IFS Assignment

Money Market Instruments T-bills as a measure to control Inflation by RBI

By: Robin Kapoor F-12

IFS Assignment
Money market is a financial market in which financial claims with maturities of one year or less are traded. The money market exist so that people, corporation and government units can borrow funds when needed or lend or invest funds to earn interest for a short period of time (liquidity financing). The money market investments therefore are characterizes by three fundamental characteristics. They have: ►Low default risk (issued by high quality borrowers) ►Low price risk (maturity is short---- one year or less) ►Low marketability risk (they can be resold easily) In addition, they ►Have low transaction cost ►Transactions are in large denominations (1 million to 10 million) The international financial market where short term trading takes place is called the money market. The money market is meant to make available the liquid funding to the financial system of the world and this liquid funding is provided for a short period. The trading of the money market consists of the Treasury Bills, Commercial Paper, etc. As a financial market; money market is very much secured in comparison to the other markets. The main participants or the borrowers and lenders of this market are the financial organizations, huge corporations and the governments of various countries. The participants of the market take part in the proceedings to make sure that their money resources are in a good condition. It may have much similarity with the bond market but the primary difference is between the participants of both the market. Again the money market is, as described, a short term market but the bond market is usually a long term market. The money market deals in the 'paper', which is a financial instrument for a short span of time. The term generally consists of 12-13 months. When national governments or the giant corporations borrow money, it is a money market. The proceedings of the money market and the stock market are very close to each other but both are not the same thing. The main difference is the huge funds that are dealt by the money market. Again, the stock market is meant for the individuals but the money market has some different trends and the individual investor has very little to do in this market. 2 Robin Kapoor, F-12

IFS Assignment
Although the returns of this market are comparatively low, the security factor of the market prompts the investor to put his or her money in this market. According to the trend, any individual investor cannot enter the market directly simply because of the giant size of the participants. But through the money market mutual funds, an individual can take part in the proceedings. The treasury bills are another portion provided to the individual investor.

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IFS Assignment
The major participants are: 1- Commercial Banks They need to adjustment their liquidity positions. They participate in the money market because of their: • • • short-term nature of their liabilities. wide variation in loan demand. legal reserve requirement imposed by the central bank regulation.

They sell and buy different money market instruments to borrow money or to make investment. 2- The Central Bank It is the most important participant in the money market. It does not have liquidity problem because it controls the supply of money. It uses the money market to: • • • conduct its monetary policy through Open Market Operations conduct its discount window operation, where banks can borrow its funds. lend its funds through this discount window (overnight borrowing)

3- The Treasury And Treasury Security Dealers Government have liquidity problem, because of timing of its expenditure and receipts. It uses the money market to finance its budget deficit. It also uses the money market to finance its debt, although most of this is done by issuing long-term securities sold in the long-run capital market. Treasury security dealers participate in the money market by making market for treasury securities. They stand ready to sell and buy from the inventories at their own risk. 4- Corporations They have liquidity problem because of timing of cash inflows and cash outflows. They use the short-term money markets to adjust their liquidity positions. They use the long-run capital market to finance investment in capital and new plants.

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IFS Assignment
Money market instruments (or claims) include: 1- Treasury bills (T-Bills) 2- Negotiable certificates of deposits (CD) 3- Commercial papers (CP) 4- Banker’s acceptance 5- repurchase agreements 6- Government agency securities (Federal agency securities) 7- Central Bank funds (Federal funds) 1. TREASUERY BILLS (T-Bills) Treasury bills are direct obligations of the government. • • • • • • • issued by Treasury Department to finance budget deficit. They have no default risk and no or little price risk and a strong secondary market. They are considered ideal money market investment. They are issued with maturities of 3-6 months, and rarely for one-year. They are issued in large denomination of 10,000, 15,000, 50,000, 100,000 and I million $. Their market is a wholesale market. They are sold on a bank discount base. (how? Pricing of T-bills)

PRICING OF TREASURY BILLS (T-Bills): Treasury bills are priced on bank discount rate bases. The bank discount rate is calculated using the following formula Face value – Price rd = --------------------------Face Value 360 X ---------------------------- X 100 Days to maturity

Where rd is the bank discount rate.

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IFS Assignment
Example: Calculate the bank discount rate on a $100,000 face value T-bills priced at $97,500 maturing in 181 days. Solution: $100,000 - $ 97,500 $100,000 361 181

rd = ------------------------------- X ----------- X 100 = 4.97%

The bank discount rate understates the true rate of return on T-bills because: • • • It assumes the full face value is paid for the T-bill rather than a discount market price. The length of the year is taken 360 day rather than 365 or 366 days. Interest earned can be reinvested along with the principal. (This is ignored when calculating rd). Because of these problems a Bond Equivalent Yield (BEY) is calculated and published for T-bills. Bond Equivalent Yield (BEY) assumes: ► The years is 365 days ► The price rather than the face value is invested in the T-bill. ► Interest is paid semiannually (every 6 months), so that principal and interest payments are reinvested. To compute the BEY: (3 steps)

1- Calculate price of T-bill.
2- Calculate effective annual rate or yield or compound annual rate of return. 3- Convert the effective annual yield into a Bond Equivalent Yield assuming interest rate is paid semiannually. Example: Calculate the Bond Equivalent Yield (BEY) of a $100,000 T-bills maturing in 181 days if bank discount rate is 4.97%. 6 Robin Kapoor, F-12

IFS Assignment
Solution: 1- Price of T-bills is given by: D P = FV – (FV X rd X --------) 360 Where: P = price; FV= Face Value; rd = Bank Discount Rate; and D = maturity From the information given we have: FV = 100,000; rd = 4.97 (=0.0497); and D = 181. So’ the price of this T-bill is: 181 P = 100,000 – (100,000 X 0.0497 X ----------) 360 = 100,000 – 2,500 = $97,500 2- calculate EAY (Effective Annual Yield): Effective annual yield is given by the formula: FV Effective annual yield = [(---------) 365/D - 1] X 100 P 100,000 = [(----------------) 365/181 - 1] X 100 97,500

= [(1.026)2 - 1] X 100 = 5.27 (> rd).

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IFS Assignment
3-Convert EAY into a BEY by assuming rate is paid semiannually: The formula to use is: BEY = 2 X [√1+effective yield /100 – 1] X 100% or = 2 X [(1+effective yield/100)1/2 - 1] X 100 In our example then, the BEY is: BEY = 2 X [√1+5.27/100 – 1] X 100% = 2 X [(1+5.27/100)1/2 - 1] X 100 = 2 X [(1.0527)1/2 - 1] X 100 = 5.20 < effective yield always because interest is semiannually. We note that EAY > BEY > rd always. So the best compression yield for competing different money market instrument is effective annual yield. Note that the BEY can be approximated by the formula: FV – P P Example: Calculate the BEY for a 180-day T-bill that is purchased at 6% “ask” price. Solution: we have to calculate the price of this T-bill first, and then use it to calculate the BEY as follows: D P = FV – (FV X rd X --------) 360 365 D

BEY = -------------- X ---------

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IFS Assignment
180 = 100 – (100 X 0.06 X --------) = 97 360 FV – P P 365 D 100 – 97 97 365 180

BEY = ------------------ X --------- = -------------- X --------- = 6.27%

Treasury Bills, also known as "T-Bills," are bonds that are issued by the US government, making them important both to the American economy and the world of finance. Although many people think The United States Department of Treasury is responsible for issuing these, they are actually issued by the Bureau of Public Department. Treasury Securities come in four separate denominations: Treasury Bills, Notes, Bonds, and Savings Bonds. Second to Savings Bonds, they are the most popular in the various secondary markets and easy options to use. The Treasury Bills do not yield any interest before they mature. They are usually sold at discounts on their respective face values. In that respect they are like zero-coupon bonds. At the time of maturity the consumer is rewarded with positive returns. Investors in the US consider these Bills to be the safest forms of investment. The average term periods range from 28 days to 91 with a maximum of 130 days. Financial organizations like banks and primary dealers are the biggest consumers of T-Bills.

2. Negotiable Certificate of Deposit (CD) Banks satisfy their short-term borrowing needs, by: 9 Robin Kapoor, F-12

IFS Assignment
issuing CDs; and purchasing central bank funds sold.

A negotiable CD is simply a bank time deposit that is negotiable. Because the receipt is negotiable, it can be traded any number of times in the secondary market before its maturing. So: • • • • CDs are a bank negotiable time deposit. The rate paid by bank is negotiated between the bank and the buyer. Sold in large denomination (range from $100,000 to $10 million). Have short maturities.

Factors affecting their rate include: current money market condition. rates paid by competing banks on their CDs. yield on other similar short-term instruments or securities. the issue characteristics of the CDs like default risk, call and put options.

The Certificates of Deposit are also called CD in the United States. These monetary products act as a form of time deposit and are normally brought out for public usage by financial institutions like the banks, credit unions and thrift institutions. The certificates of deposit are like the savings accounts by virtue of being fully insured and free of any form of risk. The certificates of deposit are insured by the Federal Deposit Insurance Corporation and the National Credit Union Administration in the United States. While the National Credit Union Administration is responsible for the certificates of deposit issued through the various credit unions, the Federal Deposit Insurance Corporation is in charge of insuring those issued through the banks. The certificates of deposit are different from the savings accounts in the sense that they have a stipulated period of maturity. The interest rates of the certificates of deposit are normally fixed, which not the case with the savings accounts is. The holders of certificates of deposit normally retain ownership till the point of maturity, when the sum could be drawn back along with the interest. The interest rates of the certificates of deposit are directly proportional to the principal and the term period. 10 Robin Kapoor, F-12

IFS Assignment
The interest rates of the certificates of deposit are inversely proportional to the stature of the bank that issues them. It has been observed that the personal certificates of deposit accounts have higher rates of interest compared to the business certificates of deposit accounts. There are certain certificates of deposit that are not insured like the callable certificates of deposit and the brokered certificates of deposit. The callable certificates of deposit are like the traditional certificates of deposit with the sole exception being the bank's right to purchase the particular money market instrument. The difference between the conventional certificates of deposit and the brokered certificates of deposit lies in the fact that the latter are owned by a group of investors who are not related.

3. Commercial Papers • • issued by large corporations to finance short-term borrowing needs. oldest money market instruments.

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IFS Assignment
• • • • short maturity (one to 2 months). strong secondary market, and so is quite liquid. Sold in large denominations. Purchased mainly by commercial banks, large insurance companies, and non-financial firms. The basic reason firms issue commercial paper is to achieve interest rate savings as an alternative to bank borrowing. Commercial Paper is primarily a form of security traded in the money market. The commercial papers are brought out by the financial institutions like the major banks and corporations. The commercial papers are not meant to act as a medium of financing investments for longer-term periods. Usually the commercial papers are used to generate working capital; the commercial papers could even be utilized for buying inventories. Since the worth of commercial papers is on the higher side individual investors are not able to accrue them. The most traditional buyers of commercial papers are the money funds. The commercial papers are amongst the safest investment options in the United States, even though the returns from them are not on the higher side. The various types of commercial papers are as follows: • • • • Promissory Notes Drafts Checks Certificates of Deposit

In the United States the commercial papers need not be enlisted with the United States Securities and Exchange Commission, as their respective maturity periods never surpass nine months. Yet another reason for this could be that the returns accrued from the commercial papers are normally employed for current transactions. The commercial papers in Canada do not have a term period that is more than a year and need not have any kind of requirement for prospectus or dealer registration. The commercial papers are 12 Robin Kapoor, F-12

IFS Assignment
primarily substitutes of banking credit lines. It is almost a norm to use commercial papers when all is well with business companies with regard to credit rating and size in the place of banking credit as the commercial papers are inevitably having a lower price range. However a lot of business enterprises maintain banking lines of credit as a support or an alternative for the commercial papers. Presently, in the United States there are as many as 1,700 firms that are dealing in commercial papers.

4. Bankers Acceptance
Is a time draft drawn on and accepted by a commercial bank. Time drafts are orders to pay a specified amount of money to the bearer on a given date. • • • Used in financing exports and imports arising from foreign trade and representing the obligation of the accepting bank. Banks accept or guarantee this operation (issuing letter of credit L.C.). Short maturity (30 to 90 days).

A banker's acceptance is an instruments produced by a nonfinancial corporation but in the name of a bank. It is document indicating that such-and-such bank shall pay the face amount of the instrument at some future time. The bank accepts this instrument, in effect acting as a guarantor. To be sure the bank does so because it considers the writer to be credit-worthy. Bankers' acceptances are generally used to finance foreign trade, although they also arise when companies purchase goods on credit or need to finance inventory. The maturity of acceptances ranges from one to six months.

5. Repurchase agreements • Borrowers sell securities along with a contract to repurchase them in the future at a price that will produce a specified yield.

• So it is backed by specified collateral (guarantee).
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• It is called a repo, like a secured loan.
• Very short maturity period.

IFS Assignment

Repurchase agreements—also known as repos or buybacks—are Treasury securities that are purchased from a dealer with the agreement that they will be sold back at a future date for a higher price. These agreements are the most liquid of all money market investments, ranging from 24 hours to several months. In fact, they are very similar to bank deposit accounts, and many corporations arrange for their banks to transfer excess cash to such funds automatically

6. Central Banks Funds (Federal Funds) • • • • Immediately available funds that can be lent on an overnight basis to financial institutions. Basically loaning to banks (borrowing and lending of funds available which central bank settles through central bank system). The rate on them is known as the central bank funds rate (Federal funds rate). Closely related to the conduct of monetary policy.

7- Government Agency Securities (Federal Agency Securities). • Issued by government agencies that run certain government programmers. Like: • Housing Bank. Bahrain Development Bank.

Short-term securities

RBI Control Inflation
Inflation is the classic condition of more money chasing few goods, and it means that the value for the currency you hold is having less value than what it used to be. There are four main components 14 Robin Kapoor, F-12

IFS Assignment
domestic production, exchange rates, interest rates and consumption rate. Here interest rates (at least short term) are more of an independent variable controlled by the central banks, domestic production depends on this and entrepreneurial skills + healthy conditions, exchange rate is semi independent in some countries controlled by government while it has to be really proportional to domestic production and consumption rate is dependent on people's psychology and all other variables. Together the effects end up at the consumer when he sees the high price and calls that inflation. Actually, it is just an end product of a whole deal of complex dependent and independent variables. Let us briefly look at each of them. Interest Rate: Interest rate is fairly direct. I give-up today's thing to you in anticipation that you will give me something better tomorrow. So, I pay you $10 today and expect you give me $11 back after a year. Here I have $10 available readily, and the other guy has expectation of making at least $1 in the year's time. The $10 ready availability is called liquidity and the $1+ that he could make with this is called productivity. Now, if the system is perfectly elastic, and I now have $20 still I can loan it to him fully and get $2 back and so on, indefinitely. But, real systems are seldom elastic. At some point, the other guy cannot take all my money and still make enough money to give me the interest. At the point the interest rate starts climbing down. Thus, in global bond markets (that is essentially a market for trading loans) as liquidity increases interest decreases. Conversely, if there is a credit crunch where I don’t have $10 even and none of the people have it then the interest rates increase. But, there is a limit here, at some point the producer cannot give enough interest to you without raising prices so much or go out of business. In the first case, when there is excess liquidity, the money fetches lesser interest rates in the long term, and this makes some people to not give-up today's comforts or they go for other sources of making money. Hence, they buy up junk instead of loaning the money and this causes inflation and asset boom. In the second case, the increase in interest rates causes the end products to be costlier and drives up the interest. Thus, inflation can be a resultant of both over liquidity and under liquidity - Damned if you do. Damned if you don’t! This is where the central banks enter the system. They first establish some mechanism in which the markets are dependent on them and keep this as a handle. For example, they always give banks the short-term loans (they can print money at will and destroy it when they get back) and mandate the banks to keep some of their long term loans with them and this is the great way in which hold control. And even more, since they are the most trustable business system (they print currencies) they can setup some rate for taking medium term loans from other people (these are called treasury notes or bonds or T-bills) and many people keep at least some portion of assets in these instruments as they are the safest. So, now they have a full handle on the system. On one end they can get money from people at pretty low interest rate and on the other end they can loan short term money to banks at any rate they choose, as they print money. So, if the liquidity goes beyond a certain limit, they start issuing more higher rate treasury notes and increase short term interest rates so that people will put more money into governments and take less money from them. Thus, contrary to what we expect, liquidity forces T-bill interest rates to go up, while the rest of the interest in other long-term instruments that offer at more interest rates might fall if they don’t find enough takers. This is what currently happening in the US. Long term bond rates have fallen and short-term T-bills have increased for a while now. At 15 Robin Kapoor, F-12

IFS Assignment
some point, the yield curve will be inverted, short-term loans fetching more interest rates than longterm loans. Now, what if there are enough takers for the loans. Then, both T-bills and long-term rates go up, and this is essentially not an over liquidity situation but actually a liquidity crunch (more demand than supply of money). This is what happening in India. Whether RBI had increased rates or not, the banks would have increased the rates, as there were more demand for loans than more supply of deposits. This is actually a healthy condition IF the loans were absorbed by the producers implying we are having rising productivity. But, most of the loans were absorbed by stupid consumers who bought houses and depreciating assets out of them, thereby not causing any increase in productivity. With the natural increase in rates these people will be priced out, but in a dramatic change of fate we will have higher inflation as the interest rates will cause producers to mark their prices up or else lose margins. The first will cause inflation, second will cause market crash. In some sectors (steel, oil and cement) Indian government deliberately muscled in to cause the second. In short, interest rate is a function of liquidity and productivity, and we are actually having a liquidity crunch in many sectors causing interest rates to spike which will also puke up the sectors that have been gorging money, like housing and auto loans. While, this could increase prices in the long term, it will reduce demand in the short and medium terms and cause asset depreciation thereby cooling the system. Exchange rates: Exchange rate control how much one good should be exchanged for to get another good, in an open market. For example, in a closed system if a farmer produces 10 kgs of rice and a gatherer produce 5 kgs of firewood, they both can exchange stuff on some fixed mechanism, say 1kg rice = 0.5 kg of firewood, so that both benefit from other's stuff. Now, if the farmer could produce 20kgs of rice, can he get 10 kgs of firewood from the market in this closed system? The answer is no. So, now the exchange rate would be adjusted such a way that 1kg rice = 0.25 kg of firewood. Thus, the price of firewood is said to be inflated, whereas it is actually the production of rice that is inflated 10 to 20kg and as a result its dependent exchange mechanism got changed. This is ECON 101.When you produce something more than the exchangeable limit, its value keeps going down and this is the natural process by which economies readjust and make things that are more valuable and productive. In the closed system case, the farmer could focus more energy on gathering some firewood too instead of overproducing rice. This is all in open market (in 2 person system it ought to be), but are they true in complex real world markets? Not necessarily. The farmer can keep producing his 20 kgs of rice and then give it to the gatherer at the same exchange rate and each time he will get 5 kgs of firewood and 5kgs of firewood in I Owe You notice, which means he writes a paper in which he says he has to give the farmer 5kgs of firewood later (and in this closed case, it is impossible unless he finds a way to dramatically improve the yield of firewood). This is the farce that is currently going on in the pegged exchange rate system done by Japan, China, Europe and others including India. Instead of allowing the exchange rate of Yen/Renmimbi/Rupee to Dollar (rice to firewood) to flow by natural process they just keep getting the stupid IOUs that the gatherer (USA) has no intention of paying back. But, it doesn’t matter: by the time the crisis occurs the old men in the central banks would have died leaving us all in the jeopardy. 16 Robin Kapoor, F-12

IFS Assignment
Now, what we like many other central banks have been doing is to keep getting IOUs from US (called dollars and T-bills) and right now we have more than $200b worth of them. This whole money has not done much good to the country and it has just made the exporters like IT sector filthy rich. The appreciation of rupee could have reduced the cost of imports and increase rupee's value thereby reducing inflation. But, instead of allowing rupee to appreciate when we got billions of dollars from investments and exports, what RBI did was to print trillions of rupees of money and got the dollars from the exporters and FIIs. Thus, our money supply went up by many trillions (2 to 3) in the last few months just because of this. In effect, indirectly we were subsidizing FIIs and exporters by putting domestic people to strain. And this has currently been stopped for a while, thereby appreciating the currency. In essence, RBI is currently doing the right thing of allowing the rupee to float freely and the markets determine the exchange mechanism instead of just gorging on the dollars that might not have any use if US falls The Reserve Bank of India (RBI) does not bring any changes in its key signaling rates in its annual policy statement for 2007-08. The apex bank seems to pave the way for more foreign exchange outflows and restricts the inflow to cut inflation. It has set a challenging inflation target of 5 per cent for the current year and expects to woo further monetary tightening with the continuing breach. The RBI has also increased the amount of cash banks are required to keep with it by 150 basis point to 6.75 per cent of deposits. Also, it has given a push to repo rate as well which is now 7.75 per cent. There will be no further tightening, says the RBI. The RBI has taken two broad measures to keep a close scrutiny on net foreign exchange inflows. First, it is making hard efforts to discourage foreign currency inflows by tightening the norms for Non Resident Indians (NRIs) investments. Second, it has encouraged greater outflows by companies and individuals. Putting the same efforts to control inflation, the RBI has reduced the interest rates that banks can pay on NRI deposits by 50 basis points. The ceiling on overseas investments by companies has been increased to 200 per cent of their net worth from 200 per cent and by mutual funds to $4 billion from $3 billion. The RBI has also reduced its medium-term inflation goal to 4.0-4.5 per cent from 5 per cent. The inflation is believed to be ruling above 6 per cent since December 2006, which has actually persuaded the central bank to ponder over tightening the monetary measures during the period. As such, the finance ministry has all praises for the RBI for taking significant steps and right decisions to control inflation without hurting economic growth rate

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