Chapter 16.2 Money and Capital Markets

Eurodollar Bonds

- *Bonds that are issued in Europe by either foreign or domestic corporations* 1. Eurodollar bond interest and principal payments *can only be made in US dollars* (Eurodollars) 2. Eurodollar bonds are normally sold at *rates lower* than the US interest rates because there is less regulation 3. They also offer diversification to investors 4. *SEC does not have jurisdiction*

Eurodollars

- *Do not confuse Eurodollars with the Euro* - Are deposits in *US dollars* that have been deposited with banks outside of the US - The Fed generally is not a major participant in the Eurodollar market

Federal Funds

- *Excess funds* deposited by commercial banks at Federal Reserve Banks - Usually *funds which are in excess of reserve requirements*

Commercial Paper

- *Think of a major corporation that wants to finance its accounts receivable* 1. Normally has a *maximum maturity of 270 days* 2. Represents an unsecured promissory note of corporations 3. The proceeds may be used in anyway by the issuer 4. Normally issued for a specific amount at a discount and redeemed at face value on a specific date, but can be issued as interest-bearing certificates 5. "Prime commercial Paper" are notes issued by major corporations 6. Usually *yields more than Treasury Bills* for the same maturity - More risk involved in trading commercial paper 7. Does not pay "semi-annual" interest 8. *NOT guaranteed by the FDIC* 9. *Is NOT issued as Callable* 10. May be sold directly by the issuer 11. The quality of commercial paper is rated by Standard & Poor's, Moody's, and Fitch but *NOT* rated by *AM Best* 12. *Has an active secondary market, very liquid* 13. Exempt from SEC registration 14. Is normally issued in book entry form

Repurchase Agreements (REPOs)

- Are not generally traded by your average investor - Are usually traded between institutions - Are short-term money market instruments - Is an *agreement to purchase* US Government (or other) securities *at a fixed price*, usually on an overnight transactions 1. Most sellers are government securities dealers 2. Most buyers are corporations with surplus funds 3. The *difference* between the purchase and re-purchase price *is interest* 4. When the Fed participates in the REPO market and: -*Buys REPOs, it increases the money supply* -*Sells REPOs, it decreases the money supply* 5. REPOs usually trade in denominations of $1 million 6. *interest paid on REPOs is competitive with the Federal Funds Rate* (is the most volatile) 7. *Repo rates are negotiated between two parties* 8. Banks and thrifts often use repos to raise temporary capital 9. *Have an active secondary market* 10. Repos are not riskless transactions 11. *Some REPOs are issued as callable*

Passbook Savings Accounts

- Interest rates are changed the least and are the least sensitive to changes in the interest rates

Interbank Market

- Is an *unregulated, decentralized global market* which *trades currencies* and debt obligations such as Eurobonds - Is free from government regulation - Governments may take actions which would affect the value of their own currencies - Trading is generally conducted in units of *$50,000,00 to $100,000,000 (formerly $1,000,000 and $5,000,000)* - *Interbank* transaction *risks* include: 1. Economic Changes in countries whose currencies are being traded 2. Changes in government policies 3. Not last sale information 4. 24-hour market

Federal Funds Rate

- The interest rate charged by banks with excess reserves to banks needing overnight loans to meet reserve requirements 1. The Fed Funds rate is the *most volatile* rate in the money market 2. The rate is *normally higher* than the rate charged at the Federal Discount Window 3. *It is a leading indicator of interest rates* since it is set daily by the market, *it is not set by the Fed* 4. There is no collateral required to borrow 5. The *"effective" Federal Funds* Rate is the daily average rate of interest costs of Federal Fund's transactions throughout the country 6. A *decline* in the Federal Funds Rate *will expand the money supply* 7. A *rise* in the Federal Funds Rate *will contract the money supply* 8. *Commercial banks, small regional banks, thrift institutions, and some foreign banks are sources of Federal Funds*

Capital Market

-Are *long-term* debt and equity instruments including: 1. Equity Instruments (Common and Preferred Stock) 2. Corporate Bonds 3. Treasury Bonds 4. Municipal Bonds 5. Mortgages 6. ADRs - American Depository Receipts *Note*: *The Federal Reserve Board does NOT issue securities*

Money Market Instruments

-Are *short-term* debt instruments *(maturities of 12 months or less)* and include: 1. *Treasury Bills (most liquid)* 2. Certificates of Deposit (CDs) 3. Commercial Paper (Maximum maturity of 270 days) 4. *Banker's Acceptances (least liquid)* 5. Federal funds 6. Repurchase Agreements (Repos) 7. Eurodollars 8. Variable Rate Demand Notes *Note*; ADRs (American Depository Receipts) are capital market instruments, not money market instruments

Certificates of Deposit (CDs)

1. *Individual CDs*: a. are issued and guaranteed by banks (generally commercial banks) in return for *time deposits* b. Are issued in denominations of *$100 up to $100,00 (or more)* c. Generally have maturities of 1 year or less d. Interest is accrued and paid at maturity e. Penalties may be incurred if cashed in prior to maturity f. *Are NOT liquid* g. Are *offered primarily by banks* to their customers but can be offered by broker/dealers

Eurodollar CDs

1. Are short term instruments issued by banks outside of the US a. Interest and principal will always be paid in US Dollars

Banker's Acceptances

1. Used to finance *foreign trade and considered to be safe* 2. Drafts or bills of exchange which become money market instruments when payment is guaranteed by a bank or other financial institution - Also called "two name paper* because if the issuer cannot pay, the bank will 3. Issued on a *discount basis* so that exporters can receive immediate payment 4. Most mature within *9 months* 5. Traded OTC 6 Dealers in Banker's Acceptances *profit* from the *spread* between the price at which they are bought and sold (discount)

Money vs Capital Markets

The difference comes down to maturities: - *Money Market* instruments are investments with maturities of *12 months or less*. - *Capital Market* Instruments are long term and have maturities of *more than 12 months or no maturity at all* (such as common stock).

Negotiable or Jumbo CDs (Sometimes called Brokered CDs)

a. Are issued and guaranteed by banks (generally commercial banks) in return for *time deposits* but are *offered by broker/dealers* b. *Have $100,000 minimum deposits* c. Generally have fixed maturities of 1 year or less (Money Market instruments) d. Usually trade *"plus interest"* *(with accrued interest) which is paid to seller on settlement date* e. Penalties may be incurred if cashed in prior to maturity f. *Have a liquid Secondary Market* as compared to the market for Individual CD's but overall are not as liquid as other securities g. *Jumbo CD's can be issued as "Callable"* h. *Are FDIC insured*