the money market 1 copyright 2013 diane scott docking

The Money Market

1Copyright 2013 Diane Scott Docking

Copyright 2013 Diane Scott Docking 2

The Money Markets Defined

The term “money market” is a misnomer. Money (currency) is not actually traded in the money markets. The securities in the money market are short term with high liquidity; therefore, they are close to being money.


Money Market Securities’ Characteristics

Maturity of ______________ from their ________ date.

Large primary market focus Secondary market for securities

Money market securities are usually sold in ________ denominations.

They have ______ default risk.


Money Market Instruments

1. Treasury Bills

2. Federal Funds

3. Repurchase Agreements

4. Commercial Paper

5. Negotiable Certificates of Deposit

6. Banker’s Acceptance

7. Eurodollars


Treasury Bills

Issued to meet the short-term needs of the

_____________________ Standard Original Maturities of 4 weeks, 13 weeks

(three month), 26 weeks (six month), or 52 weeks Denominations are $1,000; typical round lot is $5

million Virtually default risk free Interest earned is at state and local

government level.

Copyright 2013 Diane Scott Docking

Treasury Bills (continued)

______________ security do not make periodic interest payments. Instead, the security holder receives interest at the maturity date, the interest being the difference between face value (maturity value or par value) and the purchase price

6


T-Bill Quote Example:

As of July 29, 2013:

Maturity Bid Asked Chg Asked Yield

02/06/2014 0.055 0.050 -0.005 0.051

Quote is end of day 07/29/2013, assume 2 days to settle (this can vary) so day 1 = 7/31/2013…02/06/2014 is last trading day. So 191 days to maturity.

http://online.wsj.com/mdc/public/page/2_3020-treasury.html?mod=mdc_bnd_pglnk

Discount Rate Bond Equivalent Yield

Change from yesterday’s closing Ask Yield

http://online.wsj.com/mdc/public/page/2_3020-treasury.html?mod=mdc_bnd_pglnk


Treasury Bills Facts

- what dealers will pay for security (or what investors can sell it for)

- what dealers will sell security for (or what investors can buy it for)

- is the dealers profit or markup Bid price Ask price Spread is _____ in T-Bill market because market is so deep

Bid-ask quotes for T-bills are bid yields and ask yields- Bid yields Ask yields- As yields , prices


Calculating Yields/Prices on U.S. Treasury Bills

Treasury bills are priced on a discount rate basis, idy or DR, is:

maturity todays PriceFaceDiscount : where

360

Face

DiscountDR

n

ndyi

360 FaceDiscount :where

Discount FacePrice

nidy


Calculating Yields/Prices on U.S. Treasury Bills The Wall Journal lists T-Bill yields on a bond equivalent basis (asked yield)

The effective annual return

Relationship between DR and Asked Yield (ibey):

nibey

365

Price

Discount yield Asked

1Price

Face1

3651

365365

nnbey

eff n

iiEAR

nDR

DRibey

360

365


Wall Street Journal Example:

Cost to buy $1,000,000 of T-bills:

Ask Yield calculation:

Effective Return calculation:

2$999,734.7

28.265 000,000,1Price

28.265$360

1910005. $1,000,000Discount

0.051%% 0507083.0000507083.191

365

999,734.72

265.28bey

%0507144.01999,734.72

1,000,000 191365

EAR%0507144.01191365

000507083.1

191365

EAR


Problem: T-bill

You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? Ask Yield? Effective Annual Return?


Solution to Problem: T-bill

What is its discount rate?

nx

F

PFidiscount

360

__________28

360

000,1

37.996000,1

xidiscount



What is its ask yield (or bond equivalent yield)?

iyt F P

P

365

n

_____________28

365

37.996

37.996000,1

xiyt



What is its effective annual return?

1Price

Face365

n

effiEAR

__________1996.37

1,000 28365

effiEAR


T-Bill Auction

All non-competitive bids accepted. Specify quantity only. Maximum bid . Price is the competitive auction yield price.

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

Noncompetitive Bidding


T-Bill Auction

Specify price (as a yield %) and quantity desired. Minimum purchase $1,000 Single price auction used since 1998 Treasury accepts highest bids prices (lowest bid yields) Maximum amount sold to any one buyer is 35% of

offering amount

Competitive Bidding


http://www.treasurydirect.gov/instit/annceresult/press/preanre/2012/R_20120730_2.pdf

http://www.treasurydirect.gov/instit/annceresult/press/preanre/2012/R_20120730_2.pdf

Treasury Bill Auction Results (M&E 7ed, Ch.11)


Treasury Bills Rates (M&E, 7ed Ch. 11)



Example of a T-Bill Auction

The Treasury is auctioning off $120 million in 13-week (91 day)

T-bills. The following bids are received:

Noncompetitive bids: $10 million

Competitive bids:

Alpha Institution $42 mill. 4.000% bid yield

Delta Institution $10 mill. 4.200% bid yield

Gamma Fund $20 mill. 4.250% bid yield

Beta Fund $18 mill. 4.110% bid yield

Epsilon Fund $40 mill. 4.200% bid yield

Chi Institution $10 mill. 4.125% bid yield


Example of a T-Bill Auction (cont.)

1. Which institutions will have their bids filled? By how much?

2. What is the “stopout rate” or “stop yield” or “high yield”? 3. What was the price paid by the winning bidders?4. What is the $ amount of the funds received by the

Treasury?5. What is the bank equivalent yield (i.e. ask yield)?6. What is the Treasury’s annualized interest cost from this

auction (i.e., effective yield)?



1. Maximum bid amount = 35% x $120 million = $42 million

Amount available after non-competitive bids of $10 mill. filled = $110 million

2.

3.

Bidder Bid Price $ Amount Bid Running Balance

Alpha 4.000%

Beta 4.110%

Chi 4.125%

Delta 4.200%

Epsilon 4.200%

Gamma 4.250%

______1.061667 001Price 1.061667360

910420. 100Discount



4. Treasury receives:

5. Ask Yield:

6. Effective Yield:

or

______________$1.274mill. $120Price

mill. 1.274$360

910420. mill. $120Discount

____________91

365

118.726

1.274beyi

4.374%

1

mill. 118.726

mill. 120 91365

EAR______191365

0430.1

91365

EAR


Federal Funds

Interbank lending and borrowing Fed district bank debits and credits accounts for purchase

(borrowing) and sale (lending)• Fed Funds __________________ - this is a bank liability. • Fed Funds _________ - this is a bank asset.

Usually $5 million or more Federal funds rate usually slightly higher than T-bill rate Fed Funds target vs. Actual FF rate Current FF target: http://www.frbdiscountwindow.org/

Effective FF rates: http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

360365

ffbey ii

http://www.frbdiscountwindow.org/

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

Fed Funds Rates (M&E, ed. 7, Ch. 11)



Repurchase Agreements (Repo)

Repo Bank Financing – Source of funds – a bank liability “Security sold under agreement to repurchase” at given

price in future.

Reverse Repo Bank Investment/Loan – Use of funds – a bank asset “Security purchased under agreement to resell” at given

price in future.


Repurchase Agreements (cont.)

Negotiated market rate. Over telecommunications network Dealers and brokers used or direct placement No secondary market Rate is lower than the fed funds rate, since it is backed up by a

security.

Used by: Federal Reserve in open market operations. Government securities dealers to secure funds to invest in new

Treasury issues. Banks to secure funds to meet temporary liquidity needs as well as

lend funds when they have excess reserves.


Estimating Repo Rate

For Repurchase agreements:

Prepo= Repurchase price of security, which equals selling price plus interest

P0= Sales price of the security N=number of days to maturity

nx

P

PPrepo 360rateRepo

0

0


Reverse Repurchase Agreement (Aka: Securities Purchased Under Agreement to Resell)

Bank buys a security from a customer with the agreement to sell it back to customer within so many days (say 90 days). Bank takes possession and title of security In effect, a loan with collateral

Bank accounting entries:Dr) Reverse Repurchase Agreements $100,000

Cr) Cash $100,000

. . .

Dr) Cash $101,000

Cr) Reverse Repurchase Agreements $100,000

Cr) Interest Revenue 1,000 Repo Rate:

4%90

360x

100,000

100,000101,000

n

360x

P

PPrateRepo

0

0repo


Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase)

Bank sold its own security to a dealer/bank with the agreement to repurchase it within so many days (say 90 days). Bank releases possession and title of security In effect, a bank debt with security used collateral

Bank accounting entries:Dr) Cash $100,000

Cr) Repurchase Agreement $100,000

Dr) Securities Sold Under Repo $120,000

Cr) AFS Securities $120,000

…..

Dr) Repurchase Agreement $100,000

Dr) Interest Expense 1,000

Cr) Cash $101,000

Dr) AFS Securities $120,000

Cr) Securities Sold Under Repo $120,000


Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase)

Bank sold its own security to a dealer/bank with the agreement to repurchase it within so many days (say 90 days).

Repo Rate:

4%90

360x

100,000

100,000101,000

n

360x

P

PPrateRepo

0

0Repo


Commercial Paper Alternative to bank loan Short-term debt instrument

• Initial maturities days • Usually days.

Used only by well-known and creditworthy firms• ______________• Credit ratings important

Minimum denominations of $100,000 Placement

• Directly by a sales force of the borrowing firm.• Indirectly through dealers.

Not a large secondary market (generally held to maturity) Sold at a discount from par – just like T-bills.

Commercial Paper Rates (M&E, 7 ed., Ch. 11)


Commercial Paper Volume (M&E, 7 ed., Ch. 11)


Copyright 2013 Diane Scott Docking

Commercial Paper (continued)

Directly-Placed Versus Dealer-Placed Paper Commercial paper is classified as either

directly placed paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary

dealer-placed instruments are when the issuer uses the services of a security firm to sell its paper

36


Negotiable Certificates of Deposit

Development of the CD Market Issued by Citibank in 1961. Offset declining demand deposits as a source of funds.

CD Issuers Money center banks and large regional banks are the

primary issuers of domestic CDs


Negotiable Certificates of Deposit Characteristics of Negotiable CDs

Large denomination time deposit, less than six month's maturity.• minimum is ____days• most are less than l year

Negotiable - may be sold and traded before maturity.• Primary market - denominations of at least $100,000. • Secondary market - $1 million or more.

Issued at face value with coupon rate.• Interest computed on a 360 day year.• Rate negotiated between buyer and seller.• Rates higher than on T-Bills

o higher credit risk, lower marketability and higher taxability.


Example 5-9 in text: Negotiable Certificates of Deposit

Q1: A bank has issued a 6-month (182 day), $1 million NCD with a 0.72% annual interest rate. How much will the NCD holder receive at maturity?

A:

maturity todays where

,360

n

niFaceFaceFV



A:

640,003,1$

640,3000,000,1$

360

1820072.0000,000,1$000,000,1$

FV



Q2: Immediately after the CD is issued, the secondary market price falls to $999,651. What is the new yield on the CD?

A: = 0.7893%



Q3: After the price drop, what is the EAR on the NCD?

A:

%7909.01182365

007893.1

1365

1

182365

365

nbey

eff n

iiEAR

Negotiable CD Rates (M&E, 7ed., Ch. 11)


Comparing Money Market Securities : A comparison of rates



Bankers' Acceptances

1. Time draft1. Drafts are drawn on and/or accepted by commercial

bank.

2. Direct liability of bank.

2. Mostly relate to international trade.

3. Secondary market - dealer market.

4. Discounted in market to reflect yield.

5. Standard maturities of 30, 60, 90 days –270 days max.


Exhibit: Bankers Acceptance (see chart next page)

1) Importer (U.S.) places P.O. for goods.

2) Exporter (Japan) demands payment before shipment. So, Importer asks American Bank to issue a Letter of Credit.

3) American Bank presents LC to Japanese Bank.

4) Japanese Bank notifies Exporter that they have a LC and okay to ship.

5) Exporter ships goods.

6) Exporter sends shipping documents to Japanese Bank.

7) Japanese Bank sends shipping documents and Time Draft (like an invoice) to American Bank.

8) American Bank “stamps” Draft as “accepted” and a BA is created. American Bank will pay owner of BA (i.e. the Draft) so many $ in n-days.

9) American Bank returns BA to Japanese Bank who gives it to Exporter.

10) Exporter can sell BA at its current discounted PV or hold it until maturity.

11) At maturity of BA, Importer pays American Bank, who pays holder of BA.


Exhibit: (Bankers Acceptance)

1 Purchase Order

Shipment of Goods5

L/C3

Shipping Documents & Time DraftDraft Accepted (B/A Created)

7 Japanese Bank(Exporter’s Bank)

American Bank(Importer’s Bank)

Importer Exporter

2

L/C

(Le

tter

of C

redi

t) A

pplic

atio

n

4

L/C

Not

ifica

tion

6

Shi

ppin

g D

ocum

ents

& T

ime

Dra

ft

B/A sent to Japanese Bank9

10

B/A

sen

t to

Exp

orte

r w

ho k

eeps

or

sells

it

AB pays holderof B/A at maturity

11B/A created8


Eurodollars

Deposits of U.S. dollars in banks located outside the U.S. London interbank bid rate (LIBID)

• The rate paid by banks buying funds

London interbank offer rate (LIBOR)• The rate offered for sale of the funds (rate paid on ED)

Time deposits with fixed maturities Largest short term security market in the

world No reserve requirements at banks outside U.S.

Comparing Money Market Securities: Money Market Securities and Their Depth


the money market 1 copyright 2013 diane scott docking

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