ch11_santomero.ppt

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Copyri ght 2001 by The McGraw-Hi ll Companies, Inc. All ri ghts reserved.McGraw-Hill/Irwin

11-2

II. Instruments of the Money Market

Money market instruments are debt obligations with maturitiesfrom one day to a full year.

Their principal is generally very secure. Issuers are of high creditstanding. Instruments tend to be highly liquid and are usuallyissued in large denominations.

A. Treasury Bills

Treasury bills (or T-bills) are debt obligations of the U.S.Government

T-bills have no coupons and are issued at a discount from facevalue. The price is determined in an auction under the oversightof the Federal Reserve Bank of New York.

3- and 6-month T-bills are auctioned weekly, and 1-year bills areauctioned every four weeks.

Denominations begin at $10,000 and increase in $5,000 units.

T-bills are exempt from state and local taxes.


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B. Federal Agency Discount Notes

Federally Sponsored Agencies raise funds in the open market tosupport targeted activities.

Agency notes are not guaranteed but investors implicitly expectgovernment support.

These notes are issued the Federal Finance Bank or by sixprivately owned, federally sponsored credit agencies: Federal Home Loan Banks

Federal Home Loan Mortgage Corp.

Federal National Mortgage Assn.

Student Loan Marketing Assn.

Farm Credit Banks

The World Bank

Agency discount notes are similar to Treasury bills but traded lessactively and of smaller issue size.

Insert 11.1

Agency discount notes have yields that are typically 10 to 30 b.p.above T-bills because of lack of liquidity and explicit backing.


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C. Short Term Municipal Securities

Temporary needs for cash by state and local governments aremet through municipal securities.

These can be either the discount variety or coupon bearing(typically variable).

Interest earnings are exempt from federal income taxes andoftentimes, state and local taxes.

General obligation (G.O.) securities are backed by the taxingpower of the issuer.

Revenue securities are backed by the revenue arising from thespecific projects funded.

Insert 11.2

Municipal offerings often carry credit ratings provided by privatecredit rating agencies.

Insert 11.3


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D. Fed Funds

U.S. depository institutions trade funds on account at the Fed.

Those institutions with excess funds can make overnight loans(term fed funds may last for several days) to those with deficits.

The market determined interest rate is the federal funds rate.

E. Domestic Negotiable Certificates of Deposit

Negotiable certificates of deposit (NCDs) are tradable timedeposits which are issued for $100,000 or higher.

Most NCDs have a fixed interest rate to maturity.

The three general classes of NCDs are characterized by theirdiffering rates, risk, and liquidity: Domestic CDs

Yankee CDs

Thrift CDs

The credit risk of NCDs is rated by several private rating agencies.

Other types of instruments issued by banks: Deposit Notes

Bank Notes


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F. Eurodollar Deposits

Certificates of deposit issued offshore: referred to as Eurodollar deposits.

Eurodollar deposits have both fixed and variable interest rates.

Variable rate Eurodollar deposits are usually based on LIBOR. Maturity ranges from 1 to 12 months

This type of instrument is issued by:

Foreign Banks

Offshore Branches of US Banks

International Banking Facilities of US Banks

G. Commercial Paper

Commercial paper - short term unsecured promissory notes issued by bothfinancial and nonfinancial firms.

In terms of outstanding debt, this is the second largest money market

instrument after T-bills. Commercial paper is typically issued at a discount with maturities of 30 days

or less.

Issues are rated by credit agencies and most are backed by lines of creditissued by banks.

Insert 11.4, 11.5, 11.6, 11.7


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H. Bankers Acceptances

A bankers acceptance (BA) is a draft that orders payment of aspecified amount on a future date.

The bank on which the BA is drawn guarantees payment. Thebank is given trade documents, title to goods, and a commission.

BAs are sold at a discount from face value, with maturities of oneto six months.

I. Money Market Mutual Funds

Invests in short-term debt instruments.

Companies pool investor resources and remit to their owners thetotal return they receive from these investments, less operating

costs and a prearranged fee.Insert 11.8


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11-8

J. Repurchase Agreements

A repurchase agreement (REPO) is the purchase and repurchaseof a security at a price at the initial trade date.

The lender receives title. This is returned upon repurchase of thesecurities. The lender then receives interest at the repo rate.

The repo rate depends upon the nature of the collateral andcreditworthiness of the borrower.

Most repos are for less than three months.

III. Summary of Money Market Instrument CharacteristicsInsert 11.9, 11.10, 11.11

IV. Relationship Among Interest RatesInsert 11.12


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V. Price Quotation and Yield Conventions

Bond Equivalent Yieldsa YTM calculation using a semiannualyield convention.

A more accurate measure is the effective annual interest ratewhich gives the true annualized rate of return over the period.

To calculate the effective annual interest rate you must know theprice and redemption value.

V. Calculating Yields on Discount Instruments

Discount Yield Basis- the face value is reduced by the discount(prorated in relation to a 360-day year) to get the price.

Effective Annual Yield (EAY)

assumes that the investment canbe rolled over at the same interest rate in order to get the annualyield.

EAY =Face Value

Price

365

T 1


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11-10

With interest-bearing instruments, the price paid is simply the amount ofthe loan.

The stated interest rate (SIR) is simply the interest rate over the givenperiod multiplied by 360/T.

Redemption

Value

=Loan

Amount

1 T360

SIR

EAY =Redemption Value

Loan Amount

365

T 1


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11-11

NCDs and other negotiable interest bearing instruments are a bitmore complex:

where Ris the market rate of interest

RedemptionValue

= Principal 1 initial maturity length360

SIR

Purchase Price =Redemption Value

1 T360

R

EAY =Redemption Value

Purchase Price

365

T 1


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VI. Summary

There has been a proliferation of money market instruments andan increase in the volume of issues.

The money market has grown in importance as the demand forshort term funds has increased.

The investor must be careful in this market due to the myriad of

instruments and idiosyncrasies.

Varied pricing conventions complicate the picture. A return to thebasics, in the form of effective annual yield, can cut through theconfusion.

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