L03- Money Markets - Lecture notes 3 PDF

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FINANCIAL MARKETS + INSTITUTIONS: LO3 MONEY MARKETS: 3.1 MONEY MARKETS DEFINED: - Money markets contains short term and highly liquid securities, which are close to being money - Money market securities, have 3 basic characteristics 1) They are sold in large denominations 2) They have a low default risk 3) They mature in 1 year or less from their original issue date. Most securities in the money market mature in less than 120 days. - Traders arrange purchases and sales between participants over the phone to complete them electronically - Money market securities have an active secondary market, after security has been sold, it is easy to find buyers who will purchase it in the future. - Active secondary market makes MM securities flexible instruments to use for short term financial needs. - Money markets are wholesale markets, most transactions are large and in excess of $1 million. - Size of the transaction prevents most individual investors from participating directly in money markets - Due to the volume of transactions traders and brokerage firms help ring customers together. - Flexibility and innovative securities give access to small investors. - WHY DO WE NEED MONEY MARKETS?  The banking industry exists primarily to close the asymmetric information between savers and lenders = banks earn profits by providing this service= EoS  Banks must part a portion of their deposits in reserves that are held without interest at the federal reserve.  The purpose of banking regulations in the 1930s was to reduce competition between banks, with less competition = less likely to fall. Cost to consumers of greater profits earned by banks was justified as it resulted in more economic stability  The glass-Steagall act of 1933 prohibited payment of interest on checking accounts and limited interest that could be paid on deposits.  When inflation pushed short term IR above the celling level banks could legally pay, investors pulled their money out of banks and into money market securities  New investors cause MM to grow rapidly, MM established in 1986 after commercial bank IR celling’s were removed. 3.2 THE PURPOSE OF MONEY MARKETS: - Secondary market for MM instruments makes it an IDEAL PLACE FOR FIRMS TO WAREHOUSE SURPLUS FUNDS UNTIL THEY ARE NEEDED. - MM provides low cost source of funds to firms and govt if they are in need for short term infusion funds - Investors who warehouse surplus funds is to use MM as an interim investment that provides higher return bolding cash or money in banks - Is it expensive to hold surplus cash, as investors earn no income to the owner is, they are idle, therefore an opportunity cost in terms of lost interest income? - An assets opportunity cost if the amount of interest sacrificed by not holding an alternative asset. = MM PROVIDES A MEANS TO INVEST IDLE FUNDS TO REDUCE OC - Investment advisers hold funds in MM so that they will be able to act quickly to take advantage of investment opp they might identify. - Many investment funds and financial intermediaries also hold money MM securities to meet investment or deposit outflows - Sellers of money market securities, MM provides a low-cost source of temporary funds, take out funds to meet short term reserve requirements shortage. - The govt funds a large proportion of the US debt with T-bills.

- Finance companies such as general motors acceptance company, may enter MM to raise funds that it uses to make car loans - Cash flows = outflows are not always synchronized, such as govt expenditure and govt revenue might need to borrow short term funds to be able to finance these expenses and it is paid back when the revenue (tax) is received. - Business also face problems caused by revenues and expenses 3.3 WHO PARTICIPATES IN THE MONEY MARKETS: - MM has many diff players who sell and buy in the market. - For example, large bank may borrow large volume from the MM, at the same time it may lend short term funds to business through its commercial lending departments - PRIMARY MM PLAYERS 1) US TREASURY DEPARTMENTS Always a demander of money market finds never a supplier. Largest of all money market borrowers. Issues T-bills + other securities. Short term issues enable the govt to raise funds until tax revenues are received. 2) FEDERAL RESERVE SYSTEM: Federal reserve is the treasury’s agent for the distribution of all govt securities. Fed holds large quantities of treasury securities that it sells if it believes money supply should be reduced (purchases to expand MS). Fed reserves role in controlling the economy through open market operations. 3) COMMERCIAL BANKS: Holds US govt securities. Banks are not allowed to own risky securities, such as stocks or corporate bonds, able to hold treasury securities due to low risk and high liquidity. Banks are issuer of negotiable certificates of deposit (CDs), banker acceptance, federal funds and repos. Those banks that deal in secondary markets (such as MM) = money centre banks JP Morgan. 4) BUSINESS buy and sell securities in MM. limited due to large volumes of money involved. Provide warehouse for surplus funds and raise short term funds. 5) INVESTMENT + SECURITIES FIRM: Give investors will small amounts of cash access to large denomination securities. 1) INVESTMENT COMPANIES: Banks such as bank of America, Merrill lynch active in MM, primary function is to make a market for MM securities by maintaining an inventory from which to buy and sell. They assume that sellers can readily market their securities= makes MM more liquid 2) FINANCE COMAPNIES: raise funds in MM by selling commercial paper. Lend the funds to consumers for the purchase of durable goods. 3) INSURANCE COMPANIES: Property + casualty firms must have liquidity due to unpredictable need for funds. To meet demand of paying out policyholders the companies sell their MM securities to raise cash. 4) PENSION FUNDS: Invest a portion of cash in MM to take advantage of investment opp. Must have sufficient liquidity to meet their requirements. 6) INDIVIDUALS: For individuals to invest, seen a lot when the inflation rate rose above the capped IR offered to banks, many moved their idle cash to MM.

3.4 MONEY MARKET INSTRUMENTS: - TREASURY BILLS  Finance national debt US treasury issues debt securities.  Most held, and most liquid T-bills sold with 28, 91- and 182-day maturities,  Direct purchase set up online so individuals can purchase a treasury bill. First available in 1998  Govt does not pay interest on T-bills, issues at a discount from par (their value at maturity).  Investors yields comes from the  in the value of the security between the time it was purchases and the time it matures. RISK: TREASURY BILLS AUCTIONS: T- BILLS IR: ZERO DEFAULT RISK, even if Treasury accepts the bids offering the Due to being almost risk free highest price, accepts competitive the govt ran out of money the IR earned is very low. they can always print more to bids in ascending order of yield until the accepted bids reach the offering The real rate of interest has redeem when they mature. amount. been close to 0, but due to Risk of unexpected inflation Competitive bids investors state price inflation the return or earrings is low as they are short term. and amount they are willing to pay on these bills can be little or there is no change. Market for T-bills Is Deep and Each accepted bid is then awarded at Liquid, many buyers + sellers. the highest yield paid to any accepted Therefore, short term bid. temporary storage of excess Liquid market where funds as it may not keep up securities can be bought and Non-competitive bidding includes only with inflation. the amount of the securities that the sold quickly With Low investor wants. The price is set as the Transaction Costs. highest yield paid to any accepted competitive bid. = non-competitive and competitive pay the same price. NC = always end up with a security.

Book entry, procedure reduces cost of issuing treasury and cost of transferring them bought/sold in secondary markets. 1 DEALER CANNOT PURCHASE MORE THAN 35% OF 1 ISSUE.

- FEDERAL FUNDS  Short term funds (loaned or borrowed) between financial institutions, usually for 1 day.  The funds are held in the federal reserve, began in 1920s when banks with excess reserve loaned them to banks in need.  The IR for borrowing these funds was close to the rate the federal reserve charged on discount loans. PURPOSE OF FED FUNDS TERMS FOR FED FUNDS FEDERAL FUNDS IR: Market forces set the fed funds IR. Fed funds are overnight Fed set minimum reserve FED has an effective rate, the investments. requirements that all banks weighted average of rates on trades have to maintain through New York brokers. Banks analyse their reserve Must keep certain % of total positions and can either borrow FED cannot directly control the rate, can indirectly influence them by or invest in fed funds, if they deposits with FED. adjusting the level of reserves have a deficit or surplus. available to banks in the system. Provides banks with immediate infusion of If banks have excess, they will t of money in reserves, ba by buying directly from FED actively ecurities to the banks from posited in their borrowing. eral reserve. ply of reserves.

eserves by funds will .

- REPURCHASE AGREEMENTS:  Work the same way as FED funds but non-banks can participate, firm can sell treasury securities in repos agreement whereby the firm agrees to buy back the securities at a specified future date  SHORT TERM BETWEEN 3-14 DAYS, BUT THERE IS A MARKET FOR 1-3-month repos. USE OF REPO IR ON REPOS Dealer may sell securities to a bank with As they are collateralised with treasury the promise to buy securities from them securities, they are low risk investment = low IR. the next day. They are short term collateralised loans. The financial crisis impacted the repo markets when the value of securitising Securities dealers use repo to manage the collateral came under scrutiny. their liquidity and take advantage of anticipated changes in IR Federal reserve also use repo when conducting monetary policy - NEGOTIABLE CERTIFICATE OF DEPOSIT:  A bank issued security that documents a deposit and specifies the IR and maturity date.  As a maturity date is specified, the CD is a term security instead of a demand deposit  Securities have a specified maturity date; demand deposits can be withdrawn at any time.  Negotiable CD also known as bearer instruments, whoever holds the instrument at maturity received the principle and interest, can be bought and sold until maturity.  A firm sells, treasury securities but agrees to buy them back at a certain date for a certain price.  The party that buys the securities is the lender  The original seller, a borrower using their security as collateral for a secured cash loan.

TERMS OF CD Range from 100,000 – 10 million, few negotiable CDs some CDs are less than $1 million. Dealers have established a minimum quantity that can be traded without experiencing higher than normal brokerage fee. CD have a m demand for

IR ON CD; He IR paid on CDs are negotiated between the bank and consumer. Similar to the rate paid on other market instruments, as level of risk is low.

- BANKERS ACCEPTANCES:  It is an order to pay a specified amount of money to the bearer on a given date, used in the 12 th century.  They were used to finance goods that have not yet been transferred from the seller to the buyer, for example a company may want to buy large capital from an international firm, but the payment is to only be transacted after the good is received, the domestic company may provide a bankers acceptance to the international firm.  A bank can intervene in the standoff and issue a banker’s acceptance where the bank in essence substitutes its creditworthiness for that of the purchaser.  As bankers’ acceptances are payable to the bearer, they can be bought and sold until they mature.  Sold on a discounted basis like commercial paper and T-bills  Dealers in this market match up firms that want to discount a banker’s acceptance (sell it for immediate payment) with companies wishing to invest in bankers’ acceptances.  IR on bankers’ acceptance are low due to low default risk - COMMERCIAL PAPER:  Commercial paper securities are unsecured promissory notes, issued by corporations and mature in no more than 270 days.  As they are unsecured, only the largest and most creditworthy corporations’ issue commercial paper.  The IR the corporation is charged reflects the firm’s level of risk.  The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.  A special type of commercial paper, known as asset-backed com- commercial paper (ABCP) 1) played a key role in the financial crisis in 2008 backed by securitized mortgages; 2) often difficult to understand; LARS: 3) accounted for about $1 trillion.  Ma re paid in US dollars due to the stability of the dollar.  Large London banks hold dollar denominated deposits in British banks, known as the Eurodollars  Market has grown rapidly; main reason is that depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market.  at the same time the borrower is able to receive more favourable rate in the Eurodollar market than in the domestic market.

 Multinational banks are not subject to the same regulation restriction that US banks have. 1) LONDON INTERBANK MARKET; o Eurodollar deposits are time deposits therefore cannot be withdrawn for a specified period of time o Banks buy and sell overnight funds in this market o The rate paid by banks buying funds in the London interbank bid rate (LIBID), Funds are offered for sale in the market at the London interbank offer rate (LIBOR) o Very competitive market spread between the bids and the offer rate exceeds more than 0.125%. o Overnight LIBOR and FED FUNDS rate tend to be very close to each other, as they are near PERFECT SUBSTITUTES. o Demand and supply pressure will cause rapid adjustment that will cause the IR of both to come together. o Eurodollars certificate of deposits: o As Eurodollars are time deposits with fixed maturities, they are certain liquid o These new securities were transferable negotiable certificates of deposits (negotiable CD) o The Eurodollar market is short term, the market for Eurodollar negotiable CD is limited, less than 10% 2) OTHER EUROCURRENCIES: o Eurodollar market is the LARGEST SHORT-TERM SECURITY MARKET IN THE WORLD, due to international popularity of the US dollar for trade. o There are many accounts denominated in different currencies’ such as Japanese Yen = Euro yen etc

3.5 COMPARING MONEY MARKET SECURITIES: - INTEREST RATES:  The IR in money markets, for all the different instruments move closely together due to being low risk and short term.  All deep markets and priced competitively., they also have the same risk and term characteristics= close substitutes. - LIQUIDITY:  LIQUIDITY REFERS TO HOW QUICKLY, EASILY AND CHEAPLY IT CAN BE CONVERTED INTO CASH  The depth of the secondary market where the security can be resold determines its liquidly  For example T-bills has a secondary market that I well developed fur to this T-bills can be converted into cash quickly and with little cost as opposed to commercial paper where there is no developed secondary market = many keep them until maturity is they need to be sold to raise cash brokers will charge hefty fees.  Secondary markets not critical for MM as securities are short term.  Liquidity intervention, investors seek an intermediary to provide liquidity.  How MM securities are valued:  For example, bidding on T-bills, first determine the yield that you require. You decide that you need a 2% return we are bidding on a 1-year maturity, the T-bills will pay $1,000 when it matures = compute how much we will pay today find the PV of $1,000. When IR rise, the current price of the securities will decrease

MM VS CM...