Chapter Six Money Markets © 2001 South-Western College Publishing Company

2 Chapter Objectives nProvide a background on money market securities nExplain how institutional investors use money markets nExplain the globalization of money markets

3 Money Market Securities nMaturity of a year or less nIssued by corporations and governments that need short-term funds nInvestors find out about new issues in the primary market via a telecommunications network nPurchased by corporations and financial institutions nSecondary market for securities exists

4 Money Market Securities nTreasury bills 4Issued to meet the short term needs of the U.S. government 4Attractive to investors Liquidity Fairly safe from default risk due to government backing Strong secondary market exists

5 Money Market Securities nTreasury bill auction competitive bids (Fill bids in amount determined by Treasury borrowing needs) 4Bid process used to sell T-bills 4Bids submitted to Federal Reserve banks by the deadline 4Bid process Accepts highest bids Accepts bids until generates total needed

6 Money Market Securities nEstimating T-bill yield 4No coupon payments 4Par or face value received at maturity 4Yield at issue is the difference between the selling price and par or face value 4If sold prior to maturity in secondary market Yield based on the difference between price you paid to buy T-bill and price you sold it for

7 Money Market Securities nCalculating T-bill yields Annualized yield YTYT  SP - PP PP 365 n Y T = The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period) =

8 Money Market Securities nCalculating T-bill yields T-bill discount for a newly issued security Par - PP PP 360 n T-bill discount = percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity T-bill discount = 

9 Money Market Securities nCommercial paper 4Short-term debt instrument 4Used only by well-known and creditworthy firms 4Unsecured 4Minimum denominations of $100,000 4Not an active secondary market

10 Money Market Securities nCommercial paper ratings 4Past defaults means a rating for default risk helps investors evaluate risks and issuers sell the securities 4Ratings agencies assign a grade based on credit risk nCommercial paper placement choices 4Direct placement 4Commercial paper dealers

11 Money Market Securities nBacking commercial paper with a line of credit 4Used in case they can’t roll over or reissue new debt at a reasonable rate 4Rating change would affect cost 4Bank gives issuer right but not obligation to borrow a certain amount for a specified period of time 4Bank charges fees

12 Money Market Securities nEstimating commercial paper yields Y CP Par - PP PP 360 n Y CP = Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity = 

13 Money Market Securities nNegotiable certificates of deposit NCDs 4Issued by large commercial banks 4Minimum denomination of $100,000 but $1 million more common 4Purchased by nonfinancial corporations or money market funds 4Secondary market exists but issuers don’t like new issues to compete with previous issues in the secondary market

14 Money Market Securities nNCD placement 4Direct placement 4Use a correspondent institution specializing in placement 4Sell to securities dealers who resell 4Sell direct to investors at a higher price nNCD premiums 4Rate above T-bill rate to compensate for less liquidity and safety

15 Money Market Securities nRepurchase agreements 4Sell a security with the agreement to repurchase it at a specified date and price 4Borrower defaults, lender has security 4Reverse repo name for transaction from lender 4Negotiated over telecommunications network 4Dealers and brokers used or direct placement 4No secondary market

16 Money Market Securities nEstimating repurchase agreement yields Repo Rate SP - PP PP 360 n Repo Rate = Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity = 

17 Money Market Securities nFederal funds 4Depository institutions use to borrow and lend short-term funds with each other 4Federal funds rate usually slightly higher than T-bill rate 4Fed district bank debits and credits accounts 4Federal funds brokers may match up buyers and sellers using telecommunications network 4Usually $5 million or more

18 Money Market Securities nBanker’s acceptances 4A bank takes responsibility for a future payment 4Usually result from international transactions 4Exporters send goods to a foreign destination and want payment assurance before sending 4Bank stamps a draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time

19 Money Market Securities nBanker’s acceptances 4Exporter can hold until the date or sell before maturity 4If sold to get the cash before maturity, price received is a discount from draft’s total 4Return is based on calculations for other discount securities 4 Similar to the commercial paper example

20 Institutional use of Money Markets nUsed by many kinds of institutional investors both to invest and borrow nMoney market securities enhance liquidity 4Newly issued securities raise cash 4Buyers of securities generate cash when they liquidate they holdings nActive secondary market helps liquidity nShort-term maturity enhances liquidity

21 Valuation of Market Securities nMany money market securities do not make interest payments nValue is the present value of the security at maturity nPar or face value is the future value of a lump sum nDiscount rate is rate investors require nLike bonds, an inverse relationship between price and yield

22 Interaction Among Money Market Yields nSecurities in the money market have interrelated yields 4Investors can substitute among securities 4Investors trade if a price and yield disparity occurs among securities nEconomic uncertainty causes an investor shift to securities with lower possible risk of default

23 Globalization of Money Markets nSome segmentation remains in the global money market nRates among countries have become more interrelated over time nIncrease in the flow of funds 4Tax differences among countries 4Speculation on exchange rate changes 4Reduced government barriers

24 Globalization of Money Markets nEurodollar deposits and Euronotes 4Dollar deposits in banks outside the U.S. 4Increased because of international trade growth 4No reserve requirements at banks outside U.S. nEurodollar Loans 4Channel funds to other multinationals that need short-term financing

25 Globalization of Money Markets nEurodollar deposits and Euronotes nEurocurrency market consists of several banks that with loans and deposits denominated in Eurocurrencies nEurodollar CDs 4Secondary market 4Some have floating rates tied to LIBOR or London Interbank Offer Rate nEurocredit market offers longer maturity loans

26 Globalization of Money Markets nEuro-commercial paper 4Issued without the backing of a banking syndicate 4Maturity tailored to investors 4Dealers that place paper created a secondary market

27 Globalization of Money Markets nPerformance of international securities nEffective yield for international securities has two components 4The yield earned on the investment denominated in the currency of the investment 4The exchange rate effect