Money Market Instruments
Money Market Instruments
Treasury bills Commercial paper Negotiable certificates of deposits Repurchase agreements Federal funds Bankers acceptances Euro Dollar deposits
The par value of T-Bills is a maximum of $10. One year T-Bills are issued on a monthly basis. due to their short maturity and strong secondary market.
. T-Bills are attractive to investors because :
± Backed by the federal government and are free of default risk. ± Another attractive features is their liquidity.000 in multiples of $5000 thereafter.Treasury bills
Treasury bills are issued by federal government in order to borrow money on short term basis.
Its price is the present value of a par value.7
. Since it does not pay any coupon payments.345. P = Par value /(1 + K )n P = 10.000 / (1 +0.Treasury Bills
Investors in Treasury Bills: Depository institutions Individuals Corporations Money market funds Pricing Treasury Bills: The price of a T-bill depends on the required return of an investor.07) = $9.
Treasury bill Auction
The primary Treasury bill market is an auction by mail. Investors have an option of bidding:
± Competitively ± Non competitively
Treasury now applies the lowest price to all competitive and non competitive bidders. Non-competitive bidders are limited to purchasing treasury bills with a maximum par value $1 million per auction. investors can use a noncompetitive bid. After accounting for non competitive bidding. Competitive bidders can purchase more treasury bills than the maximum purchased through non competitive bidding. Since 1998. Once the auction results are completed. Treasury accepts the highest competitive bid and works it way down till it has generated its required amount.
. they write a check for the par value of the treasury bills they have requested. the treasury sends a check back to them that represents the difference between par value and the final price.Treasury bill Auction
To assure that their bid will be accepted. Since non-competitive bidders do not know this amount in advance.
000 par value for $9.Estimating the Yield
Treasury bills do not offer coupon payments and are always sold at discount from par value.600 120 = 6.$9.820 . The annualized yield from investing in a T-bill can be determined as: YT = S P * 3 65 P n S = Selling price P = purchase price N = number of days of the investment Example: If an investor purchases a T-bill with a six month (182 days) maturity and $10.$9.600 182 = 8.600 * 365 $9.36% If an investor holds this T-bill only for 120 days and sells in secondary market for $9.820 YT = $9.600. its yield is YT = $10. if this T-bill is held to maturity.000 .600 * 365 $9.97%
91% $10.000 $9. The T-bill discount represents the percent discount of the purchase price from par value for newly issued T-bills and is computed as DT = par P * 360 par n DT = $10.T BILL DISCOUNT
Business periodicals frequently quote the T-bill discount along with the T-bill yield.600 * 360 = 7.000 182
Some commercial paper is backed by standby letter of credit from banks.000 or more are common.
. Maturities are normally between 20 and 45 days but can be as short as one day or as long as 270 days. although denominations of $100. Ratings: Commercial papers face default risk and risk is influenced by the issuer s financial conditions.000. The ratings serve as an indicator of the potential risk of default. The focus is on issuer s ability to pay over short term. It is normally issued to provide liquidity or finance a firm s investment in inventory and accounts receivable. Collateralized commercial paper reduces the risk to investors and thus is easier to sell. The minimum denomination of commercial paper is $25.Commercial paper
Commercial paper is used only by well known credit worthy firms and is typically unsecured.
Others use commercial paper dealers. Backing Commercial Paper Issuers of commercial paper typically maintain backup lines of credit in case they for some reason cannot roll over commercial paper at a reasonable rate.
. since they frequently do borrowing in this manner regardless of the business cycle. Most of non-financial companies prefer to use commercial paper dealers rather than in-house resources to place their commercial paper. at a cost of usually one-eighth of one percent of the face value. Finance companies typically maintain an in-house department.Commercial paper
Placement Some firms place commercial paper directly with investors.
The yield it expects to pay investors is estimated to be Y = par P * 360 P n = $5.000 .000.000 for a price of $990. It expects to sell the commercial paper for $4.000.$990.37%
* 360 90
.000.4.000. if an investor purchases 30-day commercial paper with a par value of $1. the yield is Y = $1.000 30 = 12.000.000 = 12.000 * 360 $990.12% Consider the case of a firm that plans to issue 90-day commercial paper with a par value of $5.000.850.000 4. since commercial paper carries some default risk and is less liquid.850.850.000 .000. Like T-bills commercial paper is sold on a par value at a discount. For example.Commercial paper
The yield on commercial paper is slightly higher then the yield on a T-bill with the same maturity.
Its minimum denomination is $100.Negotiable certificates of Deposits
The negotiable certificates of deposits are issued by large commercial banks and other depository institutions as a short term source of funds.
. A secondary market for NCDS exists.000. providing investors with some liquidity. although a $1 million denomination is more common. Maturities on NCD s normally range from two weeks to one year.
Negotiable certificates of Deposits
Placement Some issuers place their NCDs directly. NCDs can normally be sold to investors directly at a higher price. others use a correspondent institution that specializes in placing NCDs.
. who in turn resell them. Another alternative is to sell NCDs to securities dealers. The premiums are generally higher during recessionary periods. Measurement of the Premium NCDs must offer a premium above the Treasury bill yield to compensate for less liquidity and safety.
Yield for an investor who buys it at par value and holds till maturity is the interest rate.Negotiable certificates of Deposits
Yield: NCDs provide return in the form of interest along with the difference in price at which it is redeemed (or sold in secondary market) and the purchase price. While yield for an investor buying or selling in a secondary market is: Y = Selling price .Purchase price + Interest Purchase price
A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them.
. a repo transaction represents a loan backed by the securities.Repurchase Agreements
A repurchase agreement represents the sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price. In essence. Repo transactions are negotiated through a telecommunications network.
Dealers and repo brokers act as financial intermediaries to create repos for firms with deficient and excess funds. a secondary market for repos does not exist. Because of the short maturities. Some companies that commonly engage in repo transactions have an in-house department for finding counterparties and executing the transactions. three and six months. receiving a commission for their services.
. The most common maturities are from one day to fifteen days and for one.
Commercial banks are the most active participants in the federal funds market.
The federal funds market allows depository institutions to effectively lend or borrow short term funds from each other at the so called federal funds rate. The federal funds rate is slightly higher than the Treasury bill rate at any point in time.
Maturities of bank s acceptance often range from 30 to 270 days. yet they frequently sell the acceptance before then at a discount to obtain cash immediately.
. The investor who purchases the acceptance then receives the payment guaranteed by the bank in the future.Banker s Acceptances
A banker s acceptance represents a bank accepting responsibility for a future payment. It is commonly used for international trade transactions. Exporters can hold the bankers acceptance until the date at which payment is to be made. like that of commercial paper. The investors return on a banker s acceptance. is derived from the difference between the discounted price paid for the acceptance and the amount to be received in the future.
As corporations outside the United States increased international trade transactions in US dollars. So only governments are large corporations participate in this market. In Eurodollar market. The deposit and loan transactions in Eurodollars are typically $1 million or more per transaction. banks channel the deposited funds to other firms that need to borrow them in the form of Eurodollar loans. the US dollar deposits in non US banks grew.
Unlike. which means that banks can lend out 100 percent of the deposits that arrive.
. other CDs Eurodollar transactions represent a loan from one commercial bank to another.Eurodollar Deposits and Euro notes
Eurodollar CDs are not subject to reverse requirements. The rates offered to Eurodollar deposits are slightly higher than rates offered on negotiable certificates of deposit.
three and six months. The Euro CP market is used by large corporations that wish to hedge future cash inflows in a particular foreign currency. with common maturities of one. Short term euro notes are issued on bearer form. at a transaction cost ranging between 5 and 10 basis points of the face value. while issuers of these CDs are adversely affected by decreasing rates. Maturities can be tailored to satisfy investors. Euro CP is sold by dealers. Investors in Eurodollar transactions are adversely affected by rising market interest rates.
. The Euro CP rate is typically between 50 and 100 basis points above LIBOR.Eurodollar Deposits and Euro notes
A secondary market for Eurodollar CDs exists. Euro-Commercial Paper Euro-commercial paper is issued without the backing of the banking syndicate.
Effective yield is dependent on: Yield earned on money market security in foreign currency The exchange rate The yield earned on the money market security : Yf = Selleing price .Purchase price Purchase price
.Performance of Foreign Money Market Securities
Performance of an investment in foreign money market security is measured by the Effective yield.
S dollar at an exchange rate of $0. After one year the investor converts his investment in to U.1 = (1. EFFECTIVE YIELD : Yc = (1 + Yf) x (1+ % S) .13 per perso.S investor invests in a one year Mexican money market security when the exchange rate is $0.(1 + Yf) x (1+ % S) .
.1 Yc = . The security earns 22 percent return.1 = 32.16% Effective yield is higher than the yield on foreign currency security when ever the foreign currency value increases over investment horizon A U.12 for a Peso.0833) .Performance of Foreign Money Market Securities
Exchange rate effect is measured by the percentage change in the spot exchange rate from the time of investment until the security was sold and the foreign currency was converted into investor s home currency.22) x (1.
Valuation of Money Market Securities
The price of most of money market securities depends on the required return of an investor. Price is the present value of a par value.07 = $9. Since they do not pay any coupon payments.000 / 1.345. P = Par value / (1 + K)n P = $10.7
A change in price: P = f ( k) where k = f( Rf . RP)
. n is measured as a fraction of a year.Money Market Price Movements
Sine maturity is less than or equal to one year.
Factors affecting price of Money Market Securities
International Economic conditions Fiscal Policy Monetary Policy Economic Conditions Issuer s Industry conditions Issuer s Unique conditions