Part-11

The Money Market

1
Introduction

2
 Introductio
n
Introduction
 All debt markets have a common
feature
On one hand we have On the other hand we
parties ready to borrow have parties willing to
by issuing securities lend in the process of
acquiring securities

 All security for cash transactions are not

identical
 A 30 year mortgage loan
vs.
 3 month loan to meet a corporation’s working

capital needs 3
 Introductio
n
Purpose of borrowing

 The purpose for which money is

borrowed differs from
 borrower-to-borrower
 transaction-to-transaction
1. A corporation may issue long term bonds to
finance the construction of a building
2. It may issue short-term promissory notes to
fund the acquisition of raw materials.

4
 Introductio
n
Types of financial assets

 Money is borrowed to create different

kinds of financial assets with

 different maturities

 different risk profiles

 short-term securities

5
 Introductio
n
Term to maturity
 Loans in the money market have an
original term to maturity of <1 year

Original term to Actual term to

maturity maturity
The original term to The actual term to
maturity of a security is maturity is the current
its term to maturity at term to maturity of the
the time of issue security
It cannot change once a It will obviously keep
security is issued declining with the
passage of time
6
 Introductio
n
Money Markets
 Money market securities have to be
debt securities
 Since equity shares have no maturity date.
 Money market consists of transactions
to meet short-term cash needs
 Meant for current account, not for capital
account
 It is the mechanism through which
holders of ‘temporary cash surpluses’
interact with parties with ‘temporary
cash deficits’
7
 The nature of transactions range from
 Introductio
n
Why?

 Why do we need money markets?

 For most individuals / institutions inflows &
outflows of cash will rarely match.
 Inflows may happen at a time different from
when outflows are required to be met

8
 Example

Example – The Government

It collects revenues by Taxes arrive in lumpy

way of taxes amounts and do not arise
uniformly throughout the
year

Disbursements must be
made throughout the When tax revenues arrive
year to meet expenses the government will be
such as Wages, Salaries, temporarily flush with
Office supplies, Fuel funds
costs At such points in time it
will enter the money
market as a lender

9
 Example

Example – The Government

However during most This will be true even if it

months of the year the were to have a budget
government will have a surplus for the year as a
cash deficit whole
During periods of a
shortfall of cash the
government will enter
the money market as a
borrower
When the government During those months
has a deficit it will when it has a temporary
borrow short-term by surplus it will buy back
issuing Treasury Bills Treasury Bills to reduce
its borrowings
10
 Example

Example – Business

Businesses collect The checking account of

revenues from sales a firm will fluctuate from
large surpluses to low or
non-existent cash
balances
The points of time at
which such revenue is During periods when it
realized may not has a surplus , a firm will
however coincide with enter the money market
budgeted expenses to as a lender
cover wages, salaries, The objective is to earn
and other operational some returns however
expenses moderate on idle money

11
 Example

Example – Business

During periods when it One way is to issue short

has a cash deficit the term unsecured
business will enter the promissory notes called
money market as a Commercial Paper
borrower

12
 Introductio
n
Why the attention?
 Why are we so concerned about short-
term transactions?
 Money is an extremely perishable
commodity
 When idle cash is not invested there is an
opportunity cost - interest income is
foregone
 Income that is lost is lost forever
 When large amounts of funds are involved,
the income that is lost from not profitably
investing idle funds for even a day can be 13
 Introductio
n
Example
 A firm has 12MM dollars available
overnight.
 Assume interest rate @ 12% p.a.
 Assume the year has 360 days
 A common assumption in money markets
 If money is kept idle the lost income will
be:
12,000,000 x 0.12 x (1/360) = $4,000
 If the money were to remain idle for a
14
 Introductio
n
Borrowers & Lenders
 It is very difficult to classify an
economic entity as a borrower or a
lender.
 The same institutions frequently operate on
both sides of the market
 E.g. Citibank
Borrower Lender
It will borrow regularly At the same time it will
in the money market by be making short term
way of Certificates of loans to corporate
Deposit, borrowings of borrowers
Federal Funds etc. 15
 Introductio
n
Borrowers & Lenders
Borrower Lender
Frequently a corporation will Only to come back into
borrow millions of dollars on the market as a lender a
a single day few days hence due to a
sudden upsurge in cash
Institutions that are presentreceipts
on both sides of the
market include Large banks, Finance companies, Non-
financial corporations, Central Banks of countries
One institution that is usually
always on the demand side is
the government. At any point
in time the U.S. Treasury is
the largest borrower in the
world 16
 Introductio
n
What do investors want?

 Investors in the market primarily seek

 Safety and liquidity

 An opportunity to earn some extra income

 Liquidity is of paramount concern

because participants may seek to enter

and exit the market in a sudden

unanticipated fashion. 17
 Introductio
n
Liquidity
 A liquid market is characterized by the
presence of a large number of buyers
and sellers at all time.
 What would happen if the market were
to be illiquid?
 If there is excess demand large buy orders
will send prices shooting up
 If there is excess supply large sell orders
will send prices crashing down.
18
 Introductio
n
Liquid market
 In a liquid market large trades can be
executed without a major price impact
 Liquid markets are characterized by low
bid-ask spreads
 Since transactions are frequent dealers
can afford to operate with a smaller
profit per round trip transaction
 Bid  the price at which the dealer buys
from the public
 Ask  the price at which the dealer sells to
the public
 Round trip  a purchase followed by a
subsequent sale
19
 Introductio
n
Safety

 Safety is important because

 Investments are made for short periods
 Investments may be liquidated at any time
 Money market investors are very
sensitive to default risk
 Even a hint of trouble regarding the
financial condition of a borrower may have a
strong impact on the market.

20
 Introductio
n
Safety - Examples
 1970: Penn Central Transportation
Company defaulted on its short-term
commercial notes.
 The short-term commercial paper market
ground to a halt
 Investors refused to buy even paper issued
by top grade companies
 1980s: Continental Illinois Bank had to
be propped up by government loans.
 Immediately rates on all short-term bank
CDs rose
 There was a fear that all large bank CDs had
21
 Introductio
n
Risks in the Market

Risks

Re-
Market Default Inflation Currency Political
investment
Risk Risk Risk Risk Risk
Risk

22
 Introductio
n
Risks in the Market

1. Market risk - the possibility that the value of

an existing security will fall when interest
rates rise, thereby leading to a capital loss.
2. Reinvestment risk - the possibility of having
to reinvest cash flows arising from securities
at lower rates, due to a decline in rates.
3. Default risk - the risk that the borrower will
fail to make principal or interest payments.

23
 Introductio
n
Risks…(Cont…)

1. Inflation risk - the risk that the purchasing

power of cash flows received from a security
could erode.
2. Currency risk - the risk that the domestic
currency may appreciate with respect to a
foreign currency.
 This will lead to lower cash inflows in terms of
domestic currency when foreign currency is
converted.
3. Political risk - the risk that changes in
24
regulations may result in reduced returns or
 Introductio
n
Risks…(Cont…)

 Money market securities generally offer

more protection against such risks as
compared to other instruments.
 The prices of such securities tend to be
relatively stable over time.
 Thus while they may not offer prospects of
significant capital gain
 There is also a lower possibility of a
significant capital loss.
25
 Introductio
n
Reasons for lower risk
1. Interest rate movements over
relatively short periods tend to be
usually moderate
2. The impact of a given interest rate
change is greater the longer the term
to maturity of the cash flow
3. Default risk is also minimal in money
markets
 Borrowers have to be well established with
impeccable credit ratings.
 Else their securities will not attract
sufficient investor interest. 26
 Introductio
n
Other Risks

 Money market securities are subject to

inflation risk
 But they offer some compensation by way
of enhanced liquidity.
 Currency and political risks are also less
in money markets
 Due to the short-term nature of the
investments.
27
 Introductio
n
Features
1. The money market is broad and deep
 It can absorb large volumes of transactions
with minimal impact on security prices and
interest rates.
2. Investors can usually sell securities at
short notice
 Often in just a matter of minutes
3. The market consists of a wide network
of
 Securities dealers
 Major banks
 Fund brokers 28
 Introductio
n
Features (Cont…)

 Traders are constantly on the look out

for arbitrage opportunities.
 Money has no loyalty
 It can move from one corner of the globe
to another in a matter of minutes in search
of higher interest rates.

29
 Introductio
n
Central Banks
 The market is overseen by the Federal
Reserve Bank in the U.S. and by the
central banks of other countries. These
are:
 U.K. – Bank of England
 Japan – Bank of Japan
 Europe – European central bank
 Germany – Bundesbank
 Australia – Reserve Bank of Australia
30
 Introductio
n
Features (Cont…)

 There is no central trading arena.

 It is a market connected by telephones and
computers
 Speed is of the essence since money is
perishable.
 Transactions are conducted in a matter of
seconds and payments are made
instantaneously 31
Categories of Money Market
Instruments

32
 Categories of
MMI
Categories

Money
Market
Instruments

Off-balance-sheet Derivative
Cash Instruments
Instruments Instruments

33
 Categories of
MMI
Categories
 Cash instruments - A contract for the
immediate borrowing or lending of
funds
 Off-balance-sheet instruments (OBS) -
Arrangements for borrowing or lending
at a future point in time
 The price is fixed in advance
 This cannot be recorded on the balance
sheet of the parties

Balance sheet can only reflect current
borrowing/lending 34
 Categories of
MMI
Cash Instruments

Cash
Instru-
ments

Bank bills
Certifi- Re-
Deposits & Commer-
Treasury cates Euro purchase
& Bankers’ cial
Bills Of notes Agreee-
Loans Accept- Paper
Deposit ments
ances

35
 Categories of
MMI
Illustration

 A bank makes a commitment to make a

3-month loan 6 months from today @ 5

% p.a.

36
 Categories of
MMI
Derivative Securities
 Some off-balance-sheet-instruments do
not involve future borrowing / lending
 They are used for managing risk
 Only a return is paid

Instruments

Forward Money Money Market Interest

Rate Market Interest Rate Rate
Agreements Futures Swaps Options
37
 Categories of
MMI
Illustration
 A bank buys a $50MM FRA @ 5%
 If 3 month LIBOR 6 months later were
higher than 5%
 The bank will be paid a return by its
counterparty equal to the interest rate
differential times $50MM
 If 3 month LIBOR 6 months later were
lower than 5%
 The counterparty will have to be paid a
return equal to the differential times $50MM
38
 Categories of
MMI
Notional Principal

 In the illustration $50MM is not paid or

received
 It is used for the calculation of return 
this is Notional Principal’
 It is not recorded on the balance sheets

39
Key Dates in Cash Market
Instruments

40
 Key Dates

Key Dates

 Transaction date
 Value date
 Maturity Date

41
 Key Dates

Transaction Date

 Date on which terms and conditions of a

financial instruments are agreed upon
 Date on which parties enter into a
contract
 Also known as Trade date, Dealing date,
Done date

42
 Key Dates

Value Date

 Date on which instrument starts to earn

or accrue a return
 This date may/may not be same as
transaction date

43
 Key Dates

Types of Value Dates

Value Date

Same Day Value Next Day Value

Or Or Spot Value
Value Today Value Tomorrow

Value Date = Value Date = Value Date =

Transaction Transaction Transaction
Date Date + 1 Date + 2

44
 Key Dates

Maturity Date
 The date on which the instrument
ceases to accrue a return
 Maturity date is often not a date
 It is a term to maturity which is a whole
number of weeks/months after the value
date
 Date of maturity follows two
conventions
 The Modified Following Business Day
Convention 45
The Modified Following Business Day
Convention
 This convention consists of the following
three rules
 1. Maturity is set for the same date as the
value date
 If the value date is 21 March
 The one month maturity will be 21 April
 The two month maturity will be 21 May
 2. If the maturity as per rule 1 is a non-
business day, then it is moved to the
following business day

46
Modified…(Cont…)
 3. If the following business day according to
rule 2 falls in the next calendar month, then
the maturity date is moved back to the last
business day of the calendar month.

47
The End/End Rule
 If the value date is the last business day
of the current calendar month, then the
maturity date will be the last business
day of the relevant calendar month.
 Consider a one month deposit with a value
date of 31 May.
 It will mature on 30 June if it is a business
day.
 Consider a one month deposit with a value
date of 30 June
 It will mature on 31 July if it is a business day

48
The End/End Rule (Cont…)
 Consider a one month deposit with a value
date of 31 January
 It will mature on 28 or 29 February
 Consider a one month deposit with a value
date of 28 or 29 February

It will mature on 31 March
 If the maturity date as per this rule were
to be a holiday then the modified
following business day convention
would apply.

49
Fed Funds & Clearinghouse
Funds

50
 Fed Funds

Fed Funds & Clearinghouse Funds

 How do funds move so fast in the

money market?
 Money market traders usually trade in
Federal Funds.
 What are Federal Funds?
 Deposit balances of commercial banks held
at the regional Federal Reserve Banks or at
large correspondent banks.

51

Fed Funds…(Cont…)
When a dealer firm buys
securities from a trader…
It will contact its bank and
request that funds be
transferred from its account
to the trader’s account at
another bank
The central bank will remove
funds from the reserve
account of the buyer’s bank
and transfer the same to the
reserve account of the seller’s
bank
Fed Funds
These transactions take
place via a public or private
wire network
The transaction is so quick
that the seller of securities
has funds available to use
on the same day that the
trade is carried out or a 52
 Fed Funds

Immediately Available Funds

 Federal funds are known as

‘Immediately Available funds’

 This is because of the speed with which

money moves from one bank’s reserve

account to that of another.

53
 Fed Funds

Clearing House Funds

 Method of payment in the capital

markets for transactions involving
businesses and households
 Most large transactions are paid for by
check or by issue of a check following a
payment by a credit card
 Funds transferred by check are called
Clearinghouse Funds.

54
 Fed Funds

Process

The buyer writes a check

It goes to the seller’s If the two institutions are

bank which forwards that in the same community
check eventually to the they will exchange
depository institution bundles of checks drawn
upon which it was drawn against each other every
day, through the local
clearinghouse

55
 Fed Funds

Funds availability
 Clearinghouse funds are not accepted in
money markets
 For money market transactions these
transactions are far too slow and risky

Federal Funds Clearinghouse funds

Money is available on Compared to Federal
same day and hence Funds it takes at least a
interest can be earned day to clear local checks
on the same and 2-3 days for outstation
Money is transferred checks
Funds have an element of
safely risk since check may be
56
returned
Global Money Markets

57
 Global Money Mkts

Global Money Markets

 Money market throughout the world
share certain characteristics
a. They support borrowing and lending for
periods ranging from 1 day to 1 year
b. They help reconcile cash imbalances for
 Public / private businesses
 Individuals / Institutions
c. They aid governments in financing their
deficits (fiscal deficit)
d. They help governments manage the growth
of money and credit and maintain stability
of currency rates (monetary policy)
58
 Global Money Mkts

National / Intl. Money Markets

 Every nation has its own money market

 Some are poorly developed.
 Others like that of the U.S extend beyond
the borders of a country or a continent.

 National money markets may be

 Security markets dominated
 Bank dominated

59
Types of National MoneyGlobal Money Mkts
Markets
 Securities dominated market  most
borrowing and lending is through open
market trading of financial instruments.
 Western markets are largely securities
dominated.
 Bank dominated market  bank
borrowing and lending is at the centre
of most transactions.
 Asian markets tend to be largely bank
dominated.
 These markets have a potential weakness -
they yield more easily to government 60
 Global Money Mkts

International Money Markets

 International money market ties all

domestic markets together.
 At its heart is the Eurocurrency market.
 Here large bank deposits are traded outside
the boundaries of the country where the
particular currency is issued.

61
Securities & Relative Volumes

62
 Sec & Rel vols

Securities and Relative Volumes

 The principal instruments that are
traded in the money market are:
a. T-bills
b. Federal agency securities
c. Dealer loans
d. Repurchase agreements
e. Commercial Certificates of Deposit
f. Federal Funds
g. Commercial paper
h. Bankers’ Acceptances
i. Financial Futures
j. Eurocurrency deposits
63
 Sec & Rel vols

Growing Volumes

 The volume of money market

securities has grown rapidly in recent
years.
1. One reason is the international economy’s
growing need for liquid, readily
marketable, and relatively safe securities.
 This is particularly true during periods when
bank rates are falling and some currencies
are rapidly losing value.
2. Another factor has been the attractive
yields offered to investors. 64
 Sec & Rel vols

Money Market Instruments

 Two of the most important money

market instruments are
 T-bills and
 Negotiable CDs
 Even larger in terms of volumes is the
market for federal agency securities.
 The commercial paper market is also
rapidly growing
 Many large corporations have found paper
to be a cheaper and more flexible source of
funds as compared to bank loans. 65
 Sec & Rel
vols
Difficult to estimate volume

 The volume of Federal funds

transactions is difficult to estimate.
 Thousands of banks are active in this
market
 All transactions are not reported
 The true size of the Eurodollar market is
also unknown
 It spans many nations and is relatively
unregulated.
66
Interbank Market

67
 Interbank
Mkt
Interbank Market
 It is a market for large or wholesale
loans and deposits
 It is an arena for transactions between
commercial banks
 Borrowing / lending is for periods <= 12
months
 Participants
 Commercial banks
 Insurance companies
 Pension funds
68
 Interbank
Mkt
Need for Interbank Market

 All commercial banks are required to

maintain an account with the central
bank
 Banks with surplus lend to banks with
deficit
 The lending bank earns some interest
 The bank with deficit covers its deficit
69
 Interbank
Mkt
Features of Interbank Market

 Loans are unsecured

 Interest rates are lower

 Banks with high credit rating play role of

intermediary

70
 Interbank
Mkt
Types of Loans

1. Overnight money: Money lent on a

given day is scheduled to be repaid on
next banking day
2. Day to Day money: The deposit is for
an unspecified time. Funds can be
called back at any time and will be
repaid on same day
 Also called ‘money at call’
71
 Interbank
Mkt
Types of Loans

1. Notice money: Money lent with a short

notice of withdrawal
 E.g. 2 days or 7 days notice

2. Fixed money: Money lent for a fixed

period
 E.g. 1 week or 1 month

3. Intra day money: Money lent and

repaid on same day
72
 Interbank
Mkt
Role of Brokers

 Provide up-to-date indicative interest

rates to market
 They charge a standard commission
 Their success depends on:
 Ability to provide good and accurate
information
 Ability to facilitate quick execution of
trades
73
 Ability to maintain confidentiality
 Interbank
Mkt
LIBOR

 LIBOR  London Interbank Offer Rate

 Rate at which bank with high credit rating is

prepared to lend to a similar bank

 LIBOR is quoted for different tenors

 Each bank quotes its own indicative LIBOR rate

74
 Interbank
Mkt
BBA LIBOR
 BBA  British Bankers’ Association
 It is the most widely used benchmark
for short term interest rates
 Rate is complied by BBA and Reuters
and released after 11 a.m. London time
 BBA maintains a panel of 8 banks
 It provides a reference panel which
reflects the balance of the market by
 Country
 Type of institution
75
 Interbank
Mkt
LIBID

 LIBID  London Interbank Bid Rate

 It is rate at which a London bank with

good credit rating will pay on funds

deposited with it by another top rated

bank

 LIBID is quoted for different tenors

76
 Interbank
Mkt
LIBID vs. LIBOR

LIBID LIBOR
Rate that banks with Rate that banks
surplus funds might seeking to borrow
have to accept on might have to pay
interbank deposit
Rate is lower Rate is higher

Some banks use LIMEAN, the average, as the

agreed upon rate
77
 Interbank
Mkt
SONIA & EURONIA
SONIA EURONIA
(Sterling Overnight Index (Euro Overnight Index
average) average)
These indices track actual market overnight funding
rates
Weighted average to 4 Weighted average to 4
decimal places of all decimal places of all
unsecured sterling unsecured euro overnight
overnight transactions
Brokered by WMBA transactions
Brokered by WMBA
between midnight and 4.15 between midnight and 4
p.m. p.m. overnight deposit
The indices are weighted average
rates for each business day. Both are published by 5
78
p.m. London time.
 Interbank
Mkt
EURIBOR
 It is a benchmark rate used by
international market for the Euro
 Produced by European Banking
Federation – Brussels
 Quotes are taken from 57 banks in the
euro zone countries
 Euribor is reported at 11 a.m. Brussels
time everday
 The rates are spot rates
 Interest is computed on Actual/360
basis 79
 Interbank
Mkt
Calculating
 Interest payable on assumption of a 360
day year

P x (r/100) x (T/360)

P  Principal
T  No. of days
r  Rate of interest

80
 Interbank
Mkt
Illustration
 Bank makes a loan = $7.5 MM
 Period: 1 year (365 days)
 Interest rate = 5.25% p.a.

Interest = 7,500,00 x (5.25/100) x

(365/360)
= $ 399,218.75

81
Securities and Relative Interest
Rates

82
 Sec & Rel. Int.
Rates
T-Bills

 The foundation of the market’s

structure is the level of yields on T-bills
 These securities have zero default risk
 They carry minimal market risk
 Secondary market for T-bills is the most
active and deep of all securities markets.
 Due to combination of low risk and
ready marketability T-bills carry the
lowest yields 83
 Sec & Rel. Int.
Rates

Other market securities

 Federal agency securities  One set of
yields that stays close to T-bill rates is
the yield on federal agency securities.
 These are considered to be virtually riskless.
 They are less marketable than T-bills.
 Federal Funds  The rate on Federal
funds also stays fairly close to the T-bill
rate
84
 Sec & Rel. Int.
Rates
Relative Rates (Cont…)
Instrument Yield Instrument Yield
Federal Funds 3.72 6-M CD 4.27
2-M Non- 3.83 1-M ED 3.87
financial CP
3-M Non- 3.86 3-M ED 4.07
financial CP
1-M Financial 3.82 6-M ED 4.25
CP
2-M Financial 3.91 Bank Prime 6.75
CP
3-M Financial 4.02 Rate
4-week T-bills 3.31
CPCD
1-M 3.89 3-M T-bills 3.65
3-M CD 4.08 6-M T-bills 3.96
85
Treasury Bills

86
 T-Bills

Treasury Bills
 Purchases / Sales of T-bills often
represent the largest volume of daily
transactions in the money market.
 Interest rates on such bills are the
benchmark for all other money market
rates.
 What are the important features of T-
bills?
a. Zero default risk
b. Ready marketability 87
 T-Bills

U.S. T-Bills
 U.S T-bills are direct obligations of the U.S.
government
 By law T-bills in the U.S must have an original
maturity of <1 year
 The government’s fiscal year runs from 1 Oct to
30 Sep

Uptil April April & Post April

Even in years with a budget
surplus the government is
likely to have a deficit in
most months
Income tax, the main
source of revenue for the
government, is not fully
collected tillthe
In April and April
months
immediately following it will
be flush with funds
88
 T-Bills

T- Bills for deficits / surplus

 T-bills are ideally suited to manage

these deficits / surpluses because

a. Their maturities are short

b. They are readily marketable

c. Their prices adjust quickly to changing

market conditions

89
 T-Bills

Volumes of U.S. T-Bills

 The volume of U.S. T-bills outstanding
grew rapidly in the 1980s and 1990s
 The main reasons were
1. Record fiscal deficits
2. Occasional recessions that reduced
revenues from income tax
3. Rapid expansion of defense programs
4. Extension of welfare subsidies to low
income individuals.
5. The global economy had grown rapidly
creating a greater need for such liquid
assets to aid institutions in the efficient
management of their cash positions
90
 T-Bills

Regular Series Bills

 Regular series bills are issued routinely

every week or month by way of
competitive auctions.
 3 and 6 month bills are issued every week
 1 year bills are issued every month
 Of the above maturities 6 month bills
provide the maximum revenue for the
Treasury.
91
 T-Bills

Irregular Series Bills

 Irregular series bills are issued only
when the Treasury has a special need
a. Strip bills
 A package of a series of bills with different
maturities
 Investors have to bid for the entire series
b. Cash management bills
 Consist of re-opened issues of bills that were
issued earlier
 E.g. assume that 6-months bills were issued 2
months ago. If we were to now issue 4-month
bills we would be adding to the amount that
is outstanding
 Normally occurs when there is an unusual or
unexpected need for funds.
92
 T-Bills

On / Off the run securities

On the run securities Off the run securities

Newly issued securities Securities for the same
for a given maturity maturity that were
issued earlier
E.g. a 6 month bill E.g. a 3 month bill
issued 3 months ago issued recently
Have 3 months to Have 3 months to
maturity, but are more maturity
liquid
93
 T-Bills

On-the-run bills more liquid

 Why are on-the-run bills more liquid?

 For a short period after issue, securities
tend to be very actively traded
 Thereafter, most securities pass into the
hands of investors who are quite content to
hold them till maturity.
 Thus compared to on-the-run securities, off-
the-run securities tend to be less liquid.

94
 T-Bills

T-Bills selling process

 T-bills are sold by an auction process.
 Prices and yields are determined by the
market and not by the Treasury.
 The process:
 Issue of a new regular bill is announced by
the Treasury on Thursday of every week
 Bids are due on the following Monday before
1:00 P.M. New York time.
 The bills are issued on the Thursday
following Monday’s auction.
95
Competitive & Non-Competitive
T-Bills

bids
 The Treasury entertains 2 types of bids.
 Competitive bids  typically are submitted
by large investors including banks and
securities dealers.
 They bid for several million dollars worth of
securities at a time.
 Non-competitive bids  submitted by small
investors who agree to accept the price set
at the auction.
 The Treasury generally fills all non-
competitive bids. 96

At the auction
Bids are arranged in descending
order from the highest price or in
ascending order from the lowest
yield
Lowest price at which at least
some bills are awarded is called
‘stop-out’ price
Once bills are acquired by
successful bidders, many will be
sold right away in the secondary
market
T-Bills
All competitive bids
must be submitted to
three decimal places
No one bidding < stop-
out price will receive
any bills in an auction
All bills are issues only
in ‘book-entry’ form,
not physical form
97
 T-Bills

Illustration

Discount Rates Bid Equivalent Prices

3.540 96.460
3.545 96.455
3.550 96.450
3.555 96.445
3.560 96.440
3.565 96.435
3.570 96.430

98
 T-Bills

Pricing at auctions

 All prices are expressed on a $100 basis

as though the bills have a face value of
$100
 In actual fact the minimum denomination
for bills is $1,000
 And they are issued in multiples of $1000
thereafter.
99
 T-Bills -
Yields
Yields
 The quoted yield for T-bills is a discount
yield.

DR = Face Value – Price 360

________________ x _____
Face Value Tm

 DR  quoted discount rate

 Tm  number of days till maturity

100
 T-Bills -
Yields
Example 1
 Assume that a T-bill with
 Face value = $100
 90 days to maturity
 Selling price = $97.50

DR = 100 – 97.50 360

____________ x _____ = 10%
100 90

101
 T-Bills -
Yields
Example (Cont…)

 In the market the price will not be

quoted as 97.50
 The dealer will quote the yields as 10%
 An investor must use the yield to calculate
the price.

102
 T-Bills -
Yields
Example – Investment Rate
 Rate of return for an investor who buys a bill at
a discount rate of DR will always be higher
than the quoted yield

Investment rate

IR = Face Value – Price 365

________________ x ____
Price Tm

= 100 – 97.50 365

___________ x _______ = 10.40%
97.50 90 103
 T-Bills -
Yields
Example (Cont…)

 Both the discount rate and the

investment rate are calculated under
the assumption that the bill will be held
till maturity.
 Several other formulas are used by
investors for calculating yields on bills
that are not held to maturity.
104
 T-Bills -
Yields
Holding Period Return
 One formula is:

HPR = P2 – P1 360
_______ x _______
100 Tm1-Tm2

= Tm1DR1 – Tm2DR2
_________________
Tm1 – Tm2

105
 T-Bills -
Yields
HPR terms

 HPR  holding period return

 DR1  discount rate when the bill was

purchased with Tm1 days to maturity

 DR2  discount rate when the bill is sold

with Tm2 days to maturity

106
 T-Bills -
Yields
Example 2
 Assume that an investor buys a
 180 day bill at a discount of 6%
 Sells it 30 days later at a discount of
5.80%

HPR is
(180x6.00) – (150x5.80)
_______________________ = 7%
180 - 150
107
 T-Bills -
Yields
Yield to Maturity
 Calculate the Yield to Maturity of a T-bill
that has more than 182 days to
maturity
 A coupon paying bond with a time to
maturity >182 days will make a coupon
payment before maturity
 To facilitate a comparison between the yield
for a discount instrument with >182 days to
maturity & the YTM of a conventional bond,
the discount security must be treated as if108
it
 T-Bills -
Yields
Yields (Cont…)

 Let us denote the bond equivalent yield by y.

109
 T-Bills -
Yields
Yields (Cont…)

110
 T-Bills -
Yields
Example - BEY

 Consider a bill with 184 days to

maturity, a quoted yield of 8% and a
face value of $1,000,000.
 Calculate the Bond Equivalent Yield

111
 T-Bills -
Yields
Yields (Cont…)
P = $959111.11
Therefore:

112
 T-Bills

Primary Dealers
 The money market depends heavily on
the buying and selling activities of
securities dealers.
 Primary Dealer
 A dealer firm which is qualified to trade
securities directly with the Federal Reserve
Bank of New York
 The firm must agree to be available to trade
securities at all times and post a capital of
at least $50m
113
 T-Bills

Exclusive Privileges
 Until recently the primary dealers
possessed several exclusive privileges
in dealing with the U.S. government
1. They held exclusive membership on the
Treasury Borrowing Advisory Committee
which helps the government decide what
kinds of securities to sell at each auction
2. They were the only traders along with
banks who could place bids for new
government securities on behalf of
themselves and their customers without
posting the normally required 5% cash
deposit on each bid amount. 114
 T-Bills

Exclusive Privileges

1. A primary dealer had to agree to share

information regularly and freely with the
Federal Reserve.
2. They also agreed to meaningfully
participate in trading with the FED at any
time the FED wishes
3. They agreed to make realistic bids
4. They agreed to trade continuously in the
full range of securities
115
 T-Bills

Why collude?
 In a large and highly competitive
market there was the risk that:
 Primary dealers could overbid thereby
eliminating potential profits
 They could underbid which would mean
that they would receive no securities at all
 Thus dealers had a strong incentive to
share information with each other on
 the size of the orders they wished to place
 the prices they hoped to bid
116
 T-Bills

New rules for auctions

 In the wake of a scandal the Treasury
and the New York FED set up new rules
for the auction
1. Customers purchasing large amount of
securities through dealers are required to
verify in writing the amount they bid.
2. Any dealer or broker registered with the
SEC could file bids on behalf of customers
without putting up a deposit or a
guarantee.
117
 T-Bills

New Rules (Cont…)

1. The Treasury promised it would stop giving
primary dealers an advance look at its
borrowing plans before releasing the
information to the public
2. It also promised it would automate the
bidding process rather than rely on
handwritten bids.
3. In 1992 the rule that a dealer must
account for at least 1% of total Treasury
market trading in order to qualify as a
competitive bidder was removed.
118
 T-Bills

New Rules (Cont…)

1. The Treasury pledged that it would re-open

security issues and issue more securities if
it detected that a market squeeze was
developing with some dealers being unable
to find reasonably priced government
securities to satisfy the needs of their
customers.

2. The Treasury also switched from a multiple

price auction to a single price auction. 119
 T-Bills

Winners’ Curse
 Multiple price auctions encouraged
dealers to bid high in order to increase
the probability of winning.
 The higher the price bid, the lower the
expected profit when securities were sold in
the secondary market
 Dealers placing higher bids faced a
‘Winners’ Curse’
 They incurred a greater probability of loss
when they attempted to resell the
securities.
 At best the winners’ curse reduced the
aggressiveness of bidding and probably 120
resulted in the Treasury getting a lower
Funding of Dealer Positions

121
 Dealer
Positions
Funding of Dealer Positions

 Government security dealers supply a

large volume of securities to the market
 They depend heavily on the money market
for borrowed funds
 Most dealers invest very little of their own
equity
 Ratios of security portfolios held to owners’
capital of even 40:1 are common.
 The bulk of their operating capital is
borrowed from banks and other financial 122
 Dealer
Positions
Sources of Dealer Funds

Most heavily used

sources of dealer funds

Demand loans from Repurchase agreements

banks with banks / lenders

123
 Dealer
Positions
Demand Loans
 Every major bank posts rates at which it
is willing to make short-term loans to
dealers.
 Generally two rates are quoted
 One for new loans
 A lower rate for the renewal of existing
loans
 A demand loan may be called at any
time.
124
 Such loans are virtually riskless because
Repurchase agreements

125
 Repurchase
Agreements
Repos
 Repurchase agreements are an
increasingly popular alternative to
demand loans.
 They represent a temporary extension
of credit collateralized by marketable
securities
Dealer Sells securities Lender

Makes commitment to buy the

securities back at a later date
126
 Repurchase
Agreements
Types of Repos

 Term Repos  Some repos called Term

Repos are for a fixed length of time.

 Continuing Contracts  Continuing

Contracts carry no explicit maturity date
but may be terminated at short notice
by either party
127
 Repurchase
Agreements
Providers of Repos

Providers
of Repos

Non- Foreign
Large State Local Insurance
Finance Financial
Banks Govts Govts Cos
Cos Institutions

128
 Repurchase
Agreements
Custodial Account
 Securities for the collateral are
supposed to be placed in a ‘custodial
account’ at a bank.
 When loan is repaid the dealer’s liability is
canceled and the securities are returned
 There is evidence that this safety
feature is not scrupulously followed.
 If a dealer goes out of business, lender may
have difficulty in recovering the securities
 Dealer firms have collapsed and many S&Ls
lost money from inadequately collateralized
loans.
 Fed authorities have imposed strict 129
 Repurchase
Agreements
Types of Repos
 Term Repos  Contracts for terms
longer than overnight e.g. contracts for
periods ranging from 1 - 3 months or
even longer
 Dollar repos  They permit the
borrower to repurchase securities that
are similar to but not necessarily the
same as the securities originally sold
 FLEX repos  They permit lenders to
withdraw a part of the loan whenever
cash is needed.
130
 Repurchase
Agreements
Value of Collateral
 The interest rate of repos is closely
linked to other money market rates.
 Usually the collateral is valued at the
current market price plus accrued
interest less a small discount called a
Haircut to reduce the lender’s exposure
to market risk.
 The longer the term of the repo, and the
riskier and less liquid the security that is
pledged, the larger will be the Haircut. 131
 Repurchase
Agreements
Value of Collateral

 Repos are periodically market to

market.

 If the price of the collateral has declined the

borrower may need to pledge additional

collateral.

132
 Repurchase
Agreements
Example of Repo - 1
 A party has made an overnight loan of
$100 MM to a dealer at 7.2%
 Thus the interest payable the next day
is:

100,000,000 x 0.072 x 1
___ = $20,000
360

133
 Repurchase
Agreements
Illustration - 2
 Take the case of a dealer who is looking
for a 30 day loan and is willing to pledge
T-notes as collateral.
 Assume accrued interest = $205,700
 The quoted price per $100 of face value
is $100.9375
 The repo is for 30 days
 The rate of interest is 9% p.a.
 The haircut is 0.005 price points
134
 Repurchase
Agreements
Illustration - 2 (Cont…)
 The amount that can be borrowed against the
securities is:
5,000,000 (1.009375 - 0.005) + 205,700
= $5,227,575

 The amount due at maturity is this principal

plus interest.
Interest = 5,227,575 x 0.09 x (30/360)
= $39,206.81

135
 Repurchase
Agreements
Illustration - 2 (Cont…)

 During these 30 days there will be

fluctuations in the value of the
collateral.
 These must be regularly monitored to
ensure adequate collateralization.
 Most repos are collateralized by government
securities.
 Sometimes other money market 136
 Repurchase
Agreements
Credit Risk

 In practice both borrower and lender are

subject to credit risk
 There is no strategy which will reduce
the risk for both the parties.
 Increasing protection for one means
enhanced risk for the other.

137
 Repurchase
Agreements
Credit Risk
Interest rates rise Interest rates
If interest rates rise decline
If interest rates decline,
sharply, the value of the value of the
the collateral will collateral will rise.
decline and the lender
will be vulnerable
In this case, if the If the lender goes
borrower were to go bankrupt, the borrower
bankrupt, the lender will be left with an
will be left with assets amount that is less
which may be worth than the market value
less than the loan of the securities.
amount.
138
 Repurchase
Agreements
Margins

 The lender can ask for margin.

 i.e. he can lend less than the market value
of the assets.
 This will increase the risk for the borrower
 The borrower can ask for reverse
margin.
 i.e. he can ask the lender to lend more than
the market value of the securities.
 This will increase the risk for the lender
139
 Repurchase
Agreements
Margins (Cont…)

 In practice it is the lenders who receive

margins.
 This is because they are parting with cash
which is the more liquid of the two assets.
 Thus the market value of the collateral
will exceed the loan amount.
 The excess is called a ‘Haircut’

140
 Repurchase
Agreements
Reverse Repo
 Such transactions offer a convenient
route for lenders to park excess funds
for short periods.
 From the perspective of the lender such
an arrangement is called a reverse
repurchase agreement or a reverse
repo.
 Thus every repo must be matched by a
reverse repo.
 A dealer looking to borrow funds will do a
repo.
 A dealer looking to place funds will do a 141
 Repurchase
Agreements
Matched Book

 Some dealers will do a repo for one

maturity with a party and a reverse
repo for another maturity with another
party.
 They hope to profit from the interest
rate differential.
 Such dealers are said to be maintaining
a ‘matched book’
142
 Repurchase
Agreements
Rates
 General collateral rate  Most
government securities can be bought at
a rate called the general collateral rate.
 Thus most securities are close substitutes
for each other.
 Special repo rates  Sometimes a
security may be in high demand and the
lender may charge a lower rate.
 Such rates are called special repo rates.
143
 Repurchase
Agreements
Repos (Cont…)

 To promote a smoothly functioning

market the Federal Reserve frequently
participates in repos with primary
dealers.
 It may buy securities on a short-term basis
and then sell them back
 It may sell securities with an agreement to
buy back
144
 Repurchase
Agreements
Repos (Cont…)

 By selling securities to dealers the FED

temporarily absorbs dealer funds and
reduces the ability of the dealers’ banks
to make loans.
 Thus while dealers use repos to
increase their earnings from trading, the
FED uses them to steady the money
market.
145
 Repurchase
Agreements
Settlement
 Parties will have accounts with the
Central Securities Depositories
 Sale of securities will be transacted by
book entry
 Payments will be made by an assured
payment system of the CSD
 Settlement may take place 1-2 days
after the date of the repo transaction
agreement
146
 Repurchase
Agreements
Repo Rates
 Bid price  Rate that the dealer is
willing to accept in return for purchasing
bonds and agreeing to sell them back
 Bid rate is the customer’s repo rate and the
dealer's reverse repo rate
 Offer rate  Rate that the dealer is
willing pay to sell and then repurchase
the bonds
 Offer rate is the customer’s reverse repo
rate and the dealer’s repo rate
 The Bid will always be higher than the
Ask 147
Federal Funds

148
 Fed Funds

Federal Funds

 They are the principal means of making

payments in the money market.
 Definition  The term Federal Funds
refers to money that is available for
immediate payment.
 Transferred from one depository institution
to another by simple book-keeping entries

149
 Fed Funds

Federal Funds
History Today
The name federal funds Today the Fed funds
came about because in the market is far broader in
earlier years the principal scope than just reserves on
source of immediately deposit with Federal
available money was the Reserve Banks
reserve balance that each
bank held with the regional
Federal
If a bankReserve
neededBank
to Virtually all banks maintain
transfer funds to another it deposits with large
needed to only contact the correspondent banks in
regional FRB and funds major cities. These
would be transferred in a deposits may be readily
matter of seconds by transferred from the
computers account of one bank to that
150
 Fed Funds

Federal Funds Today

 S&Ls, Credit Unions, and Savings Banks

maintain deposits with commercial

banks or with Federal Reserve Banks

that are available for immediate

transfer to a customer or to a financial

institution.
151
 Fed Funds

Borrowers of Fed Funds

Borrowers
of Fed
Funds

State &
Securities Corpora- Insurance Commercial
Local S & Ls
dealers tions Cos banks
Govts

They are the most important of all

borrowers since they use Federal Funds a
the principal way to adjust their legal
152
reserve account at the district Federal
Mechanics of Federal Funds Fed Funds

Trading

 The mechanics of Fed Funds trading

depends on the locations of the

borrowing and lending institutions.

153
 Fed Funds

Illustration 1

Take for example two banks that are located in New York

This is payable
The borrower would be
immediately. Fed funds
handed a check drawn on the
would be transferred to the
lender’s reserve account at
borrower’s reserve account
the Federal Reserve Bank of
before the close of business
New York

The lender on the other hand This is one day money

may be given a check drawn because it must pass
on the borrower through the New York
Clearinghouse
154
Alternative Mechanism

 The lending bank can simply contact the

New York Fed
 It can ask it to electronically move funds
from the lender’s reserve account to the
borrower’s
 The transaction can be reversed on the
following day.

155
 Fed Funds

Illustration 2
If the institutions are not located within the same
district the transaction would proceed in the same
way except that two Federal Reserve banks would be
involved
The borrower and the lender agree on the
terms of the loan

The lending institution directly or indirectly

through a correspondent bank contacts
the district Federal Reserve bank
requesting a wire transfer of funds

The reserves are then transferred to the

borrowing bank through the Fed’s wire
network FEDWIRE 156
 Fed Funds

Contact Mechanisms

 Fed Funds borrowers and lenders

contact each other using the following
mechanisms
a. Computer networks

b. Telephone

c. There are also Fed Funds brokers who

indicate by telephone and computer
screens what funds are available and at
157
 Fed Funds

Fed Funds loans features

 Most Fed Funds loans are

 Overnight transactions

 Continuing contracts with no specific

maturity date

 Continuing contracts can be terminated

without advance notice by either party

158
 Fed Funds

Fed Funds loans

 One day loans  They carry a fixed rate
of interest but continuing contracts do
not
 Term Federal Funds  Loans lasting
beyond a day.
 They are being supplied by foreign banks
and other lenders
 They are considered as a safe and profitable
way to warehouse funds until they are
needed for long-term loan commitments 159
Negotiable CDs

160
 Nego CDs

What is a CD?

 It is an interest bearing receipt for funds left

with a depository institution for short periods
of time.
 The minimum maturity as per U.S. law is 7
days.
 There is no maximum limit.
 CDs are issued at par and pay interest
explicitly.
161
 Nego CDs

True Money Market CDs

 True money market CDs are negotiable
instruments that can be resold before
maturity
 They carry a minimum denomination of
$100,000
 The round lot for trading is $1,000,000
 They may be registered on the books of the
issuing banks or else may be issued in
bearer form.

CDs issued in bearer form are more
convenient for resale.
162
 Nego CDs

Negotiable CDs

 Denominations range from $25,000 to $10MM

 A true money market CD has a minimum
denomination of $100,000
 Maturities range from a few months to 18
months
 Most CDs have a maturity of 6 months or less

 Term CDs  CDs with maturities beyond a

year are called Term CDs

163
 Nego CDs
Non-negotiable Time Deposits vs.
Negotiable CDs

Time Deposits CDs

An investor will deposit The depositor will be
a sum of money with a issued a bearer security
bank for a stated period
of time is paid interest Investor is entitled to
Investor
at a specified rate claim deposit with
interest at the end of
It cannot be easily the period
It can be liquidated at
terminated until it any time at the
matures prevailing marker rate164
 Nego CDs

Calculations
 Consider a CD with a face value of V.
 The funds owed on maturity is given by:

V + Tm
____ x V x i
360

where:
Tm  original term to maturity
i  interest rate
165
 Nego CDs

Example

 A firm purchases a $100,000 CD

 Duration = 6 months
 Interest rate @ 7.5%
 It would receive:

100,000 x {1 + (0.075 x 180/360)} =

$103,750
166
 Nego CDs

Calculations (Cont…)
 To convert the yield to a true yield for a
365 day year, multiply the quoted rate
by 365/360.
 Thus

YTMCD = i x 365
____
360

167
 Nego CDs

Example

 i = 0.075

 YTM = 0.075 x (365/360) = 7.6%

168
 Nego CDs

Yield on CDs

 The yield on CDs is normally higher than

the T-bill rate due to
 Greater default risk
 A thinner resale market
 Tax exemptions granted to T-bills by state
and local governments.

169
 Nego CDs

Types of CDs
1. Variable or floating rate CDs
2. Rollover or Rolypoly CDs
3. Jumbo CDs
4. Yankee CDs
5. Brokered CDs
6. Deposit notes
7. Bear and Bull CDs
8. Installment CDs
9. Rising rate CDs
10.Foreign-index CDs
170
 Nego CDs

1. Floating rate CDs

 They carry a maturity of up to 5 years
 Interest rate is reset every 30, 90, or
180 days.
 Gap between interest reset dates is known
as the Leg or the Roll period.
 Floating rate is usually tied to movements in
the
 The secondary market yield on fixed-rate CDs
 The prevailing Fed Funds rate
 The prime bank rate
 The going market rate on ED deposits.
 This CD gives the investor a higher return
than normally would be obtained by
171
continuously renewing short term CDs.
 Nego CDs

2. Rollover CDs
 In the 1970s the Rollover or Rolypoly CD was
introduced.
 6 month CDs are the maximum maturity traded in
the secondary markets.
 Rollover CDs are longer term CDs with higher
rates but in packages composed of a series of
6 month CDs extending for at least 2 years.
 This promised higher returns plus the ability to
retire some components of the package early
to meet cash needs.
 The customer is however obligated to
purchase the remaining certificates on each 6
month anniversary date till the contract
expires.
172
 Nego CDs

Other CDs

1. Jumbo CDs are $100000+ negotiable

CDs issued by non-bank thrift
institutions such as S&Ls and Savings
Banks.
2. Yankee CDs are issued in the U.S by
foreign banks.
3. Brokered CDs are sold through brokers
or dealers.
173
 Nego CDs

6. Deposit notes

 In the 1980s deposit notes appeared.

 These are a hybrid financial instrument
combining the features of CDs and
corporate bonds with maturities
reaching out to as long as 10 years.

174
 Nego CDs

Other CDs

1. Bear and Bull CDs have returns linked

to the performance of the stock
market.

2. Installment CDs allow customers to

make a small initial deposit and then
gradually build up the balance in the
account to a target level.
175
 Nego CDs

Other CDs

1. Rising rate CDs are longer term

deposits whose promised yield
increases over time with penalty free
withdrawals permitted on selected
anniversary dates.
2. Foreign Index CDs offer a return linked
to economic developments abroad and
to fluctuations in foreign currency
176
 Nego CDs

Global CD Markets - Canada

 In Canada the big banks issue CDs and

bearer deposit notes with maturities
ranging from 30 days to 12 months in
units of $100000 and higher.
 These are usually sold at a discount
from par.
 Some Canadian bank CDs are available
in both USD and CAD.
177
 Nego CDs

Global CDs – Japan & Asia

 In Japan CDs have been permitted since

the 1980s.
 Gradually restrictions on maturities and
minimum account sizes have been relaxed.
 Asian dollar CDs are available.
 They carry fixed rates or floating rates
linked to SIBOR.
 They normally trade in units of 1MM dollars.

178
 Nego CDs

Global CDs - Euro

 Eurodollar CDs are negotiable dollar
denominated time deposits issued by
foreign branches of U.S. banks and
foreign owned banks.
 They carry higher rates than comparable
domestic CDs due to greater perceived risk.
 They can carry maturities in excess of one
year and rates are adjusted every 3 to 6
months to match changes in the LIBOR.

179
 Nego CDs

Yields on CDs

 These are a function of demand and

supply.
 CDs are not riskless because the issuing

bank could fail.

 For the issuing bank, the effective cost of

the CD is greater than the quoted rate of

interest because of reserve requirements

180
and insurance premia.
 Nego CDs

Illustration
 A bank is quoting 8% p.a. on a 3 month
deposit
 Reserves @ 5% and are non-interest
bearing
 Effectively $8 interest is being offered
on $95 of usable funds
 Effective rate =
8
95 = 8.42%

181
 Nego CDs

Illustration

 The insurance premium is 8.33 b.p.

 Effective cost is

8.42 + 0.0833 = 8.5033%

182
Commercial Paper

183
 Comm
Paper
Commercial Paper
 Unsecured promissory notes are known
as commercial paper
 Large corporations borrow billions of
dollars in the money market through
these
 A study in U.S. found that 1000+
corporations were regularly selling
commercial paper to money market
investors
 Such paper consists of short-term
unsecured promissory notes issued by
well known companies that are
184
financially strong and carry high credit
 Comm
Paper
Funds raised for

 The funds raised are normally used for

current transactions such as:
 Purchase of raw materials
 Payment of accrued taxes
 Meeting of wage and salary obligations
 Other short-term obligations rather than for
capital account transactions.

185
 Comm
Paper
Bridge Financing

 These days a substantial number of

paper issues are used to provide
`bridge financing for long-term projects’
 Issuing firms usually plan to convert their
short-term paper into more permanent
financing when the capital market looks
more favourable.

186
 Comm
Paper
Buyers of Commercial Paper
 Paper is generally issued in multiples of
$1,000 & in denominations designed to
meet the needs of the buyer.
 It is traded mainly in the primary
market.
 Opportunities for resale in secondary
market are limited
 Investors are careful to purchase those
issues whose maturity matches their
planned holding periods. 187

 Comm
Paper
Credit rating
 Most issuers of paper enjoy a high credit
rating.
 To reduce risk for investors, borrowers
usually secure a line of credit at a
commercial bank for a small fee or a
deposit.
 The line of credit cannot be used to directly
guarantee payment if company goes
bankrupt.
 The lender may renege on the credit line if
the borrower has had a `material adverse
change’ in his condition. 188
 Comm
Paper
Letters of Credit
 Many issuers also take out irrevocable
letters of credit prepared by their banks.
 Such a letter of credit makes a bank
unconditionally responsible for repayment if
the corporation defaults.
 Banks usually charge 50 to 150 b.p. on
the amount of the guarantee that is
issued.
 Insurance companies and parent
companies of paper issuers also
guarantee issues of commercial paper.
189
 Comm
Paper
Types of Commercial Paper

 There are two major types of

commercial paper
 Direct paper
 Dealer paper

190
 Comm
Paper
Direct Paper
 The main issuers of direct paper are
 Large finance companies
 Bank holding companies
 Issuers deal directly with investors
rather than use securities dealers as
intermediaries.
 Such companies announce the rates
that they are paying on various
maturities
 Investors select maturities that closely
match their expected holding periods and
buy the paper directly from the issuer.
 Interest rates may be adjusted during the 191
day that the paper is sold to regulate the
 Comm
Paper
Direct Paper (Cont…)
 Leading finance companies that borrow
in the direct paper market include
 General Motors Acceptance Corporation
(GMAC)
 General Electric Capital Corporation (GE
Capital)
 Such firms have
 An ongoing need for short-term money
 Possess top credit ratings
 Have established working relationships with
192
 Comm
Paper
Direct Paper (Cont…)
 Directly placed paper must be sold in
large volume to cover the substantial
costs of distribution and marketing.
 On an average each direct issuer in the U.S.
borrows at least $1bn per month
 Issuers of direct paper do not have to
pay dealers’ commissions
 They must maintain a marketing division to
maintain constant contact with active
investors
 Issuers like Citicorp sell paper in weekly
auctions in which buyers bid for 193
 Comm
Paper
Funds used for
 Sometimes direct issuers must sell their
paper even when they have no need for
funds
 They have to maintain a good working
relationship with active investor groups.
 They also have to pay fees to banks for
supporting lines of credit.
 They have to pay agencies that rate their
issues
 They have to pay agents like trust
194
companies that collect funds and disburse
 Comm
Paper
Industrial Paper
 The other variety of commercial paper
is dealer paper that is issued by security
dealers on behalf of their corporate
customers.
 Such paper is also known as Industrial
Paper.
 This is issued mainly by non-financial
companies, smaller bank holding
companies and financial companies
 These borrow less frequently than
companies that issue direct paper. 195
 Comm
Paper
Buyers of Industrial Paper
 The issuing company may sell the paper
directly to the dealer who buys it less a
discount and commissions, and then
attempts to resell it at the highest
possible price in the market.
 Alternatively the issuing company may
bear all the risk with the dealer only
agreeing to sell at the best price
available less commissions.
 This is referred to as a best efforts
transaction.
196
 Comm
Paper
Value of Paper

 The value of paper outstanding has

grown rapidly due to various reasons.
 For large well known corporations
commercial paper is usually a cost
effective substitute for bank loans and
other forms of borrowing.
 This is especially true for non-financial firms
that issue paper through dealers.
197
 Comm
Paper
Growth of the Market
 The paper market has also grown
because of cutbacks in bank lending.
 Due to loan quality issues banks have
become more cautious.
 Another reason for the market’s rapid
growth is the high quality of most
paper.
 Many investors regard paper as a high
quality substitute for T-bills and other
money market instruments. 198
 Comm
Paper
Credit Enhancements

 The expanding use of credit

enhancements has also contributed to
the growth of the paper market. E.g.
 Standby letters of credit
 Indemnity bonds
 Other irrevocable payment guarantees

199
 Comm
Paper
Documented notes

 Such paper often referred to as

`documented notes’ usually carries the
higher credit rating of the guarantor
rather than the lower credit rating of the
issuer.
 In such cases even after paying the
guarantor’s fee the issuer saves on
interest costs. 200
 Comm
Paper
Yankee Paper
 Yankee paper  Foreigners also issue
paper in the U.S. market.
 Issuers can often issue Yankee paper at
a cheaper rate than what it would cost
them to borrow outside the U.S.
 Foreign issuers generally pay higher
rates than American issuers of
comparable credit quality.
 This is to compensate American investors
for the difficulty of gathering information on
foreign issuers and the lack of name
recognition.
201
 Comm
Paper
International Paper - Yen

 Yen denominated paper was allowed in

1987 after Japanese companies
threatened to move their short-term
borrowing programs abroad.
 In 1988 foreigners were allowed to issue
Samurai paper in Japan.

202
 Comm
Paper
International Paper – Canada
 Like in the U.S. paper issues in Canada
must be backed by a bank line of credit
in order to catch the attention of the
market.
 The Canadian market has a broader
range of maturities ranging from 24
hours to a year.
 Paper in Canada tends to be issued in
large denominations usually $100,000+
 Most Canadian paper is therefore
purchased by large institutions rather
203
 Comm
Paper
International Paper - Euro

 The Euro-paper market evolved in the

1980s.
 The market sees large volumes because
issuers can tap foreign investors.
 Many U.S. firms which have had
difficulty borrowing at home due to low
credit quality have found the Euro
market to be less quality conscious.
204
International Paper – Euro Comm
Paper
(Cont…)
 Large investors in Euro-paper include:
 International banks
 Private corporations
 Foreign central banks
 In contrast U.S. paper is bought mainly
by money market mutual funds.
 Euro-paper is priced below the face
value and appreciates in value as
maturity approaches.
 The quoted interest rate is a discount
rate like in the case of T-bills. 205
 Comm
Paper
Example – Euro (Cont…)

 Assume that we wish to acquire Euro-

paper with a face value of $100MM and
a time to maturity of 90 days
 If the discount rate is 6%, the price
would be
100,000,000 - 100,000,000 x 0.06 x
(90/360)
= 98,500,000 206
International Paper – Euro Comm
Paper
(Cont…)

 There appears to be an active

secondary market for Europaper unlike

in the case of US paper.

 Average maturity of Europaper = 2

times average maturity of US paper.

207
 Comm
Paper
Maturity of US Paper
 Maturities of US paper range from 3
days (weekend paper) to 270 days
 Most paper has an original maturity of
60 days or less with an average
maturity of 20 to 45 days
 US paper is generally not issued with a
maturity exceeding 270 days
 Because any security with a maturity in
excess of 270 days must be registered with
the SEC

208
 Comm
Paper
Yield on Commercial Paper

 Yields are quoted on a discount basis

like in the case of T-bills
 Most commercial paper is issued in
discount form.
 Some corporations do sell interest
bearing or coupon paper

209
 Comm
Paper
Denomination for Paper
 The minimum denomination for paper is
usually $25,000
 Among institutional investors the
minimum denomination is usually
$1,000,000
 Notes are typically issued in bearer form
to make resale easier.
 On maturity, payment is made on
presentation to the bank which is
designated as the agent.
 Settlement is made in Federal Funds on
the same day.
210
 Comm
Paper
Advantages with paper market

 Advantages for companies that are

able to tap the paper market.
a. Generally rates are less than on bank
loans.

b. The effective rate on bank loans is higher

than what is quoted due to the need to
keep a compensating deposit.

211
 Comm
Paper
Example
 Take the case of a firm that borrows
$100MM @ 8% with a compensating
balance of 20%

 The effective rate is

8,000,000
___________ = 10%
80,000,000

212
 Comm
Paper
Advantages with paper market

a. Another advantage of borrowing in the

paper market is that rates are often
more flexible than bank rates.
 A company in need can quickly raise funds
through either dealer paper or direct
paper.
 Dealers maintain close contact with the
market and generally know where funds
can be found.
 Notes can be issued and funds raised on
213
the same day.
 Comm
Paper
Lending money
 Federal & state regulations limit the
amount of money that a bank can lend
to a single borrower
 For nationally chartered banks the
maximum unsecured loan that can be
granted to a borrower is 15% of the bank’s
capital and surplus.
 Corporate needs frequently exceed an
individual bank’s loan limit.
 A consortium of banks can be assembled -
but this takes time.
 In the paper market it is much easier to
arrive at agreements for large issues.
214
 Comm
Paper
Lending Money (Cont…)

 The ability to issue paper gives a

corporation considerable leverage when
negotiating with a bank.
 A banker who knows that his customer
can draw on the paper market is likely
to be more receptive and offer more
advantageous terms.

215
 Comm
Paper
Risk of Paper

 One risk of issuing paper is that of

alienating banks whose loans may be
needed should a real emergency arise.
 It must be remembered that paper cannot
be paid off at the issuer’s discretion but
must remain outstanding till maturity.
 In contrast many bank loans can be paid off
prematurely without penalties.

216
 Comm
Paper
Master Note
 A recent innovation in the direct paper
market
 This is frequently issued to bank trust
departments and other permanent
investors by finance companies.
 Under such an arrangement the
investing firm agrees to take some
paper each day up to an agreed upon
maximum amount.
 Interest is calculated on the daily
average balance of paper taken by the
investor.
217
 Comm
Paper
Medium Term Note
 An extension of the paper market is the
Medium Term Note.
 Such notes have maturities ranging
from 9 months to 10 years and are
issued by investment grade
corporations.
 They carry fixed rates of interest and
are generally non-callable unsecured
obligations marketed through dealers.
 Particularly suited for companies with
substantial quantities of medium term
assets
 E.g. who wish to balance such assets with
liabilities that are longer in maturity than 218
conventional commercial paper.
 Comm
Paper
Ratings and Rating Agencies
 Depending on the credit standing of the
issuer paper is rated as:
 Prime
 Desirable or
 Satisfactory
 Firms issuing paper generally seek
ratings from multiple issuers.
 It is extremely difficult to market unrated
paper.
 About 75% of the firms that currently sell
paper are prime rated.
 Generally notes bearing ratings from at
least two agencies are preferred by 219
investors.
 Comm
Paper
Rating Agencies
 Prominent rating agencies include:
 Moody’s Investors Service
 Standard & Poor’s Corporation
 Fitch Investor’s Service
 Canadian Bond Rating Service
 Japanese Bond Rating Institute
 Dominion Bond Rating Service
 IBCA Ltd.

220
 Comm
Paper
Summary of the Rating Systems

Company Higher Lower Speculati Defaulte

A/ Prime A/ Prime ve d
Below
Prime
Moody’s P-1 P-2, P-3 NP NP

S&P A-1+, A-2, A-3 B, C D

A-1
Fitch F-1+,F-1 F-2,F-3 F-5 D

221
 Comm
Paper
Credit Rating

 We will illustrate using S&P’s rating

scale.
 A-1= strong degree of safety for timely
repayment
 A-2 = satisfactory degree of safety
 A-3 = adequate safety
 B,C = risky or speculative
222
 D = default history
 Comm
Paper
Credit Rating

 Agencies are paid by the issuers of

paper.
 A good rating makes it easier and
cheaper to borrow
 However rating agencies always look at
the issue from the perspective of a
potential investor.
 Their credibility is based on their track
record from the standpoint of accuracy. 223
 Comm
Paper
Evaluation Criteria

 Rating agencies use the following

criteria.
 Strong management.
 Good position for the company in a well
established industry.
 Good earnings record.
 Adequate liquidity.
 Ability to borrow to meet both anticipated
and unanticipated needs. 224
Federal Agency Securities

225
 Fed Agency
Sec
Agencies
 US government attempts to aid
disadvantaged sectors e.g.
 Agriculture
 Housing
 Small businesses
 College students
 Government has created special
agencies to make loans to these sectors
 These agencies are large enough to
complete for funds in the open market

226
 Fed Agency
Sec
Types of Federal Credit Agencies

Government True Federal

sponsored agencies Agencies
They are federally They are legally a part
chartered but privately of the government
owned, and are quasi- structure
private institutions
The borrowing and The borrowing and
lending activities of lending activities are
these agencies are not reflected in the fed
reflected in the fed’s budget
227
budget
 Types of Federal Credit Fed Agency
Sec
Agencies…
Government True Federal
sponsored agencies Agencies
They are permitted to Securities are fully
draw on US Treasury for guaranteed by the credit
funds upto specified of the US government
limit with approval – but
securities are not
guaranteed by the fed
They have capitalization They operate with less
requirements which limit capital per dollar of debt
the rate of growth of
their debt obligations 228
 Fed Agency
Sec
Sources of borrowings

 Money market borrowings are done by:

 Sponsored agencies issue short term
coupon securities and variable notes
 Long term borrowing is done by issuing
debentures

229
 Fed Agency
Sec
Features of agency securities
 They are subject to fed income taxes
 Exempt from state and local taxes
 They are short to medium term with
maximum maturity of 10 years
 Longer term have denominations of as less
as $1,000
 Shorter term are usually sold in
denominations of $50,000

230
 Fed Agency
Sec
Solicitation Method
A fiscal agent in NY will
assemble a group of
bankers, dealers, brokers to This pricing information is
bring each issue to the conveyed to the fiscal agent
market

This solicitation group The day after the order

conveys to potential books are closed, the fiscal
investors the size, agent will price the new
denomination, maturity of securities and deliver them.
new issue

Investors are not told the

Investors do not know the
price of the new securities
prices/yields until after the
but are asked for their views
sale.
231
Bankers’ Acceptances

232
 BAs

What is a bill?
 It is an undertaking to pay a specified
amount of money at a future date –
upto 12 months in the future
 It is a form of short-term finance for the
debtor
 Bills can be sold in the money market at
any time prior to their maturity date
 Bills are classified on basis of the entity
which gives the undertaking to pay
 T-Bills
 Bank bills
 Trade bills
233
 BAs

Bills of Exchange
 In international trade when goods are
exported the exporter will draw up a
Draft or a Bill of Exchange.
 A Draft is an instrument that instructs
the importer to pay the amount
mentioned upon presentation.
 A Draft may be a
 Sight Draft
 Time Draft

234
 BAs

Sight Drafts

 In such cases the importer has to pay

for the goods on sight of the draft.
 His bank will not release the shipping
document until he pays.
 Such transactions are known as
‘Documents Against Payment’
transactions.

235
 BAs

Time Drafts
 These are also known as Usance Drafts.
 The bank will release the shipping
documents in such cases as soon as the
importer accepts the draft by signing on
it.
 The importer need not pay immediately.
 In other words the exporter is offering
him credit for a period.
 When the importer accepts a draft it
becomes a ‘Trade Acceptance’. 236
 BAs

Letters of Credit (LCs)

 Most international transactions are
backed by LCs
 An LC is a written guarantee given by
the importer’s bank to honour any
drafts or claims for payment presented
by the exporter.
 LC based transactions are more secure.
 Shipments under an LC can be on the basis
of a sight draft or a time draft.
237
 BAs

LC Based Transactions
 In the case of a sight draft the
importer’s bank will pay on
presentation.
 In the case of a time draft it will accept
it by signing on it.
 A draft that is accepted by a bank is
called a Banker’s Acceptance
 It is obviously more marketable than a trade
acceptance. 238
 BAs

The Market for BAs

 In the U.S. there is an active secondary
market for BAs.
 They are short term zero coupon assets
which are redeemed at the face value on
maturity
 BAs with a face value of 5MM USD are
considered to constitute a round lot.
 Once a BA is issued the exporter can get it
discounted by the accepting bank.
 i.e. he can sell it for its discounted value.
 he can sell it to someone else in the
secondary market.
239
 BAs

Credit Risk for BAs

 The credit risk involved in holding a BA

is minimal.
 It represents an obligation on the part of the
accepting bank.
 It is also a contingent obligation on the part
of the exporter.
 i.e. if the bank fails to pay, the holder has
recourse to the exporter who is the drawer of
the draft

240
 BAs

Trade Bills
 These are issued by a commercial
enterprise
 They are bills drawn by one non-bank
company on another demanding
payment for a trade debt
 They may be used for domestic /
international trade transactions
 Financial institutions will buy only the
finest trade bills in the market
241
 BAs

Bank Bills

 These are bills of exchange drawn on

and payable by a commercial bank

 A common form is a bankers’

acceptance

242
 BAs

Sterling Acceptance Credits

 These are facilities that provide for the
drawing of sterling bills of exchange by
a corporate customer on a bank
 The bills are immediately discounted
and the company receives the sale
value less the bank’s commission
 An acceptance credit facility will be
granted to the company by the bank
concerned for a specified credit limit

243
 BAs

Advantages for the company

1. It can raise short term finance in the

money market

2. It can get a relatively low rate of

interest

3. It provides the company with an

additional and flexible form of 244

 BAs

Procedure for Acceptance Credit

The client and the bank
agree to the establishment At maturity the bill will be
of a facility presented to the bank by
the holder

When client wants to draw

funds it will inform the bank The bank will debit the
– the bank will issue the bill client’s account with the
amount paid to the holder

The bank will have the bill

discounted in the market –
the proceeds will be given to
the client
245
Buying and Selling Bills - BAs

Illustration

 A co. has drawn a bill on HSBC for

$5,000,000
 Maturity  150 days
 The bank accepted it and sold it to
Barclays at a discount @ 5.25%
 30 days hence Barclays sold the bill to
ABN Amro at a discount @ 4.75%
246
 BAs

Illustration (Cont…)

 Purchase price:

5,000,000 [1 – (5.25/100) * (150/360)]

= $4,890,625
 Sale price:

5,000,000 [1 – (4.75/100) * (120/360)]

= $4,920,833.33

247
 BAs

Illustration (Cont…)

 Profit:

$4,920,833.33 - $ 4,890,625 = $

30,208.33

 ROI on a 360-day year basis

(30,208.33/4,890,625) * (360/30)

= 7.41%
248
Eurocurrency Deposits

249
 Eurocurrency
Deposits
What is Eurocurrency?

 It is a freely convertible currency

deposited outside the country to which

it belongs.
 Dollars deposited outside the US are

Eurodollars

 Yen deposited outside Japan are Euroyen

250
 Eurocurrency
Deposits
Illustration
 A french exporter ships champagne to a
New York importer accompanied by a
bill for $10,000
 The importing firm pays for the
champagne by issuing a cheque
denominated in dollars and deposits it
in a US bank – First American bank –
where the French firm has a checking
account
251
 Eurocurrency
Deposits
Illustration (Cont…)
 After the check clears the results are:
French Exporter’s Account

Assets Liabilities

Deposit in US Bank = $10,000

First American Bank’s Account

Assets Liabilities
Deposit owed to French Exporter
= $10,000
252
 Eurocurrency
Deposits
Illustration (Cont…)

 This is not a Eurodollar deposit since

deposit occurs in the US
 The French Exporter is offered an
attractive rate of return on its dollar
deposit by its own local Paris bank
 It moves its dollar deposit there
 Paris bank wants to loan these dollars to
other customers in the US

253
 Eurocurrency
Deposits
Illustration (Cont…)
 The 4 transactions will be:
French Exporter’s Account

Assets Liabilities

Deposit in US Bank = - $10,000

Deposit in Paris Bank = + $10,000

First American Bank’s Account

Assets Liabilities
Reserves transferred to Deposit owed to French Exporter
Correspondent Bank = - $10,000 = - $10,000
254
 Eurocurrency
Deposits
Illustration (Cont…)

US Correspondent Bank’s Account

Assets Liabilities
Reserves transferred from Deposit owed to Paris Bank =
First American Bank = $10,000
$10,000
Paris Bank’s Account

Assets Liabilities
Deposit with US Correspondent Deposit owed to French Exporter
Bank = $10,000 = $10,000

255
Illustration (Cont…)

 Assume the Paris bank makes a loan of

$10,000 to a small oil company in
Manchester.
 The British company needs US dollars to
pay for shipment of petroleum drilling
equipment from Texas

256
 Eurocurrency
Deposits
Illustration (Cont…)

Paris Bank’s Account

Assets Liabilities
Loan to British company = +
$10,000
Deposit in Correspondent
Bank = - $10,000
British Oil Company’s Account

Assets Liabilities
Deposit with US Correspondent Loan from Paris Bank = $10,000
Bank = $10,000
257
 Eurocurrency
Deposits
Illustration (Cont…)

Paris Bank’s Account

Assets Liabilities
Deposit owed to French
Amount owed by British Oil
Company = + $10,000
exporter = $10,000

258