) Bid process used to sell T-bills l Bids submitted to Federal Reserve banks by the deadline l Bid process l u. Accepts highest bids u. Accepts bids until Treasury needs generated Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Noncompetitive Bidding n Treasury bill auction—noncompetitive bids ($1 million limit) l l May be used to make sure bid is accepted Price is the weighted average of the accepted competitive bids Investors do not know the price in advance so they submit check for full par value After the auction, investor receives check from the Treasury covering the difference between par and the actual price Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n Estimating T-bill yield No coupon payments l Par or face value received at maturity l Yield at issue is the difference between the selling price and par or face value adjusted for time l If sold prior to maturity in secondary market l u. Yield based on the difference between price paid for T -bill and selling price adjusted for time Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n Calculating T-Bill Annualized Yield YT = SP – PP PP 365 n YT = The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period) Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n T-bill yield for a newly issued security T-bill yield = Par – PP PP 365 n T-bill yield = percent yield of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n T-bill discont for a newly issued security T-bill discount = Par – PP par 360 n T-bill discount = percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Commercial Paper Short-term debt instrument l Alternative to bank loan l Dealer placed vs. directly placed l Used only by well-known and creditworthy firms l Unsecured l Minimum denominations of $100, 000 l Not a large secondary market l Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n Commercial paper backed by bank lines of credit Bank line used if company loses credit rating l Bank lends to pay off commercial paper l Bank charges fees for guaranteed line of credit l Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n Estimating commercial paper yields YCP = Par – PP PP 360 n YCP = Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Negotiable Certificates of Deposit (NCD) Issued by large commercial banks l Minimum denomination of $100, 000 but $1 million more common l Purchased by nonfinancial corporations or money market funds l Secondary markets supported by dealers in security l Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n NCD placement Direct placement l Use a correspondent institution specializing in placement l Sell to securities dealers who resell l Sell direct to investors at a higher price l n NCD premiums l Rate above T-bill rate to compensate for lower liquidity and safety Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Repurchase Agreements Sell a security with the agreement to repurchase it at a specified date and price l Borrower defaults, lender has security l Reverse repo name for transaction from lender l Negotiated over telecommunications network l Dealers and brokers used or direct placement l No secondary market l Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities n Estimating repurchase agreement yields Repo Rate = SP – PP PP 360 n Repo Rate = Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Federal Funds Interbank lending and borrowing l Federal funds rate usually slightly higher than Tbill rate l Fed district bank debits and credits accounts for purchase (borrowing) and sale (lending) l Federal funds brokers may match up buyers and sellers using telecommunications network l Usually $5 million or more l Copyright© 2002 Thomson Publishing. All rights reserved.

Exhibit 6. 5 Shipment of Goods 2 3 American Bank (Importer’s Bank) Exporter Shipping Documents & Time Draft 5 L/C Notification Purchase Order L/C (Letter of Credit) Application Importer 1 4 6 L/C 7 Shipping Documents &Time Draft Accepted (B/ACreated) Japanese Bank (Exporter’s Bank) Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Bankers Acceptance A bank takes responsibility for a future payment of trade bill of exchange l Used mostly in international transactions l Exporters send goods to a foreign destination and want payment assurance before sending l Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time l Copyright© 2002 Thomson Publishing. All rights reserved.

Money Market Securities Bankers Acceptance Exporter can hold until the date or sell before maturity l If sold to get the cash before maturity, price received is a discount from draft’s total l Return is based on calculations for other discount securities l Similar to the commercial paper example l Copyright© 2002 Thomson Publishing. All rights reserved.

Major Participants in Money Market n Participants l l l n n n Commercial banks Finance, industrial, and service companies Federal and state governments Money market mutual funds All other financial institutions (investing) Short-term investing for income and liquidity Short-term financing for short and permanent needs Large transaction size and telecommunication network Copyright© 2002 Thomson Publishing. All rights reserved.

Valuation of Money Market Securities Present value of future cash flows at maturity (zero coupon) n Value (price) inversely related to discount rate or yield n Money market security prices more stable than longer term bonds n Yields = risk-free rate + default risk premium n Copyright© 2002 Thomson Publishing. All rights reserved.

Exhibit 6. 7 International Economic Conditions U. S. Fiscal Policy U. S. Monetary Policy U. S. Economic Conditions Issuer’s Industry Conditions Short-Term Risk-Free Interest Rate (T-bill Rate) Issuer’s Unique Conditions Risk Premium of Issuer Required Return on the Money Market Security Price of the Money Market Security Copyright© 2002 Thomson Publishing. All rights reserved.

Interaction Among Money Market Yields Securities are close investment substitutes n Investors trade to maintain yield differentials n T-Bill is the benchmark yield in money market n Yield changes in T-bills quickly impacts other securities via dealer trading n Yield differentials determined by risk differences between securities n Default risk premiums vary inversely with economic conditions n Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Money Markets n Money market rates vary by country Segmented markets l Tax differences l Estimated exchange rates l Government barriers to capital flows l Deregulation Improves Financial Integration n Capital Flows To Highest Rate of Return n Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Money Markets n Eurodollar deposits and Euronotes Dollar deposits in banks outside the U. S. l Increased because of international trade growth and U. S. trade deficits over time l No reserve requirements at banks outside U. S. l n Eurodollar Loans l Channel funds to other multinationals that need short-term financing Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Money Markets n Euro-commercial paper Issued without the backing of a banking syndicate l Maturity tailored to investors l Dealers that place paper create a secondary market l Rates range between 50 and 100 basis points above the LIBOR rate l Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Money Markets Performance of international securities n Effective yield for international securities has two components n The yield earned on the investment denominated in the currency of the investment l The exchange rate effect l Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Money Markets Performance of international securities n Yield for an international investment n Yf = SPf – PPf Yf = Foreign investment’s yield SPf = Investment’s foreign currency selling price PPf = Investment’s foreign currency purchase Copyright© 2002 Thomson Publishing. All rights reserved.

Globalization of Money Markets n The exchange rate effect (% S) measures the percentage change in the spot during the investment period l % S measures the expected percent change in the currency u. Currency appreciated, % S is positive and adds to net yield u. Currency depreciated, % S is negative and reduces net yield Copyright© 2002 Thomson Publishing. All rights reserved.

Chapter Concepts Summary Surplus units channel investments to securities issued by deficit units n Debt securities markets n Money Market l Capital Market l n Money market securities Short-term l High quality l Very good liquidity l Copyright© 2002 Thomson Publishing. All rights reserved.