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Money market is a subsector of the fixed income market, consists of short term debt
securities that are highly marketable
Treasury Bills- most marketable of all money market instruments
o T-Bills are highly liquid, not much price risk, income is exempt from state and local
taxes
o Asked price- price you would have to pay to buy a T-Bill from a securities dealer
o Bid price- slightly lower price you would receive if you wanted to sell a bill to a
dealer
o Bid-asked price- difference in prices which is the dealers source of profit
o Bank discount method- bills discount from its maturity or face value is “annualized”
based on a 360 day year and then reported as a percentage of face value.
2 flaws:
Assumes year only has 360 days
Compute yield as a fraction of par value rather than of the price the
investor paid to acquire the bill
o Bond equivalent yield- annualizing return using a 365 days year
Certificate of Deposit (CD)- time deposit with bank
o Bank pays interest and principle at the end of the fixed term
o Insured up to $250,000 by FDIC
Commercial Paper- short term unsecured debt notes issued by large well known companies
o Backed by a bank line of credit
o Usually issued with maturities of less than 1-2 months
o There has been increase in asset backed commercial paper issued by financial firms
Bankers’ Acceptances- starts as an order to a bank by a bank’s customer to pay a sum of
money at a future date, typically within 6 months
o Bank accepts, is responsible for payments. Acceptance can be traded
Eurodollars- dollar dominated deposits at foreign banks or foreign branches of American
banks.
o Escape regulation of Fed
o Advantage of Eurodollar CDs over Eurodollar time deposits is that the holder can sell
the asset to realize its cash value before maturity
o Eurodollar CDs are less liquid and riskier than domestic CDs, thus offering higher
reward
Repos and Reserves- form of short term, usually overnight borrowing
o Dealer sells government securities to an investor on an overnight basis, with an
agreement to buy back those securities the next day at a slightly higher price.
o Increase in price is overnight interest
o Term repo- same as repo but term of implicit loan can be 30 days or more
o Repos considered safe since loans are backed by government securities
o Reverse repo- mirror image of a repo; dealer finds investor holding government
securities and buys them agreeing to sell them at a specific higher price on a future
date.
Federal Funds – funds in the bank’s reserve account
Brokers’ Calls- Individuals who buy stocks on margin borrow part of the funds to pay for the
stocks from their broker Broker may borrow funds from a bank, agreeing to repay the bank
immediately (on call) if bank requests it
London Interbank Offered Rate (LIBOR)- rate at which large banks in London are willing to
lend money among themselves
Yields on Money Markets Instruments
o Securities of the money market promise greater yields than on T-bills because of
greater risk
Composed of longer term borrowing or debt instruments than those that trade in the money
market; includes treasury notes and bonds, corporate bonds, municipal bonds, etc
Instruments are sometimes said to compromise the fixed income capital market because most
of them promise either a fixed stream of income or a stream of income that is determined by
a specific formula
Treasury Notes and Bonds
o Notes and bonds make semiannual payments called coupon payments
o Yield to maturity- calculated by determining the semiannual yield and then doubling
it
Inflation Protected Treasury Bonds
o Called TIPS (Treasury Inflation-Protected Securities)
o Principal amount of these bonds is adjusted in proportion to increases in Consumer
Price index so they provide constant stream of income in real dollars
o Yields on TIPS bonds should be interpreted as real interest rates
Federal Agency Debt
o Formed to channel credit to a particular sector of the economy that Congress believes
might not receive adequate credit through normal private sources
International Bonds
o Eurobond- bond dominated in a currency other than that of the country in which it is
issued
Municipal Bonds- issued by state and local governments
o Interest income is exempt from federal income taxation and state and local taxation in
the issuing state
o Two types of municipal bonds:
General obligation bonds- backed by the hull faith and credit of the issuer
Revenue bonds- issued to finance particular projects and are backed either by
the revenues from the project or by the particular municipal agency operating
that project. Ex: hospitals, port authorities, airports
Industrial development bond- revenue bond that is issued to finance
commercial enterprises, such as the construction of a factory that can be
operated by a private firm
Give firm the access to the municipality’s ability to borrow at tax exempt rates
but limited how many of these bonds can be issued
Tax anticipation notes- short term notes; raise funds to pay for expenses
before the actual collection of taxes
Key feature of municipal bonds is their tax exempt status
o Equivalent taxable yield- rate a taxable bond must offer to match the after tax yield
on the tax free municipal
r(1-t)=rm
If the equivalent taxable field exceeds the actual yields offered on taxable
bonds, the investor is better off after taxes holding municipal bonds
High tax bracket investors tend to hold municipals
Yield ratio rm/r is a key determinant of the attractiveness of municipal bonds;
higher the yield ratio the lower the cutoff tax bracket and the more indivudals
will prefer to hold municipal debt
Corporate Bonds- means by which private firms borrow money directly from the public
o Typically pay semiannual coupons over their lives and return the face value to the
bondholder at maturity
o Secured bonds- have specific collateral backing them in the event of firm bankruptcy
o Unsecured bonds (debentures)- have no collateral
o Subordinated debentures- lower priority claim to the firm’s assets in the event of
bankruptcy
o Callable bonds- give firm option to repurchase the bond from the holder at a
stipulated call price
o Convertible bonds- give bondholder the option to convert each bond into a stipulated
number of shares of stock
Mortgages and Mortgage Backed Securities
o Mortgage backed security- ownership claim in a pool of mortgages or an obligation
that is secured by such a pool
o Mortgage lenders originate loans and then sell packages of these loans in the
secondary market. They sell claim to the cash inflows from the mortgage as loan is
paid off. Originator continues to service the loan, collecting principle and interest
payments, and passes these payments to the purchaser of the mortgage; Called pass
throughs
o Conforming mortgages- loans must satisfy certain underwriting guidelines before
they are purchased by Fannie Mae or Freddie Mac
o Subprime mortgages- riskier loans made to financially weaker borrowers were
bundled and sold by private label issuers
Derivative Assets- instruments that provide payoffs that depend on the values of other assets
such as commodity prices, bond and stock prices or market index values.
Options
o Call option- gives holder the right the purchase an asset for a specified price, called
the exercise of strike price on or before the specified expiration date
o Put option- gives holder the right to sell an asset for a specified exercise price on or
before a specified expiration date.
Futures Contract- calls for delivery of an asset at a specified delivery or maturity date for an
agreed-upon price, called the futures price to be paid at contract maturity
Long position- held by trader who commits purchasing the asset on the delivery day
Short position- commits to delivering the asset at contract maturity
Futures contract obliges the long position to purchase the asset at the futures pice; call option
conveys the right to purchase the asset at the exercise price
Purchase price of the option is called the premium