Chapter Five

Money Markets

McGraw-Hill/Irwin 5-1 ©2009, The McGraw-Hill Companies, All Rights

 Learning Objectives

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

McGraw-Hill/Irwin 5-2 ©2009, The McGraw-Hill Companies, All Rights

 Money Markets

•• Are
Aremarkets
marketsthat
thattrade
tradedebt
debtsecurities
securitiesor
orinstruments
instrumentswith
with
maturities
maturitiesofofless
lessthan
thanone
oneyear.
year.
•• ItItprovides
providesaaflow
flowof ofliquid
liquidfunds
funds(i.e.
([Link]
shortterm
termfunds)
funds)
between
betweenshort-term
short-termborrowers
borrowersandandlenders.
lenders.
•• Money
Moneymarkets
marketsinvolve
involvedebt
debtinstruments
instrumentswithwithoriginal
original
maturities
maturitiesof ofone
oneyear
yearororless.
less.
•• Money
Moneymarket
marketdebt
debt
–– issued
issuedby
byhigh-quality
high-quality(i.e.,
(i.e.,low
lowdefault
defaultrisk)
risk)economic
economicunits
unitsthat
that
require
requireshort-term
short-termfunds
funds
–– purchased
purchasedbybyeconomic
economicunits
unitsthat
thathave
haveexcess
excessshort-term
short-termfunds
funds

McGraw-Hill/Irwin 5-3 ©2009, The McGraw-Hill Companies, All Rights

 Money Markets
•• So,
So,aamoney
moneymarket
marketinstrument
instrumentprovides
providesan an
investment
investmentopportunity
opportunitythat
thatgenerates
generatesaahigher
higherrate
rateof
of
interest
interest(return)
(return)than
thanholding
holdingcash
cash(which
(whichyields
yieldszero
zero
interest).
interest).
•• So,
So,money
moneymarket
marketfinancial
financialsecurities
securitiesisisthe
thebest
best
alternative
alternativefor
forinvestors
investorswith
withexcess
excesscash
cashandandshort
short
term
termneeds.
needs.
•• Additionally,
Additionally,these
thesesecurities
securitiescan
canbe
bequickly
quicklyconverted
converted
back
backtotocash
cashwhen
whenneeded
neededwith
withaalittle
littlerisk
riskof
oflosing
losing
value
valueasaswell
wellas
aswith
withvery
verylow
lowdefault
defaultrisk.
risk.

McGraw-Hill/Irwin 5-4 ©2009, The McGraw-Hill Companies, All Rights

 Money Markets

•• Money
Moneymarket
marketinstruments
instrumentshave
haveactive
activesecondary
secondary
markets
marketsthat
thatserve
serveto
toallocate
allocatethe
thefixed
fixedamounts
amountsof ofliquid
liquid
funds
fundsavailable
availablein
inthe
themarket
marketatatany
anyparticular
particulartime.
time.

McGraw-Hill/Irwin 5-5 ©2009, The McGraw-Hill Companies, All Rights

 Characteristics of Money Instruments

•• First:
First:are
aregenerally
generallysold
soldin inlarge
largedenominations.
denominations.
--Individual
Individualinvestors
investorsareareable
abletotoinvest
investininthese
thesesecurities
securities
indirectly
indirectlythrough
throughmoney
moneymarket
marketmutual
mutualfunds.
funds.
•• Second:
Second:have
havelow
lowdefault
defaultrisk.
risk.
--Money
Moneymarket
marketinstruments
instrumentscan canbebeissued
issuedonly
onlybybyhigh-
high-
quality
qualityborrowers
borrowerswith
withlittle
littledefault
defaultrisk.
risk.
•• Third:
Third:must
musthave
haveaamaturity
maturityof ofone
oneyear
yearofofless.
less.
--this
thisalso
alsoresults
resultsin
inlower
lowerinterest
interestrate
rateand
andprice
pricerisks.
risks.

McGraw-Hill/Irwin 5-6 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Yields

•• Calculation
Calculation of
of the
the Yield
Yield on
on money
money market
market
instruments
instruments depend
depend on:
on:

-- The
The way
way they
they are
are bought
bought and
and sold.
sold.

-- whether
whether securities
securities return
return based
based on
on aa 360-day
360-day year
year
or
or on
on aa 365-day
365-day year.
year.

McGraw-Hill/Irwin 5-7 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Yields (Cont.)
Discount Yield
•• Some
Some money
money market
market instruments
instruments are are bought
bought and
and sold
sold on
on
aa discount
discount basis
basis (e.g.,
(e.g., Treasury
Treasury billsbills and
and commercial
commercial
paper)
paper)
•• So
So the
the return
return that
that results
results from
from purchasing
purchasing these
these
securities
securities (i.e.
(i.e. newly
newly issued
issued securities)
securities) on
on discount
discount isis
called
called Discount
Discount yields
yields (i(idydy))
•• use
use aa 360-day
360-day year
year
•• Interest
Interest rates
rates or
or discount
discount yields
yields are
are quoted
quoted on
on aa discount
discount
basis
basis using
using the
the following
following equation:
equation:
McGraw-Hill/Irwin 5-8 ©2009, The McGraw-Hill Companies, All Rights
 Money Market Yields (Cont.)
Discount Yield

( Pf  P0 ) 360
idy  
Pf h
PPf f==the
theface
facevalue
valueof
ofthe
thesecurity
security
PP00==the
thediscount
discountprice
priceof
ofthe
thesecurity
security
hh==thethenumber
numberof ofdays
daysuntil
untilmaturity
maturity

McGraw-Hill/Irwin 5-9 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Yields (Cont.)

•• The
The discount
discount yield
yield isis normally
normally compared
compared with
with
yields
yields on
on U.S.
U.S. Treasury
Treasury bondsbonds (non-discount
(non-discount
securities)
securities) ..
•• Which
Which isis called,
called, bond
bond equivalent
equivalent yields
yields (i(ibey )
bey)
•• The
The return
return investors
investors will
will achieve
achieve ifif they
they hold
hold the the
security
security to
to maturity,
maturity, or or sold
sold itit before.
before.
( Pf  P0 ) 365
ibey  
P0 h

McGraw-Hill/Irwin 5-10 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Yields (Cont.)

•• But
But the
the comparison
comparison isis difficult;
difficult; because
because bond
bond
equivalent
equivalent yields
yields use
use the
the purchase
purchase price
price as
as the
the
base
base price,
price, and
and use
use 365-day
365-day yearyear in
in calculations.
calculations.
•• An
An appropriate
appropriate comparison
comparison can can bebe done
done byby
converting
converting aa discount
discount yield
yield into
into aa bond
bond equivalent
equivalent
yield.
yield.

ibey idy ( Pf / P0 )(365 / 360)

McGraw-Hill/Irwin 5-11 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Yields

•• Neither
Neither the
the discount
discount yield
yield nor
nor the
the bond
bond equivalent
equivalent
yield
yield consider
consider the
the effect
effect of
of compounding
compounding of of
interest
interest rate.
rate.
•• Convert
Convert bond
bond equivalent
equivalent yields
yields into
into effective
effective
annual
annual returns
returns (EAR)
(EAR)
365 / h
 ibey 
EAR  1   1
 365 / h 

McGraw-Hill/Irwin 5-12 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Yields

•• Money
Moneymarket
marketsecurities
securitiesthat
thatpay
payinterest
interestonly
onlyatatmaturity
maturity
use
usesingle-payment
single-paymentyields
yields(i(ispy) (e.g., jumbo CDs,
spy) (e.g., jumbo CDs,
repurchase
repurchaseagreement,
agreement,and
andfed
fedfunds)
funds)
–– since
sinceispy
ispyuses
usesaa360
360day
dayyear,
year,compare
comparetotobonds
bondsby
byconverting
convertingtotoaa
365
365day
dayyear
year
ibey ispy (365 / 360)

–– totoconvert
convertaasingle-payment
single-paymentyield
yieldtotoan
an effective
effectiveannual
annualreturn
return
365 / h
 365 / 360 
EAR  1  ispy  1
 365 / h 

McGraw-Hill/Irwin 5-13 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Instruments

•• Treasury
Treasury bills
bills (T-bills)
(T-bills)
•• Federal
Federal funds
funds (fed
(fed funds)
funds)
•• Repurchase
Repurchase agreements
agreements (repos
(repos or
or RP)
RP)
•• Commercial
Commercial paper
paper (CP)
(CP)
•• Negotiable
Negotiable certificates
certificates ofof deposit
deposit (CD)
(CD)
•• Banker
Banker acceptances
acceptances (BA)(BA)

McGraw-Hill/Irwin 5-14 ©2009, The McGraw-Hill Companies, All Rights

 Treasury Bills (T-Bills)

•• T-Bills
T-Bills are
are short-term
short-term debt debt obligations
obligations issued
issued by
by
the
the U.S.
U.S. government
government to to cover
cover current
current budget
budget
shortfalls
shortfalls and
and toto refinance
refinance maturing
maturing [Link].
•• The
The Federal
Federal Reserve
Reserve buysbuys and
and sells
sells T-bills
T-bills to
to
implement
implement monetary
monetary policypolicy
•• T-bills
T-bills are
are virtually
virtually default
default risk
risk free,
free, are
are highly
highly
liquid,
liquid, and
and have
have little
little interest
interest rate
rate risk
risk

McGraw-Hill/Irwin 5-15 ©2009, The McGraw-Hill Companies, All Rights

 Treasury Bills (T-Bills)

•• Original
Original maturities
maturities are
are 4-
4- ,, 13-,
13-, 26-
26- and
and 52-week
52-week
;T-bills
;T-bills are
are auctioned
auctioned weekly.
weekly.
•• They
They are
are issued
issued in
in denominations
denominations of of multiples
multiples of
of
$1,000.
$1,000.

•• Existing
Existing T-Bills
T-Bills can
can be
be bought
bought an an sold
sold in
in an
an
active
active secondary
secondary market
market through
through government
government
securities
securities dealers
dealers who
who purchase
purchase treasury
treasury bills
bills
form
form U.S
U.S government
government andand resell
resell them
them to
to
investors.
investors.
McGraw-Hill/Irwin 5-16 ©2009, The McGraw-Hill Companies, All Rights
 Trading Process of T-Bills
T-Bills Auctions
•• New
New issue
issue of
of T-Bills
T-Bills are
are sold
sold through
through its
its regular
regular
Treasury
Treasury bill
bill auctions.
auctions.
•• This
This happened
happened everyevery week
week on on aa Thursday,
Thursday, where
where
the
the amount
amount of of new
new issues
issues isis announced.
announced.
•• Bids
Bids are
are submitted
submitted by by government
government securities
securities
dealers,
dealers, financial
financial and
and nonfinancial
nonfinancial corporations,
corporations,
and
and individuals
individuals and and must
must bebe received
received by
by the
the
deadline
deadline ofof 11 P.M
P.M on
on the
the Monday
Monday following
following the
the
announcement.
announcement.

McGraw-Hill/Irwin 5-17 ©2009, The McGraw-Hill Companies, All Rights

 T-Bill Auctions (Cont.)

•• Allocations
Allocations & & prices
prices are
are announced
announced the the following
following
morning
morning (Tuesday)
(Tuesday) andand are
are delivered
delivered on on the
the Thursday
Thursday
following
following the the auction.
auction.
•• Bids
Bids can can be
be competitive
competitive or or noncompetitive
noncompetitive
–– competitive
competitive bids bids specify
specify the
the bid
bid price
price and
and the
the desired
desired
quantity
quantity of of T-bills
T-bills (the
(the amount
amount of of par
par value
value ofof bills).
bills).
–– Bids
Bids areare ranked
ranked from
from thethe lowest
lowest discount
discount yield
yield
(highest
(highest price)
price) to
to the
the highest
highest yield
yield (lowest
(lowest prices).
prices).
–– The
The highest
highest bidder
bidder receives
receives the
the first
first allocation
allocation of of T-
T-
bills
bills and
and subsequent
subsequent bidsbids are
are then
then filled
filled until
until all
all issue
issue
isis distributed.
distributed.
McGraw-Hill/Irwin 5-18 ©2009, The McGraw-Hill Companies, All Rights
 T-Bill Auctions (Cont.)
–– The
The yield
yield ofof the
the last
last accepted
accepted bid bid (highest
(highest accepted
accepted
discount
discount yield)
yield) isis called
called the
the cut-off
cut-off yield,
yield, stop-out-
stop-out-
yield,
yield, stop-out-rate
stop-out-rate of of the
the auction.
auction.
–– The
The price
price paid
paid by
by all
all bidders
bidders isis the
the lowest
lowest price
price of
of the
the
accepted
accepted competitive
competitive bidders.
bidders.
–– Bids
Bids withwith prices
prices above
above (Below)
(Below) thethe lowest
lowest accepted
accepted
price
price willwill receive
receive thethe full
full allocation
allocation (nothing)
(nothing) of of T-
T-
bills
bills requested.
requested.
–– IfIf the
the amount
amount of of competitive
competitive bids bids at
at the
the stop-out
stop-out yield
yield
exceeds
exceeds the the amount
amount of of bills
bills remaining
remaining to to be
be allocated
allocated
after
after thethe superior
superior bidsbids have
have been
been allocated,
allocated, thethe bids
bids at
at
the
the stop-out
stop-out rate
rate are
are distributed
distributed on on pro
pro rata
rata basis
basis
McGraw-Hill/Irwin 5-19 ©2009, The McGraw-Hill Companies, All Rights
 T-Bill Auctions (Cont.)
–– noncompetitive
noncompetitive bidders bidders get
get preferential
preferential allocation
allocation
(i.e.
(i.e. these
these bids
bids are
are met
met before
before the
the remaining
remaining T-bills
T-bills
are
are allocated
allocated to to the
the competitive
competitive bidders).
bidders).
–– They
They specify
specify thethe desired
desired amount
amount of of the
the face
face value
value ofof
the
the bills
bills (the
(the compete
compete on on quantity)
quantity)
–– they
they agree
agree toto pay
pay the
the lowest
lowest price
price of
of the
the winning
winning
competitive
competitive bids bids
–– ItIt isis used
used byby small
small investors
investors toto avoid
avoid them
them to
to bid
bid too
too
low
low priceprice oror too
too high
high price,
price, because
because they they unfamiliar
unfamiliar
with
with moneymoney market
market interest
interest rate
rate movements.
movements.

McGraw-Hill/Irwin 5-20 ©2009, The McGraw-Hill Companies, All Rights

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

McGraw-Hill/Irwin 5-21 ©2009, The McGraw-Hill Companies, All Rights

 T-Bill Auctions

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

Quantity of
T-bills

McGraw-Hill/Irwin 5-22 ©2009, The McGraw-Hill Companies, All Rights

 The Secondary Market for T-Bills

•• The
The secondary
secondary market
market for
for T-bills
T-bills isis the
the largest
largest of
of
any
any U.S.
U.S. money
money market
market instrument
instrument
•• 21
21 primary
primary dealers
dealers “make”
“make” aa market
market in in T-bills
T-bills by
by
buying
buying the
the majority
majority sold
sold at
at auction
auction andand who
who
create
create an
an active
active secondary
secondary market
market
–– primary
primarydealers
dealerstrade
tradefor
forthemselves
themselvesand
andfor
forcustomers
customers
–– The
TheT-bills
T-billsmarket
marketisisdecentralized,
decentralized,that
thatis,
is,T-bill
T-bill
purchases
purchasesand
andsales
salesare
arebook-entry
book-entrytransactions
transactions
conducted
conductedover
overFedwire
Fedwire

McGraw-Hill/Irwin 5-23 ©2009, The McGraw-Hill Companies, All Rights

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

McGraw-Hill/Irwin 5-24 ©2009, The McGraw-Hill Companies, All Rights

 T-Bill Prices

•• T-Bill
T-Billprices
pricescan
canbe
becalculated
calculatedfrom fromquotes
quotes(e.g.,
(e.g.,from
from The
The
Wall
WallStreet
StreetJournal)
Journal)by byrearranging
rearrangingthe
thediscount
discountyield
yield
equation
equation
 h 
P0 Pf   iT  Bill (dy )  Pf 
 360 
•• Or
Orby
byrearranging
rearrangingthe
thebond bondequivalent
equivalentyield
yieldequation
equation
Pf
P0 
 h 
1   
 365 / iT  Bill (bey ) 

McGraw-Hill/Irwin 5-25 ©2009, The McGraw-Hill Companies, All Rights

 Federal Funds
•• The
The federal
federal funds
funds (fed
(fed funds):
funds): areare short-term
short-term
funds
funds transferred
transferred between
between financial
financial institutions
institutions
for
for aa period
period of
of one
one day
day (overnight).
(overnight).
•• Federal
Federal funds
funds isis the
the excess
excess reserves
reserves ofof
commercial
commercial banksbanks held
held by by their
their local
local federal
federal
reserve
reserve bank
bank and
and traded
traded amongamong them.
them.
•• Fed
Fed fund
fund transactions
transactions areare short-term
short-term (mostly
(mostly
overnight)
overnight) unsecured
unsecured loans;
loans; thethe primary
primary risk
risk isis
that
that the
the borrowing
borrowing bankbank doesdoes not
not have
have toto pledge
pledge
collateral
collateral for
for the
the fund
fund itit receives.
receives.

McGraw-Hill/Irwin 5-26 ©2009, The McGraw-Hill Companies, All Rights

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

McGraw-Hill/Irwin 5-27 ©2009, The McGraw-Hill Companies, All Rights

 Federal Funds Yields
•• The
The primary
primary risk
risk of
of fed
fed fund
fund isis that
that there
there isis no
no
collateral
collateral for
for the
the funds
funds received
received by by borrowing
borrowing
bank.
bank.
•• Fed
Fed funds
funds are
are single-payment
single-payment loans;loans; paypay
interest
interest only
only once
once atat maturity,
maturity, andand thus
thus use
use
single-payment
single-payment yields.
yields.
•• Quoted
Quoted interest
interest assume
assume aa 360-day
360-day year.
year.
•• So
So itit should
should be
be converted
converted into
into aa bond
bond
equivalent
equivalent rate
rate or
or yield
yield to
to compare
compare itit withwith
other
other securities.
securities.
McGraw-Hill/Irwin 5-28 ©2009, The McGraw-Hill Companies, All Rights
 Trading of Federal Funds
•• Fed
Fed Funds
Funds Market
Market isis highly
highly liquid
liquid &
& flexible
flexible
source
source of
of funding
funding for
for banks
banks (commercial
(commercial & &
savings).
savings).
•• HOWEVER,
HOWEVER, the the largest
largest commercial
commercial banks
banks
conduct
conduct the
the vast
vast majority
majority of of transactions.
transactions.

•• Transactions
Transactions of of fed
fed funds
funds are
are initiated
initiated by
by
either
either the
the lender
lender or
or the
the borrower
borrower bank,
bank,
•• The
The negotiations
negotiations between
between themthem take
take place
place
directly
directly or
or via
via phone.
phone.
McGraw-Hill/Irwin 5-29 ©2009, The McGraw-Hill Companies, All Rights
 Trading of Federal Funds (Cont.)

•• Alternatively;
Alternatively; transactions
transactions could
could be
be arranged
arranged
by
by fed
fed funds
funds brokers,
brokers, who
who charge
charge aa small
small fee
fee
for
for bringing
bringing the
the two
two parities
parities together.
together.

•• All
All the
the transactions
transactions are
are completed
completed using
using
Fedwire,
Fedwire, the the federal
federal reserve’s
reserve’s wire
wire transfer
transfer
network.
network.

McGraw-Hill/Irwin 5-30 ©2009, The McGraw-Hill Companies, All Rights

 Trading of Federal Funds (Cont.)

McGraw-Hill/Irwin 5-31 ©2009, The McGraw-Hill Companies, All Rights

 Repurchase Agreement

•• AA repurchase
repurchase agreement
agreement (repo (repo oror RP)
RP) isis the
the
sale
sale of
of aa security
security with
with an
an agreement
agreement to to buy
buy the
the
security
security back
back atat aa set
set price
price (normally
(normally higher
higher
than
than the
the selling
selling price)
price) and
and on
on aa specified
specified date
date
in
in the
the future
future (from
(from thethe seller
seller point
point ofof view).
view).

•• Repos
Repos are
are short-term
short-term collateralized
collateralized loans
loans (i.e.
(i.e.
fed
fed fund
fund loan);
loan); (typical
(typical collateral
collateral isis U.S.
U.S.
Treasury
Treasury securities)
securities)

McGraw-Hill/Irwin 5-32 ©2009, The McGraw-Hill Companies, All Rights

 Repurchase Agreement (Cont.)

•• AA reverse
reverse repurchase
repurchase agreement
agreement isis the the
opposite
opposite side
side of
of aa repo
repo (i.e.,
(i.e., itit isis the
the purchase
purchase
of
of aa security
security with
with an an agreement
agreement to to sell
sell itit back
back
in
in the
the future)
future) (from
(from thethe buyer
buyer point point of of view).
view).

•• The
The maturity
maturity range
range from
from 11 to
to 14
14 days
days (short-
(short-
term),
term), or
or from
from 11 to
to 33 months
months (long-term).
(long-term).

McGraw-Hill/Irwin 5-33 ©2009, The McGraw-Hill Companies, All Rights

 Trading of Repurchase Agreement
(Cont.)
•• Many
Many commercial
commercial firmsfirms with
with idle
idle funds
funds in in their
their
deposit
deposit accounts
accounts at at banks,
banks, maymay deal
deal with
with repos
repos
to
to earn
earn some
some return
return until
until these
these funds
funds are
are needed.
needed.
•• These
These firms
firms use
use this
this idle
idle fund
fund to
to buy
buy T-bills
T-bills
from
from its
its bank
bank (lend
(lend the
the bank),
bank), the
the bank
bank then
then
agrees
agrees to
to repurchase
repurchase the the T-bills
T-bills in
in the
the future
future atat
higher
higher price.
price.
•• Trading
Trading process
process forfor Repos:
Repos:
•• Repos
Repos are
are arranged
arranged either
either directly
directly between
between two two
parties
parties or
or with
with the
the help
help of
of brokers
brokers andand dealers.
dealers.
McGraw-Hill/Irwin 5-34 ©2009, The McGraw-Hill Companies, All Rights
 Trading of Repurchase Agreement

McGraw-Hill/Irwin 5-35 ©2009, The McGraw-Hill Companies, All Rights

 Repurchase Agreement Yield

•• The
Theyield
yieldon
onrepos
repos(i(iRA ) is the annualized percentage
RA) is the annualized percentage
difference
differencebetween
betweenthe
theinitial
initialselling
sellingprice
priceof
ofthe
thesecurities
securities
and
andthe
thecontracted
contractedre-purchase
re-purchaseprice price(the
(theselling
sellingprice
priceplus
plus
interest
interestpaid
paidon
onthe
therepurchase
repurchaseagreement).
agreement).

•• This
Thisyield
yield (i(iRA ) uses a 360-day year like the discount rate,
RA) uses a 360-day year like the discount rate,
but
butuses
usesthe
thecurrent
currentprice
pricein
inthe
thedenominator
denominatorlike
likethe
thebond
bond
equivalent
equivalentyield
yield

McGraw-Hill/Irwin 5-36 ©2009, The McGraw-Hill Companies, All Rights

 Repurchase Agreement Yield

( Pf  P0 ) 360
iRA  
P0 h

PPf f==the
therepurchase
repurchaseprice
priceof
ofthe
thesecurity
security
PP00==the
theselling
sellingprice
priceof
ofthe
thesecurity
security
hh==thethenumber
numberof ofdays
daysuntil
untilthe
therepo
repomatures
matures

McGraw-Hill/Irwin 5-37 ©2009, The McGraw-Hill Companies, All Rights

 Commercial Paper

•• Commercial
Commercial paper paper (CP)(CP) isis the
the largest
largest money
money
market
market inin terms
terms ofof dollars
dollars outstanding,
outstanding, why???
why???
•• Companies
Companies with with strong
strong credit
credit ratings
ratings can
can
generally
generally borrow
borrow at at aa lower
lower interest
interest rate
rate by
by
issuing
issuing CP,
CP, than
than borrow
borrow from from bank.
bank.
•• SO,
SO, CP
CP isis unsecured
unsecured short-term
short-term corporate
corporate debt
debt
issued
issued to
to raise
raise short-term
short-term fundsfunds (for
(for working
working
capital
capital finance
finance purposes).
purposes).
•• Generally
Generally soldsold in
in large
large denominations
denominations (e.g.,
(e.g.,
$100,000
$100,000 to to $1
$1 million)
million) withwith maturities
maturities between
between 11
and
and 270
270 days
days
McGraw-Hill/Irwin 5-38 ©2009, The McGraw-Hill Companies, All Rights
 Commercial Paper (Cont.)
•• CP
CP isis usually
usually held
held by
by investors
investors until
until maturity
maturity andand
has
has no
no active
active secondary
secondary market
market
•• The
The credit
credit rating
rating of
of the
the issuing
issuing companies
companies isis very
very
important
important in in determining
determining the the marketability
marketability of of aa
commercial
commercial [Link].
•• The
The better
better the
the credit
credit rating
rating the
the lower
lower the
the interest
interest
rate
rate on
on the
the issue.
issue.
•• Issuers
Issuers with
with low
low credit
credit rating
rating often
often back
back their
their
commercial
commercial papers papers with
with aa line
line of
of credit
credit (loan
(loan
commitment)
commitment) obtainedobtained from
from commercial
commercial banks.
banks.
•• This
This substitutes
substitutes thethe credit
credit rating
rating of
of issuer
issuer with
with
that
that of
of the
the bank
bank ..
McGraw-Hill/Irwin 5-39 ©2009, The McGraw-Hill Companies, All Rights
 Trading of Commercial Paper
•• CP
CP isis usually
usually sold
sold to
to investors
investors either
either directly
directly
(using
(using issuers’
issuers’ own
own sales
sales forces)
forces) OR
OR
•• indirectly
indirectly through
through brokers
brokers and and dealers,
dealers, which
which are
are
normally
normally an an investments
investments banks banks that
that are
are
specialized
specialized inin underwriting
underwriting activities
activities
(approximately
(approximately 85% 85% of of the
the time).
time).
•• Indirect
Indirect way
way isis more
more expensive
expensive because
because of
of
additional
additional underwriting
underwriting cost, cost, BUT
BUT
•• Underwriters
Underwriters guarantee
guarantee the the sale
sale of
of the
the whole
whole
issue
issue through
through firm
firm commitment
commitment underwriting.
underwriting.

McGraw-Hill/Irwin 5-40 ©2009, The McGraw-Hill Companies, All Rights

 Yield of Trading of Commercial Paper
•• Like
LikeT-Bills,
T-Bills,they
theyare
aresold
soldatatdiscount.
discount.
•• Yields
Yieldsare
arequoted
quotedon
onaadiscount
discountbasis
basis(like
(likeT-bills).
T-bills).
•• The
Theyield
yield(discount
(discountreturn)
return)totoCP
CPholders
holdersisisthe
the
annualized
annualizedpercentage
percentagedifference
differencebetween
betweenthe theprice
price
paid
paidfor
forthe
thepaper
paperand
andthe
thepar
parvalue
valueusing
usingaa360-day
360-day
year
year (P  P ) f 0 360
icp ( dy )  
Pf h

•• And
Andconverted
convertedto
toaabond
bondequivalent
equivalentyield
yieldas
asfollows:
follows:

( Pf  P0 ) 365
icp (bey )  
P0 h

McGraw-Hill/Irwin 5-41 ©2009, The McGraw-Hill Companies, All Rights

 Negotiable Certificate of Deposit

•• AA negotiable
negotiable certificate
certificate ofof deposit
deposit (CD)
(CD) isis aa
bank-issued
bank-issued timetime deposit
deposit that
that specifies
specifies the
the interest
interest
rate
rate and
and the
the maturity
maturity datedate
•• CDs
CDs are
are bearer
bearer instruments;
instruments; who who ever
ever holds
holds the
the
CD
CD when
when itit matures
matures receives
receives the
the principal
principal & &
interest.
interest.
•• They
They are
are salable
salable inin the
the secondary
secondary market.
market.
•• Denominations
Denominations range range from
from $100,000
$100,000 to to $10
$10
million;
million; $1
$1 million
million being
being thethe most
most common
common ..
•• Often
Often purchased
purchased by by money
money market
market mutual
mutual funds
funds
with
with pools
pools of
of funds
funds from
from individual
individual investors
investors
McGraw-Hill/Irwin 5-42 ©2009, The McGraw-Hill Companies, All Rights
 Trading of Negotiable CD

•• The
The new
new issue
issue ofof CDs
CDs isis managed
managed as as follows:
follows:
•• Issuing
Issuing bank
bank post
post aa daily
daily set
set of
of rates
rates for
for the
the most
most
common
common maturities
maturities of of CDs.
CDs.
•• Then
Then the
the bank
bank tries
tries to
to sell
sell as
as many
many CDs
CDs to to
inventors.
inventors.
•• After
After selling
selling CDs,
CDs, the the bank
bank delivers
delivers them
them to to aa
custodian
custodian bank,
bank, which
which verifies
verifies the
the CDs,
CDs, debits
debits the
the
amount
amount toto the
the investor’s
investor’s account
account andand credits
credits the
the
amount
amount toto the
the issuing
issuing bank.
bank.

McGraw-Hill/Irwin 5-43 ©2009, The McGraw-Hill Companies, All Rights

 Trading of Negotiable CD (Cont.)

•• IfIf investors
investors want
want toto sell
sell CDs
CDs before
before maturity,
maturity, they
they
can
can do do so
so via
via secondary
secondary market.
market.
•• CDs
CDs are are transported
transported between
between traders,
traders, and
and the
the
custodian
custodian bank bank verifies
verifies the
the CD
CD and
and records
records the
the
deposits
deposits in in the
the investors'
investors' account.
account.
•• Rates
Rates on on CDs
CDs areare negotiated
negotiated between
between thethe bank
bank
and
and thethe CDs
CDs buyers.
buyers.
•• Interest
Interest rate
rate on
on negotiable
negotiable CDsCDs are
are generally
generally
quoted
quoted on on an
an interest-bearing
interest-bearing basisbasis using
using aa 360-
360-
day.
day.
McGraw-Hill/Irwin 5-44 ©2009, The McGraw-Hill Companies, All Rights
 Banker’s Acceptance

•• AABanker’s
Banker’sAcceptance
Acceptance(BA) (BA)isisaatime
timedraft
draftpayable
payabletoto
aaseller
sellerofofgoods
goodswith
withpayment
paymentguaranteed
guaranteedby byaabank
bank
•• ItItisisan
anorder
orderfor
forthe
thebank
bankto topay
payaaspecified
specifiedamount
amountof
of
money
moneyto tothe
thebearer
bearerofofthe
thetime
timedraft
draftonon aagiven
givendate.
date.
•• Used
Usedin ininternational
internationaltrade
tradetransactions
transactionsto tofinance
financetrade
trade
in
ingoods
goodsthat
thathave
haveyetyetto
tobe
beshipped
shippedfrom
fromaaforeign
foreign
exporter
exporter(seller)
(seller)to
toaadomestic
domesticimporter
importer(buyer)
(buyer)
•• Foreign
Foreignexporters
exportersprefer
preferthat
thatbanks
banksact
actasaspayment
payment
guarantors
guarantorsbeforebeforesending
sendinggoods
goodstotoimporters
importers

McGraw-Hill/Irwin 5-45 ©2009, The McGraw-Hill Companies, All Rights

 Banker’s Acceptance (Cont.)
•• The
Thebankbankinsure
insurethe
theinternational
internationaltransaction
transactionby by
stamping
stamping “Accepted”
“Accepted”on onaatime
timedraft
draftwritten
writtenagainst
against
the
theletter
letterof
ofcredit
creditbetween
betweenthetheexporter
exporterandandthe
the
importer,
importer,indicating
indicatingits
itscommitment
commitmentto topay
paythe
theforeign
foreign
exporter
exporteron onaaspecified
specifieddate
dateshould
shouldthetheimporter
importerfail
failtoto
pay
payfor forthe
thegoods.
goods.
•• After
Afterissuing
issuingBA,
BA,thetheforeign
foreignexporter
exportercancanhold
holditittill
tillthe
the
date
datespecified
specifiedononthe
theletter
letterof
ofcredit.
credit.
•• IfIfthey
theyhave
haveimmediate
immediateneedneedforforcash,
cash,they
theycan
cansell
sellitit
before
beforethe thedate
dateatataadiscount
discountto tothe
thebuyer
buyerininmoney
money
market.
market.

McGraw-Hill/Irwin 5-46 ©2009, The McGraw-Hill Companies, All Rights

 Banker’s Acceptance (Cont.)
•• The
Theultimate
ultimatebearer
bearerwill
willreceive
receivethe
theface
facevalue
valueof
ofBABAonon
maturity.
maturity.
•• Because
Becauseof oflow
lowdefault
defaultrisk,
risk,interest
interestrate
rateon
onBA
BAisisvery
very
low.
low.
•• Like
LikeT-bills,
T-bills,BAs
BAsare
aresold
soldon
ondiscount
discountbasis.
basis.

McGraw-Hill/Irwin 5-47 ©2009, The McGraw-Hill Companies, All Rights

 Money Market Participants

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

McGraw-Hill/Irwin 5-48 ©2009, The McGraw-Hill Companies, All Rights

 International Money Markets

•• The
Theimportance
importanceof ofU.S.
[Link]
dollarsas
asan
aninternational
international
medium
mediumof ofexchange,
exchange,results
resultsin
inthe
thedevelopment
developmentof of
money
moneymarket
marketinstruments
instrumentsthat
thatare
aredenominated
denominatedin in
U.S
[Link]
dollarsand
andtraded
tradedoutside
outsideUSA.
USA.
•• U.S.
[Link]
dollarsheld
heldoutside
outsidethe
theU.S.
[Link]
aretracked
trackedamong
among
multinational
multinationalbanks
banksininthe
theEurodollar
Eurodollarmarket
market
•• The
Therate
rateoffered
offeredfor
forsale
saleon
onEurodollar
Eurodollarfunds
fundsisisthe
the
London
LondonInterbank
InterbankOffered
OfferedRate
Rate(LIBOR)
(LIBOR)

McGraw-Hill/Irwin 5-49 ©2009, The McGraw-Hill Companies, All Rights

 International Money Markets

•• Eurodollar
EurodollarCertificates
CertificatesofofDeposits
Depositsare
areU.S.
[Link]
dollar
denominated
denominatedCDs CDsheld
heldininforeign
foreignbanks
banks
•• Eurocommercial
Eurocommercialpaper paper(Euro-CP)
(Euro-CP) isisissued
issuedin
in
Europe
Europeandandcan
canbe
beininlocal
localcurrencies
currenciesor
orU.S.
[Link]
dollars
and
andititcan
canbe
beheld
heldby
byinvestors
investorsinside
insideor
oroutside
outsideof
of
Europe.
Europe.

McGraw-Hill/Irwin 5-50 ©2009, The McGraw-Hill Companies, All Rights