The money market

PART 3:

THE MONEY MARKET

1. DEFINITIONS

CASH MARKETS

'Cash markets' is a term used to describe the markets for securities,

commodities and other traditional investments. They are distinguished
from the markets for derivative instruments, such as FRAs, futures
and options. The cash markets include the FX spot and forward
markets and the money markets.

MONEY MARKETS

Money markets are wholesale markets for trading short-term financial

instruments. Most money market transactions are in a maturity band
of up to three months, but some extend up to one year or even longer.

The main money market products are:

• Interbank loans/deposits

• Certificates of Deposit (CDs)

• Treasury bills

• Bankers' Acceptances

• Commercial paper (CP)

• Repurchase agreements (repos).

Repurchase agreements are described in the advanced course.

Page 1 of 26
 The money market

NEGOTIABLE INSTRUMENTS

CDs, bills and CP, unlike loans/deposits, are negotiable instruments.

A negotiable instrument is one that can be resold in a secondary
market (but cannot be 'cashed in' with the issuer) before maturity.

Negotiable money market instruments are issued and traded ‘over the
counter’, not on a recognised exchange (i.e. they are not
exchange-traded).

2. BANKS AND THE MONEY MARKETS

Banks and other deposit takers need to maintain liquidity. They must
be able to repay demand deposits if necessary. The existence of a
money market enables banks and other participants with surplus short
term funds to invest them for interest, and enables participants with a
deficit to borrow relatively easily in a liquid market

If the money markets are highly liquid, banks know that their 'cash'
needs can be met quickly and easily. This means that they can operate
with lower levels of liquidity, hence maximising their return on
assets.

Banks need to keep a certain proportion of their assets in liquid form.

They do this by placing funds on deposit with other institutions, and
by the purchase of money market instruments, which can be quickly
sold.

Central banks carry out transactions in the money markets in order to

fulfil their obligations for:

• The control of inflation through monetary policy

• Management of the exchange rate

• Management of government borrowings.

The central bank can convey 'signals' to the money market about the
desired direction and level of interest rates by means of its operations
in the market.

Page 2 of 26
 The money market

3. INTERBANK LOANS AND DEPOSITS

Major banks lend and borrow deposits between each other. The rates
at which they lend and borrow in the domestic or eurocurrency
markets depends on market conditions, the quality of the borrowing
counterparty, and so on.

Rates are quoted on electronic systems such as Reuters, and by phone

directly or via brokers. Normal trading lots are of a typical minimum
of USD 10 million.

Rates are quoted for many standard maturities, from overnight to 12

months, but the most commonly-traded loans and deposits are of
three-month maturity.

These rates represent freely floating wholesale deposits, and therefore

give the fairest picture of free market interest rates.

At any one time, different banks will be quoting different rates,

depending on their liquidity and credit positions. Banks with surplus
funds will not bid up to take deposits, and will accept offers at lower
rates to invest their funds. Banks with good credit ratings will be able
to borrow funds at better rates of interest than lowly-rated banks.

The margin between bid and offer is normally 1/8% (one eighth of
one percent, or 12.5 basis points). However, actual deals will be
struck at compromise rates, otherwise, banks would remain all day
offering three-month money at (say) 7% and bidding 6 7/8%.

A reference rate or benchmark rate is established for the eurocurrency

markets in London. This is the London Interbank Offered Rate or
LIBOR.

In terms of meeting the needs of certain legal documents (e.g. FRA

terms and conditions) it is necessary to clarify the meaning of LIBOR.
LIBOR rates for periods between one month and twelve months
published by the British Bankers Association at 11.00 am daily have
become the reference rates for many deals.

LIBOR is an internationally-recognised benchmark/reference rate,

due to the importance of London as the main centre of the eurodollar
market.

Page 3 of 26
 The money market

Many customers and corporate deals, as well as interbank

transactions, are structured around LIBOR and LIBID to take
advantage of this deep and (usually) liquid market. However, credit
considerations mean that the market cannot act in the same confident
and rapid way as the FX market. Nevertheless, the interbank
loans/deposits market is vibrant enough to cope with the massive
reallocation of resources that are demanded daily.

There are also interbank rates in many major cities, such as TIBOR'
(Tokyo Interbank Offered Rate), SIBOR' (Singapore Interbank
Offered Rate) and EURIBOR' (Euro Interbank Offered Rate).

As broad definitions

‘LIBOR’ (London Interbank Offered Rate) is the average rate at

which banks in London are currently prepared to offer to lend money
to other top quality banks.

‘LIBID’ is the average rate at which banks in London are currently

prepared to accept deposits from other banks. This is lower than
LIBOR.

CLEAN DEPOSITS

A clean deposit is a straightforward deposit (for a fixed period or at

notice) with no strings or conditions attached. An interbank deposit
could be described as a clean deposit.

START DATE FOR A LOAN/DEPOSIT

The start date for a spot interbank loan/deposit is two working days
after the loan/deposit agreement is made. The same rules apply as for
spot FX transactions.

For example, the start date for a three-month loan agreed on Tuesday
6 April will be Thursday 8 April.

Page 4 of 26
 The money market

Loans/deposits can also be arranged for ‘short dates’ (earlier than

spot) in the same way as for short-dated FX transactions. These are
described later.

MATURITY DATE (END DATE) FOR A LOAN/DEPOSIT

The maturity date for a loan/deposit of X months is normally exactly

X calendar months after the loan/deposit start date. For example, a
3-month deposit starting on Wednesday 8 May will mature on
Thursday 8 August.

There are exceptions to the rule.

• If the day that would be the maturity date falls on a weekend

(Saturday or Sunday) or on a bank holiday date, the maturity date
is deferred to the next working day.

• If the start date for the loan/deposit is the last working day in the
month (e.g. Friday 26 February, or Friday 30 March) the maturity
date is the last working day of the relevant month.

Maturity dates for loans/deposits are identified according to rules

similar for those applying to forward FX transactions. These are
described in more detail later.

4. EUROCURRENCY MARKETS

During the Cold War period, especially after the invasion of Hungary
in 1956, the Soviet Union feared that its deposits in North American
banks would be frozen as retaliation. It decided to move some of its
holdings to the Moscow Narodny Bank, a Soviet-owned bank with a
British charter. The British bank would then deposit that money in the
US banks. There would be no chance of confiscating that money,
because it belonged to the British bank and not directly to the Soviets.

Eurodollars are time deposits denominated in U.S. dollars at banks

outside the United States, and thus are not under the jurisdiction of the
Federal Reserve. Consequently, such deposits are subject to much less
regulation than similar deposits within the U.S., allowing for higher

Page 5 of 26
 The money market

margins. The term was originally coined for U.S. dollars in European
banks, but it expanded over the years to its present definition – a U.S.
dollar-denominated deposit in Tokyo or Beijing would be likewise
deemed a Eurodollar deposit. There is no connection with the euro
currency or the eurozone.

More generally, the euro-prefix can be used to indicate any currency

held in a country where it is not the official currency: for example,
euroyen or even euroeuro.

The domestic interbank market is for borrowing and lending domestic

currency. The eurocurrency markets are for borrowing and lending a
currency outside the country's currency of origin.

The main currency for eurodeposits and euroloans is the US dollar.

There are also active markets in some other currencies, particularly
euroyen, euroswiss and eurosterling.

The main centres for the eurocurrency markets include London, New
York, Singapore and Hong Kong.

In the London market, bid and offer rates in eurocurrencies are

referred to as 'dollar LIBOR', ‘Euro LIBOR’ and so on. At one time,
the spread between the bid and offer rates was narrower than in the
domestic interbank markets, but in general this is no longer the case.
The difference between domestic and euromarket interest rates is now
very small.

However, a price incentive (narrower spreads) is no longer required to

induce banks and other organisations to deal in the euromarkets.
Companies doing business internationally find it more convenient to
borrow and deposit funds in the euromarket, instead of having to deal
in a number of different domestic markets. They are able to make the
best use of temporary surpluses of foreign currency available to them.

Transactions in the eurocurrency market involve foreign currencies,

and so there will be a delay in delivery loan funds to a borrower. A
‘spot’ euroloan transaction is one where the funds will be delivered to
the borrower two working days after the transaction is agreed.

Page 6 of 26
 The money market

INTEREST IN THE INTERBANK/EUROCURRENCY

MARKETS

It is standard convention for loans or deposits to be constructed on the

basis of a 'per annum' quotation, but for interest to be paid in arrears
at the end of the loan/deposit period along with the repayment of
principal (the repayment of the loan principal in full at maturity is
known as a 'bullet' repayment).

For longer fixed term loans above 12 months, interest will normally
be payable annually, on the anniversary of the deal, and at maturity.

For example, if a depositor places funds with a bank for a fixed term
of 18 months, interest will usually be paid after 12 months and again
after 18 months.

Since the interest rate for a short-term loan or deposit is fixed for the
period, simple interest calculations apply. However, by ‘rolling over’
deposits or loans, interest can be earned on interest. In such cases, the
quoted rate of interest needs to be adjusted (by compounding) for the
frequency of payment in order to arrive at comparable rates of return.

For example, a monthly deposit at 6% p.a. (=0.5% per month) will

earn more than a 12-month deposit at 6%.

• Monthly deposit at 6% (0.5* per month)

12
Equivalent annual yield = (1.005) –1

= 0.0617 or 6.17%

• 12-month deposit at 6% yields just 6%.

YIELDS, DISCOUNT RATES AND COMPOUND ANNUAL

RATES

Below, for comparison, are some discount rates and the true or quoted
yield and compound annual rate (CAR) equivalents. All are given as
per annum percentages.

Page 7 of 26
 The money market

Term to Discount True Yield % CAR%

maturity
1 month 9.9174 10 10.47
2 months 9.8361 10 10.43
3 months 9.7561 10 10.38
6 months 9.5238 10 10.25
1 year 9.0909 10 10.00

For example, suppose that we compare:

• A three-month US dollar bill (maturity 91 days) quoted at a true

yield of 10%, with

• A three-month deposit, at a quoted yield of 10% pa.

The true yield on the discount paper (the bill) is 10%. This means that
the quoted discount on the bill is 9.7561% (see table above).

True yield = 0.097561 ÷ [1 – (0.097561 x 91/360)]

= 10%

The compound annual rate equivalent of a three-month deposit at

10% p.a. (i.e. 2.5% each quarter) is:
4
(1.025) – 1 = 0.01038, i.e. 10.38%.

This rate is also given in the table above.

The table therefore shows that a discount rate for three-month paper at
9.7561% is the equivalent of a 10% p.a. yield on a three-month
deposit, and that 10% p.a. for three months gives a compound annual
rate of 10.38% p.a.

The CAR formula assumes that reinvestment is achieved at the same

rate of interest each time. For example, most commercial banking
loans pay interest every 3 months. Thus a fixed rate loan for three
months at 10% could be said to be at a CAR of 10.38%. However,
over the life of the loan, it may not be possible to invest the interim
interest at 10% for each of the successive three-month periods, so the
out-turn would be lower than the CAR of 10.38%.

Page 8 of 26
 The money market

5. CERTIFICATES OF DEPOSIT (CDS)

Certificates of deposit originated in the domestic US market (where

they are directed primarily at the retail market). In the euromarket,
however, CDs are very closely allied to interbank deposit.

A CD is a record evidencing the placement of a deposit with the CD

issuer (borrower) for a stated period of time and at a given rate of
interest. The CD therefore recognises the obligation of the issuer to
pay the principal (face value of the CD) plus interest to the CD holder
at maturity.

Originally, CDs were all issued on security paper and were high value
bearer instruments that had to be collected by messenger from the
issuer. However, it is now usual to issue CDs in electronic (book
entry) form, and to use an international clearing system (e.g.
Euroclear) to arrange the electronic book transfer and custody of the
securities.

In London, there has also been the development of the CMO (Central
Money Markets Office) at the Bank of England which safe-keeps CDs
whilst arranging electronic records of ownership. Eventually, this may
lead to the virtual elimination of the paper CD.

CDS AND TIME DEPOSITS COMPARED

It is useful to compare a CD with an ordinary time deposit. With a

time deposit, the depositor places a sum of money with a bank for a
fixed time period. At maturity, the depositor can withdraw the money
deposited plus interest.

A CD is a certificate for a time deposit: it is a bearer security (even in

electronic form), and the CD holder can sell the entitlement to the
underlying deposit before maturity to someone else.

The great advantage of a CD over a time deposit, to the CD holder, is

that it is a liquid negotiable instrument, tradable in a secondary
market. Hence, CDs provide a means for the holder to deposit funds
short-term whilst retaining the flexibility to convert them into cash
should the requirement arise.

Page 9 of 26
 The money market

In return for this liquidity, the CD holder must accept a lower yield
than on a money market deposit. This is normally about 1/16 of 1%
(6.25 basis points) or 1/8 of 1% (12.5 basis points) below the
equivalent rate for a large deposit with the same bank.

CD MARKETS

Certificates of Deposit are issued in many centres around the world

but the prime international centre is in London. The Bank of England
authorises major banks to issue CDs in a variety of currencies:
sterling, US dollars, yen, Australian dollars, Canadian dollars and
Euros. Certificates may be issued in other currencies too, provided the
appropriate central bank is aware and does not object.

(Sterling CDs may also be issued by UK building societies. However,

the majority of CDs, whether issued by banks or building societies,
are issued as part of normal money market funding arrangements).

CD MATURITIES

Whilst most CDs are issued for periods such as one, three or six
months, some may be issued on request for broken periods
(colloquially known as 'cock dates'). Also, some CDs are issued as
part of a formal programme under which one dealer or group of
dealers undertakes to buy a large volume (and value) of CDs for
onward sale. Often these CDs will be for periods in excess of one
year, perhaps as long as 3 or 5 years.

The Bank of England does not consider that an instrument issued for
longer than 5 years is, at any time during its live, a CD. The
maximum term for which London Certificates of Deposit are issued is
therefore five years. CDs with an original life of greater than one year
will pay interest at least annually (there is no minimum maturity for a
CD).

Page 10 of 26
 The money market

INTEREST

CDs bear interest and, when issued, are quoted on a yield basis (rather
than a discount basis). Normally, interest is paid at maturity.
However, on CDs issued with a maturity beyond one year, interest is
paid annually (or perhaps semi-annually, e.g. on US domestic CDs,
but not eurodollar CDs issued in London).

ISSUE PRICE AND SECONDARY MARKET PRICE OF CDS

CDs are issued as an interest-bearing instrument. For example,

suppose that South Bank, a natural borrower of six-month Australian
dollars, is contacted by a money broker, who says that a lender is
willing to lend six-month Australian dollars at 6 1/18%, or
alternatively will buy paper at 6%.

Primary Issue

South Bank agrees to issue a CD, and a deal is agreed for 20 million
Australian dollars (4 x AUD 5 million). In other words, four CDs will
be issued, each for AUD 5 million. The lender/investor pays South
Bank AUD 20 million (5 million for each CD).

Suppose there are 183 days in the six-month period. Each individual
CD will promise to pay the presenter (bearer) at maturity the face
value of the CD, AUD 5 million, plus interest of AUD 150,410.96
(day base = 365 days).

Note

Interest at 6% is calculated, for each CD or AUD 5 million, as:

AUD 5 million x 6/100 x 183/365

Secondary market pricing

Let's now suppose that the buyer of the paper is Omega Bank, and
that three months after the purchase, Omega Bank wants to sell two of
the CDs.

Page 11 of 26
 The money market

Through a broker, a buyer has been identified who would be willing

to buy the paper to yield 5% over the remaining term to maturity of
91 days.

Each CD has a defined value at maturity of AUD 5,150,410.96. A

method has to be established for pricing such instruments (i.e. with a
fixed terminal value) in the secondary market.

Solution

An appropriate formula to use is the formula described in Part 2 for

discount securities.

V = F ÷ [1 + (D/B x Y)]

where

V is the secondary market price of the CD

F is the amount payable to the CD holder at maturity, i.e.

principal plus accrued interest

D is the number of days to maturity

Y is the investment yield for the CD holder

B is the day base.

In our example, the CD buyer requires a yield of 5%. Each CD will

therefore be sold at a price of:

AUD 5,150,410.96 ÷ [1 + (91/365 x 0.05)]

= AUD 5,086,997.70

The sale price of a CD can be higher or lower then its original

purchase price, depending on how interest rates have changed
between the purchase and resale date.

As a general rule, however, the resale price should usually be higher

than the original purchase price. Given stable interest rates, the value
of a CD should rise gradually up to maturity. However, if there is an
increase in interest rates, the value of a CD can fall.

Page 12 of 26
 The money market

In summary, you should note that for primary CDs (new issue), the
methodology for calculating interest is the same as for straightforward
interbank deposits. The pricing methodology for secondary CDs is the
'discount to yield' formula.

Exercise

Attempt your own solution to this problem before checking the

answer below.

A USD CD is issued at 5% in USD 1,000,000 4/3/06 - 29/11/06. On 2

June 2006, you buy the CD at 7 1/4%.

Required

a) What is the purchase price you have to pay?

b) If you were the seller of the CD, what was your yield for the
period in which you held the CD?

Answer

The original tenor of the CD is 270 days:

28 + 30 + 31 + 30 + 31 + 31 + 30 + 31 + 28 days = 270

The interest payable on the CD at 5% is:

USD 1,000,000 x 5% x 270/360 = USD 37,500

The value of the CD at maturity will be USD 1,037,500.

The CD is purchased on 2 June at 7.25%. The remaining period to

maturity is 180 days (29 + 31 + 31 + 30 + 31 + 28).

Purchase price

The purchase price of the CD is:

V = USD 1,037,500 ÷ [1 + (180/360 x 0.0725)]

= USD 1,001,206.27

Page 13 of 26
 The money market

Seller's yield

The yield earned by the seller of the CD is USD 1,206.27 (the

difference between the sale price and original purchase price of USD
1 million). This is earned in 90 days (270 - 180 days). The yield is
therefore:

1,206.27/1,000,000 x 360/90 x 100

= 0.48%

This is a very low return. The seller’s return is low because the yield
on the CD was just 5% at purchase, but has risen to 7 1/4% by the
time of sale. The large increase in the yield has depressed the CD's
market value.

6. TREASURY BILLS

In addition to issuing long term bonds, governments issue short-term

Treasury bills (T bills) of up to one year maturity. These do not carry
a coupon, but are sold on a discount basis.

For example, the US Treasury, UK government and the European

governments are all active and regular issuers of bills. These represent
the highest quality money market instruments available from a credit
standpoint, and are used by researchers to measure short term
risk-free rates.

In the UK, T bills are issued by the Bank of England on behalf of the
government, normally on a weekly basis and normally by tender.
Treasury bills can be issued for any term up to one year but the
tendency has been to issue for 3 or 6 month periods. At the tender the
prospective purchaser has to indicate the price he is prepared to pay.
This price is a function of the interest rate expected.

Page 14 of 26
 The money market

ISSUE PRICE OF T BILLS: DISCOUNT YIELD AND TRUE

YIELD

For example, if a bid of GBP 982,739.73 is tendered for a 90-day UK

Treasury bill of one million pounds, it is because the bidder wishes to
receive 7% discount. The amount of the discount bid is:

GBP 1,000,000 x 7% x 90/365 = GBP 17,260.27

The tendered price is therefore: GBP 982,739.73

The add-on yield equivalent is:

GBP 17,260.27/GBP 982,739.73 x 365/90 = 7.12%

SECONDARY MARKET TRADING: T BILLS

In the secondary markets, Treasury bills trade on a straight discount

basis. The rates quoted on brokers screens are discount rates. They are
therefore not comparable to euro-commercial paper (ECP) rates,
which are add-on yields, unless converted.

The issuance of T bills affects the money supply by temporarily

soaking up liquidity. Buyers pay cash in exchange for promises to
pay, and so cash is drained from the monetary system.

Conversely, bills can be bought back to inject funds into the system.
Selling unexpectedly large amounts of T bills tends to nudge interest
rates upwards, since the average rate of accepted bids rises. Selling
fewer bills than expected tends to nudge interest rates downwards.
The central banks also stand ready to buy up T bills from traders or
banks who are in need of temporary liquidity (such as when there is a
‘run on the bank’).

All the major bill markets have primary traders who are given special
information and dealing privileges in return for obligations to buy
certain percentages of the new issues. This is always a good liquid
market in Treasury bills.

Traders aim to buy at a high rate of discount and sell at a lower rate of
discount. A trader who buys USD 1,000,000 of 70-day US T-bills at

Page 15 of 26
 The money market

5.75% and sells them on at 5.625% on the same day has traded at the
following prices:

Purchase - USD 988,819.44

Sale + USD 989,062.50

Profit + USD 243.06

Exercise

Attempt your own solution to this problem.

You buy 90-day Treasuries with a yield of 4.24%. The face amount is
USD 10 million. What would you pay for them?

You sell on the Treasuries 21 days later at 4.15%. What would you
receive for them?

Answer

Purchase Price

V = F – F x D/B x d

= 10 million - 10 million x 90/360 x 0.0424

= USD 9,894,000.00

Sell-on Price

= 10 million – l0 million x 69/360 x 0.0415

= USD 9,920,458.33

7. BANKERS' ACCEPTANCES (BAS)

A Banker's Acceptance is a bill of exchange drawn to finance trade

(exports and imports) and accepted by a bank as good for payment.
Originally, such bills were all transaction-specific. In other words, a
specific cargo would be financed, typically by the exporter drawing a
bill on the importer, and then offered to a bank to accept. The bank
would place its stamp and authorised signatures on the bill and from

Page 16 of 26
 The money market

then on it became, for all intents and purposes, paper with the risk and
quality of the accepting bank.

The accepting bank may pass on its accepted bill to another bank
which, if it were of better quality than the original bank, may also
accept it - thus increasing the quality of the paper itself.

The quality of the acceptor of the paper is the guide to the rate of
interest that the bill is likely to attract. The better the quality, the finer
the rate.

A Banker's Acceptance is drawn for a specific amount (originally, the

value of a cargo) and does not bear an interest coupon. Instead, it is
discounted. The methodology for such discount is 'straight discount',
normally, although some bills go through at ‘discount to yield’.

The best quality bills in the UK are eligible for re-discount at the
Bank of England. Although bills may not necessarily be drawn to
cover specific cargoes there usually has to be an underlying trade
business that the Bank of England can recognise. However, in the
United States BAs can be drawn for more flexible reasons such as the
funding of stocks or work in progress.

Example

A bill of exchange has been drawn for GBP 1 million, payable on 14

September. On 20 June (86 days to maturity), the bill is presented to
Sahara Bank, which discounts it at 8% and pays away GBP
981,150.68. This bill is ‘ineligible’, since Sahara Bank is not a
recognised market maker in BAs.

On 22 June, Sahara Bank passes the bill to a UK discount house,

which accepts the bill and discounts it at 7 1/4%. It pays away GBP
983,315.07 to Sahara Bank. The discount house's acceptance of the
bill gives it 'eligibility', and the bill can now be traded at much finer
rates.

On 23 June, the discount house sells the acceptance to an investment

bank at 7 1/8%. The discount house receives GBP 983,797.95.

The investing bank does not accept the bill, but simply buys it with
the intention of holding it until maturity.

Page 17 of 26
 The money market

At maturity on 14 September, the investing bank receives GBP 1

million on presentation of the bill. (In the event that the bill is not paid
direct by the original 'drawee' the presenter would expect the discount
house to pay, and the discount house in turn would look to Sahara
Bank to honour its acceptance).

8. COMMERCIAL PAPER (CP)

Commercial paper (CP) is a short-term financial instrument,

consisting of unsecured promissory notes issued in bearer form which
can therefore be readily traded. At maturity, the CP issuer pays the
amount due to the person presenting the paper.

Commercial paper is an example of 'securitisation', i.e. raising loan

funds by issuing negotiable debt securities rather than by bank
borrowing. A bank acts as agent for a CP issue, packaging and selling
the paper to investors, but does not advance its own funds.
(Securitisation, such as CP, is also a form of disintermediation, i.e.
raising funds directly from investors without the banks acting as
intermediaries through their loans and deposits business).

CP is issued as a series of notes, and each note promises to pay the

bearer a stated sum of money at the maturity date. Each note shows:

• The name of the issuer

• The amount (value) of the note

• The issue date

• The maturity date

• A certificate of authentication, signed by an authorised signatory

of the issuer's issue agent.

Each note will also indicate that the note is negotiable, its bearer is
entitled to payment, and that payment will be made (on presentation
of the note at maturity through a recognised bank) by the issue agent
on behalf of the company. An issuing or paying agent handles the
administrative processes.

Page 18 of 26
 The money market

An investment bank will help arrange the issuance of CP by its large

corporate clients, and provide them with an immediate market by
undertaking to bid for the paper and on-trade it to the investor market.
A CP trader at a bank hopes to make a small margin of profit on huge
volume turnover. This margin might be as small as 2 basis points, i.e.
USD 50 on a USD lm CP issued for 90 days.

The investor in CP is buying the unsecured debt of the corporate

issuer, but in buying through a bank dealer the investor is also getting
a moral obligation from the bank dealer to buy it back again, at the
then prevailing market price, if the investor wishes to return to cash.
This obligation is not enforceable.

ORIGINS OF THE CP MARKET

Like CDs, commercial paper (CP) originated in the US and its

creation and volume growth is very much a product of the banking
environment there. The US banking scene is still very fragmented,
(despite some mergers and take-overs). About 10 or 15 years ago it
was even more so, with large numbers of small local banks. In such
an environment, it was often the case that major trading and
manufacturing companies were a better credit risk than the banks.
These institutions needed a channel through which money could be
directed from cash-rich companies to companies that needed short
term financing. The invention of commercial paper provided such a
channel avoiding the need of banks to intermediate through the loans
and deposits market.

The elimination of banks as intermediaries creates cost benefits which

are shared between:

• The borrower, who achieves cheaper funding than from bank

lending, and

• The investor, who achieves an improved yield, at low risk,

compared with bank deposits.

Page 19 of 26
 The money market

MATURITIES OF CP

In the US CP market, commercial paper is limited to a 270 days tenor,

with 14 days being the most common maturity. CP is negotiable and
in bearer form. Settlement takes place on the same day. All issues
must carry a credit rating. Only US dollar issues are possible. The
benchmark cost of funds is the Federal Reserve Composite rate.

In the euromarkets and in the domestic sterling market, CP can have a

tenor of up to one year (364 days), but the average life at issue is
about 60 days. Issues are made in the following main currencies:
USD, GBP, EUR, JPY and CHF. However, about 80% of issues are
denominated in US dollars.

CP YIELDS

Rates on US Commercial Paper, like those on bills and BAs, are

quoted on a discount basis. (However, a small amount is issued in
interest-bearing form).

In the markets outside the US, CP is issued on a discount to yield

basis, meaning that the face value of the paper which will be payable
at maturity is discounted back to the date of issue at a rate of yield
rather than at straight discount.

Some small amounts of CP in the euromarkets are issued with a rate

of interest and therefore can be treated mathematically in the same
way as a CD.

CREDIT RATINGS

Investors do not have the time or resources to investigate credit, so the

use of credit ratings is essential to the working of the CP market. The
majority of paper is rated by the two leading agencies, Standard &
Poor's and Moody's.

A rating of Al/Pl might be necessary to persuade investors to buy the

paper.

Page 20 of 26
 The money market

9. MONEY MARKET YIELD AND LIQUIDITY

MONEY MARKET INSTRUMENTS: HOW YIELDS ARE

QUOTED

The yields on money market instruments are quoted in the market:

• As a true yield - i.e. at the rate of interest payable on the

investment, or

• As a discount rate.

Here is a summary.

Quoted at a true yield Quoted at a discount

Interbank loans/deposits Treasury bills

Primary issue CDs Bank bills

Euro CP quoted at discount to Bankers Acceptances

yield
Secondary Market CDs

US CP

COMPARABLE YIELDS

In broad terms, yields have to be higher when the investor/lender has

to accept greater risk or inconvenience. For example, an organisation
with a top credit rating will be able to issue CP at a lower yield than
an organisation with a lesser credit rating. Lesser credits have to pay
more to borrow funds.

As a broad guide, here is a table of money market instruments,

showing the comparable yields on each, in ascending order (i.e.
lowest yield = highest in the table: highest yield = bottom of the
table):

• Treasury bills

• Eligible bank bills and Bankers Acceptances

Page 21 of 26
 The money market

• Sterling CDs

• CP - top-rated issuer

• CP - lower-rated issuer.

Note

In the UK, bills accepted by eligible banks (eligible bank bills) will be
purchased by the Bank of England in its open money market
operations. Similarly, eligible bills in the US will be purchased by the
Fed. For this reason, yields on eligible bank bills are virtually the
same as on the government's own Treasury bills, with perhaps 1/32 of
1% difference in yield.

MARKET LIQUIDITY

The inter-bank market is highly liquid. Other markets have varying

degrees of liquidity, and liquidity can vary over time. The CD market
in London, for example, is much less liquid than the loans/deposits
market, but is usually more liquid than the CP market.

The market in a negotiable instrument is much more liquid than the

market for non-negotiable OTC items, such as FRAs,
over-the-counter options and swaps.

Page 22 of 26
 The money market

SAMPLE QUESTIONS

1. LIBOR is:
a. London Interbank Borrowing Rate
b. London Interbank Lending Rate
c. London Interbank Offered Rate
d. Lending Interbank Offered Rate

2. Which of the following currencies has its interest calculated on a

365 day basis in its domestic money market?
a. USD
b. CHF
c. EUR
d. AUD

3. The interest rate on GBP is quoted to you as 6 3/16 - 6 1/8 for

three months (91 days). How much interest would you have to pay
on a loan of GBP 3,000,000?
a. GBP 45,811.64
b. GBP 46,279.11
c. GBP 46,447.92
d. GBP 46,921.88

4. The one-year rate on USD is quoted to you as 5.0%. How much

interest would you have to pay on a loan of USD 5,000,000 for
this term, if the year has 366 days?
a. USD 250,000.00
b. USD 250,684.93
c. USD 253,472.22
d. USD 254,166.67

5. The six-month rate on SGD is 3 7/16 - 3 5/16. How much interest

would you pay on a six-month loan of SGD 5,000,000 (183 days)?
a. SGD 84,192.71
b. SGD 85,937.50
c. SGD 86,172.95
d. SGD 87,369.79

6. The 90 day USD rate is 5.125% and the 180 day rate is 4.9375%.
What is the 120 day rate, using straight line interpolation?

Page 23 of 26
 The money market

a. 4.9375%
b. 5.0000%
c. 5.03125%
d. 5.06250%

7. If the 90 day USD rate is 3.10% and the 180 day rate is 3 50%,
what is the 120 day rate using straight line interpolation?
a. 3.20%
b. 3.21%
c. 3.23%
d. 3.30%

8. A negative yield curve is one in which:

a. Longer rates are lower than short
b. Forward exchange rates are at a discount
c. Short term rate are lower than long
d. Forward exchange rates are at a premium

9. Which of the following currencies is the only one to be quoted on

an actual/365 basis for the calculation of interest on Eurocurrency
Interbank deposits?
a. EUR
b. JPY
c. GBP
d. CHF

10. What would you call a yield curve where shorter rates are higher
than longer rates?
a. Positive
b. Parabolic
c. Inverted
d. Flat

11. A 7.5% US dollar bond pays interest semi-annually. What is the

equivalent rate of interest on an annual bond basis?
a. 7.36%
b. 7.50%
c. 7.60%
d. 7.64%

12. A 9% bond pays interest annually. What is the equivalent semi-

annual bond rate?
a. 4.40%
b. 4.50%

Page 24 of 26
 The money market

c. 8.81%
d. 9.02%

13. The maturity date for a Eurodollar transaction falls on Saturday 31

March. When will the transaction be settled?
a. Friday 30 March
b. Saturday 31 March
c. Monday 2 April
d. Tuesday 3 April

14. A piece of Commercial Paper for USD 5,000,000 was issued at

6.5%. You now buy it to yield 4.5%. Which of the following
statements is correct?
a. It will cost you less than USD 5,000,000
b. It will cost you exactly USD 5,000,000
c. It will cost you more than USD 5,000,000
d. It cannot be determined from the information supplied
whether it will cost more or less than USD 5,000,000

15. A Certificate of Deposit is re-sold in the secondary market. Which

of the following statements is true?
a. Its resale price will be less than the price originally paid
b. Its resale price will be the same as the price originally paid
c. Its resale price will be higher than the price originally paid
d. It cannot be determined from the information supplied
whether the resale price will be higher or lower than the price
originally paid

16. In the Eurodeposit markets, what is spot?

a. One working day forward
b. Two working days forward
c. The duration of the deal
d. None of these

17. What advantage is there to the purchaser of a Certificate of

Deposit compared to the placing of a Fixed Deposit?
a. It normally pays a higher rate of interest
b. It eliminates counterparty risk
c. It is a negotiable instrument
d. None of these

18. What is the name for the base against which most Euro-loans are
fixed in London?
a. BBAIRS

Page 25 of 26
 The money market

b. LIBOR
c. FRABBA
d. UCOM

19. If the interest earned on a SGD deposit of 10,000,000 for 60 days

is SGD 83,333.33, what was the interest rate?
a. 5%
b. 8.33%
c. 10%
d. None of these

20. A C/D was issued for USD 5,000,000 at 6% with a maturity of 91

days. Interest accrued to maturity will be USD 75,833.33. You
purchase it 30 days later at 5.75%. What would you expect to pay
for it?
a. USD 4,951,754.78
b. USD 5,000,000.00
c. USD 5,003,114.45
d. USD 5,026,856.39

21. A USD C/D is issued at 4 1/2% in USD 2,000,000 with a maturity

of 183 days. 90 days later, you buy the C/D at 5 3/4%. What is the
purchase price you will have to pay?
a. USD 2,000,000.00
b. USD 2,015,593.46
c. USD 2,015,806.87
d. USD 2,016,759.09

22. You buy a 90-day US Treasury bill, face value USD 1,000,000,
with a yield of 5.6%. What is the issue price?
a. USD 944,000.00
b. USD 986,000.00
c. USD 986,191.78
d. USD 1,000,000.00

Page 26 of 26