Download Chapter 14 The Money Market

Chapter 14
The Money Market
Copyright  2005 by Thomson Learning, Inc.
Learning Objectives
Specify the important features of money
markets.
 Define the money market instruments by
category.
 Calculate the taxable-equivalent yield, yield from
dividend capture, discount yield, couponequivalent yield, and effective annual yield.
 Specify types of investment risk and their effects
on yields.
 Understand yield curves and the theories that
explain them.

Copyright  2005 by Thomson Learning, Inc.
Nature of the Money Market
 Primary
and secondary markets
 Wholesale and retail markets
 Money market interest rates
 Tax status
 Market mechanics and intermediaries
Copyright  2005 by Thomson Learning, Inc.
Money Market Instruments
 Bank
instruments
 Corporate instruments
 Federal Government instruments
 State and local instruments
 Mixed instruments
Copyright  2005 by Thomson Learning, Inc.
Bank Instruments
Instrument
Denomination
Maturity
Risk
Certificates of Deposit
Primary: $100,000 +
Secondary: $2-$5m
7 days to
8 years
Time deposits
Minimum set by
bank
1 day to 3
months
* FDIC
* Fixed mat.
*Expro risk of
Eurodollar
deposits
Bankers Acceptances
$500,000 to $1m
Up to 270
days
* Bank secured
* 2ndary mkt
Loan participations
Varies
1 day to
3 months
Securitized assets such
as auto loans, etc.
Varies
1 year to
3 years
* Most have
guarantor
* Illiquid
* Diversified
portfolio
Copyright  2005 by Thomson Learning, Inc.
Corporate Instruments
Instrument
Denomination
Maturity
Risk
Commercial paper
Primary: $100,000 +
Secondary: $5m
1 to 270 days
* Usually low
* Backup line
* Liquidity
function of
issuer
Floating-rate notes
Primary: $1,000-$100,000 9 months to
Secondary: $5 million
30 years
* Function of
issuer
Common or
preferred stock
No typical
*Function of
issuer
* Function of
market
No maturity
days
Copyright  2005 by Thomson Learning, Inc.
Federal Government Instruments
Instrument
Denomination
Maturity
Risk
Treasury bills
Primary: $1,000+
3,6,12 months
*No default
risk
*Some interest
rate risk
Treasury notes/bonds
2-yr notes: $5,000
3-,5-,7-,10-yr notes
and bonds: $1,000
Government agencies
Primary: $1,000
Secondary: larger
Notes: 2-5,7,10 yrs *No default
Bonds: >10 yrs *Interest rate
risk
Varies
* Low default
* Sporadic liq.
* Interest rate
risk function
of maturity
* Event risk
Copyright  2005 by Thomson Learning, Inc.
State and Local Government
Instruments
Instrument
Denomination
Maturity
Risk
Anticipation notes
Primary: $5,000
Secondary: $100,000
Few weeks to
several years
* Low default
risk
* Liq. depends
on dealer
* Interest rate
risk function
of maturity
VRDNs
Primary: $5,000-$100,000 30 years with
Secondary: $100,000
put. Interest
rate reset
* Low default
and liq. risk
* Low liquidity
risk due to
rate reset
Tax-exempt CP
Primary: $50,000-$100,000 Few days to
Secondary: $100,000
several years
* Same risk as
anticipation
Copyright  2005 by Thomson Learning, Inc.
Mixed Instruments
Instrument
Denomination
Maturity
Risk
MMMFs
$10,000 for institutions
25-60 days
* No FDIC
* No liquidity
risk
* No interest
rate risk
Repurchase Agreements Typical: $1 million
Mostly overnite * Depends on
Term RPs
institution
are 7-30 days
* Linked to
collateral
* Some liq risk
* Event risk
Sweep accounts
Overnight
None
* Depends on
institution
Copyright  2005 by Thomson Learning, Inc.
Money Market Rate Calculations
D
365
Ycap = ------ x -----P
n
Dividend capture yield
(14.2)
Ycap [1 - (.30 x T)]
Ycap-te = --------------------- Tax-equivalent yield
(14.3)
(1 -T)
Where:
.30 is related to the dividend exclusion
T is the investors marginal tax rate
D is the dividend
P is the security price
n is the holding period
Copyright  2005 by Thomson Learning, Inc.
Money Market Rate Calculations
FACE-P
360
Yd = ------------ x ------FACE
n
Yce
FACE-P
365
= ----------- x ------P
n
Discount yield
(14.4)
Coupon-equivalent yield
(14.5)
Copyright  2005 by Thomson Learning, Inc.
Term Structure Theories

Yield,%
Time to Maturity

What explains the shape of the yield curve?
Copyright  2005 by Thomson Learning, Inc.
Term Structure: Unbiased
Expectations

The prevailing yield curve is derived from the
present short-term rate and expectations for rates
that will exist in the future.
 (1+tRn)

= [(1+tR1)(1+t+1r1,t)(1+t+2r1,t)......] 1/n
Thus, long-term rates are higher than current
short-term rates if future short-term rates are
expected to be higher than current short-term
rates...and long-term rates fall below current shortterm rates if future expected short-term rates are
expected to be less than the current level of shortterm rates.
Copyright  2005 by Thomson Learning, Inc.
Term Structure: Liquidity
Preference

Preference for liquidity is thought to characterize
enough investors that the yield curve (in absence of
expectations or other influences) should slope
upward from left to right. The longer the maturity,
the higher the premium demanded by investors.

Yield,%
Yield, %
Liquidity
Premium
Time to Maturity
Copyright  2005 by Thomson Learning, Inc.
Term Structure: Segmentation
hypothesis
 Instead
of being close substitutes, securities
with short, medium, and long maturities are
seen by investors (fund suppliers) and
issuers (fund demanders) as quite different.
 The markets are thus separated, or
segmented, by the self-limiting behavior of
institutions staying within their preferred
habitats.
Copyright  2005 by Thomson Learning, Inc.
Term Structure: Biased expectations
 A combination
of the unbiased expectations
theory and the liquidity preference
hypothesis.
Copyright  2005 by Thomson Learning, Inc.
Risk Structure of Interest Rates
 Default
risk
 Liquidity risk
 Interest rate risk
 Reinvestment rate risk
 Event risk
 Foreign exchange and political risk
Copyright  2005 by Thomson Learning, Inc.
Risk-Return Assessment in Practice
 Yield
spread analysis
 Safety ratings
 Assessing liquidity risk
Copyright  2005 by Thomson Learning, Inc.
Summary
 We
surveyed the menu of short-term
investment alternatives.
 Investment objectives rank safety first,
followed by liquidity and then yield.
 We learned how to calculate various money
market rates of return.
 We studied possible explanations for the shape
of the yield curve.
 We concluded with a discussion of the risk
structure of interest rates.
Copyright  2005 by Thomson Learning, Inc.