7QQMM203

Principles of Finance

Shulin Deng
King’s Business School
King’s College London

Class 2

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The Capital Markets

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The Money Markets

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The Money Markets
1 Calculate the annualized discount rate and annualized investment rate
on the purchase of 91-day T-bill, if the face value is $3,000 and
purchase price is $2,900
2 What would be the annualized discount rate % and the annualized
investment rate % if a Treasury bill was purchased for $9,360
maturing in 270 days for $10,000?
3 Suppose you want to earn an annualized discount rate of 2.5%. What
would be the most you would pay for a 182-day Treasury bill that
pays $10,000 at maturity?
4 The price of a 145-day commercial paper is $4,525. If the annualized
investment rate is 5.25%, what will the commercial paper pay at the
day of maturity?
5 A commercial paper’s annualized discount rate is 4.85%. Its face
value is $18,000,000, and it matures in 72 days. What would its price
be? What would its price be if it matures in 125 days?
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The Money Markets
Question 1 solution

Calculate the annualized discount rate and annualized investment rate on

the purchase of 91-day T-bill, if the face value is $3,000 and purchase
price is $2,900.

annualized discount rate

=[(3,000 - 2,900)/3,000] ×(360/91) = 0.1319or 13.19%
annualized investment rate
=[(3,000 - 2,900)/2,900] ×(365/91) = 0.1383or 13.83%

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The Money Markets
Question 2 solution

What would be the annualized discount rate % and the annualized

investment rate % if a Treasury bill was purchased for $9,360 maturing in
270 days for $10,000?

Discount rate=(F - P)/F ×360/n

Discount rate=(10,000 - 9,360)/10,000 ×(360/270)
Discount rate=0.0853=8.53%
Investment rate=(F - P)/P ×365/n
Investment rate=(10,000 - 9,360)/9,360 ×(365/270)
Investment rate=0.0924=9.24%

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The Money Markets
Question 3 solution

Suppose you want to earn an annualized discount rate of 2.5%. What

would be the most you would pay for a 182-day Treasury bill that pays
$10,000 at maturity?

Discount rate = (F − P )/F × 360/n

0.025 = (10, 000 − x )/10, 000 × 360/182
0.025 = (3, 600, 000 − 360x )/1, 820, 000
45, 500 = 3, 600, 000 − 360x
360x = 3, 600, 000 − 45, 500
x = 3, 554, 500/360 = $9, 873.61

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The Money Markets
Question 4 solution

The price of a 145-day commercial paper is $4,525. If the annualized

investment rate is 5.25%, what will the commercial paper pay at the day
of maturity?
Let X be what the paper will pay at the day of maturity

(X − 4, 525)/4, 525 × 365/145 = 0.0525

(X − 4, 525)/4, 525 × 2, 5172 = 0.0525
(X − 4, 525)/4, 525 = 0.02086
X − 4, 525 = 94.38
X = 4, 619.37

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The Money Markets
Question 5 solution

A commercial paper’s annualized discount rate is 4.85%. Its face value is

$18,000,000, and it matures in 72 days. What would its price be?

Discount rate = (F − P )/F × 360/n

0.0485 = (18, 000, 000 − x )/18, 000, 000 × 360/72
0.0485 = (6, 480, 000, 000 − 360x )/1, 296, 000, 000
62, 856, 000 = 6, 480, 000, 000 − 360x
360x = 6, 480, 000, 000 − 62, 856, 000
x = 6, 417, 144, 000/360 = $17, 825, 400

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The Money Markets
Question 5 solution

What would its price be if it matures in 125 days?

Discount rate = (F − P )/F × 360/n

0.0485 = (18, 000, 000 − x )/18, 000, 000 × 360/125
0.0485 = (6, 480, 000, 000 − 360x )/2, 250, 000, 000
109, 125, 000 = 6, 480, 000, 000 − 360x
360x = 6, 480, 000, 000 − 109, 125, 000
x = 6, 370, 875, 000/360 = $17, 696, 875

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Discussion on Money Markets

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The Money Markets
1 What characteristics define the money markets? Why should a
company trade in the money market? Discuss.
2 Distinguish between a term security and a demand security. Give a
example.
3 Why do businesses use the money markets?
4 Which of the money market securities is the most liquid and
considered the most risk-free? Why?
5 Who issues commercial paper and for what purpose?
6 What cost advantages does the money market have over the banking
sector?
7 What are the main purposes of the money markets? Why is there
need for money market?
8 How did ABCP contribute to the financial crisis of 2007/2008?
9 Why do commercial papers securities mature within 270 days or less?
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The Money Markets
Question 1 solution

What characteristics define the money markets?

The market in which the securities traded are short-term and highly liquid,
therefore, they are close to being money. The three characteristics of the
money market securities:
They are usually sold in large denominations.
They have low default risk.
They mature in one year or less from their original issue date.
These securities: are traded over the phone; have a very active secondary
market; are very flexible; are wholesale markets.

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The Money Markets
Question 1 solution

Why should a company trade in the money market? Discuss.

Firms or financial institution use the money markets to ”warehouse”

surplus funds until they are needed.
Firms, the government, and intermediaries use the money markets which
provide a low-cost source of funds when they need a short-term infusion of
funds.
Idle cash represents an opportunity cost in terms of lost interest income.

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The Money Markets
Question 2 solution

Distinguish between a term security and a demand security. Give an

example.

Term securities have a specified maturity date; demand deposits can be

withdrawn at any time.
A negotiable certificate of deposit is a term security, because a maturity
date is specified.

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The Money Markets
Question 3 solution

Why do businesses use the money markets?

Businesses face problems caused by revenues and expenses occurring at

different times.
The money markets provide an efficient, low-cost way of solving these
problems.
Many businesses buy and sell securities in the money markets. Such
activity is usually limited to major corporations because of the large
amounts involved.
The money markets are used extensively by businesses both to warehouse
surplus funds and to raise short-term funds.

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The Money Markets
Question 4 solution

Which of the money markets securities is the most liquid and considered
the most risk-free? Why?

The most widely held and most liquid security is the Treasury bill.
They are extremely liquid, can be bought and sold quickly and with low
transaction costs.
They have virtually zero default risk because even if the government ran
out of money, it could simply print more to redeem them when they
mature.
The risk of unexpected changes in inflation is also low because of the short
term to maturity.

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The Money Markets
Question 5 solution

Who issues commercial paper and for what purpose?

Commercial paper securities are unsecured promissory notes, issued by

corporations, that mature in no more than 270 days.
Because these securities are unsecured, only the largest and most
creditworthy corporations issue commercial paper.
The interest rate the corporation is charged reflect the firm’s level of risk.
Corporations use commercial paper to raise fund in short term and at low
cost.

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The Money Markets
Question 6 solution

What cost advantages does the money market have over the banking
sector?

The banking industry is subject to more regulations and governmental

costs than the money markets. For instance, commercial banks have
interest-rate ceilings, limited interest payments on deposits, etc.
Though some of these regulations have been eliminated, banks still face
more restrictions than money markets. Thus, the money market has
relative advantage in cost effectiveness.

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The Money Markets
Question 7 solution

What are the main purposes of the money markets? Why us there a need
for money market?

The well-developed secondary market for money market instruments makes

the money market an ideal place for a firm or financial institution to
”warehouse” surplus funds until they are needed.
Similarly, the money markets provide a low-cost source of funds to
companies, the government and intermediaries that need a short-term
infusion of funds.
These are the main purposes of money markets. Money markets are
needed because revenues and expenses occur at different times.
At times when there is no cash inflow but corporations and the
government need funds quickly, money markets provide an efficient,
low-cost means of borrowing cash.
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The Money Markets
Question 8 solution

How did ABCP contribute to the financial crisis of 2007/2008?

The majority of the sponsors of the asset-based commercial paper (ABCP)

programs had credit ratings from major rating agencies, but the quality of
the pledged assets was not understood properly.
When the poor quality of the subprime mortgages used to secure ABCP
was exposed in 2007-2008, a run on them began.
Moreover, issuers of such papers had exercised their option to extend the
maturities at low rates which threatened the money market mutual fund
market.
In September 2008, the Federal Reserve set up a guarantee program to
prevent the collapse of the money market mutual fund and to allow for an
orderly liquidation of the ABCP holdings.

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The Money Markets
Question 9 solution

Why do commercial papers securities mature within 270 days or less?

The 270-day maximum maturity is due to Securities and Exchange

Commission (SEC) rule that securities with a maturity of 270 days and
above must register with the SEC and be subject to its regulations for
public issuance.

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The Money Markets

Which of the following are true about money markets?

1 Money markets supply finance for long periods of time
2 Governments only lend to or borrow from their own citizens
3 Money market rates take no account of inflation
4 Governments are the biggest borrowers in the money markets
5 Companies are the biggest borrowers in the money market
6 Money markets enable companies and governments to lend money
7 Money market instruments are only sold to retail investors
8 Money markets enable companies and governments to borrow money

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The Money Markets
Solution

The true answers are: 4,6,8.

Money markets allow large corporations, banks, governments, non-banking
financial institutions to lend and borrow large sums of money for a short
period of time (i.e. 30 days and from £500,000/£1,000,000)
This means that retail customers usually do not act in these markets, as
they can rely on credit cards for example.

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The Money Markets
Solution

1 is false because money markets supply finance for short periods.

2 is false because governments are among those entities which lend and
borrow in these markets, notably issuing Treasury bills which od not carry
an explicit interest but merely promise to pay a sum of money after a
specific period.
3 is false because inflation is taken into account when lenders calculate
real returns over a loan.
5 is false because not only companies are the biggest borrowers, but also
banks and governments.
7 is false because retail investors do not act in these markets.

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