Chapter 7 : Money Market

Prepared by A. Al Mannaei
 Money Market ( features )
• Short-term debt market - most under 120
days.
• Maturity : less than one year.
• High liquidity.
• Low risk.
• Low return ( yield ).
• Large transactions (wholesale).
• Purposes : Short borrowing / investing.
(managing liquidity).
Money Market

• Main characters of Money Market

Securities :
– Low default risk.
– Short maturity.
– High Liquidity.
Types of Money Market securities

– U.S. Treasury bills.

– Negotiable certificates of deposit (CDs).
– Bankers acceptances.
– Commercial paper.
– Municipal notes.
– Repurchase agreements (repos).
U.S. Treasury Bills
• Characteristics:
– Issued & guaranteed by U.S. Gov.
– Sold at discount from Par.
– Maturities up to one year.
– Minimum denomination is usually $10,000, but
smaller investors can invest in multiples of
$1,000 through the Treasury Direct Program
offered by the Fed.
– Considered free of default risk.
Calculating the Yield of the MM Securities

• Money Market Securities has two Yields :

1.Bank Discount Yield
- Denominator : Par y 
d
Par  Price

360
100%
Par Days To Maturity
- Number of Days 360

2.Bond Equivalent Yield (BEY)

- Denominator : Price y 
Par  Price

365
 100%
be Price Days To Maturity
- Number of Days 365
U.S. Treasury Bills

• Pricing Treasury Bills

– Treasury bills are priced on a bank
discount rate basis, a traditional yield
calculation.
– The bank discount rate, yd , is:
Par  Price 360
y   100%
d Par Days To Maturity

Copyright© 2008 John Wiley &

Sons, Inc. 7
 Example : U.S. Treasury Bills

• 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?
 Example : U.S. Treasury Bills

• 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%
d 10,000 91

y
d = 7.91%

9
Example
• 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 ?
Par  Price 365
y    100%
be Price Days To Maturity
Example
• 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
y   100%
be 9,800 91
U.S. Treasury Bills : Price Calculation

• Computing T-bills price using the

discount yield:
 
P0  P f   yd 

n
360
 Pf 


• Using the Bond equivalent yield, the

price is:
Pf
P0 
  n 
1   ybe  365 
  
12
U.S. Treasury Bills : Price Calculation

Calculate the Price of the following T-bill :

Pf = $10,000
yd= 4.94%  
n= 161 days
P0  P f   yd 

n
360
 Pf 


Pf
P0 
  n 
1   ybe  365 
  
13
U.S. Treasury Bills : Price Calculation

• Answer :

 
P 0  $10,000   0.0494

161
360
10 , 000 


P 0  $9,779.07
Commercial Papers
• Unsecured corporate debt .
• Issued by firms with highest credit standing.
• Maturities are 1 to 270 days.
• Large denominations $100,000 and up.
• A wholesale money market instrument - few
individual investors.
• Sold at a discount from par.
• Purpose : is to achieve interest rate savings as an
alternative to bank borrowing.
Calculating the Yield for CP
• For Calculating the Bank Discount Yield :

Pf  P 0 360
y   100%
cp Pf n

• For Calculating the Bond equivalent yield :

Pf  P 0 365
y   100%
cpbe P0 n
Example
• 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:
Pf  P 0 360
y    100%
cp Pf n
Pf  P 0 365
y   100%
cpbe P0 n
Example
• 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%
cp $1,000,000 45
y  4.80%
cp
Example
• 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  $994,000 365
y    100%
cpbe $994,000 45
y  4.90%
cpbe
 Repurchase Agreements (Repo)

Day 1 Maturity :
Risk :
Borrower Investor Return :
Denom:

Day 5
Borrower Investor
 Repurchase Agreements (Repo)

– Sale of security (usually T-bills) with agreement

to buy it back later at a higher price.
Difference in prices is interest
Securities serve as collateral
Bank Financing - Source of funds
 Way to pay interest to corporate customers.
 Negotiated market rate.
Bank Investment – Reverse Repo
 Security purchased under agreement to resell
at given price in future.
 Smaller banks are able to invest excess
liquidity in a secured investment.
21
Repurchase Agreements (Repo)
• Most commonly made for 1 day or for very
short terms.
• In recent years, the market has expanded to
include a substantial volume of 1-3 month
(and even longer) transactions.
• Smallest denomination for a repo is $1
million
• A Reverse REPO involves the purchase of
short-term securities with the promise to sell
the securities back to the original seller at a
predetermined price at a given date in the
future. Copyright© 2006 John Wiley
22 & Sons, Inc.
 Repurchase Agreements (contd.)

• The interest rate on a repo is lower than the

fed funds rate, since it is backed up by a
security.
• Repos are used by the Federal Reserve in open
market operations.
• Government securities dealers use repos to
secure funds to invest in new Treasury issues.
• Banks participate in the repo market to secure
funds to meet temporary liquidity needs as
well as lend funds when they have excess
reserves.

23
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 : P
r epo  P 360
0
y  
repo P0 n
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 :
Bankers' Acceptances

•Time draft - order to pay in future.

•Drafts are drawn on and/or accepted by
commercial bank.
•Direct liability of bank.
•Mostly relate to international trade.
•Secondary market - dealer market.
•Sold at discount ( But issued at par ) .
•Standard maturities of 30, 60, or 90 days -max
of 180.
26
Bankers' Acceptances
• 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

Amount : 20,000
Beneficiary : Holder
Due Date : 01/2016
Signature : Al Salam
Bankers' Acceptances
• 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

Amount : 20,000
Beneficiary : Holder
Due Date : 01/2016
Signature : Al Salam
Creating a Banker's Acceptance

• Importer initiates purchase from foreign

exporter, payable in future.
• Importer needs financing; exporter
needs assurance of payment in future.
• Importer's bank writes irrevocable letter
of credit for exporter
– Specifies purchase order.
– Authorizes exporter to draw time draft on
bank.

Copyright© 2008 John

29 Wiley & Sons, Inc.
Creating a Banker's Acceptance

• Importer's bank accepts draft (liability

to pay) and creates a banker's
acceptance (BA).
• Advantages of a BA:
– Exporter receives funds by selling BA in the
market.
– Exporter eliminates foreign exchange risk.
– Importer's bank guarantees payment of
draft in future.

Copyright© 2008 John

30 Wiley & Sons, Inc.
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