2. Chapter Outline
Money market securities
Institutional use of money markets
Valuation of money market securities
Risk of money market securities
Interaction among money market yields
2
3. Money Market Securities
Money market securities:
Have maturities within one year
Are issued by corporations and governments
to obtain short-term funds
Are commonly purchased by corporations and
government agencies that have funds
available for a short-term period
Provide liquidity to investors
3
4. Money Market Securities (cont’d)
Treasury bills:
Are issued by the U.S. Treasury
Are sold weekly through an auction
Have a par value of $1,000
Are attractive to investors because they are backed
by the federal government and are free of default risk
Are liquid
Can be sold in the secondary market through
government security dealers
4
5. Money Market Securities (cont’d)
Treasury bills (cont’d)
Investors in Treasury bills
Depository institutions because T-bills can be easily
liquidated
Other financial institutions in case cash outflows exceed
cash inflows
Individuals with substantial savings for liquidity purposes
Corporations to have easy access to funding for
unanticipated expenses
5
6. Money Market Securities (cont’d)
Treasury bills (cont’d)
Pricing Treasury bills
The price is dependent on the investor’s required rate of
return:
Pm = Par /(1 + k )n
Treasury bills do not pay interest
To price a T-bill with a maturity less than one year, the
annualized return can be reduced by the fraction of the
year in which funds would be invested
6
7. Computing the Price of a
Treasury Bill
A one-year Treasury bill has a par value of
$10,000. Investors require a return of 8 percent
on the T-bill. What is the price investors would
?be willing to pay for this T-bill
Pm = Par /(1 + k )n
= $10,000 /(1.08)
= $9,259
7
8. Money Market Securities (cont’d)
Treasury bills (cont’d)
Treasury bill auction
Investors submit bids on T-bill applications for the maturity of
their choice
Applications can be obtained from a Federal Reserve district
or branch bank
Financial institutions can submit their bids using the Treasury
Automated Auction Processing System (TAAPS-Link)
Institutions must set up an account with the Treasury
Payments to the Treasury are withdrawn electronically from the
account
Payments received from the Treasury are deposited into the
account
8
9. Money Market Securities (cont’d)
Treasury bills (cont’d)
Treasury bill auction (cont’d)
Weekly auctions include 13-week and 26-week T-bills
4-week T-bills are offered when the Treasury anticipates a
short-term cash deficiency
Cash management bills are also occasionally offered
Investors can submit competitive or noncompetitive bids
The bids of noncompetitive bidders are accepted
The highest competitive bids are accepted
Any bids below the cutoff are not accepted
Since 1998, the lowest competitive bid is the price applied to
all competitive and noncompetitive bids
9
10. Money Market Securities (cont’d)
Treasury bills (cont’d)
Estimating the yield
T-bills are sold at a discount from par value
The yield is influenced by the difference between the
selling price and the purchase price
If a newly-issued T-bill is purchased and held until
maturity, the yield is based on the difference between
par value and the purchase price
10
11. Money Market Securities (cont’d)
Treasury bills (cont’d)
Estimating the yield (cont’d)
The annualized yield is:
SP − PP 365
YT = ×
PP n
Estimating the T-bill discount
The discount represents the percent discount of the
purchase price from par value for newly-issued T-bills:
Par − PP 360
T - bill discount = ×
Par n
11
12. Computing the Yield of a
Treasury Bill
An investor purchases a 91-day T-bill for $9,782. If
the T-bill is held to maturity, what is the yield
?the investor would earn
SP − PP 365
YT = ×
PP n
10,000 − 9,782 365
= ×
9,782 91
= 8.94%
12
13. Estimating the T-Bill Discount
Using the information from the previous example,
?what is the T-bill discount
Par − PP 360
T - bill discount = ×
Par n
10,000 − 9,782 360
= ×
10,000 91
= 8.62%
13
14. Money Market Securities (cont’d)
Commercial paper:
Is a short-term debt instrument issued by well-known,
creditworthy firms
Is typically unsecured
Is issued to provide liquidity to finance a firm’s investment in
inventory and accounts receivable
Is an alternative to short-term bank loans
Has a minimum denomination of $100,000
Has a typical maturity between 20 and 270 days
Has no active secondary market
Is typically not purchased directly by individual investors
14
15. Money Market Securities (cont’d)
Commercial paper (cont’d)
Ratings
The risk of default depends on the issuer’s financial condition
and cash flow
Commercial paper rating serves as an indicator of the
potential risk of default
Corporations can more easily place commercial paper that is
assigned a top-tier rating
Junk commercial paper is rated low or not rated at all
15
16. Money Market Securities (cont’d)
Commercial paper (cont’d)
Volume of commercial paper:
Has increased substantially over time
Is commonly reduced during recessionary periods
Placement
Some firms place commercial paper directly with investors
Most firms rely on commercial paper dealers to sell
Some firms (such as finance companies) create in-house
departments to place commercial paper
16
17. Money Market Securities (cont’d)
Commercial paper (cont’d)
Backing commercial paper
Issuers typically maintain a backup line of credit
Allows the company the right to borrow a specified maximum
amount of funds over a specified period of time
Involves a fee in the form of a direct percentage or in the form
of required compensating balances
Estimating the yield
The yield on commercial paper is slightly higher than on a T-
bill
The nominal return is the difference between the price paid
and the par value
17
18. Estimating the Commercial
Paper Yield
An investor purchases 120-day commercial paper
with a par value of $300,000 for a price of
$289,000. What is the annualized commercial
?paper yield
300,000 - 289,000 360
Ycp = ×
289,000 120
= 11.42%
18
19. Money Market Securities (cont’d)
Commercial paper (cont’d)
The commercial paper yield curve:
Illustrates the yield offered on commercial paper at various
maturities
Is typically established for a maturity range from 0 to 90 days
Is similar to the short-term range of the Treasury yield curve
Is affected by short-term interest rate expectations
Is similar to the yield curve on other money market
instruments
19
20. Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs):
Are issued by large commercial banks and other
depository institutions as a short-term source of funds
Have a minimum denomination of $100,000
Are often purchased by nonfinancial corporations
Are sometimes purchased by money market funds
Have a typical maturity between two weeks and one
year
Have a secondary market
20
21. Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs)
(cont’d)
Placement
Directly
Through a correspondent institution
Through securities dealers
Premium
NCDs offer a premium above the T-bill yield to
compensate for less liquidity and safety
21
22. Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs)
(cont’d)
Yield
NCDs provide a return in the form of interest and
the difference between the price at which the NCD
was redeemed or sold and the purchase price
If investors purchase a NCD and hold it until
maturity, their annualized yield is the interest rate
22
23. Money Market Securities (cont’d)
Repurchase agreements
One party sells securities to another with an agreement to
repurchase them at a specified date and price
Essentially a loan backed by securities
A reverse repo refers to the purchase of securities by one party
from another with an agreement to sell them
Bank, S&Ls, and money market funds often participate in repos
Transactions amounts are usually for $10 million or more
Common maturities are from 1 day to 15 days and for one,
three, and six months
There is no secondary market for repos
23
24. Money Market Securities (cont’d)
Repurchase agreements (cont’d)
Placement
Repo transactions are negotiated through a
telecommunications network with dealers and repo brokers
When a borrowing firm can find a counterparty to a repo
transaction, it avoids the transaction fee
Some companies use in-house departments
Estimating the yield
The repo yield is determined by the difference between the
initial selling price and the repurchase price, annualized with
a 360-day year
24
25. Estimating the Repo Yield
An investor initially purchased securities at a price
of $9,913,314, with an agreement to sell them
back at a price of $10,000,000 at the end of a
?90-day period. What is the repo rate
SP − PP 360
Repo rate = ×
PP n
10,000,000 − 9,913,314 360
= ×
9,913,314 90
= 3.50%
25
26. Money Market Securities (cont’d)
Federal funds
The federal funds market allows depository
institutions to lend or borrow short-term funds from
each other at the federal funds rate
The rate is influenced by the supply and demand for funds in
the federal funds market
The Fed adjusts the amount of funds in depository
institutions to influence the rate
All firms monitor the fed funds rate because the Fed
manipulates it to affect economic conditions
The fed funds rate is typically slightly higher than the T-bill
rate
26
27. Money Market Securities (cont’d)
Federal funds (cont’d)
Two depository institutions communicate directly
through a communications network or through a
federal funds broker
The lending institution instructs its Fed district bank to
debit its reserve account and to credit the borrowing
institution’s reserve account by the amount of the loan
Commercial banks are the most active participants in
the federal funds market
Most loan transactions are or $5 million or more and
usually have one- to seven-day maturities
27
28. Money Market Securities (cont’d)
Banker’s acceptances:
Indicate that a bank accepts responsibility for a future
payments
Are commonly used for international trade
transactions
An unknown importer’s bank may serve as the guarantor
Exporters frequently sell an acceptance before the payment
date
Have a return equal to the difference between the
discounted price paid and the amount to be received
in the future
Have an active secondary market facilitated by
dealers
28
29. Money Market Securities (cont’d)
Banker’s acceptances (cont’d)
Steps involved in banker’s acceptances
First, the U.S. importer places a purchase order for goods
The importer asks its bank to issue a letter of credit (L/C)
on its behalf
Represents a commitment by that bank to back the payment
owed to the foreign exporter
The L/C is presented to the exporter’s bank
The exporter sends the goods to the importer and the
shipping documents to its bank
The shipping documents are passed along to the importer’s
bank
29
30. Sequence of Steps in the Creation
of A Banker’s Acceptance
1 Purchase Order
Importer Exporter
5 Shipment of Goods
4 L/C Notification
2 L/C Application
6 Shipping Documents & Time Draft
3 L/C
American Bank Shipping Documents
Japanese Bank
(Importer’s Bank) 7 & Time Draft Accepted
(Exporter’s Bank)
30
31. Institutional Use of Money Markets
Financial institutions purchase money market securities
to earn a return and maintain adequate liquidity
Institutions issue money market securities when
experiencing a temporary shortage of cash
Money market securities enhance liquidity:
Newly-issued securities generate cash
Institutions that previously purchased securities will generate
cash upon liquidation
Most institutions hold either securities that have very active
secondary markets or securities with short-term maturities
31
32. Institutional Use of Money Markets
(cont’d)
Financial institutions with uncertain cash in- and
outflows maintain additional money market
securities
Institutions that purchase securities act as a
creditor to the initial issuer
Some institutions issue their own money market
instruments to obtain cash
32
33. Valuation of Money Market
Securities
For money market securities making no
interest payments, the value reflects the
present value of a future lump-sum
payment
The discount rate is the required rate of return
by investors
33
34. Valuation of Money Market
Securities (cont’d)
Explaining money market price movements
The price of a noninterest-paying money market
security is:
Pm = Par /(1 + k )n
A change in the price can be modeled as:
∆Pm = f ( ∆k ) and ∆k = f ( ∆Rf , ∆RP )
34
35. Valuation of Money Market
Securities (cont’d)
Indicators of future money market security prices
Economic growth is monitored since it signals changes in
short-term interest rates and the required return from
investing in money market securities
Employment
GDP
Retail sales
Industrial production
Consumer confidence
Indicators of inflation
35
36. Risk of Money Market Securities
Because of the short maturity, money market
securities are generally not subject to interest rate
risk, but they are subject to default risk
Investors commonly invest in securities that offer a slightly
higher yield than T-bills and are very unlikely to default
Although investors can assess economic and firm-specific
conditions to determine credit risk, information about the
issuer’s financial condition is limited
Measuring risk
Money market participants can use sensitivity analysis to
determine how the value of money market securities may
change in response to a change in interest rates
36
37. Interaction Among Money Market
Yields
Money market instruments are substitutes for
each other
Market forces will correct disparities in yield and
the yields among securities tend to be similar
In periods of heightened uncertainty,
investors tend to shift from risky money
market securities to Treasuries
Flight
to quality
Creates a greater differential between yields
37
38. Globalization of Money Markets
Interest rate differentials occur because geographic
markets are somewhat segmented
Interest rates have become more highly correlated:
Conversion to the euro
The flow of funds between countries has increased because
of:
Tax differences
Speculation on exchange rate movements
A reduction in government barriers
Eurodollar deposits, Euronotes, and Euro-commercial paper
are widely traded in international money markets
38
39. Globalization of Money Markets
(cont’d)
Eurodollar deposits and Euronotes
Eurodollar certificates of deposit are U.S. dollar deposits
in non-U.S. banks
Have increased because of increasing international trade and
historical U.S. interest rate ceilings
In the Eurodollar market, banks channel deposited funds to
other firms that need to borrow them in the form of
Eurodollar loans
Typical transactions are $1 million or more
Eurodollar CDs are not subject to reserve requirements
Interest rates are attractive for both depositors and borrowers
Rates offered on Eurodollar deposits are slightly higher than
NCD rates
39
40. Globalization of Money Markets
(cont’d)
Eurodollar deposits and Euronotes (cont’d)
Investors in fixed-rate Eurodollar CDs are adversely affected
by rising market rates
Issuers of fixed-rate Eurodollar CDs are adversely affected
by declining rates
Eurodollar-floating-rate CDs (FRCDs) periodically adjust to
LIBOR
The Eurocurrency market is made up of Eurobanks that
accept large deposits and provide large loans in foreign
currencies
Loans in the Eurocredit market have longer maturities than
loans in the Eurocurrency market
Short-term Euronotes are issued in bearer form with
maturities of one, three, and six months
40
41. Globalization of Money Markets
(cont’d)
Euro-commercial paper (Euro-CP):
Is issued without the backing of a banking
syndicate
Has maturities tailored to satisfy investors
Has a secondary market run by CP dealers
Has a rate 50 to 100 basis points above LIBOR
Is sold by dealers at a transaction cost between 5
and 10 basis points of the face value
41
42. Globalization of Money Markets
(cont’d)
Performance of foreign money market
securities
Measured by the effective yield (adjusted for the
exchange rate
Ye = (1 + Yf ) × (1 + %∆S ) − 1
Depends on:
The yield earned on the money market security in the
foreign currency
The exchange rate effect
42
43. Computing the Effective Yield
A U.S. investor buys euros for $1.15 and invests in
a one-year European security with a yield of 8
percent. After one year, the investor converts
the proceeds from the investment back to
dollars at the spot rate of $1.16 per euro. What
?is the effective yield earned by the investor
Ye = (1 + Yf ) × (1 + %∆S ) − 1
= 1.08 × 1.0087 − 1
= 8.94%
43