06-Money Markets-Focus Notes PDF

Preview

Summary

Financial Markets and Business Finance subject. Topic is Money Markets....

Description

CHAPTER 6 - MONEY MARKETS Money Market Securities -

-

-

Debt securities with a maturity of one year of less Issued in the primary market through a telecommunications network by the Treasury, corporations, and financial intermediaries that wish to obtain shortterm financing Commonly purchased by households, corporations, and governments that have funds available for a short time period Can be sold in the secondary market Liquid

•

•

•

liquidated to accommodate withdrawals. Other financial institutions invest in Tbills in case cash outflows exceed cash inflows. Individuals with substantial savings invest indirectly through money market funds. Corporations invest in T-bills to cover unanticipated expenses.

Credit Risk of Treasury Bills – Backed by federal government, virtually free of credit (default) risk Liquidity of Treasury Bills – high liquidity due to short maturity and strong secondary market. Pricing Treasury Bills Priced at a discount from their par value Price depends on the investor’s required rate of return o Value of a T-bill is the present value of the par value

o o

-

Example: If investors require a 4% annualized return on a one-year T-bill with a $10,000 par value, the price that they are willing to pay is:

(Exhibit 6.1 how money markets facilitate the flow of funds)

P =

The more popular money market securities are:

P = $9,615.38

-

Treasury bills (T-bills) Commercial paper Negotiable certificates of deposit Repurchase agreements Federal funds Banker’s acceptances

Treasury Bills -

-

-

Issued when the U.S. government needs to borrow funds. The Treasury issues T-bills with 4-week, 13week, and 26-week maturities on a weekly basis. It periodically issues T-bills with terms shorter than 4 weeks, which are called cash management bills. It also issues T-bills with a 1-year maturity on a monthly basis.

Investors in Treasury Bills •

Depository institutions retain a portion of their funds in assets that can be easily

•

$10,000 (1.04 )

Yield from Investing in Treasury Bills YT =

SP − PP 365  PP n

Where: SP = selling price PP = purchase price n = number of days of the investment (holding period)

•

Treasury Bill Discount

NOTE: For a newly issued T-bill that is held to maturity, TB YIELD > TB Discount. The difference occurs because the purchase price is the denominator of the yield equation whereas the par value is the denominator of the T-bill discount equation, and the par value will always exceed the purchase price of a newly issued T-bill.

-

Treasury Bill Auction: • Investors can submit bids online for newly issued T-bills at www.treasurydirect.gov. • Investors have the option of bidding competitively or noncompetitively.

Commercial Paper -

-

-

-

Short-term debt instrument issued by wellknown, creditworthy firms; typically unsecured *credit risk is not high on this kind of investment; this is unsecured no need to back up with other assets. Normally issued to provide liquidity or to finance a firm’s investment in inventory and accounts receivable *use commercial paper in financing working capital The issuance of commercial paper is an alternative to short-term bank loans. *there are times companies cannot acquire shortterm bank loans from commercial banks then it may opt to issue commercial paper Major issuers: Finance companies and bankholding companies It is cheaper source of funds than commercial banks. Provide less liquidity bcos secondary markets is limited: still possible to sell the paper back to the dealer who initially placed it.

Common Investors in Commercial Paper o

Major investors: Money market funds.

*Commercial banks or money market funds dealer pooled funds from diff (small) investors, it’s the financial institution who will then invest in the commercial market Credit Risk of Commercial Paper o

o

Issued by corporations susceptible to failure, therefore subject credit risk Risk is affected by issuer’s financial condition and cash flow.

Credit Risk Ratings of Commercial Paper o

o o

Assigned by rating agencies such as Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Investor Service. Serves as an indicator of the potential risk of default. Higher credit ratings suggest lower expectancy of credit default. (Exhibit 6.2)

Placement of Commercial Paper o

o

Firms place commercial paper directly with investors: there might be a need for an in-house department to facilitate the placement; or rely on commercial paper dealers to sell their commercial paper: corporation will pay transaction costs

*Which choice is better depends on the frequency of the issuance of commercial papers.

(Exhibit 6.2 Possible Ratings Assigned to Commercial Paper) Asset-Backed Commercial Paper (Other premium) o

Some backed by assets of the issuer and offer lower yield than unsecured commercial paper.

o

Issuers of commercial paper typically maintain backup lines of credit.

o

Issuers obtain guarantee from sponsoring institutions in case dili sila kabayad.

Denomination of Commercial Paper o

o

The minimum denomination of commercial paper is usually $100,000. Maturities are normally between 20 and 45 days but can be as short as 1 day or as long as 270 days.

*entails high min. amount that is why most investors of cp are large financial institutions, hence, mostly not available to households

Yield from Investing in Commercial Paper o

Commercial paper does not pay interest and is priced at a discount from par value.

o

The yield on commercial paper is higher than the yield on a T-bill with

the same maturity because of credit risk and less liquidity.

-

Commercial Paper Yield Curve o o

Represents the yield offered on commercial paper at various maturities. The same factors that affect the Treasury yield curve affect the commercial paper yield curve, but they are applied to very shortterm horizons.

Issued in large denominations, so this is bought most often by large institutional investors that typically use them as a way to invest in a lower risk and low interest security. What they do is pull out funds from mall investors and sila na mo invest ani nga security.

Placement of NCDs -

(Exhibit 6.3 Commercial Paper Rate over Time)

Some issuers place their NCDs directly; others use a correspondent institution that specializes in placing N C Ds.

Yield from Investing in NCDs -

Provide a return in the form of 1. interest along with the 2. difference between the price at which the N C D is redeemed (or sold in the secondary market) and the purchase price.

YNCD =

Note: The shaded area indicates a recession. Source: Federal Reserve.

-

SP − PP + interest PP

Offer a premium above the T-bill yield in order to compensate for less liquidity and safety.

(Exhibit 6.4 Value of Commercial Paper Outstanding over Time)

Repurchase Agreements Note: The shaded area indicates a recession. Source: Federal Reserve.

-

Negotiable Certificates of Deposit -

-

Certificates issued by large commercial banks and other depository institutions as a short-term source of funds. The minimum denomination is $100,000. Maturities on N C Ds normally range from two weeks to one year. A secondary market for N C Ds exists, providing investors with some liquidity. More liquid than Commercial Papers Cannot be cashed in before maturity; u always must wait for the maturity period.

-

With a repurchase agreement (repo), one party sells securities to another with an agreement to repurchase the securities at a specified date and price. (Represents a loan backed by a security. If borrower defaults on the loan, the lender has a claim to the securities) A reverse repo is the purchase of securities by one party with an agreement to sell them. A repurchase agreement (or repo) represents a loan backed by the securities. Financial institutions (banks, savings and non-financial institutions) are common borrowers....