Money and Capital Markets

1010C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Introduction to the Money MarketIntroduction to the Money Market

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 2

Learning Objectives

To understand the many roles and functions performed by the money market.

To identify the key money market players. To see how money market loans and securities

differ from other financial services and instruments in the financial system.

To appreciate the importance of speed and efficiency to money market participants and to learn how risk is handled.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 3

Introduction

All the transactions carried out in the financial markets seem to be basically the same: borrowers issue securities that lenders buy.

However, the different purposes for which money is borrowed can result in the creation of different kinds of financial assets having different maturities, risks, etc.

For instance, the money market is the market for short-term (one year or less) credit.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 4

Characteristics of the Money Market

The money market is the mechanism through which holders of temporary cash surpluses meet holders of temporary cash deficits.

The money market arises because for most individuals and institutions, cash inflows and outflows are rarely in perfect harmony with each other, and the holding of idle surplus cash is expensive.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 5

Borrowers and Lenders in the Money Market

Central Banks(supplying funds and informationand promoting market stability)

Corporate Borrowers& Cash-ManagementCustomers Needing toInvest Cash Surpluses

SecurityDealers &Brokers

MoneyCenterBanks

NonbankFinancial

Institutions(mutual funds,insurers, etc.)

GovernmentTreasuries

(borrowing andredeemingsecurities)

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 6

Characteristics of the Money Market

The key money market instruments include: Treasury bills and short-term government notes Federal agency notes Federal funds CDs and eurocurrency deposits Discount window loans Commercial paper and bankers’ acceptances Financial futures contracts on bills, federal funds,

CDs, Eurodeposits, etc.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 7

Characteristics of the Money Market

Money market investors seek mainly safety and liquidity, plus the opportunity to earn some interest income.

Because funds invested in the money market represent only temporary cash surpluses and are usually needed in the near future, money market investors are especially sensitive to risk.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 8

Types of Investment Risk

Market risk – The risk that the market value of an asset will decline, resulting in a capital loss when sold. Also called interest rate risk.

Reinvestment risk – The risk that an investor will be forced to place earnings from a security into a lower-yielding investment because interest rates have fallen.

Default risk – The probability that a borrower fails to meet one or more promised principal or interest payments on a security.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 9

Types of Investment Risk

Inflation risk – The risk that increases in the general price level will reduce the purchasing power of earnings from the investment.

Currency risk – The risk that adverse movements in the price of a currency will reduce the net rate of return from a foreign investment. Also called exchange rate risk.

Political risk – The probability that changes in government laws or regulations will reduce the expected return from an investment.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 10

Characteristics of the Money Market

Original maturities on money market instruments range from as short as one day on many loans to banks and security dealers to a full year on some bank deposits and T-bills.

But because there are so many money market securities outstanding, some of which reach maturity each day, investors have a wide menu of actual maturities from which to make their selections.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 11

Characteristics of the Money Market

The money market is extremely broad and deep. It can absorb a large volume of transactions with only small effects on security prices and interest rates.

The money market is also very efficient. Securities dealers, major banks, and funds brokers maintain constant contact with one another through a vast telephone and computer network and are hence alert to any bargains.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 12

Characteristics of the Money Market

Federal funds are mainly deposit balances of commercial banks held at regional Federal Reserve banks and at larger correspondent banks across the U.S.

Federal funds are often called immediately-available funds because of the speed with which money moves from one bank’s reserve account to that of another.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 13

Characteristics of the Money Market

In contrast, funds transferred by checks are known as clearinghouse funds. The clearinghouse is a location where checks and other cash items are delivered and passed from one depository institution to another.

Clearinghouse funds are an acceptable means of payment for most purposes, but not in the money market, where speed is of essence. Clearinghouse funds also have an element of risk.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 14

Characteristics of the Money Market

The money market is a wholesale market for funds – most trading occurs in multiples of a million dollars.

The market is dominated by a relatively small number of large financial institutions that account for the bulk of federal funds trading.

Securities also move readily from sellers to buyers through the market-making activities of major security dealers and brokers.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 15

Characteristics of the Money Market

And, of course, governments and central banks around the world play major roles in the money market as the largest borrowers and as regulators.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 16

Volume of Selected Money Market Instruments ($ Billions at Year-End)

Data Source: Board of Governors of the Federal Reserve System

Financial Instruments 1990 1992 1994 1996 1998 2000

U.S. Treasury bills $527 $658 $734 $777 $ 691 $ 647

Federal agency securities 435 484 742 926 1296 1852

Commercial paper 561 549 595 775 1163 1624

Bankers’ acceptances 55 38 30 26 14 10Federal funds borrowings & REPOs 409 448 482 610 572 618Net Euro$ borrowings by domestic banks from their own branches 37 71 76 114 152 191Certificates of deposit ($100,000 or more) 432 367 364 413 576 720

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 17

The Pattern of Money Market Interest Rates

The foundation of the market’s structure is the level of yields on Treasury bills.

Most other yields in the money market are scaled upward from Treasury bill rates.

The key price and yield determinants are safety, liquidity, marketability, and taxability.

The Pattern of Money Market Interest Rates

10 - 18

The Pattern of Money Market Interest Rates

10 - 19

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 20

Money and Capital Markets in Cyberspace

As the money market grows in size, it attracts great attention on the world wide web. Websites that are related to the money market include: http://homepage.swissonline.net/FinCalc/ http://www.enth.com/ask.asp http://www.economagic.com/fedbog.htm

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 21

Chapter Review

Introduction Characteristics of the Money Market

The Need for a Money Market Borrowers and Lenders in the Money Market The Goals of Money Market Investors Types of Investment Risk Money Market Maturities Depth and Breadth of the Money Market Federal Funds versus Clearinghouse Funds A Market for Large Borrowers and Lenders

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

10 - 22

Chapter Review

The Volume of Market Market Securities The Pattern of Interest Rates in the Money

Market