1. The Money Market Chapter 9 © 2003 South-Western/Thomson Learning

2. Slide 2 Learning Objectives  Primary participants and instruments of money markets  How money markets are used by various participants  Recent trends in money market instruments  How money markets have become international in scope  What money market mutual funds are and why they have become important intermediaries

3. Slide 3 Money Market Short-term credit market: where debt securities having original maturities of 1 year or less are traded

4. Slide 4 Money Market Characteristics  Issued in large denominations  Usually $1 million or more  Money market instruments have short maturities  Less than 3 months  Ranging from 1 day to 1 year  Money market instruments characterized by:  Low liquidity  Default risk  Does not occupy one particular geographic location or trading floor

5. Slide 5 Money Market Benefits  More efficient source of credit for largest:  Financial institutions  Nonfinancial corporations  Governmental bodies

6. Slide 6 Money Market Benefits  Advantages over bank borrowing  Banks required to hold noninterest- bearing required reserves:  As vault cash  On deposit at Fed  only 90-97% of banks’ domestic transactions deposits can be lent out  Banks face regulatory constraints on:  size of loan they can make to one particular borrower  Particular types of assets they are allowed to hold on their balance sheet

7. Slide 7 Money Market Participants  Commercial banks and savings associations  GSEs  The Federal Reserve  Corporations and finance companies  Pension funds and insurance companies  Brokers and dealers  MMMFs and individuals

8. Slide 8 Commercial Banks and Savings Associations  Play five important roles:  Borrow in money market:  To meet their reserve needs  To make loans to their commercial or household customers  Hold significant levels of Treasury securities on asset side of their balance sheets

9. Slide 9 Commercial Banks and Savings Associations 3.Assist other participants by:  Providing credit enhancements for a fee to those issuing commercial paper and bankers’ acceptances 4.Serve as agents and underwriters in commercial paper market 5.Serve as primary dealers of U.S. government securities  Enables them to trade money market securities on behalf of their corporate customers

10. Slide 10 GSEs  Governments & Government-Sponsored Enterprises (GSEs):  U.S. Treasury is world’s single largest borrower  Issues U.S. Treasury bills (T-bills)  Treasury notes and bonds that have longer maturities  Privately owned GSEs:  Federal National Mortgage Association (Fannie Mae)  Federal Farm Credit Banks Funding Corporation (FFCBFC)  Student Loan Marketing Association (Sallie Mae)

11. Slide 11 Privately-owned GSEs  Engaged in assisting with finance of:  Housing  Agriculture  Education  State and municipal (local governments and special districts) governments issue short-term municipal notes to finance:  Their own expenditures  Expenditures of local schools, hospitals and private firms

12. Slide 12 The Federal Reserve  Fed controls level of reserves available to depository institutions  open market purchase and sale of T- bills  repurchase agreements

13. Slide 13 Corporations/Finance Companies  Use money markets to  raise funds  store funds  Issue large amounts of commercial paper as primary source of funds  which they lend to consumers and firms  use to make up for temporary shortfalls of cash

14. Slide 14 Pension Funds and Insurance Companies  Both use money market for  cash management  to provide needed liquidity

15. Slide 15 Brokers and Dealers  Ensure the regular functioning of the money market  Market new issues of securities  Repurchase securities  Establish secondary market  Act as intermediaries in the RP market  Match buyers and sellers

16. Slide 16 The Broker’s Role in the Federal Funds Market

17. Slide 17 Money Market Instruments  Commercial paper  Unsecured, short-term promissory notes as alternative to:  Short-term bank loans  Other forms of borrowing  Primary benefit to largest & most creditworthy issuers is:  Cost of borrowing is lower than at a commercial bank

18. Slide 18 Money Market Instruments  Commercial paper  Characteristics largely defined by legislation and issuers’ attempt to avoid costly disclosure requirements mandated for other types of securities  Expensive requirements avoided if these are met:  Paper issued must mature in less than 270 days  Paper must be issued in large denomination so that it is not typically purchased directly by public  Proceeds must be used to fund current transactions

19. Slide 19 Money Market Instruments  Commercial paper  Financial companies (specifically nonbank financial companies responsible for issuing majority:  Domestic paper  Foreign paper  Companies choose to issue paper:  Through a dealer  Engage in direct placements

20. Slide 20 Money Market Instruments  Federal (Fed) Funds  When institutions anticipate insufficient reserves, they often turn to Federal (fed) funds market.  Here they can borrow reserves from other institutions on an overnight basis.  Institutions with excess reserves can turn to the fed funds market to loan these reserves and earn interest.

21. Slide 21 Money Market Instruments  Fed Funds  Fed funds are lent:  on an overnight basis  in denominations of $5 million or more  Fed Funds Rate:  Interest rate charged on overnight loans of reserves among commercial banks

22. Slide 22 Money Market Instruments  Repurchase Agreements  Short-term contract in which seller agrees to:  Sell government security to a buyer  Buy it back on a later date at a higher price  Reverse Repurchase Agreements or Matched Sale-Purchase (MSP) Agreement  Repurchase agreement viewed from perspective of initial buyer  Short-term agreements in which:  Buyer buys a government security from seller  Agrees to sell it back on a later date at a higher price

23. Slide 23 Money Market Instruments Most money market instruments are sold at a discount.

24. Slide 24 Money Market Instruments  CERTIFICATES of DEPOSIT (CDs)  Debt instruments issued by commercial banks with:  Minimum denomination of $100,000  Fixed interest rate  Return the principal at maturity  Debt instruments issued by commercial banks that may be:  Negotiable (tradable)  Non-negotiable (not tradable)  Thrift CDs  Certificates of deposit issued by:  Savings associations  Credit unions

25. Slide 25 Money Market Instruments  CERTIFICATES of DEPOSIT (CDs)  Interest rates on negotiable CDs tend to be higher than T-bill rates:  CD holders exposed to default risk - only a portion of deposit is insured  Unlike T-bills, earnings on CDs subject to state/local income taxes  Secondary market for CDs much thinner than T-bills, making negotiable CDs less liquid than T-bills  Euro CDs  Certificates of deposit issued by foreign branches of commercial banks but denominated in currency of the branch’s home country

26. Slide 26 Money Market Instruments  Foreign CDs  Certificates of deposit issued by the foreign branches of commercial banks but denominated in currency of the branch’s host country  Yankee CDs  Certificate of deposit issued by a foreign bank in a foreign currency, but sold in the United States

27. Slide 27 Money Market Instruments  U.S. TREASURY BILLS  Sold to a variety of different types of buyers with:  Low minimum denominations  $10,000  Short maturities  Sold on a discount basis  Sold at price below its face, or par, value  Original issues are sold at regularly scheduled auctions

28. Slide 28 Money Market Instruments  U.S. Treasury Bills – Auction Methods  Multiple-Price Method  Seller accepts bids prior to selling securities  Sales awarded beginning with highest bidder  Buyers end up paying different prices for same securities based upon their respective bids  Treasury discontinued this method in November 1998  Stop-Out Yield  Lowest accepted bid price or yield in securities auction  Uniform Price Method  Seller accepts bids prior to selling securities  Sales awarded beginning with highest bidder  Buyers pay same price for securities based on stop-out yield

29. Slide 29 Money Market Instruments  EURODOLLARS  Dollar-denominated deposit liabilities exempt from U.S. banking regulations  International Banking Facilities (IBFs)  Financial institutions in U.S.  Cater to needs of foreign individuals, corporation, and/or governments  Allow non-U.S. residents to hold unregulated Eurodollar deposits  London Interbank Bid Rate (LIBID)  Interest rate London banks are willing to borrow Eurodollar balances  London Interbank Offered Rate (LIBOR)  Interest rate London banks are willing to loan Eurodollar balances

30. Slide 30 The Anatomy of Eurodollar Borrowing

31. Slide 31 Money Market Instruments  BANKERS’ ACCEPTANCES (BAs)  Allow bank to “accept” responsibility or guarantee payment of one of its customers  Important in international trade when export company may not know or easily determine the credit-worthiness of foreign company

32. Slide 32 Money Market Instruments  MONEY MARKET MUTUAL FUNDS (MMMFs)  Short-term investment pools use proceeds they raise from selling shares to invest in various money market instruments  Disintermediation  Reversal of financial intermediation process whereby funds are:  Pulled from financial intermediaries  Moved directly into open market instruments