Chapter Five Money Markets McGraw-Hill/Irwin

Money Markets Liquid funds flow between short-term borrowers and lenders through money markets Money markets involve debt instruments with original maturities of one year or less Money market debt issued by high-quality (i.e., low default risk) economic units that require short-term funds purchased by economic units that have excess short-term funds low rates of return Money market instruments have active secondary markets which provides liquidity

Money Market Yields Money market securities use special rate quoting conventions: Discount yields (idy): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of redemption price or face value Single payment yields (ispy): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of purchase price Both may be converted to a bond equivalent yield (ibey) for comparison with bonds Note that ibey is an APR.

Money Market Yields Treasury bills and commercial paper are bought and sold on a discount basis Discount yields (idy) use a 360-day year Pf = the face value of the security P0 = the discount price of the security h = the number of days until maturity

Money Market Yields Compare discount securities to U.S. Treasury bonds with bond equivalent yields (ibey) Convert bond equivalent yields into effective annual returns (EAR)

Example: T-Bill Face value = $10,000; Maturity = 73 days; Sells for $9,800 Discount yield: Period yield = (10,000-9,800)/10,000 = 2% Annualized = 2% x 360/73 = 9.863% Bond Equivalent Yield: Period yield = (10,000 – 9,800)/9,800 = 2.0408% Annualized = 2.0408% x 365/73 = 10.2041% Effective Annual Yield: = (1 + 2.0408%)365/73 - 1 = 10.6292%

Money Market Yields Money market securities (Negotiable or jumbo)CDs and fed funds that pay interest only at maturity use single-payment yields (ispy) (e.g., jumbo CDs and fed funds) since ispy uses a 360 day year, compare to bonds by converting to a 365 day year to directly convert a single-payment yield to an effective annual return

Example: CD Yield Face: 10,000; maturity 73 days; pays 6% Interest for the period = 6%x73/360=1.22% or $ 21.67 Bond Equivalent Yield: = 6% x 365/360 = 6.0833% Effective Annual Yield Note: no of periods/year = 365/73 = 5 = (1 + 1.22%)5 - 1 = 6.2332%

Money Market Yields Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (ispy) to convert a single-payment yield to a bond equivalent yield: to directly convert a single payment yield to an EAR:

Sample Calculations of Money Market Yields A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the commercial paper: The bond equivalent yield for the commercial paper is 2.038%

Sample Calculations of Money Market Yields A $1M investment in 90 day commercial paper has a 2% discount yield and an equivalent size and risk 90 day CD has a 2% single payment yield. Which security offers the better return? For the CD: The bond equivalent yield for the CD is 2.0278% The commercial paper has the better return since its bond equivalent yield is 2.038%

Money Market Instruments Treasury bills (T-bills) Federal funds (fed funds) Repurchase agreements (repos or RP) Commercial paper (CP) Negotiable certificates of deposit (CD) Banker acceptances (BA)

Treasury Bills (T-Bills) T-Bills are short-term debt obligations issued by the U.S. government The Federal Reserve buys and sells T-bills to implement monetary policy T-bills are virtually default risk free, are highly liquid, and have little interest rate risk Strong international demand for T-bills as safe haven investment

T-Bill Auctions 13- and 26-week T-bills are auctioned weekly Bids are submitted by government securities dealers, financial and nonfinancial corporations, and individuals Bids can be competitive or noncompetitive competitive bids specify the bid price and the desired quantity of T-bills noncompetitive bidders get preferential allocation and agree to pay the lowest price of the winning competitive bids

T-Bill Auctions T-Bill Auctions Noncompetitive Bids Bid Price 1 SC ST 2 3 4 5 6 Stop-out price (PNC) 7 Quantity of T-bills

The Secondary Market for T-Bills The secondary market for T-bills is the largest of any U.S. money market instrument 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market primary dealers trade for themselves and for customers T-bill purchases and sales are book-entry transactions conducted over Fedwire T-Bills are sold on a discount basis

Transaction Between Primary Dealers J.P. Morgan Chase Sell $10 million in T-Bills Lehman Brothers Buy $10 million in T-Bills Interbank Transaction Fedwire Fedwire Federal Reserve Bank of NY Transfers $10 million from Chase to Lehman Transaction Recorded in Fed’s Book Entry System

Purchase by Individual Buy $50,000 in T-Bills Local Bank or Broker Primary Dealer JP Morgan Chase Sells $50,000 in T-Bills FRBNY -$50,000 in T-Bills from JP Morgan + $50,000 in T-Bills to Individual Fedwire Wire Transfer Engraved T-Bill

T-Bill Prices T-Bill prices can be calculated from quotes (e.g., from The Wall Street Journal) by rearranging the discount yield equation Or by rearranging the bond equivalent yield equation

Example: T-Bill Prices 30 days TB, Face value=$10,000, sells at 6% Price? = $10,000 - $10,000 x 6% (30/360) = $9,950

Federal Funds The federal funds (fed funds) rate is the target rate in the conduct of monetary policy Fed fund transactions are short-term (mostly overnight) unsecured loans Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Fed funds are single-payment loans and thus use single-payment yields Multimillion dollar loans may be arranged in a matter of minutes

FEDERAL FUNDS TRANSACTIONS J.P. Morgan Chase Lends (Sell) $75 million in Federal Funds Bank of America Borrows (Buy) $75 million in Federal Funds FRBNY Today: Takes $75 mil. From reserve account of JPM ------------------------------ Tomorrow: Adds $75 mil. plus one day’s interest to JPM account FRB of San Francisco Today: Adds $75 mil. To reserve account of BOA ------------------------------ Tomorrow: Takes $75 mil. plus one day’s interest from BOA account Fedwire Fedwire

Repurchase Agreement A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities) Similar to a fed fund loan, but collateralized Funds may be transferred over FedWire system If collateralized by risky assets, the repo may involve a ‘haircut’

Repurchase Agreement Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations A reverse repurchase agreement is the opposite side of a repo (i.e., it is the purchase of a security with an agreement to sell it back in the future) The repo rate is typically lower than the Fed funds rate because repos are collateralized loans.

Repurchase Agreement The yield on repurchase agreements (iRA) uses a 360-day year like the discount rate, but uses the current price in the denominator like the bond equivalent yield Pf = the repurchase price of the security P0 = the selling price of the security h = the number of days until the repo matures

Repurchase Agreement J.P. Morgan Chase Buys $75 million Repo Bank of America Sells $75 million Repo FRBNY Today: $75 mil. reserve account of JPM + $75 mil to T-Bill account of JPM ------------------------------ Tomorrow: + $75 mil. plus one day’s interest to JPM reserve a/c - $75 mil to T-Bill account of JPM FRB of San Francisco Today: +$75 mil. reserve account of BOA - $75 mil to T-Bill account of BOA ------------------------------ Tomorrow: - $75 mil. plus one day’s interest to BOA reserve a/c + $75 mil to T-Bill account of BOA Fedwire Fedwire

Commercial Paper Commercial paper (CP) is the largest money market in terms of dollars outstanding CP is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital) Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time) CP is usually held by investors until maturity and has no active secondary market Yields are quoted on a discount basis (like T-bills)

Asset-Backed Commercial Paper A type of commercial paper that is backed by assets of the issuing firm Grew very rapidly prior to the financial crisis peaking at $2.16 trillion, much of it was backed by mortgage investments The market collapsed during the financial crisis

Negotiable Certificate of Deposit A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date CDs are bearer instruments and thus are salable in the secondary market Denominations range from $100,000 to $10 million; $1 million being the most common Often purchased by money market mutual funds with pools of funds from individual investors

Banker’s Acceptance A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank Used in international trade transactions to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) Foreign exporters prefer that banks act as payment guarantors before sending goods to importers Banker’s acceptances are bearer instruments and thus are salable in secondary markets

Creation of a Banker’s Acceptance Purchase order sent by U.S. buyer to Chinese seller Chinese seller requests a letter of credit Notification of letter of credit and draft authorization Order shipped Time draft and shipping papers sent to Chinese seller’s bank Time draft and shipping papers sent to U.S. bank; banker’s acceptance created Payments sent to foreign bank (immediately if Chinese seller wishes to discount the draft and collect immediately, at maturity if not) Payments sent to Chinese seller (see #7) Payment to U.S. bank by U.S. buyer at maturity, paid in full 0 Shipping papers delivered

Money Market Participants The U.S. Treasury The Federal Reserve Commercial banks Money market mutual funds Brokers and dealers Corporations Other financial institutions Individuals

International Money Markets U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR) Eurodollar Certificates of Deposits are U.S. dollar denominated CDs held in foreign banks Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

2011 Money Market Yields Instrument Federal Funds* Commercial Paper CDs Euro CP Rate 0.11% 0.17% 0.23% 1.18% LIBOR Banker’s Acceptances Euro$ Repo* 0.27375% 0.22% 0.25% 0.08% Treasury Bills** Inflation***   0.060 2.7% Data from the Wall Street Journal Online Money Rates Section April 2011. Rates are for 3 month maturities except as noted. * Overnight; ** 13 week, *** Year over year, all items as measured by the CPI

Rates for maturities of 3 months - November 2004 Instrument Federal Funds* Commercial Paper CDs Euro CP Rate 2.06% 2.38% 3.03% 4.69% LIBOR Banker’s Acceptances Euro$ T–bill** 2.71875% 2.75% 2.70% 1.80%

Money Market Securities Outstanding   Billions $ Instrument 1990 2004 2007 2010 Treasury Bills $ 527 $ 982 $1,010 $1,856 Fed funds & Repos 372 1,585 2,731 1,656 Commercial Paper 538 1,310 2,109 1.083 Negotiable CDs 547 1,379 2,149 1,822 Banker's Acceptances 52 4 1 Total $2,036 $5,260 $8,000 $6,418 % of Total in Given Year 26% 19% 13% 29% 18% 30% 34% 25% 17% 27% 28% 3% 0.1% 0.0% 100% The increase in Treasury Bills is due to increased government borrowing during and after the financial crisis. The decline in Fed funds and repos coincides with the growth of excess reserves held by banks. Commercial paper amounts declined with the financial crisis due to default risk concerns as did the quantity of negotiable CDs. See the Instructor’s Manual for potential reasons for the decline in Banker’s Acceptances Source: Text

International Money Markets U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR) Eurodollar Certificates of Deposit are U.S. dollar-denominated CDs held in foreign banks Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars

International Money Markets

PROBLEMS

Discount yield: idy = (($1m. - $973,750)/$1m.)(360/65) = 14.538% Bond equivalent yield: ibey = (($1m. - $973,750)/$973,750)(365/65) = 15.138% EAR: EAR = (1 + .15138/(365/65))365/65 - 1 = 16.111%

The nominal bond equivalent yield is calculated as ibey = 6.56%(365/360) = 6.651% The EAR on the CD is calculated as EAR = (1 + (.06651)/(365/115))365/115 - 1 = 6.804%

The yield on this repo to the bank is calculated as follows iRA = $25,000,000 - $24,950,000 x 360 = 10.31% $24,950,000 7 b. The yield on this repo to the bank is calculated as follows iRA = $25,000,000 - $24,950,000 x 360 = 3.44% $24,950,000 21

The return on the commercial paper is calculated as icp(dy) = $500,000 - $495,000 360 = 8.00% $500,000 45 And icp(bey) = $500,000 - $495,000 365 = 8.19% $495,000 45

a. Before the rate change, the CD holder will receive FV = $500,000 (1 + .055/3) = $509,167 in four months in exchange for $500,000 deposited in the bank today. Immediately after the market rate on the CD rises to 6 percent, the CD value decreases to PV = 509,167/(1 + .06/3) = $499,183.33 b. Immediately after the market rate on the CD falls to 5.25 percent, the CD value decreases to PV = 509,167/(1 + .0525/3) = $500,409.83