Participants Instruments Money Markets Participants Instruments

Money Markets - Participants & Instruments Remember Money Market instruments implies an original maturity of <= 12 months Securities generally don’t pay a coupon and are sold at a discount 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Market Participants Original lenders & borrowers Households, firms & governments Brokers Don’t always bring two parties together. Often act on behalf of a borrower or lender to get the best deal Issuing House Intermediary who issues new securities on behalf of a borrower Merchant or investment Banks 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Market Participants Market Makers Intermediaries who hold securities and quote buy/sell prices Securities division of major banks Arbitrageurs Buy and sell to make a profit from pricing anomalies As you know these anomalies disappear quickly Move large quantities of money to make profit 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Market Participants Speculators Takes a position hoping to beat the market Unlike arbitrageurs, speculators take on a risk Hedgers Buys or sells instruments to avoid a risk For example an importer entering a contract today to take deliver of foreign currency at a point in the future 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments The City of London has two broad classifications of Money Markets Traditional Market The Discount Market Parallel Market Interbank Market Certificate of Deposit Market Gilt & Repo Market Local Authority Market Eurocurrency Markey 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments The Markets Volumes are large and a small variation can result in a large monetary swing Therefore interest rate changes are usually quoted in basis points One basis point = one hundredth of one percent Like stock markets there is:- A primary market Where borrowers raise money A secondary market Where investors can trade existing securities 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Common MM Securities Treasury Bills No coupon, sold at discount to par value Short maturities – eg 4, 13, 26 week Commercial Paper Finance inventory and accounts receivable High min denomination Only reputable companies can sell No coupon – sold at a discount Discount often depends on ratings agency rating Limited secondary market 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Common MM Securities Negotiable Certificates of Deposit Certificates issued by large commercial banks and other depository institutions as a short term source of funds Secondary market exists Repurchase Agreements Interbank Markets EURIBOR, LIBOR, Federal Funds (US) Bankers Acceptance 2nd Feb 2012 Money Markets - Participants & Instruments

Repurchase Agreements In a repo one party sells securities with an agreement to buy back at a future date and price Why? In essence a loan backed by the security Gov paper, commercial paper, or NCD In a reverse repo, one party buys a security with an agreement to sell back on a future date at an agreed price Can be same transaction but from different perspective 2nd Feb 2012 Money Markets - Participants & Instruments

Repurchase Agreements Repo market is approx $4.5 trillion Transaction amounts usually >= $10million Maturities -> 1 to 15 days, 1, 3, 6 months Secondary market does not exist Usually firms borrow for minimal period and refinance using new repos if they still have a financing need at maturity Brokers and repo dealers arrange transactions Or some large companies have in house teams Firms can be borrowers at one stage and lenders at another time 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Bear Stearns Large securities firm that relied on repo’s to raise finance Used mortgage backed securities as collateral in the repurchase agreements During credit crisis in 2008, uncertainty surrounding mortgage securities mean Bear Stearns couldn’t raise finance Almost collapsed, but US govt. bailed out Collateral must be trusted by the market! 2nd Feb 2012 Money Markets - Participants & Instruments

Repurchase Agreements Yield Repo rate is determined by the difference between selling price and agreed repurchase price, annualized with a 260 day year 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Bankers Acceptance Bank accepts responsibility for future payment Used to guarantee payment in international trade Essentially a draft that bank guarantees to pay Exporter can hold the acceptance until maturity date receive payment But frequently they need the money sooner, so they sell at a discount Investor makes return on the difference between the repayment amount and the discounted price paid. 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Bankers Acceptance Maturities typically range between 30 and 270 days There is a default risk associated with banks so the yield is typically higher than treasury bills An active secondary market exists Dealers match buyers and sellers Spread of between 1/8% and 7/8% 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Sequence of Events Example – US imported of Japanese goods Importer places a purchase order Exporter will probably seek payment up front if they are unfamiliar with the importer Importer will not agree to that Compromise with Banker’s Acceptance Importer asks their bank to draw up a letter of credit Commitment by bank to back the payment to the importer 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Sequence of Events LC presented to exporters bank (bank to bank) This bank in turn informs the exporter Exporter ships goods.. And shipping documents to it’s bank These are then passed to importer’s bank At this point bankers acceptance is created, which obligates the importers bank to make a payment to the bearer at a specified future date. 2nd Feb 2012 Money Markets - Participants & Instruments

Money Markets - Participants & Instruments Bankers Acceptance The BA allows the importer to receive the goods without having to pay up front Exporter can receive payment earlier than normal by selling the acceptance (at a discount) Risk to investor is similar to NCD Though the exporting firm also backs the asset, so the perceived risk is slightly lower 2nd Feb 2012 Money Markets - Participants & Instruments