CHAPTER THREE

DEBT
MARKET
THE MONEY MARKET

Alem H(PhD) 2
 Money Markets
•• Liquid
Liquid funds
funds flow flow between
between short-term
short-term
borrowers
borrowers and and lenders through money
lenders through money
markets
markets
•• Money
Money markets involve debt
markets involve debt instruments
instruments with with
original
original maturities
maturities of of one
one year
year oror less
less
•• Money
Money market
market debt
debt
–– issued
issued by
by high-quality
high-quality (i.e.,
(i.e., low
low default
default risk)
risk)
economic
economic units
units that
that require
require short-term
short-term funds
funds
–– purchased
purchased by by economic
economic units units that
that have
have
excess
excess short-term
short-term fundsfunds
•• Money
Money market
market instruments
instruments have have active
active
secondary
secondary markets
markets
Alem H(PhD) 5-3
 Money Market Yields
•• Some
Some money
money market
market instruments
instruments areare
bought
bought and
and sold
sold on
on aa discount
discount basis
basis (e.g.,
(e.g.,
Treasury
Treasury bills
bills and
and commercial
commercial paper)
paper)
•• Discount
Discount yields
yields (i(idy )) use
use a
a 360-day
360-day year
year
dy

( Pf  P0 ) 360
idy  
Pf h
P
Pff =
= the
the face
face value
value of
of the
the security
security
PP00 =
= the
the discount
discount price
price of
of the
the security
security
hh= = the
the number
number ofof days
days until
until maturity
maturity

Alem H(PhD) 5-4

 Money Market Yields
•• If
If we
we are
are comparing
comparing securities
securities with
with different
different
compounding
compounding periods
periods we we need
need to
to put
put them
them on
on aa
common
common basis.
basis.
•• Treasury
Treasury bonds with bond
bonds with bond equivalent
equivalent yields
yields (i
(ibey )
bey)
( Pf  P0 ) 365
idy  
P0 h
•• Convert
Convert bond
bond equivalent
equivalent yields into effective
yields into effective
365 / h
annual
annual returns
returns (EAR)
(EAR)  ibey 
EAR   1  365 / h    1
 
•• 365/h=
365/h= the
the number
number of of compounding
compounding periods
periods per per
year.
year. Example:
Example: toto find
find the
the effective
effective annual
annual rate
rate ifif
the
the nominal
nominal rate
rate is is 6%
6% and
and semiannual
semiannual
compounding
compounding is is used.
used. Answer=0.0609=6.09%
Answer=0.0609=6.09%
Alem H(PhD) 5-5
 Money Market Instruments
•• Treasury
Treasury bills
bills (T-bills)
(T-bills)

•• Repurchase
Repurchase agreements
agreements (repos
(repos or
or RP)
RP)

•• Commercial
Commercial paper
paper (CP)
(CP)

•• Negotiable
Negotiable certificates
certificates of
of deposit
deposit (CD)
(CD)

•• Banker
Banker acceptances
acceptances (BA)
(BA)
Alem H(PhD) 5-6
 Treasury Bills (T-Bills)
•• T-Bills
T-Bills are
are short-term
short-term debt
debt obligations
obligations
issued
issued by.
by. governments
governments

•• The
The Federal
Federal Reserve(National
Reserve(National Banks)
Banks)
buys
buys and
and sells
sells T-bills
T-bills to
to implement
implement
monetary
monetary policy
policy

•• 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
Alem H(PhD) 5-7
 T-Bill Prices
•• T-Bill
T-Bill prices
prices can can be be calculated
calculated from
from
quotes
quotes (e.g.,
(e.g., from
from The The Wall
Wall Street
Street
Journal)
Journal) byby rearranging
rearranging
 h 
the
the discount
discount
P P   i (dy )  P 
yield equation
yield equation
0

f T  Bill
360 
f

•• Or P
by rearranging
Or by rearranging
P  0
the
the bond
bond equivalent
equivalent f

yield equation  h 
yield equation
1   
 365 / iT  Bill (bey ) 

Alem H(PhD) 5-8

 Repurchase Agreement
•• AA repurchase
repurchase agreement(RA)
agreement(RA) is is
the
the sale
sale of of aa security
security with
with anan
agreement
agreement to to buy
buy the
the security
security back
back at
at
aa set
set price
price in
in the
the future
future

•• RAs
RAs are
are short-term
short-term collateralized
collateralized
loans
loans (typical
(typical collateral
collateral isis U.S.
U.S.
Treasury
Treasury securities)
securities)

Alem H(PhD) 5-9

 Repurchase Agreement
•• The
The yield
yield on
on repurchase
repurchase agreements
agreements
(i
(iRA ) uses a 360-day year like the discount
RA) uses a 360-day year like the discount
rate,
rate, but
but uses
uses the the current
current price
price in
in the
the
denominator
denominator (like
Pf  Pthe
like bond
) 360
0the bond equivalent
equivalent yield
yield
i 
RA

P0 h

P
Pff =
= the
the repurchase
repurchase price
price ofof the
the security
security
P
P00 =
= the
the selling
selling price
price of
of the
the security
security
h
h= = the
the number
number of of days
days until
until the
the repo
repo
matures
matures

Alem H(PhD) 5-10

 Commercial Paper
•• Commercial
Commercial paper
paper (CP)
(CP) is
is the
the largest
largest
money
money market
market

•• CP
CP is
is unsecured
unsecured short-term
short-term corporate
corporate debt
debt
issued
issued toto raise
raise short-term
short-term funds
funds (e.g.,
(e.g., for
for
working
working capital)
capital)

•• CP
CP is
is usually
usually held
held by
by investors
investors until
until
maturity
maturity and
and has
has no
no active
active secondary
secondary
market
market

•• Yields
Yields are
are quoted
quoted on
on aa discount
discount basis
basis (like
(like
T-bills)
T-bills) Alem H(PhD) 5-11
 Negotiable Certificate of
Deposit
•• AA negotiable
negotiable certificate
certificate of
of deposit
deposit (CD)
(CD)
is
is aa bank-issued
bank-issued time
time deposit
deposit that
that specifies
specifies
the
the interest
interest rate
rate and
and the
the maturity
maturity date
date

•• CDs
CDs are
are bearer
bearer instruments
instruments and
and thus
thus are
are
salable
salable in
in 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 the
the most
most common
common

•• Often
Often purchased
purchased by
by moneymoney market
market mutual
mutual
funds
funds with
with pools
pools of
of fundsfunds from
from individual
individual
investors
investors Alem H(PhD) 5-12
 Banker’s Acceptance
•• AA Banker’s
Banker’s Acceptance
Acceptance (BA)
(BA) is
is aa time
time draft
draft
payable
payable to
to aa seller
seller of
of goods
goods with
with payment
payment
guaranteed
guaranteed by
by aa bank
bank

•• Used
Used in
in international
international trade
trade transactions
transactions to
to finance
finance
trade
trade in
in goods
goods that
that have
have yet
yet to
to be
be shipped
shipped from
from aa
foreign
foreign exporter
exporter (seller)
(seller) to
to aa domestic
domestic importer
importer
(buyer)
(buyer)

•• Foreign
Foreign exporters
exporters prefer
prefer that
that banks
banks act
act as
as payment
payment
guarantors
guarantors before
before sending
sending goods
goods to
to importers
importers

•• Banker’s
Banker’s acceptances
acceptances are are bearer
bearer instruments
instruments and
and
thus
thus are
are salable
salable in
in secondary
secondary
Alem H(PhD)
markets
markets 5-13
 Money Market Participants
•• The
The Federal
Federal Reserve(National
Reserve(National Banks)
Banks)
•• 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

Alem H(PhD) 5-14

 International Money Markets
•• Eurodollar
Eurodollar market
market

•• London
London Interbank
Interbank Offered
Offered Rate
Rate (LIBOR)
(LIBOR)

Alem H(PhD) 5-15