1. Money and Fixed-Income Market
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Money and Fixed-Income Market
Fed Funds
Treasury Bills
Rates and Yields
Repos and Reverses
Fixed-Income Securities
Today, we are going to cover the money market. As we said earlier, this is an important part of our capital market.
The money market is part of the debt market, it composes of mainly liquid short term securities, including Treasury bills, bank loans, CDs, etc.

2. Introduction Money Market Instruments
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Introduction
Money Market
Cash equivalents, short-term (maturity  1 year), liquid (marketable), low-risk debt securities
Instruments
Federal funds
Treasury bills (T-bills)
Certificate of deposit
Commercial paper
Bankers’ acceptances
Eurodollars
Repurchase agreements (repos) and reverses
Brokers’ calls
We will have a detailed coverage of T-bills and Repos.
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3. Federal Funds Rate charged for Federal Funds among the banks
Most widely quoted “Fed” rate
Is it set really set by the Fed?
Effective Rate vs. Target Rate (Aug 27, 2008)
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4. Treasury Bills Definition Characteristics
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Treasury Bills
Definition
Short-term Gov. security issued at discount
e.g., pay $900 today for 1yr T-bill of $1000 par value
Characteristics
Highly liquid
Extremely safe (virtually risk free)
Exempt of state and local taxes
Initial maturity at 4, 13, and 26 weeks
Pay $900
Receive $1000 face (par) value
Today
Maturity
How does the government pay off its old debt when it matures?
New debt
Tax revenue
Printing money
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5. Treasury Bills Quotation
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Treasury Bills
Quotation
Market convention is to use rate rather than price for T-bill quote
Bank Discount Rate (BD)
rBD: bank discount rate
F: face value (par)
P: price
n: days to maturity
Another to look at it is
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6. Treasury Bills Example
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Treasury Bills
Example
A 90-day T-Bill of par $10,000 trades at $9,600. What’s the bank discount rate?
n = 90, F = $10,000, P = $9,600
Annualized return on the investment?
rBEY: bond equivalent yield (APR)
Is the bank discount rate the return for your investment?
No. Bond equivalent yield is.
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7. Treasury Bills Bond Equivalent Yield (BEY)
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Treasury Bills
Bond Equivalent Yield (BEY)
Measures (simple) annualized return on
T-bill investment
Facilitates comparison of yields between
T-bill and T-bond
Bank discount rate is NOT a true interest rate
Bank discount rates are converted to yields
Bonds quoted in yields
Converted Yields = Bond Equivalent Yield
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8. Treasury Bills Sample quotes from WSJ (Sep 1 2005) Actual # days – 2
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Treasury Bills
Sample quotes from WSJ (Sep )
Actual # days – 2
Bank discount rate
Bond Equivalent yield
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9. Treasury Bills What about price?
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Treasury Bills
What about price?
9/1/05, on WSJ you see 12/1/05 T-bill is quoted at 3.43% (ask). How much does it cost to buy $1,000 par of that T-bill?
F = $1,000, rBD = 3.43%, n = 91, P = ?
Bond equivalent yield
7/27/00 Maturity date.
6/28/00 quote for 6/27/00 price, settle on 6/29/00, so n = 28 days.
is the price you pay for 1,000 face value.
5.44% is the annualized return you get.
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10. Certificates of Deposit (CD)
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Certificates of Deposit (CD)
Issued by
Denomination
Maturity
Liquidity
Default risk
Interest type
Taxation
Depository Institutions
Any, $100,000 or more are marketable
Varies, typically 14 day minimum
3 months or less are liquid, if negotiable
First $100,000 ($250,000) is insured
Add on
Interest income is fully taxable
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11. Commercial Paper Issued by Maturity Denomination Liquidity
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Commercial Paper
Issued by
Maturity
Denomination
Liquidity
Default risk
Interest type
Taxation
Large creditworthy corporations and financial institutions
Maximum 270 days, usually 1 to 2 months
Minimum $100,000
3 months or less are liquid if marketable
Unsecured, Rated, Mostly high quality
Discount
Interest income is fully taxable
New Innovation: Asset backed commercial paper is backed
by a loan or security. In summer 2007 asset backed CP
market collapsed when subprime collateral values fell.
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12. Repos and Reverses Repo screen from Bloomberg: 8/19/99 Investments 2
The other important money market instrument is the repurchase agreement. This is a secured financing vehicle.
Suppose you hold $10 MM T-bond. You need some cash, but do not want to sell the bond because you believe the bond is going to appreciate. Then you can borrow money using the bond as collateral.
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13. Repos and Reverses Repurchase Agreement (Repo)
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Repos and Reverses
Repurchase Agreement (Repo)
Sale of high grade security with agreement to buy it back at higher prices
Repo rate:
Repo dealer’s borrowing rate implied in the repo price differentials.
Convention: 360 day
Treasury Security
Repo Dealer
Lender
Day 0:
Cash (P )
Treasury Security
Day n:
Repo Dealer
Lender
Cash (F )
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14. Repos and Reverses Reverse Repo
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Repos and Reverses
Reverse Repo
Purchase of high grade security with agreement to sell it back at higher prices
Rev/Repo rate: repo dealers’ lending rate implied in the price differentials
Treasury Security
Repo Dealer
Borrower
Day 0:
Cash (P )
Treasury Security
Day n:
Repo Dealer
Borrower
Cash (F )
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15. Repos and Reverse Example
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Repos and Reverse
Example
You have $2M worth of 26 weeks T-bill you’d like to hold to maturity. However, you need $2M cash urgently for a week. What to do?
(Term) Reverse/Repo
Day 0: Get $2M from a repo dealer by giving him T-bill
Look at the reverse/repo rate to determine the amount of money to pay back
Day 7: get the T-bill back by paying $2,001,925 to the repo dealer
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16. Money Market Instrument Yields
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Money Market Instrument Yields
Yields on money market instruments are not always directly comparable!
Factors influencing “quoted” yields
Par value vs. investment value
360 vs. 365 days assumed in a year (366 leap year)
Simple vs. Compound Interest
Par Value is the face value of the instrument. Investment value is what you paid for it.
Some rate methods use 360 days instead of 365 days
BEY uses simple instead of compound interest.
Three popular yield measurements used in quotations:
Bank Discount Rate
Bond Equivalent Yield
Effective Annual Yield
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17. Major Components of the Money Market
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Major Components of the Money Market
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18. MMMF and the Credit Crisis of 2008
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MMMF and the Credit Crisis of 2008
Between 2005 and 2008 money market mutual funds (MMMFs) grew by 88%.
MMMFs had their own crisis in 2008 when Lehman Brothers filed for bankruptcy on September 15.
Some funds had invested heavily in Lehman’s commercial paper.
On Sept. 16, Reserve Primary fund “broke the buck.” What does this mean?
A run on money market funds ensued, and unsecured money market rates jumped up.
The U.S. Treasury temporarily offered to insure all money funds (close to $3.4 trillion) to stop the run.
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19. Spreads on CDs and Treasury Bills
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Spreads on CDs and Treasury Bills
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20. Spreads on Commercial Paper and T-Bills
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Spreads on Commercial Paper and T-Bills
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21. Fixed-Income Securities
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Fixed-Income Securities
Publicly Issued
Treasury Notes and Bonds
Agency Issues (Federal Government)
Municipal Bonds
Federal tax exemption
Local and state tax exemption for state residents
Privately Issued
Corporate Bonds
Mortgage-Backed Securities
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22. Fixed-Income Securities
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Fixed-Income Securities
What are they?
A security promising full payment of coupon and principal according to a fixed time schedule
E.g., A 10 year $10,000 T-note with 6¼% coupon
Three Prominent Characteristics
Principal
Face value of a bond
Interest
Coupon of a bond
Maturity
Life span of a bond
We believe Clinton has no principle.
We have no interest in Gore.
And we think Lewinski has no maturity.
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