Money and Capital Markets

1212C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Money Market Instruments: Commercial Paper, Federal Agency Securities, Bankers’ Acceptances, and Eurocurrency Deposits

Money Market Instruments: Commercial Paper, Federal Agency Securities, Bankers’ Acceptances, and Eurocurrency Deposits

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To discover the important roles that large corporations, government agencies and banks play in the money market.

To explore the nature and characteristics of commercial paper.

To learn how federal agencies aid various economic sectors in finding low-cost credit.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To see the trend toward the internationalization of the money market, and examine how bankers’ acceptances and Eurodeposits are employed in aiding both domestic and international trade.

To understand how the transfers of money from one spending unit to another across international boundaries can impact a nation’s economy.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Commercial Paper

Commercial paper consists of short-term, unsecured promissory notes issued by well-known and financially strong companies.

Commercial paper is traded mainly in the primary market. Opportunities for resale in the secondary market are more limited.

Commercial paper is rated prime, desirable, or satisfactory, depending on the credit standing of the issuing company.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Types of Commercial Paper

There are two major types of commercial paper.

Direct paper is issued mainly by large finance companies and bank holding companies directly to the investor.

Dealer paper, or industrial paper, is issued by security dealers on behalf of their corporate customers (mainly nonfinancial companies and smaller financial companies).

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Structure of the Commercial Paper Market

Investors in commercial paper

Money market fundsBanks

Insurance companies

Pension fundsIndustrial companies

Other investors

Demand SideSupply Side

Issuers of commercial paper

Finance companies

Bank holding companies

Nonfinancial firms

Direct or finance paper

Paper dealer housesDealer or

industrial paper

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Maturities & Rate of Return

Maturities of U.S. commercial paper range from three days (“weekend paper”) to nine months.

Most commercial paper is issued at a discount from par, and yields to the investor are calculated by the bank discount method, just like Treasury bills.

DR = Par value – Purchase price 360 . Par value Days to maturity

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Growth of Commercial Paper

The volume of commercial paper has grown rapidly due to its relatively low cost and high quality, as well as the expanding use of credit enhancements.

1960 $ 4.5 billion1970 33.41980 124.41990 562.72000 1,615.32001 1,438.8

YearOutstanding Volumeof Paper in the U.S.

Effect of weaker economy

& terrorism

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Market Yields on Commercial Paper

Data Source: Board of Governors of the Federal Reserve System

2

3

4

5

6

7

8

9

1991 1993 1995 1997 1999 2001

Federal FundsCommercial PaperBankers' AcceptancesBank Prime LoansTreasury Bills

%

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Commercial Paper

AdvantagesRelatively low interest rates Flexible interest rates - choice of dealer or

direct paperLarge amounts may be borrowed convenientlyThe ability to issue paper gives considerable

leverage when negotiating with banks

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Commercial Paper

DisadvantagesRisk of alienating banks whose loans may be

needed when an emergency develops May be difficult to raise funds in the paper

market at timesCommercial paper must generally remain

outstanding until maturity - does not permit early retirement without penalty

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Continuing Innovation in the Paper Market

Innovations and extensions of the paper market include: Master note – the investing firm agrees to take

some paper each day up to an agreed-upon maximum amount

Medium-term notes – 9-month to 10-year notes Asset-backed commercial paper – loans or credit

receivables are pooled and paper is then issued as a claim against that pool

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Federal Agency Securities

Certain sectors of the economy, such as agriculture, housing, small businesses, and college students, appear to have an unusually difficult time raising funds in the money and capital markets.

Beginning in 1916, the U.S. federal government created special agencies to make direct loans or guarantee private loans to these “disadvantaged” borrowers.

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Types of Federal Credit Agencies

Government-sponsored agencies are federally chartered but privately owned. Their borrowing and lending activities are not reflected in the federal government’s budget.

Examples: Federal Farm Credit Banks (FFCB) Federal Home Loan Mortgage Corp (Freddie Mac) Student Loan Marketing Association (Sallie Mae) Financing Assistance Corporation (FAC)

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Types of Federal Credit Agencies

Federal agencies are legally a part of the government structure, and their borrowing and lending activities are included in the federal budget.

Examples: Export-Import Bank (EXIM) Farmers Home Administration (FMHA) Government National Mortgage Association

(Ginnie Mae) Federal Deposit Insurance Corporation (FDIC)

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The Roles of Federal Credit Agencies

Performing the Roles of a Financial Intermediary

Federal & government-

sponsored credit

agencies

Borrowing funds from the open market and from other government agencies

Granting loans to disadvantaged sectors

Guaranteeing loans made by other lenders

Buying loans from the secondary market

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Federal Agency Securities

The agency market has soared in recent years, with the volume of outstanding securities climbing from about $2 billion during the 1950s to almost $2 trillion today.

Agency securities are generally short to medium term in maturity (running out to about 10 years).

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The Marketing of Agency Issues

The most active buyers of agency securities include banks, state and local governments, government trust funds, and the Federal Reserve System.

The Federal Reserve is authorized to conduct open market operations in agency IOUs.

Major securities dealers who handle U.S. government securities also generally trade in agency issues.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Bankers’ Acceptances

A bankers’ acceptance is a time draft drawn on and endorsed by an importer’s bank.

Acceptances are used in international trade because most exporters are uncertain of the credit standing of their importers.

The issuing bank unconditionally guarantees to pay the face value of the acceptance when it matures, thus shielding exporters and investors in international markets from default risk.

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Bankers’ Acceptances

Acceptances carry maturities ranging from 30 to 270 days, with 90 days being the most common.

They are traded among financial institutions, industrial corporations, and securities dealers as a high-quality investment and source of ready cash.

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How Acceptances Arise

Importer applies for line of credit

Importer’s bank issues letter of credit in favor of exporter

Letter of credit authorizes the drawing of a time draft

Importer’s bank accepts time draft from exporter’s bank

Importer’s bank pays exporter’s bank discounted value of bankers’ acceptance, and then holds or sells it

Bankers’ acceptance is redeemed at maturity

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The Growth and Decline of Acceptance Financing

The volume of US$ acceptances outstanding grew rapidly, from less than $400 million in 1950, to slightly more than $7 billion in 1970, and almost $80 billion in 1984.

Then the volume declined sharply to $10 billion in 2000, as several leading export nations entered a recession, as economic problems developed in Asia, and as businesses turn to other payment and financing methods.

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Acceptance Rates

Acceptances do not carry a fixed rate of interest, but are sold at a discount in the open market like Treasury bills.

The yield on acceptances is usually only slightly higher than the yield on Treasury bills, and close to the negotiable CD rates offered by major banks, because of the high credit quality of the banks that issue the acceptances and CDs.

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Acceptance Rates

Data Source: Board of Governors of the Federal Reserve System

%

3

3.5

4

4.5

5

5.5

6

6.5

1991 1993 1995 1997 1999 2001

Commercial Paper

Bankers' Acceptances

Treasury Bills

Certificates of Deposit

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Investors in Acceptances

Investors in acceptances include banks, industrial corporations, money market mutual funds, local governments, federal agencies, and insurance companies.

To many investors, acceptances are a close substitute for Treasury bills, negotiable CDs, or commercial paper in terms of quality, although the acceptance market is far smaller in terms of the volume of trading.

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Eurocurrency Deposits

The Eurocurrency market has arisen because of the tremendous need worldwide for funds denominated in dollars, Euros, pounds, and other relatively stable currencies.

The Eurocurrency market represents the largest of all money markets worldwide, with total funds probably in excess of $4 trillion.

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Eurocurrency Deposits

Eurodollars are deposits of U.S. dollars in banks located outside the U.S.

The large majority of Eurodollar deposits are held in Europe, although Europe’s share of the total is declining.

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Eurocurrency Deposits

Eurodollars and other Eurocurrency deposits are continually on the move in the form of loans.

They are employed to finance the import and export of goods, to supplement government tax revenues, to provide working capital for the foreign operations of multinational corporations, and to provide liquid reserves for the largest banks.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Eurocurrency Deposits

When a dollar deposit is moved to a bank located outside the U.S., that bank then holds claim to the original dollar deposit in the U.S.

When a Eurodollar loan is made, the borrower receives a claim against dollars deposited in U.S. banks.

Funds are merely passed from one U.S. bank to another. The total amount of dollar deposits and U.S. bank reserves remains unchanged.

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Eurocurrency Maturities and Risks

Most Eurocurrency deposits are short-term deposits ranging from overnight to one year, although a small percentage are long-term time deposits.

Eurocurrency deposits are known to be volatile and highly sensitive to fluctuations in interest rates and currency prices. They also carry political risk and default risk.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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The Supply of Eurocurrency Deposits

Eurocurrency deposits come from … foreign investment tourism balance of payments (trade) settlements interbank funds government funds large corporations’ cash balances central banks supplying or absorbing funds from

the banking system

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Eurodollars in U.S. Domestic Bank Operations

Since the late 1960s, U.S. banks have drawn heavily on Eurodollar deposits as a means of adjusting their domestic reserve positions.

Eurodollars usually carry higher reported interest rates than many other sources of bank reserves. However, there are fewer legal restrictions on the borrowing of Eurodollars.

U.S. banks also aid their customers in acquiring Eurocurrency deposits and loans.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Interest Rates on Eurodollar Deposits

3

3.5

4

4.5

5

5.5

6

6.5

1991 1993 1995 1997 1999 2001

Treasury Bills

Certificates of Deposit

Federal Funds

Eurodollar Deposits (London)

Data Source: Board of Governors of the Federal Reserve System

%

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Benefits and Costs of the Eurocurrency Markets

Benefits Makes possible an efficient mobilization of

funds around the globe. Encourages international cooperation among

nations. Creates a cash-management source to aid the

financial operations of corporations and governments around the globe.

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Benefits and Costs of the Eurocurrency Markets

Costs The capacity to mobilize massive amounts of

funds may contribute to instability in currency values.

Monetary and fiscal policies designed to cure domestic economic problems may not achieve their desired impact.

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Money and Capital Markets in Cyberspace

More information about the various money market instruments can be found at: http://www.investopedia.com/university/

moneymarket/ http://www.ny.frb.org/pihome/fedpoint/ http://www.federalreserve.gov/releases/ http://www.fanniemae.com/ http://www.freddiemac.com/ http://www.bis.org/publ/

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Commercial Paper What Is Commercial Paper? Types of Commercial Paper Structure of the Commercial Paper Market Maturities & Rate of Return on Commercial Paper Growth of Commercial Paper Market Yields on Commercial Paper Advantages & Disadvantages Continuing Innovation in the Paper Market

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Federal Agency Securities Types of Federal Credit Agencies The Roles of Federal Credit Agencies Growth of the Agency Market Terms on Agency Securities The Marketing of Agency Issues

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Bankers’ Acceptances Why Acceptances Are Used in International Trade How Acceptances Arise The Growth and Decline of Acceptance Financing Acceptance Rates Investors in Acceptances

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Eurocurrency Deposits What is a Eurodollar? The Creation of Eurocurrency Deposits Eurocurrency Maturities and Risks The Supply of Eurocurrency Deposits Eurodollars in U.S. Domestic Bank Operations Benefits and Costs of the Eurocurrency Markets