money markets ch. 9 (uts)
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Chapter 6
Money Markets
Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline
Money market securities Institutional use of money markets Valuation of money market securities Risk of money market securities Interaction among money market yields
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Money Market Securities
Money market securities:Have maturities within one yearAre issued by corporations and governments
to obtain short-term fundsAre commonly purchased by corporations and
government agencies that have funds available for a short-term period
Provide liquidity to investors
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Money Market Securities (cont’d)
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
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Money Market Securities (cont’d)
Treasury bills (cont’d) Investors 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
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Money Market Securities (cont’d)
Treasury bills (cont’d) Pricing Treasury bills
The price is dependent on the investor’s required rate of return:
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
nm kP )1/(Par
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Computing the Price of a Treasury Bill
A one-year Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill?
259,9$
)08.1/(000,10$
)1/(Par
nm kP
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Money Market Securities (cont’d)
Treasury bills (cont’d) Treasury bill auction
Investors submit bids on T-bill applications for the maturity of their choice
Applications can be obtained from a Federal Reserve district or branch bank
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
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Money Market Securities (cont’d)
Treasury bills (cont’d) Treasury bill auction (cont’d)
Weekly auctions include 13-week and 26-week T-bills 4-week T-bills are offered when the Treasury anticipates a
short-term cash deficiency Cash management bills are also occasionally offered Investors can submit competitive or noncompetitive bids The bids of noncompetitive bidders are accepted The highest competitive bids are accepted Any bids below the cutoff are not accepted Since 1998, the lowest competitive bid is the price applied to
all competitive and noncompetitive bids
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Money Market Securities (cont’d)
Treasury bills (cont’d)Estimating 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
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Money Market Securities (cont’d)
Treasury bills (cont’d) Estimating the yield (cont’d)
The annualized yield is:
Estimating the T-bill discount The discount represents the percent discount of the
purchase price from par value for newly-issued T-bills:
nPP
PPSPYT
365
n
PP 360
Par
Pardiscount bill-T
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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?
%94.8
91
365
782,9
782,9000,10
365
nPP
PPSPYT
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Estimating the T-Bill Discount
Using the information from the previous example, what is the T-bill discount?
%62.8
91
360
000,10
782,9000,10
360
Par
Pardiscount bill-T
n
PP
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Money Market Securities (cont’d)
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 Has no active secondary market Is typically not purchased directly by individual investors
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Money Market Securities (cont’d)
Commercial paper (cont’d) Ratings
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
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Money Market Securities (cont’d)
Commercial paper (cont’d) Volume of commercial paper:
Has increased substantially over time Is commonly reduced during recessionary periods
Placement Some firms place commercial paper directly with investors Most firms rely on commercial paper dealers to sell Some firms (such as finance companies) create in-house
departments to place commercial paper
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Money Market Securities (cont’d)
Commercial paper (cont’d) Backing commercial paper
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
The yield on commercial paper is slightly higher than on a T-bill
The nominal return is the difference between the price paid and the par value
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Estimating the Commercial Paper YieldAn 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?
%42.11
120
360
289,000
289,000- 300,000
cpY
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Money Market Securities (cont’d)
Commercial paper (cont’d) The commercial paper yield curve:
Illustrates the yield offered on commercial paper at various maturities
Is typically established for a maturity range from 0 to 90 days Is similar to the short-term range of the Treasury yield curve Is affected by short-term interest rate expectations Is similar to the yield curve on other money market
instruments
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Money Market Securities (cont’d)
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
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Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs) (cont’d)Placement
Directly Through a correspondent institution Through securities dealers
Premium NCDs offer a premium above the T-bill yield to
compensate for less liquidity and safety
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Money Market Securities (cont’d)
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
If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate
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Money Market Securities (cont’d)
Repurchase agreements One party sells securities to another with an agreement to
repurchase them at a specified date and price 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
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Money Market Securities (cont’d)
Repurchase agreements (cont’d) Placement
Repo transactions are negotiated through a telecommunications network with dealers and repo brokers
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 The repo yield is determined by the difference between the
initial selling price and the repurchase price, annualized with a 360-day year
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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 $10,000,000 at the end of a 90-day period. What is the repo rate?
%50.3
90
360
9,913,314
314,913,9000,000,10
360rate Repo
nPP
PPSP
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Money Market Securities (cont’d)
Federal funds The federal funds market allows depository
institutions to lend or borrow short-term funds from each other at the federal funds rate
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
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Money Market Securities (cont’d)
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
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Money Market Securities (cont’d)
Banker’s acceptances: Indicate that a bank accepts responsibility for a future
payments Are commonly used for international trade
transactions 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
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Money Market Securities (cont’d)
Banker’s acceptances (cont’d) Steps involved in banker’s acceptances
First, the U.S. importer places a purchase order for goods The importer asks its bank to issue a letter of credit (L/C)
on its behalf 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
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Sequence of Steps in the Creation of A Banker’s Acceptance
Importer Exporter
American Bank(Importer’s Bank)
Japanese Bank(Exporter’s Bank)
1 Purchase Order
5 Shipment of Goods
2 L/C Application
3 L/C
7Shipping Documents& Time Draft Accepted
4 L/C Notification
6 Shipping Documents & Time Draft
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Institutional Use of Money Markets
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
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Institutional Use of Money Markets (cont’d) 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
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Valuation of Money Market Securities For money market securities making no
interest payments, the value reflects the present value of a future lump-sum paymentThe discount rate is the required rate of return
by investors
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Valuation of Money Market Securities (cont’d) Explaining money market price movements
The price of a noninterest-paying money market security is:
A change in the price can be modeled as:
nm kP )1/(Par
),( and )( RPRfkkfP fm
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Valuation of Money Market Securities (cont’d) 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
Employment GDP Retail sales Industrial production Consumer confidence Indicators of inflation
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Risk of Money Market Securities
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
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
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Interaction Among Money Market Yields Money market instruments are substitutes for
each other Market forces will correct disparities in yield and
the yields among securities tend to be similar
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
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Globalization of Money Markets
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: 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
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Globalization of Money Markets (cont’d) Eurodollar deposits and Euronotes
Eurodollar certificates of deposit are U.S. dollar deposits in non-U.S. banks
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
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
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Globalization of Money Markets (cont’d) 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
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
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Globalization of Money Markets (cont’d) 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
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Globalization of Money Markets (cont’d) Performance of foreign money market
securities Measured by the effective yield (adjusted for the
exchange rate
Depends on: The yield earned on the money market security in the
foreign currency The exchange rate effect
1)%1()1( SYY fe
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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?
%94.8
10087.108.1
1)%1()1(
SYY fe