ObjectivesforSession2

Tounderstandthescopeofthemoneymarket
Tounderstanddifferencesbetweenthemoney
andbondmarkets
Tounderstandthevariousconceptsofyield
employedinthemoneymarkets
Tounderstandmoneymarketquotes
TounderstandthemainfeaturesoftheFed
fundsandRPmarkets

TheMoneyMarket
Securitiestradedinthemoneymarketare

Shortterm
Ratedinvestmentgradeorbetter
Activelytraded
Lessvolatilethanbonds

TheMoneyMarket
Examples

Shorttermgovernments
Bankersacceptances
DomesticandEurodollarCDs
Fedfunds
RPs

ConceptsofYield
Measurementissues
Basis
Days
Interestaccrual

Threeconventions
Discountbasis
Simpleinterestbasis
Compoundinterest

SomeNotation
y= simple yield

d = discount yield
F = face value or value at maturity
P = price or principal amount invested
tsm = time,in days,from settlement to maturi

DiscountBasis
Thediscountyieldonasinglepaymentsecurity
isdefinedas
Thedifferencebetweentheamountpayableat
maturityandthepriceofthesecuritynow
Dividedbytheamountpayableatmaturity
( F P)
d=
F

Example
Discount Security
Face Amount (payable at maturity)
Days until maturity
Price
Discount

$1,000
1 year
$920
$80

( F P) ($1,000$920)
d=
=
=8%
F
$1,000

AnnualizedDiscountYield
Toannualize,multiplytherawdiscountyield
bythenumberofinvestmentperiodsinayear
Convention:1year=360days
F P 360
d=
F tsm

Example
Discount Security (<1 year)
Face Amount (payable at maturity)
$1,000
Days until maturity
180
Price
$960
Discount
$40
Days per year (convention)
360

( F P) 360 ($1,000$960) 360

d=
=
=8%

F tsm
$1,000
180

ForExample
GE Capital Commercial Paper
Face Amount (payable at maturity) $1,000,000
Purchase date
10/4/00
Price
$991,417
Maturity date
11/30/00
Days from settlement to maturity
57
annualized discount yield
5.42%

$1,000,000$991,417 360
=5.42%

$1,000,000
57

PriceofaDiscountSecurity
Givenaquoteddiscountyieldofd,thepriceof
asecuritywithfacevalueFis
tsm

P =F 1d
360

ForExample
T-bill

Settlement date
Maturity date
Days from settlement to maturity
Discount quote
Price per $100 of face value

2/4/00
12/16/00
316
5.26%
$ 95.3829

316

$1001.0526
=$95.3829

360

TheValueofan01
Thevalueofan01measuresthepricechange
causedbya.01%(onebasispoint)changein
thediscountyield
Thevalueofan01indexesrisk
For$1,000,000facevalueofa90daysecurity,
thevalueofan01is$25
90

$1,000,0001.0001
=$25

360

QuickCheck
Whatwouldbethevalueofan01for
$1,000,000facevalueofa180daysecurity?
Of$1,000,000facevalueofa360day
security?
Whichofthethreesecurities(90day,180day,
360day)ismostsensitivetochangesininterest
rates?
Howisthissensitivityrelatedtorisk?

SimpleInterestYield
Thesimpleinterestyieldisdefinedas
Thedifferencebetweentheamountpayableat
maturityandthepriceofthesecuritynow
Dividedbythepriceofthesecuritynow
Annualizedusingeither360dayor365dayyear

(F P )
365

y=
P tsm
Whenthesimpleyieldisannualizedusinga360dayyear,
itiscalledamoneymarketyield

Example
Simple Interest

Principal amount
Interest (dollar amount)
Total payment at maturity
Settlement date
Maturity date

$
$
$

Days from settlement to maturity

Simple yield (365-day year)
Money market yield

1,000,000
60,000
1,060,000
3/2/00
11/11/00
254
8.62%
8.50%

RelationtoDiscountYield
Thesimpleyieldonasecurityhavinga
discountyieldofdis
d 365

y =
tsm
1d 360 360

QuickCheck
Wouldyoupreferaninvestmentoffering
Asimpleyield(365dayyear)of8%,or
Amoneymarketyieldof8%?

ForgivenF,P,settlementdateandmaturity
date,whichisgreater
Thediscountyield
Thesimpleyield
Themoneymarketyield

SimpleInterest
IfyouinvestPatthesimpleyieldyforaperiod
oftsmdays,howmuchwillyoureceiveatthe
endoftheperiod?
Fromtheformulaforsimpleyield

t
Maturity amount
=F =P 1+y sm
365

SimpleInterest
Similarly,ifyouinvestPatthesimpleyieldy
forafraction1/nofayear,howmuchwillyou
receiveattheendoftheperiod?
Fromtheformulaforsimpleyield

1
y
Maturity amount
=F =P 1+y =P 1+
n
n

Example
Simple Interest

Principal amount
Simple interest yield
Fraction of the year
Total payment at maturity
Dollar interest

$
$

1,000,000
8.00%
1/2
1,040,000
40,000

CompoundInterest
IfyouinvestPatthesimpleyieldyfora
fraction1/nofayear,
Andthenreinvesttheresultatthesameyield
foranother1/nyears,howmuchwillyou
receiveattheendoftheperiod?
2
y y
y
F = P 1+
1+ =P 1+
n
n n

CompoundInterest
Ifyoucontinuereinvestingforawholeyear,at
theendoftheyearyouwillreceive
n

y
F =P 1+
n

EffectiveInterest
Theeffectiveyieldonacompounded
investmentistheamounttheinvestorendsup
withattheendoftheyearlesstheamounthe
investedatthebeginningoftheyeardivided
bytheamountinvestedatthebeginningofthe
year
n

y
y
1+r = 1+
r = 1+
1
n
n

Example
Compound Interest

Principal amount
Simple interest yield
Compoundings per year
Total payment at maturity
Dollar interest
Effective yield

$
$

1,000,000
8.00%
4
1,082,432
82,432
8.24%

EffectiveInterest
Themorefrequentthecompounding,thehigher
theeffectiveyield
Simple Compoundings Effective
Yield
per year
Yield
8.00%
2
8.16%
4
8.24%
12
8.30%
365
8.33%
continuous
8.33%

EffectiveInterest
Theeffectofcompoundingisgreaterthehigher
thesimpleyield
Simple
Yield
4%
6%
8%
10%
12%

Compoundings Effective
per year
Yield
12
4.07%
12
6.17%
12
8.30%
12
10.47%
12
12.68%

ShortInvestmentPeriod
Occasionally,wewanttheeffectiveyieldonan
investmentheldforlessthanafullyear.
Iftherearencompoundingperiodsduringa
fullyearandmcompoundingperiodsduring
theinvestmentperiod,weusetheformula
ym 365
r = 1+
1
n
tsm

BondEquivalentYield
IntheUS,bondspayinterestsemiannually,
butbondyieldsarequotedassimpleinterest.
Forexample,abondpaying8%actuallypays
interestof4%=(8%/2)twiceyearly.
Theeffectiveyieldonthisbondwouldbe
2

.08
r = 1+
1=8.16%

QuickCheck
Wouldyouratherhaveaoneyearinvestment
thatpays8.15%simpleinterestoronethatpays
8%compoundedmonthly?Explain.
Whyareeffectiveyieldgreaterthansimple
yields?
Isabondequivalentyieldaneffectiveyield?

Application:TreasuryBills
Review

WhatareTbills?
Whenaretheyissued?
Howaretheysoldintheprimarymarket?
Howaretheytradedinthesecondarymarket?
Insideandoutsidemarkets
WItrading
Ontherunandofftherunissues

TBillRates
Tbillsarequotedasbidandaskeddiscount
yieldstotwodecimalplaces
Bid:whatdealersareofferingtopayforbills
Ask:whatdealersarewillingtosellbillsfor

Thequoteddiscountyieldsimplyprices:

t
Pbid = 1 sm dbid
360

t
Pask = 1 sm dask
360

Example
T-bill Quote
Settlement date
Maturity date
Days from settlement to maturity
Bid quote
Ask quote
Implied bid price (per $1 of face value)
Implied ask price (per $1 of face value)
Bid ask spread (per $1,000,000)

2/19/99
5/20/99
90
4.43%
4.42%
$0.988925
$0.988950
$25.00

TBillAskYields
TheaskyieldquotedforTbillsisabond
equivalentyield.
BEQsunderstateeffectiveyieldsfor
investmentswithmorethan1/2yeartomaturity
ForTbillswithlessthan182.5daysto
maturity,theaskyieldisthesimpleyield:
dask 365

yask = tsm
1360dask 360

TBillAskYields
ButthesimpleyieldisbiggerthantheBEQfor
billswithmorethan182.5daystomaturity
Thesimpleyieldisaneffectiveyieldforthelifeof
theTbill;theBEQunderstatestheeffectiveyield

Thecorrectformulaintroducestheright
amountofunderstatement
yask =

tsm
365

+ (

tsm 2
365

tsm182.5
4
)
( 730 )(1P1ask )
182.5
2( tsm730
)

Application:Repo

Arepurchaseagreement,orrepo,isasingle
transactionconsistingof
1) Aspotportioninwhichasecurityissoldforcash
and
2) Aforwardportioninwhichthesecurityis
repurchasedforlatersettlement

Repocanbeforovernight,termoropen

Repo
Collateral
Securities
Dealer

Investor

Day1
Cash(Principal)
Collateral

Securities
Dealer

Day2

Investor

Cash(Principal+
Interest)

Repo
Collateral
Securities
Dealer

Investor

Day1
Cash(Principal)

Atsettlement,thecollateralissoldforcashto
theinvestor.

Repo
Collateral
Securities
Dealer

Investor

Day2
Cash(Principal+
Interest)

Atmaturity,thedealerrepurchasesthe
collateralforcash.Theextracashpaidat
maturityisinterestandisdeterminedbythe
reporate.

Example
7-day Repo

Term repo rate

Day 1
Collateral value (market)
Margin
Repo principal
Day 7
Collateral value
Repurchase price

5.00%
$

$1,000,000
$1,000,972.22

t sm
Prepurchase
=Pinitial(1+y 360
)

1,000,000
0%
$1,000,000

RepoMechanics
Margin
Marginiscollateralinexcessoftheprincipal
amountofthetransaction
Demandedtolimitcreditexposure
Typically1%to3%(5%to10%forriskier
collateral)
Example:Ifmarginis2%,adealerwoulddeliver
$10.2million(marketvalue)ofcollateralagainsta
principalamountof$10million.

Example:TbillMargin
T-bill Financing
Settlement day
Bill maturity
Days to maturity

2/19/99
8/19/99
181

Bid
Margin
Market price (at bid)
Margin value
Repo principal

4.45%
0.10%
0.977626389
0.977123611
$10,000,000

Face amount of collateral required:

with margin
$10,234,119.70
without margin
$10,228,856.46
margin amount
$5,263.25
Percent of face value
0.051%
market value of margin
$5,145.49

RepoMechanics
MarkingtoMarket
Collateralmaybemarkedtomarketandthe
tradeadjusted
Margincall:Ifcollateralvaluedeclinesadditional
collateralmayberequiredtorestoretheoriginal
margin.(Dealerdeliversmorecollateraltoinvestor.)
Repricing:Ifcollateralvaluedeclines,theprincipal
amountofthetransactioncanbereducedtorestore
theoriginalmargin.(Dealerwirescashbackto
investor.)

RepoMechanics
Collateral
Substitution
Dealermayrequesttheinvestortoreturnthe
originalcollateralinexchangefordifferent
collateralhavingthesamemarketvalue
Ifcollateralcannotbesubstituted,itisspecial

Cashflows
Thereposellerisentitledtoreceiveanyinterestor
principalpaymentsoffthecollateral

RepoMechanics
Collateral
Delivery
Outright:Sellerdeliversthecollateraltothebuyer.
Buyerreturnsthecollateralatmaturity.
Safekeeping:Sellerholdsthecollateralforthe
buyer.Alsoknownasletterrepoorheldin
custodyrepo.
Thirdparty:Sellerdeliverscollateraltopurchasers
custodialaccountatsellersclearingbank.

Reverses
Areverseisarepoviewedfromtheperspective
ofthecounterpartylendingcash
Therearetworeasonsfordoingreverses:
Investorsseekingshorttermrelativelysafe
investmentsmayinvestinrepo.
Tradersseekingtocoverashortpositionina
securitymayborrowtheneededsecuritiesbydoing
areverseforspecificcollateral

RepoRates
Generalcollateralrates
RelationtotheFedfundsrate

Specials
Ratescangospecialwhenthereisstrongdemand
forspecificcollateral
Example:Tradersasagroupbuildupasizeable
shortpositioninaparticularissue.

RepoBooks
Dealersoftenworkbothsidesofthemarket,
doingrepowithonegroupofinvestorsand
reverseswithanother.
Inamatchedbook,adealerreversesin
securitiesfromoneparty,reposthemoutto
anotherparty,andprofitsfromthespread.

ForExample
ABrazilianbankfinancessomeofitsBrazilian
Bradyholdingsbydoingarepowithadealerin
NewYorkforLIBOR+1%
TherepodealerinNewYorkusesthecollateral
todoarepowithanAmericaninvestorfor
LIBOR
Thedealerpocketsthespread(1%)

Application:Tailing
Ifyoubuya90dayTbillandholditfor30
days,itbecomesa60daybill.
TocreateaTbilltail
BuyaTbillwitht1daystomaturity
Financeitfort2dayswithtermrepo
InheritaTbillwitht1t2daystomaturitywhenthe
financingcomesoff.

DealersusethisstrategytobuyTbillsforward

ForExample
Settlement date
Bill maturity date
Days to maturity
90-day bill rate
Amount (face)
Market value
Repo rate
Margin (in bp)
Repo amount
Dealer equity
Unwinding date
Days financed
Financing cost
Days until the bill matures
Implied 83-day bill cost
Implied 83-day bill rate

$
$

2/19/99
5/20/99
90
4.42%
1,000,000
988,950

$
$

4.625%
10
988,700
250

$
$

Adealercreatesan
83daybilltail

Ineffect,the
dealerpurchases
the83daybill
forarateof
4.41%

2/26/99
7
889
83
989,839
4.41%

QuickCheck
The91dayTbillisquotedatbid6.06andask
6.05.Howmuchwouldacustomerhavetopay
toacquire$1,000,000facevalueofthebill?
Explainthemechanicsofarepotransaction.
Whatismarginintherepomarket?Whyisit
needed?Howdoesitvarybycollateral?
Howdoreporatesgospecial?

Review
Scopeofthemoneymarketandrelationto
bondmarket
Threebasesformeasuringyield
Effectiveyield

DetailsoftheTbillmarket
MechanicsoftheRPmarket