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Money Markets

What is Money Markets?


 Refers to the network of corporations, financial institutions,
investors and governments which deals with the flow of short-
term capital.

 Money market is a specialized market geared to cater to the short


term needs. It is a market for short term financial assets which
near substitutes for money.

 The most active financial market in terms of volumes of trading.


Purpose of Money Markets

The purpose of money markets is to facilitate the


transfer of short- term funds from agents with excess
funds to those market participants who lack funds for
short- term needs.
Money Market Segments
1. Interbank Market – banks and non- deposit financial institutions settle
contracts with each other and with central bank, involving temporary liquidity
surpluses and deficits.

2. Primary Market – market that absorbs the issues and enabling borrowers to
raise new funds.

3. Secondary Market – for different short- term securities, it redistributes the


ownership, ensures liquidity, and as a result, increases the supply of lending
and reduces its price.

4. Derivatives Market – market for financial contracts whose values are derived
from the underling money market instruments.
INTERBANK MARKET
- is a market which involves bank borrowing and lending of any funds in
reserve accounts at the central bank.
- Interbank Market is defined mainly in terms of participants, while other
markets are defined in terms of instruments issued and traded. Therefore,
there is a considerable overlap between these segments. Interbank market is
referred mainly as the market for very short deposits and loans (overnight or
up to two weeks). Nearly, all types of money market instruments can be
traded in interbank market.
- in the US, the interbank market is the federal funds market, in which
involves the borrowing and lending any funds in reserve accounts at the
Federal Reserved Bank.
INTERBANK MARKET
Major Characteristics of interbank market:
• the transfer of immediately available funds
• Short time horizons
• Unsecured transfers

 Individual banks have a possibility to invest or lend surplus funds and have a source of
borrowing when their reserves are low, so they manage their reserves position and fund
their assets portfolio by trading at the interbank market.
 It is used by all types of banks, involved in loans for very short periods, from overnight
to 14 days mostly.
 If the bank borrows in the interbank market, it is said to be a funds buyer.
 And if the bank lends immediately available reserve accounts, it is said to be a seller.
PRIMARY MARKET

Primary market is the market where the securities


are issued via a regularly scheduled auction process.
Upon the securities’ announcement of the size of
upcoming auction, tenders or sealed bids are being
solicited.
PRIMARY MARKET
Two types of bids:
1. Competitive Bidder
- are the largest financial institutions that generally purchase largest amounts of securities.
- specifies both the amount of the security that the bidder wants to buy, as well as the price
that the bidder wants to pay.
- the price is set in terms of yield. The price of the securities in the auction is set based on the
prices offered in competitive bids, taking the average of all accepted competitive prices.
- the longer the maturity, the greater would be the percentage of accepted bids.
2. Non- competitive bidder
- they are the retail customers, who purchases low volumes of the issues and are not enough
sophisticated to submit a bid price.
- specifies only the amount of the security that the bidder wants to buy, without providing
the price, and automatically pay the defined price.
- the bids of these type of bidders are limited that was set on the auction.
PRIMARY MARKET
Two types of auction forms:
1. Uniform Price Auction
- all bidders pay the same price.
2. Discriminatory Price Auction
- each bidder pays the bid price.
- type of auction that is more sophisticated.
- at first, all the non- competitive bids are totals, and their sum is subtracted
from the total issue amount.
SECONDARY MARKET
• The secondary market is where investors buy and sell securities they already own.

• In secondary markets, investors exchange with each other rather than with the issuing entity.

• Secondary Market is a market where securities are offered to the general public after being
offered in the primary market. These securities are usually listed on the Stock Exchange.

• Secondary Market Pricing


Primary market prices are often set beforehand, while prices in the secondary market are
determined by the basic forces of supply and demand. If the majority of investors believe a
stock will increase in value and rush to buy it, the stock's price will typically rise. If a company
loses favor with investors or fails to post sufficient earnings, its stock price declines as demand
for that security dwindles.
SECONDARY MARKET
• Direct Search Market: This secondary market example is the least
efficient as the buyers and the sellers get involved in the search of
each other without taking any assistance. Transactions are not as
frequent as other secondary markets. No broker gets interested in the
market as transactions are infrequent. And there’s very little chance
for each party to get the best price.
• Broker Market: This secondary market example is more efficient than
direct search market. The brokers are involved in the transactions as
they earn a commission for bringing the buyers and the sellers
together. In the broker market, the brokers share extensive
information about the prices of the stocks.
• Dealer Market: In this secondary market example, efficiency is much
more than the broker market. The reason behind this is in the dealer
market there is constant bidding of the stocks, thus no time gets
wasted in order to search a partner. Dealers own the inventories of
stocks and these stocks are being sold and bought to earn profits.
There are two things that are important here. Firstly, in the dealer
market, there is no time wastage. Secondly, the dealers can provide a
guarantee for the inventories of stock they hold. NASDAQ is the best
dealer market.
• Auction Market: In an auction market, the buyers and sellers get into
a negotiation and bargain for the price. The person who acts as an
arbitrator between the buyers and sellers is the specialist and
facilitates proper dealing and filling orders by public customers. This
person is also a dealer of a certain stock. The New York Stock
Exchange (NYSE) is the most efficient stock exchange in the USA.
PRIMARY MARKET vs
SECONDARY MARKET
POINT OF DIFFERENCE PRIMARY MARKET SECONDARY MARKET
Source of the purchase In the primary market, investors buy Here the investors buy stocks and
stocks directly from the company. other securities from other
investors.
Type of deal In the primary market, companies In this market, investors buy stocks
sell their stocks for the first time. It’s via stock exchanges.
called an initial public offering (IPO).
Parties involved In the primary market, companies In this market, investors hire brokers
usually hire investment bankers to to make their purchases.
buy a large number of shares from
an IPO.
Propensity In the primary market, when There are many small investors.
companies buy a share, usually it’s
in huge quantity.
Fluctuation The prices of share don’t usually Here the prices of shares fluctuate
fluctuate. daily.
Money Markets Instruments
• Treasury bills and other short- term government securities
• Interbank loans, deposits and other bank liabilities
• Repurchase agreements and similar collateralized short- term loans
• Commercial papers, issued by non- deposit entities
• Certificate of deposit
• Interest rate and currency derivative instrument

Money markets also consist of tradable instruments and non- tradable


instruments.
Money Markets Instruments

Characteristics of Money Market


Instruments
• Short- term nature
• Low risk
• High liquidity
• Close to money
Three Basics Characteristics of Money Markets
and Money Market Instrument/Securities
1. Money market instrument are generally sold in large
dominations.

2. Money market instruments have low default risk; the risk of late
or nonpayment of principal and/or interest is generally small.

3. Money market securities must have an original maturity of one


year or less.
In terms of risk, the two specific money- market segments are:

1. Unsecured debt instruments market


- deposits with various maturities (overnight to 1 year)
2. Secured debt instruments markets
- REPOs with maturities (overnight to 1 year)
Differences in amount of Risk

- are the characteristic to the secured and the unsecured segments of the
money markets.

- credit risk is minimized by limiting access to highly- quality counter- parties.


When providing unsecured interbank deposits, a bank transfers funds to
another bank for a specified period of time during which it assumes full
counterparty credit risk.

- in the secure REPO markets, this counterparty credit risk is mitigated as the
bank that provides liquidity that receives collateral in return.
MONEY MARKET INTEREST
RATES AND YIELDS
 Short- term money market instruments have different
interest rate and yield quoting conventions.
 The yield on short- term money market instruments is often
calculated using simple interest as opposed to compound
interest, and as a result is not directly comparable with the
yields to maturity.
MONEY MARKET INTEREST RATES
AND YIELDS
1. Rate on discount basis/ discount yield
id = (Pf – P0) 360
Pf n
n = Number of days of the until maturity
Pf = face value
P0 = purchase price of the security

Example:
A 90- days US Dollar Treasury bill is issued at 99% of its par value. It will be
redeemed at its par value (100%) 90 days after the issuance. It is traded on a
discount basis.
MONEY MARKET INTEREST RATES
AND YIELDS
2. Add- on rate
y = (Pf – P0) 360
P0 n

Example:
Assume Php 990,000 is lent for 90 days period at the add- on rate. The par
value is Php 1 million.
MONEY MARKET INTEREST RATES
AND YIELDS
3. Bond- equivalent yield

ibe = (Pf – P0) 365


P0 n

Example:
A 90- days US Dollar Treasury bill is issued at 99% of its par value. It will be
redeemed at its par value (100%) 90 days after the issuance.
MONEY MARKET INTEREST RATES
AND YIELDS

•4. Annual yield to maturity

y= (PAR / P) - 1

Example:
A 90- days US Dollar Treasury bill is issued at 99% of its par value. It will be
redeemed at its par value (100%) 90 days after the issuance.
MONEY MARKET INTEREST RATES
AND YIELDS
•5. Semiannual yield to maturity

y= 2 * (PAR / P) - 2

Example:
A 90- days US Dollar Treasury bill is issued at 99% of its par value. It will be
redeemed at its par value (100%) 90 days after the issuance.
MONEY MARKET INTEREST RATES
AND YIELDS
6. Effective Annual Return

EAR = (1 + ibe
365/n ) -1

Example:
Suppose you can invest in a money market security that
matures in 75 days and offers a 7 percent nominal interest rate
(i.e., bond equivalent yield).
MONEY MARKET INSTRUMENT
1. Treasury Bills
 Treasury bills are short- term money market instruments issued by
government and backed by the government. Therefore, market participant view
these government securities as have a little or even no risk.
 A typical life to maturity is from 4 weeks to 12 months.
 T- Bills do not have specified coupon. They are in effect of zero- coupon
instruments and are issued at a discount to their par or nominal value.
 T- Bills are typically issued at only certain maturities dependent upon the
government budget deficit financing requirement.
 Large volumes of Treasury securities have to be sold each year to cover the
annual deficit, as well as the maturing Treasury securities, that were issued in the
past. The mix of Treasury offerings determines the maturity structure of the
government’s debt.
TREASURY BILLS: Price of a
Treasury Bill
Price of a Treasury bill
-is the price that an investor willing to pay for a particular maturity Treasury
security, depending upon the investor’s required return on it.
- the price is determined as the present value of the future cash flows to be
received.
- since the T- Bills does not pay interest, investors will pay a price for a one- year
security that will ensure that the amount they receive 1 year later will generate the
desired return.
TREASURY BILLS: Price of a
Treasury Bill
P0 = Pf
(1 + d)
Pf = face value/ par value
d = Yield or rate of return

Example:
Assume that the investor requires a 5% annualized return on a 1
year Treasury bill with Php 100,00 par value. He will be willing to pay
the price.
TREASURY BILLS: Price of a
Treasury Bill
On a discount rate basis:
P0 = Pf * [1- (d * n / 360)]
Number of days of the investment
Yield or rate of return

Example:
Assume that the investor requires a 8% annualized return on a 91-
day Treasury bill with a Php 100,000 par value.
TREASURY BILLS: Yield of a
Treasury Bill

Yield of a Treasury bill is determined taking into account the


difference between the selling price and purchase price. Since the
Treasury bill do not offer coupon payments, the yield the investor will
receive, if he purchases the security and holds it until maturity, will be
equal to the return based on difference between par value and the
purchase price.
TREASURY BILLS: Yield of a
Treasury Bill Asked Discount Yield
iT-bill,d = (Pf – P0) 360
Pf n
n = Number of days of the until maturity
Pf = face value
P0 = purchase price of the security

Example:
Suppose that you purchase the T-bill maturing on October 24, 2013,
for $9,000. The T-bill mature 123 days after the settlement date, June
23, 2013, and has a face value of $10,000.
TREASURY BILLS: Yield of a
Treasury Bill Asked Bond
Equivalent Yield
iT-bill,be = (Pf – P0) 365
P0 n
Finally, the EAR on the T-bill is calculated as:

EAR = (1 + iT-
bill,be
365/n
) -1
MONEY MARKET INSTRUMENTS
2. Repurchase Agreements
Repurchase Agreements (REPO)
- is an agreement to buy any securities from a seller with the agreement that they will repurchased ate
some specified date and price in the future.
- it is a fully collateralized loan in which the collateral consists of marketable securities.
- it is arranged either directly between two parties or with the help of brokers and dealers.
Reverse REPO
-purchase of securities by one party from anther with the agreement to sell them.
Open REPO
- is a REPO agreement with no set of maturity date, but renewed each day upon agreement of both
counterparties.
Overnight Repo
- is a REPO with one day maturity.
Term REPO
REPURCHASE AGREEMENTS
 The participants of REPO transactions are banks, money market
funds, non- financial institutions.

 There is no secondary market for repos

 In REPO, the seller is the equivalent of the borrower and the buyer is
the lender.

 The repurchase price is higher than the initial sale price, and the
difference in price constitutes the return to the lender.
REPURCHASE AGREEMENT:
Yield of a Repurchase Agreement
irepo,sp = (Pf – P0) 360
P0 n
Pf = Repurchase price of the securities (equals the selling price plus interest paid on the repurchase
agreement)

P0 = Selling price of the securities


n = Number of days until the repo matures

Example:
Suppose a bank enters a reverse repurchase agreement in which it agrees
to buy fed funds from one of its correspondents banks at a price of
$1,000,000, with the promise to sell these funds back at a price of $1,001,000
($1,000,000 plus interest of $1,000) after five days.
COMMERCIAL PAPERS

 It is a short- term debt instrument issued by large, well known, creditworthy


companies and is typically unsecured.
 The aim of its issuance is to provide liquidity or finance company’s
investments.
 Its initial maturity is usually between seven and forty- five days.
 CPs can be directly sold by the issuer or may be sold to dealers who charge a
placement fee.
 However, dealers may repurchase CPs for free.
COMMERCIAL PAPERS: Price of
Commercial Paper

P0 = Pf * [1 – (d * n / 360)]

Example:
A 30- day Commercial paper with Php 10 million par value yields
4.75.
COMMERCIAL PAPERS: Yield of
Commercial Paper
icp,d = (Pf – P0) 360
Pf n

Example:
Suppose an investor purchases 30-day commercial paper with a
par value of $1,000,000 for a price of $990,000
CERTIFICATES OF DEPOSIT
 Certificate of Deposit (CD) states that a deposit has been made with a bank for a
fixed period of time, at the end of which it will be repaired with interest rate.
 An institution is said to “issue” a CD when it accepts a deposit and to “hold” a CD
when it itself make a deposit or buys a certificate in the secondary market.
 [Advantage of the depositor]: the certificate can be tradable.
 [Advantage of the bank]: it has the use of a deposit for a fixed period but because
of the flexibility given to the lender, at a slightly lower price than it would have had to
pay for a normal time deposit.
 The minimum denomination ca be 100,000 USD but the issue can be as large as 1
million USD.
 The maturities of CDs usually range from 2 weeks to 1 year.
CERTIFICATES OF DEPOSIT
Negotiable certificates of deposit
- is a bank-issued time deposit that specifies an interest rate and maturity date
and is negotiable in the secondary market.
- a bearer instrument, whoever holds the CD when it matures receives the
principal and interest.
- are the certificates that are issued by the large commercial banks and other
depository institutions as a short- term source of funds.
- it must be priced offering a premium above government securities to
compensate for less liquidity and safety.
- the premiums are generally higher during the recessionary periods.
- negotiable CDs are priced on a yield basis.
CERTIFICATES OF DEPOSIT
icd,sp = (Pf – P0) 360
P0 n

Example:
A 3- months CD fro Php 100,000 at 6% that matures in 73
days. It is currently trading at Php 99,000.
CERTIFICATES OF DEPOSIT

P0 = Pf / [1- (i *n / 360)]
Short- term interest rate

Example:
Find the price of a 3- months Php 150,000 CD, 4%, if it has
36 days to maturity and short- term interest rates are 4%.
INTERBANK MARKET LOANS

 The interbank interest rates and interest rates in the traditional market are
interconnected. If the banks are short of liquidity, they will lend less to both
markets and will cause interest rates to rise. When Central bank provides funds to
the discount market, less attractive terms are offered by banks. So, they may
choose other markets to invest and will cause the drop in interest rates.

 Interbank rates are generally slightly higher and more volatile that interest
rates in the traditional market. In periods of great shortage f liquidity, the eeds of
banks which do not have sufficient funds to meet the central bank requirements
drive up the overnight rates significantly.
INTERBANK MARKET LOANS
Two types of interbank transactions:

1. Reserve Management Transactions


- allows complying with contemporaneous bank reserve
requirements.
2. Portfolio Management Transactions
- banks use interbank market to finance their assets’ portfolio. These
are encouraged by the interbank market liquidity and flexibility.
INTERBANK MARKET LOANS

 Credit risk in the interbank market is controlled through


the interbank rate.
 It is determined entirely by the supply and demand of
banks for funds.
 If the demand for fund purchases increases, it drives up
the interbank interest rates.
Money Market Participants
• Ultimate lenders- are the households and companies with a financial surplus which they
want to lend

• Ultimate borrowers- are companies and government with a financial deficit which need
to borrow.

• Government- they plays the important role as money market participant, in which they
issues money market securities and use the proceeds to finance state budget deficits.

• Central bank- employs money markets to execute monetary policy. Through monetary
intervention means and by fixing the terms at which banks are provided with money,
central banks ensure economy’s supply with liquidity.
Money Market Participants
• Large non- financial corporations- they issues money market securities and use the proceeds
to support their current operations or to expand their activities through investments.
• Credit institutions- they issue money market securities to finance loans to households and
corporations. These institutions rely on the money market for the management of their short-
term liquidity positions and for the fulfillment of their minimum reserve requirements.

 The issuance of money market securities allow market participants to increase their
expenditures and finance economic growth.
 Money market securities are purchased mainly by corporations, financial intermediaries
and government that have funds available for a short- term period. Individuals (households)
plays a limited role in the market by investing indirectly through money market funds.
Money Market Participants
• The U.S Treasury
• The Federal Reserve
• Commercial Banks
• Money Market Mutual Funds
• Brokers and Dealers
• Corporations
• Other Financial Institutions
• Individuals