Chapter 5 Domestic and International Money Markets Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Money Market Money Market Instrument: They are defined as securities that when issued have a year or less to maturity. Money Market: A market that trades money market instruments involving transfer of funds for less than a year. Instruments: Treasury bills, Commercial paper, Bankers’ Acceptances, Certificate of Deposit, Eurocurrency Deposits Money market has two interrelated parts. The Domestic Money Market deals with short-term domestic currency deposits/loans that are held in the country of issue. International Money Market consists of national currencies that are held on short-term deposit in countries other than the country issue of the currency. Offshore Market - Eurocurrency Market Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Types of Domestic Money Market Instruments There are a number of domestic short-term money market instruments that vary in their degree of riskiness, return and liquidity. Domestic Treasury bills provide the basis for all other short-term interest rates. Interest rate is often expressed as basis points. One basis point=(1/100) of a percent i.e. 0.01% Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Treasury Bills Treasury bills are issued by the treasury of the country concerned. Characteristics Risk free instruments as the government guarantees to pay their face value upon maturity. Highly liquid instruments with a well developed secondary markets Discount security - upon issue the security is sold at a discount to its face value. The size of the discount will be a determinant of the yield on holding the Treasury bill. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Treasury Bills The current yield on a Treasury bill (assuming a 360 day year convention): y: annualized yield D: discount to face value P: current market price t: number of days remaining to maturity Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Treasury Bills Example Six month (180 day) Treasury Bill with a face value of $100 is sold at $95. The current yield is: Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Commercial Paper Unsecured promissory note issued by a corporation into the money market. The issuer promises to pay purchasers of the issue the face value of the paper which is sold at a discount. It usually has 270 days or less duration. It is sold as a discount to its face value. It does not need to be registered with the Securities Exchange Commission. Issuers of commercial paper are given credit ratings by credit-rating agencies. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Interbank Market Commercial and investment/merchant banks as well as other non-bank financial intermediaries can lend and borrow money with each other. A short term market with most loans ranging from overnight to 14-day loans . The key rate of interests are: $LIBOR, £ LIBOR, €LIBOR, Note there is 1 week, 1 month, 3 month , 6 month and 12 month LIBOR rates for these currencies. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

LIBOR & Treasury Bills There is a high correlation between LIBOR and the rate of interest prevailing in the Treasury bill market. LIBOR is usually marginally higher and more volatile than the Treasury bill market since all loans are unsecured. Example: If banks have a surplus of funds they tend to buy Treasury bills, leading to a lower rate of interest in the Treasury bill market, this means fund will then then tend to be diverted to the interbank market so lowering LIBOR. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Banker’s Acceptance It is simply a financial instrument that facilitates a commercial trade transaction. It is a short term draft by a company to pay a certain sum of money in the future. It is guaranteed for payment by a bank once it has been stamped ‘accepted’ and can thereafter be traded on the secondary markets at a discount to its face value. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Repurchase Agreement (REPO) It involves the sale of a security with a commitment by the seller to repurchase the security as a specified price at a future date. It is a collateralized loan with the seller handing over the security as collateral. Haircut on the REPO: The difference between the current market price of the security and the lower price at which it is sold. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Certificate of Deposits (CDs) A Certificate of Deposit (CD) is issued by a deposit-taking institution, usually a bank, to acknowledge that a specified sum of money has been deposited with the institution. They have two forms: Negotiable CD: can be sold by the initial depositor on the open market before maturity. Non-negotiable CD: must be held by the depositor until maturity. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The International Money Market-Euromarkets Eurocurrency markets are defined as banking markets which are conducted outside of the legal jurisdiction of the authorities of the currency that is used for banking transaction. Example: Eurodollar deposits/loans are short term dollar deposits or loans made outside of the United States eg: London or Paris . Example: Eurosterling deposits/loans are pound deposits or loans made outside of the United Kingdom eg: held in Caribbean. Eurodollar accounts for approximately 65 % of all Eurocurency activity Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The gross size of the Eurocurrency market in selected years Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Characteristics of the Eurodollar Market Centres for Eurobank activity: London, Paris, Luxembourg & Frankfurt Offshore Banking Centre: Bahrain, The Bahamas, The Cayman Islands, Hong Kong, Panama, Netherland Antilles, Singapore, North American & Japan. Main users: Eurobanks, non-Eurobanks, financial institutions, multinational corporations, international institutions, central and local government. Pivotal rate of interest: LIBOR Keith Pilbeam ©: Finance and Financial Markets 4th Edition

TED SPREAD TED Spread= 3 month dollar LIBOR- 3 month US Treasury Bill Ex: 3 month dollar Treasury bill: 4.20%, 3 month $LIBOR: 4.50% TED Spread=4.5%-4.2%=30 basis points Increase in the TED is the sign of Funding become more difficult in the interbank market Banks become more distrustful of each other Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The TED spread in basis points Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Comparative Advantage of Eurobanks The Eurobanks pay a higher rate on deposits and charge lower rate for loans than US banks for similar facilities. The reasons: Unlike domestic banks Eurobanks are free of regulatory control Eurobanks benefit from economies of scale Eurobanks avoid much of the personnel expense, administration costs The Eurobanks business is highly competitive internationally with relatively easy entrance requirements compared to domestic ones this drives up deposit rates and drives down loan rates Eurobanks do not have to pay deposit insurance whereas US banks have to deposit their insurance with Federal Deposit Insurance Corporation(FDIC) Eurbank lending is almost exlusively to high quality customers with a negligible default rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 5.2 Comparison of Eurodollar deposit and loan rates with US banking deposit and loan rates Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The creation of Eurobanking activity Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Syndicated Loans It is one of the most important forms of bank lending. It is a loan made by a syndicate of banks into a single borrower. Floating rate of interest based on a spread over LIBOR with the rate adjusted once every 6 to 12 months to reflect changes in LIBOR. Usually 3 to 8 years maturity Advantages: The opportunity for a bank to participate in a number of such loans allowing it to loan out large sums of money and diversify its loan book at relatively low cost. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Euronotes Euronotes are basically short-term borrowing market made up of three types of issue: Note-Issuing Facilities (NIFs): The original Euro-notes were note-issuing facilities underwritten by syndicate of banks with medium-term. Eurocommercial paper: Short-term borrowing, usually less than 9 months, that is not underwritten by syndicates of banks. Euro medium-term notes (EMTNs): These note issues are above 9 months and less than 10 years. It is an increasingly popular means of raising finance for companies over the traditional bond market. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Global market syndicated loans Keith Pilbeam ©: Finance and Financial Markets 4th Edition