MFIN 503 – Fixed Income

Lecture 2
Money Markets
Outline
 I. Features of Fixed Income

 II. Money Market

Features of Fixed Income
Basics bond features

Par Value
The par or “face” value
generally describes how
much will be repaid at
maturity.

Coupon Rate Issuer

The percentage of face The company responsible
amount to be periodically for issuance and
paid as interest on the repayment. Issuer credit
bond. quality affects the
interest rate paid.

Maturity and Tenor Denomination

Maturity and tenor

Maturity Money Market Bond Market Tenor

The original Securities with Securities with The time
duration of the original maturity original maturity remaining until
bond; how long of one year or greater than one par value is
at initiation less. year. repaid.
until par value is
repaid.
Bond issuers

Sovereign Government Non-Government Orgs

Countries that typically Supranational or quasi-
have currency issuing government entities.
capability.

Local Government Companies or SPEs

Entities with ability to Firms or special purpose
issue debt and raise taxes companies set up
to pay, but no currency specifically to finance
control. assets.
Bond price factors
Bond prices depend on 4 factors:

 Par or Face Value: Amount issued or amount repaid at maturity

 Coupon Rate: interest paid to the bondholder
 Number of years to maturity
 Yield to Maturity (YTM) The “interest rate” that makes the
discounted present value of the bond’s coupons equal to its market
price (also called internal rate of return of a bond).
Yield to Maturity (YTM)
The yield to maturity (YTM) is an interest rate such that present value
of the bond’s coupons and the face value equals the current market
price.

Often simply called the bond’s yield as in “The yield on the 10 year
bond is 5%.”

Important: YTM is quoted as an Annual percentage rate (APR).

*** Inverse relation between Bond Prices and Yields ***

Example 1
Compute the yield to maturity of the following bond:
The time to maturity is 1 year
The coupon is 10%.
The face value is $1,000

a) Suppose that the bond is trading at (below par) $900

b) Suppose that the bond is trading at (par) $1,000
c) Suppose that the bond is trading at (above par) $1,111
Example 2
Suppose that a bond is trading at $1,200.
The time to maturity is 2 years
The coupon is 15%.
The face value is $1,000

150 150 1,000

1,200 = 1
+ 2
+ 2
1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚
150 1,150
1,200 = 1
+
1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚 2
Using SOLVER in Excel we find that: ytm = 4.34%
Example 3
Suppose that a bond is trading at $1,500.
The time to maturity is 10 years
The coupon is 15%.
The face value is $1,000

150 150 1,000

1,500 = 1
+⋯+ 10
+
1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚 10
150 150 1,150
1,500 = 1
+ 2
+ ⋯+
1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚 1 + 𝑦𝑡𝑚 10
Using SOLVER in Excel we find that: ytm = 7.66%
Money Markets
The Money Market
The Money Market refers to the market for short-term borrowing and
lending, usually undertaken by banks.

 Federal Funds Rate: rate for balances kept at the Federal Reserve
 Eurodollar Rate: rate of interest on dollar deposits at a European bank
 LIBOR: average interest rate the banks charge to each other.
 SOFR: is a broad measure of the cost of borrowing cash overnight
collateralized by Treasury securities
 Repo Rate: interest rate charged for borrowing/lending with collateral.
The Money Market
1. Repo
A Repurchase Agreement (Repo) is an agreement to sell some securities
to another party and buy them back at a fixed date and for a fixed
amount.

The price at which the security is bought back is greater than the selling
price and the difference implies an interest called Repo Rate

A Reverse Repo is the opposite transaction, namely, it is the purchase of

the security for cash with the agreement to sell it back to the original
owner at a predetermined price, determined, once again, by the Repo
Rate
1. Repo
Collateralized loan:
 Buy a T-bond
 Use the T-bond as a collateral to get a loan
Alternative path:
 Buy a T-bond
 Repo out the T-bond:
 Sell the T-bond to a dealer with a promise to buy it back
 Price = selling price + interest

Receive money now and pay back later with interest.

T-bond is used as collateral or owned by counter-party:
1. Repo

Repo market: one of the

largest and most active in the
US money market

Collateral: treasuries,
agencies, MBS.

Term of the loan: overnight

and term-repo (mostly 3
months or less).
1. Repo pricing
𝑁
Repurchase Price: 𝑃𝑡 1 − ℎ 1+ 𝑟
360

where
Pt is the market value of the collateral
h is the haircut
N is the repo maturity (repo term)
r is the repo rate

Very highly levered position.

The trader earns the accrued interest between t and T.
The repo rate for most Treasury securities is called the General Collateral
Rate.
1. Repo
At time t, a trader takes a long position until time T
Example 4
You are entering into a 20-day repo to repo out a T-note currently selling
for $100 million at a repo rate of 5%. Assume that there is a haircut of 5%.

a) Are you trying to lend or borrow money?

b) How much will you pay or receive from your counter-party 20 days
from now?
Example 4
You are entering into a 20-day repo to repo out a T-note currently selling
for $100 million at a repo rate of 5%. Assume that there is a haircut of 5%.

Are you trying to lend or borrow money?

When you repo out a T-note you are trying to borrow money, effectively
using the T-note as collateral.
Example 4
You are entering into a 20-day repo to repo out a T-note currently selling
for $100 million at a repo rate of 5%. Assume that there is a haircut of 5%.

How much will you pay or receive from your counter-party 20 days
from now?

Since you are borrowing you will need to pay back 20 days from now. The
amount lent to you was: 95% x $100 = $95 million. The repo rate is 5%.
Therefore, you will have to pay:
Primary Dealer Fail to Deliver
2. Treasury bills
Zero coupon debt that matures in one year or less.

Issued at a discount of par value.

T-bills are commonly issued with maturity dates of 4, 8, 13, 17, 26 and 52
weeks
2. Treasury bills: Pricing
T-bill prices are often quoted by a discount rate:

𝑁
𝑃 = 𝐹𝑉 1 − 𝑑
360

Where:

- 10,000 is the face value of the T-bill

- N is the number of days until maturity
- D is the discount rate
Example 5
A 60-day T-bill with a discount rate of 6% and the face value of $10,000 will
be worth?

𝑁
𝑃 = 𝐹𝑉 1 − 𝑑
360

60
𝑃 = 10,000 1 − 6%
360

𝑃 = $9,900

10,000 365
Thus, the interest rate 9,900
− 1 = 1.01% ➔ 1.01% × 60
= 6.14% p.a.
Mini case
A Pension Fund need extra liquidity. The PF needs to sell $100 million face
of 90-day T-bill currently trading at 5%.

The PF approaches X-trade, a trading desk, to sell the T-bills. To avoid

liquidity problems, the trading desk decides to seek external funding from
the repo market. Z-lend is willing to lend the money through a 3-day repo
for a repo rate of 4.5% and no haircut.

3 days later, X-trade found a mutual fund (MF) interested to buy the T-bill
which now is trading at 4.95%.

What are the cash flows involved at t=0 and t=3 for each firm?