Chapter Five

Money Markets
Money Markets

 Money markets involve debt instruments with original

maturities of one year or less
 Money market debt
 Issued by high-quality (i.e., low default risk) economic units that
require short-term funds
 Purchased by economic units that have excess short-term funds
 Little or no chance of principal loss
 Low rates of return
 Most money market instruments have active secondary
markets to provide liquidity
Money Markets
 In theory, money markets are not needed due to the
efficiency advantages found in the banking industry
 Used extensively by businesses: (1) to warehouse
surplus funds and (2) to raise short-term funds
 Fewer regulations and distinct cost advantages
support the survival of money market
 FIs such as banks, brokerage firms, pension funds
and finance companies take part in the money
markets with various activities
 Among all participants, the Bank of Canada is most
influential because it formulates a suitable monetary
policy by regulating liquidity in the economy
Money Market Yields
 Money market securities use special quoting
conventions:
 Discount yield method (id): return rate is quoted on an
annual basis assuming simple interest with the bank
practice of a 360 day year as a percent of face value
 Investment yield method (isp): return rate is quoted on
an annual basis also assuming simple interest with a
365 day year, but given as a percent of purchase
price
 For proper comparison, discount yields can be
converted to equivalent investment yields
 Iby = [(F – P)/P] × (365/N)
Discount Yield Method

 Treasury bills and commercial paper rates are

quoted as discount yields because they often
mature before interest is paid
 Discount yield formula (id) use a 360-day year

( Pf  P0 ) 360
id  
Pf n
Pf = the face value of the security
P0 = the purchase price of the security
n = the number of days until maturity
 Example: Discount Yields
 What is the discount yield on a 91-day T-bill
purchased at $990.13 with a face value of
$1,000?
F  P 360 1,000  990.13 360
yus      0.00987 3.956  3.9%
F t 1,000 91
 Discount yield understates the return on T-bills
because:
 (1) use F, not P, overstating the required investment
 (2) use 360, not 365, cutting down the time to earn
interest
Investment Yield Method
 Negotiable CDs and overnight funds are money market
securities that pay interest only at maturity. They are add-
ons. The investment yield formula (isp)
( Pf  P0 ) 365
isp  
P0 n
 Simple interest is assumed for calculating investment yields,
to directly convert to this yield to an EAR:
365/ n
 isp 
EAR   1   1
 365 / n 
Example: Investment Yields

 What is the investment yield for a 91-day T-

bill currently selling at a price of $990.13 per
$1,000 of face amount?
 ISP = [(1,000 – 990.13)/990.13] × (365/91) =
0.009968 × 4.011 = 0.04
 IBE = ISP = 4%
 EAR = [1 + 0.04/(365/91)]365/91 – 1 =
(1.00997)4.011 – 1 = 0.0406 = 4.06%
Example
 A $1M investment in 90 day commercial paper has a 2%
discount yield. What price should this commercial paper
sell for?
( Pf  P0 ) 360 ($1M  P0 ) 360
id   0.02    P0  $995,000
Pf n $1M 90

 The investment yield for this commercial paper is 2.038%

( Pf  P0 ) 365 ($1M  $995,000) 365
isp 
P0

n isp    2.038%
$995,000 90
 The EAR for this commercial paper is 2.0537%
365/ n
 
365/90
isp  0.02038 
EAR  1    1  1   1  0.020537
 365 / n   365 / 90 
Example: Equivalent Investment Yield

 A $1 million face value T-bill with 170 days to

maturity has a discount yield of 3.22%.
 Purchase price (P) is found by solving: 0.0322 =
[(1,000,000 – P)/1,000,000]×(360/170). P =
$984,794.44
 isp = (15,205.56/984,794.44)×(365/170) = 0.03315
 Alternatively, investment yield = (365 × Discount rate
yield) / [(360 – Days to maturity × Discount rate
yield)] = (365 × 0.0322) /[360 – (170 × 0.0322)] =
11.753/354.526 = 0.03315 = 3.315%
Money Market Instruments
 Money markets provide liquidity adjustments
due to a short-term timing difference between
money received and spent
 Ideal features include:
 Low default risk: issuers have the highest credit
standing
 Short maturity: short-term nature reduces price risk
 High liquidity: securities can be turned into cash
quickly with active secondary markets
 Low transaction cost: large wholesale denominations
water down the per-dollar cost
Money Market Instruments

 Many of these instruments of the money

market are part of the Canadian money
supply. They include:
 Treasury bills (T-bills)
 Overnight market funds
 Repurchase agreements (repos or RP)
 Commercial paper (CP)
 Negotiable certificates of deposit (CD)
 Banker’s acceptances (BA)
Money Market Instruments
 Have short maturities, high liquidity and low default risk
Type Maturity Liquidity Default Pricing 2nd Market
Risk
Treasury Bill 4 – 52 Excellent Risk free Discount Yes
weeks
Commercial 1 – 270 Limited Low Discount Limited
Paper days
Banker’s 30 – 180 Limited Low Discount Yes
Acceptances days
Negotiable 2 – 52 Good Low Add-on Yes
Cert. of Dep. weeks
Overnight 1 – 7 days Excellent Low Add-on No
Funds
Repurchase 1 – 15 Good Low Add-on No
Agreements days
Treasury Bills (T-Bills)
 T-Bills are short-term debt obligations issued by
the federal government of Canada first time in 1934
 T-bills are virtually default risk free, are highly liquid,
and have little interest rate risk
 Most T-bills offered at auction are purchased by the
primary government securities distributors who are
entities eligible to participate directly in the tender
process
 Strong international demand for T-bills as safe
haven investment
T-Bill Quotes
Maturity Days to Bid Ask Chg Ask
Maturity Yield
Nov 30 2018 85 3.42 3.41 0.04 3.49
Feb 08 2019 155 3.52 3.51 -0.02 3.61
 The bid discount yield is used by T-bill dealers to
state what they are willing to pay for a T-bill.
 The ask discount yield is used to state what price a
dealer will accept to sell a T-bill
 The CHG shows the change in the ask discount
yield from the previous day
 The ASK YLD is a “bond equivalent yield” assuming
a 365-day calendar year. y  365  y d
360  ( DTM  yd )
be


Bank of Canada T-Bill Auctions

 Standard maturities of 3-, 6-month and 1-year T-bills

are auctioned biweekly, other maturities available
 Bids are submitted by ten dealers on their own
behalf and on behalf of their customers, subject to
auction limits of 250% of auction amount per tranche
 Bids can be competitive or noncompetitive
 Competitive bids specify the amount of par value of bills
desired and the bid discount yield, rather than the price
 Bid yields must state to three decimal places. The
calculation of the purchase price for accepted bids are
carried to five decimals.
 Noncompetitive bidders get preferential allocation and
agree to pay the price established by the auction.
T-Bill Auctions

Noncompetitive Bids
Bid Price 1
SC ST
2
3
4
5
6
Stop-out
price (PNC) 7

Quantity of
T-bills
Example

 Bank of Canada announces an offering of T-bills

maturing in 182 days with a face value amount
of $1,000 million.
 The response is $70 million of non-competitive
bids, along with top four competitive bids
Bidder Equivalent Bid Bid discount Amount Bid
Price per $100 Yield (%)
(A) $97.62338 4.701 $600 million
(B) $97.62187 4.704 $200 million
(C) $97.62035 4.707 $200 million
(D) $97.61984 4.708 $300 million
Example

 All non-competitive bids are accepted automatically and will

be first subtracted from the total issue amount.
 Only $930 million are left in this auction. T-bills are
allocated in accordance with the bid discount yield
 Market is cleared at 4.707% (i.e. cut-off yield) at which the
sum of competitive and non-competitive bid amounts
equals the issuing amount
 Competitive bids at or below 4.707% are accepted.
Bidders A, B and C are awarded with the T-bills of $600m,
$200m and $130m, respectively.
 Bids above the cut-off yield (e.g. 4.708%) are rejected
 With an uniform pricing scheme, price paid by all bidders is
$97.62035 per $100
Example: Auction Results
 After the auction, some statistics are released:
 lowest bid discount yield = 3%; highest bid discount yield = 5.5%
 non-competitive bids tendered: $5 billion with all accepted
 competitive bids tendered: $35 billion, with $20 billion accepted.
 With a cut-off yield = 4.5% (i.e. highest accepted rate) and the
average-yield = 3.75% = (3%+4.5%)/2, tail = 0.75% = 4.5% - 3.75%.
Short tail implies strength.
 Auction coverage (i.e. total bids received) = $40 billion = $35 billion
+ $5 billion
 Bids awarded = $25 billion = $20 billion + $5 billion
 Bid-to-cover ratio = 1.6 = $40 billion/$25 billion. A higher number implies
a greater demand in the auction.
 Money raised by the entire offering = $23.875 billion = (0.955)(25)
given $95.50 is corresponding stop-out bid price of the cut-off yield
Secondary Market for T-Bills
 The secondary market for T-bills is the largest of
any Canadian money market instrument
 Primary dealers “make” a market in T-bills by
directly buying the majority from the government at
auction, with an intention of reselling them to others
by creating an active secondary market
 They sell the yet-to-be-issued T-bills for forward delivery to
customers at a small margin above the price expected to
be paid at the primary auction.
 When issued (WI) trading with new T-bills exposes banks
to the off-balance sheet risk
Primary Dealers for T-bills
 Currently, there are 10 primary dealers having a certain
threshold level of activity in the government securities
markets including:
 Bank of Montreal
 CIBC
 Desjardins Securities Inc
 HSBC Bank Canada
 Laurentian Bank Securities Inc
 Merill Lynch Canada Inc
 National Bank Financial Inc
 RBC Dominion Securities Inc
 Scotia Capital Inc
 Toronto-Dominion Bank
Reference: T-Bill Equivalent Prices

 The convention in Canada is to quote T-bills in discount yield

terms when submitting bids.
 T-Bill prices can be calculated from quotes (e.g., from Globe
and Mail) by rearranging the discount yield equation
 n 
P0  Pf  id   Pf 
 360 
 Or, by rearranging the investment yield equation
Pf
P0 
 n 
1  
 365 / i
 sp 
 Treasury yields tell us how investors feel about the economy.
Overnight Market Funds
 The overnight rate is the target interest rate in conducting
the monetary policy by Bank of Canada
 Transactions for overnight market funds are the shortest-term
unsecured loans among banks
 Lenders agree to lend borrowers funds only “overnight”
 Borrowers must repay the borrowed funds plus interest at the start of
next business day
 Banks with excess reserves lend funds to banks with
deficient reserves with multimillion dollar loans being
arranged in a matter of minutes
 Overnight funds are add-on instruments involving single-
payment loans based on investment yield method for interest.
 Overnight Funds
 The interest charged in the overnight market (i.e. overnight rate) is
the lowest rate at which banks lend money given the very short
period of the loan.
 Although overnight rate has nothing to do with Bank of Canada or
the federal government, they can be influential.
 Since overnight market is sensitive to the credit needs of the banks,
the overnight rate can be used as a good predictor for the
movement of short-term interest rates for consumers in the broader
economy
 Bank of Canada can somewhat control the overnight funds interest
rate by adjusting the level of settlement balances to banks in the
system.
 By buying (selling) securities that adds (↓) settlement balances, thereby
lowering (↑) the interest rate
Repurchase Agreement
 A repurchase agreement (repo or RP) introduced in
1969 is the sale of a security with an agreement to buy the
security back at a set price in the future
 Repos are short-term collateralized loans (typical collateral
is the Treasury securities)
 Similar to the overnight market funds, but collateralized

 Most have a 3 – 14 day maturity with typical

denominations of $25 million
 If collateralized by risky assets, the repo may involve a
‘haircut’ (i.e. repos have to be slightly over-collateralized)
 To borrow $100, the repo seller would have to sell
securities currently worth $102, for a $2 haircut.
Repurchase Agreement

Financing needs of a bank buying T-bonds

Time Line
2:00 p.m. 5:00 p.m. 9:00 a.m.
January 15 January 15 January 16
Bank buys Bank sells Bank repurchases
$450 million $400 million $400 million and
of T-bonds of T-bonds as pays overnight
repo interest
Example: Repo
 Day 1 (Jan 15): ABC Bank sells T-bonds to
XYZ Pension Fund in exchange for cash
T-Bonds
Bank Pension Fund
Cash

 Day 2 (Jan 16): Bank repurchases T-bonds

from the Pension Fund in exchange for cash +
interest T-bonds returned
Bank Pension fund
Cash + Interest paid
Example
 Using repos, if ABC Bank has sold $20 million
worth of Treasury securities overnight at 8%,
what will be the interest expense the bank must
pay to gain this temporary liquidity?
 Interest = ($20 m) × (0.08) × (1/365) = $4,383.56
 ABC Bank should pay the lender (e.g. XYZ
Pension Funds) principal plus interest =
$20,004,383.56 when it buys back its securities
 With term-repo transactions, the interest
incomes goes to the lender holding ABC’s
securities as collateral
Reference: Repurchase
Agreement Yield
 The yield on repurchase agreements (iRA) uses a
360-day year, like the discount rate, but uses the
current price in the denominator, like the bond
equivalent yield
( Pf  P0 ) 360
irepo, sp  
P0 n

Pf = the repurchase price of the security

P0 = the selling price of the security
n = the number of days until the repo matures
Commercial Paper

 Commercial Paper (CP) is unsecured short-term

corporate debt issued to raise short-term funds as such
for working capital
 Rating agencies rank CP according to the issuer’s ability
to meet short-term debt obligation
 Generally sold in large denominations (e.g., $100,000 to
$1 million) with maturities between 1 and 270 days
 The majority of CP is sold directly to investors with help
from brokers and without the use of dealers
 CP is usually held by investors until maturity and has no
active secondary market
 Yields are quoted on a discount basis
Commercial Paper
 Not open to all companies, CP can be issued only by
the large and most creditworthy corporations
 As an unsecured debt note, size, creditworthiness
and financial stability of the issuer back the guarantee
 Very often, CPs are backed by a bank line of credit,
giving the issuer access to cash (if needed)
 Asset-backed commercial paper (ABCP) is backed by
assets of the issuing firm
 Grew very rapidly prior to the financial crisis peaking
at $2.16 trillion, much of it was backed by mortgage
investments
 The market collapsed during the financial crisis
Example

 Suppose a company purchases $1 million of 45-

days commercial paper issued by GE Capital (a
large finance company) for a price of $997,200.
 The investment yield for investors is
$1, 000, 000  $997, 200 365
ycp    100%  2.28%
$997, 200 45

 CP should not be in the same category as low

risk investments such as T-bills.
Certificates of Deposit
 In Canada, certificate of deposit (CD) is known as
guaranteed investment certificate (GIC)
 It is a bank-issued, fixed maturity, interest-bearing time
deposit that specifies the interest rate, amount
deposited and the maturity date
 Wholesale CD must have denominations larger than
$100,000 in bearer format usually with a maturity of 1 –
4 months
 Bearer deposit notes (BDN) are salable in the
secondary market and often purchased by money
market mutual funds with pools of funds from individuals
 Safety is the main advantage, typically with a roll-over
option
Example
 What is the effective interest rate that banks pay
to obtain deposits for a retail CD with a 3% rate
of interest?
 There are other expenses CDs costing the bank
who issue them more than merely the interest
rate on the CD.
 Banks are required to pay for CDIC insurance on
CD deposits (e.g. 0.08%). Therefore, the all-in
effective cost of issuing the CD = 3.08%
 Retail CDs (i.e. GICs) are nontransferable in
Canada
Banker’s Acceptances

 A banker’s acceptance (BA) is a time draft payable to a

seller of goods, with payment guaranteed by a bank
 Used in international trade transactions to finance trade in
goods that have yet to be shipped from a foreign exporter
(seller) to a domestic importer (buyer) serving like a bank
loan
 Foreign exporters prefer that banks act as payment
guarantors before sending goods to importers
 Banker’s acceptances are bearer instruments and thus are
salable at a discount before maturity in secondary markets
 BAs are available in terms ranging from one month to one
year, but 1 – 3 months is the most common
Creation of a Banker’s Acceptance
U.S. buyer 1 Chinese seller
(importer) (exporter)
4

2 9 10 3 5 8

6
U.S. bank Chinese bank
(importer’s bank) 7 (exporter’s bank)

1. Purchase order sent by U.S. buyer to Chinese seller

2. Chinese seller requests a letter of credit
3. Notification of letter of credit and draft authorization
4. Order shipped
5. Time draft and shipping papers sent to Chinese seller’s bank
6. Time draft and shipping papers sent to U.S. bank; banker’s
acceptance created
7. Payments sent to foreign bank (immediately if Chinese seller
wishes to discount the draft and collect immediately, at
maturity if not)
8. Payments sent to Chinese seller (see #7)
9. Payment to U.S. bank by U.S. buyer at maturity, paid in full
10. Shipping papers delivered
Bankers’ Acceptances

Canadian Pays in future Canadian

Importer Bank
Goods $

$
Japanese Japanese Bank
Exporter
BA $
Importer’s bank
Money guarantees
Market payment
Example
 An exporter receives a 2-month draft with a face
value of $50,000. The acceptance fee (stamping
fee) is $300 payable immediately. Suppose the
banker is willing to discount the BA at a rate of 6%.
What is the cost of using the BA as a source of
financing?
 Actual amount realized by exporter = $50,000 × [1 –
6%×(2/12)] - $300 = $49,200
 Because maturity value = FV in 2 months = $50,000
 Implied cost of financing = $800/$49,200 = 1.626%
per 2-month.
 Annual equivalent EAR = (50,000/49,200)12/2 – 1 =
10.16%
Money Market Participants
Participant Role
Bank of Canada Buy/sell government securities as its primary method of
controlling the money supply
Banks and other Buy government securities; Sell CDs to make short-term
depository institutes loans; Offer investors MMMF accounts
Businesses Buy and sell various short-term securities as a regular
part of their cash management
Brokerage Firms Trade on behalf of commercial accounts
Finance Companies Lend funds to individuals
Insurance Maintain liquidity need to meet unexpected demands
Companies
Pension Funds Maintain funds in money market instruments in
readiness for investment in stocks and bonds
Individuals Buy money market mutual funds
Mutual Funds Allow small investors to take part in the money market
by aggregating their funds to invest in money market
securities
Money Market Participations
 Flow of funds in Money Markets
$ to buy government
T-bills Bank of $ programs
Canada
HouseholdsB $ to buy
money business
usinessesand market
Corporations
Governments securities
$ operations
that have $ loan
short-term
funds $ to buy FIs
money
available market $ loan
securities
$ Spending
Households on cars,
home
International Money Markets

 Canadian dollars held outside Canada are tracked among

multinational banks in the Euro-currency market
 The rate offered for sale on Euro-currency funds is the
London Interbank Offered Rate (LIBOR)
 Euro-Canadian dollar Certificates of Deposit are
Canadian dollar-denominated CDs held in foreign banks
 Eurocommercial paper (Euro-CP) is issued in Europe
and can be in local currencies or U.S. dollars