Chapter 7 Summary

Prepared by Mr. Al Mannaei

What is Money Market ?!

Simply its short term market, highly liquid, low risk and return with wholesale transaction.
Money market securities issued mainly by government and large corporation with high credit
rating.

Definition in details

Short term : maturity less than one year.

Highly liquid : because many issuers and lender investors. (easy to find sellers and buyers)

Low risk and return: because its issued by government and large corporation with high credit
rating (low default risk) . Also, because short term (low price risk).

wholesale transaction : because the yield of money market is low in general, it is not worthy to
invest small amount.

Money Market securities : U.S. Treasury bills, negotiable certificates of deposit (CDs), bankers
acceptances, commercial paper, municipal notes and repurchase agreements (repos).

What is the role of Money Market ?!

MM provide an efficient means for economic units to adjust their liquidity positions. In other
word, MM manage liquidity. For example, MM securities allow economic units (Government
and Corporation) to fill the gap between revenue and expense.

1. U.S. Treasury Bills : a debt instrument issued and guaranteed (backed) by US

government. Sold at a discount from par (par = $10,000), with maturities less than one
year. Considered risk free securities because its issued by government and maturity is
low.

Why US government or a government issue T-bills ?!

Since T-bill is a debt instrument, the buyers consider a lender and the government
consider a borrower. WHY?! Simply to cover deficits (expense exceeds revenue)
,finance a national debt.
Chapter 7 Summary
Prepared by Mr. Al Mannaei

Calculating the Yield of the MM Securities :

 Bank Discount Yield Par  Price 360

- Denominator : Par y   100%
d Par Days To Maturity
- Number of Days 360

 Bond Equivalent Yield (BEY) Par  Price 365

- Denominator : Price y    100%
be Price Days To Maturity
- Number of Days 365

Note : for T-Bills, commercial papers and banker acceptance the yield calculation is the same.
For repurchase agreements, there is a small difference.

Example 1:

• Suppose you decide to purchase a 91-day Treasury Bill with a face value of $10,000 at a
price of $9,800. What is the T-bill’s annualized yield?

10,000  9,800 360

y    100%  7.91%
d 10,000 91

• Suppose you decide to purchase a 91-day Treasury Bill with a face value of $10,000 at a
price of $9,800. Calculate Bond Equivalent Yield ?

10,000  9,800 365

ybe    100%  8.19%
98,000 91

Question 1:why Bond Equivalent Yield (BEY) is always higher than Bank Discount Yield ?

Because the denominator in BEY formula is the price.

Trick! Why Bank Discount Yield is always lower than Bond Equivalent Yield (BEY)?!

Because the denominator in Bank discount yield formula is the par.

Question 2 : which one is more accurate ?!

Answer : Bank Discount Yield

Chapter 7 Summary
Prepared by Mr. Al Mannaei

Price Calculation :

• Computing T-bills price using the discount yield:

 
P0  Pf   yd 

n
360
 Pf 


• Using the Bond equivalent yield, the price is:

Pf
P0 
  n 
1   ybe 365 
  
P 0  Pr ice, Pf  Par _ value, n  Days , Ybe  BEY

Using the following information, calculate the Price of the following T-bill :

Pf = $10,000 yd= 4.94% n= 161 days

P 0  $10,000   0.0494 161

360

10, 000


P 0  $9,779.07

2. Commercial papers : An unsecured, short-term debt instrument issued by a corporation,

typically for meeting short-term liabilities. Maturities on commercial paper rarely range
any longer than 270 days. The debt is usually issued at a discount from par ( par =
$100,000).

Unsecured : Not backed with an assets (No collateral).

Since there is no collateral, is it high risk securities ?! NO because its issued by high credit
rating ( corporation with very default risk such as AAA, AA and A). but indeed the risk of T-
bills is lower than the risk of commercial papers.
Chapter 7 Summary
Prepared by Mr. Al Mannaei

Why corporations issue commercial papers ?! Mostly, it is cheaper than taking a loan.
Suppose a company purchases a $1 million of 45-day commercial paper issued by GE capital, a
large finance company, for a price of $994,000. The Discount yield & Bond equivalent yield on
the commercial paper is calculated:

$1,000,000  $994,000 360

y    100%  4.8%
cp $1,000,000 45

$1,000,000  $994,000 365

y    100%  4.9%
cpbe $994,000 45

3.Repurchase Agreements (Repo) : Sale of security (mostly T-bills) with agreement to buy it
back later at a higher price. The security serve as a collateral.

Used by governments and large corporation for very short borrowing ( 1 – 7 days).

Low risk because issued governments and large corporation and because of the collateral.

Low return, even lower than T-bills ( in most cases).

Smallest denomination for a repo is $1 million

Question : Why T-bills are the most common security used as a collateral ?!

Simply because T-bills consider risk free security and has very liquid (low liquidity risk).

How does Repo work ?!

CBB would like to borrow money for one week.

Step 1: The CBB sell T-bills for 100M for ABC Bank (investor) at day 0.

Step 2: ABC sell the T-bills for 100.5M for CBB after seven days (maturity).

The CBB consider a Borrower where it Sell then Buy for higher price (this called Repo).

The ABC consider an INVESTOR where it Buy then Sell for higher price (this called Rev.
Repo).
 Chapter 7 Summary
Prepared by Mr. Al Mannaei

Example :

KFH does a reverse repo with one of corporate customers who needs funds for 3 days. The bank
agrees to buy treasury securities from the corporation at a price of $1,000,000. and promises to
sell the securities back to the corporation customer for $1,000,145 . After 3 days. The yield on
the reverse repo is calculated is :
Pr epo  P 0 360
y   100%
repo P0 n

4. Banker Acceptance : A short-term debt instrument issued and guaranteed by a commercial

bank. ,traded at a discount from par on the secondary market (but issued at par!), which can be
an advantage because the banker's acceptance does not need to be held until maturity.

Maturities : Standard maturities of 30, 60, or 90 days -max of 180

Mostly relate to international trade.

Direct liability of the issuer (the bank).

Mostly used for international trade.

How does Banker acceptance work?!

Mariam contact BMW agency to buy a car from Germany , the Agency ask her to bring Bank
Acceptance in order to make the payment .The price of the Car is 20,000 Euro .

Al Salam Mariam BMW Investor

Step 1 : Mariam go to the bank, pay 8000 BD, the bank issued BA for 20000 euro ( equal 8000
BD so it is issued at Par) due to two months.

Step 2 : Mariam give the BA to the BMW in Germany and receive the car immediately.

Step 3 : The BMW got the BA, then the BMW got two options, option 1 : wait for two months to
collect the 20,000 euro. Option 2 : sell the BA at discount (less than 20,000 euro).
Chapter 7 Summary
Prepared by Mr. Al Mannaei

What if the value of the euro decrease ?! shall mariam bring new BA ?!

NO, once its issued, the value of euro wont changed. BA eliminates foreign exchange risk.

What if the BA defaulted ?!

In case of default, which extremely rare case, the BMW or the holder of the BA should contact
the bank, since its issued and signed by the bank. (Direct liability of the issuer)

Please refer to the exercise solved in the class.