You are on page 1of 35

Chapter 10

Money Market and Instruments

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
To understand the many roles and
functions performed by the money market.

To identify the key money market players.

Money Market Instruments

All the transactions in the financial markets may
appear to be the same: borrowers issue
securities that lenders buy

However, the different purposes for which money

is borrowed can result in the creation of different
kinds of financial assets having different
maturities, etc.

For instance, the money market is the market for

short-term (one year or less) credit and is
designed to provide needs for working capital
Characteristics of the
Money Market
The money market is the mechanism through
which holders of temporary cash surpluses
meet holders of temporary cash deficits

The money market arises because for most

individuals and institutions, cash inflows and
outflows are rarely in perfect harmony with
each other, and the holding of idle surplus
cash is expensive

Key Borrowers and Lenders
in the Money Market
Corporate Borrowers
& Cash-Management
Customers Needing to
Government Invest Cash Surpluses Nonbank
Treasuries Financial
(borrowing and Institutions

Security Money
Dealers & Center
Brokers Banks

Central Banks
(supplying funds and information
and promoting market stability)
Characteristics of the
Money Market

Characteristics of the
Money Market
Funds invested in the money market
represent temporary cash surpluses

Usually surpluses needed in the near future

Investors are especially sensitive to risk

Investors seek mainly safety and liquidity

Ensure surpluses are accessible when needed

Opportunity to earn interest income is secondary

Types of Risk Confronting Investors

Characteristics of the
Money Market
Original maturity is the interval of time between
the issue date of a security and its promised
redemption date
It can extend up to one year
It can be as short as overnight

Actual maturity is the interval of time between

the current date and the promised redemption
date of a security
Thousands of money market instruments
Some reach maturity every day
Characteristics of the
Money Market
Money market is extremely broad and deep
It can absorb a large volume of transactions
Transactions have only small effects on
security prices and interest rates

The money market is also very efficient

Securities dealers, major banks, and funds
brokers maintain constant contact
Computer network
Hence alert to any bargains 10-11
Characteristics of the
Money Market
Federal funds are mainly deposit
balances of commercial banks held at
the central bank and at larger
correspondent banks across a country.

Federal funds are often called

immediately-available funds because of
the speed with which money moves
from one banks reserve account to
that of another.
Characteristics of the
Money Market
Clearinghouse funds
Alternate structure to the federal funds
The clearinghouse is a location where
checks and other cash items are delivered
and passed from one financial
organization to another
Clearinghouse funds are an acceptable
means of payment for most purposes
Too slow for the money market
Clearinghouse funds also have an element
of risk
Characteristics of the
Money Market
The money market is a wholesale
market for funds
Most trading occurs in multiples of a
million dollars
Dominated by a relatively small number of
large financial institutions Securities also
move readily from sellers to buyers
through the market-makers
Major security dealers
Characteristics of the
Money Market

Governments and central banks around

the world play major roles in the money
market as the largest borrowers and as

Treasury Bills
Treasury bills (T-bills)
Direct obligations of the government
Have an original maturity of one year or less

Tax revenues or any other source of government

funds may be used to repay the debt

They carry great weight in the financial system

Zero (or nearly zero) default risk
Ready marketability
High liquidity
Types of Treasury Bills

Regular-series bills are issued routinely

every week or month
In competitive auctions
Various original maturities
One month (4 weeks)
Three months (13 weeks)
Six months (26 weeks)
Most revenues from the six month maturity

Types of Treasury Bills

Irregular-series bills are issued when the

Treasury has an emergency cash need
Strip bills
Package of offered bills
Investor bids for a package of different
Cash management bills
Reopening an issue of bills that were sold
in a prior week
Issued at the actual maturity of the original
U.S. Treasury Bills:
Total Amount Outstanding

Source: Board of Governors of the Federal Reserve System

* 2006 figures are for the third quarter of 2006
How U.S. T-Bills are Sold

T-bills sold using an auction

Marketplace sets the bill prices and yields
New regular bill issues announced by
On Thursday of every week except
Bids due the following Monday before 1
p.m. EST
Must be filed with one of the regional
Federal Reserve banks or branches, or the
How Bills are Sold

Accepts two types of offers

Competitive tender
Submitted by large investors
Typically millions of dollars
Bid a discount rate of interest (DR)
Compete for limited supply
Noncompetitive tender
Normally under $1 million
Small investors accept price
determined by the auction
Investors in Treasury Bills
T-bills are held mainly by commercial banks,
nonfinancial corporations, state and local
governments, and the central banks

Commercial banks and private corporations

hold T-bills as a reserve of liquidity

The central banks conduct part of their open

market operations in T-bills because of the
depth and volume of activity of the market

Dealers Borrowing and Lending
Activities In the Money Market
The bulk of the dealers operating capital is
obtained through borrowings from commercial
banks and other institutions
Heavily used two sources of funds

Demand loans from the largest banks

May be called at any time if bank needs funds
Virtually riskless since collateralized

Repurchase agreements with banks and other

Dealers Borrowing and Lending
Activities In the Money Market
Repurchase agreements (RP or Repo)
Dealer sells securities to a lender
Makes a commitment to buy back the
At a later date
At a fixed price plus interest
RPs are simply a temporary extension of credit
collateralized by marketable securities
Term RPs are for a set length of time
(overnight, a few days, 1 month, 3 months, )
Continuing contracts may be terminated by
either party on short notice.
Dealers Borrowing and Lending
Activities In the Money Market
Interest income from RPs
= Amount Current Number of days
loaned ___ RP rate
. 360 days
Amt of loan

Commercial Paper

In the global money market, commercial paper is an unsecured

promissory note with a fixed maturity of 1 to 270 days.
Commercial Paper is a money-market security issued (sold) by
large banks and corporations to get money to meet short term
debt obligations (for example, payroll), and is only backed by
an issuing bank or corporation's promise to pay the face
amount on the maturity date specified on the note.

Since it is not backed by collateral, only firms with excellent

credit ratings from a recognized rating agency will be able to
sell their commercial paper at a reasonable price. Commercial
paper is usually sold at a discount from face value, and carries
higher interest repayment dates than bonds.
Bankers Acceptance

A banker's acceptance, or BA, is a negotiable instrument

or time draft drawn on and accepted by a bank. It is an
order by the drawer to the bank to pay a specified sum of
money on a specified date to a named person or to the
bearer of the draft. Upon acceptance, which occurs when
an authorized bank accepts and signs it, the draft
becomes a primary and unconditional liability of the bank.

The accepted draft may be readily sold in an active

market. A banker's acceptance is also a money market
instrument a short-term discount instrument that
usually arises in the course of international trade.
Eurocurrency Deposit

A short-term certificate of deposit with a

fixed interest rate made in a currency
outside the jurisdiction of the issuing central
bank. For example, one may purchase a CD
in U.S. dollars and deposit it in a bank in
Great Britain. Eurocurrency deposits help
persons and businesses hedge against
short-term fluctuations in exchange rates.
Markets on the Net

Board of Governors of the Federal Reserve

System at
Browse Data of the Federal Reserve Board at
European Central Bank at
Federal Reserve Bank of New York at
Investopedia at

Markets on the Net
Federal Deposit Insurance Corporation at
Primary Dealers - Federal Reserve Bank of
New York at
U.S. Treasury Department Bureau of the
Public Debt at
Treasury Direct at

Chapter Review

Introduction: The market for short-term

Characteristics of the money market
What the money market does
The Need for a money market
Key borrowers and lenders in the money
The goals of money market investors
Types of Investment risk that investors
Chapter Review

Characteristics of the money market

Money market maturities
Depth and breadth of the money market
The speed of money market payments:
federal funds versus clearinghouse funds
A market for large borrowers and lenders

Chapter Review

Dealers borrowing and lending

activities in the money market
Demand loans for dealers
Repurchase agreements (RPs or REPOs)
for dealers and other money market
A New type of RP: The GCF REPO
Sources of dealer income
Dealer positions in securities
Dealer transactions and government
security brokers
Calculating the Return on T-Bills

T-bills do not carry a promised interest

rate. Instead, they are sold at a
discount from their par or face value.
Bill yields are determined by the bank
discount method, which does not
compound interest rates and uses a
360-day year for simplicity.
The bank discount rate (DR) on T-bills
= Par value Purchase price 360 .

Par value Days to maturity

Calculating the Return on T-Bills

Because the rates of return on most

other debt instruments are not figured
in the same way, comparisons with
other securities cannot be made
The investment yield or rate (IR) on T-
= Par value Purchase price 365 .

Purchase price Days to maturity