The Money Market Notes

7/30/2019 The Money Market Notes

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Definition of Money Markets: The term money market is a misnomer. Money (currency) is not

actually traded in the money markets. The securities in the money market are short-term with high

liquidity; therefore, they are close to being money.

Main functions of money market:

Provide a place to trade financial assetsProvide an efficient pricing system

Increase liquidity via secondary markets

Reduce transaction costs

London is one of the three major financial centres (the other two being New York & Tokyo). This is

because of the large number of overseas banks transacting in foreign currencies on the financial

markets.

The purpose of money market: (Borrowing and lending short-term)A well-developed secondary market

for money market instruments make the money market an ideal place for a firm or financial institution

to handle surplus funds until they are needed. The money market provide a low cost source of funds to

firms, government and intermediaries that need a short-term infusion on funds. Investors use money

market as an investment that provides a higher return than holding cash or money in banks. They hold

the money market securities until a better investment opportunity is created.

Securities with maturities within one year are called money market securities (T-bills, CP, CDs, repos,

interbank, bankers acceptance).The money market securities have three basic characteristics: they are

usually sold in large denominations (more than 50 000, but usually 500 000 and 1 000 000); they

have low default risk; they mature in one year or less from their original issue date. (less than 120 days).

Money market securities are issued by corporations and governments. They are usually purchased by

corporations and governments that have short term funds. They usually provide liquidity to investors.

Treasury bills: to finance the national debt, the U.S Treasury Department issues a variety of debt

securities. The most widely held and most liquid security is the Treasury Bill. Treasury bills are sold with

maturity form 28 to 1 year maturity. The government does not pay an interest for treasury bills. The

investors yield comes from the increase in value of the security between the time it is purchased and the

time it is matured. Treasury bills have virtually zero default risk, because even if the governments run

out of money, it could simply print more money or increase tax (revenues). The risk of unexpected

inflation is also low because of the short term to maturity. Thus the market for treasury bills is

extremely deep and liquid.

Who invest on treasury bills?Depository institutions because T-bills can be easily liquidated

Other financial institutions in case cash inflows exceed cash outflows

Individuals with substantial savings for liquidity purposes

Corporations to have easy access to funding for unanticipated expenses


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Estimating the Yield:

T-bills do not offer coupon payments but are sold at a discount frompar value. So, their yield is

influenced by the difference between face value and purchase price: Y= (F-P)/F * (360/t).

Business periodicals often quote the T-bill discount which represents the percent discount of the

purchase price from face value

Ie. At which discount rate would a T-bill with 100 days to maturity, a face value of $100,000 and selling

for $97,569 be quoted?

Y= ( F-P /F) *(360/t) = (2,431/ 100,000)* (360 /100)=8.75%

Investment rate equation: Y= ( F-P /F) *(365/t) Annualized yield (or bond equivalent yield)

The difference between a bond equivalent yield and discount yield:

Most of money market securities do not pay interest. Instead, the investor pays less for the security

than it will be valued when it matures, thus the increase in price provides a return. This is called

discounting and is common to short term securities. The bond equivalent yield (investment rate) is a

more accurate representation of what an investor will earn since it uses the actual number of days per

year and the true initial investment on the calculations.

Commercial paper: are issued by large creditworthy corporations and represents a short term

unsecured promissory note. It Is an alternative to short-term bank loans and has a minimum

denomination of $100,000. Moreover, it has a typical maturity between 20 and 270 days. Usually Is

issued by financial institutions such as finance companies and bank holding companies. Has no active

secondary market and it Is typically not purchased directly by individual investors. Non bank

corporations use commercial paper to finance the loans they extend to their customers. For example

General Motors Acceptance Corporation borrows money by issuing commercial paper and uses the

money to make loans to consumers. Some of the large issuers of commercial paper choose to distribute

their securities with direct placements (direct sell of securities to the end investors). The advantage of

this method is that the issuer saves 0.125% commission that dealer charges. Companies with high credit

ratings can borrow funds at more competitive rates than they can obtain from banks.

Disintermediation? Companies by-pass Financial Institutions and deal directly with the wholesale money

markets (it is a concern for banks).

CP ratings and placement:

Ratings: The risk of default depends on the issuers 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.Placement: Some firms place commercial paper directly with investors. Most firms rely on commercial

paper dealers to sell it.

Who invests in CP? Institutional investors (MMMF 1/3 of all CPs); Pension Funds; State and local

government; Commercial banks.


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The minimal amount invested is 25 000-100 0000). There is not much secondary activity. Maturity less

than 270 days (typically: 30-50days) in order to avoid costs of registration with the SEC.

In recent years, lower credit companies manage to issue commercial paper by:

- means of credit support from a high credit firm (ie. A credit supported CP is one supported by a letter

of credit (LOCP))- collateralising the issue with high quality assets (ie asset-backed CP)

CP issued by foreign entities in the US= Yankee CP

1987: Japanese companies issue CPs in Japan & non-Japanese in Yen (Samurai CP)

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?

Nagotionable Certificates of Deposit

Issued by large commercial banks and other depository institutions as a short term source of funds. A CD

bears a maturity date and a specified interest rate. A CD may be nonnegotiable or negotiable (early

60s). Issuers place their NCDs directly or via a specialist or by selling them to securities dealers. NCDs

offer a premium over the T-bill yield. Premiums are generally higher during recessionary periods.

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

According to the issuing institution, NCDs are classified in

- NCDs issued by domestic banks

- NCDs denominated in a major currency but issued outside the country of currency jurisdiction (e.g.,

Eurodollar CDs, CDs issued outside the US but denominated in $)

- NCDs denominated in the home currency but issued by foreign banks (e.g., Yankee NCDs, CD in $

issued by a foreign bank in the US)

- Thrift NCDs issued by S&L Associations and savings banks

Birth of Eurodollar

The Eurodollar market is one of the most important financial markets, but oddly enough, it was fathered

by the Soviet Union.In the 1950s, the USSR had accumulated large dollar deposits, but all were in USbanks. They feared the US might seize them, but still wanted dollars. So, the USSR transferred the

dollars to European banks, creating the Eurodollar market.


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Yield of the CD

CDs yield is higher than that of Treasury securities of the same maturity. Yield depends on:

Credit rating of issuing bank (prime vs non-prime CDs),

Maturity of CD,

D&S of CDs

(ie. Banks issue CDs as part of their liability mgt, so, the supply of CDs is driven by the demand for bank

loans & the cost of alternative sources of funds. In turn, bank loan demand will depend on the cost of

alternative borrowing sources (ie CP). If loan demand is weak, CD rate falls)

Repurchase Agreement: A repo represents the sale of securities by one party to another with an

agreement to repurchase the securities at a specified date and price (in essence, 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. Repo transactions use government securities, CP or NCDs. Transactions

amounts are usually for $10 million or more. Common maturities are from 1 day to 15 days and for 1, 3

& 6 months. A secondary market for repos does not exist

Example: A Treasury dealer wants to borrow $10,000,000. He can use $10m securities that he owns ascollateral for the loan (term of loan & repo rate are specified). He will agree to sell the $10m securities

to someone with unused funds for an amount determined by the repo rate and buy (repurchase) the

same securities for a higher price than $10m. So, with a repo, I sell a security & I repurchase it later. The

sale & repurchase price are specified in the agreement. The difference is the dollar interest cost of the

loan. For the borrower, the cost is less than the cost of bank financing. For the lender, the yield is

attractive on a S/T secured transaction (highly liquid)

Estimating 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?

Interbank Funds

This market allows depository institutions to effectively lend or borrow short term funds from each

other at the interbank rate. Commercial banks are the most active participants in the interbank market.

Negotiations take place directly over a communications network or through a Fed funds broker. The

effective interbank rate is defined as the weighted average of rates on trades through all brokers.

Interbank rate is higher than both the T-bill & the repo rate

Bankers Acceptance

It represents a bank accepting responsibility for a future payment and is commonly used for

international trade transactions (Facilitate commercial trade transactions). Banks act as guarantors on

behalf of importers and receive a fee. Exporters hold the bankers acceptance until maturity, or sell it

before maturity at discount. There is a relatively active secondary market for acceptances. The yield of

bankers acceptances is higher than that of T-bill rates (credit risk, liquidity).


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Steps Involved in bankrs 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 exporters bank. The exporter sends the goods to the

importer and the shipping documents to its bank. The shipping documents are passed along to the

importers bank.

Sequence of Steps in the Creation of A Bankers Acceptance

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 issuersfinancial condition is limited.

The Money Market Notes

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