Financial Markets and Institutions: 13 Edition

Financial Markets and Institutions
13th Edition
by Jeff Madura
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6 Money Markets
Chapter Objectives
• Describe the features of the most popular money

market securities.
• Explain how money markets are used by
institutional investors.
• Explain how money markets have become globally
integrated.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
Money Market Securities (1 of 19)
• Money market securities are debt securities with a

maturity of one year or less.
• Issued in the primary market through a
telecommunications network by the Treasury,
corporations, and financial intermediaries that wish to
obtain short-term financing.(Exhibit 6.1)
• Are commonly purchased by households, corporations,
and governments that have funds available for a short
time period.
• Can be sold in the secondary market and are liquid.
3 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Exhibit 6.1 How Money Markets Facilitate
the Flow of Funds
The more popular money market securities are:

• Treasury bills (T-bills)
• Commercial paper
• Negotiable certificates of deposit
• Repurchase agreements
• Federal funds
• Banker’s acceptances
Treasury Bills
• Issued when the U.S. government needs to borrow
funds.
• The Treasury issues T-bills with 4-week, 13-week, and
26-week maturities on a weekly basis.
• It periodically issues T-bills with terms shorter than 4
weeks, which are called cash management bills.
• It also issues T-bills with a 1-year maturity on a monthly
basis.
Treasury Bills (continued)

• Investors in Treasury Bills
• Depository institutions retain a portion of their funds in assets that
can be easily liquidated to accommodate withdrawals.
• Other financial institutions invest in T-bills in case cash outflows
exceed cash inflows.
• Individuals with substantial savings invest indirectly through
money market funds.
• Corporations invest in T-bills to cover unanticipated expenses.
• Credit Risk of Treasury Bills— Backed by federal
government, virtually free of credit (default) risk
• Liquidity of Treasury Bills — high liquidity due to short
maturity and strong secondary market.

• Pricing Treasury Bills
• Priced at a discount from their par value
• Price depends on the investor’s required rate of return
• Value of a T-bill is the present value of the par value
Example: If investors require a 4% annualized return on a

one-year T-bill with a $10,000 par value, the price that
they are willing to pay is:
$10,000
P 
 1.04 
P  $9,615.38

• Yield from Investing in Treasury Bills
SP  PP 365
YT  
PP n
Where
SP = selling price
PP = purchase price
n = number of days of the investment (holding period)
• Treasury Bill Discount

Par  PP 360
YT  
PP n
Treasury Bill Auction

• Investors can submit bids online for newly issued T-bills
at www.treasurydirect.gov.
• Investors have the option of bidding competitively or
noncompetitively.
Commercial Paper
• Short-term debt instrument issued by well-known,
creditworthy firms; typically unsecured
• Normally issued to provide liquidity or to finance a
firm’s investment in inventory and accounts receivable
• The issuance of commercial paper is an alternative to
short-term bank loans.
• It is cheaper source of funds than commercial banks.
Commercial Paper (continued)

• Placement of Commercial Paper
• Firms place commercial paper directly with investors or rely
on commercial paper dealers to sell their commercial paper.
• Denomination of Commercial Paper
• The minimum denomination of commercial paper is
usually $100,000.
• Maturities are normally between 20 and 45 days but
can be as short as 1 day or as long as 270 days.
• Common Investors in Commercial Paper
• Money market funds are major investors in commercial
paper.

• Credit Risk of Commercial Paper
• Issued by corporations susceptible to failure, therefore
subject to failure.
• Risk is affected by issuer’s financial condition and cash flow.
• Credit Risk Ratings of Commercial Paper
• Assigned by rating agencies such as Moody’s Investors
Service, Standard & Poor’s Corporation, and Fitch Investor
Service.
• Serves as an indicator of the potential risk of default.
• Higher credit ratings suggest lower expectancy of credit
default. (Exhibit 6.2)
Exhibit 6.2 Possible Ratings Assigned
to Commercial Paper
MOODY ’S STANDARD & POOR’S F ITCH

Highest P1 A1 F1
High P2 A2 F2
Medium P3 A3 F3
Low NP B or C F4
Default NP D F5

• Asset-Backed Commercial Paper
• Some backed by assets of the issuer and offer lower yield than
unsecured commercial paper.
• Issuers of commercial paper typically maintain backup lines of
credit.
• Yield from Investing in Commercial Paper
• Commercial paper does not pay interest and is priced at a discount
from par value.
• The yield on commercial paper is higher than the yield on a T-bill
with the same maturity because of credit risk and less liquidity.
• Commercial Paper Yield Curve
• Represents the yield offered on commercial paper at various
maturities.
• The same factors that affect the Treasury yield curve affect the
commercial paper yield curve, but they are applied to very short-
term horizons.

• Commercial Paper Rate Over Time
• Highly correlated with the T-bill rate with the same maturity. (Exhibit
6.3)
• Credit Risk of Commercial Paper Following Lehman’s Default
• Lehman heavily invested in mortgage-backed securities and used
these securities as collateral when issuing commercial paper to
borrow funds.
• When the housing market crashed and the value of mortgage-
backed securities declined in 2008, institutional investors were no
longer willing to purchase Lehman’s commercial paper because
they questioned the value of the collateral.
• When Lehman filed for bankruptcy in September 2008, it defaulted
on hundreds of millions of dollars of commercial paper that it had
issued.
• The amount of commercial paper outstanding reached a high of
about $2.2 trillion in 2007, but now is less than $1.2 trillion. (Exhibit
6.4)
Exhibit 6.3 Commercial Paper Rate
over Time
Note: The shaded area indicates a recession.

Source: Federal Reserve.
Exhibit 6.4 Value of Commercial Paper
Outstanding over Time
Note: The shaded area indicates a recession.

Source: Federal Reserve.
Negotiable Certificates of Deposit

• Certificates issued by large commercial banks and other
depository institutions as a short-term source of funds.
• The minimum denomination is $100,000.
• Maturities on NCDs normally range from two weeks to one
year.
• A secondary market for NCDs exists, providing investors
with some liquidity.
Negotiable Certificates of Deposit (continued)

• Placement of NCDs
• Some issuers place their NCDs directly; others use a
correspondent institution that specializes in placing
NCDs.
• Yield from Investing in NCDs
• Provide a return in the form of interest along with the
difference between the price at which the NCD is
redeemed (or sold in the secondary market) and the
purchase price.
SP  PP  interest
YNCD 
PP
• Offer a premium above the T-bill yield in order to
compensate for less liquidity and safety.
Repurchase Agreements
• With a repurchase agreement (repo), one party sells
securities to another with an agreement to repurchase the
securities at a specified date and price.
• A reverse repo is the purchase of securities by one party
with an agreement to sell them.
• A repurchase agreement (or repo) represents a loan
backed by the securities.
• Financial institutions often participate in repos.
• The size of the repo market is about $4.5 trillion.
Transaction amounts are usually for $10 million or more.
• The most common maturities are from 1 day to 15 days and
for one, three, and six months.
Repurchase Agreements
• Repurchase Agreement Transactions
• Negotiated through a telecommunications network.
• Dealers and repo brokers act as financial intermediaries to
create repos for firms with deficient or excess funds,
receiving a commission for their services.
• Impact of the Credit Crisis
• Many financial institutions that relied on the market for
funding were not able to obtain funds.
• Investors became more concerned about the securities that
were posted as collateral.
• Estimating the Yield on Repurchase Agreements
SP  PP 360
Repo rate  
PP n
Federal Funds
• Enable depository institutions to lend or borrow short-term
funds from each other at the federal funds rate.
• The Federal Reserve adjusts the amount of funds in
depository institutions in order to influence the federal
funds.
• The rate is normally slightly higher than the T-bill rate at any
given time.
• Federal Funds Market Transactions
• Federal funds brokers serve as intermediaries in the market,
matching up financial institutions that wish to sell (lend) funds
with those that wish to purchase (borrow) them.
• The brokers receive a commission for their service.
Banker’s Acceptances
• Indicate that a bank accepts responsibility for a future payment.
• Commonly used for international trade transactions.
• Secondary Market for Banker’s Acceptances —Exporters can
hold a banker’s acceptance until the date at which payment is to be
made, but they frequently sell the acceptance before then at a
discount to obtain cash immediately. Because acceptances are
often discounted and sold by the exporting firm prior to maturity, an
active secondary market exists.
• Return on Banker’s Acceptances—The investor’s return on a
banker’s acceptanceis derived from the difference between the
discounted price paid for the acceptance and the amount to be
received in the future.
• Steps Involved in Banker’s Acceptances The sequence of steps
involved in a banker’s acceptance is illustrated in Exhibit 6.5.
Exhibit 6.5 Sequence of Steps in the Creation
of a Banker’s Acceptance
Summary of Money Market Securities

• Exhibit 6.6 summarizes the various types of money
market securities.
• Pricing of Money Market Securities(Exhibit 6.7)—The
prices of money market securities change in response to
a change in the required rate of return, which itself is
influenced by the risk-free interest rate and the perceived
credit risk over time.
Exhibit 6.6 Survey of Commonly Issued
Money Market Securities
SECURITY ISSUED BY COMMON COMMON SECONDARY
INVESTORS MATURITIES MARKET
ACTIVITY
Treasury bills Federal government Households, firms, 13 weeks, 26 High
and financial weeks, 1
institutions year
Negotiable Large banks and savings Firms 2 weeks to 1 Moderate
certificates of institutions year
deposit (NCDs)
Commercial paper Bank holding companies, Firms 1 day to 270 Low
finance companies, and days
other companies
Banker’s Banks (exporting firms can Firms 30 days to High
acceptances sell the acceptances at a 270 days
discount to obtain funds)
Federal funds Depository institutions Depository 1 day to 7 Nonexistent
institutions days
Repurchase Firms and financial Firms and 1 day to 15 Nonexistent
agreements institutions financial days
institutions
Exhibit 6.7 Framework for Pricing Money
Market Securities
Institutional Use of Money Markets
• Institutional Use of Money Markets (Exhibit 6.8)

• Financial institutions purchase money market securities in
order to earn a return while maintaining adequate liquidity.
Exhibit 6.8 Institutional Use of Money
Markets
TYPE OF FINANCIAL PARTICIPATION IN THE MONEY MARKETS
INSTITUTION
Commercial banks • Bank holding companies issue commercial paper.
and savings • Some banks and savings institutions issue N CDs, borrow or lend
institutions funds in the federal funds market, engage in repurchase agreements,
and purchase T-bills.
• Commercial banks create banker’s acceptances.
• Commercial banks provide backup lines of credit to corporations that
issue commercial paper.
Finance companies • Issue large amounts of commercial paper.
Money market mutual • Use proceeds from shares sold to invest in T-bills, commercial paper,
funds NCDs, repurchase agreements, and banker’s acceptances.
Insurance companies • May maintain a portion of their investment portfolio as money market
securities for liquidity.
Pension funds • May maintain a portion of their investment portfolio as money market
securities that may be liquidated when portfolio managers desire to
increase their investment in bonds or stocks.
Globalization of Money Markets (1 of 3)
• As international trade and financing have grown,

money markets have developed in Europe, Asia, and
South America.
• The flow of funds between countries has increased
as a result of tax differences among countries,
speculation on exchange rate movements, and a
reduction in government barriers that were
previously imposed on foreign investment in
securities. (Exhibit 6.10)
International Interbank Market — facilitates the transfer

of funds from banks with excess funds to those with
deficient funds.
• LIBOR Scandal — In 2012, some banks falsely reported their
rates that they periodically report in the interbank market.
Eurodollar Securities: dollar deposits in Europe
• Eurodollar CDs — large, dollar-denominated deposits (such as $1
million) accepted by banks in Europe.
• Euronotes — short-term securities issued in bearer form with
common maturities of one, three, and six months.
• Euro-commercial paper — issued without the backing of a
banking syndicate. Maturities can be tailored to satisfy investors.
Performance of Foreign Money Market Securities

Measured by the effective yield Ye
(yield adjusted for the exchange rate)
SPf  PPf
Yf 
PPf
Where
SPf = selling price of the foreign money market security in the
foreign currency
PPf = purchase price of the foreign money market security in the
foreign currency
Ye  (1  Yf )  (1  %S )  1
SUMMARY (1 of 2)
• The main money market securities are Treasury bills,

commercial paper, NCDs, repurchase agreements,
federal funds, and banker’s acceptances. These
securities vary according to the issuer. Consequently,
their perceived degree of credit risk can vary. They also
have different degrees of liquidity. Therefore, the quoted
yields at any given point in time vary among money
market securities.
• Financial institutions manage their liquidity by
participating in money markets. They may issue money
market securities when they experience cash shortages
and need to boost liquidity. They can also sell holdings of
money market securities to obtain cash.
SUMMARY (2 of 2)
• Interest rates vary among countries. Some investors are

attracted to high interest rates in foreign countries, which
cause funds to flow to those countries. Consequently,
money markets have become globally integrated.
Investments in foreign money market securities are
subject to exchange rate risk because the foreign
currency denominating the securities could depreciate
over time.

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Financial Markets and Institutions

• Describe the features of the most popular money

• Money market securities are debt securities with a

The more popular money market securities are:

Treasury Bills (continued)

Treasury Bills (continued)

Example: If investors require a 4% annualized return on a

Treasury Bills (continued)

• Treasury Bill Discount

Treasury Bill Auction

Commercial Paper (continued)

Commercial Paper (continued)

MOODY ’S STANDARD & POOR’S F ITCH

Commercial Paper (continued)

Commercial Paper (continued)

Note: The shaded area indicates a recession.

Note: The shaded area indicates a recession.

Negotiable Certificates of Deposit

Negotiable Certificates of Deposit (continued)

Summary of Money Market Securities

• Institutional Use of Money Markets (Exhibit 6.8)

• As international trade and financing have grown,

International Interbank Market — facilitates the transfer

Performance of Foreign Money Market Securities

• The main money market securities are Treasury bills,

• Interest rates vary among countries. Some investors are

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