Copyright 2014 Diane Scott Docking The Money Market Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Learning Objectives Define money markets Identify the major types of money market securities Examine the process used to issue Treasury securities Copyright 2014 Diane Scott Docking

The Money Markets Defined The term “money market” is a misnomer. Money (currency) is not actually traded in the money markets. The securities in the money market are short term with high liquidity; therefore, they are close to being money. Copyright 2014 Diane Scott Docking

Money Market Securities’ Characteristics Maturity of ___________________from their ________ date. Large primary market focus Secondary market for securities Money market securities are usually sold in large denominations. They have low default risk. Copyright 2014 Diane Scott Docking

Money Market Instruments Treasury Bills Federal Funds Repurchase Agreements Commercial Paper Negotiable Certificates of Deposit Banker’s Acceptance Eurodollars Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Treasury Bills Issued to meet the short-term needs of the ________________ Standard Original Maturities of 4 weeks, 13 weeks (three month), 26 weeks (six month), or 52 weeks Denominations are $1,000; typical round lot is $5 million Virtually default risk free Interest earned is at state and local government level. http://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm Copyright 2014 Diane Scott Docking

Treasury Bills (continued) security do not make periodic interest payments. Instead, the security holder receives interest at the maturity date, the interest being the difference between face value (maturity value or par value) and the purchase price. Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking T-Bill Quote Example: As of June 9, 2014: Maturity Bid Asked Chg Asked Yield 12/11/2014 0.045 0.040 0.005 0.041 Quote is end of day 6/9/2014, assume 2 days to settle (this can vary) so day 1 = 6/11/2014…12/11/2014 is last trading day. So 184 days to maturity. http://online.wsj.com/mdc/public/page/2_3020-treasury.html?mod=wsj_mdc_additional_interestrates Bond Equivalent Yield Discount Rate Change from yesterday’s closing Asked Quote Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Bid & Ask Facts - what dealers will pay for security (or what investors can sell it for) - what dealers will sell security for (or what investors can buy it for) - is the dealers profit or markup Bid price Ask price Spread is in T-Bill market because market is so deep Bid-ask quotes for T-bills are bid yields and ask yields - Bid yields Ask yields - As yields , prices Copyright 2014 Diane Scott Docking

Calculating Yields/Prices on U.S. Treasury Bills Treasury bills are priced on a discount rate basis, idy or DR, is: Copyright 2014 Diane Scott Docking

Calculating Yields/Prices on U.S. Treasury Bills The Wall Journal lists T-Bill yields on a bond equivalent basis (asked yield) The effective annual return/rate Relationship between DR and Asked Yield (ibey): Copyright 2014 Diane Scott Docking

Wall Street Journal Example: Cost to buy $1,000,000 of T-bills: Asked Yield calculation: Effective Return calculation: Copyright 2014 Diane Scott Docking

Problem: Calculating the T-bill rates You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? Asked Yield? Effective Annual Return? Copyright 2014 Diane Scott Docking

Solution to Problem: Calculating the T-bill rates What is its discount rate? where F = face, P = price, and n = days to maturity Copyright 2014 Diane Scott Docking

Solution to Problem: Calculating the T-bill rates What is its ask yield (or bond equivalent yield)? where F = face, P = price, and n = days to maturity Copyright 2014 Diane Scott Docking

Solution to Problem: Calculating the T-bill rates What is its effective annual return? Copyright 2014 Diane Scott Docking

T-Bill Auction Noncompetitive Bidding All non-competitive bids accepted. Specify quantity only. Maximum bid . Price is the competitive auction yield price. Noncompetitive Bidding Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking T-Bill Auction Competitive Bidding Specify price (as a yield %) and quantity desired. Minimum purchase $100 Single price auction used since 1998 Treasury accepts highest bids prices (lowest bid yields) Maximum amount sold to any one buyer is 35% of offering amount Copyright 2014 Diane Scott Docking

Treasury Bill Offering Copyright 2014 Diane Scott Docking http://www.treasurydirect.gov/instit/annceresult/press/preanre/2014/A_20140123_4.pdf#page=1&zoom=auto,0,761

Treasury Bill Auction Results Copyright 2014 Diane Scott Docking http://www.treasurydirect.gov/instit/annceresult/press/preanre/2014/R_20140127_2.pdf

T-Bill rates vs. Inflation Copyright 2014 Diane Scott Docking

Example of a T-Bill Auction The Treasury is auctioning off $120 million in 13-week (91 day) T-bills. The following bids are received: Noncompetitive bids: $10 million Competitive bids: Alpha Institution $42 mill. 4.000% bid yield Delta Institution $10 mill. 4.200% bid yield Gamma Fund $20 mill. 4.250% bid yield Beta Fund $18 mill. 4.110% bid yield Epsilon Fund $40 mill. 4.200% bid yield Chi Institution $10 mill. 4.125% bid yield Copyright 2014 Diane Scott Docking

Example of a T-Bill Auction (cont.) Which institutions will have their bids filled? By how much? What is the “stopout rate” or “stop yield” or “high yield”? What was the price paid by the winning bidders? What is the $ amount of the funds received by the Treasury? What is the bank equivalent yield (i.e. ask yield)? What is the Treasury’s annualized interest cost from this auction (i.e., effective yield)? Copyright 2014 Diane Scott Docking

Example of a T-Bill Auction (cont.) 1. Maximum bid amount = 35% x $120 million = $42 million Amount available after non-competitive bids of $10 mill. filled = $110 million 2. 3. Bidder Bid Price $ Amount Bid Running Balance Alpha 4.000% Beta 4.110% Chi 4.125% Delta 4.200% Epsilon Gamma 4.250% Copyright 2014 Diane Scott Docking

Example of a T-Bill Auction (cont.) Treasury receives: Ask Yield: Effective Yield: or Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Federal Funds lending and borrowing Fed district bank debits and credits accounts for purchase (borrowing) and sale (lending) Fed Funds _______________________- this is a bank liability. Fed Funds _____________ - this is a bank asset. Usually $5 million or more Federal funds rate usually slightly higher than T-bill rate Fed Funds target vs. Actual FF rate Current FF target: http://www.frbdiscountwindow.org/ Effective FF rates: http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm Copyright 2014 Diane Scott Docking

Repurchase Agreements (Repo) Bank Financing – Source of funds – a bank liability “Security sold under agreement to repurchase” at given price in future. Reverse Repo Bank Investment/Loan – Use of funds – a bank asset “Security purchased under agreement to resell” at given price in future. Copyright 2014 Diane Scott Docking

Repurchase Agreements (cont.) Negotiated market rate. Over telecommunications network Dealers and brokers used or direct placement No secondary market Rate is lower than the fed funds rate, since it is backed up by a security. Used by: Federal Reserve in open market operations. Government securities dealers to secure funds to invest in new Treasury issues. Banks to secure funds to meet temporary liquidity needs as well as lend funds when they have excess reserves. Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Estimating Repo Rate For Repurchase agreements: Prepo= Repurchase price of security, which equals selling price plus interest P0= Sales price of the security N=number of days to maturity Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Example: Reverse Repurchase Agreement (Aka: Securities Purchased Under Agreement to Resell) Bank buys a security from a customer for $100,000 with the agreement to sell it back to customer for $101,000 within 90 days. Bank takes possession and title of security In effect, a loan with collateral Bank accounting entries: Dr) Reverse Repurchase Agreements $100,000 Cr) Cash $100,000 . . . Dr) Cash $101,000 Cr) Reverse Repurchase Agreements $100,000 Cr) Interest Revenue 1,000 Repo Rate: Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Example: Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase) Bank sold its own security to a dealer/bank for $100,000 with the agreement to repurchase it within 90 days for $101,000. The value of the securities that the bank sold was $120,000. Bank releases possession and title of security In effect, a bank debt with security used collateral Bank accounting entries: Dr) Cash $100,000 Cr) Repurchase Agreement $100,000 Dr) Securities Sold Under Repo $120,000 Cr) AFS Securities $120,000 ….. Dr) Repurchase Agreement $100,000 Dr) Interest Expense 1,000 Cr) Cash $101,000 Dr) AFS Securities $120,000 Cr) Securities Sold Under Repo $120,000 Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Repurchase Agreement (Aka: Securities Sold Under Agreement to RePurchase) Bank sold its own security to a dealer/bank with the agreement to repurchase it within so many days (say 90 days). Repo Rate: Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Commercial Paper Alternative to bank loan Short-term debt instrument Initial maturities ____________ days Usually ___________ days. Used only by well-known and creditworthy firms ________________ Credit ratings important Minimum denominations of $100,000 Placement Directly by a sales force of the borrowing firm. Indirectly through dealers. Not a large secondary market (generally held to maturity) Sold at a discount from par – just like T-bills. Copyright 2014 Diane Scott Docking

Commercial Paper Rates vs. Prime Rates Copyright 2014 Diane Scott Docking

Commercial Paper Volume (M&E, 7 ed., Ch. 11) Copyright 2014 Diane Scott Docking

Commercial Paper (continued) Directly-Placed Versus Dealer-Placed Paper Commercial paper is classified as either directly placed paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary dealer-placed instruments are when the issuer uses the services of a security firm to sell its paper Copyright 2014 Diane Scott Docking

Negotiable Certificates of Deposit Development of the CD Market Issued by Citibank in 1961. Offset declining demand deposits as a source of funds. CD Issuers Money center banks and large regional banks are the primary issuers of domestic CDs Copyright 2014 Diane Scott Docking

Negotiable Certificates of Deposit Characteristics of Negotiable CDs Large denomination time deposit, less than six month's maturity. minimum is ______ days most are less than _________ Negotiable - may be sold and traded before maturity. Primary market - denominations of at least $100,000. Secondary market - $1 million or more. Issued at face value with coupon rate. Interest computed on a 360 day year. Rate negotiated between buyer and seller. Rates higher than on T-Bills higher credit risk, lower marketability and higher taxability. Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking

Example 5-9 in text: Negotiable Certificates of Deposit Q1: A bank has issued a 6-month (182 day), $1 million NCD with a 0.72% annual interest rate. How much will the NCD holder receive at maturity? A: Copyright 2014 Diane Scott Docking

Example 5-9 in text: Negotiable Certificates of Deposit Q2: Immediately after the CD is issued, the secondary market price falls to $999,651. What is the new yield on the CD? A: 𝑖= 360 𝑛 𝐹𝑉 𝑃𝑉 −1 = 360 182 1,003,640 999,651 −1 = 0.7893% Copyright 2014 Diane Scott Docking

Example 5-9 in text: Negotiable Certificates of Deposit Q3: After the price drop, what is the EAR on the NCD? A: Copyright 2014 Diane Scott Docking

Negotiable CD Rates (M&E, 7ed., Ch. 11) Copyright 2014 Diane Scott Docking

Comparing Money Market Securities : A comparison of rates Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Bankers' Acceptances Time draft Drafts are drawn on and/or accepted by commercial bank. Direct liability of bank. Mostly relate to international trade. Secondary market - dealer market. Discounted in market to reflect yield. Standard maturities of 30, 60, 90 days –270 days max. Copyright 2014 Diane Scott Docking

Exhibit: Bankers Acceptance (see chart next page) Importer (U.S.) places P.O. for goods. Exporter (Japan) demands payment before shipment. So, Importer asks American Bank to issue a Letter of Credit. American Bank presents LOC to Japanese Bank. Japanese Bank notifies Exporter that they have a LOC and okay to ship. Exporter ships goods. Exporter sends shipping documents and Time Draft (like an invoice) to Japanese Bank. Japanese Bank sends shipping documents and Time Draft to American Bank. American Bank “stamps” Draft as “accepted” and a BA is created. American Bank will pay owner of BA (i.e. the Draft) so many $ in n-days. American Bank returns BA to Japanese Bank who gives it to Exporter. Exporter can sell BA at its current discounted PV or hold it until maturity. At maturity of BA, Importer pays American Bank, who pays holder of BA. Copyright 2014 Diane Scott Docking

Exhibit: (Bankers Acceptance) Importer 1 Purchase Order Exporter Shipment of Goods 5 10 B/A sent to Exporter who keeps or sells it 2 L/C (Letter of Credit) Application 6 Shipping Documents & Time Draft 4 L/C Notification American Bank (Importer’s Bank) Japanese Bank (Exporter’s Bank) AB pays holder of B/A at maturity 11 L/C 3 B/A created 8 Shipping Documents & T ime Draft Draft Accepted (B/A Created) 7 Copyright 2014 Diane Scott Docking B/A sent to Japanese Bank 9

Banker’s Acceptance Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Eurodollars Deposits of U.S. dollars in banks located outside the U.S. London interbank bid rate (LIBID) The rate paid by banks buying funds London interbank offer rate (LIBOR) The rate offered for sale of the funds (rate paid on ED) Time deposits with fixed maturities Largest short term security market in the world No reserve requirements at banks outside U.S. Copyright 2014 Diane Scott Docking

Copyright 2014 Diane Scott Docking Comparing Money Market Securities: Money Market Securities and Their Depth Copyright 2014 Diane Scott Docking