Chapter 12: Money Markets, Short-Term Investing and Borrowing
what is a money market
1. Money markets refer to a global marketplace for short-term financial investments that are easily converted to cash (e.g., highly liquid). 2. Money market securities have a maturity of one year or less and are generally debt instruments. 3. Examples of money market securities include negotiable certificates of deposit, banker's acceptances, government securities (e.g., US Treasury bills, municipal securities), commercial paper, municipal notes, federal funds, and repurchase agreements.
why is investment reporting important
+++Reliable investment reporting is important to ensure that performance and risk management goals are met, as well as to satisfy any external reporting requirements. +++The investment report should clearly illustrate the composition of a portfolio according to maturity distribution, quality ratings, and security classes. +++This presentation furnishes a simplified means for assessing investment policy compliance and affords a reader a concise overview of the investment pool and its risk exposure. +++If multiple fund managers are used, then each manager should provide separate reports for its portion of the overall portfolio.
what is the main advantage of a passive ST investment strategy
+++The main advantages of the buy-and-hold strategy are that funding needs are always met, as long as securities are structured or laddered properly to meet cash needs, and interim price fluctuations can largely be ignored since the maturity will always fulfill the investment's initial return expectation. +++The disadvantage of this investment strategy is that the firm may forego potentially lucrative alternative investments.
what is the primary advantage of a fee-based third party for securities custody
+++The primary advantage of using a fee-based third party for securities custody is that reporting is consolidated and control over the investor's entire group of holdings is established. This is especially important when an organization uses multiple investment managers (as discussed in the previous section), who otherwise might execute trades through their own brokerage. +++Since all of the portfolio's trades are handled by a single custodian, it is much easier to monitor compliance with policy and operating guidelines and identify any irregularities in trading or undue concentration. Further, since this process requires managers (internal or external) to trade through a particular custodian rather than using their own facilities, it can be an important separation-of-duties control feature. +++While some firms may be able to take advantage of complimentary custody services extended by brokerage firms to reduce expenses, third-party custodians are often required for investors using outsourced investment management.
what are the threats to an active ST investment strategy
+++The threats to cash assets from this strategy arise when time passes but prices do not rise—capital gains therefore do not materialize, and the investor's portfolio has a longer duration than intended due to the lack of capital gains. +++Investing in an actively managed portfolio, or using a total-return approach, is only appropriate for amounts of cash that can be seen as required no earlier than the longest-maturity security that might be purchased with such a strategy. +++An active short-term investment strategy requires that the in-house or outside investment manager forecast the course of interest rates over the very short term.
describe the three basic ST investment strategies
+++Varieties of short-term investment strategies are available to an organization, including a(n): >Buy-and-hold-to-maturity strategy >Actively managed portfolio strategy >Tax-based strategy +++These strategies may be used individually or in combination, depending on the organization's investment needs and strategic objectives.
compare in-house mgmt to outsourced mgmt
++In-house management (or internally managed) is generally appropriate only to the extent that the individuals charged with this responsibility have the training and experience required to effectively manage the portfolio. ++ A further requirement is that appropriate controls are in place to approve and monitor investment activity. ++The primary advantage of in-house management is that the firm maintains control over the investment process. ++However, a key disadvantage of in-house management is that it is costly to hire, train, and retain employees with the skills needed to execute the short-term investment strategy. Some firms deal with this issue by investing only in money market funds (MMFs). ++This practice may help alleviate some of the need for market knowledge and research, but does not relieve the firm of its overall responsibility to effectively manage its portfolio. ++With outsourced management (or external management) the short-term investment portfolio duties are assigned to a third party provider, such as a MMF manager or an outside money manager (e.g., an investment bank or registered investment advisor). ++While management costs or fees will be incurred (e.g., 10-100 basis points), these fees should be balanced against the cost needed to hire and maintain appropriate internal expertise. The use of external managers may also be dictated by the size and complexity of the organization's portfolio. ++External fund and money managers will typically have greater resources and experience than those usually found within an organization's treasury department. ++One of the most important of these resources is ready access to securities research. While in-house treasury managers can usually get access to research information from their broker-dealers, they must ask for it and in some cases may be required to pay for it. ++A potential disadvantage of outsourcing is that investment policies and guidelines must be communicated clearly to the outside manager, who must be able to make individual, tactical investment decisions within a portfolio independent of the investor client and within the policy guidelines (or exception provisions). ++This may become an issue when using MMFs, as the manager's investment choices may not be aligned with the client's preferences completely. Other issues can include compliance monitoring and general due diligence with regard to the safety and soundness of the outside manager.
what should a ST investment policy include
--Formulating a short-term investment policy requires (1) recognition of the primary short-term investment objective of preservation of principal and (2) that the firm's board and management determine the firm's overall risk tolerance. Additionally, a board-approved investment policy should include the following: ++Investment objectives with respect to risk and return ++Permissible and prohibited investment vehicles or classes of investments ++Minimum and acceptable security ratings ++Maximum maturity for individual securities ++Maximum weighted average maturity or duration for the portfolio ++Maximum amounts or concentration limits (either by percentage, total dollar amount, or both) of the portfolio that may be invested in individual securities, companies, instrument classes, geographic areas, or industries ++Policies/guidelines for investing in foreign securities ++Specific responsibilities for implementing the policy, by organizational title ++Methods of monitoring compliance with policies, procedures, and internal controls ++Provisions for performance measurement, evaluation, and reporting ++Responsibilities and reporting requirements for custodians, external investment managers, broker-dealers, and other investment counterparties ++Exception management and related approval processes
who are the primary participants in the money market
1. Issuers include governments, securities dealers, commercial banks, and other corporations (including not-for-profits). 2. In money markets, investors are lenders and issuers are borrowers. That is, investors purchasing money market securities are making short-term loans to issuers. 3. In many cases, money market participants are simultaneously issuers and investors, depending on their liquidity needs at a specific point in time. 4. A broker-dealer is an entity that trades securities for its own account or on behalf of its customers. 5. When executing trade orders on behalf of a customer, the institution acts as a broker. 6. When executing trades for its own account, the institution acts as a dealer. Securities bought from clients or other firms in the capacity of a dealer may be sold to clients or to other firms, acting again in the capacity of a dealer, or they may become a part of the broker-dealer's own holdings.
what are the rating classes used by most credit rating agencies (CRAs)
>>Issuer credit ratings: This type of credit rating represents the CRA's opinion on the issuer's overall capacity to meet its financial obligations. These include counterparty, corporate, and sovereign credit ratings. Counterparty ratings are made for key counterparties in financial transactions (e.g., financial institutions and insurance companies). Corporate credit ratings are on corporate debt issuers, and sovereign ratings are on government debt issuers. >>Issue-specific credit ratings: These ratings of specific long- and short-term securities consider the attributes of the issuer, as well as the specific terms of the issue, the quality of the collateral, and the creditworthiness of the guarantors.
what are the major risk factors for a ST investment portfolio
>A short-term investment portfolio will consist primarily of money market instruments, which are typically low-risk investments. Such low-risk levels are accompanied by lower returns, but this is consistent with the primary short-term investment objective of preservation of principal. >The major risk factors associated with short-term investments include: +++Credit or default risk --The risk that payments to investors of a security will not be made under the original terms of the security +++Asset liquidity risk -- The risk that a security cannot be sold quickly without experiencing an unacceptable loss +++Price/interest rate risk --The risk that arises when there are changes in interest rates for securities that are identical or nearly identical to portfolio securities +++Foreign exchange (FX) risk --The risk of a change in the exchange rate between the currency in which a security is denominated and the investor's local currency (applies to foreign currency investments only)
what is a yield curve
>A yield curve is a plot of the yields to maturity on the same investment instrument or class of instruments, but with varying maturities, as of a specific date. >For example, a yield curve for US Treasury instruments is a plot of yields to maturity for US Treasury bond issues with varying maturities as of the close of business on a particular date. >Similarly, a plot of yields to maturity for AA rated industrial bonds with various maturities is a yield curve for that class of instruments.
what are the major categories of investment risk that must be considered
>Although money market instruments are primarily low-risk/low-yield investments, it is critical for treasury professionals to understand the risks associated with this asset class. Specific risk considerations covered here include: **default/credit risk **liquidity risk **price/interest risk **foreign exchange risk.
what are bank obligations
>Banks raise funds in the money markets through time deposits, banker's acceptances (BAs), and repurchase agreements (covered later in this chapter). These are sometimes collectively referred to as bank paper or bank obligations. >Examples of time deposits include savings accounts, certificates of deposit (CDs), and negotiable CDs. Negotiable CDs are large-value time deposits issued by banks and other financial institutions that are bought and sold on the open market. Negotiable CDs are usually traded in multiples of 100,000 or more (USD or foreign currency equivalent). While all CDs have a fixed maturity, there is an active secondary market for negotiable CDs. >Nonnegotiable or retail CDs are issued in many different denominations to consumers and businesses. Drawbacks associated with nonnegotiable CDs include the lack of a secondary market and an inability to redeem them prior to maturity without a penalty
what is commercial paper (CP)
>CP refers to tradable promissory notes that represent an unsecured obligation or debt of the issuer (e.g., the CP is not backed or "secured" by any collateral of the issuer). >Maturity can range from overnight to 270 days for publicly traded CP (issued in the United States under the SEC Securities Act of 1933 Section 3(a)(3)) and up to 397 days for private-placement CP (issued under Section 4(a)(2) of the same act), but most CP matures in less than 45 days. >CP does not usually pay interest during its term. Instead, it is issued at a discounted price and the face value is paid at maturity. Therefore, the yield on CP is primarily influenced by the difference between the purchase price and the face value. The dollar discount and yield on CP are influenced by the credit rating of the issuer and on the rating for the specific issue of CP. >Most CP is purchased for a specific maturity and is held for the full term. However, CP can be traded prior to maturity on the secondary market
what is a central securities depository (CSD)?
>Central securities depositories (CSDs) are companies that hold securities to enable book-entry transfer of securities. In addition, CSDs may provide trade matching and clearing and settlement, thereby increasing the liquidity of the money market. Nearly all short-term securities are issued in noncertificated or book-entry form. >A US-based example of a CSD is the Depository Trust Company (DTC). Other examples include Euroclear (e.g., Belgium) and the Singapore Exchange (SGX) (e.g., Singapore). >Many central securities depositories settle trades in both domestic and international securities through links to local CSDs. The DTC holds over $2 trillion in non-US securities and in American depositary receipts from over 100 nations, due to the large number of trades executed in the United States.
what is a bid ask quote
>Dealers buy and sell T-bills in a secondary market and typically utilize a bid-ask quote framework. >The ask quote is the discount at which the dealer will sell the T-bill, while the bid quote is the discount at which the dealer will purchase security T-bill. >Both the bid and the ask quotes are based on a 360-day year basis because they are given in terms of a discount.
what is a floating rate note (FRN)
>Firms, banks, sovereigns, and government agencies raise short-term funds via FRNs. In terms of maturity, FRNs sit at the longer end of the money market maturity spectrum, with maturities typically of one year or longer. FRNs pay a regular coupon, as well as the promise of a return of their face value at maturity. The actual return, or margin, on a FRN is a combination of the coupon interest rate and the capital gain or loss that results from a FRN transaction, since FRNs are traded on the secondary market at a discount. If a FRN is trading at par value, then the return is identical to the coupon rate. >The name floating-rate note derives from the fact that the rate of interest resets periodically, based on a reference rate such as the London Interbank Offered Rate (LIBOR) or the Euro Interbank Offered Rate (Euribor). As a result, FRNs are sold at a quoted spread over the stated reference rate. The spread is a rate that remains constant while the reference rate can vary. FRNs can have a variety of special features, such as minimum or maximum coupon rates. Perpetual FRNs are a type of FRN that is issued with no maturity date, and investors can only recapture their capital by selling them on the secondary market.
what is a base rate
>For most borrowers, the cost of funds is expressed as the sum of a base rate plus an appropriate adjustment or spread to account for other risks involved in the arrangement. >The base rate will generally include the adjustments for inflation and maturity premiums, while the spread will factor in adjustments for the default and liquidity premiums. >The difference between the common base rates discussed below and the T-bill rate is that the rates below are essentially interbank rates (i.e., the rate at which one bank will lend to another bank). >The interbank rates will be slightly higher than the T-bill rate at any given time due to a small amount of default risk inherent in bank-to-bank borrowing arrangements.
what is a repurchase agreement (repo) and how does it work
>In a typical repo, a bank or securities dealer sells government securities it owns to an investor and agrees to repurchase them at a later date and at a slightly higher price. In most cases, this type of agreement is referred to as a repo agreement from the perspective of the entity selling the securities and agreeing to repurchase them at a later date. >From the perspective of the entity that buys the security with a promise to sell it back at a later date, it is generally known as a reverse repo. Thus, the repo side of the transaction is actually a short-term borrowing arrangement while the reverse repo side is a short-term investment arrangement.
how do intercompany loans work
>Intercompany lending may provide a low-cost source of funds. Multiple units of a firm—typically separate subsidiaries of a multinational firm that are often in different countries—may borrow and lend among themselves through an in-house bank or other internal borrowing mechanism. >Termed intercompany lending, these arrangements are formal and typically involve promissory notes or a memorandum of understanding. They are typically priced at market rates, or arm's length rates, to comply with tax and regulatory requirements; however, the entity as a whole retains the money.
what is meant by the term breaking the buck
>Money market funds generally have a net asset value (NAV) set at one until of the currency of offering, such as dollars, pounds, or euros. The primary goal of MMFs is stability and security. As long as the NAV of a fund does not fall below one unit (e.g., - $1), referred to as "breaking the buck," the investor's initial principle is secure. Historically, MMFs have been secure investments, and many treasury professionals regard them as the equivalent of cash in the bank. >It should be emphasized that MMFs are not riskless assets and funds can differ substantially in terms of risk, maturity, and return. In September 2008, the Reserve Primary Fund became the second US MMF to "break the buck." The fund held a considerable amount of commercial paper issued by Lehman Brothers, which was considered worthless after the investment bank failed. This event created a run on the Reserve Primary Fund, which then spread to other MMFs. The funds begin to sell securities and hoard cash in order to meet redemption demands. Since MMFs held approximately 40% of outstanding commercial paper at that time, corporations had difficulty finding buyers for new short-term debt. The SEC implemented several rule changes to prevent future runs on MMFs. Initial reforms adopted in 2010 reduced risk by mandating liquidity requirements to allow funds to more easily meet demand for redemptions. >Additional reforms are scheduled for implementation in October 2016. These measures apply to institutional money market funds that do not qualify as government funds. The new rules include a floating NAV, redemption fees if a fund's weekly liquid assets fall below a threshold, and the ability to suspend redemptions (redemption gates) for a period of up to 10 business days. Government MMFs which hold 99.5% or more of their assets in cash, government securities, or repurchase agreements collateralized by government securities are not subject to these rules.
what are some of the ST funding alternatives
>Short-term debt instruments mature within one year and are generally used by firms to finance current assets such as accounts receivable and inventory. >There are a number of alternatives to short-term debt issuance, including trade financing, intercompany loans, and the sale of receivables. >These are all potential sources of liquidity funding that should be considered as part of a company's short-term funding strategy.
Describe government paper
>State and local government agencies raise funds in the money market by issuing short-term promissory notes, referred to here as government paper. >The market for most country's government paper is liquid and highly active, due to the government's backing. The yields on government paper tend to be lower than other instruments of comparable maturity because of the lower default risk. >In most cases government paper is issued on a discount basis. A variety of maturities are generally available, depending on the government's borrowing requirements, allowing investors to closely match their liquidity requirements. >UK gilts, US Treasuries, German bonds, Japanese government bonds (JGBs), and Mexican government bonds are all examples of sovereign government bonds. The United States, Japan, and Europe have historically been the biggest issuers in the government bond market. >While US Treasury issues include T-bills, notes, and bonds, only those maturing within one year are classified as money market instruments. Due to a perception of low liquidity and low default risk, US treasuries are generally considered risk-free and serve as the benchmark against which interest rates on other debt securities are compared. >T-bills are money market instruments that are sold at a discount to their par value at maturity and are issued with original maturities of less than one year. At the time of this writing, bills are issued with maturities of 4, 13, 26, and 52 weeks. >Newly issued T-bills are sold through a multiple-price, sealed-bid auction. T-bills can be purchased on either a competitive or a noncompetitive basis. For investors submitting competitive bids, the bids are accepted starting with the highest price (e.g., lowest yield) offered, down to the lowest price necessary to sell the entire issue. Noncompetitive bids may also be submitted. In this case, the bidder is guaranteed to receive the desired amount of T-bills at the average price from the competitive bid process.
what does the all in cost of commercial paper include
>The all-in or total costs to issue CP include the interest rate implied in the discount, a dealer fee, and a fee for credit enhancement in the form of a backup or standby line of credit.
what is trade credit
>Trade credit arises when a customer receives goods or services but payment is not made to the supplier until a later date. >Trade credit is the primary source of short-term financing used by many firms. Since trade credit lets a buyer use the supplier's goods or services while simultaneously using the cash it otherwise would have had to pay in advance or upon delivery. >Trade credit provides a tangible economic benefit as a source of financing because the buyer may avoid liquidating investments or incurring debt over the credit period. >A firm that pays its suppliers before the invoice's due date (assuming no discount for early payment) may be foregoing an inexpensive source of short-term financing.
what are the two yields commonly quoted for ST investments
>Two yields that are commonly quoted for short-term investments include the money market yield (MMY) and the bond equivalent yield (BEY). In essence, both yields annualize the holding period yield. >The key difference in the determination of these yields is the number of days used in the calculations. The MMY is based on a 360-day year, while the BEY is based on a 365-day year. The use of a 360-day year has its roots in historical convention. The year was treated as consisting of 12 months, each with 30 days. >Rate quotes and interest payments on money market instruments are still computed using a 360-day year. An investor's effective annual yield is computed using a 365-day year.
describe the commercial book-entry system (CBES)
Operated by the US Treasury, the CBES is a multitiered, automated system for purchasing, holding, and transferring marketable treasury securities. CBES exists as a delivery system that provides for the simultaneous transfer of securities against the settlement of funds. Securities owners (or their brokers on their behalf) receive interest and redemption payments wired directly to their linked accounts. At the top tier of the CBES is the National Book-Entry System (NBES), which is operated by the Fed. For Treasury securities, the Fed operates the NBES in its capacity as the fiscal agent of the US Treasury. The Federal Reserve Banks maintain book-entry accounts for depository institutions, the US Treasury, foreign central banks, and most government-sponsored enterprises (GSEs). At the middle tier of the CBES, depository institutions hold book-entry accounts for their customers (e.g., brokers, dealers, institutional investors, and trusts). At the lower tier, each broker, dealer, and financial institution maintains book-entry accounts for individual customers, corporations, and other entities. When an investor purchases securities through a broker, dealer, or financial institution, the securities are held on the book-entry system of that firm. Holding Treasury securities in this manner is known as indirect holding since there are one or more entities between the investor and the issuer (US Treasury). The CBES has succeeded in replacing paper securities with electronic records, eliminating the potential for theft, loss, or counterfeiting.
