Chapter Five

Money Markets

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 Learning Objectives

• Overview of money markets.

• Define and review the various money
market instruments that exist.
• Introducing the new issue and secondary
market trading process.
• Who are the market participants trading
these securities.

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 Money Markets

• Are markets that trade debt securities or instruments with

maturities of less than one year.
• It provides a flow of liquid funds (i.e. short term funds)
between short-term borrowers and lenders.
• Money markets involve debt instruments with original
maturities of one year or less.
• Money market debt
– issued by high-quality (i.e., low default risk) economic units that
require short-term funds
– purchased by economic units that have excess short-term funds

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 Money Markets
• So, a money market instrument provides an
investment opportunity that generates a higher rate of
interest (return) than holding cash (which yields zero
interest).
• So, money market financial securities is the best
alternative for investors with excess cash and short
term needs.
• Additionally, these securities can be quickly converted
back to cash when needed with a little risk of losing
value as well as with very low default risk.

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 Money Markets

• Money market instruments have active secondary

markets that serve to allocate the fixed amounts of liquid
funds available in the market at any particular time.

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 Characteristics of Money Instruments

• First: are generally sold in large denominations.

- Individual investors are able to invest in these securities
indirectly through money market mutual funds.
• Second: have low default risk.
- Money market instruments can be issued only by high-
quality borrowers with little default risk.
• Third: must have a maturity of one year of less.
- this also results in lower interest rate and price risks.

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 Money Market Yields

• Calculation of the Yield on money market

instruments depend on:

- The way they are bought and sold.

- whether securities return based on a 360-day year

or on a 365-day year.

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 Money Market Yields (Cont.)
Discount Yield
• Some money market instruments are bought and sold on
a discount basis (e.g., Treasury bills and commercial
paper)
• So the return that results from purchasing these
securities (i.e. newly issued securities) on discount is
called Discount yields (idy)
• use a 360-day year
• Interest rates or discount yields are quoted on a discount
basis using the following equation:

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 Money Market Yields (Cont.)
Discount Yield

( Pf  P0 ) 360
idy  
Pf h
Pf = the face value of the security
P0 = the discount price of the security
h = the number of days until maturity

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 Money Market Yields (Cont.)

• The discount yield is normally compared with

yields on U.S. Treasury bonds (non-discount
securities) .
• Which is called, bond equivalent yields (ibey)
• The return investors will achieve if they hold the
security to maturity, or sold it before.
( Pf  P0 ) 365
ibey  
P0 h

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 Money Market Yields (Cont.)

• But the comparison is difficult; because bond

equivalent yields use the purchase price as the
base price, and use 365-day year in calculations.
• An appropriate comparison can be done by
converting a discount yield into a bond equivalent
yield.

ibey  idy ( Pf / P0 )(365 / 360 )

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 Money Market Yields

• Neither the discount yield nor the bond equivalent

yield consider the effect of compounding of
interest rate.
• Convert bond equivalent yields into effective
annual returns (EAR)
365 / h
 ibey 
EAR  1   1
 365 / h 

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 Money Market Yields
• Example: Suppose you can purchase a $1 million T-bill that is
currently selling at 97½ percent of its face value. The T-bill
is 140 days from maturity, what is the Discount yield, bond equivalent
yield, and EAR?

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 Money Market Yields
• Example: An investor bought a $10,000 T-Bill with 6 month maturity
(182days) for $9,600, if the T-Bill is hold to maturity, what is the BEY
? If the investor decides to sell the T-Bill prior to maturity after 120
day at selling price $9,820, what is the BEY?

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 Money Market Yields

• Money market securities that pay interest only at maturity

use single-payment yields (ispy) (e.g., jumbo CDs,
repurchase agreement, and fed funds)
– since ispy uses a 360 day year, compare to bonds by converting to a
365 day year
ibey  ispy (365 / 360)
– to convert a single-payment yield to an effective annual return
365 / h
 365 / 360 
EAR  1  ispy  1
 365 / h 

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 Money Market Yields
• Example: Suppose you can purchase a $1 million negotiable CD that is
currently 105 days from maturity. The CD has a quoted annual interest
rate of 5.16 percent for a 360-day year. What are the BEY and EAR?

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 Money Market Instruments

• Treasury bills (T-bills)

• Federal funds (fed funds)
• Repurchase agreements (repos or RP)
• Commercial paper (CP)
• Negotiable certificates of deposit (CD)
• Banker acceptances (BA)

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 Treasury Bills (T-Bills)

• T-Bills are short-term debt obligations issued by

the U.S. government to cover current budget
shortfalls and to refinance maturing debt.
• The Federal Reserve buys and sells T-bills to
implement monetary policy
• T-bills are virtually default risk free, are highly
liquid, and have little interest rate risk

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 Treasury Bills (T-Bills)

• Original maturities are 4- , 13-, 26- and 52-week

;T-bills are auctioned weekly.
• They are issued in denominations of multiples of
$1,000.

• Existing T-Bills can be bought an sold in an

active secondary market through government
securities dealers who purchase treasury bills
form U.S government and resell them to
investors.
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 Trading Process of T-Bills
T-Bills Auctions
• New issue of T-Bills are sold through its regular
Treasury bill auctions.
• This happened every week on a Thursday, where
the amount of new issues is announced.
• Bids are submitted by government securities
dealers, financial and nonfinancial corporations,
and individuals and must be received by the
deadline of 1 P.M on the Monday following the
announcement.

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 T-Bill Auctions (Cont.)

• Allocations & prices are announced the following

morning (Tuesday) and are delivered on the Thursday
following the auction.
• Bids can be competitive or noncompetitive
– competitive bids specify the bid price and the desired
quantity of T-bills (the amount of par value of bills).
– Bids are ranked from the lowest discount yield
(highest price) to the highest yield (lowest prices).
– The highest bidder receives the first allocation of T-
bills and subsequent bids are then filled until all issue
is distributed.
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 T-Bill Auctions (Cont.)
– The yield of the last accepted bid (highest accepted
discount yield) is called the cut-off yield, stop-out-
yield, stop-out-rate of the auction.
– The price paid by all bidders is the lowest price of the
accepted competitive bidders.
– Bids with prices above (Below) the lowest accepted
price will receive the full allocation (nothing) of T-
bills requested.
– If the amount of competitive bids at the stop-out yield
exceeds the amount of bills remaining to be allocated
after the superior bids have been allocated, the bids at
the stop-out rate are distributed on pro rata basis
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 T-Bill Auctions (Cont.)
– noncompetitive bidders get preferential allocation
(i.e. these bids are met before the remaining T-bills
are allocated to the competitive bidders).
– They specify the desired amount of the face value of
the bills (the compete on quantity)
– they agree to pay the lowest price of the winning
competitive bids
– It is used by small investors to avoid them to bid too
low price or too high price, because they unfamiliar
with money market interest rate movements.

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 T-Bill Auctions (Cont.)
– If noncompetitive bids exceeds the amount of bills
auctioned , all non competitive bids are satisfied on a
pro rate basis, all competitive bids are rejected, and
the price of the bills is set at par, reflecting a yield at
zero.

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 T-Bill Auctions (Cont.)
Example: on T-Bills Auction: Suppose the US Government wants
to issue $11 billion T-Bills. The competitive bids tendered was $15
billion submitted by 6 competitive bidders, and the total of non-
competitive bids was $1 billion.
Com. Bids Price $ Idy QTY

B1 $ 987.16 5.08% $ 3.50

B2 $ 987.13 5.90% $ 2.50

B3 $ 987.11 5.10% $ 3.00

B4 $ 987.11 5.10% $ 3.00

B5 $ 987.08 5.11% $ 2.00

B6 $ 987.06 5.12% $ 1.00

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 T-Bill Auctions

Noncompetitive Bids
Bid Price 1
SC ST
2
3
4
5
6
Stop-out
price (PNC) 7

Quantity of
T-bills

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 The Secondary Market for T-Bills

• The secondary market for T-bills is the largest of

any U.S. money market instrument
• 21 primary dealers “make” a market in T-bills by
buying the majority sold at auction and who
create an active secondary market
– primary dealers trade for themselves and for customers
– The T-bills market is decentralized, that is, T-bill
purchases and sales are book-entry transactions
conducted over Fedwire

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 T-Bill Prices
• T-Bills are sold on a discount basis
• So the return comes from the difference between
the purchase price paid for T-Bills and the face
value received at maturity.
• Dealers of T-Bills quote both bid and ask prices
• Bid price: is the discount yield on the T-bill given
the current selling price available to holders.
• Ask price: is the discount yield based on the
current purchase price set by dealers that is
available to investors.

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 T-Bill Prices

• T-Bill prices can be calculated from quotes (e.g., from The

Wall Street Journal) by rearranging the discount yield
equation
 h 
P0  Pf  iT  Bill (dy )   Pf 
 360 
• Or by rearranging the bond equivalent yield equation
Pf
P0 
 h 
1   
 365 / iT  Bill (bey ) 

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 T-Bill Prices

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 T-Bill Prices

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 T-Bill Prices

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 Federal Funds
• The federal funds (fed funds): are short-term
funds transferred between financial institutions
for a period of one day (overnight).
• Federal funds is the excess reserves of
commercial banks held by their local federal
reserve bank and traded among them.
• Fed fund transactions are short-term (mostly
overnight) unsecured loans; the primary risk is
that the borrowing bank does not have to pledge
collateral for the fund it receives.

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 Federal Funds (Cont.)
• Banks with excess reserves lend fed funds, while banks
with deficient reserves borrow fed funds
• Borrowers of fed funds incur liabilities that appear
as federal funds purchased in their balance sheet.
• Lenders of fed funds record an asset that appears
as federal funds sold in their balance sheet.
• The interest rate charged on borrowing Fed Funds is
the federal funds rate; is the target rate in the
conduct of monetary policy.

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 Federal Funds Yields
• The primary risk of fed fund is that there is no
collateral for the funds received by borrowing
bank.
• Fed funds are single-payment loans; pay
interest only once at maturity, and thus use
single-payment yields.
• Quoted interest assume a 360-day year.
• So it should be converted into a bond
equivalent rate or yield to compare it with
other securities.
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 Federal Funds Yields
• Example If the overnight fed funds rate on June 21, 2013, was 0.13
percent. The conversion of the fed funds rate to a bond equivalent rate
is calculated as follows:

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 Trading of Federal Funds
• Fed Funds Market is highly liquid & flexible
source of funding for banks (commercial &
savings).
• HOWEVER, the largest commercial banks
conduct the vast majority of transactions.

• Transactions of fed funds are initiated by

either the lender or the borrower bank,
• The negotiations between them take place
directly or via phone.
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 Trading of Federal Funds (Cont.)

• Alternatively; transactions could be arranged

by fed funds brokers, who charge a small fee
for bringing the two parities together.

• All the transactions are completed using

Fedwire, the federal reserve’s wire transfer
network.

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 Trading of Federal Funds (Cont.)

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 Repurchase Agreement

• A repurchase agreement (repo or RP) is the

sale of a security with an agreement to buy the
security back at a set price (normally higher
than the selling price) and on a specified date
in the future (from the seller point of view).

• Repos are short-term collateralized loans (i.e.

fed fund loan); (typical collateral is U.S.
Treasury securities)

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 Repurchase Agreement (Cont.)

• A reverse repurchase agreement is the

opposite side of a repo (i.e., it is the purchase
of a security with an agreement to sell it back
in the future) (from the buyer point of view).

• The maturity range from 1 to 14 days (short-

term), or from 1 to 3 months (long-term).

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 Trading of Repurchase Agreement
(Cont.)
• Many commercial firms with idle funds in their
deposit accounts at banks, may deal with repos
to earn some return until these funds are needed.
• These firms use this idle fund to buy T-bills
from its bank (lend the bank), the bank then
agrees to repurchase the T-bills in the future at
higher price.
• Trading process for Repos:
• Repos are arranged either directly between two
parties or with the help of brokers and dealers.
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 Trading of Repurchase Agreement

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 Repurchase Agreement Yield

• The yield on repos (iRA) is the annualized

percentage difference between the initial selling
price of the securities and the contracted re-
purchase price (the selling price plus interest paid
on the repurchase agreement).

• This yield (iRA) uses a 360-day year like the

discount rate, but uses the current price in the
denominator like the bond equivalent yield

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 Repurchase Agreement Yield

( Pf  P0 ) 360
iRA  
P0 h

Pf = the repurchase price of the security

P0 = the selling price of the security
h = the number of days until the repo matures

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 Repurchase Agreement Yield
• Example:Calculation of a Yield on a Repurchase Agreement: Suppose a bank
enters a reverse repurchase agreement in which it agrees to buy fed funds from
one of its correspondent banks at a price of $10,000,000, with the promise to
sell these funds back at a price of $10,000,291.67 ($10,000,000 plus interest of
$291.67) after five days. The yield on this repo to the bank is calculated as
follows:

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 Commercial Paper
• Commercial paper (CP) is an unsecured short-
term promissory note issued by a corporation to
raise short-term cash, often to finance working
capital requirements.
The money market of CP is the largest in terms of
dollars outstanding, why???
• Companies with strong credit ratings can generally
borrow at a lower interest rate by issuing CP, than
borrow from bank.
• Generally sold in large denominations (e.g.,
$100,000 to $1 million) with maturities range
from 1 and 270 days; the most common maturities
are between 20 – 45 days.
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 Commercial Paper
• Commercial paper can be sold directly by the
issuers to a buyer such as a mutual fund (a direct
placement) or can be sold indirectly by dealers in
the commercial paper market.
• CP is usually held by investors until maturity, and
thus, has no active secondary market
• Because CP is unsecured debt and not actively
traded, the credit rating of the issuing companies
is very important in determining its marketability.
• The better the credit rating the lower the interest
rate on the issue.

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 Commercial Paper (Cont.)
• Issuers with low credit rating often back their
CPs:
1- With a latter of credit obtained from commercial banks
- In these cases, the bank agrees to make the promised
payment on the CP if the issuer cannot pay off the debt
on maturity.
- This substitutes the credit rating of issuer with that of
the bank.
- This reduces the risk to the purchasers of the paper and
results in a lower interest rate (and higher credit rating)
on the CP.

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 Commercial Paper (Cont.)
2- By arranging a line of credit (loan commitment) with a
bank.
- The issuer draws on this line if it has insufficient funds
to meet the repayment of the CP issue at maturity.

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 Trading of Commercial Paper
• CP is usually sold to investors either directly OR
indirectly.

• In case of direct issuance of CP:

- CP is issued directly from an issuer to a buyer (using
issuers’ own sales forces).
- The issuer saves the cost of the dealer (and the
underwriting services) but must find appropriate investors
and determine the discount rate on the paper that will
place the complete issue.

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 Trading of Commercial Paper
• In case of indirect issuance:
- CPs are issued through brokers and dealers, which are
normally an investments banks that are specialized in
underwriting activities (approximately 85% of the time).
- Indirect way is more expensive because of additional
underwriting cost, BUT
- Underwriters guarantee the sale of the whole issue
through firm commitment underwriting.
- To achieve this goal, the dealer contacts prospective
buyers of the CP, determines the appropriate discount
rate on the CP, and relays any special requests for the
CP in terms of specific quantities and maturities to the
issuer.

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 Commercial Paper Yields
• Like T-Bills, they are sold at discount.
• Thus, yields are quoted on a discount.
• The yield (discount return) to CP holders is the
annualized percentage difference between the price
paid for the paper and the par value using a 360-day
year
( Pf  P0 ) 360
icp ( dy )  
Pf h

• And converted to a bond equivalent yield as follows:

( Pf  P0 ) 365
icp (bey )  
P0 h

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 Commercial Paper Yields
• Suppose an investor purchases 95-day commercial paper
with a par value of $1,000,000 for a price of $990,023. The
discount yield and bond equivalent yield on the CP are
calculated as:

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 Negotiable Certificate of Deposit
• A negotiable certificate of deposit (CD) is a bank-
issued time deposit that specifies the interest rate and
the maturity date
• CDs are bearer instruments; who ever holds the CD
when it matures receives the principal & interest.
• They are salable in the secondary market.
• Denominations 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,
• Negotiable CD maturities range from two weeks to one
year, with most having a maturity of one to four
months.

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 Trading of Negotiable CD
• The new issue of CDs is managed as follows:
• Issuing bank post a daily set of rates for the most
common maturities of CDs.
• Then the bank tries to sell as many CDs to inventors.
• After selling CDs, the bank delivers them to a
custodian bank specified by the investor, which
verifies the CDs, debits the amount to the investor’s
account and credits the amount to the issuing bank.
• This is done through the Fedwire system by
transferring fed funds from the custodian bank’s
reserve account at the Fed to the issuing bank’s
reserve account.

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 Trading of Negotiable CD (Cont.)
• If investors want to sell CDs before maturity, they
can do so via secondary market.
• it is not a very active market, the secondary market
for negotiable CDs is made up of a linked network
of approximately 15 brokers and dealers using
telephones to transact.
• Certificates are physically transported between
traders or their custodian banks. The custodian
bank verifies the CD and records the deposits in
the investors' account.

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 Negotiable CD Yields
• Rates on CDs are negotiated between the bank and the
CDs buyers.
• Large, well-known banks can offer CDs at slightly lower
rates than smaller, less well-known banks. Why?
- The lower perceived default risk
- Greater marketability of well-known banks and
- Partly to the belief that larger banks are often “too big to fail”—
regulators will bail out troubled large banks and protect large depositors
beyond the explicit ($250,000) deposit cap under the current FDIC
insurance program.

• Negotiable CDs are single-payment securities. Thus,

interest rates on negotiable CDs are generally quoted using
a 360-day year.

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 Banker’s Acceptance
• A Banker’s Acceptance (BA) is a time draft payable to
a seller of goods with payment guaranteed by a bank
• It is an order for the bank to pay a specified amount of
money to the bearer of the time draft on a given date.
• Used in international trade transactions 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 payment
guarantors before sending goods to importers

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 Banker’s Acceptance (Cont.)
• The bank insure the international transaction by stamping
“Accepted” on a time draft written against the letter of
credit between the exporter and the importer, indicating
its commitment to pay the foreign exporter on a specified
date should the importer fail to pay for the goods.
• After issuing BA, the foreign exporter can hold it till the
date specified on the letter of credit.
• If they have immediate need for cash, they can sell it
before the date at a discount to the buyer in money
market.
• The ultimate bearer will receive the face value of BA on
maturity.

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 Banker’s Acceptance (Cont.)
• Because BA are payable to the bearer at maturity, they can
and are traded in secondary markets.
• Maturities on BA traded in secondary markets range from
30 to 270 days.
• Denominations of BA are determined by the size of the
original transaction (between the domestic importer and the
foreign exporter).
• In the secondary markets, however, BA are often bundled
and traded in round lots, mainly of $100,000 and $500,000.
• Because of low default risk, interest rate on BA is very low.
• Like T-bills, BAs are sold on discount basis.

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 Money Market Participants

• The U.S. Treasury

• The Federal Reserve
• Commercial banks
• Money market mutual funds
• Brokers and dealers
• Corporations
• Other financial institutions
• Individuals

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 International Money Markets

• The importance of U.S. dollars as an international

medium of exchange, results in the development of
money market instruments that are denominated in
U.S dollars and traded outside USA.
• U.S. dollars held outside the U.S. are tracked among
multinational banks in the Eurodollar market
• The rate offered for sale on Eurodollar funds is the
London Interbank Offered Rate (LIBOR)

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 International Money Markets

• Eurodollar Certificates of Deposits are U.S. dollar

denominated CDs held in foreign banks
• Eurocommercial paper (Euro-CP) is issued in
Europe and can be in local currencies or U.S. dollars
and it can be held by investors inside or outside of
Europe.

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