Money and Fixed-Income Market
Fed Funds
Treasury Bills
Rates and Yields
Repos and Reverses
Fixed-Income Securities
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Introduction Money Market
Cash equivalents, short-term (maturity 1 year), liquid (marketable), low-risk debt securities
Instruments Federal funds Treasury bills (T-bills) Certificate of deposit Commercial paper Bankers’ acceptances Eurodollars Repurchase agreements (repos) and reverses Brokers’ calls
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Federal Funds Rate charged for Federal Funds among
the banks Most widely quoted “Fed” rate
Is it set really set by the Fed?
Effective Rate vs. Target Rate (Aug 27, 2008)
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Treasury Bills Definition
Short-term Gov. security issued at discount e.g., pay $900 today for 1yr T-bill of $1000 par value
Characteristics Highly liquid Extremely safe (virtually risk free) Exempt of state and local taxes Initial maturity at 4, 13, and 26 weeks
Pay $900
Today Maturity
Receive $1000 face (par) value
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Treasury Bills Quotation
Market convention is to use rate rather than price for T-bill quote
Bank Discount Rate (BD)
rBD: bank discount rate F: face value (par) P: price n: days to maturity
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Treasury Bills Example
A 90-day T-Bill of par $10,000 trades at $9,600. What’s the bank discount rate?
n = 90, F = $10,000, P = $9,600
Annualized return on the investment?
rBEY: bond equivalent yield (APR)
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Treasury Bills
Bond Equivalent Yield (BEY) Measures (simple) annualized return on
T-bill investment Facilitates comparison of yields between
T-bill and T-bond Bank discount rate is NOT a true interest rate Bank discount rates are converted to yields Bonds quoted in yields Converted Yields = Bond Equivalent Yield
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Treasury Bills Sample quotes from WSJ (Sep 1 2005)
MaturityDays to
MatrurityBid Asked Chg Ask Yield
Nov 10 05 70 3.38 3.37 -0.04 3.44Nov 17 05 77 3.4 3.39 -0.03 3.46Nov 25 05 85 3.42 3.41 -0.05 3.49Dec 01 05 91 3.44 3.43 -0.05 3.51
Actual # days – 2 Bank discount rate Bond Equivalent yield
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Treasury Bills What about price?
9/1/05, on WSJ you see 12/1/05 T-bill is quoted at 3.43% (ask). How much does it cost to buy $1,000 par of that T-bill?
F = $1,000, rBD = 3.43%, n = 91, P = ?
Bond equivalent yield
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Certificates of Deposit (CD)
Issued by Denomination Maturity Liquidity Default risk Interest type Taxation
Depository Institutions
Any, $100,000 or more are marketable
Varies, typically 14 day minimum
3 months or less are liquid, if negotiable
First $100,000 ($250,000) is insured
Add on
Interest income is fully taxable
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Commercial Paper Issued by
Maturity Denomination Liquidity Default risk Interest type Taxation
Large creditworthy corporations and
financial institutions
Maximum 270 days, usually 1 to 2 months
Minimum $100,000
3 months or less are liquid if marketable
Unsecured, Rated, Mostly high quality
Discount
Interest income is fully taxable
New Innovation: Asset backed commercial paper is backed
by a loan or security. In summer 2007 asset backed CP
market collapsed when subprime collateral values fell.
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Repos and Reverses Repo screen from Bloomberg: 8/19/99
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Repos and Reverses Repurchase Agreement (Repo)
Sale of high grade security with agreement to buy it back at higher prices
Repo rate: Repo dealer’s borrowing rate implied in
the repo price differentials. Convention: 360 day
Repo Dealer
Lender
Lender
Repo Dealer
Treasury Security
Cash (P )Treasury Security
Cash (F )
Day 0:
Day n:
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Repos and Reverses Reverse Repo
Purchase of high grade security with agreement to sell it back at higher prices
Rev/Repo rate: repo dealers’ lending rate implied in the price differentials
Repo Dealer
Borrower
Borrower
Repo Dealer
Treasury Security
Cash (P )Treasury Security
Cash (F )
Day 0:
Day n:
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Repos and Reverse Example
You have $2M worth of 26 weeks T-bill you’d like to hold to maturity. However, you need $2M cash urgently for a week. What to do?
(Term) Reverse/Repo Day 0: Get $2M from a repo dealer by giving him T-
bill Look at the reverse/repo rate to determine the
amount of money to pay back
Day 7: get the T-bill back by paying $2,001,925 to the repo dealer
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Money Market Instrument Yields
Yields on money market instruments are not always directly comparable!
Factors influencing “quoted” yields Par value vs. investment value 360 vs. 365 days assumed in a year
(366 leap year) Simple vs. Compound Interest
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Major Components of the Money Market
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MMMF and the Credit Crisis of 2008 Between 2005 and 2008 money market mutual funds
(MMMFs) grew by 88%. MMMFs had their own crisis in 2008 when Lehman
Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehman’s
commercial paper. On Sept. 16, Reserve Primary fund “broke the buck.”
What does this mean? A run on money market funds ensued, and unsecured
money market rates jumped up. The U.S. Treasury temporarily offered to insure all
money funds (close to $3.4 trillion) to stop the run.
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Spreads on CDs and Treasury Bills
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Fixed-Income Securities Publicly Issued
Treasury Notes and Bonds Agency Issues (Federal Government) Municipal Bonds
Federal tax exemption Local and state tax exemption for state residents
Privately Issued Corporate Bonds Mortgage-Backed Securities
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Fixed-Income Securities What are they?
A security promising full payment of coupon and principal according to a fixed time schedule
E.g., A 10 year $10,000 T-note with 6¼% coupon
Three Prominent Characteristics Principal
Face value of a bond Interest
Coupon of a bond Maturity
Life span of a bond
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