Assingment on money market

1 Money Market @ Amanullah Trino, Finance and Banking, Rajshahi University

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ASSIGNMENT

ON Money Market

Course Title: Financial Institutions & Markets

Course Code: E-603 Submitted By: Md. Amanullah ID: 10254015 Year of Study: 5th Batch 4th Semester EMBA Program Dept. of Finance and Banking Rajshahi University

Submitted to: Professor Dr. A.H.M. Ziaul Haq Dept. of Finance and Banking Rajshahi University

Date of Submission: Saturday, May 19, 2012

Rajshahi University



Contents

Introduction

What is Money market?

What the Money Market does?

Why is such a Market needed?

The Need for a Money Market

Who are the Principal Borrowers and Lenders in the Money Market?

Who Participates in the Money Markets?

The Goals of Money Market Investors

What kind of risk do investors face in the financial markets?

Money Market Maturities

Depth and Breadth of the Money Market

Money Market Instruments

Certificate of deposit.

Repurchase agreements

Commercial paper

Treasury bill.

References


Introduction:

The financial markets channel savings to those individuals and institutions needing

more funds for spending than are provided by their current incomes.

The financial markets make possible the exchange of current income for future

income and the transformation of savings into investment so that production,

employment, and income can grow.

A financial market is a market in which people and entities

can trade financial securities, commodities, and other fungible items of value at

low transaction costs and at prices that reflect supply and demand. Securities

include stocks and bonds, and commodities include precious metals or agricultural

goods.

There are both general markets (where many commodities are traded) and

specialized markets (where only one commodity is traded). Markets work by

placing many interested buyers and sellers, including households, firms, and

government agencies, in one "place", thus making it easier for them to find each

other. An economy which relies primarily on interactions between buyers and

sellers to allocate resources is known as a market economy in contrast either to

a command economy or to a non-market economy such as a gift economy.

In finance, financial markets facilitate:

The raising of capital (in the capital markets)

The transfer of risk (in the derivatives markets)

Price discovery

Global transactions with integration of financial markets

The transfer of liquidity (in the money markets)

International trade (in the currency markets)

Financial Market

Money market Capital Market



Money Market:

Money market means market where money or its equivalent can be traded. Money is synonym of liquidity. Money market consists of financial institutions and dealers in money or credit who wish to generate liquidity. It is better known as a place where large institutions and government manage their short term cash needs. For generation of liquidity, short term borrowing and lending is done by these financial institutions and dealers. Money Market is part of financial market where instruments with high liquidity and very short term maturities are traded. Due to highly liquid nature of securities and their short term maturities, money market is treated as a safe place. Hence, money market is a market where short term obligations such as treasury bills, commercial papers and bankers acceptances are bought and sold.

Money markets exist to facilitate efficient transfer of short-term funds between holders and borrowers of cash assets. For the lender/investor, it provides a good return on their funds. For the borrower, it enables rapid and relatively inexpensive acquisition of cash to cover short-term liabilities. One of the primary functions of money market is to provide focal point for RBI’s intervention for influencing liquidity and general levels of interest rates in the economy. RBI being the main constituent in the money market aims at ensuring that liquidity and short term interest rates are consistent with the monetary policy objectives.

Money Market & Capital Market: Money Market is a place for short term lending and borrowing, typically within a year. It deals in short term debt financing and investments. On the other hand, Capital Market refers to stock market, which refers to trading in shares and bonds of companies on recognized stock exchanges. Individual players cannot invest in money market as the value of investments is large, on the other hand, in capital market, anybody can make investments through a broker. Stock Market is associated with high risk and high return as against money market which is more secure. Further, in case of money market, deals are transacted on phone or through electronic systems as against capital market where trading is through recognized stock exchanges. The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called "paper." This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity. The core of the money market consists of interbank lending--banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

What is Money market?

The money market is the market for short-term (one year or less) credit.


The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames.

What the Money Market does?

The money market, like all financial markets, provides a channel for the exchange of financial assets for money. To meet short-term cash needs

The money market is the mechanism through which holders of temporary cash surpluses meet holders of temporary cash deficits.

Why is such a Market needed?

The money market arises because for most individuals and institutions, cash inflows and outflows are rarely in perfect harmony with each other, and the holding of idle surplus cash is expensive.

To cover the wages and salaries of government employees, office supplies, repairs, and fuel costs as well as unexpected expense.

The Need for a Money Market

• Need for short term funds by Banks.

• Outlet for deploying funds on short term basis .

• Optimize the yield on temporary surplus funds

• Regulate the liquidity and interest rates in the conduct of monetary policy to achieve the broad objective of price stability, efficient allocation of credit and a stable foreign exchange market

Who are the Principal Borrowers and Lenders in the Money Market?



Who Participates in the Money Markets?

1. Central Bank

2. Commercial Banks, Co-operative Banks, Finance, industrial and service companies, Money market mutual funds and Primary Dealers are allowed to borrow and lend.

3. Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders.

4. Individuals, firms, companies, corporate bodies, trusts and institutions can purchase the treasury bills, CPs and CDs.

5. All other financial institutions (investing)

6. Short-term investing for income and liquidity

7. Short-term financing for short and permanent needs

8. Large transaction size and telecommunication network

The Goals of Money Market Investors:

Money market investors seek mainly safety and liquidity, plus the opportunity to earn some interest income.

Because funds invested in the money market represent only temporary cash surpluses and are usually needed in the near future to meet tax obligation, cover wage and salary costs, pay stockholder dividends, and so one. money market investors are especially sensitive to risk.

What kind of risk do investors face in the financial markets?

Market risk – The risk that the market value of an asset will decline, resulting in a capital loss when sold. Also called interest rate risk.

Reinvestment risk – The risk that an investor will be forced to place earnings from a security into a lower-yielding investment because interest rates have fallen.

Default risk – The probability that a borrower fails to meet one or more promised principal or interest payments on a security.

Inflation risk – The risk that increases in the general price level will reduce the purchasing power of earnings from the investment.



Currency risk – The risk that adverse movements in the price of a currency will reduce the net rate of return from a foreign investment. Also called exchange rate risk.

Political risk – The probability that changes in government laws or regulations will reduce the expected return from an investment.


Money market investments cover a relatively narrow range of maturities – one year or less.

Original Maturity- The interval of time between the issue date of a security and the date on which the borrower promises to redeem it is the security

Actual maturity- refers to the number of days, months, or years between today and the date the security


Money market investments cover a relatively narrow range of maturities – one year or less.

Original Maturity- The interval of time between the issue date of a security and the date on which the borrower promises to redeem it is the security

Actual maturity- refers to the number of days, months, or years between today and the date the security

Original maturities on money market instruments range from as short as one day on many loans to banks and security dealers to a full year on some bank deposits and T-bills.

But because there are so many money market securities outstanding, some of which reach maturity each day, investors have a wide menu of actual maturities from which to make their selections.

Depth and Breadth of the Money Market

The money market is extremely broad and deep. It can absorb a large volume of transactions with only small effects on security prices and interest rates.

The money market is also very efficient. Securities dealers, major banks, and funds brokers maintain constant contact with one another through a vast telephone and computer network and are hence alert to any bargains.



Money Market Instruments

Certificate of deposit - Time deposit, commonly offered to consumers by banks, thrift institutions, and credit unions.

It is a short term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in form of a certificate entitling the bearer to receive interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any denomination. They are stamped and transferred by endorsement. Its term generally ranges from three months to five years and restricts the holders to withdraw funds on demand. However, on payment of certain penalty the money can be withdrawn on demand also. The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk. While buying Certificate of Deposit, return method should be seen. Returns can be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more than once in a year, it is beneficial to opt APY over APR.

A certificate of deposit (CD) is an interest-bearing receipt for funds left with a depository institution for a set period of time. True money market CDs are negotiable CDs that may be sold any number of times before maturity and that carry a minimum denomination of $100,000.They were introduced in 1961 to attract lost deposits back into the banking system.

CD interest rates are computed as a yield to maturity (ytm) on a 360-day basis.

Interest income = term in days deposit principal promised ytm 360

In secondary market trading, the bank discount rate (DR) is used as a measure of CD yields.

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

The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions.

Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market.


The Market Structure for Negotiable CDs

Bankers are becoming increasingly innovative in packaging CDs to meet the needs of customers.

New types of CDs include variable-rate CDs, rollover or rolypoly CDs, jumbo CDs, Yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising-rate CDs, and foreign index CDs.

Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

Repurchase transactions, called Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities viz. GOI and State Govt. Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchase agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction. The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. Effectively the seller



of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions.

Under a repurchase agreement (RP), the dealer sells securities to a lender but makes a commitment to buy back the securities at a later date at a fixed price plus interest.

RPs is simply a temporary extension of credit collateralized by marketable securities.

Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months, …) while continuing contracts may be terminated by either party on short notice.

Interest income from RPs = Amount of loan Current RP rate Number of days loaned 360 days

Periodically, RPs are marked to market. If the price of the pledged securities has dropped, the borrower may have to pledge additional collateral.

Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value. 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.

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).


Structure of the Commercial Paper Market:

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

Advantages

Relatively low interest rates

Flexible interest rates - choice of dealer or direct paper

Large amounts may be borrowed conveniently

The ability to issue paper gives considerable leverage when negotiating with banks

Disadvantages

Risk of alienating banks whose loans may be needed when an emergency develops

May be difficult to raise funds in the paper market at times



Commercial paper must generally remain outstanding until maturity - does not permit early retirement without penalty

Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months. Treasury bills (T-bills) are direct obligations of the U.S. government that have an original maturity of one year or less.Tax revenues or any other source of government funds may be used to repay the holders of these financial instruments.They carry great weight in the financial system due to their zero (or nearly zero) default risk, ready marketability, and high liquidity.

Types of Treasury Bills:

Regular-series bills are issued routinely every week or month in competitive auctions with original maturities of three months (13 weeks), six months (26 weeks), and one year (52 weeks).

Irregular-series bills are issued only when the Treasury has a special cash need. These instruments include strip bills and cash management bills.

How Bills Are Sold

T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value.



Bill yields are determined by the bank discount method, which does not compound interest rates and uses a 360-day year for simplicity.

The bank discount rate (DR) on T-bills

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

Because the rates of return on most other debt instruments are not figured in the same way, comparisons with other securities cannot be made directly.

The investment yield or rate (IR) on T-bills

= Par value – Purchase price 365 . Purchase price Days to maturity

Bankers’ Acceptances

It is a short term credit investment created by a non financial firm and guaranteed by a bank to make payment. It is simply a bill of exchange drawn by a person and accepted by a bank. It is a buyer’s promise to pay to the seller a certain specified amount at certain date. The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The person drawing the bill must have a good credit rating otherwise the Banker’s Acceptance will not be tradable. The most common term for these instruments is 90 days. However, they can very from 30 days to180 days. For corporations, it acts as a negotiable time draft for financing imports, exports and other transactions in goods and is highly useful when the credit worthiness of the foreign trade party is unknown. The seller need not hold it until maturity and can sell off the same in secondary market at discount from the face value to liquidate its receivables. 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.

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.


The money market is a wholesale market for funds – most trading occurs in multiples of a million dollars.

The market is dominated by a relatively small number of large financial institutions that account for the bulk of federal funds trading.

Securities also move readily from sellers to buyers through the market-making activities of major security dealers and brokers.

And, of course, governments and central banks around the world play major roles in the money market as the largest borrowers and as regulators. The money market supplies the cash needs of short-term borrowers and provides savers who hold temporary cash surpluses with an interest-bearing outlet for their funds.



Reference:

1. Money and Capital Market

Peter S. Rose Milton H. Marquis

2. Capital Budgeting and long-term Financing Decisions Neil Seitz Mitch Ellison

3. www.investopedia.com/university/moneymarket/ 4. http://en.wikipedia.org/wiki/Money_market 5. http://www.caalley.com/

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