1 tarheel consultancy services manipal, karnataka
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1
Tarheel Consultancy Services
Manipal, Karnataka
2
Corporate Training and Consulting
3
Course on Fixed Income Securities
For XIM -Bhubaneshwar
4
For
PGP-II 2003-2005 Batch
Term-V: September-December 2004
5
Module-I
Part-VBasics of Money Market Securities
6
Introduction There are fundamental differences
between Money and Capital markets. The same borrower may tap both
markets to fulfill different needs. For instance, a corporate borrower may
issue long term bonds in the capital market to raise funds to build a factory.
The same borrower may issue commercial paper in the money market to finance his inventories.
7
Introduction (Cont…)
The purpose for which funds are borrowed therefore differs from borrower to borrower and often in the case of the same borrower from transaction to transaction. The different motives for borrowing
lead to the creation of different instruments with unique risk and return features.
8
Maturity Money market securities by
definition have an original maturity of one year or less. The term original maturity refers to
the maturity at the time of issue of the instrument.
The maturity of the instrument at a subsequent point of time is called its actual maturity.
9
Why Money Markets?
From the standpoint of both business entities as well as the government, inflows and outflows will rarely match.
Consequently at certain points in time, an enterprise may be in need of funds, while at other times, it may have a surplus.
10
Why? (Cont…) Take the case of a government. It will collect revenues primarily by way
of taxes. Such revenues tend to arrive in lumps
during certain months of the year. However the government has to incur
expenses throughout the year, both on account of developmental works as well as on account of wages and salaries.
11
Why? (Cont…)
Consequently during most of the year the government will be a borrower, and will issue T-bills to meet its short-term needs.
However at certain points in time when it is flush with tax revenues, it may turn a net lender for short periods and may buy back T-bills.
12
Why? (Cont…) The same it true for a business. The balance in a current account will
constantly fluctuate. If surplus funds are available a business
may temporarily park its funds in money market securities.
Else if there is a deficit it will issue instruments like commercial paper to raise short-term funds.
13
Perishable Money
Money is an extremely perishable commodity.
The longer money remains idle, the greater is the lost income.
And income that is lost can never be recovered.
We will give an illustration.
14
Illustration Assume that a corporation has a
surplus of 12 MM USD that can be invested at 12% per annum.
The year we will assume has 360 days, which is a standard assumption in money markets.
What will be the lost income if money remains idle for a day?
15
Illustration (Cont…)
Interest for a day:12,000,000 x 0.12 x 1/360 = $ 4,000.
Loss of income if money lies idle for a week = $ 28,000
16
Borrowers & Lenders
It is a difficult task to characterize an entity as a borrower or a lender.
An enterprise that is a borrower at one point in time may turn a net lender subsequently.
Certain institutions tend to be on both sides of the market at the same time.
17
Borrowers & Lenders (Cont…)
Take an organization like a commercial bank.
It may borrow short term in the money market by issuing negotiable certificates of deposit.
It may at the same time extend working capital loans to its clients.
18
Borrowers & Lenders (Cont…)
Governments inevitably are borrowers.
At any point in time, the U.S. Treasury is the largest borrower in the global money market.
19
Characteristics Investors are primarily concerned with
safety and liquidity. Liquidity is important because most
investments are for very short periods of time.
The global money market has a lot of depth and can absorb large issues of securities as well as redemptions without a significant price impact.
20
Characteristics (Cont…)
The market is an OTC network of securities dealers, banks, and funds brokers, who are linked by telephones and computers.
The market as a whole is supervised by the Federal Reserve and other central banks.
21
Characteristics (Cont…)
Speed is of the essence. Transactions are sealed and executed
in a matter of minutes or even less. Traders are constantly looking for
arbitrage opportunities and will routinely move funds from one part of the globe to another.
22
Characteristics (Cont…)
National money markets may be securities dominated or bank dominated.
Securities dominated markets are characterized primarily by the buying and selling of marketable securities. Examples include the U.S., U.K. and
Canadian markets.
23
Characteristics (Cont…)
In bank dominated markets most of the activity is in the form of inter-bank and bank-client deals. Examples include Japan, China, and
Korea.
24
Features of The Market It is a wholesale market.
Not for small investors. However they can participate indirectly through
MMMFs.
The money market facilitates large scale transfer of funds. For most banks except the Bank of America,
fund requirements usually exceed deposits. For smaller state and local banks, deposits
usually exceed fund requirements.
25
The Federal Reserve The Federal Reserve is the central
bank of the United States. It is a key component of the money
market. It consists of 12 member banks
located in the following cities.
26
The Federal Reserve System Boston New York Philadelphia Cleveland Richmond Atlanta
Chicago St. Louis Minneapolis Kansas City Dallas San Francisco
27
Open Market Operations
The money market is where the Federal Reserve carries out open-market operations. The term refers to the buying and
selling of Treasury securities by the FED in the secondary market.
This is done to regulate the money supply and influence interest rates.
28
Open Market Operations In order to increase the money
supply, the FED will buy Treasury securities.
To decrease the money supply, it will sell Treasury securities.
The decision to undertake such operations is taken by the Federal Open Market Committee (FOMC).
It is implemented by the Federal Reserve of New York.
29
Features of Trading Because of the large volumes involved,
skill and expertise in trading are of the utmost importance. Most traders specialize in narrow segments of
the market. The market is bound by a strict code of honour. Billions of dollars worth of business is
conducted over the phone, and no one reneges. The market is relatively unregulated and
therefore highly innovative.
30
Types of Instruments The most transactions in the global
money markets take the form of: T-bills Federal agency securities Dealer loans Repurchase agreements Bankers’ acceptances Commercial paper Eurocurrency deposits Federal funds
31
Volumes
As of 1998 over 700 billion worth of T-bills were outstanding constituting about 13% of the Federal government’s debt.
Large (over $100,000) face value CDs were outstanding to the extent of about 500 billion.
32
Volumes (Cont…)
Agency securities and commercial paper were outstanding to the extent of over 1 trillion dollars.
Bankers’ acceptances totaled about 15 billion.
And Eurocurrency deposits exceeded 2 trillion dollars.
33
Benchmark Rates The rates on various instruments
revolve around the prevailing T-bill rates.
T-bills are devoid of default risk and have a deep and active secondary market.
Consequently they have the lowest yields.
34
Benchmark Rates (Cont…) Federal agency securities are
perceived to be virtually riskless since it is unlikely that the government will permit them to fail.
However the market for such securities is less liquid.
Consequently the rate on such securities will be slightly higher.
35
Benchmark Rates (Cont…)
Federal funds which are low risk inter-bank loans also have rates which are fairly close to T-bill rates.
For instance the average T-bill rate in 1999 was about 4.40% where the Fed Funds rate was fairly close to 5%.
36
Treasury Bills
These are a direct obligation of the U.S. government.
By law these must have an original maturity of one year or less.
Which explains why the Treasury does not issue zero coupon instruments with a maturity exceeding one year.
37
T-bills (Cont…) The financial year for the U.S. government
runs from 1 October till 30 September. However most of its income by way of
taxes arises in April. Consequently even when the government
is running a surplus budget, it tends to have a shortfall during most of the year.
These temporary deficits are bridged by issuing T-bills.
38
T-bills (Cont…) The Treasury issues several types of
T-bills. Regular-series bills are issued at
fixed intervals by way of competitive auctions.
13 and 26 week bills are issued every week.
52 week bills are issued once a month.
39
T-bills (Cont…) Irregular series bills are issued only
when a special need arises. These take on two forms:
Strip bills Cash management bills.
A strip bill is essentially a series of bills with different maturities. Lenders have to buy the strip as a
whole.
40
T-bills (Cont…) Cash management bills are a re-opening
of an existing issue. What is a re-opening? Consider a six month bill that was issued
two months ago? It will have four months to maturity today. So if new four month bills are issued they
will essentially add to the size of the existing issue. This is the meaning of reopening a maturity.
41
Auctions The Treasury sells T-bills via an
auction procedure. That is, the price is determined by the
market based on competitive bidding, and is not set by the Treasury.
13-week and 26-week bills are issued every week.
52 week bills are issued once a month.
42
Auctions (Cont…) In the case of 13-week and 26-
week bills the auction is announced on Thursdays.
If Thursday were to be a holiday then it will be announced on the next business day.
Bidders have until 1 P.M. EST on the following Monday to submit their bids.
43
Auctions (Cont…) An investor can submit multiple bids.
That is he can bid at different yields. For instance an investor may bid for
$500,000 worth of bids at a yield of 5.01% and for an additional $500,000 at a yield of 5%.
Bids have to be submitted at one of the 37 Federal Reserve banks and their branches or at the Treasury’s bureau of public debt.
44
Auctions (Cont…) Bids may be submitted by person or by
mail, or may be submitted electronically through a securities dealer.
Online bidding is also possible at www.publicdebt.treas.gov
Most dealers do not charge commissions for T-bills bought at auctions, but they may levy a processing fee.
45
Auctions (Cont…) For bids that are filed directly with the
Treasury or through Federal Reserve banks obviously no commissions are payable.
Investors may choose to hold a Treasury Direct account.
For such account holders interest payments and principal repayments can be credited directly to their bank accounts.
46
Auctions (Cont…) Instructions can be given by such
account holders to have the proceeds from maturing issues to be automatically reinvested in new issues.
There is no service charge for accounts with a face value of less than $100,000.
For higher balances there is a small maintenance fee.
47
Auctions (Cont…) The Treasury permits both
competitive as well as non-competitive bids.
Most individual bidders submit non-competitive bids.
Such bidders indicate only the quantity sought and agree to accept the yield that is determined by the auction process.
48
Auctions (Cont…) Institutional investors however submit
competitive bids by indicating both the quantity sought and the minimum yield that they are prepared to accept.
Non-competitive bids cannot be for more than $1,000,000 per bidder in the case of T-bills, and for $5,000,000 per bidder in the case of T-notes and bonds.
49
Auctions (Cont…)
The Treasury generally accepts all non-competitive bids.
Once the bids are received, the amount sought by non-competitive bidders is first subtracted from the total issue quantity.
All competitive bids are then ranked.
50
Auctions (Cont…) In a price based auction bids will be
ranked in descending order of price. In a yield based auction they will be
ranked in ascending order of yield. All bids are required to be submitted to
three decimal places. In principle the Treasury can conduct a
uniform price/yield auction or a discriminatory price/yield auction.
51
Auctions (Cont…) Of late the Treasury has been
conducting only single yield auctions.
In a uniform yield auction, all successful bidders get the bills at the market clearing yield.
In a discriminatory yield auction, all successful bidders get the bids at the yield that they bid.
52
Example Assume that the Treasury has
announced an issue of $500,000,000.
Non-competitive bidders have bid $75 MM.
So $425 MM will be offered to the competitive bidders.
Assume that the following bids have been received.
53
Example (Cont…)
Bidder Yield Quantity
ABC Investments
5.010 25,000,000
XYZ Investments
5.070 75,000,000
Merrill Lynch 5.035 150,000,000
GE 5.050 100,000,000
Morgan Stanley 5.035 200,000,000
Orange County 5.080 125,000,000
Bank of Japan 5.025 120,000,000
54
Example (Cont…)
The bids will be ranked in ascending order of yield, and the aggregate demand will be determined.
55
Example (Cont…)Bidder Yield Quantity Aggregate
Quantity
ABC Investments
5.010 25,000,000 25,000,000
Bank of Japan 5.025 120,000,000 145,000,000
Merrill Lynch 5.035 150,000,000 295,000,000
Morgan Stanley
5.035 200,000,000 495,000,000
GE 5.050 100,000,000 595,000,000
XYZ Investments
5.070 75,000,000 670,000,000
Orange County
5.080 125,000,000 795,000,000
56
Example (Cont…)
Allocation will begin from the top. ABC Investments will receive 25 MM. That will leave 400 MM. Bank of Japan will get 120 MM. That will leave 280 MM. Both Merrill Lynch and Morgan
Stanley have bid 5.035.
57
Example (Cont…)
Their total bid is for 350 MM. Since only 280 MM is available, pro-
rata allocation will take place. Merrill Lynch will get 3/7 of 280 MM,
while Morgan Stanley will get 4/7. So Merrill Lynch will get 120 MM and
Morgan Stanley will get 160 MM.
58
Example (Cont…)
The remaining bidders will get nothing.
They are said to be shut-out. The market clearing yield of 5.035
is called the stop-out yield. All non-competitive bidders will get
the quantities that they asked for at this yield.
59
Example (Cont…)
Although the remaining bidders have been shut-out they can always buy in the secondary market after the auction.
60
Discriminatory Yield Auction What if the above auction had been
conducted on a discriminatory yield basis? ABC would get 25 MM at 5.010. Bank of Japan would get 120 MM at 5.025. Merrill Lynch and Morgan Stanley would get
120 MM and 160 MM respectively at 5.035. The remaining bidders would be shut-out.
61
Discriminatory (Cont…) All non-competitive bidders would get the
quantities sought by them at a weighted average of the successful bids.
The average in this case would be:25 x 5.010+120 x 5.025+280 x 5.035___ ___ ____425 425 425
= 5.0307
62
T-bills These days all bills are issued in book
entry form. The minimum denomination is $1,000. They trade in multiples of $1,000
thereafter. They are zero coupon instruments. The income for an investor is equal to
the difference between the price and the face value.
63
T-bills
As per Federal law the income is treated as ordinary income and not as capital gains.
Income is subject to Federal taxes but is exempt from state and local taxes.
64
Calculation of The Discount
For all calculations involving money market instruments the year is assumed to have 360 days.
Let us use the following symbols: V = Face Value Tm = Days to Maturity d = Quoted Yield
65
Price Calculation
Dollar Discount: D = d x V x
360mT
Price = P = V - D
66
Example
A bill with a face value of $1,000,000 has 80 days to maturity.
The quoted yield is 8%. D = 1,000,000x.08 x
360
80
= 177,77.78
P = 1,000,000 – 177,77.78 =$982,222.22
67
Rate of Return
The rate of return if the bill is purchased at this price will be greater than the quoted yield.
R.O.R =
.
22.222,982
22.222,982000,000,1 80
360x
= 8.1448%
68
Primary Dealers Who is a primary dealer? A primary dealer is one who is
authorized to deal directly with the Federal Reserve Bank of New York.
To qualify as a Primary Dealer the dealer must agree to make a market in government securities at all times and is required to post a capital of 50 MM USD.
69
Primary Dealers (Cont…)
More than one-third of all primary dealers are controlled by corporation outside the U.S – in Canada, the U.K. Switzerland, Hong Kong, and Japan.
By getting primary dealer status, these dealers get a solid foothold in the U.S.
There are currently 30 primary dealers.
70
Primary Dealers (Cont…)
In addition to these dealers there are more than 1500 other dealers who perform a variety of dealing and market making functions in the Treasury market.
The primary dealer system was established by the Federal Reserve.
71
Primary Dealers (Cont…) What is the advantage of having
primary dealers? It enables the central bank to conduct
its monetary policy efficiently with a small group of well capitalized dealers.
These dealers are expected to participate in Treasury auctions, to distribute Treasury issues, and to make a market in them.
72
Repos
A Repo or a repurchase agreement is an arrangement that facilitates the borrowing of funds by a dealer.
Under this arrangement the dealer will sell the securities to another party with a simultaneous commitment to buy it back later at a fixed price plus interest.
73
Repos (Cont…)
Thus a repo is a temporary extension of credit that is collateralized by marketable securities.
Dealers routinely take positions in debt securities.
If a dealer anticipates that interest rates will fall he will take a long position.
74
Repos (Cont…) He will either hold the security as
an investment or else will wait for a client to come along.
The question is, how will he finance this position.
After all a dealer’s capital is limited and dealers often hold positions that are as high as 40 times their capital in value.
75
Repos (Cont…)
This is where repos come in. Take the case of a dealer who is
looking for a 30 day loan and is willing to pledge T-notes as collateral.
76
Repos (Cont…)
Assume that the accrued interest is $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% per
annum. The haircut is 0.005 price points.
77
Repos (Cont…)
What is this haircut? The lender has to protect himself
against the risk that the market value of the collateral may decline.
Hence he will not lend the full value of the collateral but will apply a discount.
This discount is called a haircut.
78
Repos (Cont…)
The amount that can be borrowed against the securities is:
5,000,000(1.009375 - .005) + 205,700= $5,227,575
The amount due at maturity is this principal plus interest.
Interest = 5,227,575x.09x360
30
= $39,206.81
79
Repos (Cont…) Notice that the haircut is applied to the
clean price and not to the accrued interest.
This is because the accrued interest is not a function of yield.
During these 30 days there will be fluctuations in the value of the collateral.
These must be regularly monitored to ensure adequate collateralization.
80
Types of Repos Most repos are done on an overnight
basis. Typically a dealer will locate a
corporation or MMMF which has funds to invest overnight.
Some dealers may also undertake long term speculative positions, which consequently need to be financed for longer periods.
Such repos are called Term Repos and carry a higher rate of interest.
81
Types of Repos (Cont…)
Some Repos are known as Continuing Contracts.
They have no explicit maturity date but may be terminated at short notice by either party.
These days repos with bells and whistles are available.
82
Types of Repos (Cont…)
In the case of a Dollar repo the borrower can ask for a security that is similar to what was sold a the outset, but is not necessarily the same.
In a Flex repo the lender can take back a part of the loan whenever required.
Thus it is like a bank account.
83
Collateral for Repos Most repos are collateralized by
government securities. Sometimes other money market
instruments like commercial paper and BAs may be used.
84
Credit Risk
In practice both the borrower and the lender are subject to credit risk. If interest rates rise sharply, the value
of the collateral will decline and the lender will be vulnerable.
In this case, if the borrower were to go bankrupt, the lender will be left with assets which may be worth less than the loan amount.
85
Credit Risk If interest rates decline the value of
the collateral will rise. Now if the lender goes bankrupt, the
borrower will be left with an amount that is less than the market value of the securities.
There is no strategy which will reduce the risk for both the parties.
Increasing protection for one means enhanced risk for the other.
86
Credit Risk The lender can ask for margin.
What this means is that he can lend less than the market value of the assets.
But this will increase the risk for the borrower.
The borrower can ask for reverse margin. That is, he can ask the lender to lend more
than the market value of the securities. But this will increase the risk for the lender.
87
Credit Risk
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.
88
Haircuts
The size of the haircut would depend on: The maturity of the collateral. Its liquidity. Its price volatility. The term to maturity of the repo, Creditworthiness of the borrower.
89
Market Risk and Marking to Market Market risk is the risk that the
value of the collateral may decline. To reduce market risk, the collateral
must be periodically marked to market.
That is the market value of the security should be checked to see if it is adequately in excess of the loan amount.
If not more collateral should be asked for. Or else a partial return of cash must be
demanded.
90
Repos (Cont…)
In the case of an ordinary repo there will be a single interest rate that is applicable for the duration of the loan.
In the case of a continuing contract the rate will change from day to day.
The interest will be calculated on a daily basis but will be collected at the end.
91
Repos (Cont…)
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.
92
Repos (Cont…)
Thus every repo must be matched by a reverse repo.
Thus a dealer looking to borrow funds will do a repo.
A dealer looking to place funds will do a reverse repo.
93
Repos (Cont…) Who will do a reverse repo? A repo will be done by a person who
wants to finance a long position. That is he will buy the security and
do a repo thereby getting the funds to pay for the long position.
He will have to pay interest on the funds borrowed.
94
Repos (Cont…) However he will be entitled to any
coupons and accrued interest from the underlying security.
A dealer who wishes to go short in a debt security will borrow and sell it, and will pledge the cash proceeds as collateral.
This will be an example of a reverse repo transaction.
95
Repos (Cont…)
In this case the short seller will earn the reverse repo rate on the cash proceeds.
But will be eligible to pay any coupon or accrued interest for the period for which he is short.
96
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.
97
Repos (Cont…) Most government securities can be bought
at a rate called the general collateral rate. Thus most securities are close substitutes
for each other. But sometimes a security may be in high
demand. If so the lender may charge a lower rate. Such rates are called special repo rates.
98
Banker’s Acceptances (BAs)
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 or a Time Draft.
99
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.
100
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.
101
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.
102
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.
103
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.
104
The Market for BAs Once a BA is issued the exporter can
get it discounted by the accepting bank.
That is he can sell it for its discounted value.
Or he can sell it to someone else in the secondary market.
105
The Market for BAs
The credit risk involved in holding a BA is minimal. This is because it represents an
obligation on the part of the accepting bank.
In addition it is also a contingent obligation on the part of the exporter.
That is if the bank fails to pay, the holder has recourse to the exporter who is the drawer of the draft
106
Negotiable Certificates of Deposit A CD is an instrument issued by a bank
in return for a time deposit. The term negotiable indicates that there is
an active secondary market where these deposit receipts can be bought and sold.
As per Federal law a CD must have a minimum maturity of 7days. There is no ceiling on the maturity.
Most CDs have maturities ranging from one to three months.
107
CDs (Cont…) A CD must be issued at par. In practice banks issue many types
of CDs. A true money market CD must be
negotiable, and have a denomination of $100,000+.
CDs usually trade in market lots of 1 MM dollars.
108
CDs (Cont…) Rates are set by negotiations between
borrowers and lenders and are a reflection of prevailing market conditions.
The concept started in 1961 when Citibank started offering this to large corporate customers and organized a group of dealers to make a secondary market.
109
CDs (Cont…) The motivation was the following. Over a period of time, corporate
Treasury managers had found that instruments like T-bills and repos were excellent short term investments.
Thus banks which were losing business came up with this innovative instrument.
110
CDs
CDs may be issued in registered form or bearer form.
Those issued in bearer form are more easily tradeable.
Denominations range from $25,000 to $10 MM. Most traded CDs have denominations of $1,000,000.
111
CDs (Cont…)
Maturities can be as long as 18 months.
Most traded CDs have a maturity of 6 months or less.
CDs with maturities in excess of one year are called Term CDs.
112
CDs (Cont…) CDs issued by large, financially
sound banks are called Prime CDs. Those issued by smaller and less
sound banks are called Non Prime CDs.
CDs are insured up to $100,000. Buyers include banks, corporations,
foreign central banks and governments, HNIs and institutions.
113
CDs
Insurance companies. Pensions funds, insurance companies, and MMMFs are large buyers.
They find CDs to be attractive because they are liquid, carry low risk and can be issued for any desired maturity.
114
CDs (Cont…)
These days floating rate CDs with up to 5 years to maturity are available.
Interest is reset every 30, 90 or 180 days.
The gap between reset rates is called the leg or roll period.
115
CDs CDs are interest bearing instruments
and not discount instruments. So to get a certificate with a face value of
$100,000 one has to actually deposit $100,000.
CDs pay interest on an Actual/360 basis.
116
Example Assume that you deposit 1MM USD
for 270 days at a rate of 10% per annum.
At maturity you will receive the principal plus interest equal to:1,000,000x.10x 270
------- = $ 75,000360
117
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 and insurance premia.
118
Illustration
A bank is quoting 8% per annum on a 3 month deposit.
Reserves are 5% and are non-interest bearing.
So effectively $8 of interest is being offered on $95 of usable funds.
Effective rate = 95
8= 8.42%
119
Illustration
The insurance premium is 8.33b.p. So the effective cost is 8.42 + .0833 = 8.5033%
120
Commercial Paper (CP)
Commercial Paper is a short term unsecured promissory note. Unsecured means that the loan is not
not backed by a pledge of assets. Thus it is backed only by the liquidity
and earning power of the borrower. CP markets are wholesale because
the denominations are large.
121
Commercial Paper For a large credit worthy issuer CP
issues offer low cost alternatives to a bank loan.
Unlike T-Bills CPs carry a risk of default.
Consequently investors demand higher yields.
122
Sale of Paper Most paper is sold through dealers who
buy it from the issuer and resell it mainly to banks. They get a fee for this. Dealers also provide advice on what rate to
offer on newly issued paper. Dealers also undertake to buy unsold paper.
Large and regular issuers of paper often employ their own sales force.
123
Rating of Commercial Paper
Paper is rated by one or more of the following main rating agencies in the U.S. Moody’s Standard and Poor Duff and Phelps Fitch
124
Summary of the Rating Systems
Company HigherA/ Prime
LowerA/ Prime
SpeculativeBelow Prime
Defaulted
Moody’s
P-1 P-2,P-3 NP NP
S&P A-1+,A-1
A-2, A-3
B, C D
Duff & Phelps
Duff-1+,Duff-1,Duff-1-
Duff-2,Duff-3
Duff-4 Duff-5
Fitch F-1+,F-1
F-2,F-3 F-5 D
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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 D = default history
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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. This is because their credibility is based on
their track record from the standpoint of accuracy.
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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.