Part II: Security Markets

Topic 6 Money Markets

Copyright 2006 Scott Bauguess

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

Market size in 2004: $5.3 Trillion

Copyright 2006 Scott Bauguess

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

Copyright 2006 Scott Bauguess

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

Copyright 2006 Scott Bauguess

Money Market Participants

(excluding brokers/dealers)
Security Borrower (issuer) Lender (investor)

Treasury bills

U.S. Treasury (Federal Government)

FED, Commercial banks, Mutual Funds, Corporations, etc.

Commercial banks, other FIs Corporations, Mutual funds, other FIs Corporations, Mutual funds, other FIs Corporations, Community banks

Federal Funds & Commercial banks, Repurchase agreements other FIs Commercial paper Negotiable CDs Bankers acceptances Corporations, Commercial banks Commercial banks Commercial banks

Copyright 2006 Scott Bauguess

Treasury securities
Issued 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 Ri = Rf + beta*(Rm Rf)

Interest rate: No coupon payment T-bills sold at a discount to face value (implied rate of return)
Copyright 2006 Scott Bauguess

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 bids
1. 2. 3. Requires $1 million minimum bid, generally made by dealers and large institutions Bidders submit a quantity and lowest yield (highest price) that they are willing to accept No single bidder can win more than 35% of the issue.

Non-competitive bids:
1. 2. 3. Purchasers seeking less than $1 million do not participate in the auction Indicate the quantity of securities desired to be purchased at the stop yield Get preferential allocation (all bids are met)

Non-public bids:
1. 2. The Federal Reserve Bank participates in this market (open market transactions) and submits the quantity that they wish to purchase This quantity is guaranteed similar to non-competitive bids.

Copyright 2006 Scott Bauguess

Treasury Auctions
Winning bid:
1. Competitive bids are sorted from lowest to highest yield (highest to lowest price) After non-competitive and non-public purchaser orders are filled, the Treasury accepts the highest price (lowest yield) bids until the issuance is completed The highest yield accepted by the treasury is the stop yield Bidders above the stop yield are shut out
yield (%) 3.50 3.52 3.54 3.57 3.60 3.61 3.62 3.63 3.64 3.65

2.

> $7.5 Billion

stop yield

3.

4.

5.

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

Copyright 2006 Scott Bauguess

percent of face value stop yield

Pro rated

Source: www.publicdebt.treas.gov
Copyright 2006 Scott Bauguess

Treasury Auctions
Bid Price
(% of face)

1
2 3

competitive

Noncompetitive Bids $239 million total

4 winners 5 6 7 losers

99.6633222% Stop yield

$15,761 million $15,522 million

Quantity of T-bills

Copyright 2006 Scott Bauguess

Secondary Treasury Market

Largest of any Money Market security: Participants: Buy for their own account or on behalf of their customers
1. 2. 3. 4. Government approved dealers (approx 20, designated by the NYFRB) Secondary dealers (approx 500 trade in secondary market) Commercial banks, insurance companies, pension funds Federal reserve bank

Trading: takes place between

1. 2. 3. Primary market dealers (fed wire transfers requiring no paper work) Dealers and their customers 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

Copyright 2006 Scott Bauguess

Secondary Treasury Market

J.P. Morgan Chase sells $10m. In T-bills

Between government security dealers

Lehman Brothers buy $10m. In T-bills

Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan Chase to Lehman Brothers Transaction recorded in Feds Book-Entry System Purchase by individual Individual buy $50,000 in T-bills Local Bank or Broker J.P. Morgan Chase sell $50,000 in T-bills FRBNY -$50,000 in T-bills from J.P. Morgan Chases account + $50,000 T-bill to Individual

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

Secondary Treasury Market

On-the-run: Trading in the most recent treasury market auction (most current issue)

Off-the-run: Once a new auction takes place, older issues of the same maturity are
referred to as off-the-run Liquidity in off-the-run markets is far lower than new issues. A 6-month off-the-run T-bill with three months remaining is competing with an newly issued 3-month T-bill that is on-the-run. Investors have substitutes in treasury securities that allows for more efficient pricing of new securities.

When-issued market:
Treasury securities are traded prior to the time that they are issued. This market extends from the day that the treasury auction is announced until the auction day. This, too, increases pricing efficiency since dealers have an indication of what the stop yield will be before the auction takes place. When-issued turn into an on-the-run secondary market once the auction is completed.

Copyright 2006 Scott Bauguess

Federal Funds
Short term transactions between financial institutions:
1. 2. 3. 4. Term is generally over night/week-end Not backed by collateral - unsecured loans Highly liquid market 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 discount 2. 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 bank 2. Banks or FIs that are not FRB members can use a correspondent bank (that is a member) to conduct the transaction 3. Transactions take place over the Fedwire

Copyright 2006 Scott Bauguess

Repurchase agreements
Definition: 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 Pf P0 360 x P0 days

iRA =

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.

Copyright 2006 Scott Bauguess

Commercial Paper
Unsecured short-term promissory note:
1. 2. 3. 4. Terms: 1. 2. 3. 4. 5. Generally issued by corporations or financial institutions Sold directly to institutions or through dealers Is the largest (total $ value) of the money market securities Funds used to finance working capital requirements

Sold in denominations of $100k, $250k, $500k and $1 million. Maturity less than 270 days (registration required otherwise) Common maturities are between 20 and 45 days Sold at discount and held to maturity no active secondary market 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 agency 2. Low cost alternative to bank loans, but requires that lenders can tell your type the adverse selection problem 3. 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 Tycos downgrade from tier 1 to tier 3 forced them out of the market

Copyright 2006 Scott Bauguess

Negotiable Certificates of Deposits (CDs)

A bank issued time deposit: Not a demand deposit
1. 2. 3. 4. Fixed interest rate and maturity Terms are negotiable (e.g. 6 month at 4.1% or 1 year at 5.2%) Common maturities are less than 12 months These funds are more certain to banks that demand deposits that can leave at any time.

Terms and Trading:

1. 2. 3. 4. Most CDs are sold directly to investors who hold to maturity Investors receive both principal and interest Rates are quoted using a 360 day year A network of about 15 brokers/dealers make a secondary market

Risk:
1. Small CDs are similar to demand deposits wrt insurance 2. Large CDs (called Jumbo CDs) are not federally insured through FDIC 3. Large banks, with perceived lower risk due to too-big-to-fail (TBTF) doctrine, often have lower rates than smaller banks

Copyright 2006 Scott Bauguess

Bankers Acceptance
Banks act as intermediaries between trading partners:
1. Banks guarantee payments to secure orders of goods from manufacturers 2. Are a type of letter of credit that guarantees a payment by the bank on a specific date 3. 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 manufacturer 2. 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 pay 4. Lubbock Acme doesnt 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
Copyright 2006 Scott Bauguess

Bankers Acceptance
Locality 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 delivered 2. Maturity is typically 30 to 270 days 3. Denominations are bundled into $100,000 and $500,000 levels for trading 4. 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

Copyright 2006 Scott Bauguess

Eurodollars
Eurodollar: U.S. dollars held as deposits in foreign banks
Risk: 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

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)

Copyright 2006 Scott Bauguess

Money Market Rates

2002 Federal Funds Non fin CP Fin CP CD Euro $ T-bill AAA Muni AAA Corp 1.67 1.67 1.68 1.72 1.72 2 4.87 6.49 2003 1.13 1.11 1.12 1.15 1.15 1.24 4.52 5.66 2004 1.35 1.38 1.41 1.45 1.45 1.89 4.5 5.63 2005 3.26 3.27 3.31 3.38 3.55 3.64 4.18 5.06

Copyright 2006 Scott Bauguess