6
Money
Markets
© 2003 South-Western/Thomson Learning
Chapter Objectives Provide a background on money market
securities Explain how institutional investors use money
markets Explain the globalization of money markets
Money 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
4
Money Market Securities
Treasury Bills Commercial paper Negotiable certificates of deposits Repurchase agreements Federal funds Banker’s acceptances
Money Market Securities 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
Money Market Securities
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
Money Market Securities
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
Money Market Securities 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
Money Market Securities 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)
=
Money Market Securities T-bill yield for a newly issued security
Par – PP
PP
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
n = number of days to maturity
T-bill discount =
Money Market Securities
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
Money Market Securities 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
Money Market Securities Estimating commercial paper yields (same as t-bill)
YCP
Par – PP
PP
360
n
YCP = Commercial paper yield
Par = Face value at maturity
PP = Purchase price
n = number of days to maturity
=
Money Market Securities
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)
Money Market Securities 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
Money Market Securities
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
Money Market Securities Estimating repurchase agreement yields
Repo RateSP – PP
PP
360
n
Repo Rate = Yield on the repurchase agreement
SP = Selling price
PP = Purchase price
n = number of days to maturity
=
Exhibit 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
(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
Money Market Securities
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
Money Market Securities
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
21
Major 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
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Valuation 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 6.7InternationalEconomicConditions
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
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Interaction Among Money Market Yields 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
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Globalization 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
Globalization of Money Markets 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
Globalization of Money Markets Performance of international securities Yield for an international investment Yf
SPf – PPf
PPf
Yf = Foreign investment’s yield
SPf = Investment’s foreign currency selling price
PPf = Investment’s foreign currency purchase
=
Globalization of Money Markets The exchange rate effect (%ΔS) measures the
percentage change in the spot during the investment period
% ΔS measures the expected percent change in the currency Currency appreciated, % ΔS is positive and adds to net yield Currency depreciated, % ΔS is negative and reduces net yield
111 )%()( SYY fe