BSAD 184- Slide 6 Money Markets

Globalization of Money Markets

-As international trade and financing have grown, money markets have developed in Europe, Asia, and South America. -The flow of funds between countries has increased as a result of tax differences among countries, speculation on exchange rate movements, and a reduction in government barriers that were previously imposed on foreign investment in securities

Negotiable Certificates of Deposit

-Certificates issued by large commercial banks and other depository institutions as a short-term source of funds. -The minimum denomination is $100,000. -Maturities on NCDs normally range from two weeks to one year. -A secondary market for NCDs exists, providing investors with some liquidity. Placement -Some issuers place their NCDs directly; others use a correspondent institution that specializes in placing NCDs. -Offer a premium above the T-bill yield in order to compensate for less liquidity and safety.

Investors in Treasury Bills

-Depository institutions retain a portion of their funds in assets that can be easily liquidated to accommodate withdrawals. -Other financial institutions invest in T-bills in case cash outflows exceed cash inflows. -Individuals with substantial savings invest indirectly through money market funds (tax benefits) -Corporations invest in T-bills to cover unanticipated expenses. -Credit Risk - Backed by federal government, virtually free of credit (default) risk -Liquidity - high liquidity due to short maturity and strong secondary market.

Federal Funds

-Enables depository institutions to lend or borrow short-term funds from each other at the federal funds rate. -The Federal Reserve adjusts the amount of funds in depository institutions in order to influence the federal funds. -The rate is normally slightly higher than the T-bill rate at any given time. -Commercial banks are the most active participants.

Institutional use of money markets

-Financial institutions purchase money market securities in order to earn a return while maintaining adequate liquidity.(Exhibit 6.6) -Money market securities can be used to enhance liquidity in two ways. -Newly issued securities generate cash. - Purchased money market securities will generate cash upon liquidation. -Financial institutions that purchase money market securities are acting as creditors to the initial issuers of the securities.

Interest Rate Risk

-If short-term interest rates increase, the required rate of return on money market securities will increase and the prices of money market securities will decrease. -An increase in interest rates is not as harmful to a money market security as it is to a longer term bond. Measuring Interest Rate Risk -Participants in the money markets can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates.

Banker's Acceptances

-Indicates that a bank accepts responsibility for a future payment. -Commonly used for international trade transactions. -Exporters can hold a banker's acceptance until the date at which payment is to be made, but they frequently sell the acceptance before then at a discount to obtain cash immediately. -Because acceptances are often discounted and sold by the exporting firm prior to maturity, an active secondary market exists.

Treasury Bill Auction

-Investors can submit bids online for newly issued T-bills at www.treasurydirect.gov. -Investors have the option of bidding competitively or noncompetitively.

Treasury Bills

-Issued when the U.S. government needs to borrow funds. -The Treasury issues T-bills with 4-week, 13-week, and 26-week maturities on a weekly basis. -The par value (amount received by investors at maturity) of T-bills was historically a minimum of $10,000, but now it is $1,000 and multiples of $1,000. -Are sold at a discount from par value, and the gain is the difference between par value and the price paid -Backed by the federal government and are virtually free of credit (default) risk. -Highly liquid, due to short maturity and strong secondary market.

Money Market Securities

-Money market securities are debt securities with a maturity of one year or less. -Issued in the primary market through a telecommunications network by the Treasury, corporations, and financial intermediaries that wish to obtain short-term financing. -Are commonly purchased by households, corporations, and governments that have funds available for a short time period. -Can be sold in the secondary market and are liquid.

Pricing Treasury Bills

-Priced at a discount from their par value -Price depends on the investor's required rate of return -Value of a T-bill is the present value of the par value -Example: If investors require a 4 percent annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is: P = $10,000 / (1.04) P = $9,615.38

Commercial Paper

-Short-term debt instrument issued by well-known, creditworthy firms and is typically unsecured. -Normally issued to provide liquidity or to finance a firm's investment in inventory and accounts receivable. -An example of "Disintermediation" Denomination -The minimum denomination of commercial paper is usually $100,000. -Maturities are normally between 20 and 45 days but can be as short as 1 day or as long as 270 days. Credit Risk -Issued by corporations susceptible to failure, therefore subject to failure. -Risk is affected by issuer's financial condition and cash flow.

The more popular money market securities are

-Treasury bills (T-bills) -Commercial paper -Negotiable certificates of deposit -Repurchase agreements -Federal funds -Banker's acceptances

Repurchase Agreements

-With a repurchase agreement (repo), one party sells securities to another with an agreement to repurchase the securities at a specified date and price. -A reverse repo is the purchase of securities by one party with an agreement to sell them. -A repurchase agreement (or repo) represents a loan backed by the securities. -Financial institutions often participate in repos. -The size of the repo market is about $4.5 trillion. Transaction amounts are usually for $10 million or more. -The most common maturities are from 1 day to 15 days and for one, three, and six months. Placement -Negotiated through a telecommunications network. -Dealers and repo brokers act as financial intermediaries to create repos for firms with deficient or excess funds, receiving a commission for their services. Impact of the Credit Crisis -Many financial institutions that relied on the market for funding were not able to obtain funds. -Investors became more concerned about the securities that were posted as collateral

Eurodollar Securities

-dollar deposits in Europe -Eurodollar CDs - large, dollar-denominated deposits (such as $1 million) accepted by banks in Europe. -Euronotes - short-term securities issued in bearer form with common maturities of one, three, and six months. -Euro-commercial paper - issued without the backing of a banking syndicate. Maturities can be tailored to satisfy investors.

International Interbank Market

-facilitates the transfer of funds from banks with excess funds to those with deficient funds. -LIBOR Scandal - In 2012, some banks falsely reported their rates that they periodically report in the interbank market.

Commercial Paper(Cont)

Credit Risk Ratings -Assigned by rating agencies such as Moody's Investors Service, Standard & Poor's Corporation, and Fitch Investor Service. -Serves as an indicator of the potential risk of default. -Higher credit ratings suggest lower expectancy of credit default. (Exhibit 6.2) Placement -Firms place commercial paper directly with investors or rely on commercial paper dealers to sell their commercial paper. Backing Commercial Paper -Some backed by assets of the issuer and offers lower yield than unsecured commercial paper. -Issuers of commercial paper typically maintain backup lines of credit. Estimating the Yield -Commercial paper does not pay interest and is priced at a discount from par value. -The yield on commercial paper is higher than the yield on a T-bill with the same maturity because of credit risk and less liquidity. Commercial Paper Yield Curve -Represents the yield offered on commercial paper at various maturities. -The same factors that affect the Treasury yield curve affect the commercial paper yield curve, but they are applied to very short-term horizons. Commercial Paper Rate Over Time -Highly correlated with the T-bill rate with the same maturity. (Exhibit 6.3)

Impact of Changes in Credit Risk

Credit risk following Lehman's default -Institutional investors were less willing to invest in commercial paper because of concerns that other firms might default. As a result, many firms were no longer able to rely on the commercial paper market for short-term funding. -The Emergency Economic Stabilization Act of 2008 was enacted, which helped to stabilize the money markets. -In November 2008, the Fed began to purchase commercial paper issued by highly rated firms to increase liquidity in the commercial paper market Risk Premiums following Lehman's default -During periods of heightened uncertainty, investors shift from risky money market securities to Treasury securities in a flight to quality.

Effective Annual Yield (rate of return) on a pure discount bond:

K=(FV/P)^1/T -1 Where: FV is the future value (or Par value) of the bond ($10,000) P is the current transaction price of the bond ($9,600) T is the time to maturity in years, days to maturity over 365 (assume 182)