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11
Chapter
Money Market Instruments:
Treasury Bills, Repurchase Agreements,
Federal Funds, and Bank CDs
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
11 - 2
 Learning Objectives 
 To examine the characteristics of Treasury
bills and the workings of the government
securities market.
 To learn how securities dealers operate and
why they are so important to the functioning of
the money market.
 To understand how banks borrow and lend
funds through Federal funds trading and the
issuance of CDs.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
11 - 3
 Learning Objectives 
 To see the impact that the managerial strategy
known as liability management has on bank
performance and practice in recent years.
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11 - 4
Introduction
 The money market supplies the cash needs of
short-term borrowers and provides savers who
hold temporary cash surpluses with an interestbearing outlet for their funds.
 In this chapter, we focus on securities dealers
and banks, and explore in detail four popular
money market instruments – Treasury bills,
repurchase agreements, Federal funds, and
bank CDs.
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11 - 5
U.S. Treasury Bills
 U.S. Treasury bills (T-bills) are direct
obligations of the U.S. government that have
an original maturity of one year or less.
 Tax revenues or any other source of
government funds may be used to repay the
holders of these financial instruments.
 They carry great weight in the financial system
due to their zero (or nearly zero) default risk,
ready marketability, and high liquidity.
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11 - 6
Volume of U.S. Treasury Bills Outstanding
End
of
Year
Total Volume
of Bills
Outstanding
($ Billions)
Marketable
Public Debt
of the U.S.
($ Billions)
1960
1965
1970
1975
1980
1985
1990
1995
2000
2001
$ 39.4
60.2
87.9
157.5
216.1
399.9
527.4
760.7
646.9
811.2
$ 189.0
214.6
247.7
263.2
623.2
1,437.7
2,195.8
3,307.2
2,966.9
2,983.0
T-bills as a %
of the Total
Marketable
Public Debt
20.8 %
28.1
35.5
43.4
34.7
27.8
24.0
23.0
21.8
27.2
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
11 - 7
Types of Treasury Bills
 Regular-series bills are issued routinely every
week or month in competitive auctions with
original maturities of three months (13 weeks),
six months (26 weeks), and one year (52
weeks).
 Irregular-series bills are issued only when the
Treasury has a special cash need. These
instruments include strip bills and cash
management bills.
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11 - 8
How Bills Are Sold
Source:
McGraw
U.S.
HillBureau
/ Irwinof the Public Debt
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
11 - 9
How Bills Are Sold
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Calculating the Yield on Bills
 T-bills do not carry a promised interest rate.
Instead, they are sold at a discount from their
par or face value.
 Bill yields are determined by the bank discount
method, which does not compound interest
rates and uses a 360-day year for simplicity.
 The bank discount rate (DR) on T-bills
360
= Par value – Purchase price 
Par value
Days to maturity
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Calculating the Yield on Bills
 Because the rates of return on most other debt
instruments are not figured in the same way,
comparisons with other securities cannot be
made directly.
 The investment yield or rate (IR) on T-bills
365
= Par value – Purchase price 
Purchase price
Days to maturity
.
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11 - 12
Market Interest Rates on Treasury Bills
%
3-Month
14
12
12-Month
10
8
6
4
2
1961
1966
1971
1976
1981
1986
1991
1996
2001
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
11 - 13
Investors in Treasury Bills
 T-bills are held mainly by commercial banks,
nonfinancial corporations, state and local
governments, and the Federal Reserve banks.
 Commercial banks and private corporations
hold T-bills as a reserve of liquidity.
 The Federal Reserve banks conduct part of
their open market operations in T-bills because
of the depth and volume of activity of the
market.
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11 - 14
Primary Dealers
 Primary dealers are dealer firms that are
qualified to trade securities directly with the
Federal Reserve Bank of New York.
 Primary dealers agree to “meaningfully
participate” in trading with the Federal
Reserve at any time the Fed wishes, to make
“realistic” bids, and to trade continuously in
the full range of government securities.
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11 - 15
Primary Dealers
 Primary dealers have a significant incentive to
attempt to corner the government securities
market and to collude and place common bids,
so that all the dealers can get some share of the
new securities to fill their customers’ orders
and make a profit.
 In the wake of a scandal involving Salomon
Brothers in 1991, auction rules were tightened
and a market-surveillance committee was
created.
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11 - 16
Primary Dealers
 Then in 1998, the U.S. Treasury abandoned its
first-price sealed-bid, or English auction
approach, in which each successful bidder paid
the price that it had bid.
 It adopted the uniform-price, or Dutch auction
method, in which all successful bidders receive
securities at the same price – the marketclearing or stop-out price.
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11 - 17
Dealers in the Money Market
 The bulk of the dealers’ operating capital is
obtained through borrowings from commercial
banks and other institutions.
 The two most heavily used sources of dealer
funds are demand loans from the largest banks
and repurchase agreements with banks and
other lenders.
 A demand loan may be called in at any time if
the banks need cash urgently.
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11 - 18
Dealers in the Money Market
 Under a repurchase agreement (RP), the dealer
sells securities to a lender but makes a
commitment to buy back the securities at a
later date at a fixed price plus interest.
 RPs are simply a temporary extension of credit
collateralized by marketable securities.
 Term RPs are for a set length of time
(overnight, a few days, 1 month, 3 months, …)
while continuing contracts may be terminated
by either party on short notice.
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11 - 19
Dealers in the Money Market
 Interest income from RPs
= Amount  Current  Number of days loaned
of loan
RP rate
360 days
.
 Periodically, RPs are marked to market. If the
price of the pledged securities has dropped, the
borrower may have to pledge additional
collateral.
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11 - 20
Sources of Dealer Income
 Dealers hope to earn a profit (the positive
spread between the bid and ask prices) from
their market-making activities.
 By correctly anticipating interest rate
movements, dealers may earn sizable position
profits too.

If interest rates fall (and security prices rise),
dealers will experience capital gains on a long
position (but losses on a short position).
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11 - 21
Sources of Dealer Income
 Dealers also receive carry income, the
difference between interest earned on the
securities they hold and their cost of borrowing
funds.
 In addition, dealers receive miscellaneous
service fees for their advice and assistance to
customers.
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11 - 22
Dealer Positions in Securities
 Dealer holdings of securities are both huge and
subject to erratic fluctuations, due mainly to
interest rate movements and expectations.
 Today, dealers make heavy use of interest rate
hedging tools to further protect their portfolios
from losses due to changes in interest rates.

They are active participants in the financial futures
markets and are also making increased use of
forward commitments.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
11 - 23
Government Security Brokers
 Government securities dealers usually trade
among themselves through brokers.
 Government security brokers do not take
investment positions themselves, but try to
match bids and offers placed with them by
dealers and other investors.
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11 - 24
Banks in the Money Market
Banks’ Money Market Roles
Principal channel
for payments for
loans, securities &
other transactions
Custody agents
for safekeeping
securities owned
by market
participants and
pledged as
collateral for
loans
Agents in trust for
property management
on behalf of bank
customers
Direct lenders to
money market
borrowers
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Guarantors of
performance
& payment
Channel for
government
money & credit
policy
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
11 - 25
Federal Funds
 Federal funds are any monies available for
immediate payment (i.e. same-day money).
 They are generally transferred from one
depository institution to another by simple
bookkeeping entries requested via an on-line
computer system, by wire, or by telephone.
 Federal funds are the principal means of
making payments in the money market.
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11 - 26
Federal Funds
 The term federal funds came about because
early in the development of the market, the
principal source of immediately-available
money was the reserve balance that each
Federal Reserve System member bank had to
keep at the Federal Reserve bank in its region.
 Today, the federal funds market is broader in
scope – some deposits with commercial banks
are also available for immediate transfer.
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11 - 27
Federal Funds
 Banks and other depository institutions must
hold in a special reserve account liquid assets
equal to a fraction of the funds deposited with
them by the public.
 The required legal reserves may be either vault
cash or reserve balances with the regional
Federal Reserve banks.
 Since the reserves earn little or no income,
most bankers try to lend out excess reserves.
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11 - 28
The Structure of the Federal Funds Market
Banks & large
depositors with
excess reserves
available
(suppliers)
Banks needing
more legal
reserves & other
money market
borrowers
(demanders)
Accommodating
banks
Funds brokers
Absorbing
excess funds
Supplying
additional
funds
The Central Bank
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11 - 29
Federal Funds
 Total federal funds borrowings by banks in the
U.S. exceeded $600 billion as the 21st century
began.
 Most federal funds loans are either overnight
transactions or continuing contracts that have
no specific maturity and that can be terminated
without advance notice by either party.
 One-day loans carry a fixed rate of interest, but
continuing contracts often do not.
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11 - 30
Interest Rates on Federal Funds
%
Federal Funds
16
14
12
10
8
6
4
3-Month T-Bill
(secondary market)
2
0
1961
1966
1971
1976
1981
1986
1991
1996
2001
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
11 - 31
Federal Funds
 Beginning 1989, the Federal Reserve has
routinely set target levels for the federal funds
rate, and raised or lowered those targets
depending on whether it wishes to slow down
borrowing and spending in the economy or
speed them up.
 Through daily open market operations (buying
and selling securities), the Fed is able to push
the funds rate in the desired direction.
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11 - 32
Intended Federal Funds Rate
%
10
Actual Federal Funds Rate
8
6
4
Intended Federal Funds Rate
2
0
1/1/91
1/1/93
1/1/95
1/1/97
1/1/99
1/1/01
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Data
McGraw
Source:
HillBoard
/ Irwinof Governors of the Federal Reserve System
11 - 33
Negotiable Certificates of Deposit
 A certificate of deposit (CD) is an interestbearing receipt for funds left with a depository
institution for a set period of time.
 True money market CDs are negotiable CDs
that may be sold any number of times before
maturity and that carry a minimum
denomination of $100,000.
 They were introduced in 1961 to attract lost
deposits back into the banking system.
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11 - 34
Negotiable Certificates of Deposit
 CD interest rates are computed as a yield to
maturity (ytm) on a 360-day basis.
Interest = term in days  deposit  promised
income
360
principal
ytm
 In secondary market trading, the bank discount
rate (DR) is used as a measure of CD yields.
360
DR = Par value – Purchase price 
Par value
days to maturity
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.
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11 - 35
Negotiable Certificates of Deposit
 The principal buyers of negotiable CDs
include corporations, state and local
governments, foreign central banks and
governments, wealthy individuals, and a
variety of financial institutions.
 Most buyers hold CDs until they mature.
However, prime-rate CDs are actively traded
in the secondary market.
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11 - 36
The Market Structure for Negotiable CDs
Money
center
banks
Large
Issue primary market CDs
depositors
(corporations
& other
Funds raised to meet legal
customers)
reserve requirements and
other bank cash needs
Redemption
of CDs at
maturity
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Sale of
Immediately
negotiable
available
CDs
funds
Buyers in the
secondary
CD market
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11 - 37
Negotiable Certificates of Deposit
 Bankers are becoming increasingly innovative
in packaging CDs to meet the needs of
customers.
 New types of CDs include variable-rate CDs,
rollover or rolypoly CDs, jumbo CDs, Yankee
CDs, brokered CDs, bear and bull CDs,
installment CDs, rising-rate CDs, and foreign
index CDs.
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11 - 38
Bank Activity in the Money Market
 In the 1960s and 1970s, competition forced
major corporations to seek out alternative
investments for their short-term funds.
 Bankers thus turned to the money market for
additional funds – negotiable CDs appeared
and the federal funds market was broadened.
 Then, as policies were tightened, many
bankers turned to the Eurocurrency market,
commercial paper, and RPs.
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11 - 39
Bank Activity in the Money Market
 All the clever bank maneuvers form part of a
technique called liability management.
 By varying the daily interest rates offered on
CDs and other funds sources, bankers can gain
a measure of control over their liabilities.

If a bank needs more funds on a given day, the
bank can simply offer a higher yield on the
particular money market instrument that it desires
to use.
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11 - 40
Money and Capital Markets in Cyberspace
 More information about the various money
market instruments can be found at:

http://www.publicdebt.treas.gov

http://www.treasurydirect.gov/

http://www.federalreserve.gov/fomc/

http://www.economagic.com/fedbog.htm

http://www.toerien.com/neg_financial_instruments
/negotiable_financial_instuments.htm
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11 - 41
Chapter Review
 Introduction
 U.S. Treasury Bills
Volume of Bills Outstanding
 Types of Treasury Bills
 How Bills Are Sold
 Calculating the Yield on Bills
 Market Interest Rates on Treasury Bills
 Investors in Treasury Bills

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
11 - 42
Chapter Review
 Primary Dealers
Scandal Rocks the Market for Government
Securities
 A New Way to Auction Government Securities

 Dealers in the Money Market

Reliance on Borrowed Funds
• Demand Loans and Repurchase Agreements
Sources of Dealer Income
 Dealer Positions in Securities
 Government Security Brokers

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11 - 43
Chapter Review
 Banks in the Money Market
 Federal Funds
Nature of Federal Funds
 Use of the Federal Funds Market to Meet Deposit
Reserve Requirements
 Mechanics of Federal Funds Trading
 Volume of Borrowings in the Funds Market
 Interest Rates on Federal Funds
 Federal Funds and Government Economic Policy

McGraw Hill / Irwin
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11 - 44
Chapter Review
 Negotiable Certificates of Deposit
Terms Attached to CDs
 Buyers of CDs
 New Types of CDs

 Bank Activity in the Money Market
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.