Chapter 14 The Money Market

Learning Objectives To specify the important features of money markets. Define the money market instruments by category. Calculate the taxable-equivalent yield, yield from dividend capture, discount yield, coupon-equivalent yield, and effective annual yield. Specify types of investment risk and their effects on yields. To understand yield curves and the theories that explain them.

Nature of the Money Market Primary and secondary markets Wholesale and retail markets Money market interest rates Tax status Market mechanics and intermediaries

Money Market Instruments Bank instruments Corporate instruments Federal Government instruments State and local instruments Mixed instruments

Bank Instruments Instrument Denomination Maturity Risk Certificates of Deposit Primary: $100,000 + 7 days to * FDIC Secondary: $2-$5m 8 years * Fixed mat. *Expro risk of Time deposits Minimum set by 1 day to 3 Eurodollar bank months deposits Bankers Acceptances $500,000 to $1m Up to 270 * Bank secured days * 2ndary mkt Loan participations Varies 1 day to * Most have 3 years guarantor * Illiquid Securitized assets such Varies 1 year to * Diversified as auto loans, etc. 3 years portfolio

Corporate Instruments Instrument Denomination Maturity Risk Commercial paper Primary: $100,000 + 1 to 270 days * Usually low Secondary: $5m * Backup line * Liquidity function of issuer Floating-rate notes Primary: $1,000-$100,000 9 months to * Function of Secondary: $5 million 30 years issuer Common or No typical No maturity *Function of preferred stock days issuer * Function of market

Federal Government Instruments Instrument Denomination Maturity Risk Treasury bills Primary: $10,000+ 3,6,12 months *No default risk *Some interest rate risk Treasury notes/bonds 2-yr notes: $5,000 Notes:2-5,7,10 yrs *No default 5-,7-,10-yr notes Bonds: >10 yrs *Interest rate and bonds: $1,000 risk Government agencies Primary: $1,000 Varies * Low default Secondary: larger * Sporadic liq. * Interest rate risk function of maturity * Event risk

State and Local Government Instruments Instrument Denomination Maturity Risk Anticipation notes Primary: $5,000 Few weeks to * Low default Secondary: $100,000 several years risk * Liq. depends on dealer * Interest rate risk function of maturity VRDNs Primary: $5,000-$100,000 30 years with * Low default Secondary: $100,000 put. Interest and liq. risk rate reset * Low liquidity risk due to rate reset Tax-exempt CP Primary: $50,000-$100,000 Few days to * Same risk as Secondary: $100,000 several years anticipation

Mixed Instruments Instrument Denomination Maturity Risk MMMFs $10,000 for institutions 25-60 days * No FDIC * No liquidity risk * No interest rate risk Repurchase Agreements Typical: $1 million Mostly overnite * Depends on Term RPs institution generally 3 wks * Linked to collateral * Some liq risk * Event risk Sweep accounts None Overnight * Depends on institution

Money Market Rate Calculations D 365 Ycap = ------ x ------ Dividend capture yield (14.2) P n Ycap [1 - (.30 x T)] Ycap-te = --------------------- Tax-equivalent yield (14.3) (1 -T) Where: .30 is related to the dividend exclusion T is the investors marginal tax rate D is the dividend P is the security price n is the holding period

Money Market Rate Calculations FV - P 360 Yd = ------------ x ------- Discount yield (14.4) FV n FV - P 365 Yce = ----------- x ------- Coupon-equivalent yield (14.5) P n

Term Structure Theories What explains the shape of the yield curve? Yield,% Time to Maturity

Term Structure: Unbiased Expectations The prevailing yield curve is derived from the present short-term rate and expectations for rates that will exist in the future. (1+tRn) = [(1+tR1)(1+t+1r1,t)(1+t+2r1,t)......] 1/n Thus, long-term rates are higher than current short-term rates if future short-term rates are expected to be higher than current short-term rates...and long-term rates fall below current short-term rates if future expected short-term rates are expected to be less than the current level of short-term rates.

Term Structure: Liquidity Preference Preference for liquidity is thought to characterize enough investors that the yield curve (in absence of expectations or other influences) should slope upward from left to right. The longer the maturity, the higher the premium demanded by investors. Yield,% Yield, % Liquidity Premium Time to Maturity

Term Structure: Segmentation hypothesis Instead of being close substitutes, securities with short, medium, and long maturities are seen by investors (fund suppliers) and issuers (fund demanders) as quite different. The markets are thus separated, or segmented, by the self-limiting behavior of institutions staying within their preferred habitats.

Term Structure: Biased expectations A combination of the unbiased expectations theory and the liquidity preference hypothesis.

Risk Structure of Interest Rates Default risk Liquidity risk Interest rate risk Reinvestment rate risk Event risk Foreign exchange and political risk

Risk-Return Assessment in Practice Yield spread analysis Safety ratings Assessing liquidity risk

Summary We surveyed the menu of short-term investment alternatives Investment objectives: corporate investors rank safety first, followed by liquidity and then yield. We learned how to calculate various money market rates of return We studied possible explanations for the shape of the yield curve We concluded with a discussion of the risk structure of interest rates