Topic 3 - The Money Market canvas PDF

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Financial Markets Topic 3: The Money Market

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Outline 1. Nature, features and functions 2. Participants

3. Money market instruments 4. Pricing a discount security

5. Introduction to Money Market Dealing

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1. Nature, features and functions 1.1. Nature of the Money Market

• Only short-term debt financial assets are traded • Loans and financial assets: less than one year

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1.2. Features of the market No Physical Location • Connected By Vast Communications Network

Over The Counter Market • Direct Contact Between Market Participants

Primarily Wholesale Market • Million Dollar Transactions

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Features of the market (cont) Financial Markets

Money markets

Capital markets

Primary money markets (maturities to one year)

Secondary money markets (residual maturities to one year)

Primary capital markets (new shares and longterm debt issues)

Secondary capital markets (trading in existing securities)

Domestic short-term money markets

International short-term money markets

Domestic capital markets

International capital markets

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1.3. Functions of the market • Transfer of funds from surplus economic units to deficit economic units for periods of less than 1 year

• Trading of existing debt financial assets which have maturities of less than 1 year

• Mechanism by which Government can raise short-term funding (e.g. Treasury notes)

• Instrument of monetary policy

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How do participants profit? Borrow from

Borrowers

Money

Lenders

Invest to

Only Intermediaries: profit 3/29/2021

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How do participants profit? (cont) E.g. Activity

Rate of interest

Total $ interest

Loan $1 million

5.00%

$50,000

Accept a deposit of $1 million 4.50%

$(45,000)

Profit

$5,000

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2. Participants

Central banks

Investment banks

Commercial banks

Participants

Brokers

Finance companies

Corporations

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2.1. Central banks Central Banks Short-term government funding

Open market operations (OMO)

Money supply

Interest rates, inflation, unemployment

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2.2. Commercial banks Commercial Banks Deposits from individuals

Lend to companies

Bill acceptance/ endorsement

Assist fund raising

Purchase government securities

Short-term government funding

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2.3. Investment banks Investment Banks Fixed-term deposits Short-term loans Wide range of financial services Interbank money market 3/29/2021

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Manage liquidity among bans 12

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2.4. Finance companies Finance Companies Obtain short-term finance

Manage liquidity

Lease finance

Investment & portfolio management 3/29/2021

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2.5. Brokers Dealers ???

Brokers Match borrowers & lenders Ensure anonymity

Wide range of financial services 3/29/2021

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2.6. Corporations Corporations Borrow & lend in overnight money market

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Place deposits Take out loans Use overdrafts

indirect finance

Issue commercial bills & promissory notes

direct finance

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3. Money market instruments Deposits 1. Cash products

Loans Commercial bills

2. Discount securities

Promissory notes Treasury bills or notes

3. Certificates of deposits (CD’s)

4. Repurchase agreements (repos)

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3.1. Cash Products Lending normally takes place on an unsecured basis The size of loans or deposits vary but two main terms are: o 11.00 am or overnight money: deposits and loans are initially made overnight and withdrawn by 11 am next day

o 7-day cash or 24-hour cash • term fixed for 7 days and then at 24-hour

call/notice 3/29/2021

• rate is reset daily after the initial period RMIT University

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3.2. Discount Securities

Commercial bills

Discount securities

Promissory notes Treasury bills or notes

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3.2.1. Commercial Bills A major source of short-term funding for companies. Commercial bills comprise - bank accepted bills - bank endorsed bills - non-bank bills

If the bill is sold in the secondary market, it must be endorsed (by sellers), which incurs a “contingent liability” 3/29/2021

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Commercial Bills - parties involved Example of a bank-accepted commercial bill (face side) Due Date 3/12/20xx To:

ABC Bank Ltd

Accepted 7 June 20xx

On the

Third

Payable at:

Pay to the order of

Borrowing Corporation Ltd

ABC Bank Ltd

The sum of:

One hundred thousand dollars ****

Day of December 20xx fixed

290 Martin Place, Sydney

$100,000 ****

For and on behalf of

Dated this

Seventh

ABC Bank Ltd

For and on behalf of

Borrowing Corporation Ltd

Authorised signatories of acceptor Place of payment Acceptor/guarantor/drawee

Date of acceptance

Day of June 20xx

Payee

Authorised signatories of drawer Drawer Date of drawing

Maturity date

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Commercial Bills – Flow of Fund Flow of funds: bank-accepted bills Drawer/borrower Borrowing Corporation Ltd

Bill accepted

Funds lent ($95,000)

Acceptor/Guarantor ABC Bank Ltd

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Bill discounted Discounter/Investor

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Commercial Bills – Flow of Fund (cont) Flow of funds: bank-accepted bills (cont)

Repay acceptor ($100,000 plus fees and margin) Acceptor: ABC Bank Ltd

Drawer: Borrowing Corporation Ltd

Present mature bill

Bill charged (holder receives $100,000)

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Discounter (current holder of bill)

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Commercial bills - Features Features o Terms 7 – 185 days o Traded on yields/rates o $5 - $10 million parcels o Two way pricing (bid-ask) o Extra fees apply to borrowers

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3.2.2. Promissory Notes •

Also known as: - P- Notes - Commercial Paper or - ‘One name paper’

•

“A written unconditional promise to pay a sum certain in money to the bearer at some time in the future”.

•

Essentially an IOU: Only issued by large companies with excellent credit ratings.

•

No endorsement is required if sold in the secondary market. So traders have no contingent liability.

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Higher yields than BAB’s because P-Notes are riskier than BAB’s.

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3.2.3. Treasury Notes (T-Notes) • Essentially P-notes but issued by the Government rather than corporations

• Maturities are 5, 13 and 26 weeks • Considered to be the most liquid instrument beside cash. • Lower yields than BAB’s because of lower risk • Main purchasers are banks and Non-Bank Financial Intermediaries (NBFIs)

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3.3. Negotiable certificates of deposit (CD’s) • “A negotiable certificate issued by a bank to a bearer such that bank agrees to pay a sum certain in money on a specified date.”

• Similar to a P-Note but issued by a bank rather than a corporation

• Yields are the same as those on BAB’s (they both carry the bank’s credit rating)

• Maturities range up to 180 days • Minimum amount is usually $50,000 • The short-term money market has an active secondary market in CDs

• Calculations—use discount securities formulae 3/29/2021

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3.4. Repurchase agreement (Repos) • A repo is an agreement to sell (buy) a security (such as shares or bonds) with a corresponding agreement to buy (sell) it back on an agreed date at an agreed price.

• Repos are usually conducted between banks and the Central Bank - Banks use repos to manage their liquidity

- Central Bank uses repos to implement monetary policy.

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4. Pricing a discount security • FV=PV 1+i n • PV=

FV 1+ yt

• “y” is substituted for “i” to denote yield • “t” is substituted for “n” and is days to maturity/365 • Note:365 days – Australia, Canada and Singapore 360 days – USA and Japan

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Pricing a discount security Example #1

• What is the price of a 90-day bank accepted bill, face value of $500,000 when 90 day BAB’s are trading at 12%?

500,000 90 1 + .12 × 365 3/29/2021

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= 485,631

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Example #2 • If a company sells a $1,000,000 promissory note at a yield of 9% for 92 days, how much money will it raise?

1,000,000 P= = 977,818.26 92 1 +(0.09) 365 3/29/2021

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5.Money Market dealing • Normally two prices for each product traded in the money market - a buy price or bid - a sell price or offer/ask • Prices are quoted by the dealer who is a market

maker (e.g., banks)

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Two-way pricing of cash products ▪ Market makers (such as banks) will provide both a bid and offer quote ▪ e.g. overnight cash quote 7.45/60

▪ This means the bank will borrow (buy) at 7.45% or lend (sell) at 7.60% ▪ The market takers (lenders and borrowers) must do the opposite – lend (deposit) at 7.45% or borrow at 7.60%

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Practice question Your company would like to borrow $5,000,000 overnight. You receive the following quotes: Bank A 5.82/85

Bank B 5.75/80

• Which bank do you choose?

• At what rate do you deal? • How much interest do you pay? • Is there an opportunity for arbitrage? 3/29/2021

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Two-way pricing of cash products •

Cash products = Loan; your company would like to borrow → bank

will lend you → offer/ask rate

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Two-way pricing of discount securities • Market makers (such as banks) will again provide both a bid and offer quote where they will buy and sell a security e.g. a commercial bill • Two-way pricing of securities is different but concept the same • A bank might quote 7.65/60 → bank will buy a bill at a yield of 7.65% and will sell a bill at a yield of 7.60%. A price taker must do the opposite – sell at a yield of 7.65% or buy at a yield of 7.60%.

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Two-way pricing of discount securities • Buying a commercial bill = lending money • Selling a commercial bill = borrowing money • A price maker (banks) will always lend at a higher rate of interest than they will borrow • The opposite applies to price takers

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Practice question A corporation calls Bank X and Y to buy 30-day bank bills. Bank X quotes: 7.00/6.95 Bank Y quotes: 6.98/93 • At what rate is bank Y willing to sell 30-day bills? • Which rate is most attractive for the Corp.?

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Practice question

•

At what rate is bank Y willing to sell 30-day bills? 6.93%

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Which rate is most attractive for the Corp.? (Corp buys bills→ Bank sells → ask/offer rate → Corp. prefers buying at a lower price (higher rate) → 6.95% (Bank X)

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Or corporation buys means lending money → want a higher rate → Bank X at 6.95%

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