Financial Markets and Institutions

T-bills are considered to be the safest investments. TYPES OF T-BILLS They are issued with the maturities of • • • Three-months (12-Weeks / 90-days) Six-months (24-Weeks) Twelve-months (one-year) INVESTMENT CHARACTERISTICS OF TREASURY BILLS • • • Default Risk-T-bills are on the guarantee of government. When an investor wishes to purchase a treasury bill. so they have minimum default risk. HOW TO CALCULATE RETURN ON T-BILLS? Page 2 .100 in Pakistan and in denominations of multiples of 100. Finally. A treasury bill differs from other types of investments in that they do not pay interest in the traditional way. Returns are less because Treasuries are usually safe. the government pays the holder the full par value. Minimum Denomination-T-bills are trade on the face value of Rs. Securities can be liquidated when ever the holder wants.MONEY MARKET INSTRUMENTS TREASURY BILLS “T-bills are the Government debt securities that matures in one year or less from their issue date.” The Government of Pakistan raise large portion of floating and permanent debt through the auctions of short term Government of Pakistan Market Treasury Bills (MTBs) T-bills are issued through a competitive bidding process rather than paying fixed interest payments for a price that is less than their face (par) value and when they mature. they buy it at a discount rate. because in these Government confirms the holder of security to pay back face value. Liquidity-T-bills are highly liquid instrument of financial market. the interest is the difference between the purchase price of the security and what you get at maturity.

Afterwards when the government moved to a marketbased system as part of the process of economic deregulation. Bill yields are determined by the discount method. which ignores the compounding of interest rates.” Concept taken from (Rose & Marquis 2005) .06 100 360 90 x This shows that for this T-bill the discount rate will be 6%. Thus their yield is based on their appreciation in price between time of issue and the time they mature or are sold by the investor. Treasury bills were issued on ‘tap basis’ for six months at 6 percent per year. instead of “on tap. Primary dealers were appointed. and uses a 360-day year for simplicity.98 and keep it until maturity having face value of rs.MONEY MARKET INSTRUMENTS “As we have studied earlier that T-Bills do not carry any interest rate but instead are sold at a discount from their par value or face value. HOW T-BILLS ARE TRADED IN PAKISTAN? “At start. treats the par value as the investment base. Then the discount rate on this bill can be calculated as: 360 Number of Days to Maturity x Dr = (100 .98) = 0. and decentralization in April 1991 then the following changes were made: • • • Introduce the American-style auction-based system.” allowing for the development of a secondary market.100. disinvestment.” Page 3 . The role of primary market restrict to fortnightly auctions. The Discount Rate for T-Bills can be calculated by the following formula: Par Value-Purchase Discount Rate = Price Par Value Explained With Example: Suppose you buy a 12 Weeks T-bill at Rs.

which include commercial banks and non bank financial institutions are only allowed to submit any number of sealed price-quantity bids on their own behalf or on behalf of clients. In the auctions of treasury bills yield is not set by the central bank but the bidder. Primary dealers.  The actual yield to the investor depends on the accepted bid price at each auction. so each bid formulate in the expectation that. as opposed to a single price for all the accepted bids. • All the commercial banks (having account with SBP) • NBFIs (Non Banking Financial Institutions) If the primary dealer wants to buy a T-bill. if Page 4 . All auctions were conducted on a discriminatory price basis. • • Non-Competitively Competitively The Non-competitive bids are normally submitted by the small investors who agree to accept the price determined by the auction. The Competitive bids are submitted by large investors . AUCTION SYSTEM “SBP is acting as an agent on behalf of the government for raising short term funds from the market.MONEY MARKET INSTRUMENTS State Bank of Pakistan use following two methods to trade T-bills. The auctions conduct after every two weeks at Wednesday and are announced approximately one week in advance. • • Auction System Open Market Operations(OMO) PRIMARY DEALERS Only primary dealers can participate in the auctions and OMOs. must submit a bid that is prepared either. Each bidder at an auction gets the amount at his bid price (if accepted). The MTBs are sold by SBP to approved Primary Dealers through multiple price sealed bids auction.who bid for several millions. They have to specify the return that they want to receive. might not receive any securities. If the return specified is too high.  The Auction for MTBs is held under a fixed schedule on fortnightly basis.

The Ministry of Finance decides on the cut-off price after seeing the bids. in practice the cut-off price seems to have been the main decision variable and the amount allocated bore little relation to the pre-announced size. After the deadline for bid submission.g. After the opening of bids. Although notionally the size of the auction issue are pre-announced. • On a number of occasions the authorities decide to reject all bids because when they feel that the bids are unreasonably low. the highest competitive bidders receives bills and those who bid successively lower price also receive bills until all available securities have been awarded. that how urgently funds are required. e. of which • Debt service costs-cost of the factors related to the debt services. also influence the cut-off price. Fig: Steps Involve in Auction SETTLEMENT OF BID Page 5 .” Information taken from Daniel C Hardy (2001) Summary of auction process shown in the figure. the bids open in the presence of the bidders. cost for organizing auction etc. The setting of the cut-off price was influenced by a number of factors. the price bid would be that paid.MONEY MARKET INSTRUMENTS accepted. Need for funding-having insufficient funds for regular operations.

which is adjusted against their final tax rate.300.MONEY MARKET INSTRUMENTS “Settlement is normally done through book entry and securities can be issued with in one or two days after finalizing cut-off price.0mln (multiples of PKR 100.0mln .” Page 6 .0mln). The marketable lot-size for MTBs will be in range of PKR 100. The positions of primary dealers are maintained by the SBP in these accounts.” TAX LIABILITY “Investors in T-bills are subject to a withholding tax. because the earnings of T-bills are treated as income of the security holder not the capital gain. Primary dealers must have to maintain a current account (for cash settlement) with the SBP.

At the time of issue of Commercial Paper Company rating should not be more then two Page 7 . Commercial paper is generally used to meet immediate cash needs. Commercial papers are mainly in the primary market. and “A2” (short-term).MONEY MARKET INSTRUMENTS COMMERCIAL PAPER Commercial paper consists of short-term. • The equity of the company is not less than Rs. Funds raised from commercial paper are commonly used for current transactions i.e. as it is unsecured and investors can only depend upon the creditworthiness of the issuer. WHO CAN ISSUE COMMERCIAL PAPER • Only highly rated companies and financial institutions can issue Commercial Paper. • The company has obtained the credit rating from a rating agency.SBP and SECP started process of creating commercial paper market in Pakistan in 2003. 100 million as per the latest audited balance sheet. pay taxes and cover other shortterm obligations rather than for capital transactions like long-term investments. to purchase inventories. Opportunities for resale in secondary markets are very limited. unsecured promissory notes issued by well-known companies that are financially strong and carry high credit rating. The minimum credit rating of the issuer shall be “A-” (medium to long-term) months old. MATURITY PERIOD OF COMMERCIAL PAPER The commercial paper shall be issued for maturities between 30 days and one year from the date of subscription.

doc - MODE OF ISSUE AND DISCOUNT RATE The commercial paper shall be in the form of a promissory note and be issued at such discount to face value as may be determined by the issuer keeping in view the prevailing T-Bill rates. in case of private placement. CALCULATION OF RATE OF RETURN ON COMMERCIAL PAPER Most commercial paper is issued at discount from par and Yield to investor can be calculated by bank discount method just like treasury bills.000 (face value) or in multiples thereof and in case of offer to general public.10 million. Concept taken from Guideline for issuing commercial paper www. 950.000. The commercial paper.000.000) / 1.000 or in multiples thereof. if a million Rs commercial paper with a maturity of 120 days is acquired by an investor at a discount price of Rs. Invester’s yield arises from the price of security between its purchase date and maturity date.15 so.000. KIBOR and its Credit Rating. 100. would be denominated in Rs.000 – 950.000 * 360 /120 = 0. For example. may be denominated in Rs./Guidelines_CommercialPaper.the discount rate of return on commercial paper will be DRcp = (Par Value – Purchase Price) / Par Value * 360 / Days to Maturity DRcp = (1.MONEY MARKET INSTRUMENTS • The company should have no overdue loan or defaults in the Report obtained from the Credit Information Bureau (CIB) of the State Bank of Pakistan (SBP). SIZE AND DENOMINATION The minimum size of the issue of commercial paper shall not be less than Rs. Page 8 rate of return on this commercial paper will be

1 million Security Dealer + Rs 1 million Page 9 . Financial Institution . investments in commercial papers may bring in higher yields than time deposits with lower risks.Rs. {Rose. Example: we assume a financial institution has Rs 1 million cash surplus. The borrowing dealer and lending company agree on 1 million RP loan collateralized by treasury bills. Most Repo agreements mark the collateral to market daily. Commonly commercial papers are bought by Money market funds as the issue size is often too high for individual investors. higher price. REPURCHASE AGREEMENT (REPO) Repurchase agreements are agreements between a borrower and a lender where the borrower. Financial Institutions etc. then the borrower must send more securities to the lender to maintain margin or some money to reduce the principal outstanding. with the dealer agreeing to buy back the bills within a few days and the interest on loan. marquis (2005) page 334} WHO INVESTS IN COMMERCIAL PAPER Commercial paper may be issued by way of Public offer and/or to Scheduled Banks.MONEY MARKET INSTRUMENTS Rate of return on commercial paper fluctuate with the daily ebb and flow of supply and demand in marketplace. in effect. The securities serve as collateral for the loan. sells securities to the lender with the stipulation that the securities will be repurchased on a specified date and at a specified.  It is considered to be a safe investment since the financial situation of a company can easily be predicted over a short period. If the value of the collateral drops below the required margin. Generally regarded as a safe investment and not backed by collaterals ADVANTAGES FOR INVESTOR  Due to varying credit standings.

Government securities are the main collateral for most repos. and large banks.Rs 1million + Securities worth 1 MAJOR BORROWERS AND LENDERS Major borrowers include government bond dealers of Treasuries and federal agency securities.MONEY MARKET INSTRUMENTS + Securities worth 1 million million After Maturity of Agreement + Rs. relatively low risky way to invest temporary surplus cash that may be retrieves quickly when the need arises. Page 10 . 1 million . insurance companies. along with federal agency securities and mortgage-backed securities etc. Active lenders include state and local governments.Securities worth 1 million Securities worth 1 million . and foreign financial institutions who find the market a convenient. non-financial corporations.

The interest rate on open repos is slightly higher than on overnight repos. an overnight loan of Rs 1 million to a dealer at 12% Repo rate would yield interest income of Rs 333. Usually the securities pledged behind a Repo are valued at their current market price plus accrued interest on security less a small “haircut” (discount) to reduce the lender’s exposure to market risk.12 x (1/360) = Rs 333.000.33 {Rose.000 x . Interest income from repurchase agreement can be determined by this formula RP Interest income = Amount of loan x Current Repo Rate x (Repo Term in days/360 days) For example.33. without signing a new contract. larger the “haircut” will be charged. RP Interest income = 1. However.MONEY MARKET INSTRUMENTS CALCULATION OF REPO INTEREST INCOME The difference between the underlying securities current price and repurchase price is the amount of interest paid by the borrower to the lender. Longer the term and riskier or less liquid the security pledged. marquis (2005) page 293} TYPES OF REPO (ACCORDING TO MATURITY) • Overnight repos Overnight repos are 1 day loans • Term repos Term repos have terms of greater than 1 day—usually weeks to months • Open repo Open repo or continuing contracts are a contractual relationship that allows the borrower to borrow funds up to a certain limit. PURPOSE OF REPO Large banks borrow from dealers and other non-bank institutions through Repo in order to avoid deposit reserve requirements and prohibitions Page 11 . each party has the right to terminate the contract on a short notice.

Companies and financial institutions eager to loan its temporary cash surplus to avoid losing even a single day’s interest.MONEY MARKET INSTRUMENTS against their paying interest on deposit accounts. while the dealers enter in RPs to borrow at the low cost RP interest rate in order to purchase interest bearing securities. Page 12 .

The bank becomes the primary obligor. Banker’s acceptance is usually used in trade.  The main benefit to lenders over other money market instruments is that the maturity of the Repo can be precisely tailored to the lender's needs. The document which is the evidence of this promise is called a draft. The promissory puts his • • • Signature The word accepted on top of his signatures and The date on which the amount will be . The person who will pay is called as the promissory while the one who will receive is the beneficiary.eagletraders. In case of a bankers acceptance the initial promissory is obliged to pay the sum of money and the interest money charged before or on the maturity date to the bank while the bank is obliged to pay the money to the beneficiary. In financial terms acceptance means a vow to pay a definite amount of money. Now the promissory is legally obliged to pay the amount as mentioned in the draft to the beneficiary because it has been accepted properly by him according to all requirements of official acceptance. BANKER’S ACCEPTANCE The literal meaning of the term acceptance is approval. When this draft tells the promissory to pay the money on a predetermined specified date then this draft is termed as a time draft. mostly for international business but is also frequently used for domestic Page 13 http://www. If the time draft is formally accepted by a bank then it becomes a banker’s acceptance.MONEY MARKET INSTRUMENTS ADVANTAGES OF REPO  The main benefit of Repo to borrowers is that the Repo rate is less than borrowing from a bank.

(2005). The issuing bank after verifying stamps the word accepted on the have a problem of trusting each other. This draft has now become a banker’s acceptance. The bank trusts you because of your good credit rating and it signs the draft adds its signature and mentions the date. Trade Acceptance” http://www.htm According to Rose the importer secures a line of credit from his bank and sends the documents to the importer. The exporter goes to his bank which is called the accepting bank.fraudaid. pg. As the dealing firms have not met or may even never meet. Concept taken from “Acceptance: Banker's Acceptance. Page 14 . Hence the beneficiary is satisfied. A very easy way to resolve this problem is that you go straight to your bank with which you have a very good past record. Now this bank gives the importer that specified sum of money and sends the shipment documents and the time draft to the issuing bank.322-327 So by deploying both of these ways a banker’s acceptance can be created. Now that dealer does not know your credit worthiness. The accepting bank is paid that specific sum of money. Milton. By doing this it has become liable to paying that some of money to the bank. It allows the international as well as national dealers to trade with each other. Concept taken from Rose.MONEY MARKET INSTRUMENTS dealing as well. Most probably the date mentioned will be one or two weeks later after getting the shipment. The promissory uses the bank’s credit worthiness instead. The draft is then sent to the manufacturer who is very much satisfied now as he knows the banks credit rating. So banker’s acceptance minimizes their risk. Now the foreign dealer can draw a time draft against the issuing bank. EXAMPLE TO ILLUSTRATE BANKER’S ACCEPTANCE THE MECHANISM OF Suppose that you own a software house and you need computers. Meanwhile the promissory also gets more time to make the payments. Peter & Marquis. In essence whenever any bank will agree to pay any importer on behalf of the exporter that document having all these abiding will be termed as the banker’s acceptance. You order a dealer in Japan to send you ten computers on credit. There you get a time draft issued on which the date you will pay the money is mentioned. The maturities of banker’s acceptance mostly range from 30 to 180 days.

MECHANISM OF EURODOLLAR DEPOSITS Page 15 . Eurodollars are the deposits of US dollars in banks which are located outside United States. referred to as a two-name paper. It can be retained as well to meet the reserve requirements and to maintain liquidity. There is a need for Eurocurrency markets because funds are required in international currencies worldwide mainly in Dollars. The issuing bank can either keep it in his portfolio or sell the bankers acceptance in the money market. EURODOLLAR DEPOSITS Eurodollars are the leading component of the Eurocurrency markets today. The secondary obligor has the unconditional responsibility to pay the acceptance if the primary obligor dishonors it. The Eurodollar deposits are always moving in the form of loans. The deposits are recorded in the denomination of dollars rather than their home currency. Some banks also purchase the BAs which are nearing their maturity in order to increase their liquidity. These deposits are loaned to the home offices of the banks in US. lent to business enterprises that have to make their payments in dollars. Generally. It is sold at a discount from the value which will be payable on maturity. In this way the seller is getting funds from the money market hence it provides liquidity to the seller. These can also be the branches of the US banks located outside US. a safe investment instrument usually with lower rates than might be available in a direct borrowing.MONEY MARKET INSTRUMENTS SECONDARY ACCEPTANCE MARKET FOR THE BANKER’S There is a very strong and affluent market for it. Euros and Pounds. If the accepting bank which is the primary obligor fails to pay the amount the holder of the BA (assuming the bank has sold the BA in the open market) has recourse back to the issuer of the draft the secondary obligor. BA provides a very low risk interest income to the buyer. They are mostly sold at a spread over t-bills and this rate is referred to as the BA rate. This characteristic makes the BA. These can be lent to government if it needs dollars and to private investors as well. the "euro" prefix can be used to indicate any currency held in a country where it is not the official currency.

They are mostly interbank liabilities when loaned so a fixed interest rate is charged on them. Hence they did not create money but they act as an efficient distributor of liquidity. Eurocurrencies are not without risk. The chain of Eurocurrency and Eurodollars will remain functioning until they are in demand and funds are being deposited in the international banking system. To keep the example simple we assume that you shipped an assignment worth one million to the American importer.MONEY MARKET INSTRUMENTS We suppose that you own a textile firm in Pakistan. Many are held for one month that is the usual time period for the shipment of goods. In all these transactions this fact should be acknowledged that the amount of dollars was merely transferred in between the banks but the original dollar amount remained the same. As it is a dollar account maintained outside US. The Eurocurrency accounts are formed by giving out loans and are destroyed when the loan is repaid. The daily cost of funds derived from Eurodollars is Amount to be loaned * interest rate * 1/360 FEDERAL FUNDS Federal funds refer to the overnight borrowings which are undertaken in order to meet the state bank’s reserve requirements. They are volatile and sensitive to fluctuations in interest rates and currency values. After all these transactions a Eurodollar deposit has not been created. The importer pays the bills in dollars and deposits it in your account held at the American bank. The dollar amount in the Pakistani account can be given as a loan to an investor who is liable to pay the money in dollars. Difference of interest rate or value between two countries can initiate the massive flow of funds from one to another. There is no central location for the trading of the Eurocurrency deposits. They move rapidly from one bank to another to meet the liquidity requirements of corporations. If we further mature the same example and presume that you transfer that one million dollars in your bank in Pakistan then the deposit that is now created in Pakistan is a Eurodollar deposit. There is a political risk as well that the governments might restrict the flow of money across borders. These are Page 16 . Eurocurrency deposits are usually held from one day till one year so they are pure money market instruments. Here we also suppose that you have an account in an American bank as well. governments and Eurobanks themselves. Eurodollar activity did not alter the total reserves of the US banking system.

This is equal to the fraction of the deposits which are kept with a bank. It depends on the volume of funds which is surplus in the market and the volume of fund needed by the market. When they are repaid then an entry in books satisfies the whole loan. Most federal funds are for overnight basis and they have a fixed interest rate. The funds are not physically transferred. The most important borrower in the federal funds market is the commercial banks. Today the online system has made it very easy to know that which institutions are short of funds and which have surplus. The banks and DFIs are legally obliged to keep a certain amount of funds in the reserve account which is kept with the state bank of Pakistan. The interest rates which are levied on these funds highly fluctuate daily. The one who is short gets the benefit that its immediate requirement of money is fulfilled while the one with surplus gets interest income on its funds and thus earns it through the federal fund market.MONEY MARKET INSTRUMENTS transferred from the lending institution’s account to the borrowers account. business corporations and the local government provide readily available funds for lending in the federal market. Page 17 . Other financial institutions. To meet the requirement of this legal reserve ratio the banks borrow funds mostly on overnight basis from the federal funds market. security dealers.

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