Fundamentals of Financial Markets

and Securities Analysis

Part III

Money Markets and Its Operations

AAU, School of Commerce, Capital Market Project Office

 Outline

• Introduction
• The Objective and Importance of Money Markets
• Major Participants of Money Market
• Common Money Instruments, Their Yields and Values

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 Introduction
• Money market refers to the network of corporations, financial institutions, investors
and governments which deal with the flow of short-term capital.
• Liquid funds flow between short-term borrowers and lenders through money
markets
• Money markets involve debt instruments with original maturities of one year or
less
• Money market debt instruments are
– highly liquid
– easily marketable
– with low default risk
– with low cost of executing transactions.
– purchased by economic units that have excess short-term funds
• Money market instruments have active secondary markets
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 Importance of Money Market
• Providing borrowers such as individual investors, government, etc. with
short-term funds at a reasonable price
• Enabling lenders to turn their idle funds into an effective investment.
• Helping central banks to regulate the level of liquidity in the economy.
• Providing an opportunity for the banks to park their surplus funds.
• Maintains a balance between the supply of and demand for the
monetary transactions
• Facilitates the financial mobility from one sector to the other

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 Activity 1
• Discuss the importance of the money market to the government,
the individuals and the economy.
• How do short-term interest rates on money markets influence long-
term interest rates

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 Major Participants of Money Market (Cont’d)

1.Central Bank
• It is regarded as an apex institution (the monetary authority)
• No money market can exist without the central bank
• It raises or reduces the money supply and credit to ensure economic stability
in the economy
• It controls the money market through changes in the bank rate, bank
reserves and open market operations.

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 Major Participants of Money Market (Cont’d)

2. Commercial Banks
• Back bone of the money market
• The commercial banks put their excess reserves in different forms or channels
of investment
• Play three important roles:
» they borrow in the money market to fund their loan portfolios & satisfy reserve
requirements
» as dealers in the market for over-the-counter interest rate derivatives
» provide, in exchange for fees, commitments that help ensure that investors in
money market securities will be paid on a timely basis

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 Major Participants of Money Market (Cont’d)

3. Government
• raise funds in the money market through the sale of both fixed- and
variable-rate securities.
4. Corporations
• raise funds in the money market primarily by issuing commercial
papers & banker acceptances
5. Money Market Mutual Funds and Other Short-Term Investment Pools
• purchase large pools of money market instruments and sell shares in
these instruments to investors

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 Major Participants of Money Market (Cont’d)
6. Futures Exchanges
• Money market futures contracts and futures options are traded on organized
exchanges that set and enforce trading rules
7. Dealers and Brokers
• smooth functioning of the money market depends critically on brokers and
dealers
• play a key role in marketing new issues of money market instruments and in
providing secondary markets
8. Discount Houses and Acceptance Houses
• Discount houses specialize in trading, discounting, and negotiating bills of
exchange or promissory notes
• Acceptance Houses act as agents between exporters and importers and lender
and borrower traders

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 Activity 2
• How can brokers and dealers make money in the money market?
Which activity is riskier? Why?
• How do increases and decreases in commercial banks reserves
affect the general inflation?
• Why money markets are needed in the presence of commercial
banks?

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 Money Market Instruments
• Treasury bills
• Negotiable certificates of deposit
• Commercial paper
• Money market funds
• Repurchase agreements (repos or RP)
• Banker acceptances (BA)
• Eurodollars
• Inter bank loans
• Short-Term Municipal Securities

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 1. Treasury Bills (T-Bills)
▪ T-Bills are short-term debt obligations issued by national governments
▪ The Government buys and sells T-bills to implement monetary policy
▪ National Bank of Ethiopia issues treasury bills on behalf of the
government with maturities of 28, 91, 182 and 364 days.
▪ T-bills are generally considered the safest of all possible investments
▪ They are virtually default risk free, are highly liquid, and have little
interest rate risk
▪ In cases where a government is unable to convince investors to buy its
longer-term obligations, treasury bills may be its principal source of
financing
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 1. Treasury Bills (Cont’d)
▪ Are now popular in emerging economies with history of inflation
and political instability
▪ As countries develop reputations for better economic and fiscal
management, they are often able to borrow for longer terms rather
than relying exclusively on short-term instruments
▪ Characteristics:
▪ Default Risk
▪ Liquidity
▪ Taxes
▪ Minimum Denomination

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 1. Treasury Bills (Cont’d)
T-Bill Auctions
• Bids are submitted by government securities dealers,
financial and nonfinancial corporations, and individuals
• Bids can be competitive or noncompetitive
– competitive bids specify the bid price and the desired quantity of
T-bills
– noncompetitive bidders get preferential allocation and agree to
pay the lowest price of the winning competitive bids

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 NBE’s Auction results

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 1. Treasury Bills (Cont’d)
• General calculation for yield on Treasury bills (discount rate)

• This rate is underestimated

– Uses face value as denominator rather than price paid
– Uses 360 days rather than 365
• To calculate the true yield of a Treasury bill (investment rate) for comparison
with other money market yields, the discount must be divided by the price
and a 365-day year used.
• Example: In the weekly auction of treasury bills, an average price is Br97,912
per Br100,000 of face amount for a six-month (182-day) bills. Calculate the
annual rate of return on discount basis (discount rate) and the true yield.

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 1. Treasury Bills (Cont’d)
• The Price of Treasury bills is
– If the quote refers to discount rate
Price = Nominal value x (1 – discount rate x Days to maturity/360)
– If the quoted bill price is based on the rate of return or market yield
Price = Nominal value ÷ (1 + rate of return x Days to maturity/365)
• Example: Calculate the issue price of Treasury bills if the nominal value is Br1
million, the discount rate is 9%, market yield is 9.19% and maturity is 28 days.

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 2. Negotiable Certificates of Deposit
• A negotiable certificates of deposit (CDs) is a bank-issued time deposit that
specifies the interest rate and the maturity date
• Are interest-bearing bank deposits that cannot be withdrawn without penalty
before a specified date
• Negotiable CDs are bearer instruments and thus are salable in the secondary
market
• The redemption value and price of CDs can be calculated as follows:
– Redemption value = Initial deposit × (1 + coupon rate x term to maturity (fraction of a
year))
– Price = Redemption value ÷ (1 + current short-term interest rate x days to maturity/360)
• For example, assume a Br1 million, 90-day CDs with a 9% coupon rate. Calculate
its redemption value and its price 36 days before maturity with 10% short-term
interest rate
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 3. Commercial Paper (CP)
• CP is unsecured short-term corporate debt issued to raise short-
term funds (e.g., for working capital)
• Generally sold in large denominations with maturities between 1
and 270 days
• CP is usually sold to investors indirectly through brokers and dealers
• For many large, creditworthy issuers, commercial paper is a low-cost
alternative to bank loans
• Money market mutual funds (MMFs) and commercial bank trust
departments are the major investors in commercial paper.

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 3. Commercial Paper (Cont’d)
• The yield and price of commercial papers are computed in
the same manner as Treasury bills.
• For example, Tana Corporation issued a 90-day, Br2,500,000
commercial paper at a discount of Br60,000. Calculate the true yield
on the commercial papers. The paper was sold 49 days later when
the market rate of return was 10.5%. Calculate the price of the
commercial paper on its date of sale.

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 4. Money Market Funds
• is a mutual fund that invests in a number of money market vehicles (CDs, T-bills,
etc.)
• are designed to pay the owner interest, as well as provide the owner with the ability
to sell at any time.
• divided into two categories:
– taxable funds
– tax-exempt funds
• Four factors are primarily responsible for changes in money market funds’ per-share
market values
– Changes in interest rates
– The maturity of a fund’s portfolio
– Flows of net new money into and out of funds
– Credit events affecting securities held in a fund’s portfolio
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 5. Repurchase Agreement
• A repurchase agreement (repo or RP) 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
• A reverse repurchase agreement is the opposite side of a repo (i.e., it is the
purchase of a security with an agreement to sell it back in the future)
• characteristics of repos
– Maturities: overnight or a few days
– Principal Amounts: usually arranged in large amounts
– Yields: agreed upon interest rate or the difference between repurchase price and initial
sales price as percentage
– Determinants of RP Rates: Interest rate on repo is set independently of the coupon rate
or rate on the underlying security.

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 5. Repurchase Agreement (Cont’d)
• Yield or repo rate if the repurchase price is set above the initial sales price can
be computed as follows:
Yield = (Repurchase Price – Initial Sales Price) ÷ (Initial Sales Price x Days to
maturity/365)
• If there is an agreed repo rate, the amount of payment at maturity would be
Initial Sales Price × (1 + repo rate x days to maturity/365)
Example
• A trader enters into a repurchase agreement with a hedge fund by agreeing to
sell Treasury bills with a market value of Br10,000,000 to a hedge fund at a repo
rate of 9% with a fixed one-week tenor. What is the total payment that the trader
must make to the hedge fund at the end of the repurchase agreement? If the
repurchase price is Br10,020,000, What will be the repo rate (yield)?

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 6. Bankers Acceptance
• A Bankers Acceptance (BA) 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

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 6. Bankers Acceptance (Cont’d)
• Bond equivalent yield of BA is calculated as follows:
Yield = (365 x discount yield) ÷ (360 – Days to maturity x Discount yield)
• The banker acceptance price using the bond equivalent yield method
would then be
Face value ÷ (1 + Bond equivalent yield x days to maturity/365)
• The Bank Discount Basis method of computing price of BA is follows:
Current price = Face value x (1 – discount yield x Days to maturity/360)
Example: Suppose a banker’s acceptance that will be paid is 90 days has a
face value of Br1,000,000 and the discount yield of 10%. Calculate
i) Bond equivalent yield
ii) Price of Bankers Acceptance using both methods

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 7. Eurodollars

• refers to U.S. dollar-denominated deposits at foreign banks or at the overseas

branches of American banks.
• Eurodollar deposits are time deposits
• Their offshore location makes them subject to political and economic risk in the
country of their domicile.
• Some large London banks act as brokers in the inter-bank Eurodollar market.
• The rate paid by banks buying these funds is the London interbank bid rate
(LIBID).
• They are offered for sale in this market at the London Interbank offer rate
(LIBOR)

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 8. Inter Bank loans
• loans extended from one bank to another with which it has no
affiliation
• Banks borrow and lend money in the interbank lending market in
order to manage liquidity and satisfy regulations such as reserve
requirements.
• The interbank rate is the rate of interest charged on short-term
loans between banks.
• There is a wide range of published interbank rates, including
the federal funds rate (USA), the LIBOR (UK) and
the Euribor (Eurozone).

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 9. Short-Term Municipal Securities
• are debt securities issued by state and municipal governments and
the special districts and statutory authorities they establish.
• Include notes such as bond anticipation notes, tax anticipation
notes, and revenue anticipation notes that provide funds for short
periods
• Most large banks and securities firms act as dealers in the short-
term municipal market.
• Municipal issuers frequently enter credit or liquidity substitution
agreements

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 Activity 3
• What are the characteristics of money market instruments?
• What is the difference between overnight and continuing contracts
of repos?
• Assuming a face value of Br10,000, what is the price of a T-bills with
91 days to maturity if its yield is 5 percent?

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 Discussion Question
• Entity A paid Br4,890,270.04 on the date of issue for a Br5,000,000
face value T-bills with a 364-day term. Entity A received
Br4,963,020.21 when it sold it to Entity B 217 days after the date of
issue. Entity B held the T-bills until maturity. Determine the
following:
i. Entity A’s actual rate of return.
ii. Entity B’s actual rate of return.
iii. If Entity A held onto the T-bills for the entire 364 days instead of selling it
to Entity B, what would its rate of return have been?
iv. Comment on the answers to (a) and (c).

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Thank you

AAU, School of Commerce, Capital Market Project Office