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Money Markets
Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
Money market securities Institutional use of money markets Valuation of money market securities Risk of money market securities Interaction among money market yields Globalization of money markets
maturities within one year Are issued by corporations and governments to obtain short-term funds Are commonly purchased by corporations and government agencies that have funds available for a short-term period Provide liquidity to investors
Treasury bills:
Are
issued by the U.S. Treasury Are sold weekly through an auction Have a par value of $1,000 Are attractive to investors because they are backed by the federal government and are free of default risk Are liquid Can be sold in the secondary market through government security dealers
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in Treasury bills
Depository institutions because T-bills can be easily liquidated Other financial institutions in case cash outflows exceed cash inflows Individuals with substantial savings for liquidity purposes Corporations to have easy access to funding for unanticipated expenses
Treasury bills
Pm Par /(1 k )n
Treasury bills do not pay interest To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested
Institutions must set up an account with the Treasury Payments to the Treasury are withdrawn electronically from the account Payments received from the Treasury are deposited into the account
the yield
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Estimating
The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:
Commercial paper:
Is a short-term debt instrument issued by well-known, creditworthy firms Is typically unsecured Is issued to provide liquidity to finance a firms investment in inventory and accounts receivable Is an alternative to short-term bank loans Has a minimum denomination of $100,000 Has a typical maturity between 20 and 270 days Is issued by financial institutions such as finance companies and bank holding companies Has no active secondary market Is typically not purchased directly by individual investors
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The risk of default depends on the issuers financial condition and cash flow Commercial paper rating serves as an indicator of the potential risk of default Corporations can more easily place commercial paper that is assigned a top-tier rating Junk commercial paper is rated low or not rated at all
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of commercial paper:
Has increased substantially over time Is commonly reduced during recessionary periods Some firms place commercial paper directly with investors Most firms rely on commercial paper dealers to sell it Some firms (such as finance companies) create in-house departments to place commercial paper
Placement
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Allows the company the right to borrow a specified maximum amount of funds over a specified period of time Involves a fee in the form of a direct percentage or in the form of required compensating balances
Estimating the yield The yield on commercial paper is slightly higher than on a Tbill The nominal return is the difference between the price paid and the par value
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issued by large commercial banks and other depository institutions as a short-term source of funds Have a minimum denomination of $100,000 Are often purchased by nonfinancial corporations Are sometimes purchased by money market funds Have a typical maturity between two weeks and one year Have a secondary market
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NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate
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Repurchase agreements
One party sells securities to another with an agreement to repurchase them at a specified date and price
A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them Bank, S&Ls, and money market funds often participate in repos Transactions amounts are usually for $10 million or more Common maturities are from 1 day to 15 days and for one, three, and six months There is no secondary market for repos
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Estimating the yield The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with a 360-day year
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Federal funds
The
federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate
The rate is influenced by the supply and demand for funds in the federal funds market The Fed adjusts the amount of funds in depository institutions to influence the rate All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions The fed funds rate is typically slightly higher than the T-bill rate
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depository institutions communicate directly through a communications network or through a federal funds broker The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institutions reserve account by the amount of the loan Commercial banks are the most active participants in the federal funds market Most loan transactions are or $5 million or more and usually have one- to seven-day maturities
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Bankers acceptances:
Indicate that a bank accepts responsibility for a future payments Are commonly used for international trade transactions
An unknown importers bank may serve as the guarantor Exporters frequently sell an acceptance before the payment date
Have a return equal to the difference between the discounted price paid and the amount to be received in the future Have an active secondary market facilitated by dealers
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Represents a commitment by that bank to back the payment owed to the foreign exporter
The L/C is presented to the exporters bank The exporter sends the goods to the importer and the shipping documents to its bank The shipping documents are passed along to the importers bank
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Importer
5
Exporter
L/C Notification
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Financial institutions purchase money market securities to earn a return and maintain adequate liquidity Institutions issue money market securities when experiencing a temporary shortage of cash Money market securities enhance liquidity:
Newly-issued securities generate cash Institutions that previously purchased securities will generate cash upon liquidation Most institutions hold either securities that have very active secondary markets or securities with short-term maturities
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Financial institutions with uncertain cash in- and outflows maintain additional money market securities Institutions that purchase securities act as a creditor to the initial issuer Some institutions issue their own money market instruments to obtain cash Many money market transaction involve two financial institutions
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For money market securities making no interest payments, the value reflects the present value of a future lump-sum payment
The
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Pm Par /(1 k )n
A
Pm f ( k ) and k f (Rf , RP )
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of September 11
The weak economy combined with this event caused investors to transfer funds into money market securities The additional demand placed upward pressure on their price and downward pressure on their yields The Fed added liquidity to the banking system and reduced the federal funds rate
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Economic growth is monitored since it signals changes in short-term interest rates and the required return from investing in money market securities
Employment GDP Retail sales Industrial production Consumer confidence Indicators of inflation
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Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk
Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuers financial condition is limited
Measuring risk
Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates
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forces will correct disparities in yield and the yields among securities tend to be similar
In periods of heightened uncertainty, investors tend to shift from risky money market securities to Treasuries
Flight
Interest rate differentials occur because geographic markets are somewhat segmented Interest rates have become more highly correlated:
Conversion to the euro The flow of funds between countries has increased because of:
Eurodollar deposits, Euronotes, and Euro-commercial paper are widely traded in international money markets
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Have increased because of increasing international trade and historical U.S. interest rate ceilings
In the Eurodollar market, banks channel deposited funds to other firms that need to borrow them in the form of Eurodollar loans
Typical transactions are $1 million or more Eurodollar CDs are not subject to reserve requirements Interest rates are attractive for both depositors and borrowers Rates offered on Eurodollar deposits are slightly higher than NCD rates
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Investors in fixed-rate Eurodollar CDs are adversely affected by rising market rates Issuers of fixed-rate Eurodollar CDs are adversely affected by declining rates
The Eurocurrency market is made up of Eurobanks that accept large deposits and provide large loans in foreign currencies Loans in the Eurocredit market have longer maturities than loans in the Eurocurrency market Short-term Euronotes are issued in bearer form with maturities of one, three, and six months
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issued without the backing of a banking syndicate Has maturities tailored to satisfy investors Has a secondary market run by CP dealers Has a rate 50 to 100 basis points above LIBOR Is sold by dealers at a transaction cost between 5 and 10 basis points of the face value
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Ye (1 Yf ) (1 %S ) 1
Depends
on:
The yield earned on the money market security in the foreign currency The exchange rate effect
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