Power Point Slides for:

Financial Institutions, Markets, and

Money, 10th Edition

Authors: Kidwell, Blackwell, &Whidbee

Prepared by: Vladimir Kotomin,

University of Wisconsin – Eau Claire

And
Lanny R. Martindale, Texas A&M University

Copyright© 2008 John Wiley & Sons, Inc. 1

 CHAPTER 7

Money Markets
 Overview of the Money Market

Short-term debt market - most under 120

days.
A few high quality borrowers.
Many diverse investors.
Informal market centered in New York
City.
Standardized securities -- one security is a
close substitute for another.

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 Overview of the Money Market (concluded)

Good marketability - secondary market.

Large, wholesale open-market transactions.
Many brokers and dealers are competitively
involved in the money market.
Payments in immediately available funds.
Physical possession of securities seldom
occurs - centralized safekeeping.

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Money Market Securities Outstanding

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 Economic Role of Money Market (MM)
The money market is a market for liquidity
Liquidity is stored in MM by investing in MM
securities.
Liquidity is bought in MM by issuing securities
(borrowing).
Liquidity status of commercial banks is
reflected
Provides a place for Fed’s reserve
transactions (open market operations)
Indicator of economic conditions

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 Characteristics of Money Market Instruments

Low default risk.

Short maturity.
High marketability.

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 U.S. Treasury Bills

Characteristics
Sold on discount basis.
Maturities up to one year.
Minimum denomination is usually $10,000, but
smaller investors can invest in multiples of
$1,000 through the Treasury Direct Program
offered by the Fed.
Considered free of default risk.

Copyright© 2008 John Wiley & Sons, Inc. 8

How to Read T-Bill Quotes

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 U.S. Treasury Bills

Pricing Treasury Bills

Treasury bills are priced on a bank discount
rate basis, a traditional yield calculation.
The bank discount rate, yd , is:

Par  Price 360

y    100%
d Par Days To Maturity

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U.S. Treasury Bills

The Wall Street Journal reports T-Bill yields

on a bond equivalent basis where the
discounted price is the denominator and 365
days is used as the annualizer:

Par  Price 365

y    100%
be Price Days To Maturity

The effective annual yield assuming

compounding a year is:
Effective Yield = [(Face Value/Price)365/D -1] x 100%.

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 Auctioning New Bills
Weekly sale by U. S. Treasury of four-, 13-,
and 26-week maturities
T-bills are sold through an auction process
using both competitive and noncompetitive
bids.

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 Auctioning New Bills contd.
Competitive Bids
Specify price and quantity desired.
Minimum $10,000 & in multiples of
$5,000 above $10,000.
Mostly professionals - dealers & banks.
No more than 35 percent of an issue is
sold under the competitive bidding
process in order to ensure a competitive
secondary market.

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 Auctioning New Bills contd.
Non-competitive Bids
All non-competitive bids accepted.
Specify quantity only.
Maximum $5,000,000.
Mostly individuals & small investors.
Pays weighted average price of
competitive bids accepted.

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 Book-entry Securities

No physical securities: only record entries.

Book-entry record keeping
Most of marketable Treasury debt is now in
book- entry form.
Participants in Treasury Direct program are
book-entry accounts.

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 Types of Federal Agencies

Farm credit agencies - loans to farmers.

Housing credit agencies - loans and
secondary market support for mortgage
market.
Other agencies - special purposes.
Federal Financing Bank - purchases
securities of agencies and issues its own
obligations.

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 Characteristics of Agency Debt

Government-owned agencies have an

explicit guarantee of the government.
Government-sponsored agencies are
perceived to have an implicit guarantee of
the government.
Marketability varies with the development
of the secondary market.
Yields are higher than T-Bills.
Greater default risk & lower marketability

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 Negotiable Certificates of Deposit
Characteristics of Negotiable CDs
Large time deposits (> $100,000), maturity less
than six months.
Negotiable - may be sold and traded before
maturity.
Issued at face value, interest is based on a 360-day
year.
Secondary market deals are for $1 million or more.
Interest rates depend on the issuing bank’s
creditworthiness.
Yields are higher than on T-Bills - higher credit
risk, lower marketability, and higher taxability.

Copyright© 2008 John Wiley & Sons, Inc. 18

 Negotiable Certificates of Deposit
Development of the NCD Market
First issued by Citibank in 1961.
Offset declining demand deposits as a source of funds.
The NCD Market
Rate negotiated between buyer and seller.
Market is sensitive to rates above or below the market
rates.
Rates are lower for money center banks and are tiered
upward for regional banks.
Purchased mainly by corporate businesses.

Copyright© 2008 John Wiley & Sons, Inc. 19

 Commercial Paper
Unsecured corporate debt.
Maturities are 1 to 270 days.
Large denominations -- $100,000 and up.
Issued by high-quality borrowers.
A wholesale money market instrument -
few individual investors.
Sold at a discount from par.

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 The Commercial Paper Market
Major investors
Commercial banks.
Insurance companies.
Nonfinancial business firms.
Bank trust departments.
State and local pension funds.
Banks are involved
Backup lines of credit.
Act as agents in issuance.
Hold notes in safekeeping.

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 The Commercial Paper Market (concluded)
Credit ratings important for commercial
paper issuance.
Over 95% of issues are in the top two rating
categories.
Backup lines of credit from banks support
or guarantee quality.
Placement
Directly by a sales force of the borrowing firm.
Indirectly through dealers.

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 Bankers' Acceptances

Time draft - order to pay in future.

Drafts are drawn on and/or accepted by
commercial bank.
Direct liability of bank.
Mostly relate to international trade.
Secondary market - dealer market.
Discounted in market to reflect yield.
Standard maturities of 30, 60, or 90 days -
max of 180.
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 Creating a Banker's Acceptance

Importer initiates purchase from foreign

exporter, payable in future.
Importer needs financing; exporter needs
assurance of payment in future.
Importer's bank writes irrevocable letter of
credit for exporter
Specifies purchase order.
Authorizes exporter to draw time draft on bank.

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 Creating a Banker's Acceptance (concluded)
Importer's bank accepts draft (liability to
pay) and creates a banker's acceptance
(BA).
Advantages of a BA:
Exporter receives funds by selling BA in the
market.
Exporter eliminates foreign exchange risk.
Importer's bank guarantees payment of draft in
future.

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Tracing a Banker’s Acceptance Transaction

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Federal Funds
Short-term interbank loans
Market for depository institutions.
Most liquid of all financial assets.
Related to monetary policy implementation.
Yields related to the level of excess bank reserves.
Originally a market for excess reserves - Now a
source of investment (federal funds sold) and
continued financing (federal funds purchased).
Most are one-day, unsecured loans.
Bookkeeping entry -interest paid separately.
Traded in Immediately Available Funds.

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 Repurchase Agreements (Repo)
Sale of security with agreement to buy it back
later at a higher price.
Difference in prices is interest
Securities serve as collateral
Bank Financing - Source of funds
Way to pay interest to corporate customers.
Negotiated market rate.
Bank Investment – Reverse Repo
Security purchased under agreement to resell at
given price in future.
Smaller banks are able to invest excess liquidity
in a secured investment.
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 Repurchase Agreements (concluded)
The interest rate on a repo is lower than the
fed funds rate, since it is backed up by a
security.
Repos are used by the Federal Reserve in
open market operations.
Government securities dealers use repos to
secure funds to invest in new Treasury
issues.
Banks participate in the repo market to
secure funds to meet temporary liquidity
needs as well as lend funds when they have
excess reserves.
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Money Market Position of Major Participants

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 Commercial Banks

Most important participant in the MM

Bank assets or investments
Treasury bills.
Agency securities.
Bankers' acceptances (from other banks).
Federal Funds sold.
Reverse repurchase agreements (securities
purchased under agreements to resell).

Copyright© 2008 John Wiley & Sons, Inc. 31

 Commercial Banks,cont.

Bank liabilities or borrowing

Negotiable CDs.
Commercial paper.
Bankers' acceptances.
Federal Funds purchased.
Repurchase agreements (securities sold under
agreements to repurchase).
Due to fluctuations in loans and deposits
banks need MM securities to provide
sources and uses of liquidity.

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 The Federal Reserve in the Money Markets

MM securities are the major asset category

of the Fed.
Open-market operations (buying and selling
of MM securities by Fed) is the primary
tool for implementing monetary policy.
Purchase - increases member bank reserves.
Sale - decreases member bank reserves.

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 Dealers in U.S. Securities
Involved in both primary and secondary
markets.
Purchase new Treasury debt and resell it
(primary market).
"Make a market" by buying/selling (dealer)
securities (secondary market).
Purchases are financed by repurchase
agreements or fed funds.
Dealers have a small capital base and are
highly leveraged.
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 Interrelationship of Money Market Interest Rates

Due to similarities in general

characteristics, various MM instruments are
close substitutes in investment portfolios.
MM interest rates move together over time.
Deviations from traditional spreads are
quickly eliminated by interest rate
arbitrage.

Copyright© 2008 John Wiley & Sons, Inc. 35