FINC 3310 Chapter 11 Homework
Eurodollars (Money Market Instruments)
- Eurodollars represent Dollar denominated deposits held in foreign banks - the market is essential since many foreign contracts call for payment in U.S. dollars due to the stability of the dollar, relative to other currencies - 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 Eurodollar market is one of the most important financial markets, but oddly enough it was fathered by the Soviet Union - the USSR transferred the dollars to European banks, creating the Eurodollar market
Negotiable Certificates of Deposit (money market instruments)
- a bank-issued security that documents a deposit and specifies the interest rate and the maturity date - denominations range from $100,000-$10 million- CD rates and T-bill rates track fairly closely - a term security
Banker's Acceptances (money market instruments)
- 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 - Advantages: exporter paid immediately, exporter shielded from foreign exchange risk, exporter does not have to assess the financial security of the importer, importer's bank guarantees payment, crucial to international trade - 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
When inflation rose in the late 1970s...
- brokerage houses introduced highly popular money market mutual funds, which drew significant amounts of money out of bank deposits
Money Market Characteristics
- money 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 - usually sold in large denominations (1 million or more) - low default risk - mature in one year or less from issue date (most mature in less than 120 days)
Fed Funds (money market instrument)
- short-term funds transferred (loaned and borrowed) between financial institutions, usually for a period of one day - used by banks to meet short-term needs to meet reserve requirements - fed funds rate and T-bill rates track fairly closely
Which of the following statements about money market securities are true?
- the interest rates on all money market instruments move very closely together over time - the secondary market for T-bills is extensive and well developed - there is no well-developed secondary market for commercial paper (all of the above are true!)
Commercial Paper (money market instruments)
- unsecured promissory notes, issued by corporations, that mature in more than 270 days - the use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans - commercial paper volume fell significantly during the recent economic recession, but annual market is still large - a special type of commercial paper known as asset-backed commercial paper (ABCP) played a key role in the financial crisis in '08 as it was backed by securitized mortgages - caused a run on ABCP
Repurchase Agreements (money market instruments)
- 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 (3-14 days) for a certain price - 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 Fed purchases/sells Treasury securities in the repo market
Popularity Reasons for Mutual Funds
1. Diversify investment risk by buying different types of investment 2. Managed by professional fund managers 3. Allow people to invest with small amounts
Money market instruments include
1.) Treasury Bills (Most liquid / short term) 2.)Negotiable Certificate's of Deposit 3.)Commercial Paper (unsecured promissory note) -Maximum of 270 Days -Not guaranteed by FDIC 4.)Demand Deposits (cash or cash equivalents) -Can be withdrawn without prior notice
Noncompetitive bid
An order placed for Treasury bills in which the investor agrees to pay stop out price and, in return, is guaranteed that the order will be filled.
Why are banker's acceptances so popular for international transactions?
Banker's acceptances substitute the credit worthiness of a bank for that of a business. when a company sells a product to a company it is unfamiliar with, it often prefers to have the promise of a bank that payment will be made.
_____ is/are popular with businesses located in different countries because the seller does not have to look at the buyer's financials.
Bankers Acceptances
What factor was instrumental in banks not being able to meet the short-term financing need that was filled by the creation and growth of the money markets?
Banks are exposed to greater regulations than money market instruments. These rules imposed reserve requirements and interest rate hikes on the banks. The banks could not compete with the funding needs of the money market instruments.
The Federal Reserve is the governmental organization responsible for ___ .A. controlling the deficit B. controlling the money supply C. controlling interest rates Both A. and C. Both B. and C.
Both B. and C.
_____ issue Commercial Paper.
Corporations
_____ are short-term funds transferred between financial institutions.
Federal Funds
Who issues federal funds, and what is the usual purpose of these funds?
Federal funds are sold by banks to other banks. Used by banks to meet short-term needs to meet reserve requirements.
What was the purpose motivating regulators to impose interest ceilings on bank savings accounts? What impact did this eventually have on the money markets?
Following the Great Depression, regulators were primarily concerned with stopping banks from failing. By removing interest-rate competition, bank risk was substantially reduced. The problem with these regulations was that when market interest rates rose above the established interest rate ceiling, investors withdrew their funds from banks.
London Interbank Offered Rate (LIBOR)
Lending rate among banks in the London market
Why are more funds from property and casualty insurance companies than funds from life insurance companies invested in the money markets?
Life insurance companies can invest for the long term because the timing for their liabilities is known with reasonable accuracy. Property and casualty insurance companies cannot predict the natural disasters that cause large payouts on policies.
What purpose initially motivated Merrill Lynch to offer money market mutual funds to its customers?
Merrill Lynch initially felt that it could better service its regular customers by making it easier to buy and sell securities from an account held at the brokerage house. The brokerage could offer a market interest rate on these funds by investing in them in the money markets.
Why do banks not eliminate the need for Money Markets?
Money Markets have a lower cost structure and pay a higher interest rate.
______ funds are not guaranteed or backed by the U.S. government like bank accounts are backed.
Money market
What are the main features that distinguish all money market securities from other securities?
Money market securities are sold in large denominations, low default risk, mature in one year or less from the original date.
Why is it important for money markets to be deep and liquid?
Money markets need to minimize the risk that investors cannot sell their securities.
wholesale market
Most transactions are very large, usually in excess of $1 million.
book entry
Ownership of Treasury securities is documented only in the Fed's computer. Ledger entry replaces actual security.
asset-backed commercial paper
Short-term commercial paper secured by a bundle of assets, usually mortgages. Short-term securities with more than half having maturities of 1 to 4 days. The average maturity is 30 days.
Money Markets Defined
Short-term instruments. Most have a low default probability.
Does the federal reserve directly set the federal funds interest rate? How does the fed influence this rate?
The federal reserve cannot directly set the federal funds rate of interest. It can influence the interest rate by adding funds to or withdrawing reserves from the economy.
Why are money market mutual funds popular with individuals?
These individuals have access to high dollar securities even though they may have a small amount of money to invest.
Why do Property and Casualty insurance companies invest large amounts of funds in money market securities?
To maintain liquidity to meet unexpected demands.
What is the purpose of Federal Funds?
To provide banks with an immediate infusion of reserve funds.
The _____ sell(s) Treasury securities to fund the national debt.
Treasury Department
Who participates in Money Markets?
U.S. Treasury Commercial Banks Businesses Individuals (through mutual funds)
Purpose of money markets
Used to store funds. Returns are low because of low risk and high liquidity.
demand deposit
a deposit of money that can be withdrawn without prior notice.
How can a change in interest rates affect the profitability of financial institutions?
a. affects the cost of acquiring funds & c. affects the income on loans. Both a. & c.
Businesses use money markets to _________.
a. invest in Money Market certificates in lieu of holding cash b. borrow for short term cash flow needs Both a. and b.
bearer instrument
an instrument payable to cash or to whoever is in possession of the instrument
In _____ bidding for Treasury securities, the buyers submit bids.
competitive
The Fed is an active participant in money markets mainly because of its responsibility to...
control the money supply.
Typically, increasing interest rates _____ and _______..
d. encourages savings; discourages business expansion
A _____ market is one with many buyers and sellers.
deep
Money Market securities are ______ because they have no _______.
discounted; stated interest rate
term security
have a specified maturity date
Treasury Bills mature in _____.
less than 1 year
What is the sequence of events in creating a banker's acceptance?
letter of credit, shipping documents, time draft, banker's acceptance.
Money market funds have _____ and are _________.
low default risk; highly liquid
The interest rate on negotiable CDs is usually very close to the T-bill interest rate; however, the gap between these rates increased substantially between March 2008 and mid-2009. Why do you think this happened?
rising short-term interest rates. regulations that limited what banks could pay for deposits. both A & B
Why does the US Government use Money Markets?
support government spending
direct placement
the issuer bypasses the dealer and sells directly to the end investor. the advantage of this method is that the issuer saves the 0.125% commission that the dealer charges.
London Interbank Bid Rate (LIBID)
the rate paid by banks buying funds
Which of the money market securities is the most liquid and considered the most risk-free? Why?
treasury bills are usually viewed as the most liquid and least risky of securities because they are backed by the strength of the US government and trade in extremely large volumes.
