1. 1 Money Markets Defined - The market in which debt (fixed income) instruments with maturities less than one year are traded Function - They exist because, for most entities, revenues and expenditures do not occur simultaneously. Additionally, there is an opportunity cost associated with holding cash in the form of currency. Example - Counties collect property taxes in November but they have expenditure needs throughout the year. Result - They facilitate the transfer of short-term excess funds from suppliers to borrowers

2. 2 Money Market Securities Key Characteristics –Maturities less than one year Short duration of securities limits their potential for price volatility –Generally traded in large denominations “Round-lot” is considered $1 million or more –Typically high credit quality (low default risk) A short-term rating of A1 / P1 or better –Traded on an over- the-counter (OTC) market

3. 3 “Investment Grade” Ratings - S&P RatingDefinition AAAHighest rating; extremely strong security. AAVery strong security; differs from AAA in only a small degree. AStrong capacity but more susceptible to adverse economic effects than two above categories. BBBAdequate capacity but adverse economic conditions more likely to weaken capacity. Long-Term Ratings RatingDefinition A-1+Highest degree of safety. A-1Very strong degree of safety. A-2Strong degree of safety. A-3Satisfactory degree of safety. Short-Term Ratings Source: Wells Capital Management – Guideline development presentation

4. 4 Correlation between Long-term & Short-term ratings - S&P AAA AA+ AA A-1+ AA- A+A-1 A A- BBB+ A-2 BBB BBB- A-3 BB+ BBB BB- Long-term rating Short-term rating Source: Wells Capital Management – Guideline development presentation

5. 5 Common money market instruments Treasury Bills –Short-term obligations issued by the U.S. government –Issued via a weekly auction The bid process has competitive and non-competitive components – Issued in 3 and 6 month maturities Until recently there was issued a 1 year T-Bill –Considered to be “risk-free” –Quoted on a discount basis Discount Yield T-Bill = ((P F - P O )/P F ) X (360/days) 6.92% = ((10,000 - 9,650)/10,000) X (360/182) –Translation to a bond equivalent yield (BEY) BEY T-Bill = ((P F - P O )/P O ) X (365/days) 7.27% = ((10,000 - 9,650)/9,650) X (365/182)

6. 6 Treasury Market Snapshot - 02/09/04 Source: Bloomberg

7. 7 Common money market instruments Federal Funds (Fed Funds) –Short-term funds transferred between financial institutions Commercial banks are the primary participants in the Fed Funds market –Borrowing & lending excess reserves that they have at the Fed –Maturity is usually one to seven days –Pay interest once, at maturity –Quoted on a 360 day basis Translation to a bond equiv yield is: FF bey = i FF (365/360) –A 6% fed funds interest rate equates to a 6.083% bond equivalent yield –Generally, the Fed Funds rate revolves around the “target” rate set by the Federal Reserve Fed maintains the Fed Funds rate around the target rate through the open market operations discussed in previous lecture

8. 8 Source: Bloomberg

9. 9 Common money market instruments Repurchase Agreements (Repo) –An agreement involving the sale of securities by one entity to another with a promise to repurchase the securities at a specified price and date Reverse repurchase agreements (Reverse repo) –An agreement involving the purchase of securities by one entity from another with the promise to sell them back at a specified price and date These are different sides of the same transaction –Title to the securities trades hands for the period of the transaction –Federal Reserve uses repo to conduct its open market operations –i RA = ((P F - P O )/P O ) X (360/days) –6.15% = ((10,008,548 - 10,000,000)/10,000,000) X (360/5) –6.24% BEY = ((10,008,548 - 10,000,000)/10,000,000) X (365/5) –Repo less liquid than fed funds because collateral needs to be arranged

10. 10 Common money market instruments Commercial Paper –Short-term unsecured promissory notes issued by corporations –Largest money market instrument in terms of $’s outstanding –Maturities range from 1 to 270 days Corporate debt longer than 270 days requires SEC registration –Distributed directly from issuer to investor or through a dealer Less expensive for the issuer to directly place but Dealers provide “firm commitment underwriting” to place entire issue Distribution via electronic interfaces is becoming more common –Issuers of CP and investors in CP are very sensitive to credit quality –Quoted on a discount basis Discount Yield CP = ((P F - P O )/P F ) X (360/days) 6.92% = ((10,000 - 9,650)/10,000) X (360/182) –Translation to a bond equivalent yield (BEY) 7.27% BEY = ((10,000 - 9,650)/9,650) X (365/182)

11. 11 Commercial Paper Distribution Source: Federal Reserve Board website Dealer vs. Direct Placement 1991-1999

12. 12 Commercial Paper Yields Source: Federal Reserve Board website CP vs. “Prime Rate” 1971 - 1999

13. 13 Goldman Sachs Commercial Paper Inventory - 2/3/03 Source: Bloomberg

14. 14 Common money market instruments Asset-backed commercial paper –Fast growing sector of the commercial paper market –Instead of being unsecured, this type of commercial paper has various forms of collateral “backing it up” –Quoted on a discount basis See notes on Treasury bills and commercial paper

15. 15 Common money market instruments Negotiable Certificates of Deposit (NCD’s) –Bank-issued time deposit with a specified interest rate and maturity –NCD’s are bearer instruments The holder at maturity receives the principal & interest –Became negotiable (“tradeable”) in the 1960’s –Yields are quoted on a 360 day basis –Yield calculation $1 million, 6 month, 7 percent interest rate –FV = $1,000,000 x (1 + (.07 x (180/360))) = $1,035,000 Immediately after purchase, yields drop to 6 percent for the same CD –PV = $1,035,000 / (1 + (.06 x (180/360))) = $1,004,854

16. 16 Common money market instruments Bankers Acceptances (BA’s) –A time draft payable to a seller of goods, with payment guaranteed by a bank. Exporter wants a guarantee it will be paid if it ships an order to an importer US Bank writes letter of credit covering the importer –Exporter takes the credit risk of the bank, not the importer Exporter can hold the BA for payment in full on the specified date or sell it for a discounted cash payment immediately The buyer of the BA gets the par value at maturity –BA’s are bearer instruments –Majority of BA’s are originated in New York, Chicago, San Fran –Yields are quoted on a discount basis See notes on Treasury bills or commercial paper

17. 17 Money Market Participants Treasury –Issues treasury notes and bills to fund short-term expenditure needs Federal Reserve –Buys/Sells treasuries and repos to conduct open market operations Commercial Banks –Money market participation driven largely by reserve requirements If a bank is short on reserves it issues money market securities If a bank has excess reserves it invests in money market securities Broker / Dealers –Link buyers and sellers of money market instruments Corporations –Use money markets to raise cash for short-term operational needs Other financial institutions –Invest in money market securities to maintain large, liquid cash pools

18. 18 International Aspects of Money Markets London Interbank Offered Rate (LIBOR) –The rate paid on Eurodollars –Alternative to Fed Funds for short-term (overnight) funding As a result, LIBOR and Fed Fund rate movements are closely correlated Typical spread between LIBOR and Fed Funds is.125% LIBOR typically higher than Fed Funds because of perceived credit risk Other international money market securities –Euro CD’s –Euro Notes –Euro Commercial Paper

19. 19 Capital Markets revisited Capital Markets –Securities with maturities longer than one year –Composed of: Bond market Asset-backed market Equity market

20. 20 Bond Markets Defined - The market in which debt (fixed income) instruments with maturities greater than one year are issued and traded Result - They facilitate the transfer of excess funds from suppliers to borrowers Traditionally categorized as follows: –Treasuries –Municipal bonds –Corporate bonds

21. 21 Bond Market Instruments Treasury notes and bonds –Backed by the full faith and credit of the U.S. government –Note maturities range from 2 - 10 years –Bond maturities range from 10 - 30 years –Pay interest semi-annually –Primary issuance via an auction process Competitive and noncompetitive bids (like T-bills) –Broker / Dealers maintain a very liquid secondary market Minimum denomination is $1000 Treasury STRIPS (Separate Trading of Registered Interest & Principal Securities) –Process whereby the coupon payments and the final principal payment of a bond are separated into individual securities –Dealers initiated this process in 1985 to better meet investors needs and to enrich themselves

22. 22 Present Value Example Source: Financial Markets & Institutions – Saunders/Cornett

23. 23 Bond Market Instruments Municipal Bonds –Securities issued by state and local governments General obligation bonds –Bonds backed by the full faith and credit of the issuing municipality Revenue bonds –Bonds sold to finance a specific revenue-generating project and are backed by cashflows from that project –The majority of municipal issuance: Is exempt from Federal taxes –Some bonds are also exempt from State taxes Pays interest semi-annually –Taxable equivalent yield calculation Tax Equiv Yield = Tax Exempt Yield / ( 1 - Tax Rate ) 2.31% = 1.50% / ( 1 -.35 )

24. 24 Municipal Bond Example

25. 25 Municipal Bond Example

26. 26 Municipal Bond Yield Example 4.52% Yield if called on 6/1/03

27. 27 Bond Market Instruments Corporate Bonds –Debt issued by corporations Term bonds - a bond issue in which the entire issue matures on one date Serial bonds - bonds that mature in a series of dates Mortgage bonds - bonds issued to finance a specific project, the project gets pledged as collateral for the bond issue Equipment Trust Certificates - bonds collaterized with tangible non-real estate property (e.g. - railcars, airplanes) Debentures - unsecured debt Subordinated debentures - unsecured debt that are junior in rights to mortgage bonds and debentures Convertible bonds - bonds that may be exchanged for another security of the issuing firm at the discretion of the bond holder Callable bonds - bonds that allow the issuer to force the bond holder to sell the bond back to the issuer at a specified price

28. 28 Present Value Example Source: Financial Markets & Institutions – Saunders/Cornett

29. 29 Valuation and Accruals Bond valuation –V b =  PV disc coups + PV disc principal Accrued interest calculation –Par x (Coup/2) x (Days since last coup / Days in coup period) –$1000 x (5%/2) x (21days / 181days) = $2.90