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CHAPTER 11

The Money
Markets
Now thats a lot!

In its 2009 annual report, Microsoft listed $25


billion in short-term securities on its balance
sheet, plus $6 billion in actual cash
equivalents. Microsoft does not keep this in
its local bank. But where?
This is, of course, this topic of chapter 11
Money Markets.

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Chapter Preview
We review the money markets and the securities
that are traded there. In addition, we discuss why
the money markets are important in our financial
system. Topics include:
The Money Markets Defined
The Purpose of Money Markets
Who Participates in Money Markets?
Money Market Instruments
Comparing Money Market Securities

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The Money Markets Defined

The term money market is a misnomer.


Money (currency) is not actually traded in
the money markets. The securities in the
money market are short term with high
liquidity; therefore, they are close to
being money.

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Definition of Money Markets
According to Crowther, "The money market is a name
given to the various firms and institutions that deal in the
various grades of near money."
According to the RBI, "The money market is the centre for
dealing mainly of short character, in monetary assets; it
meets the short term requirements of borrowers and
provides liquidity or cash to the lenders. It is a place where
short term surplus investible funds at the disposal of
financial and other institutions and individuals are bid by
borrowers, again comprising institutions and individuals
and also by the government."

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The Money Markets Defined
A segment of the financial market in which financial instruments
with high liquidity and very short maturities are traded. The
money market is used by participants as a means for borrowing
and lending in the short term, from several days to just under a
year. Money market securities consist of negotiable certificates
of deposit (CDs), bankers acceptances, U.S. Treasury bills,
commercial paper, municipal notes, federal funds and
repurchase agreements (repos).
History: The money market developed because there are
parties that had surplus funds, while others needed cash. [3
Today it comprises cash instruments as well.

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The Money Markets Defined

Money Markets Defined


1. Money market securities are usually sold in
large denominations ($1,000,000 or more)
2. They have low default risk
3. They mature in one year or less from their
issue date, although most mature in less than
120 days

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The Money Markets Defined:
Why Do We Need Money Markets?

In theory, the banking industry should handle the


needs for short-term loans and accept short-term
deposits. Banks also have an information
advantage on the credit-worthiness of participants.
Banks do mediate between savers and borrowers;
however, they are heavily regulated. This creates a
distinct cost advantage for money markets over
banks.

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Functions of Money Market
Money market is an important part of the economy. It plays very
significant functions. As mentioned above it is basically a market for
short term monetary transactions. Thus it has to provide facility for
adjusting liquidity to the banks, business corporations, non-banking
financial institutions (NBFs) and other financial institutions along with
investors.
The major functions of money market are given below:-
To maintain monetary equilibrium. It means to keep a balance
between the demand for and supply of money for short term monetary
transactions.
To promote economic growth. Money market can do this by making
funds available to various units in the economy such as agriculture,
small scale industries, etc

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Functions of Money Market

To provide help to Trade and Industry. Money market


provides adequate finance to trade and industry. Similarly it
also provides facility of discounting bills of exchange for
trade and industry.
To help in implementing Monetary Policy. It provides a
mechanism for an effective implementation of the monetary
policy.
To help in Capital Formation. Money market makes
available investment avenues for short term period. It helps
in generating savings and investments in the economy..

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Characteristics of Money
Markets

Money Market have an active secondary market.


Money markets is that they are wholesale markets.
Flexibility
Innovation

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The Money Markets Defined:
Cost Advantages
Reserve requirements create additional expense for
banks that money markets do not have
Regulations on the level of interest banks could
offer depositors lead to a significant growth in
money markets, especially in the 1970s and 1980s.
When interest rates rose, depositors moved their
money from banks to money markets to earn a
higher interest rate.

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The Money Markets Defined:
Cost Advantages

Even today, the cost structure of banks


limits their competitiveness to situations
where their informational advantages
outweighs their regulatory costs.
Figure 11.1 shows that limits on interest
banks could offer was not relevant until the
1950s. But in the decades that followed, the
problem became apparent.

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3-month T-bill rates and
Interest Rate Ceilings

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The Purpose of Money Markets

Investors in Money Market: Provides a


place for warehousing surplus funds for
short periods of time
Borrowers from money market provide low-
cost source of temporary funds

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The Purpose of Money Markets

Corporations and U.S. government use


these markets because the timing of cash
inflows and outflows are not well
synchronized. Money markets provide a
way to solve these cash-timing problems.

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The Importance of Money
Markets
A well-developed money market is essential for a modern economy.
Though, historically, money market has developed as a result of
industrial and commercial progress, it also has important role to play
in the process of industrialization and economic development of a
country. Importance of a developed money market and its various
functions are discussed below:
1. Financing Trade: Money Market plays crucial role in financing both
internal as well as international trade. Commercial finance is made
available to the traders through bills of exchange, which are
discounted by the bill market. The acceptance houses and discount
markets help in financing foreign trade.

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The Importance of Money
Markets
2. Profitable Investment: Money market enables the
commercial banks to use their excess reserves in
profitable investment. The main objective of the
commercial banks is to earn income from its reserves as
well as maintain liquidity to meet the uncertain cash
demand of the depositors. In the money market, the
excess reserves of the commercial banks are invested in
near-money assets (e.g. short-term bills of exchange)
which are highly liquid and can be easily converted into
cash. Thus, the commercial banks earn profits without
losing liquidity.

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The Importance of Money
Markets
3. Self-Sufficiency of Commercial Bank: Developed
money market helps the commercial banks to become
self-sufficient. In the situation of emergency, when the
commercial banks have scarcity of funds, they need not
approach the central bank and borrow at a higher interest
rate. On the other hand, they can meet their requirements
by recalling their old short-run loans from the money
market.

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The Importance of Money
Markets
4. Self-Sufficiency of Commercial Bank: Developed
money market helps the commercial banks to become
self-sufficient. In the situation of emergency, when the
commercial banks have scarcity of funds, they need not
approach the central bank and borrow at a higher interest
rate. On the other hand, they can meet their requirements
by recalling their old short-run loans from the money
market.

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The Importance of Money
Markets
5. Financing Industry: Money market contributes to the growth of
industries in two ways:
(a) Money market helps the industries in securing short-term loans to
meet their working capital requirements through the system of finance
bills, commercial papers, etc.
(b) Industries generally need long-term loans, which are provided in
the capital market. However, capital market depends upon the nature
of and the conditions in the money market. The short-term interest
rates of the money market influence the long-term interest rates of the
capital market. Thus, money market indirectly helps the industries
through its link with and influence on long-term capital market.

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The Importance of Money
Markets
5. Help to Central Bank: Though the central bank can function and
influence the banking system in the absence of a money market, the
existence of a developed money market smoothens the functioning
and increases the efficiency of the central bank. Money market helps
the central bank in two ways:
(a) The short-run interest rates of the money market serves as an
indicator of the monetary and banking conditions in the country and, in
this way, guide the central bank to adopt an appropriate banking
policy,
(b) The sensitive and integrated money market helps the central bank to
secure quick and widespread influence on the sub-markets, and thus
achieve effective implementation of its policy.

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Who Participates
in the Money Markets?

We will discuss, in turn, each of the major


borrowers and lenders in the money
market.
Before we do that, lets examine some of
the current rates offered in the U.S. money
markets. Some of these rates have been
discussed in previous chapters. Other rates
will be explored throughout this chapter.

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Who Participates in the Money Markets?:
A Sample from the Wall Street Journal

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Who Participates
in the Money Markets?

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Money Market Instruments

We will examine each of these in the


following slides:
Treasury Bills
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper
Eurodollars

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Money Market Instruments
(cont.)

We will examine each of these in the


following slides (continued):
Commercial Paper
Bankers Acceptance
Eurodollars

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Money Market Instruments:
Treasury Bills

T-bills have 28-day maturities through


12- month maturities.
Discounting: When an investor pays less
for the security than it will be worth when it
matures, and the increase in price provides
a return. This is common to short-term
securities because they often mature before
the issuer can mail out interest checks.

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Money Market Instruments:
Treasury Bills Discounting Example

You pay $996.37 for a 28-day T-bill. It is


worth $1,000 at maturity. What is its
discount rate?

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Money Market Instruments:
Treasury Bills Discounting Example

You pay $996.37 for a 28-day T-bill. It is


worth $1,000 at maturity. What is its
annualized yield?

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Money Market Instruments:
Treasury Bill Auctions

T-bills are auctioned to the dealers


every Thursday.
The Treasury may accept both competitive
and noncompetitive bids, and the price
everyone pays is the highest yield paid to
any accepted bid.

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Money Market Instruments:
Treasury Bill Auctions Example
The Treasury auctioned $2.5 billion par value
91-day T-bills, the following bids were received:
Bidder Bid Amount Bid Price
1 $500 million $0.9940
2 $750 million $0.9901
3 $1.5 billion $0.9925
4 $1 billion $0.9936
5 $600 million $0.9939

The Treasury also received $750 million in


noncompetitive bids. Who will receive T-bills,
what quantity, and at what price?
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Money Market Instruments:
Treasury Bill Auctions Example

The Treasury accepts the following bids:


Bidder Bid Amount Bid Price
1 $500 million $0.9940
5 $600 million $0.9939
4 $650 million $0.9936

Both the competitive and noncompetitive


bidders pay the highest yieldbased on the
price of 0.9936:

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Money Market Instruments:
Treasury Bill Rates

The next slide shows the results of several


Treasury bill auctions, from 2007.
It also shows some other data about each
auction. Do you know what each term
means?

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Money Market Instruments:
Treasury Bill Auction Results

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Money Market Instruments:
Treasury Bill Rates

The next slide shows actual T-bill rates and


the annual rate of inflation from 1973 through
2010.
Notice that the inflation rate exceeds the rate
on T-bills in several on the years. This
indicates a negative real return for
T-bill investors during these periods.

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Money Market Instruments:
Treasury Bills

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Mini-Case: Treasury Bill
Auctions Go Haywire

In 1991, Salomon Smith Barney violated


Treasury auction rules to corner the auction
on an $11 billion issue.
Several top Salomon officials were forced
to retire (or fired) as a result of the incident.
The Treasury also changed the auction
rules to ensure a competitive auction.

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Money Market Instruments:
Fed Funds

Short-term funds transferred (loaned or


borrowed) between financial institutions,
usually for a period of one day.
Used by banks to meet short-term needs to
meet reserve requirements.

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Money Market Instruments:
Fed Funds Rates

The next slide shows actual fed funds rates


and T-bill rates 1990 through 2010.
Notice that the two rates track fairly closely.
What does this suggest about
the market for T-bills and the market for
fed funds?

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Money Market Instruments:
Fed Funds Rates

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Chapter Summary

The Money Markets Defined


Short-term instruments
Most have a low default probability

The Purpose of Money Markets


Used to warehouse funds
Returns are low because of low risk and
high liquidity

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Chapter Summary (cont.)

Who Participates in Money Markets?


U.S. Treasury
Commercial banks
Businesses
Individuals (through mutual funds)

Money Market Instruments


Include T-bills, fed funds, etc.

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