FMI Lecture 7 Money markets PDF

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Financial Markets and Institutions Lecture 7 The Money Markets

Definition of money market:  

Money (currency) is not actually traded in the money markets. It instead refers to the short term credit market where debt securities have original maturities of one year or less are traded. The securities in the money market are short term with high liquidity, therefore they are close to being money

Characteristics of money markets (MM) 1. MM securities are usually sold in large dominations (£1mn or more) 2. MM securities mature in one year or less from their issue date, although most mature in less than 120 days 3. MM securities have low default risk and high liquidity 4. MM do not occupy one particular geographic location or trading floor 5. MM securities usually have an active secondary market

Why do money market exist? Ideally the banking industry should handle the needs for short term loans and accept short term deposits. So why do money markets exist? They provide efficient sources of credit for:  Financial institutions  Nonfinancial corporations  Government institutions

Advantages over bank borrowings  Banks do mediate between savers and borrowers, but o Banks are required to hold noninterest-bearing reserves:  As vault cash and on deposit at fed. Only part of a banks’ domestic transaction deposits can be lent out

o Banks face regulatory constraints on:  Size of loans  Types of asset they can hold on their balance sheet  These restrictions create a cost advantage of MM over banks. When i.r. rise depositors move their money from banks to money markets to earn higher interest rates

The purposes of money markets    

For investors o MM provide a place for warehousing the surplus funds for short periods of time For borrowers o MM provide low-cost sources of temporary funds For govt o They use MM because the timing of cash inflows and outflows are not very well synchronized MM provide a way for investors, borrowers and govt to solve these cash timing problems

5 Functions of MM  

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Financing domestic and international trade Helping growth of industries. o MM help industries secure short-term loans for they meet their working capital requirements. Industries for large loans usually use the capital market, however the interest rates in the short-term MM influence the i.r. in the capital markets. Enabling commercial banks to use their excess reserves in profitable investments. o The main objective of commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of its depositors. In the MM the excess reserves of commercial banks are invested in near money assets which are easily converted into cash. Therefore, commercial banks earn profits without sacrificing their liquidity Helping commercial banks to become self-sufficient. o When commercial banks have scarcity of funds they need not approach the central bank and borrow at a high i.r., they can instead meet their requirements by recalling short term loans from MM Smoothing the functioning and increasing the efficiency of the central bank. o Although the central bank can function and influence the banking system with the absence of the money market, the existence of an developed MM smooths the functioning and increasing the efficiency of the central bank. The MM can help the bank in two ways:  The short term interest rate serve as an indicator as the monetary and banking conditions. In this way guide the central bank to have the correct banking policy  Sensitive and intergraded MM help the central bank secure quick and wide spread influence.

Who are the MM participants?

MM instruments

Further examples of instruments are Negotiable Certificate of Deposit and Eurocurrency

Treasury Bill  Have a 28-day maturities through 12 month maturities  Characteristics o Debt of the US department of the treasury o Discount paper  Primary market o Auctions  Secondary market o OTC Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return.

Commercial paper 

Unsecured promissory notes, issued by corporations with a discount, that mature in no more than 270 days (average of 1 month)

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The use of commercial paper increased significantly in the early 80’s because cost of borrowing is lower than at a commercial bank Primary market o Directly placed/dealer placed Secondary market o None

Banker’s acceptance (Bas) 

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Issued by Banks to finance a specific self-liquidating commercial transaction and allow a bank to ‘accept’ responsibility of guarantee payment of one of its customers o Bas are important in international trade when export firm may not know or easily determine the credit worthiness of a foreign firm o Bas are an order to pay a specific amount to the bearer on a given date if specified conditions have been met, usually delivered of promised goods o Bas are often used when buyers/sellers of expensive goods live in different countries A BA is a promised future payment, or time draft, which is accepted and guaranteed by a bank and drawn on a deposit at the bank. The BA specifies the amount of money, the date and the person to whom the payment is due. o Exporter gets paid immediately o Exporter is shielded from FOREX risk o Exporter does not have to assess the financial credit of the importer o Importers bank guarantees payment

Certificate of deposit (CD) 

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A bank issued security that documents a deposit and specifies the i.r. and the maturity date. A CD is a timed deposit, a financial product commonly sold by banks, thrift institutions and credit unions. CDs differ from saving accounts in that the CD has a specific fixed term and fixed i.r.. The maturity day is normally 1,3 or 6 months The i.r. tends to be higher than the T-bill rate i.r. rates on CDs tend to be higher than T-bill rates but the default risk is higher o Only a portion of large deposit is insured

Federal funds

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Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day Used by banks to meet short term needs and reserve requirements o When firms anticipate insufficient reserves, they often turn to FED funds markets o Here financial institutions can borrow reserves from other institutions on an overnight basis o Institutions with excess reserves can turn to the FED funds market to loan these reserves and earn interest

Repurchase agreement (REPO)    

These work similar to the market for fed funds, but nonbanks can participate A firm sells treasury securities, but agree to buy them back at a certain date (usually 1-14 days) for a certain price This set-up makes a REPO agreement essentially a short-term collateralized loan This is one market the FED may use to conduct its monetary policy, whereby the FED purchases/sells treasury securities in the REPO market

Eurocurrency 

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Is currency held on deposit help on deposit outside its home market, i.e. held in banks located outside of the country which issues the currency e.g. a deposit of US dollars held back in a bank in London would be considered Eurocurrency as the US dollar is deposited outside of its home market o Has nothing to do with the euro o Advantages  Lower cost  Less regulation  Able to deal in a very large amounts Eurodollars represent dollar denominated deposit held in foreign banks The market is essential since many foreign contracts call for payment is the US dollars due to the stability of the dollar, relative to other currencies London interbank bid rate (LIBID) o I.R. London banks are willing to borrow Eurodollar balances London interbank offer rate (LIBOD)

o I.R. London banks are willing to loan Eurodollar balances The US Libor is an average international inter bank interest rate The Euribor is a reference rate constructed form the average interest rate that euro banks offer and secure short term lending on the interbank market The euro overnight index average swap (Eonia swap) is a derivate financial instrument in which a fixed i.r. is swapped for a reference rate that is used for overnight money. The blue curve represents the credit risk in the US market, the red curve represents the risk in the European markets. Right after the default of Lehman brothers we observe the jump of the blue curve in the US market, therefore the credit risk jumped in the US market.

MM showed signs of stress  

Instead of having a well functioning market, where banks lend out excess cash to other banks in return for interest After the Lehman bankruptcy, the spreads soared` o Liquidity stopped flowing between cash rich and cash poor banks even with high i.r. because of the credit risk. o Cash poor banks were forced to get liquidity from central banks

Money market mutual funds (MMMFS) 

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A MMMFS is an open-end mutual fund which invests in highly liquid market instruments, typically t-bills, currencies and federal funds o Short-term investment pools use proceeds they raise from selling shares to invest in various MM instruments Reversal of financial intermediation process whereby funds (disintermediation) are: o Pulled from financial intermediaries o Moved directly into open market instruments

Banks vs MMMFS  

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They are both equally convenient and highly liquid MMMFS’ interest rates are much higher than those provided by banks o The higher i.r. are possible because the govt/central bank regulates commercial banks and restricts them in the form of interest rate ceilings so the banks aren’t allowed to offer very high i.r. o Where MMMFs base their i.r. on the market , so the i.r. is determined by supply and demand. So, if the supply of money is low or the demand for money is high, the i.r. of MMMfs grow substantially (not regulated) Banks charge interest spreads, while MMMFs do not o Banks profits: charge interest spread, they earn money by borrowing money at low interest rates and lending it at high i.r.

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o MMMFs charge a relatively low annual fee based on the service (expense ratio) and a one-time local fee, so theres no spread (like for banks). MMMFs lend to firms at high i.r. and pay their investors at high i.r., so they do not act as a bank who charges the i.r. spread Banks and MMMFs have entirely different functions o Money that is saved in a bank is insured (limit at 250k$ in US by FDIC). Banks resolve information asymmetry between the borrowers and lenders by using their resources to look into the companies who are lending money and borrowers, and charge the spread in return for the service (based on their ability of solving information asymmetry). Additionally, banks will put in resources in case that the lending company defaults (less risky) o Whereas MMMFs are investment firms who look at a money market security’s price, volatility, and cash flows and then decide whether they are going to invest in the security. So, banks have an information advantage, the cost of which is the lower i.r., because they need the spread to pay resources to gather information

Summary:

 The Money Markets Definition  – Short-term instruments  – Most have a low default probability  The Purpose of Money Markets  – Used to “warehouse” funds  – Returns are low because of low risk and high liquidity  Who Participates in Money Markets?  – Central banks  – Commercial banks  – Businesses  – Individuals (through MMMFs)  Money Market Instruments  – Include T-bills, fed funds, etc....