Chapter 5 Summary - book \"Financial Markets and Institutions\" PDF

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Chapter 5: Money Markets Money Markets Money markets: markets that trade debt securities or instruments with maturities of less than one year o The purpose of money markets is to transfer funds from those with shortterm excess funds (suppliers of funds) to those with needs for funds (users of funds)...

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Chapter 5: Money Markets Money Markets  Money markets: markets that trade debt securities or instruments with maturities of less than one year o The purpose of money markets is to transfer funds from those with shortterm excess funds (suppliers of funds) to those with short-term needs for funds (users of funds) o Once issued, MM instruments trade in active secondary markets o Money markets are important because they serve to reallocate the fixed amounts of liquid funds available in the market in any particular time o MM played a major role in the financial crisis of 2008-2009 o As MBS started to experience large losses, money and markets froze and banks stopped lending to each other at anything but high overnight rates  The need for money markets arise because the immediate cash needs  Because excessive holdings or cash balances involve a cost in the form of forgone interest, called opportunity cost, those economic unites with excess cash usually keep such balances to the minimum needed to meet their day-to-day transaction On purchaser’s side: Holding excess cash is expensive because it earns zero interest  Three characteristics of Money Markets o Money market instruments are generally sold in large dominations  Often unites of 1M to 10M o Money markets have low default risk: the risk of late or nonpayment of principal and/or interest is generally small o Money market securities must have an original maturity of one year or less  Longer maturity of a debt security, the greater its interest risk and the higher is its required rate of return Yields on Money Market Securities  Discount Yields o Treasury bills and commercial paper are bought and sold on a discount basis, meaning that the purchase price is less than the face value of the security when it matures. o instead of directly reseved interst payments over the invesmtn horzon, the tretunr on thse securities results from the purchase of the security at a discount from its face value and the cepcpt of face value at maturity o Yields take into account the fact that maturities are less than one year o Yiled use a 360-day year rather than 365 (equation on pg. 130) Example: T-bill has maturity of $1M and sells at 97.5% of its face value. It matures in 140 days. Calculate the discount yield.

Money Market Securities

 Issued by corporations and government unites to obtain short-term funds  Treasury Bills: short-term obligations of the U.S. government issued to cover government budget deficits and to refinance maturing government debt. o Original maturities are 4,13,26 and 52 weeks and they are issued in denominations of multiples of $100 o Typical purchase is around lot of $5M o T-bills are virtually default risk free o Because of their short term nature and active secondary market, T-bills have little interest rate risk and liquidity risk o Treasury Bill Auctions: the formal process by which the US treasury sells new issues of treasury bills  Every week, usually a Thursday  Bills may be submitted by government securities dealers, financial and nonfinancial corporations  Competitive or non-competitive  Competitive bids specify the amount of pay value of bills desired  The amount of noncompetitive bids is subtracted from the total face value of the auctions bills, with the remainder to be allocated to completive bidders  Competitive bids are then ranked from lowest to highest  Treasury Bill Secondary Market o The largest secondary market of any US money market security o Decentralized market, occurring in the trading rooms of the primary dealers, a lot of trades over the phone o Primary government securities dealers as well as smaller dealers o Designated at primary government securities by FRB New York, consisting of 21 finaical instittions who purchase majoty of t-bills sold competive at auction and who create an active secondary market o There are apprimiately 500 samller dealers who directly trade in secondary market o Primary dealers make a market for t-bills by buying and selling securities for their own account and by trading for their customers, including deporoty insitaitons, incusrance companies, pension funds  Treaury Bill yields in Secdonary Market o He return comes from the difference between the purchase price paid for the t-bill and the fae value received at maturity o Bid= The yield calculated based on the price that dealers purchase T-Bills from investors. o Asked= The yield calculated based on the price that investors can buy T-Bills at from dealers o Asked Yield is the discount yield (Asked) converted to a bond equivalent yield

Wall Street Journal Quotes, July 7, 2010 (See Table 5-5)

Maturity Yield 2010 Sep 23 (77 days away)

Bid

Asked

Chg

Asked

0.163

0.158

-0.003

0.160

1. Using “Asked” (discount yield), calculate T-Bill price, assuming face value of $10,000.

2. Using “Asked Yield” (bond equivalent yield), calculate T-Bill price, assuming face value of $10,000.

Instrument and

Denomination and

Trading

Notes

Description Commercial Paper unsecured, shortterm promissory note (debt)

Maturity generally sold in denominations of $100K, 250K, 1M

Primary Market: can be sold directly or through a dealer

Secondary market: no maturities range from 1 to secondary market, issuer 270 days, most common is holds it to maturity, 20 to 45 days Federal Funds short-term funds transferred between financial institutions, usually for a period of one day

no specific denomination

Repurchase Agreements an agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specified date

generally sold in denominations of $10 or $10M or 25M

maturity is typically 1 day but can be longer

Primary market: highly liquid transactions occur as negotiations between two banks or through a fed funds broker Secondary market: none

maturity is generally from 1 to 14 days, occasionally from 1 to 3 months

Primary market: trades are arranged directly between two parties or with the help of brokers/dealers

Secondary market: none

-yields: trade on a discount basis, like T-bills -credit rating is particularly important -purpose is to raise short term cash -CP is a major source of competition to traditional bank loans -interest rate for borrowing federal funds is the “fed funds rate” that the Federal Reserve targets -single-payment unsecured loans that pay interest once, at maturity -essentially, this is a collateralized fed funds loan Differences from fed funds: -yields are lower than fed funds since the transaction is collateralized - Less liquid than fed funds b/c the collateral must be arranged -commercial firms may also buy repos as a way to use idle cash

Federal Funds: short-term funds transferred between financial institutions usually for a period of one day Example: 5-6

Repurchase agreements: an agreement involving he sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specified date Ex: 5-7

Commerical Paper: an insecuried short-term promissory note issued by a company to rise shor-term cash, often to fiancé working captual reuiremets Example: Investor purchases 95-day commercial paper with a par (face) value of $1,000,000 for a price of $990,023. Calculate the discount yield and the bond equivalent yield

Instrument and Description Negotiable

Denomination and Maturity denominations range from

Trading

Notes

Primary Market: bank

-bearer of the CD

Certificates of Deposit bank-issued time deposit that specifies an interest rate and maturity date and can be sold in the secondary market

100K to 10M with 1M the most common

Banker’s Acceptances a time draft payable to a seller of goods, with payment guaranteed by the bank

denominations: grouped together to form round lots of 100K to 500K

maturities range from two weeks, with most having a maturity of 1 to 4 months

maturities range from 30 to 270 days

posts rates for CDs daily and sell them until they meet their funding needs. sometimes rates are privately negotiated

is promised the principal plus stated interest at maturity

Secondary market: Exists but is not very active Primary Market: Originated by large banks

Secondary market: can be sold in secondary markets

Money Market Participants (insert chart on pg. 151) READ

-increasingly small part of the money markets often used to pay a foreign exporter (overseas manufacturer) who want the bank to act as a guarantee of payment from the domestic importer

International Aspects of Money Markets (READ)  Eurodollar deposits: dollar denominated deposits held offshore  The rate paid on Eurodollar funds in the LIBOR (London Interbank Offer Rate)  Manufactueres in Italy, but need to pay supplier I doal  Slarge banks buy and sell ollars, create overnight lending market

 Rate paid on euor dollar is LIBOR  Commercial paper is often quited as spread over LIBOR  Differences in LIBOR and Federal Funds curing crisi o Deposit insurance o Impocit guarantee of US government for budiling out banks o Federal funds rate was lower than LIBOR...