Chapter 5: Money Markets
CBES Tiers
1. Fed based National Book Entry System = Depository institutions, US Treasury, foreign central banks, and most government sponsored enterprises (GSEs). 2. Depository Institution-based = customers which include dealers, brokers, institutional investors, and trusts 2. Broker, dealer, and FI-based = individual customers, corporations, and other entities.
Repurchase Agreements
A bank or securities dealer sells government securities it owns to an investor and agrees to repurchase them at a later date and a slightly higher price.
Asset-backed Securities
A form of debt that requires a greater degree of due diligence prior to investing and often requires sophisticated analytical skills not normally associated with a typical corporate treasury function because both the security issue and all assets that are used as part of the collateral must be fully investigated.
Certificate of Deposit Account Registry Service (CDARS)
A private service that makes it possible to receive full FDIC insurance coverage on amounts up to $50 million by distributing the funds among CDs issued by a network of banks. The investor receives the quoted rate offered by the bank where the total deposit was made, and the service provides the investor with one periodic statement detailing the locations and amounts of the deposits.
Coupon Payment
A regular payment of interest on the face value of the investment. Typically used in instruments with maturities of greater than one year.
Open Repo
A repo with no maturity date, but rather either party can terminate the agreement on a day-by-day basis.
Liquid Security
A security that can be converted quickly and easily into cash with very little exposure to market price risk and for a small transaction cost.
Perpetual FRNs
A type of floating rate note that is issued with no maturity date, and investors can only recapture their capital by selling them on the secondary market.
Reinvestment Risk
A type of price risk associated with fixed-income and money market securities that occurs when the proceeds from an investment that has been sold, matured, or redeemed must be reinvested after market interest rates have declined.
Government National Mortgage Association (GNMA, Ginni Mae)
A wholly owned agency of the US what provides liquidity for government-sponsored mortgage programs through its mortgage-backed securities (MBSs)plan. Yields are lower than those for most other MBSs because of the backing of the US government. Individual mortgages insured or guaranteed by certain government agencies are pooled and interests in them are sold, either as MBSs or as real estate mortgage investment conduits (REMICs), supported by Ginnie Mae's guarantee. Subject to prepayment and extension risk.
Municipal Notes
Agencies, authorities, and subdivisions of the federal, state, and local governments issue these instruments. Maturities of three months to one year are typical, and range up to 270 days for CP. Most of these issues are used by local governments to provide interim financing for general obligation bond projects or short-term working capital in anticipation of future (tax) revenues. Tax-exempt.
Broker-dealer
An entity that trades securities for its own account or on behalf of it's customers.
Depository Trust & Clearing Company (DTCC)
An investment-industry owned corporation that works through its subsidiaries to provide clearing, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments, and OTC derivatives. A holding place for most stock and bond certificates; nets transactions among brokers, dealers, mutual funds, insurance companies, and other large institutional investors.
Put
An option to sell an instrument back to the issuer at par.
Banker's Acceptance
Arises out of commercial trade; represents a time draft that is issued by a purchaser of goods to pay a supplier that has been accepted by the bank on which the draft is drawn. The holder of the acceptance can either wait until the maturity to receive payment in full, or sell it at discount and receive less than face value immediately.
Credit Ratings
Assigned to specific securities based on the issue's default risk and seniority, with additional consideration given to collateral, backup lines of credit, bond insurance, or any credit enhancement provided to support the obligation.
International Central Securities Depositories (ICSDs)
Central securities depositories that settle trades in international securities as well as domestic securities, through links to local CSDs. (i.e., Clearstream, Euroclear, and SIX Securities)
Money Market Funds
Commingled pools of money market instruments typically held by banks or investment firms, which fund investors have an ownership interest. Not insured but offer daily liquidity and pay dividends (usually monthly) based on the fund's average yield for the dividend period. Adv: low cost, low risk, daily liquidity, pay dividends, easy to lock in rates or drop and move to new fund, same-day settlement Dis: Not insured
Central Securities Depositories (CSDs)
Companies that hold securities in either certificated or noncertificated (dematerialized) form, to enable book-entry transfer of securities. Nearly all short-term securities are issued in noncertificated or book-entry form. (i.e., Depository Trust Company)
Investment Sweep Accounts
Firms may have their depository institution sweep any excess end-of-day funds into an investment account. Offer investment in repos or other money market instruments, managed accounts, and mutual funds. Depending on where the funds are invested and the legal agreement with the bank, these investments may or may not be covered by gov't deposit insurance or guarantee program. Low risk/low return.
US Treasury securities
Generally considered free of default risk due to the size and strength of the US government, and are not subject to external credit ratings.
Asset-Backed Commercial Paper
Has most of the features of standard CP, but is secured against specific assets - usually short term trade receivables from a single company or a range of companies. Issued through a sponsoring FI, rather than directly by an issuing company.
Credit Enhancement
If a financial institution intermediary provides __ __ by issuing an instrument such as a standby LC or surety bond to guarantee the obligation of the borrower, then the obligation assumes the credit rating of the institution providing the enhancement.
Money Market Securities
Instruments that are traded on the various money markets, usually with a term of less than a year. Consist of negotiable CDs, banker's acceptances, government securities, commercial paper, municipal notes, federal funds, and repos.
Variable-Rate Demand Obligations (VRDOs)
Issued as long-term bonds that carry a short-term liquidity feature, or put. Generally, this put option allows for liquidation either weekly or monthly and is typically supported by a credit facility, such as a bank L/C. While interest is often tax-exempt, these securities exist as both taxable and nontaxable instruments.
Negotiable CDs
Large-value time deposits issued by banks and other financial institutions that are bought and sold on the open market. Usually traded in multiples of 100,000 or more, fixed maturity, active secondary market.
Bank Paper (Bank Obligations)
Methods banks use to raise funds in the money markets. Examples include: 1. Time deposits (CDs) 2. Repurchase agreements 3. Banker's acceptances 4. Eurodollars 5. Yankee CDs
Investment Risk
Overall __ __ considerations include: 1. Credit/Default Risk 2. Liquidity Risk 3. Price/Interest Rate Risk 4. Foreign Exchange Risk
Government-Sponsored Enterprises
Private companies that act as financial intermediaries to provide funds for loans made in the housing, education, and agriculture sectors. They do not carry the credit backing of the US government, though there is a strong implication that the federal government would intervene in a crisis to help repay investors because of the importance of their importance to public welfare.
Tranches
REMICs offer some control over default, prepayment and extension risks by allocating principal and interest payments from pools of mortgages to classes with different maturities and differing prepayment and interest characteristics that appeal to a variety of investment risk profiles.
SEC Rule 2a-7
Restricts investments in MMFs by quality, maturity, and diversity. The 2010 version of this rule imposes minimum liquidity requirements, implements daily and weekly liquidity requirements and restricts the ability of funds to purchase illiquid and lower-quality securities.
Sovereign Risk
Risk that a government itself may default.
Prepayment Risk
Risk that arises in MBS investments because as interest rates fall, mortgage refinancings increase, resulting in a higher prepayment rate. The risk associated with the early unscheduled return of principal on a fixed-income security. When principal is returned early, future interest payments will not be paid on that part of the principal. When a loan is refinanced, the original loan gets paid off, and investors then have to invest their proceeds at the new, lower market rate.
Extension Risk
Risk that arises in MBS investments because as interest rates rise, refinancings decrease, resulting in a lower prepayment rate and effectively extending the maturity of the investment. The risk of a security's expected maturity lengthening in duration due to the deceleration of prepayments. If the loans in a pool underlying a mortgage-related security are being prepaid at a slower rate, investors are unable to capitalize on higher interest rates because their investments are locked in at a lower rate for a longer period of time.
Price/Interest Rate Risk
Risk that the security being held will have a lower yield than similar securities on the market. Securities with longer maturities generally are subject to great amounts of risk than similar securities with shorter maturities because their market values are more responsible to changes in market interest rates. Exists because a fixed-rate security may have to be sold prior to maturity due to rising interest rates causing loss of principle. Managed with swaps and derivatives.
Street Name Securities
Securities held in the broker's name on behalf of the broker's customer; does not affect the rights of the actual owner of the securities, but does eliminate the need to reregister or reissue securities in the name of the actual owner.
Non-negotiable CDs
Smaller value time deposits offered in many different denominations to consumers and businesses, generally cannot be redeemed prior to maturity without a penalty and lack a secondary market.
Government Paper
State and local government agencies and authorities, as well as other government entities raise funds in the short-term money market by issuing a range of short-term paper. The market tends to be liquid and highly active, with investors having the ultimate reassurance of a sovereign issuer. Examples: T-bills: Sold at a discount to their maturity value and issued with original maturities of less than one year. Issued with maturities of 4, 13, 26, and 52 weeks. Treasury Notes Treasury Bonds
Conduit
The FI sponsoring an asset-backed commercial paper issue, rather than the issuing company. Single Seller: Backed by one institution Multi Seller: backed by assets purchased by multiple issuers
Spread
The difference between the ask and bid prices; represents the dealer's profit on a specific transaction.
Risk Premium
The extra yield above that of a comparable risk-free security that investors require as added compensation for assuming the additional risk.
Floating Rate Notes (FRNs)
The name of this money market security derives from the fact that the rate if interest resets periodically, based on a reference rate such as the LIBOR or Euribor. Both companies and banks use this security to raise funds in the ST market. These pay a regular coupon, as well as the promise of a return of their face value at maturity. Adv: variable rate, less volatility, published credit ratings Dis: Capital value can fluctuate between resets, bid-offer spread creates disincentives for trading, small denominataions
Money Market
The part of the global financial market that deals with financial instruments that are easily converted to cash (highly liquid) and have very short maturities, usually one year or less.
Counterparty
The person or entity on the other side of a financial transaction.
Reverse Repo
The perspective of the entity that buys securities with a promise to sell them back at a later date
Bid Price
The price or yield at which the dealer will purchase a security.
Ask Price
The price or yield at which the dealer will sell a security.
FX Risk
The risk of a change in the rate of exchange between the currency in which a security is denominated and the company's local currency. Typically only allowed when the security is being issued in a stable country or when the security is suitable as part of an overall currency hedging strategy.
Settlement Risk
The risk that a repo would need to be sold if the selling counterparty defaults on the agreement. Taking legal possession of the underlying security (usually through a broker-dealer) also gives the investor a higher degree of comfort.
Liquidity Risk
The risk that a security investment cannot be sold quickly without experiencing an unacceptable loss; it can also affect the yield and pricing on a security. The primary determinants of this risk are its marketability and maturity. The existence of an active secondary market ensures that the short-term securities suitable for liquidity management purposes are readily marketable.
Credit/Default Risk
The risk that payments to investors on a security will not be made under the original terms. The evaluation of this risk assesses the probability that the issuer might not repay the obligation; higher yields are typically associated with higher risk. Most acceptable investment securities carry credit ratings assigned by credit rating agencies which helps to lower this risk for investors.
Short-Duration Mutual Funds
These mutual funds invest in securities with maturities that exceed the maturities of most money market instruments. Maturity is typically between one and three years. Place the majority of their holdings in government issues, CDs or CP. Could be used to match investments with forecasted cash flow needs. Adv: higher returns Dis: higher risk, no fixed NAV
Unrated Securities
These securities increase liquidity risk, must be evaluated for credit risk, and if included in an org's short-term portfolio would most likely require footnotes about the securities on any audited financial statements.
Federal Reserve Bank
This entity's role in the money markets includes : 1. Managing the initial sale and subsequent settlement of most book-entry Treasury security sales/purchases. 2. Implements US monetary policy through the FOMC by buying and selling Treasury securities often using repos 3. Buys, sells, and redeems Treasury securities in its role as fiscal agent for the US Treasury.
Commercial Book Entry System (CBES or Treasury/Reserve Automated Debt Entry System, TRADES)
This system processes and clears Treasury securities. Multi-tiered, automated system for purchasing, holding, and transferring marketable Treasury securities. Exists as a delivery system that provides for the simultaneous transfer of securities against the settlement of funds.
Commercial Paper
Tradable promissory notes issued by companies, as opposed to banks, and is normally an unsecured obligation or debt of the issuing company. Does not pay interest during it's term, but is offered at a discount and pays the face value at maturity. Maturity can range from 1 - 270 days for public securities and up to 397 days for private-placement securities. Most matures in less than 45 days. Advantages: highly liquid, easily diversifiable, broad range of maturities, active markets available. Disadvantages: not secured
Money Market Instruments
Types of __ __ __ and Investments include: 1. Commercial Paper 2. Asset-backed commercial paper 3. Bank obligations 4. Government Paper 5. Floating Rate Notes 6. Repurchase Agreements 7. Money Market Funds 8. Short Duration Mutual Funds 9. Investment Sweep Accounts
Yankee CDs
USD-denominated CDs that are sold by US branches of non-US banks. Typically have a higher rate of interest, although this is changing; remaining benefit may be geographic diversification.
Eurodollars
USD-denominated deposits held in financial institutions outside the US and may be issued as negotiable CDs or as nonnegotiable time deposits, both of which are interest-bearing. Typically have a higher rate of interest than comparable US bank securities.
Indirect Holdings
When an investor purchases securities through a broker, dealer, or financial institution, and the securities are held on the book-entry system of that firm. There are one or more entities between the investor and the issuer.
Broker
When executing trade orders on behalf of a customer, the institution is said to be acting as a ___________.
Dealer
When executing trades for its own account, the institution is said to be acting as the _______. These parties also take positions in securities so they act as the counterparty in the purchase and sale of transactions.
Participants
__ in money markets include: 1. Issuers (borrowers) 2. Investors (lenders) 3. Brokers (customer deals) 4. Dealers (bank deals) 5. Central Securities Depository (CSDs) 6. International Central Securities Depositories (ICSDs)
