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Copyright 2005 by Thomson Learning, Inc. Chapter 14 The Money Market.

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Presentation on theme: "Copyright 2005 by Thomson Learning, Inc. Chapter 14 The Money Market."— Presentation transcript:

1 Copyright 2005 by Thomson Learning, Inc. Chapter 14 The Money Market

2 Copyright 2005 by Thomson Learning, Inc. Learning Objectives v Specify the important features of money markets. v Define the money market instruments by category. v Calculate the taxable-equivalent yield, yield from dividend capture, discount yield, coupon- equivalent yield, and effective annual yield. v Specify types of investment risk and their effects on yields. v Understand yield curves and the theories that explain them.

3 Copyright 2005 by Thomson Learning, Inc. Nature of the Money Market v Primary and secondary markets v Wholesale and retail markets v Money market interest rates v Tax status v Market mechanics and intermediaries

4 Copyright 2005 by Thomson Learning, Inc. Money Market Instruments v Bank instruments v Corporate instruments v Federal Government instruments v State and local instruments v Mixed instruments

5 Copyright 2005 by Thomson Learning, Inc. Bank Instruments InstrumentDenominationMaturityRisk Certificates of DepositPrimary: $100,000 +7 days to* FDIC Secondary: $2-$5m8 years* Fixed mat. *Expro risk of Time depositsMinimum set by 1 day to 3 Eurodollar bankmonths deposits Bankers Acceptances$500,000 to $1mUp to 270* Bank secured days* 2ndary mkt Loan participations Varies1 day to * Most have 3 months guarantor * Illiquid Securitized assets suchVaries1 year to * Diversified as auto loans, etc.3 years portfolio

6 Copyright 2005 by Thomson Learning, Inc. Corporate Instruments InstrumentDenominationMaturityRisk Commercial paperPrimary: $100,000 +1 to 270 days* Usually low Secondary: $5m* Backup line * Liquidity function of function of issuer issuer Floating-rate notesPrimary: $1,000-$100,0009 months to * Function of Secondary: $5 million30 years issuer Common or No typicalNo maturity*Function of preferred stockdays issuer * Function of market market

7 Copyright 2005 by Thomson Learning, Inc. Federal Government Instruments InstrumentDenominationMaturityRisk Treasury billsPrimary: $1,000+3,6,12 months*No default risk risk *Some interest rate risk rate risk Treasury notes/bonds2-yr notes: $5,000 Notes: 2-5,7,10 yrs*No default 3-,5-,7-,10-yr notesBonds: >10 yrs*Interest rate and bonds: $1,000 risk Government agenciesPrimary: $1,000Varies* Low default Secondary: larger* Sporadic liq. * Interest rate risk function risk function of maturity of maturity * Event risk

8 Copyright 2005 by Thomson Learning, Inc. State and Local Government Instruments InstrumentDenominationMaturityRisk Anticipation notesPrimary: $5,000Few weeks to* Low default Secondary: $100,000several years risk * Liq. depends on dealer on dealer * Interest rate risk function risk function of maturity of maturity VRDNsPrimary: $5,000-$100,00030 years with* Low default Secondary: $100,000put. Interest and liq. risk rate reset* Low liquidity risk due to risk due to rate reset rate reset Tax-exempt CPPrimary: $50,000-$100,000Few days to * Same risk as Secondary: $100,000several yearsanticipation

9 Copyright 2005 by Thomson Learning, Inc. Mixed Instruments InstrumentDenominationMaturityRisk MMMFs$10,000 for institutions25-60 days* No FDIC * No liquidity risk risk * No interest rate risk rate risk Repurchase AgreementsTypical: $1 millionMostly overnite* Depends on Term RPs institution are 7-30 days* Linked to collateral collateral * Some liq risk * Event risk Sweep accountsNoneOvernight* Depends on institution institution

10 Copyright 2005 by Thomson Learning, Inc. Money Market Rate Calculations D 365 D 365 Y cap = ------ x ------Dividend capture yield(14.2) P n P n Y cap [1 - (.30 x T)] Y cap [1 - (.30 x T)] Y cap-te = ---------------------Tax-equivalent yield(14.3) (1 -T) (1 -T) Where:.30 is related to the dividend exclusion T is the investors marginal tax rate D is the dividend P is the security price n is the holding period D 365 D 365 Y cap = ------ x ------Dividend capture yield(14.2) P n P n Y cap [1 - (.30 x T)] Y cap [1 - (.30 x T)] Y cap-te = ---------------------Tax-equivalent yield(14.3) (1 -T) (1 -T) Where:.30 is related to the dividend exclusion T is the investors marginal tax rate D is the dividend P is the security price n is the holding period

11 Copyright 2005 by Thomson Learning, Inc. Money Market Rate Calculations FACE-P 360 FACE-P 360 Y d = ------------ x -------Discount yield(14.4) FACE n FACE n FACE-P 365 FACE-P 365 Y ce = ----------- x -------Coupon-equivalent yield(14.5) P n P n FACE-P 360 FACE-P 360 Y d = ------------ x -------Discount yield(14.4) FACE n FACE n FACE-P 365 FACE-P 365 Y ce = ----------- x -------Coupon-equivalent yield(14.5) P n P n

12 Copyright 2005 by Thomson Learning, Inc. Term Structure Theories v What explains the shape of the yield curve? Time to Maturity Yield,%

13 Copyright 2005 by Thomson Learning, Inc. Term Structure: Unbiased Expectations v The prevailing yield curve is derived from the present short-term rate and expectations for rates that will exist in the future. v (1+ t R n ) = [(1+ t R 1 )(1+ t+1 r 1,t )(1+ t+2 r 1,t )......] 1/n v Thus, long-term rates are higher than current short-term rates if future short-term rates are expected to be higher than current short-term rates...and long-term rates fall below current short- term rates if future expected short-term rates are expected to be less than the current level of short- term rates.

14 Copyright 2005 by Thomson Learning, Inc. Term Structure: Liquidity Preference v Preference for liquidity is thought to characterize enough investors that the yield curve (in absence of expectations or other influences) should slope upward from left to right. The longer the maturity, the higher the premium demanded by investors. v Yield,% Time to Maturity Yield, % Liquidity Premium

15 Copyright 2005 by Thomson Learning, Inc. Term Structure: Segmentation hypothesis v Instead of being close substitutes, securities with short, medium, and long maturities are seen by investors (fund suppliers) and issuers (fund demanders) as quite different. v The markets are thus separated, or segmented, by the self-limiting behavior of institutions staying within their preferred habitats.

16 Copyright 2005 by Thomson Learning, Inc. Term Structure: Biased expectations v A combination of the unbiased expectations theory and the liquidity preference hypothesis.

17 Copyright 2005 by Thomson Learning, Inc. Risk Structure of Interest Rates v Default risk v Liquidity risk v Interest rate risk v Reinvestment rate risk v Event risk v Foreign exchange and political risk

18 Copyright 2005 by Thomson Learning, Inc. Risk-Return Assessment in Practice v Yield spread analysis v Safety ratings v Assessing liquidity risk

19 Copyright 2005 by Thomson Learning, Inc. Summary v We surveyed the menu of short-term investment alternatives. v Investment objectives rank safety first, followed by liquidity and then yield. v We learned how to calculate various money market rates of return. v We studied possible explanations for the shape of the yield curve. v We concluded with a discussion of the risk structure of interest rates.


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