Money Market Securities

Financial Markets and Institutions6th Edition

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By Jeff MaduraPrepared byDavid R. DurstThe University of Akron

CHAPTER

66 Money Markets

Copyright© 2002 Thomson Publishing. All rights reserved.

Chapter ObjectivesChapter Objectives

Provide a background on money market securities

Explain how institutional investors use money markets

Explain the globalization of money markets


Money Market SecuritiesMoney Market Securities

Maturity of a year or less Debt securities issued by corporations and

governments that need short-term funds Large primary market focus Purchased by corporations and financial

institutions Secondary market for securities



Treasury Bills Commercial paper Negotiable certificates of deposits Repurchase agreements Federal funds Banker’s acceptances



Treasury bills Issued to meet the short-term needs of the U.S.

government Attractive to investors

Minimal default risk—backed by Federal Government Excellent liquidity for investors

Short-term maturity Very good secondary market



Treasury bill auction (fill bids in amount determined by Treasury borrowing needs) Bid process used to sell T-bills Bids submitted to Federal Reserve banks by the

deadline Bid process

Accepts highest bids Accepts bids until Treasury needs generated

Competitive Bidding



Treasury bill auction—noncompetitive bids($1 million limit) 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

Noncompetitive Bidding



Estimating T-bill yield No coupon payments Par or face value received at maturity Yield at issue is the difference between the selling

price and par or face value adjusted for time If sold prior to maturity in secondary market

Yield based on the difference between price paid for T-bill and selling price adjusted for time



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)

=



T-bill yield for a newly issued security

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

T-bill yield =



T-bill discont for a newly issued security

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


T-bill discount =



Short-term debt instrument Alternative to bank loan Dealer placed vs. directly placed Used only by well-known and creditworthy firms Unsecured Minimum denominations of $100,000 Not a large secondary market

Commercial Paper



Commercial paper backed by bank lines of credit Bank line used if company loses credit rating Bank lends to pay off commercial paper Bank charges fees for guaranteed line of credit



Estimating commercial paper yields

YCP

Par – PP

PP

360 n

YCP = Commercial paper yield

Par = Face value at maturity

PP = Purchase price


=



Issued by large commercial banks Minimum denomination of $100,000 but $1

million more common Purchased by nonfinancial corporations or money

market funds Secondary markets supported by dealers in

security

Negotiable Certificates of Deposit (NCD)



NCD placement Direct placement Use a correspondent institution specializing in

placement Sell to securities dealers who resell Sell direct to investors at a higher price

NCD premiums Rate above T-bill rate to compensate for lower

liquidity and safety



Sell a security with the agreement to repurchase it at a specified date and price

Borrower defaults, lender has security Reverse repo name for transaction from lender Negotiated over telecommunications network Dealers and brokers used or direct placement No secondary market

Repurchase Agreements



Estimating repurchase agreement yields

Repo Rate SP – PP

PP

360 n

Repo Rate = Yield on the repurchase agreement

SP = Selling price

PP = Purchase price


=



Interbank lending and borrowing Federal funds rate usually slightly higher than T-

bill rate Fed district bank debits and credits accounts for

purchase (borrowing) and sale (lending) Federal funds brokers may match up buyers and

sellers using telecommunications network Usually $5 million or more

Federal Funds


Exhibit 6.5Exhibit 6.51 Purchase Order

Shipment of Goods5

L/C3

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

7Japanese Bank

(Exporter’s Bank)American Bank

(Importer’s Bank)

Importer Exporter

2

L/C

(Let

ter o

f Cre

dit)

App

licat

ion

4

L/C

Not

ifica

tion

6

Shi

ppin

g D

ocum

ents

& T

ime

Dra

ft



A bank takes responsibility for a future payment of trade bill of exchange

Used mostly in international transactions Exporters send goods to a foreign destination and

want payment assurance before sending Bank stamps a time draft from the importer

ACCEPTED and obligates the bank to make good on the payment at a specific time

Bankers Acceptance



Exporter can hold until the date or sell before maturity

If sold to get the cash before maturity, price received is a discount from draft’s total

Return is based on calculations for other discount securities

Similar to the commercial paper example

Bankers Acceptance


Major Participants in Money MarketMajor Participants in Money Market

Participants 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


Valuation of Money Market SecuritiesValuation of Money Market Securities

Present value of future cash flows at maturity (zero coupon)

Value (price) inversely related to discount rate or yield

Money market security prices more stable than longer term bonds

Yields = risk-free rate + default risk premium


Exhibit 6.7Exhibit 6.7

InternationalEconomicConditions

U.S.FiscalPolicy

Issuer’sIndustry

Conditions

RiskPremiumof Issuer

Short-TermRisk-Free

InterestRate

(T -bill Rate)

Issuer’sUnique

Conditions

U.S.Monetary

Policy

U.S.Economic

Conditions

Required Returnon the Money

Market Security

Price of theMoney Market

Security


Interaction Among Money Market Interaction Among Money Market YieldsYields Securities are close investment substitutes Investors trade to maintain yield differentials T-Bill is the benchmark yield in money market Yield changes in T-bills quickly impacts other

securities via dealer trading Yield differentials determined by risk

differences between securities Default risk premiums vary inversely with

economic conditions


Globalization of Money MarketsGlobalization of Money Markets

Money market rates vary by country Segmented markets Tax differences Estimated exchange rates Government barriers to capital flows

Deregulation Improves Financial Integration Capital Flows To Highest Rate of Return



Eurodollar deposits and Euronotes Dollar deposits in banks outside the U.S. Increased because of international trade growth

and U.S. trade deficits over time No reserve requirements at banks outside U.S.

Eurodollar Loans Channel funds to other multinationals that need

short-term financing



Euro-commercial paper Issued without the backing of a banking syndicate Maturity tailored to investors Dealers that place paper create a secondary market Rates range between 50 and 100 basis points

above the LIBOR rate



Performance of international securities Effective yield for international securities has

two components The yield earned on the investment denominated

in the currency of the investment The exchange rate effect



Performance of international securities Yield for an international investment

YfSPf – PPf

PPfYf = Foreign investment’s yield

SPf = Investment’s foreign currency selling price

PPf = Investment’s foreign currency purchase

=



The exchange rate effect (%S) measures the percentage change in the spot during the investment period

% S measures the expected percent change in the currency Currency appreciated, % S is positive and adds to net

yield Currency depreciated, % S is negative and reduces net

yield

111 )%()( SYY fe


Chapter Concepts SummaryChapter Concepts Summary

Surplus units channel investments to securities issued by deficit units

Debt securities markets Money Market Capital Market

Money market securities Short-term High quality Very good liquidity

Money Market Securities

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