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Chapter Five
Money Markets
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Definition and Purpose of Money
Markets
• The Money Markets are associated with the issuance and
trading of short-term debt obligations of large corporations,
FIs and government
• Only High-Quality Entities can borrow in the Money
Markets and individual issues are large
• Investors in Money Market Instruments include
corporations and FIs who have idle cash but are restricted
to a short-term investment horizon
• The Money Markets essentially serve to allocate the
nation’s supply of liquid funds among major short-term
lenders and borrowers
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Market Securities
• Treasury Bills - short-term obligations issued by the U.S.
government
• Federal Funds - short-term funds transferred between financial
institutions usually for no more than one day
• Repurchase Agreements - agreement involving the sale of
securities between parties with a promise to repurchase the
security at a specific date and price
• Commercial Paper - short-term unsecured promissory notes
issued by a company to raise short-term cash
• Negotiable Certificates of Deposit - negotiable bank-issued
time deposit with specific interest rate/maturity
• Banker Acceptances - time draft payable to seller of goods with
payment guaranteed by a bank
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Market Instruments Outstanding,
December 1990 and 1999 (in billions of
dollars)
Amount Outstanding
Rate of Return
1990
1990
Treasury bills
$527.0
Federal funds and
repurchase agreements 372.3
Commercial paper
537.8
Negotiable certificates
of deposit
546.9
Banker’s acceptance
52.1
McGraw-Hill /Irwin
1999
$ 674.8
1999
7.85%
5.23%
1,006.1
1,284.5
8.10
8.06
5.30
5.87
836.8
8.3
8.15
7.93
6.05
5.24
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Treasury Bill Basics
• Issued by the U.S. Treasury to cover
government budget deficits and to
refinance maturing debt
• Standard Original Maturities of 13
weeks, 26 weeks, or 52 weeks
• Denominations are $1,000 but typical
round lot is $5 million
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
The Auction Process for T-bills
• Amount of new 13-week and 26-week T-bills offered
announced weekly
• Bids submitted by government securities dealers,
financial and nonfinancial corporations and individuals
• Competitive bids limited to 35% total issue size, can
submit more than one bid, allocations made beginning
with highest bidder
• Noncompetitive bidders indicate quantity desired and
agree to pay weighted-average of the winning
competitive bids, get preferential allocation
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Treasury Auction Results
Bid Price
98.678%
Noncompetitive Bids
1
SC
2
ST
3
98.648%
(PNC)
(stop-at
price low
bid
accepted)
4
5
6
7
$10,581.9m
McGraw-Hill /Irwin
$11,778.1m
Quantity of
T-bills
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
The Secondary Market for T-bills
• The largest of any U.S. money market security
• Approximately 30 financial institutions “make”
a market in T-bills by buying and selling
securities for their own accounts and by trading
for their customers, including depository
institutions, insurance companies, pensions
funds, etc
• T-bills are the FOMC’s instrument of choice for
its open market operations
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Secondary Market T-bill Transaction
J.P. Morgan
sells $10m. In T-bills
Lehman Brothers
buy $10m. In T-bills
Federal Reserve Bank of New York
Transfers $10m. In T-bills from
J.P. Morgan to Lehman Brothers
Transaction recorded in Fed’s Book-Entry System
Individual
buy $50,000
in T-bills
McGraw-Hill /Irwin
Local Bank
or Broker
J.P. Morgan
sell $50,000
in T-bills
FRBNY
-$50,000 in T-bills
from J.P. Morgan’s
account
+ $50,000 T-bill
to Individual
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
T-bill Rates and Yields
• No interest paid on T-bills (coupon rate is zero),
issued at a discount from their par (or face) value
• T-bill rates are quoted in Wall Street Journal
• Discount Yield
– the price dealers are willing to pay T-bill holders to purchase
their T-bills for them
• Asked
– the discount yield based on the current purchase price set by
dealers that is available to investors
• Spread
– the percentage difference in the ask and bid yield, part of
transaction cost, the profit for dealers
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Calculating T-bill Yields from Discount
Rates
iT-bill(dy) = PF - PO
PF
Where:

360
h
PF = Annualized yield on the T-bill
PO = Price (face value) paid to the T-bill holder
h = Number of days until the T-bill matures
Example: iT-bill(dy) = $10,000 - $9,650  360 = 6.92%
$10,000
182
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Federal Funds Basics
• Short-term funds transferred between
financial institutions, usually for a period of
one day
• Federal Funds rate
– the interest rate for borrowing fed funds
– a focus or target rate in the conduct of monetary
policy
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Trading in the Fed Funds Market
• Commercial banks conduct the majority of
transactions in the fed funds market
• Banks with excess reserves lend fed funds,
while banks with deficient reserves borrow
fed funds
• Fed funds transactions can be initiated by
either the lending or borrowing institution or
handled through a broker
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Repurchase Agreements (RPs or Repos)
• An agreement involving the sale of securities by
one party to another with a promise to repurchase
the securities at a specified price on a specified
date
• Essentially a collateralized fed funds loan with
collateral in the form of securities (e.g. T-bills and
Fannie Mae)
• Reverse repurchase agreement
– involves the purchase of securities between parties with the
promise to sell them back at a given date in the future
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Trading Process for Repurchase
Agreements
• Arranged either directly between two parties
or with the help of brokers and dealers
• The repo buyer arranges to purchase T-bills
from the repo seller with an agreement that
the seller will repurchase the T-bills within a
stated period of time
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Commercial Paper
• An unsecured short-term promissory note issued by a
corporation to raise short-term cash, often to finance
working capital requirements
• The largest (in terms of dollar value) of the money
market instruments
• Generally sold in denominations of $100,000,
$250,000, $500,000 and $1 million with maturities of
1-270 days (if maturity is greater than 270 days, SEC
requires registration)
• Generally held until maturity so there is not an active
secondary market
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Trading Process for Commercial Paper
• CPs are sold either directly to investors (25%)
or indirectly through brokers and dealers such
as investment banks or major bank
subsidiaries
• Selling through brokers more expensive for
issuer due to underwriting costs
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Negotiable Certificates of Deposits
• A bank-issued time deposit that specifies an interest
rate and maturity date and is negotiable in the
secondary market
• Bearer Instrument
– whoever holds the CD when it matures receives the principal
and interest
• Denominations that range from $100,000 to $10
million, $1 million being the most common
• Often purchased by money market mutual funds with
pools of funds from individual investors
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Trading Process for NCDs
• Banks issuing CDs post daily rates for the more
popular maturities and subject to funding needs,
tries to sell to investors who are likely to hold
them as investments rather than sell them to the
secondary market
• In some cases, the bank and investor negotiate the
size, rate and maturity
• Secondary market consists of a linked network of
approximately 15 brokers and allows investors to
buy existing CD’s rather than new issues
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Banker’s Acceptances
• A time draft payable to a seller of goods with
payment guaranteed by a bank
• Arise from international trade transactions and
are used to finance trade in goods that have yet
to be shipped from a foreign exporter (seller) to
a domestic importer (buyer)
• Foreign exporters prefer that banks act as
guarantors for payment before sending goods to
importer
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Trading Process for BAs
Domestic
Importer
2 9
1
10
3
U.S.
Bank 7
1. Purchase order sent
2. Letter of credit requested
3. Notification of letter credit
and draft authorization
4. Order shipped
5. Time draft and shipping papers
sent to foreign bank
McGraw-Hill /Irwin
Foreign
4 Exporter
5
8
6 Foreign
Bank
6. Time draft and shipping papers sent
to U.S. bank; BA created
7. Payments sent to foreign bank
8. Payments sent foreign exporter
9. Payment to U.S. bank
10. Shipping papers delivered
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Market Participants
Instrument
Principal Issuer
Principal Investor
Treasury bills
U.S. Treasury
Federal funds
Repurchase agreement
Negotiable CDs
Commercial banks
FRS, Comm banks
Brokers and dealers
Other Fis
Comm banks
Other FIs, Corps
Commercial banks
Banker’s acceptances
Commercial banks
FRS, Comm banks
Brokers and dealers
Other FIs, Corps
Commercial banks
FRS, Comm banks
Brokers and dealers
Other FIs, Corps
Brokers and dealers
Corporations
Brokers and dealers
Corps, Other FIs
Comm banks, Corps
Brokers and dealers
Commercial Paper
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
International Aspects of Money
Markets
• While U.S. money markets are the largest, the
international market is growing
– U.S. securities bought/sold by foreign investors
– foreign money market securities
• Euro money market instruments
– Eurodollar deposits, Eurodollar CDs, Euro notes,
Euro CP
• London Interbank Offered Rate (LIOR)
– the rate paid on Eurodollars
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Euronotes and Euro CPs
Amount outstanding
Amount outstanding
Type of instrument
1995
1999
Type of instrument
1995
1999
Euronotes
Currency type
U.S. dollar
Euro currencies
Japanese yen
Other
Issuer type
FIs
Gov/state agencies
International Inst
Corporations
$45.5
$72.8
$87.0
$170.9
27.9
0.5
0.4
16.7
30.6
22.8
1.5
17.9
55.7
9.1
2.1
20.0
84.4
52.3
2.5
31.7
41.4
0.4
1.2
2.5
61.2
10.5
---1.1
Euro CPs
Currency type
U.S. dollar
Euro currencies
Japanese yen
Other
Issuer type
FIs
Gov/state agencies
International inst
Corporate issuers
40.5
14.2
2.1
30.2
107.4
15.1
5.1
43.2
McGraw-Hill /Irwin
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.