Financial Markets and Institution: The Money Market

Financial Markets and Institution
Lecture 5
THE MONEY MARKET
Learning Objectives
To review the characteristics of money market
instruments.
To discuss the purpose of money market.
To examine each money market instrument.
2012 Pearson Prentice Hall. All rights reserved.
11-2
Learning Outcomes
At the end of the chapter, you will be able to
discuss the characteristics of money market

instruments.
discuss the purpose of money market.
differentiate each money market instrument.
11-3
Microsoft Corporation
In its 2013 annual report, Microsoft listed $73
billion ($25 billion in 2009) in short-term
securities on its balance sheet, plus $3 billion
($6 billion in 2009) in actual cash
equivalents. Microsoft does not keep this in
its local bank. But where?
Money Markets!
11-4
The Money Markets Defined

Money (currency) is not actually traded in
the money markets.
The securities in the money market are
short term, low risk with high liquidity;
therefore, they are close to being money.
11-5
The Money Markets Defined

Three common characteristics of money
market securities:
1. Money market securities are usually sold in
large denominations ($1,000,000 or more)
2. They have low default risk
3. They mature in one year or less from their
issue date, although most mature in less than
120 days
11-6
The Money Markets Defined:

Why Do We Need Money Markets?
In theory, the banking industry should handle the
needs for short-term loans and accept short-term
deposits. Banks also have an information advantage
on the credit-worthiness of participants.
Banks do mediate the asymmetric problem between
savers and borrowers; however, they are heavily
regulated, in turn caused the high governmental costs
that outpace the benefits. This creates a distinct cost
advantage for money markets over banks.
11-7

Cost Advantages
Reserve requirements create additional expense
for banks that money markets do not have
Regulations on the level of interest banks could
offer depositors lead to a significant growth in
money markets, especially in the 1970s and
1980s. When interest rates rose, depositors
moved their money from banks to money markets
to earn a higher interest rate.
11-8
3-month T-bill rates and

Interest Rate Ceilings
11-9

Cost Advantages
Even today, the cost structure of banks
limits their competitiveness to situations
where their informational advantages
outweighs their regulatory costs.
11-10
The Purpose of Money Markets

Borrowers from Money Market: Obtain low-cost source
of temporary funds.
From investors perspective:
Provide a place warehousing surplus funds for short
periods of time.
Interim investment that provides a higher return than
holding cash when they feel that market condition is
not right.
Money market provides a mean to invest idle funds
and to reduce the opportunity cost of idle cash.
11-11
The Purpose of Money Markets

Corporations and U.S. government use
these markets because the timing of cash
inflows and outflows are not well
synchronized. Money markets provide a
way to solve these cash-timing problems.
11-12
A Sample from the Wall Street Journal
11-13
Who Participates
in the Money Markets?
11-14
Money Market Instruments

We will examine each of these in the
following slides:
Treasury Bills (grp 7)

Federal Funds (grp 2)
Repurchase Agreements (grp 5)
Negotiable Certificates of Deposit (grp 8)
Commercial Paper (grp 3)
Eurodollars (grp 4)
11-15
Money Market Instruments

(cont.)
We will examine each of these in the
following slides (continued):
Bankers Acceptance (grp 1)
Bill of exchange (grp 6)
11-16
Money Market Instruments:

Treasury Bills
T-bills have 28-day
12- month maturities.
maturities
through
Does not pay an interest but issued at a

discount from par. It is common for short-term
securities because they often mature before
the issuer can mail out interest checks.
http://www.bnm.gov.my/index.php?
tpl=govtsecuritiesyield
11-17

Treasury Bills Discounting Example
You pay $996.37 for a 28-day T-bill. It is
worth $1,000 at maturity. What is its
discount rate?
11-18

Treasury Bills Discounting Example
You pay $996.37 for a 28-day T-bill. It is
worth $1,000 at maturity. What is its
annualized yield (investment return)?
11-19

Treasury Bill Auctions
T-bills are auctioned to the dealers
every Thursday.
The Treasury may accept both competitive
and noncompetitive bids, and the price
everyone pays is the highest yield paid to
any accepted bid.
11-20

Treasury Bill Auctions Example
The Treasury auctioned $2.5 billion par value
91-day T-bills, the following bids were received:
Bidder
Bid Amount
Bid Price
1
$500 million
$0.9940
2
$750 million
$0.9901
3
$1.5 billion
$0.9925
4
$1 billion$0.9936
5
$600 million
$0.9939
The Treasury also received $750 million in

noncompetitive bids. Who will receive T-bills, what
quantity, and at what price?
11-21

Treasury Bill Auctions Example
The Treasury accepts the following bids:
Bidder
1
5
4
Bid Amount
$500 million
$600 million
$650 million
Bid Price
$0.9940
$0.9939
$0.9936
Both the competitive and noncompetitive

bidders pay the highest yieldbased on
the price of 0.9936.
11-22

Treasury Bill Auction Results
11-23

Treasury Bill Rates
The next slide shows actual T-bill rates and
the annual rate of inflation from 1973 through
2010.
Notice that the inflation rate exceeds the rate
on T-bills in several on the years. This
indicates a negative real return for
T-bill investors during these periods.
11-24

Treasury Bills
11-25

Fed Funds
Short-term funds transferred (loaned or
borrowed) between financial institutions,
usually for a period of one day.
Used by banks to meet short-term needs to
meet reserve requirements.
11-26

Fed Funds Rates
Determined by the forces of supply and
demand on the fed funds.
Fed fund rates also known as effective rate.
Fed Reserve can indirectly influence the
rate by adjusting the level of reserves
available to bank in the system.
11-27

Fed Funds Rates
11-28

Repurchase Agreements
These work similar to the market for fed
funds, but nonbanks can participate.
A firm sells Treasury securities, but agrees
to buy them back at a certain date (usually
314 days later) for a certain price.
11-29

Repurchase Agreements
This set-up makes a repo agreements essentially
a short-term collateralized loan.
Can be used to manage liquidity and take
advantage of anticipated changes in interest rate.
This is one market the Fed may use to conduct
its monetary policy, whereby the Fed
purchases/sells Treasury securities in the repo
market.
11-30

Negotiable Certificates of Deposit
A bank-issued security that documents a
deposit and specifies the interest rate and
the maturity date
Denominations range from $100,000
to $10 million
11-31

Negotiable CD Rates
11-32

Commercial Paper
Unsecured promissory notes, issued by
corporations, that mature in no more than
270 days.
Issued on a discounted basis.
Direct placement vs. indirect placement
The use of commercial paper increased
significantly in the early 1980s because of the
rising cost of bank loans.
11-33

Commercial Paper Rates
11-34

Commercial Paper
The next slide shows actual commercial
paper volume by year from 1990
through 2010.
Notice that the volume fell significantly during
the recent economic recession. Even so, the
annual market is still quite large, at well over
$1.5 trillion outstanding.
11-35

Commercial Paper Volume
11-36

Commercial Paper
A special type of commercial paper, known as
asset-backed commercial paper (ABCP), played a
key role in the financial crisis in 2008.
These were backed by securitized mortgages, the
quality of assets often difficult to understand.
This special part of the commercial paper market
accounted for about $1 trillion.
11-37

Commercial Paper
When the poor quality of the underlying assets
was exposed, a run on ABCP began.
Because ABCP was held by many money market
mutual funds (MMMFs), these funds also
experienced a run. $1 fund can only be redeemed
for an amount lesser than $1.
The government eventually had to step in to
prevent the collapse of the MMMF market.
11-38

Bankers Acceptances
An order to pay a specified amount to the
bearer on a given date if specified
conditions have been met, usually delivery
of promised goods.
These are often used when buyers / sellers
of expensive goods live in different
countries.
11-39
Life cycle of a typical bankers

acceptance
11-40

Bankers Acceptances Advantages
1. Exporter paid immediately
2. Exporter shielded from foreign
exchange risk
3. Exporter does not have to assess the
financial security of the importer
4. Importers bank guarantees payment
5. Crucial to international trade
11-41

Bankers Acceptances
As seen, bankers acceptances avoid the
need to establish the credit-worthiness of a
customer living abroad.
There is also an active secondary market
for bankers acceptances until they mature.
The terms of note indicate that the bearer,
whoever that is, will be paid upon maturity.
11-42

Eurodollars
Eurodollars represent Dollar denominated
deposits held in foreign banks.
The Eurocurrency market (market for Eurodollars)
developed during the 1960s and 1970s,
stimulated by regulatory changes in the U.S. and
the growing importance of OPEC.
11-43

Eurodollars
The Eurodollar market has continued to grow
rapidly because depositors receive a higher
rate of return on a dollar deposit in the
Eurodollar market than in the domestic market.
Multinational banks are not subject to the
same regulations restricting U.S. banks and
because they are willing to accept narrower
spreads between the interest paid on deposits
and the interest earned on loans.
11-44

Eurodollars Rates
London interbank bid rate (LIBID)
The rate paid by banks buying funds
London interbank offer rate (LIBOR)

The rate offered for sale of the funds
Time deposits with fixed maturities

Largest short term security in the world
11-45
Comparing Money Market Securities:

Money Market Securities and Their Depth
11-46
Reference
Mishkin & Eakins. 2012. Financial Markets
and Institutions, 7th ed. Pearson.
(pg. 317) Questions 1, 3, 4, 10, 14
11-47

Financial Markets and Institution: The Money Market

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Financial Markets and Institution

THE MONEY MARKET

2012 Pearson Prentice Hall. All rights reserved.

discuss the characteristics of money market

discuss the purpose of money market.

differentiate each money market instrument.

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

The Money Markets Defined

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The Money Markets Defined

2012 Pearson Prentice Hall. All rights reserved.

The Money Markets Defined:

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The Money Markets Defined:

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3-month T-bill rates and

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The Money Markets Defined:

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The Purpose of Money Markets

The Purpose of Money Markets

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A Sample from the Wall Street Journal

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2012 Pearson Prentice Hall. All rights reserved.

Money Market Instruments

Treasury Bills (grp 7)

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Money Market Instruments

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Money Market Instruments:

Does not pay an interest but issued at a

Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

The Treasury also received $750 million in

Money Market Instruments:

Both the competitive and noncompetitive

Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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Money Market Instruments:

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