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Global Financial Markets and Products

FIN ZG 512

Debt Markets – Money Markets

Krishnamurthy Bindumadhavan, CFA, FRM

Associate Professor, Management - Finance
Email: k.bindumadhavan@pilani.bits-

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956


• Money markets

• Treasury Bills

• Commercial Paper

• Certificates of Deposit

• Bankers Acceptance

• Repurchase Agreement

• Federal Funds market

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Money Markets - Introduction

 Money market instruments are short term debt obligations,

typically with a maturity of 1 year or less.

 Market comprises of few high quality borrowers and a

number of diverse investors
 Government, Government agencies, Corporations and
municipalities borrow money on ST basis from this market
 Instruments include: Treasury bills, Commercial paper,
Medium term notes, bankers acceptances, short term (ST)
federal agency securities, ST municipal obligations,
certificate of deposits, repurchase agreements, and
federal funds

Money Markets - Introduction

 High marketability due to extensive secondary market

 Large, wholesale open - market transactions
 Many brokers and dealers are competitively involved in
the money market
 Payment in Federal Funds – hence funds are immediately
 Low default risk
 Overall, the liquidity of the market is very high

US Treasury Bills

 Issued by US Department of Treasury and backed by the

full faith and credit of the US government
 Hence perceived to carry no default/ credit risk
 T-Bills have maturities up to one year
 Treasury also issues the following:
 Notes: 2 years to 5 years
 Bonds: more than 5 years
 The cut-off for notes vs. bonds classification varies from 3 years to
10 years depending on country, author, and other factors
 Sold on discount basis.
 Denominations are in multiples of $1000.

US T-bills- Pricing
 Bid and offers on T-bills are quoted in a unique manner
 Unlike medium or long term bonds T-bills are quoted on a
bank discount basis not on the usual price/ PV basis
 The yield on a bank discount basis is calculated as
(D) or (Face Value  Price) 360
yd  x  100%
Face Value (t) or Days to Maturity
 Example: Calculate the yield on a T bill with 100 days to
maturity and face value of $100,000 and selling at
(1,111.11) 360
yd  x  100%  4%
100,000 (100) or Days to Maturity

US T-bills- Pricing
 However, the yield calculated (in prior slide) is not a
meaningful measure primarily because it is based on the
“Face Value” and not on the “Price” or the actual amount
 Additionally it is calculated on a 360 day basis whereas
bond yields are calculated on a 365 day basis.
 But by convention this is the method followed in this
 But to make it comparable to other MM securities there is
a measure called MM Equivalent yield which is computed
as follows:
MM _ Equivalent_ Yield 
360 - t( y d )
US T-bills- Pricing
 Alternately, given the yield we can compute the Price of T-
bill as follows
 Since D = Face Value – Price  Price = Face Value - D
 Where D is calculated as follows:
D  y d xFaceValuex
 Example: Calculate the Price of a T bill with 200 days to
maturity and face value of $100,000 if the Yield on a bank
discount basis is quoted as 5%.
D  5% x100,000x  $2,777.78
 Hence, Price = $100,000 - $2,777.78 = $97,222.22
Commercial Paper
 Short term – up to 270 days, but majority are of 90 days
 They are unsecured and issued in large denominations of
$100,000 or higher
 They are issued by high-quality borrowers and represent the
obligation of the borrowing entity
 It is a wholesale market dominated by institutional investors
with very few individual investors
 These instruments are sold at a discount from par
 While both financial institutions as well as other corporations
issue CP, the majority of the CP issues are from the former
 They are sold either directly or via a dealer and backed by
bank lines of credit

Certificates of Deposit (CD)
 Certificates of Deposit are issued by banks to raise money to fund their business

 CDs may be negotiable (can be sold in secondary market) or non-negotiable

(penalty for early withdrawal)

 Our focus will be on the negotiable CDs

 Characteristics of Negotiable CDs

 Large denomination time deposit, less than six month's maturity.
 These CD’s are Negotiable instruments and may be sold and traded (in the
secondary market) before maturity.
 Four Categories (based on issuing institution):
 Domestic CDs (issued by domestic banks - large money center, regional banks)
 Eurodollar or Euro CDs (dollar denominated debt issued outside the US)
 Yankee CDs (dollar denominated debt issued by foreign bank with US branch)
 Thrift CDs (issued by smaller banks such as thrifts, and savings and loans
 Yields on CDs are quoted on an interest bearing basis (not discount basis)
 Hence they are issued at face value with a coupon (or interest) rate

Certificates of Deposit (CD)
 Development of the CD Market
 Issued by Citibank in 1961.
 With a view towards offsetting declining demand deposits as a source of
funds for business expansion

 Yields on CDs are a function of three factors:

 Credit rating of the issuing bank
 Maturity of the CD
 Supply and Demand for CDs

 Credit risk is an important factor in the pricing of CDs

 Consequently CD yields are higher than yield on Treasury securities (of similar
maturity) because CDs are exposed to credit risk of the issuer. Additionally CDs
are a little less liquid compared to Treasury securities

 Particularly during a crisis situation (like the 2008 financial crisis) the spread
widens because of “flight to quality”, wherein a majority of investors shift their
funds to high quality government issued debt (with little risk)

Bankers Acceptance (BA)
 Bankers Acceptance are used to facilitate international trade.
 They are called as such because a bank “accepts” the
responsibility to repay a loan to the holder of the BA
document in case the debtor fails to perform
 These are also sold on a discount basis similar to T-Bills and
 BA’s are time drafts or pay orders with the objective of a
future payment
 Drafts are drawn on and/or accepted by commercial bank.
 Direct liability of bank.
 There is an active secondary market comprising of dealers
for Bankers Acceptance
 Discounted in market to reflect yield.
 Standard maturities of 30, 60, 90, or maximum of 180 days
Genesis of a Bankers Acceptance (BA)

 Importer initiates purchase from foreign exporter, payable in


 Importer needs financing; exporter needs assurance of

payment in future.

 This is how and where the BA comes into play!

 Importer's bank writes irrevocable letter of credit for exporter

 Specifies purchase order
 Authorizes exporter to draw time draft on bank.

Repurchase Agreement (Repo)
 A repo is a lending transaction where the borrower uses a security as a
collateral for borrowing

 It is called a Repo because of how it is structured

 Repo agreement specifies the sale of a security and its subsequent

repurchase at a future date

 The difference between the repurchase price and the sale price
represents the cost of borrowing

 Overnight repos (most popular) are for one day and other repos (>1 day)
are called term repos

 The collateral may be either a T Security, other Money market

instruments, Federal agency security or MBS

 Parties to a Repo are exposed to credit risk limited by posted margin and
marking to market of securities
Repurchase Agreement (Repo)
 Bank Financing -- Source of funds
 Security sold under agreement to repurchase at given price in future.
 Way to include corporate business in Federal Funds market (due to
attractive yields)

 Bank Investment – Reverse Repo

 Security purchased under agreement to resell at given price in future.
 Smaller banks are able to invest excess liquidity in a secured

 Repos are also used by the Federal Reserve in open market

operations with a view towards implementing its monetary
 Repo rates are a function of Quality (credit), Term of the
repo, delivery requirement (of collateral), and availability of
Federal Funds Market (Fed)
 In the Federal Funds market, banks and other depository institutions
borrow (buy) or sell (lend) excess reserves held in the form of deposits in
a Federal Reserve Bank (central bank)

 Characteristics of Federal Funds

 Market for depository institutions.
 Most liquid of all financial assets.
 Related to monetary policy implementation.

 Yields related to the level of excess bank reserves.

 This yield is referred to as the Fed Funds Rate and is the reference rate
for determination of all other money market rates

 Originally a market for excess reserves -- Now a source of investment

(federal funds sold) and continued financing (federal funds purchased).

 This rate is subject to the Federal Reserve’s monetary policy and hence
exhibits wide range of variability over time