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56 Cards in this Set
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Money Markets Learning objectives
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Define money market securities
Explain why money markets co-exist with banks Describe how money markets serve the needs of investors, corporations and governments Identify the major money market securities Compute the yields of different money market securities Describe key features of different money markets |
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Money Market Securities
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Debt securities
Mature in one year or less from issue date (short-term) Many have active secondary markets After issuance, easy to find buyers Default risk is usually low. Return is also low as a result. Usually sold in large denominations Transactions of $1 mil or more are not unusual Many are discount instruments Do not pay interest Return comes from appreciation in value from purchase price to face value at maturity (“discounting”) |
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Why do money markets co-exist with banks? (Sl. 1)
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Money markets channel funds from short-term investors to short-term borrowers
This is EXACTLY what banks do! Banks: Accept short-term deposits and make short-term loans 1) Have efficiency advantage in gathering information relative to markets 2) Deposits are more liquid and safer than money market securities Why don’t banks take all business from money markets? |
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Why do money markets co-exist with banks? (Sl. 2)
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Banks face more regulations than money markets => banks less competitive
Regulations that reduce bank competitiveness: Reserves Banks cannot invest 100% of deposits in high return loans => pay lower interest rates on deposits Interest rate regulations/ ceilings on deposits Glass-Steagall Act of 1933: no interest on checking accounts, limit interest on time deposits High interest rates in 1970s, 1980s: investors moved $ from banks to money markets |
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Purpose of money markets
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For surplus units (e.g., investors)
Money markets allow surplus units to earn some return on cash while they look for more attractive investments Holding idle cash is expensive because you are forgoing interest income (opportunity cost) For deficit units (e.g., companies, govts) Money markets provide a low-cost source of temporary (short-term) funds Why need short-term funds? Cash inflows and outflows are not synchronized |
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Who participates in the money markets? (Sl. 1)
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U.S. Treasury Department--Sells U.S. Treasury securities to fund the national debt
The Fed-- Buys and sells U.S. Treasury securities as its primary method of controlling the monetary supply Commercial Banks--Buy U.S. Treasury securities; sell certificates of deposit and make short term loans; offer individual investors accounts that invest in money market securities |
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Who participates in the money markets? (4-6)
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Business: Buy and sell various short-term securities as a regular part of their cash management
Investment companies (brokerage firms): Trade on behalf of commercial accounts Finance companies (commercial leasing companies)--Raise funds in money markets by selling commercial paper |
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Who participates in the money markets? (7-8)
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Insurance companies (property and casualty insurance companies)--Maintain liquidity needed to meet unexpected demands
Pension funds--Maintain funds in money market instruments inreadiness for investment in stocks and bonds |
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Who participates in the money markets? (8-9)
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Individuals-- Buy money in mutual funds
Money market mutual funds-- Allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities |
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Types of money market securities
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Treasury bills (T-bills)
Federal funds (Fed funds) Repurchase agreements (Repos) Negotiable certificates of deposit (NCDs) Commercial papers (CPs) |
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Treasury bills (T-bills) (sl. 1)
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Issued by Treasury Department to finance the national debt
Sold with 28, 91, 182-day maturities Par values are multiples of $1000 Smallest is $1000 Individuals can buy Treasury securities, including T-bills over the Internet at www.treasurydirect.gov |
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Treasury bills (T-bills) (sl. 2)
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Sold at a discount from par value
Investor’s return comes from increase in security’s value between time of purchase and maturity Advantages No default risk Very liquid securities |
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Types of money market securities
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Treasury bills (T-bills)
Federal funds (Fed funds) Repurchase agreements (Repos) Negotiable certificates of deposit (NCDs) Commercial papers (CPs) |
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Valuation of T-bills
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Value of T-bill is present value of par value discounted at investor’s required rate of return
T-bill price = Par value/ (1 + r) Where r = required rate of return or discount rate Required rate of return must be adjusted to reflect the maturity of the T-bill |
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Treasury bills (T-bills) (sl. 1)
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Issued by Treasury Department to finance the national debt
Sold with 28, 91, 182-day maturities Par values are multiples of $1000 Smallest is $1000 Individuals can buy Treasury securities, including T-bills over the Internet at www.treasurydirect.gov |
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Valuation problem 1
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1) If investors require a 7% annualized return on a one-year T-bill with a par value of $10,000, what is the T-bill’s price?
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Treasury bills (T-bills) (sl. 2)
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Sold at a discount from par value
Investor’s return comes from increase in security’s value between time of purchase and maturity Advantages No default risk Very liquid securities |
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Valuation of T-bills
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Value of T-bill is present value of par value discounted at investor’s required rate of return
T-bill price = Par value/ (1 + r) Where r = required rate of return or discount rate Required rate of return must be adjusted to reflect the maturity of the T-bill |
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Valuation problem 1
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1) If investors require a 7% annualized return on a one-year T-bill with a par value of $10,000, what is the T-bill’s price?
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Valuation problem 2
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2) If investors require a 6% annualized return on a six-month T-bill with a par value of $5,000, what is the T-bill’s price?
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Valuation problem 3
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3) If investors require a 5% annualized return on a three-month T-bill with a par value of $20,000, what is the T-bill’s price?
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T-bill yield
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YT, Annualized yield from investing in T-bill
Y subscript T = [ (Selling Price- Purchase Price) / Purchase Price ] x (365 / n) |
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T-bill yield problem 1
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1) Suppose an investor purchased a 6-month T-bill at $9,600 and subsequently sold it after 120 days at a price of $9,820. What is the annualized yield?
Verify that annualized yield is 6.97%. |
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T-bill yield problem 2
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2) An investor purchases a T-bill with a six-month (182-day) maturity and $2,000 par value for $1,960. If this T-bill is held to maturity, what is its annualized yield?
Verify that annualized yield is 4.09% |
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T-bill discount
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T-bill discount is the percent discount of the purchase price from par value for newly issued T-bills
Use 360-day year to compute discount. T-bill discount = (Par Value- purchase price) / Par Value x (360/n) Par value aka Face Value |
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T-bill discount problem
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An investor purchases a T-bill with a six-month (182-day) maturity and $2,000 par value for $1,960. What is the T-bill discount?
Verify that T-bill discount is 3.96%. If held till maturity, verify that T-bill yield is 4.09% |
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Fed Funds
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Reserves that depository institutions lend to one another on a short term, unsecured basis
Help depository institutions to meet reserve requirement should they be short of reserves Loans are usually for 1 day (“overnight”) For further details refer to “Federal Reserve” slides |
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Valuation problem 2
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2) If investors require a 6% annualized return on a six-month T-bill with a par value of $5,000, what is the T-bill’s price?
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Valuation problem 3
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3) If investors require a 5% annualized return on a three-month T-bill with a par value of $20,000, what is the T-bill’s price?
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T-bill yield
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YT, Annualized yield from investing in T-bill
Y subscript T = [ (Selling Price- Purchase Price) / Purchase Price ] x (365 / n) |
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T-bill yield problem 1
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1) Suppose an investor purchased a 6-month T-bill at $9,600 and subsequently sold it after 120 days at a price of $9,820. What is the annualized yield?
Verify that annualized yield is 6.97%. |
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T-bill yield problem 2
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2) An investor purchases a T-bill with a six-month (182-day) maturity and $2,000 par value for $1,960. If this T-bill is held to maturity, what is its annualized yield?
Verify that annualized yield is 4.09% |
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T-bill discount
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T-bill discount is the percent discount of the purchase price from par value for newly issued T-bills
Use 360-day year to compute discount. T-bill discount = (Par Value- purchase price) / Par Value x (360/n) Par value aka Face Value |
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T-bill discount problem
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An investor purchases a T-bill with a six-month (182-day) maturity and $2,000 par value for $1,960. What is the T-bill discount?
Verify that T-bill discount is 3.96%. If held till maturity, verify that T-bill yield is 4.09% |
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Fed Funds
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Reserves that depository institutions lend to one another on a short term, unsecured basis
Help depository institutions to meet reserve requirement should they be short of reserves Loans are usually for 1 day (“overnight”) For further details refer to “Federal Reserve” slides |
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Repurchase agreements (Repos) (sl. 1)
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Repurchase agreement (repo)
One party sells securities to another party with an agreement to buy back the securities at a specified date and price Reverse repurchase agreement (reverse repo) One party buys securities from another with an agreement to sell back the securities at a specified date and price |
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Repurchase agreements (Repos) (sl. 2)
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Repo is a loan backed by the securities
Borrower: seller of securities, lender: buyer of securities If borrower defaults, lender keeps the securities What securities are used? Mostly government securities, sometimes also commercial paper, negotiable certificates of deposit Who use repos? Financial institutions (e.g., banks) and nonfinancial institutions (e.g., municipality) Federal Reserve uses repos to conduct open market operations |
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Yield on Repo / Repo rate
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Based on the difference between the initial selling price and the agreed-upon repurchase price, annualized with a 360-day year
Repo rate= [(Repurchase price- Initial selling price) / Initial selling price]x (360/ n) |
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Repo rate question 1
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An investor initially purchased securities at a price of $9,852,217, with an agreement to sell them back at a price of $10,000,000 at the end of a 60-day period. What is the repo rate?
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Repo rate question 2
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Suppose the term of the repo is one day (an ‘overnight repo’) and suppose the repo rate is 6.5% p.a. The borrower agrees to sell government securities at $9,998,195. What is the dollar interest of the loan?
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Repurchase agreements (Repos), Sl. 1
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Repurchase agreement (repo)
One party sells securities to another party with an agreement to buy back the securities at a specified date and price Reverse repurchase agreement (reverse repo) One party buys securities from another with an agreement to sell back the securities at a specified date and price |
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Repurchase agreements (Repos), Sl. 2
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Repo is a loan backed by the securities
Borrower: seller of securities, lender: buyer of securities If borrower defaults, lender keeps the securities What securities are used? Mostly government securities, sometimes also commercial paper, negotiable certificates of deposit Who use repos? Financial institutions (e.g., banks) and nonfinancial institutions (e.g., municipality) Federal Reserve uses repos to conduct open market operations |
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Yield on Repo / Repo rate
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Based on the difference between the initial selling price and the agreed-upon repurchase price, annualized with a 360-day year
Repo rate= [(Repurchase price- Initial selling price) / Initial selling price] x (360/n) |
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Repo rate question 1
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An investor initially purchased securities at a price of $9,852,217, with an agreement to sell them back at a price of $10,000,000 at the end of a 60-day period. What is the repo rate?
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Repo rate question 2
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Suppose the term of the repo is one day (an ‘overnight repo’) and suppose the repo rate is 6.5% p.a. The borrower agrees to sell government securities at $9,998,195. What is the dollar interest of the loan?
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Negotiable Certificates of Deposit (NCDs) (1)
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A bank-issued security that documents a deposit and specifies the interest rate and maturity date
“Negotiable” means a secondary market exists NCDs can be traded among investors till maturity Bearer instrument: whoever holds the NCD at maturity receives the principal (deposit) and interest |
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Negotiable Certificates of Deposit (NCDs) (2)
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Denominations range from $100k to $10m
Typical maturities: 1 to 6 months Placement: sold directly to investors or through dealers NCD yield usually higher than T-bill yield because Credit risk, less liquid |
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Commercial paper (1)
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Issued by largest, most credit-worthy firms
Issuers: financial institutions (e.g., finance companies, bank holding companies), nonfinancial institutions (e.g., GMAC, GE Capital) Major buyers include money market funds, insurance companies, pension funds Typically unsecured, i.e., no collateral Denominations in multiples of $1 million Minimum denomination is usually $100,000 Maturity: usually 20-45 days, can vary between 1 and 270 days |
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Commercial paper (2)
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Commercial paper is exposed to default risk
Issuers are corporations, not the US government Examples of default: 1989, Wang Labs, Lomas Financial, Drexel Burnham Lambert To assess default risk, investors can use ratings assigned by credit rating agencies Higher default risk (lower credit rating) increases issuer’s borrowing cost (i.e., yield required by investors) Can increase by as much as 150 basis points (1.5%) |
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Commercial paper (3)
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Credit rating
Commercial paper usually carry credit ratings from one or more rating agency Like bonds, better ratings are associated with lower default risk |
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Commercial paper (4)
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Volume of issuance
Affected by economic conditions Issuance drops during recessions because Corporations tend to borrow less Default risk increases, borrowing cost increases Placement Sell directly to investors (60% of CP) Sell through commercial paper dealers (the rest) Backup line of credit:↓ non-payment risk |
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Commercial paper yield
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CP yield is higher than T-bill yield because
Credit risk, less liquid CP is sold at a discount from par value YCP, Annualized yield from investing in commercial paper Y subscript CP = [(Selling price- Purchase price)/ Purchase price] x (360/ n) |
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CP problem (1)
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If an investor purchases 30-day commercial paper with a par value of $1,000,000 for a price of $990,000, what is the yield if the investor:
Sells the paper after 15 days at $994,500? Holds the paper till it matures and receives the face value? |
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CP problem (2)
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Deadbeat Corp recently took advantage of the Fed’s Commercial Paper Funding Facility (CPFF) to raise short term funds. Deadbeat sold 3-month unsecured commercial paper with a face value of $3 million to CPFF LLC, the special purpose vehicle that runs CPFF.
CPFF LLC paid an interest rate of 3-month Overnight Index Swap (OIS) plus 100 b.p. for the commercial paper. If the 3-month OIS was 1.2% at issuance, how much money did Deadbeat raise? [Assume 3 months=90 days and 360 days in a year. State your answer is millions, rounded to 2 decimal places] |
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CP problem (3)
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The price of 182-day commercial paper is $7,840. If the annualized yield is 4.093%, what will the paper pay at maturity?
[State your answer rounded to two decimal places. Assume 365 days in a year] |
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Summary
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Money markets facilitate the transfer of short term funds from surplus units to deficit units.
Money markets can co-exist with banks because money markets are less regulated and thus have cost advantages Money market securities mature within a year, have large denominations, are typically discount instruments, have low risk and low return. Major money market securities include T-bills, Fed Funds, Repos, NCDs, and commercial paper |
