Money Markets

Money Markets

• Short-term debt instruments• Maturity of < 1 year• Services immediate cash needs

– Borrowers need short-term “working capital”– Lenders need an interest-earning “parking space” for excess

funds

• Instruments trade in an active secondary market– Liquid market provides easy entry & exit for participants– Speed and efficiency of transactions allows cash to be “active”

even for very short periods of time (over night).

• Market size in 2008: .$ 8 Trillion

Money Markets

Large denominations – Units of $1 - $10 million– Transactions costs low in relative terms– Individual investors do not participate in this market

Low default risk– Only high quality borrower participate– Low time maturities reduce the risk of “changes” in borrower

quality

Insensitive to interest rate changes– Maturity (< 1 year) too short to be adversely affected, in general,

by changes in rates

Money Market Securities

• Treasury Bills• Federal Funds• Repurchase agreements• Commercial paper• Negotiable Certificates of Deposit (CDs)• Bankers acceptances

All of these instruments are what comprise YOUR money market investment account at your local bank

Money Market Participants(excluding brokers/dealers)

Security Borrower (issuer) Lender (investor)

Treasury bills U.S. Treasury (Federal Government)

Commercial banks, Mutual Funds, Corporations, etc.

Federal Funds & Repurchase agreements

Commercial banks, other FIs

Commercial banks, other FIs

Commercial paper Corporations, Commercial banks

Corporations, Mutual funds, other FIs

Negotiable CDs Commercial banks Corporations, Mutual funds, other FIs

Bankers acceptances Commercial banks Corporations, Community banks

Treasury securitiesIssued by Federal Government:

• Finance annual deficits (budget shortfalls)• Refinance maturing debt

Standard maturities: • 4, 13, 26 or 52 weeks (1, 3, 6, 12 months)

Denominations: • Face value $1,000• Round lots are sold as $5 million (new issues)

Risk:• Assumed risk/default free

Interest rate:• No coupon payment• T-bills sold at a discount to face value (implied rate of return)

Treasury Auctions(Primary Market)

Auction cycle: Weekly for 4, 13 & 26 week securities

Auction process: Single price auction (all winning bidders by the same)Competitive bids1. Requires $1 million minimum bid, generally made by dealers and large institutions2. Bidders submit a quantity and lowest yield (highest price) that they are willing to

accept3. No single bidder can win more than 35% of the issue.

Non-competitive bids: 1. Purchasers seeking less than $1 million do not participate in the auction2. Indicate the quantity of securities desired to be purchased at the stop yield3. Get preferential allocation (all bids are met)

Non-public bids:1. The Federal Reserve Bank participates in this market (open market transactions)

and submits the quantity that they wish to purchase2. This quantity is guaranteed similar to non-competitive bids.

Treasury Auctions Winning bid:

1. Competitive bids are sorted from lowest to highest yield (highest to lowest price)

2. After non-competitive and non-public purchaser orders are filled, the Treasury accepts the highest price (lowest yield) bids until the issuance is completed

3. The highest yield accepted by the treasury is the “stop yield”

4. Bidders above the stop yield are “shut out”

5. Bidders at the stop yield have their orders filled on a pro rata basis

yield (%) 3.503.52 > $7.5 Billion3.543.573.603.613.623.633.643.65

stop yield

stop yield

Pro rated

percentof facevalue

Source: www.publicdebt.treas.gov

Treasury Auctions

Quantity ofT-bills

Bid Price(% of face) 1

2

3

4

5

6

7

competitive total

Noncompetitive Bids$239 million

99.6633222%Stop yield

$15,522 million

$15,761 million

winners losers

Secondary Treasury MarketLargest of any Money Market security:

Participants: Buy for their own account or on behalf of their customers1. Government approved dealers (approx 20, designated by the NYFRB)2. Secondary dealers (approx 500 trade in secondary market)3. Commercial banks, insurance companies, pension funds4. Federal reserve bank

Trading: takes place between…1. Primary market dealers (fed wire transfers requiring no paper work)2. Dealers and their customers3. Volume greater than $100 billion daily (larger than NYSE)

Prices: determine the interest rate paid (T-bills are sold at discount)1. Dealers earn a bid-ask spread in secondary market

Regulation: Very little government oversight since traders are large institutions

Secondary Treasury Market

Federal Reserve Bank of New York

Transfers $10m. In T-bills fromJ.P. Morgan Chase to Lehman Brothers

Transaction recorded in Fed’s Book-Entry System

J.P. Morgan Chasesells $10m. In T-bills

Lehman Brothersbuy $10m. In T-bills

FedwireTransactionFedwire

Transaction

Individualbuy $50,000

in T-bills

Local Bank or Broker

J.P. MorganChase

sell $50,000in T-bills

FRBNY-$50,000 in T-billsfrom J.P. MorganChase’s account+ $50,000 T-billto Individual

Source: reprinted from Saunders Cornett “Financial Markets and Institutions, 3rd Edition”, McGraw-Hill Irwin, 2006.

Purchase by individual

Between government securitydealers

Federal FundsShort term transactions between financial institutions:

1. Term is generally over night/week-end2. Not backed by collateral - unsecured loans3. Highly liquid market4. Depository institutions use this market to buy/sell excess deposits in order to

manage their liabilities.5. For banks, this is sometimes referred to as “hot money”

Federal Fund Yields: 1. No coupon payment - sold at a discount2. Quoted rates assume a 360 day year, conversion ibond = iff (365/360)

Federal Funds Market:1. Trades take place between banks that buy/sell excess reserves held at their

federal reserve bank2. Banks or FIs that are not FRB members can use a correspondent bank (that is a

member) to conduct the transaction3. Transactions take place over the Fedwire

Repurchase agreementsDefinition: selling an asset with an explicit agreement to repurchase the asset

after a set period of time

Example: A bank has deficient reserves and needs to borrow overnight.1. Bank A sells a treasury security to Bank B at P0

2. Bank A agrees to buy the treasury back at a higher price Pf > P0

3. Bank B earns a rate of return implied by the difference in prices

4. Since the loan is backed by collateral, the rate is usually lower than the rate available in the Federal Funds market

5. Fed conducts open market transactions through RAs, using transactions that are generally less than 15 days.

iRA = Pf – P0

P0

360

daysx

Commercial Paper

Unsecured short-term promissory note: 1. Generally issued by corporations or financial institutions2. Sold directly to institutions or through dealers3. Is the largest (total $ value) of the money market securities4. Funds used to finance working capital requirements

Terms:1. Sold in denominations of $100k, $250k, $500k and $1 million.2. Maturity less than 270 days (registration required otherwise)3. Common maturities are between 20 and 45 days4. Sold at discount and held to maturity – no active secondary market5. Yields are quoted based on 360 day year

Issuers need good reputation to issue:1. Issuers must have excellent credit and be rated by a rating agency2. Low cost alternative to bank loans, but requires that lenders can tell your “type” –

the adverse selection problem3. Firms in trouble are immediately cut off from this market in the same way that

troubled banks are quickly cut off from the federal funds market• Tyco’s downgrade from tier 1 to tier 3 forced them out of the market

Negotiable Certificates of Deposits (CDs)

A bank issued time deposit: Not a demand deposit1. Fixed interest rate and maturity2. Terms are negotiable (e.g. 6 month at 4.1% or 1 year at 5.2%)3. Common maturities are less than 12 months4. These funds are more “certain” to banks that demand deposits that can leave at

any time.

Terms and Trading:1. Most CDs are sold directly to investors who hold to maturity2. Investors receive both principal and interest3. Rates are quoted using a 360 day year4. A network of about 15 brokers/dealers make a secondary market

Risk:1. Small CDs are similar to demand deposits wrt insurance2. Large CDs (called Jumbo CDs) are not federally insured through FDIC3. Large banks, with perceived lower risk due to too-big-to-fail (TBTF) doctrine, often

have lower rates than smaller banks

Bankers AcceptanceBanks act as intermediaries between trading partners:

1. Banks guarantee payments to secure orders of goods from manufacturers2. Are a type of “letter of credit” that guarantees a payment by the bank on a specific

date3. Particularly useful between foreign trading partners where there is a high level of

asymmetric information – Banks resolve this AI

Example: 1. Lubbock Acme Enterprises orders 50,000 Red Raider flags from a Peruvian textile

manufacturer2. The Peruvian manufacturer pulls out a globe to figure out where Lubbock is – they

have no idea who the buyer is.3. Since the Peruvian manufacturer has to retool the factor to make the flags, they want

some guarantee that Lubbock Acme is actually going to pay4. Lubbock Acme doesn’t want to pay until they know that they are going to get the

goods delivered as promised.5. Bank of America steps in as intermediary with a contract that provides a credible

delivery of payment once the goods are delivered.6. Bank of America agrees to pay the amount of the BA if the Lubbock Acme fails to

pay

Bankers AcceptanceLocality of BAs: San Francisco, New York and Chicago originate most BAs

• Only the largest banks engage in this market

Trading: 1. Trading of BAs take place on secondary markets until such time that the payment is

delivered2. Maturity is typically 30 to 270 days3. Denominations are bundled into $100,000 and $500,000 levels for trading4. If the manufacturer has an immediate need for cash, they can sell the BA prior to

delivery of the goods.

Risk: Default risk is low since both the bank and importer must default on payment, and resulting interest rates are low

EurodollarsEurodollar: U.S. dollars held as deposits in foreign banks

• Corporations often find it more convenient to hold deposits at foreign banks to facilitate payments in their foreign operations

• Can be held in U.S. bank branches or foreign banks• Dollar denominated deposits are referred to as Eurodollars

Risk:• They are not subject to reserve requirements • Nor are they eligible for FDIC depositor insurance (U.S. government is not interested

in protecting foreign depositors)• The resulting rates paid on Euro dollars are higher (higher risk)

Trading:• Over night trading as in the Federal Funds market• Eurodollars are traded in London, and the rates offered are referred to as LIBOR

(London Interbank Offered Rate)• Rates are tied closely to the Fed Funds rate• Should the LIBOR rate drop relative to the Fed Funds rate, U.S. banks can

balance their reserves in the Eurodollar market (arbitrage)

Money Market Rates