Download Valuation of Money Market Securities

PowerPoint Slides for:
Financial Markets
and Institutions
6th Edition
By Jeff Madura
Prepared by
David R. Durst
The University of Akron
CHAPTER
6
Money
Markets
Chapter Objectives
Provide a background on money market
securities
 Explain how institutional investors use money
markets
 Explain the globalization of money markets

Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Maturity of a year or less
 Debt securities issued by corporations and
governments that need short-term funds
 Large primary market focus
 Purchased by corporations and financial
institutions
 Secondary market for securities

Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Treasury Bills
 Commercial paper
 Negotiable certificates of deposits
 Repurchase agreements
 Federal funds
 Banker’s acceptances

Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities

Treasury bills
Issued to meet the short-term needs of the U.S.
government
 Attractive to investors

Minimal
default risk—backed by Federal Government
Excellent liquidity for investors


Short-term maturity
Very good secondary market
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Competitive Bidding

Treasury bill auction (fill bids in amount
determined by Treasury borrowing needs)
Bid process used to sell T-bills
 Bids submitted to Federal Reserve banks by the
deadline
 Bid process

Accepts
highest bids
Accepts bids until Treasury needs generated
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Money Market Securities
Noncompetitive Bidding

Treasury bill auction—noncompetitive bids
($1 million limit)




May be used to make sure bid is accepted
Price is the weighted average of the accepted competitive
bids
Investors do not know the price in advance so they submit
check for full par value
After the auction, investor receives check from the
Treasury covering the difference between par and the
actual price
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Money Market Securities

Estimating T-bill yield
No coupon payments
 Par or face value received at maturity
 Yield at issue is the difference between the selling
price and par or face value adjusted for time
 If sold prior to maturity in secondary market

Yield
based on the difference between price paid for Tbill and selling price adjusted for time
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities

Calculating T-Bill Annualized Yield
YT =
SP – PP
PP

365
n
YT = The annualized yield from investing in a T-bill
SP = Selling price
PP = Purchase price
n = number of days of the investment (holding period)
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities

T-bill yield for a newly issued security
T-bill yield
=
Par – PP
PP

365
n
T-bill yield = percent yield of the purchase price from par
Par = Face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities

T-bill discont for a newly issued security
T-bill discount =
Par – PP
par

360
n
T-bill discount = percent discount of the purchase price from par
Par = Face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Commercial Paper
Short-term debt instrument
 Alternative to bank loan
 Dealer placed vs. directly placed
 Used only by well-known and creditworthy firms
 Unsecured
 Minimum denominations of $100,000
 Not a large secondary market

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Money Market Securities

Commercial paper backed by bank lines of
credit
Bank line used if company loses credit rating
 Bank lends to pay off commercial paper
 Bank charges fees for guaranteed line of credit

Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities

Estimating commercial paper yields
YCP =
Par – PP
PP

360
n
YCP = Commercial paper yield
Par = Face value at maturity
PP = Purchase price
n = number of days to maturity
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Negotiable Certificates of Deposit (NCD)
Issued by large commercial banks
 Minimum denomination of $100,000 but $1
million more common
 Purchased by nonfinancial corporations or money
market funds
 Secondary markets supported by dealers in
security

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Money Market Securities

NCD placement
Direct placement
 Use a correspondent institution specializing in
placement
 Sell to securities dealers who resell
 Sell direct to investors at a higher price


NCD premiums

Rate above T-bill rate to compensate for lower
liquidity and safety
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Repurchase Agreements
Sell a security with the agreement to repurchase it
at a specified date and price
 Borrower defaults, lender has security
 Reverse repo name for transaction from lender
 Negotiated over telecommunications network
 Dealers and brokers used or direct placement
 No secondary market

Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities

Estimating repurchase agreement yields
Repo Rate =
SP – PP
PP

360
n
Repo Rate = Yield on the repurchase agreement
SP = Selling price
PP = Purchase price
n = number of days to maturity
Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Federal Funds
Interbank lending and borrowing
 Federal funds rate usually slightly higher than Tbill rate
 Fed district bank debits and credits accounts for
purchase (borrowing) and sale (lending)
 Federal funds brokers may match up buyers and
sellers using telecommunications network
 Usually $5 million or more

Copyright© 2002 Thomson Publishing. All rights reserved.
Exhibit 6.5
Purchase Order
5
Shipment of Goods
3
American Bank
(Importer’s Bank)
Shipping Documents & Time Draft
2
L/C Notification
Exporter
L/C (Letter of Credit) Application
Importer
1
4
6
L/C
7 Shipping Documents & Time Draft
Draft Accepted (B/ACreated)
Japanese Bank
(Exporter’s Bank)
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Money Market Securities
Bankers Acceptance
A bank takes responsibility for a future payment of
trade bill of exchange
 Used mostly in international transactions
 Exporters send goods to a foreign destination and
want payment assurance before sending
 Bank stamps a time draft from the importer
ACCEPTED and obligates the bank to make good
on the payment at a specific time

Copyright© 2002 Thomson Publishing. All rights reserved.
Money Market Securities
Bankers Acceptance
Exporter can hold until the date or sell before
maturity
 If sold to get the cash before maturity, price
received is a discount from draft’s total
 Return is based on calculations for other discount
securities
 Similar to the commercial paper example

Copyright© 2002 Thomson Publishing. All rights reserved.
Major Participants in Money Market

Participants








Commercial banks
Finance, industrial, and service companies
Federal and state governments
Money market mutual funds
All other financial institutions (investing)
Short-term investing for income and liquidity
Short-term financing for short and permanent needs
Large transaction size and telecommunication
network
Copyright© 2002 Thomson Publishing. All rights reserved.
Valuation of Money Market Securities
Present value of future cash flows at maturity
(zero coupon)
 Value (price) inversely related to discount rate
or yield
 Money market security prices more stable than
longer term bonds
 Yields = risk-free rate + default risk premium

Copyright© 2002 Thomson Publishing. All rights reserved.
Exhibit 6.7
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
Issuer’s
Industry
Conditions
U.S.
Economic
Conditions
Short-Term
Risk-Free
Interest
Rate
(T-bill Rate)
Issuer’s
Unique
Conditions
Risk
Premium
of Issuer
Required Return
on the Money
Market Security
Price of the
Money Market
Security
Copyright© 2002 Thomson Publishing. All rights reserved.
Interaction Among Money Market
Yields
Securities are close investment substitutes
 Investors trade to maintain yield differentials
 T-Bill is the benchmark yield in money market
 Yield changes in T-bills quickly impacts other
securities via dealer trading
 Yield differentials determined by risk
differences between securities
 Default risk premiums vary inversely with
economic conditions

Copyright© 2002 Thomson Publishing. All rights reserved.
Globalization of Money Markets

Money market rates vary by country
Segmented markets
 Tax differences
 Estimated exchange rates
 Government barriers to capital flows

Deregulation Improves Financial Integration
 Capital Flows To Highest Rate of Return

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Globalization of Money Markets

Eurodollar deposits and Euronotes
Dollar deposits in banks outside the U.S.
 Increased because of international trade growth
and U.S. trade deficits over time
 No reserve requirements at banks outside U.S.


Eurodollar Loans

Channel funds to other multinationals that need
short-term financing
Copyright© 2002 Thomson Publishing. All rights reserved.
Globalization of Money Markets

Euro-commercial paper
Issued without the backing of a banking syndicate
 Maturity tailored to investors
 Dealers that place paper create a secondary market
 Rates range between 50 and 100 basis points
above the LIBOR rate

Copyright© 2002 Thomson Publishing. All rights reserved.
Globalization of Money Markets
Performance of international securities
 Effective yield for international securities has
two components

The yield earned on the investment denominated
in the currency of the investment
 The exchange rate effect

Copyright© 2002 Thomson Publishing. All rights reserved.
Globalization of Money Markets
Performance of international securities
 Yield for an international investment

Yf
=
SPf – PPf
PPf
Yf = Foreign investment’s yield
SPf = Investment’s foreign currency selling price
PPf = Investment’s foreign currency purchase
Copyright© 2002 Thomson Publishing. All rights reserved.
Globalization of Money Markets

The exchange rate effect (%S) measures the
percentage change in the spot during the
investment period
Ye  (1  Yf )  (1  %S )  1

% S measures the expected percent change in
the currency
Currency
appreciated, % S is positive and adds to net
yield
Currency depreciated, % S is negative and reduces net
yield
Copyright© 2002 Thomson Publishing. All rights reserved.
Chapter Concepts Summary
Surplus units channel investments to securities
issued by deficit units
 Debt securities markets

Money Market
 Capital Market


Money market securities
Short-term
 High quality
 Very good liquidity

Copyright© 2002 Thomson Publishing. All rights reserved.