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CHAPTER 7: The Money Market
Answers to End-of-Chapter Questions
1. Calculate the bond equivalent yield for a 180-day T-bill that is purchased at a 6%
"ask" rate. If the bill has a face value of $10,000, calculate its price.
First, calculate the price of the T-bill,
YD = (F - P) * 100% * (360/D) = (100 - P) * 100% * (360/180) = 6%,
F
100
where YD is the discount yield (6%).
P = F - (F * YD * D/360) = 100 - (100 * 0.06 * 180/360) = 97 per 100 of face value
Second, calculate the bond equivalent yield,
YBE = (F - P) * 100% * (365/D) = (100 - 97) * 100% * (365/180) = 6.27%
P
97
2. What are the characteristics of money market instruments? Why must a financial
claim possess these characteristics to function as a money market instrument?
The three fundamental characteristics of money market instruments are: (a) low default risk,
(b) short-term to maturity, and (c) high marketability. These characteristics give money
market instruments their characteristic of being low risk.
3. How are U.S. Treasury and federal agency securities different? What difference
primarily explains the yield differential between the two securities?
Agency securities have greater default risk and are less marketable than Treasury securities.
As a result, Agency securities sell for higher yield than similar Treasury securities.
4. What types of firms issue commercial paper? What are the characteristics critical to
being able to issue commercial paper?
Large high-rated businesses issue commercial paper as an inexpensive source of short-term
borrowing. Commercial paper is an alternative to prime rate borrowing from a commercial
bank and, typically, the rates are lower than rates charged by banks.
Most investors, an in attempt to protect their principal, only want paper rated high by rating
agencies. Rating agencies will quickly write down or remove their ratings for commercial
paper if the financial conditions of a company decrease. The number companies issuing
commercial paper in the economic boom of the late 1990's, shrunk considerably by 2001 as
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rating agencies pulled their commercial paper ratings.
5. Why is a bank line of credit necessary to back up an issue of commercial paper?
Back up lines of credit, which would pay off commercial paper in case of financial
difficulties, are required by investors (and rating agencies) to assure protection of their
principal and liquidity of the investment.
6. Describe the steps in a typical banker's acceptance transaction. Why is the banker's
acceptance form of financing ideal in foreign transactions?
See the discussion of Exhibit 7-11 for the steps in creating a banker's acceptance. Banker's
acceptance provides two basic services: (a) financing, and (b) services and expertise
specifically related to an international transaction. The latter makes banker's acceptances an
attractive means of financial international transactions.
7. Explain how repurchase agreement transactions provide short-term investments to
businesses. In what sense is a repo a collateralized loan?
The corporate treasurer purchases government securities from a bank for a specified period.
The business would have idle cash deposit balances that it would transfer out to invest. The
bank retains the funds by providing a repurchase transaction whereby it sells securities owned
(stored offsite in depository) to the business and agrees to buy it back at a higher price, thus
paying the money market rate for the business' funds. The purchased price and sale price are
agreed upon at the time the deal is made. The interest paid the corporation is the difference
between the purchase and repurchase price of the collateralized securities. The repurchase
agreement, while a short-term money market investment of the business, are close to being
short-term collateralized loans to the bank.
8. Suppose Fargood Corporation engages in a repurchase agreement with The National
Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury
securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000.
a. Is this transaction a loan, and if so, who is the borrower and who is the lender?
Defend your answer.
In this case, the transaction is a reverse repurchase agreement (reverse repo) for the bank.
It agrees to purchase securities under agreement to resell. The bank is buying
(investment of funds) the Treasuries owned by Fargood (liquidity provided; funds gained
for period of reverse repo). Technically, it is not a loan, but a purchase (by the bank) with
agreement to resell, but the effect is the same as a loan to a customer.
b. Is the loan collateralized? What is the Collateral? Who holds the collateral during
the term of the agreement?
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The bank or offsite depository would hold the securities during the contract period. It
technically a purchase/sale, but is a type of short-term collateralized loan.
c. What interest rate (or yield) is earned by the lender?
The annualized yield to the bank (cost to Fargood) would be
YREPO = (PREPO - P0) * 100% * (360/D) = ($10,000,000 - $9,987,950) * 100% * (360/30)
P0
$9,987,950
= 1.45%
d. Draw T-accounts for this transaction, similar to the example earlier in the chapter.
Show the assets and liabilities for each party before and after the transaction.
Δ Assets
Fargood Corp
Δ Liabilities
(1) +Deposit in
Bank $9.9875m
Δ Assets
National Bank
Δ Liabilities
(1) +T. Sec.
$9.9875m
(1) +Deposit (Fargood)
$9.9875m
(1) -T. Sec.
$9.9875m
(2) -Deposit in
Bank $10m
(2) +T. Sec. 10m
(2) -Capital
Loss on Repo
$12,050
(2) -T. Sec. $10m (2) -Deposit (Fargood)
$10m
(2) +Capital Gain on
Repo $12,050
9. Suppose 7-day federal funds trade at 1.65 percent annually. What is the yield on
federal funds on a bond-equivalent basis?
To compare yields in the federal funds market with those of other money market instruments,
the federal funds rate must be converted into a bond equivalent yield.
YBE = YFF * (365/360) = 1.65% * (365/360) = 1.673%
10. Why did several large well-known firms find it so difficult to raise funds in the
commercial paper market in 2002?
In 2002, the U.S. economy slowed and many sectors and industries had reduced earnings and
stock values. As soon as words of financial difficulty (earnings or negative information)
started to flow, rating agencies downgraded or dropped their commercial paper rating, a
necessity for selling commercial paper.