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Transcript of Money and Capital Markets 11 C h a p t e r Eighth Edition Financial Institutions and Instruments in...
Money and Capital Markets
1111C 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
Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds, and Bank CDs
Money Market Instruments: Treasury Bills, Repurchase Agreements, Federal Funds, and Bank CDs
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Learning Objectives
To examine the characteristics of Treasury bills and the workings of the government securities market.
To learn how securities dealers operate and why they are so important to the functioning of the money market.
To understand how banks borrow and lend funds through Federal funds trading and the issuance of CDs.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Learning Objectives
To see the impact that the managerial strategy known as liability management has on bank performance and practice in recent years.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Introduction
The money market supplies the cash needs of short-term borrowers and provides savers who hold temporary cash surpluses with an interest-bearing outlet for their funds.
In this chapter, we focus on securities dealers and banks, and explore in detail four popular money market instruments – Treasury bills, repurchase agreements, Federal funds, and bank CDs.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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U.S. Treasury Bills
U.S. Treasury bills (T-bills) are direct obligations of the U.S. government that have an original maturity of one year or less.
Tax revenues or any other source of government funds may be used to repay the holders of these financial instruments.
They carry great weight in the financial system due to their zero (or nearly zero) default risk, ready marketability, and high liquidity.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Volume of U.S. Treasury Bills Outstanding
Data Source: Board of Governors of the Federal Reserve System
1960 $ 39.4 $ 189.0 20.8 %1965 60.2 214.6 28.11970 87.9 247.7 35.51975 157.5 263.2 43.41980 216.1 623.2 34.71985 399.9 1,437.7 27.81990 527.4 2,195.8 24.01995 760.7 3,307.2 23.02000 646.9 2,966.9 21.82001 811.2 2,983.0 27.2
End of
Year
Total Volume of Bills
Outstanding($ Billions)
Marketable Public Debt of the U.S.($ Billions)
T-bills as a % of the Total Marketable Public Debt
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Types of Treasury Bills
Regular-series bills are issued routinely every week or month in competitive auctions with original maturities of three months (13 weeks), six months (26 weeks), and one year (52 weeks).
Irregular-series bills are issued only when the Treasury has a special cash need. These instruments include strip bills and cash management bills.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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How Bills Are Sold
Source: U.S. Bureau of the Public Debt
How Bills Are Sold11 - 9
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Calculating the Yield on Bills
T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value.
Bill yields are determined by the bank discount method, which does not compound interest rates and uses a 360-day year for simplicity.
The bank discount rate (DR) on T-bills
= Par value – Purchase price 360 . Par value Days to maturity
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Calculating the Yield on Bills
Because the rates of return on most other debt instruments are not figured in the same way, comparisons with other securities cannot be made directly.
The investment yield or rate (IR) on T-bills
= Par value – Purchase price 365 . Purchase price Days to maturity
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Market Interest Rates on Treasury Bills
2
4
6
8
10
12
14
1961 1966 1971 1976 1981 1986 1991 1996 2001
3-Month
12-Month
Data Source: Board of Governors of the Federal Reserve System
%
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Investors in Treasury Bills
T-bills are held mainly by commercial banks, nonfinancial corporations, state and local governments, and the Federal Reserve banks.
Commercial banks and private corporations hold T-bills as a reserve of liquidity.
The Federal Reserve banks conduct part of their open market operations in T-bills because of the depth and volume of activity of the market.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Primary Dealers
Primary dealers are dealer firms that are qualified to trade securities directly with the Federal Reserve Bank of New York.
Primary dealers agree to “meaningfully participate” in trading with the Federal Reserve at any time the Fed wishes, to make “realistic” bids, and to trade continuously in the full range of government securities.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Primary Dealers
Primary dealers have a significant incentive to attempt to corner the government securities market and to collude and place common bids, so that all the dealers can get some share of the new securities to fill their customers’ orders and make a profit.
In the wake of a scandal involving Salomon Brothers in 1991, auction rules were tightened and a market-surveillance committee was created.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Primary Dealers
Then in 1998, the U.S. Treasury abandoned its first-price sealed-bid, or English auction approach, in which each successful bidder paid the price that it had bid.
It adopted the uniform-price, or Dutch auction method, in which all successful bidders receive securities at the same price – the market-clearing or stop-out price.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Dealers in the Money Market
The bulk of the dealers’ operating capital is obtained through borrowings from commercial banks and other institutions.
The two most heavily used sources of dealer funds are demand loans from the largest banks and repurchase agreements with banks and other lenders.
A demand loan may be called in at any time if the banks need cash urgently.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Dealers in the Money Market
Under a repurchase agreement (RP), the dealer sells securities to a lender but makes a commitment to buy back the securities at a later date at a fixed price plus interest.
RPs are simply a temporary extension of credit collateralized by marketable securities.
Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months, …) while continuing contracts may be terminated by either party on short notice.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Dealers in the Money Market
Interest income from RPs
= Amount Current Number of days loaned . of loan RP rate 360 days
Periodically, RPs are marked to market. If the price of the pledged securities has dropped, the borrower may have to pledge additional collateral.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Sources of Dealer Income
Dealers hope to earn a profit (the positive spread between the bid and ask prices) from their market-making activities.
By correctly anticipating interest rate movements, dealers may earn sizable position profits too. If interest rates fall (and security prices rise),
dealers will experience capital gains on a long position (but losses on a short position).
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 21
Sources of Dealer Income
Dealers also receive carry income, the difference between interest earned on the securities they hold and their cost of borrowing funds.
In addition, dealers receive miscellaneous service fees for their advice and assistance to customers.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Dealer Positions in Securities
Dealer holdings of securities are both huge and subject to erratic fluctuations, due mainly to interest rate movements and expectations.
Today, dealers make heavy use of interest rate hedging tools to further protect their portfolios from losses due to changes in interest rates. They are active participants in the financial futures
markets and are also making increased use of forward commitments.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Government Security Brokers
Government securities dealers usually trade among themselves through brokers.
Government security brokers do not take investment positions themselves, but try to match bids and offers placed with them by dealers and other investors.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Banks in the Money Market
Principal channel for payments for
loans, securities & other transactions
Banks’ Money Market Roles
Agents in trust for property management
on behalf of bank customers
Direct lenders to money market
borrowers
Guarantors of performance & payment
Channel for government
money & credit policy
Custody agents for safekeeping securities owned
by market participants and
pledged as collateral for
loans
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Federal Funds
Federal funds are any monies available for immediate payment (i.e. same-day money).
They are generally transferred from one depository institution to another by simple bookkeeping entries requested via an on-line computer system, by wire, or by telephone.
Federal funds are the principal means of making payments in the money market.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Federal Funds
The term federal funds came about because early in the development of the market, the principal source of immediately-available money was the reserve balance that each Federal Reserve System member bank had to keep at the Federal Reserve bank in its region.
Today, the federal funds market is broader in scope – some deposits with commercial banks are also available for immediate transfer.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Federal Funds
Banks and other depository institutions must hold in a special reserve account liquid assets equal to a fraction of the funds deposited with them by the public.
The required legal reserves may be either vault cash or reserve balances with the regional Federal Reserve banks.
Since the reserves earn little or no income, most bankers try to lend out excess reserves.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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The Structure of the Federal Funds Market
Banks & large depositors with excess reserves
available (suppliers)
Banks needing more legal
reserves & other money market
borrowers (demanders)
Accommodating banks
Funds brokers
The Central Bank
Absorbing excess funds
Supplying additional funds
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Federal Funds
Total federal funds borrowings by banks in the U.S. exceeded $600 billion as the 21st century began.
Most federal funds loans are either overnight transactions or continuing contracts that have no specific maturity and that can be terminated without advance notice by either party.
One-day loans carry a fixed rate of interest, but continuing contracts often do not.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Interest Rates on Federal Funds
Data Source: Board of Governors of the Federal Reserve System
0
2
4
6
8
10
12
14
16
1961 1966 1971 1976 1981 1986 1991 1996 2001
%
3-Month T-Bill(secondary market)
Federal Funds
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Federal Funds
Beginning 1989, the Federal Reserve has routinely set target levels for the federal funds rate, and raised or lowered those targets depending on whether it wishes to slow down borrowing and spending in the economy or speed them up.
Through daily open market operations (buying and selling securities), the Fed is able to push the funds rate in the desired direction.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Intended Federal Funds Rate
0
2
4
6
8
10
1/1/91 1/1/93 1/1/95 1/1/97 1/1/99 1/1/01
Data Source: Board of Governors of the Federal Reserve System
%
Intended Federal Funds Rate
Actual Federal Funds Rate
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Negotiable Certificates of Deposit
A certificate of deposit (CD) is an interest-bearing receipt for funds left with a depository institution for a set period of time.
True money market CDs are negotiable CDs that may be sold any number of times before maturity and that carry a minimum denomination of $100,000.
They were introduced in 1961 to attract lost deposits back into the banking system.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Negotiable Certificates of Deposit
CD interest rates are computed as a yield to maturity (ytm) on a 360-day basis. Interest = term in days deposit promised income 360 principal ytm
In secondary market trading, the bank discount rate (DR) is used as a measure of CD yields.
DR = Par value – Purchase price 360 .
Par value days to maturity
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 35
Negotiable Certificates of Deposit
The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions.
Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 36
The Market Structure for Negotiable CDs
Largedepositors
(corporations& other
customers)
Buyers in thesecondaryCD market
Moneycenterbanks
Issue primary market CDs
Funds raised to meet legal reserve requirements and
other bank cash needs
Immediatelyavailable
funds
Sale ofnegotiable
CDsRedemption
of CDs atmaturity
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 37
Negotiable Certificates of Deposit
Bankers are becoming increasingly innovative in packaging CDs to meet the needs of customers.
New types of CDs include variable-rate CDs, rollover or rolypoly CDs, jumbo CDs, Yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising-rate CDs, and foreign index CDs.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 38
Bank Activity in the Money Market
In the 1960s and 1970s, competition forced major corporations to seek out alternative investments for their short-term funds.
Bankers thus turned to the money market for additional funds – negotiable CDs appeared and the federal funds market was broadened.
Then, as policies were tightened, many bankers turned to the Eurocurrency market, commercial paper, and RPs.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Bank Activity in the Money Market
All the clever bank maneuvers form part of a technique called liability management.
By varying the daily interest rates offered on CDs and other funds sources, bankers can gain a measure of control over their liabilities. If a bank needs more funds on a given day, the
bank can simply offer a higher yield on the particular money market instrument that it desires to use.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Money and Capital Markets in Cyberspace
More information about the various money market instruments can be found at: http://www.publicdebt.treas.gov http://www.treasurydirect.gov/ http://www.federalreserve.gov/fomc/ http://www.economagic.com/fedbog.htm http://www.toerien.com/neg
_financial_instruments/negotiable_financial_instuments.htm
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Chapter Review
Introduction U.S. Treasury Bills
Volume of Bills Outstanding Types of Treasury Bills How Bills Are Sold Calculating the Yield on Bills Market Interest Rates on Treasury Bills Investors in Treasury Bills
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Chapter Review
Primary Dealers Scandal Rocks the Market for Government
Securities A New Way to Auction Government Securities
Dealers in the Money Market Reliance on Borrowed Funds
• Demand Loans and Repurchase Agreements Sources of Dealer Income Dealer Positions in Securities Government Security Brokers
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 43
Chapter Review
Banks in the Money Market Federal Funds
Nature of Federal Funds Use of the Federal Funds Market to Meet Deposit
Reserve Requirements Mechanics of Federal Funds Trading Volume of Borrowings in the Funds Market Interest Rates on Federal Funds Federal Funds and Government Economic Policy
2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
11 - 44
Chapter Review
Negotiable Certificates of Deposit Terms Attached to CDs Buyers of CDs New Types of CDs
Bank Activity in the Money Market