Money Markets Money Markets n…to facilitate the transfer of short-term funds from individuals, corporation and governments n…to maintain liquidity Money Markets Securities n…debt securities with maturity of one year or less n…issued in primary market to obtain short term financing n…liquidity provides by secondary market ncommonly purchase by households, corporations and government agencies nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Money Market Securities nT-Bills - government nCommercial paper - companies nNegotiable certificates of deposit - banks nRepurchase agreements- banks nFederal funds nBanker’s acceptance – banks (use companies) Treasury Bills (T-Bills) nIssued to meet the short-term needs of government nTypical q4-week, 13-week, 26-week maturities on a weekly basis nPeriodically issued T-Bills qCash management bills nThe par value (face value) was historically a minimum of $10.000, but now $1.000 and its multiples nNo pay any interest issue with dicount from par value qGain difference between par value and money paid nBacked by federal government qLow default (credit) risk nHigh level of liquidity qSecondary market and government security dealers q q Treasury Bills (T-Bills) nInvestors in T-Bills qDepository institutions nRetain portfolio nLiquidity qIndividuals (indirectly) nMoney market funds (liquidity) qCorporation nLiquidity n n Treasury Bills (T-Bills) nPricing T-Bills qNot pay interest qPriced at discount from their par value qPrice that investor will pay depends on investor‘s required rate of return qPrice = present value of the future cash flows to be received nPresent value of par value (face value) Pricing T-Bills Treasury Bills (T-Bills) nTreasury Bill Auctions qThe primary market with T-Bills is organized as an auction nCompetitively or noncompetitively (max. $5 million per auction) qIndividuals online bids www.treasurydirect.gov nhttp://www.treasurydirect.gov/instit/marketables/tbills/tbills.htm qFinancial institutions online by Treasury Automated Auction Processing System TAAOSLink q n n nTreasury bill auction—noncompetitive bids n ($5 million limit) qMay be used to make sure bid is accepted qPrice is the weighted average of the accepted competitive bids qInvestors do not know the price in advance so they submit check for full par value qAfter the auction, investor receives check from the Treasury covering the difference between par and the actual price n Noncompetitive Bidding nTreasury bill auction (fill bids in amount determined by Treasury borrowing needs) qBid process used to sell T-bills qBids submitted to Federal Reserve banks by the deadline qBid process nAccepts highest bids nAccepts bids until Treasury needs money n Competitive Bidding Treasury Bills (T-Bills) nEstimating the Yield qDifference between the selling price and the purchase price q nEstimating the T-bills discount qThe percent discount of the purchase price from par value nFor a newly issued T-Bills that will be held till maturity qT-Bill yield > T-Bill discount q n Commercial paper nShort-term debt instrument q20 and 45 days n1 day or 270 days (SEC, otherwise registered) nAlternative to bank loan nDealer placed vs. directly placed nUsed only by well-known and creditworthy firms nUnsecured nMinimum denominations of $100,000 qTypical denomination are in multiples of $1 million nNot a secondary market or very limited qSometime it is possible to sell the paper back to the dealer qIn most cases hold till maturity n Commercial paper nPlacement qDirectly qDealers nTransaction cost at 1/8 to 1 percentage of FV nBacking Commercial Paper qBackup lines of credit Commercial paper nEstimating of Yield qDo not pay interest qPriced at a discount qYield slightly higher than the yield on T-Bills with same maturity nCredit risk nLess liquid qThe nominal return nDifference between the price paid and the par value q Rating nRatings qCredit or default risk qIndicator of a the potential risk of default qMoney market funds – top or second tire (5 % of assets) rating qJunk commercial papers low or no rating nCredit risk during the Credit Crisis qHistorically the percentage of issues that have defaulted is very low Rating grades https://slacabos.files.wordpress.com/2011/10/schermata-10-2455841-alle-12-51-39.png Negotiable Certificates of Deposit (NCDs) nIssued by large commercial banks or depository institutions nMinimum denomination of $100,000 but $1 million more common nPurchased by nonfinancial corporations or money market funds nProvide return in he form of interest nMaturity qTwo week to one year nSecondary markets supported by dealers in security n Repurchase Agreements (Repos) nSell a security with the agreement to repurchase it at a specified date and price qLoan backed by securities nGovernment securities, commercial papers nBorrower defaults, lender has security nMaturity qFrom 1day to 15 days or 1, 3, 6 months nReverse repo name for transaction from lender nNegotiated over telecommunications network nDealers and brokers used or direct placement nNo secondary market Repurchase Agreements (Repos) nEstimating the Yield qDifference between initial selling price and the agreed-on repurchase price, annualized with a 360-days year Repo and Reverse Repo http://cfile8.uf.tistory.com/image/1221B0584D2E9423228290 Federal Funds nInterbank lending and borrowing nFederal funds rate usually slightly higher than T-bill rate qCredit risk nFed district bank debits and credits accounts for purchase (borrowing) and sale (lending) nFederal funds brokers may match up surplus and deficit using telecommunications network nUsually $5 million or more n Banker‘s Acceptance nA bank takes responsibility for a future payment qInternational trade transactions nExporters send goods to a foreign destination and want payment assurance before sending qBank acts as a guarantor nBank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time qThe importer will pay the bank what is owed to the exporter along with a fee to the bank for guaranteeing the payment nMaturity qFrom 20 to 270 days n Shipment of Goods 5 L/C 3 Shipping Documents & T ime Draft Draft Accepted (B/A Created) 7 Japanese Bank (Exporter’s Bank) American Bank (Importer’s Bank) Importer Exporter 2 4 6 nSource: Madura, J.: Financial Markets and Institutions, 9th Edition nSource: Madura, J.: Financial Markets and Institutions, 9th Edition nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Valuation of Money Markets Securities nPresent value of future cash flows at maturity (zero coupon) nValue (price) inversely related to discount rate or yield nMoney market security prices more stable than longer term bonds nYields = risk-free rate + default risk premium n nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Interest Rate Risk nRisk Premium among Money Market Securities qT-Bills slightly lower yields than the other securities nOthers offer compensation for credit risk nIf short-term interest rates increase, the required rate of return on money market securities will increase qPrices of money market securities will decrease qNot so sensitive as bonds nShorter term of maturity n nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Globalization of Money Markets nMoney market rates vary by country qSegmented markets qTax differences qEstimated exchange rates qGovernment barriers to capital flows nMoney market rates vary by country qSegmented markets qTax differences qEstimated exchange rates qGovernment barriers to capital flows nDeregulation Improves Financial Integration nCapital Flows To Highest Rate of Return n nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Globalization of Money Markets Globalization of Money Markets nEurodollar deposits and Euronotes qDollar deposits in banks outside the U.S. qIncreased because of international trade growth and U.S. trade deficits over time qNo reserve requirements at banks outside U.S. nEurodollar Loans qChannel funds to other multinationals that need short-term financing nEuro-commercial paper q n n International Interbank Market nPerformance of Foreign Money Market Securities qEffective yield nYield adjusted for the exchange rate q1. yield earned on the money market security in the foreign currency q2. the exchange rate effect q Globalization of Money Markets nPerformance of international securities nYield for an international investment Yf SPf – PPf PPf Yf = Foreign investment’s yield SPf = Investment’s foreign currency selling price PPf = Investment’s foreign currency purchase = Globalization of Money Markets nThe exchange rate effect (%ΔS) measures the percentage change in the spot during the investment period q q q% Δ S measures the expected percent change in the currency nCurrency appreciated, % Δ S is positive and adds to net yield nCurrency depreciated, % Δ S is negative and reduces net yield Summary nSurplus units channel investments to securities issued by deficit units nDebt securities markets qMoney Market qCapital Market nMoney market securities qShort-term qHigh quality qVery good liquidity n