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

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

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, Corporations invest in T-bills to cover unanticipated expenses

Risk Premiums among Money Market Securities

During periods of heightened uncertainty, investors shift from risky money market securities to Treasury securities in a flight to quality

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. The volume of interbank loans on commercial bank balance sheets over time is an indication of the importance of lending between depository institutions.

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.

Institutional Use of Money Markets

Financial institutions purchase money market securities in order to earn a return while maintaining adequate liquidity. 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.

Placement

Firms place commercial paper directly with investors or rely on commercial paper dealers to sell their commercial paper

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.

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.

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

Premium

Offer a premium above the T-bill yield in order to compensate for less liquidity and safety

If investors require a 7 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 / (1.07) P = $9,345.79

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

Yield

Provide a return in the form of interest along with the difference between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase price

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

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, 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

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

Placement

Some issuers place their NCDs directly; others use a correspondent institution that specializes in placing NCDs

SUMMARY

The main money market securities are Treasury bills, commercial paper, NCDs, repurchase agreements, federal funds, and banker's acceptances. These securities vary according to the issuer. Consequently, their perceived degree of credit risk can vary. They also have different degrees of liquidity. Therefore, the quoted yields at any given point in time vary among money market securities. Financial institutions manage their liquidity by participating in money markets. They may issue money market securities when they experience cash shortages and need to boost liquidity. They can also sell holdings of money market securities to obtain cash. The value of a money market security represents the present value of the future cash flows generated by that security. Since money market securities represent debt, their expected cash flows are typically known. However, the pricing of money market securities changes in response to a shift in the required rate of return by investors. The required rate of return changes in response to interest rate movements or to a shift in the security's credit risk. Interest rates vary among countries. Some investors are attracted to high interest rates in foreign countries, which cause funds to flow to those countries. Consequently, money markets have become globally integrated. Investments in foreign money market securities are subject to exchange rate risk because the foreign currency denominating the securities could depreciate over time.

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

International Interbank Market

facilitates the transfer of funds from banks with excess funds to those with deficient funds.