CH 11
Mini-Case: Treasury Bill Auctions Go Haywire In 1991, Salomon Smith Barney violated Treasury auction rules to corner the auction on an...
$11 billion issue (94% supposed to be max 35%). -Several top Salomon officials were forced to retire (or fired) as a result of the incident. -The Treasury also changed the auction rules to ensure a competitive auction.
In its 2016 annual report, Alphabet (Google) listed $___ _____ in short-term securities on its balance sheet, plus $__ ___ in actual cash equivalents. Apple does not keep this in its local bank. But where? This is, of course, this topic of chapter 11—Money Markets.
$58 billion, $14 billion
CS: Comparing Money Market Securities
- Issuers range from the US government to banks to large corporations - Mature in as little as 1 day to as long as 1 year - The secondary market liquidity varies substantially
CS: The Money Markets Defined
- Short-term instruments - Most have a low default probability
Money Market Instruments: Treasury Bill Auctions
- T-bills are auctioned to the dealers every Thursday. - The Treasury may accept both competitive (state both amount desired and price willing to pay) and noncompetitive (only amount of securities desired and all are accepted) bids, and the price everyone pays is the highest yield paid to any accepted bid.
CS: Who Participates in Money Markets?
- U.S. Treasury - Commercial banks - Businesses - Individuals (through mutual funds)
CS: Purpose of Money Markets
- Used to "warehouse" funds - Returns are low because of low risk and high liquidity
Table 11.2 Money Market Participants -Investment companies (brokerage firms) -Finance companies (commercial leasing companies)
-Trade on behalf of commercial accounts -Lend funds to individuals by raising funds in money market primarily by selling commercial paper
Investment rate
-more accurate representation of what an investor will earn, since it uses the actual number of days per year
Money Market Instruments: Eurodollars Rates -London interbank bid rate (LIBID) -London interbank offer rate (LIBOR) -Time deposits with fixed maturities
1. (LIBID) - The rate paid by banks buying funds 2. (LIBOR) - The rate offered for sale of the funds 3. Time deposits with fixed maturities - Largest short term security in the world
Money Market Instruments: Banker's Acceptances Advantages (5)
1. Exporter paid immediately 2. Exporter shielded from foreign exchange risk 3. Exporter does not have to assess the financial security of the importer 4. Importer's bank guarantees payment 5. Crucial to international trade
The Money Markets Defined: Why Do We Need Money Markets? (4)
1. The banking industry should handle the needs for short-term. 2. Banks have an information advantage. 3. Banks, however, are heavily regulated. 4. Creates a distinct cost advantage for money markets over banks.
Money Market Instruments (7)
1. Treasury Bills 2. Federal Funds 3. Repurchase Agreements 4. Negotiable Certificates of Deposit 5. Commercial Paper 6. Banker's Acceptance 7. Eurodollars
The Money Markets Defined (3)
1. Usually sold in large denominations ($1,000,000 or more) 2. Low default risk 3. Mature in one year or less from their issue date, although most mature in less than 120 days
Money Market Instruments: Commercial Paper Commercial paper volume: (2)
1. fell significantly during the recent economic recession 2. annual market is still large, at well over $0.85 trillion outstanding
Money Market Instruments: Commercial Paper A special type of commercial paper, known as asset-backed commercial paper (ABCP) (3)
1. played a key role in the financial crisis in 2008 backed by securitized mortgages 2. often difficult to understand 3. accounted for about $1 trillion -secured by a bundled of assets
Money Market Instruments: Negotiable Certificates of Deposit
A bank-issued security that documents a deposit and specifies the interest rate and the maturity date --Term security since the maturity date is specified as opposed to a demand deposit which can be withdrawn at any time - Denominations range from $100,000 to $10 million --few negotiable CD's are less than $1 million -2nd most popular money market instrument behind T-bill
Table 11.2 Money Market Participants -Money Market Mutual Funds
Allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities
Money Market Instruments: Banker's Acceptances
An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods. -These are often used when buyers / sellers of expensive goods live in different countries.
Figure 11.6 Interest Rates on Money Market Securities, 1990-2016
Appear to move very closely over time -all are very low risk and short term -close substitutes all have deep markets (competitive)
Table 11.2 Money Market Participants -Commercial Banks
Buy U.S. Treasury securities; sell certificates of deposit and make short-term loans; offer individual investors accounts that invest in money market securities -Biggest Money Center Banks: Citigroup, Bank of America, JP Morgan, and Wells Fargo
Table 11.2 Money Market Participants -Businesses
Buy and sell various short-term securities as a regular part of their cash management -limited to major corps due to the large dollar amounts involved
Table 11.2 Money Market Participants -Federal Reserve System
Buys (interest should be lowered) and sells (if interest should be raised) U.S. Treasury securities as its primary method of controlling interest rates
Table 11.2 Money Market Participants -Individuals
Buys and sells U.S. Treasury securities as its primary method of controlling interest rates
Figure 11.4 Return on Commercial Paper and the Prime Rate, 1990-April 2016
Commercial paper has become an important alternative to bank loans because of it lower cost
Money Market Instruments: Eurodollars
Eurodollars represent Dollar denominated deposits held in foreign banks. -The market is essential since many foreign contracts call for payment is U.S. dollars due to the stability of the dollar, relative to other currencies.
Figure 11.5 Volume of Commercial Paper Outstanding
Firms are attracted by the relatively low default risk, short maturity, and somewhat higher yields these maturities offer
Table 11.2 Money Market Participants -Insurance companies (property and casualty insurance companies)
Maintain liquidity needed to meet unexpected demands
The Purpose of Money Markets -Investors in Money Market: -Borrowers from Money Market:
Provides a place for warehousing surplus funds for short periods of time - Borrowers from money market provide low-cost source of temporary funds
Table 11.2 Money Market Participants -Pension Funds
Sells U.S. Treasury securities to fund the national debt -invest a portion of their cash in money markets to take advantage of stock and bond investment opportunities
Table 11.2 Money Market Participants -U.S. Treasury Department
Sells U.S. Treasury securities to fund the national debt until tax revenues are received -always a demander of funds and never a supplier -largest of all money market borrowers worldwide
Money Market Instruments: Federal Funds
Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. - Used by banks to meet short-term needs to meet reserve requirements. -Main Purpose: provide banks with an immediate infusion of reserves
Figure 11.3 Federal Funds and Treasury Bill Interest Rates, January 1990-April 2016
Shows actual fed funds rates and T-bill rates 1990 through 2016. -Notice that the two rates track fairly closely. What does this suggest about the market for T-bills and the market for fed funds?
Money Market Instruments: Treasury Bills -maturities
T-bills have 28-day maturities through 12- month maturities. - no interest paid, instead is bought at a discount
Money Market Instruments: Treasury Bill Auctions Example -The Treasury auctioned $2.5 billion par value 91-day T-bills, the following bids were received: Bidder Bid Amount 1 $500 million 2 $750 million 3 $1.5 billion 4 $1 billion 5 $600 million Bid Price $0.9940 $0.9901 $0.9925 $0.9936 $0.9939 -The Treasury also received $750 million in noncompetitive bids. Who will receive T-bills, what quantity, and at what price?
The Treasury accepts the following bids: Bidder Bid Amount 1 $500 million 5 $600 million 4 $650 million Bid Price 1. $0.9940 5. $0.9939 4. $0.9936 -Both the competitive and noncompetitive bidders pay the highest yield—based on the price of 0.9936:
Figure 11.1 Three-Month Treasury Bill Rate and Ceiling Rate on Savings Deposits at Commercial Banks, 1933 to 1986
The limits on interest rates became troublesome to banks in the late 1970s and early 1980s when inflation pushed short term interest rates above the level that banks could legally pay. -investors pulled money out of banks and into money market -ceiling removed 1986, but money market was by then well established
Money Market Instruments: Repurchase Agreements
These work similar to the market for fed funds, but nonbanks can participate. - A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3-14 days later) for a certain price.
Figure 11.2 Treasury Bill Interest Rate and the Inflation Rate, January 1973-January 2016
Treasury bills are among the lowest interest rates in the economy -use only for temporary storage as it may not even keep up with inflation
Money Market Instruments: Commercial Paper
Unsecured promissory notes, issued by corporations, that mature in no more than 270 days. -Because they are unsecured only the largest and most creditworthy corporations issue commercial paper - The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.
Money Market Instruments: Treasury Bills -Discounting
When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks.
Money Market Instruments: Commercial Paper When the poor quality of the underlying assets was exposed,..
a run on ABCP began. Because ABCP was held by many money market mutual funds (MMMFs), these funds also experienced a run. -The government eventually had to step in to prevent the collapse of the MMMF market.
The Money Markets Defined: Cost Advantages The cost structure of banks limits their...
competitiveness to situations where their informational advantages outweighs their regulatory costs. -Limits on interest banks could offer was not relevant until the 1950s. In the decades that followed, the problem became apparent.
Money Market Instruments: Eurodollars The Eurodollar market has continued to grow rapidly because...
depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market. -Multinational banks are not subject to the same regulations restricting U.S. banks and because they are willing to accept narrower spreads between the interest paid on deposits and the interest earned on loans.
The Money Markets Defined -Active secondary market:
easy to find buyers who will purchase it in future. -very flexible for short term needs
Money Market Instruments: Banker's Acceptances As seen, banker's acceptances avoid the need to...
establish the credit-worthiness of a customer living abroad. -There is also an active secondary market for banker's acceptances until they mature. The terms of note indicate that the bearer, whoever that is, will be paid upon maturity.
The Money Markets Defined: Cost Advantages Reserve requirements create additional...
expense for banks that money markets do not have -Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets, especially in the 1970s and 1980s. -When interest rates rose, depositors moved their money from banks to money markets.
Money Market Instruments: Treasury Bills Discounting Example You pay $999.813 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate?
i discount = (1,000 − 999.813) / 1,000 × 360/28 = .240%
Money Market Instruments: Treasury Bills Discounting Example You pay $999.813 for a 28-day T-bill. It is worth $1,000 at maturity. What is its investment rate?
i yt = (1,000 − 999.813) / 999.813 × 365/28 = .243%
Global: Birth of the 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 US banks. They feared the US might seize them, but still wanted dollars. So, the USSR transferred the dollars to European banks, creating the Eurodollar market.
The Money Markets Defined -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. -Active secondary market: -Wholesale markets:
The Money Markets Defined -Wholesale markets:
most transactions are very large, usually in excess of $1 million -dealers and brokers bring customers together because the large size of the transactions prevents direct participation
Money Market Instruments: Repurchase Agreements This set-up makes a..
repo agreements essentially a short-term collateralized loan. -This is one market the Fed may use to conduct its monetary policy, whereby the Fed purchases/sells Treasury securities in the repo market.
The Purpose of Money Markets -Corporations and U.S. government use these markets because...
the timing of cash inflows and outflows are not well synchronized. -Money markets provide a way to solve these cash-timing problems.
Comparing Money Market Securities -Liquidity is also an important feature,
which is closely tied to the depth of the secondary market for the various instruments PV= FV/ (1 + i)^n
Money Market Instruments: Treasury Bill Risk
zero default risk because even if the gov runs out of money they can print more to redeem when they mature -Deep market: many buyers and sellers -Liquid market: securities can be bought and sold quickly with low transaction costs