FINANCIAL MARKETS & INSITUTIONS

COURSE OUTLINE:
PRELIM TRACK: MODULE 3 MONEY MARKETS AND MONEY MARKET SECURITIES
MONEY MARKETS
Definition
o Money markets involve debt instruments with original
maturities of one year or less.
o Money Market Debt
 Issued by high-quality (i.e., low default risk) economic
units that require short-term funds.
 Purchased by economic units that have excess short-
term funds.
 Little or no chance of principal loss.
 Low rates of return
 Most money market instruments have active secondary
markets to provide liquidity.

Yields on Money Market Securities

o Discount Yields
 Treasury bills and commercial paper rates are quoted as
discount yields.
 Discount yields (id) use a 360-day year.
(Pf  P0 ) 360
id  
Pf n
Where:
Pf = the face value of the security
P0 = the purchase price of the security
n = the number of days until maturity

o Bond Equivalent Yields & Effective Annual Return

 Compare discount securities to bonds with bond
equivalent yields (ibe).

(Pf  P0 ) 365
ibe  
P0 n
 Convert bond equivalent yields into effective annual
returns (E A R).
365
  n
 ibe 
EAR   1  1
365 
 
 n 
 o Single-Payment Yields
 Negotiable CDs and fed funds are money market
securities that pay interest only at maturity. These use
single-payment yields (isp).

(Pf  P0 ) 360
isp  
P0 n
 to convert a single-payment yield to a bond equivalent
yield:
 365 
ibe  isp  
 360 
 to directly convert a single payment yield to an E A R:

365
 365  n
 
EAR   1  i sp 360  1
365
 
 n 
Sample Calculations of Money Market Yields
o A $1M investment in 90day commercial paper has a 2% discount
yield. An equivalent size and risk 90day CD has a 2% single
payment yield. Which security offers the better return?

For the Commercial Paper:

(Pf  P0 ) 360 ($1M  P0 ) 360
id   0.02   ;P0  $995,000
Pf n $1M 90
(Pf  P0 ) 365 ($1M  $995,000) 365
ibe   ibe    2.038%
P0 n $995,000 90
 The bond equivalent yield for the commercial paper is
2.038%.

For the CD:

 365   365 
ibe  isp   ibe  0.02     2.0278%
 360   360 
 The bond equivalent yield for the CD is 2.0278%.
 The commercial paper has the better return since its bond
equivalent yield is 2.038%.
  What is the commercial paper’s E A R?
365
  n
 ibe 
EAR   1  1
365 
 
 n 

Money Market Securities

o https://www.desjardins.com/ca/co-opme/action-plans-
tips/savings-investment/treasury-bills-money-market-
securities/index.jsp
o Treasury Bills
https://smartasset.com/investing/what-are-t-bills-and-should-
you-invest-in-them
 are short-term debt obligations issued by the
government
 In the US:
 issued by the Treasury Department
 T-Bill Auctions
o 13- and 26-week T-bills are auctioned
weekly, other maturities available.
o Bids are submitted by government
securities dealers, financial and
nonfinancial corporations, and
individuals.
o Bids can be competitive or
noncompetitive.
a) Competitive Bids
 specify the amount of
par value of bills desired
and the discount yield,
rather than the price.
b) Noncompetitive Bid
 bidders get preferential
allocation and agree to
pay the lowest price of
the winning competitive
bids.
 In the PHILIPPINES:
 Treasury Bills (T-bills) are direct and
unconditional obligations of the national
government.
 They are issued by the BTr (Bureau of Treasury).
 They carry maturity of one year or less and can
be traded in the secondary market before
maturity. Various tenors of T-bills exist: (1) 91
day, (2) 182 or (3) 364 days. Banks that comprise
majority of the Government Security Eligible
Dealers (GSED) bid for T-bills in the weekly
auctions held by the BTr. The banks then resell
the T-bills to investors.
 T-bills are virtually default risk free, are highly liquid, and
have little interest rate risk.
 The Central bank buys and sells T-bills to implement
monetary policy.
 Strong international demand for T-bills as safe haven
investment.
 The Secondary Market for T-Bills
 The secondary market for T-bills is the largest of
any U.S. money market instrument.
 23 primary dealers “make” a market in T-bills by
buying the majority sold at auction and by
creating an active secondary market.
o Primary dealers trade for themselves
and for customers.
o T-bill purchases and sales are book-entry
transactions conducted over Fedwire.
 T-Bills are sold on a discount basis.
 T-Bill Prices
o T-Bill prices can be calculated from quotes (e.g.,
from The Wall Street Journal) by rearranging the
discount yield equation.
 n 
P0  Pf   iT Bill d   Pf 
 360 
Or, by rearranging the bond equivalent yield
equation.

Pf
P0 
 
 n 
1 
 365 
 i 
 T Bill be 
o Federal funds
 https://www.investopedia.com/terms/f/federalfunds.as
p
 The federal funds (fed funds) rate is the target rate in the
conduct of monetary policy.
 Fed fund transactions are short-term (mostly overnight)
unsecured loans.
 Banks with excess reserves lend fed funds, while banks
with deficient reserves borrow fed funds.
 Multimillion dollar loans may be arranged in a matter of
minutes.
 Fed funds are single-payment loans and thus use single-
payment yields.
o Repurchase Agreements
 https://www.investopedia.com/terms/r/repurchaseagr
eement.asp
 is the sale of a security with an agreement to buy the
security back at a set price in the future.
 Repos are short-term collateralized loans (typical
collateral is U.S. Treasury securities).
 Similar to a fed fund loan, but collateralized.
 Funds may be transferred over FedWire system.
 If collateralized by risky assets, the repo may involve a
‘haircut’
(https://www.investopedia.com/terms/h/haircut.asp)
 Typical denominations on repos of one week or less are
$25 million and longer term repos usually have $10
million denominations.
 A reverse repurchase agreement is the purchase of a
security with an agreement to sell it back in the future.
 Repurchase Agreement Yield
a. The yield on repurchase agreements (iRA) uses a
360-day year, like the discount rate, but uses the
current price in the denominator, like the bond
equivalent yield.
(Pf  P0 ) 360
irepo ,sp  
P0 n
Pf = the repurchase price of the security
P0 = the selling price of the security
n = the number of days until the repo matures
o Commercial Paper
 https://www.investopedia.com/terms/c/commercialpa
per.asp
 Commercial Paper (CP) is unsecured short-term
corporate debt issued to raise short-term funds (e.g., for
working capital).
 Generally sold in large denominations (e.g., $100,000 to
$1 million) with maturities between 1 and 270 days.
 CP is usually sold to investors indirectly through brokers
and dealers.
 C P is usually held by investors until maturity and has no
active secondary market.
 Yields are quoted on a discount basis (like T-bills).
 Asset-Backed Commercial Paper
a. https://www.investopedia.com/terms/a/asset_
backed_commercial_paper.asp#:~:text=An%20a
sset%2Dbacked%20commercial%20paper%20(A
BCP)%20is%20a%20short,assets%20such%20as
%20trade%20receivables.
b. A type of commercial paper that is backed by
assets of the issuing firm.
c. Grew very rapidly prior to the financial crisis
peaking at $2.16 trillion, much of it was backed
by mortgage investments.
d. The market collapsed during the financial crisis.
o Negotiable Certificates of Deposit
 https://www.investopedia.com/terms/n/negotiable-
instrument.asp#:~:text=A%20negotiable%20instrument
%20is%20a,future%20date%20or%20on%2Ddemand.
 is a bank-issued, fixed maturity, interest-bearing time
deposit that specifies the interest rate and the maturity
date.
 C Ds are bearer instruments and thus are salable in the
secondary market.
 Denominations range from $100,000 to $10 million; $1
million being the most common.
 Often purchased by money market mutual funds with
pools of funds from individual investors.
o Banker’s Acceptances
 https://www.investopedia.com/terms/b/bankersaccept
ance.asp
 is a time draft payable to a seller of goods, with payment
guaranteed by a bank.
 Used in international trade transactions to finance trade
in goods that have yet to be shipped from a foreign
exporter (seller) to a domestic importer (buyer).
 Foreign exporters prefer that banks act as payment
guarantors before sending goods to importers.
 Banker’s acceptances are bearer instruments and thus
are salable in secondary markets.
o Comparison of Money Market Securities
 Different securities have a number of characteristics in
common:
a. Large denominations
b. Low default risk
c. Short maturities
 It should also be noted that these securities are quite
different in terms of their LIQUIDITY.
1. Treasury bills – have an extensive secondary
market. Thus, thee money market securities can
be converted into cash quickly and with little loss
in value.
2. Commercial paper – has no organized secondary
market. These securities cannot be converted
into cash quickly unless resold to the original
dealer/underwriter. Conversion may entail
higher costs.
3. Federal funds – no secondary market trading
because these securities are typically overnight
loan transactions and are not intended to be
held beyond very short horizons.
4. Negotiable CDs – can be traded in secondary
markets, but in recent years trading has been
relatively inactive, as most of this type of
securities are being bought by “buy & hold”
oriented market mutual funds.
5. Banker’s Acceptances – same with negotiable
CDs.
Money Market Participants

International Aspects of Money Markets

o Euro Money Markets
 https://www.investopedia.com/terms/e/eurodollar.asp
o U.S. dollars held outside the U.S. are tracked among
multinational banks in the Eurodollar market.
o The rate offered for sale on Eurodollar funds is the London
Interbank Offered Rate (L I B O R).
o Eurodollar Certificates of Deposit are U.S. dollar-denominated
CDs held in foreign banks.
o Eurocommercial paper (Euro-C P) is issued in Europe and can be
in local currencies or U.S. dollars.