Financial Markets and Institutions

Abridged 11th Edition

by Jeff Madura

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 Classification of Financial Markets

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 DEBT
MARKET
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3
 What is debt market ?

1. The debt market is the market where debt instruments are traded.

2. Debt instruments are assets that require a fixed payment to the holder,
usually with interest. Examples of debt instruments include bonds
(government or corporate) and mortgages.

3. Debt market is an important source of fund and a useful substitute of

banking channel.

4. Debt market may range from short-term to long-term loans. Short-term

loans (less than one year) belong to money market and long term fall in
capital market.

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 Types of Debt Markets

Debt Market

Money Market Capital Market /

Bond Market

Primary Secondary Primary Secondary

Market Market Market Market

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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 the valuation and risk of money market securities

■ explain how money markets have become globally integrated

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 Money Market

 Money market refers to short term loan market. Securities

issued in money market are debt securities with a maturity of
one year or less.
 These securities are issued in the primary market through a
telecommunications network by the Treasury, corporations, and
financial intermediaries that wish to obtain short-term
financing.
 Commonly purchased by households, corporations, and
governments that have funds available for a short time period.
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 Money Market

 Trading in money markets is done over the counter and is 

wholesale.
 At the retail level, it includes money market mutual funds
bought by individual investors and money market accounts
opened by bank customers.
 Money market has active secondary market which ensures high
liquidity.
 Money market is characterized by a high degree of safety and
relatively low rates of return.
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 Money Market Securities

The more popular money market securities are:

 Treasury bills (T-bills)
 Commercial paper
 Negotiable certificates of deposit
 Repurchase agreements
 Federal funds
 Banker’s acceptances

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 Money Market Securities

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 1. Treasury Bills (T-Bills)
 Issued when the government needs to borrow funds.
 The Treasury issues T-bills with 4-week, 13-week, and 26-week maturities on a
weekly basis, with terms shorter than 4-week periodically, with a 1-year maturity
on a monthly basis.
 The par value (maturity value) of T-bills is $1,000 and multiples of $1,000.
 T-Bills are sold at a discount from par value, and the gain is the difference between
par value and the price paid
 Backed by the federal government and are virtually free of credit (default) risk.
 Highly liquid, due to short maturity and strong secondary market.
 Value of a T-bill is the present value of the par value and price depends upon
investor’s RRR.
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 1. T-Bills in Pakistan
• Treasury bills are zero coupon instruments issued by the
Government of Pakistan and sold through the SBP via fortnightly
auctions.
Salient features are:
• Issued in tenors of 3, 6 and 12 months;
• Denominated in multiples of PKR 5,000;
• A 10% withholding tax is deducted at source by SBP upon maturity;
• Non-paper instrument;
• Negotiable instruments and have an active secondary market;
• Redemption of the face value upon maturity is guaranteed by GoP.
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 T-Bill - Example
Example: If investors require a 4 percent annualized return on a one-
year T-bill with a $10,000 par value, the price that they are willing to
pay is:
P = $10,000 / (1.04)
P = $9,615.38
Example: If investors require a 4 percent annualized return on a 6-
month T-bill with a $10,000 par value, the price that they are willing to
pay is:
P = $10,000 / (1.02)
P = $9,803.92
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 Estimating the T-Bills Yield (Annualized)

This formula is used for investors who hold the T-bill until maturity or sell it
before maturity.

SP  PP 365
YT  
PP n
where
SP  selling price
PP  purchase price
n  number of days of the investment (holding period)

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 T-Bill Yield - Examples
• An investor purchased a T-bill with a 6-month (182 days) maturity and
$10,000 par value for $9,800. If this T-bill is held until maturity, its yield is:

10000  9800 365

YT    4 . 09 %
9800 182
• Suppose the investor plans to sell the T-bill after 120 days and forecasts a
selling price of $9,950 at that time. The expected annualized yield is

9950  9800 365

YT    4 . 66 %
9800 120

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 Estimating the Treasury Bill Discount - Example

This formula is usually used for the newly issued T-bills. It represents the
percentage discount of the purchasing price from par value.

Par  PP 360
Y T  
Par n

If a newly issued 6-month (182-day) T-bill with a par value of $10,000 is

purchased for $9,800, the T-bill discount is

10000  9800 360

YT    3 . 956 %
10000 182

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 2. Commercial Paper

 Commercial papers are short-term unsecured promissory notes

(debt instrument) issued by well-known, creditworthy firms.
 Normally issued to provide liquidity or to finance a firm’s
investment in inventory and accounts receivable.
 Not backed by any form of collateral so only organizations with
strong credit ratings can find buyers easily.
 Maturities are normally between 20 and 45 days but can be as
short as 1 day or as long as 270 days.

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 2. Commercial Paper
 Denomination :The minimum denomination of commercial paper is
usually $100,000.
 Credit Risk: Risk is affected by issuer’s financial condition and
cash flow.
 Credit Risk Ratings: 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.

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 2. Commercial Paper
 Placement
 Firms place commercial paper directly with investors or rely on
commercial paper dealers to sell their commercial paper.
 Backing Commercial Paper
 Some backed by assets of the issuer and offers lower yield than
unsecured commercial paper.
 Estimating the Yield
 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.

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 Commercial Paper yield - Example
1. If an investor purchases 30 day commercial paper with a par value of
$1,000,000 for a price of $996,000, and holds it until maturity, the
yield is

1,000,000  996,000 360

YT    4.82%
996,000 30

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 3. Certificates of Deposits (CoD)
• A CD is a promissory note issued by a bank.

• It is a fixed term, time deposit (often 1, 3, 6 months, or 1-5 years) with

either a fixed or a variable profit rate and the principal amount to be held to
maturity.

• When the CD matures, the entire amount of principal as well as interest

earned is available for withdrawal.

• They carry a slightly higher rate of return due to the high risk exposure and
a higher return than return on money in saving accounts of banks.

• COIs and CODs are often used interchangeably.

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 3. Negotiable Certificates of Deposits
 Placement
 Some issuers place their NCDs directly; others use a dealer that
specializes in placing NCDs.
 Yield
SP  PP  interest
Y NCD 
PP

 Offer a premium above the T-bill yield in order to compensate

for less liquidity and safety.

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 NCD yield - Example
1. An investor purchased an NCD a year ago for $990,000, He redeems it
today upon maturity and receives $1,000,000. He also received interest of
$40,000. His annualized yield is

1,000 ,000  990 ,000  40 ,000

Y NCD   5 .05 %
990 ,000

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 4. Repurchase Agreements
• Repurchase agreements are short term borrowing agreements where the borrower,
sells securities to the lender with the stipulation that the securities will be
repurchased on a specified date and at a specified, higher price. Securities serve as
collateral for the loan.

• Party which lends securities (or borrows cash) is said to be doing the repo and the
party which lends cash (or borrows securities) is said to be doing the reverse repo.

• Example: A financial institution has Rs 1 million cash surplus. The borrowing

dealer and lending company agree on 1 million RP loan collateralized by treasury
bills, with the dealer agreeing to buy back the bills within a few days and the
interest on loan.

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 4. Repurchase Agreements
• Rate of interest paid on the loan is known as the Repo Rate. 

• Repos can be of any duration but are most commonly overnight (one day)
loans. 

• Repos for longer than overnight usually weeks and months are known
as Term Repos. 

• There are also open repos that can be terminated by either side on a day’s

notice.

• A Reverse Repo is the purchase of securities by one party with an

agreement to sell them.
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 Repurchase Agreements
 Placement
 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.

 Estimating the Yield

SP  PP 360
Repo rate  
PP n

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 5. Federal Funds
 Federal funds, often referred to as fed funds, are excess reserves
that commercial banks and other financial institutions deposit at
regional Federal Reserve banks; these funds can be lent, then, to other
market participants with insufficient cash on hand to meet their lending and
reserve needs.
 The loans are unsecured and are made at a relatively low interest rate but
higher than T-bill rate, called the federal funds rate or overnight rate, as that
is the period for which most such loans are made.
 Karachi Interbank Offered Rate (KIBOR), is a daily reference rate based on the 
interest rates at which banks offer to lend unsecured funds to other banks in the 
Karachi wholesale (or "interbank") money market.

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 6. Banker’s Acceptance

• In financial terms acceptance means a vow to pay a definite amount of

money. The person who will pay is called promissory while the one who
will receive is the beneficiary. The document which is the evidence of this
promise is called a draft.

• When this draft tells the promissory to pay the money on a predetermined
specified date then it is termed as a time draft. 

• When the promissory puts his signature with the word accepted and the
date, on which the amount will be paid. Now the promissory is legally
obliged to pay the amount to the beneficiary because it has been duly
accepted properly by him.

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 6. Banker’s Acceptance
• If the time draft is formally accepted by a bank then it becomes a banker’s
acceptance. In case of a bankers acceptance the initial promissory is
obliged to pay the sum of money and the interest money charged before or
on the maturity date to the bank while the bank is obliged to pay the money
to the beneficiary. The bank becomes the primary obligor.

• Banker’s acceptance is usually used in trade - domestic and mostly for

international. Maturities of banker’s acceptance mostly range from 30 to
180 days. As the dealing firms do not know each other and have trust
issues, so banker’s acceptance minimizes their risk. 

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 6. Banker’s Acceptance

 Indicates that a bank accepts responsibility for a future payment.

Therefore the promissory uses the bank’s credit worthiness instead.
 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.
 Steps Involved in Banker’s Acceptances (Exhibit 6.4)

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 Exhibit 6.4 Sequence of Steps in the Creation of a Banker’s Acceptance

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 Exhibit 6.5 Survey of Commonly Issued Money Market Securities

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 Institutional Use of Money Markets

 Financial institutions purchase money market securities in order to

earn a return while maintaining adequate liquidity.
 Money market securities are used to enhance liquidity in two ways.
• Newly issued securities generate cash.
• Purchased money market securities will generate cash upon
liquidation.
 Financial institutions that purchase money market securities are
acting as creditors to the initial issuers of the securities.

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 Valuation of Money Market Securities

Market Price of Money Market Security (Pm)

Par
Pm 
(1  k ) n
where Par  par value or principal amount to be provided at maturity
k  required rate of return by investors
n  time to maturity

A change in Pm can be modeled as:

 P m  f (  k ) and  k  f (  R f ,  RP )
where R f  risk - free interest rate
RP  risk premium

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 Valuation of Money Market Securities
Interest Rate Risk

 If short-term interest rates increase, the required rate of return on money

market securities will increase and the prices of money market securities
will decrease.

 An increase in interest rates is not as harmful to a money market security as

it is to a longer term bond.

 Measuring Interest Rate Risk

 Participants in the money markets can use sensitivity analysis to determine
how the value of money market securities may change in response to a
change in interest rates.
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 Globalization of Money Markets

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.
International Interbank Market - facilitates the transfer of funds from banks
with excess funds to those with deficient funds.
 LIBOR
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 Exhibit 6.9 Money Market Yields over Time (Annualized Yields, One-Month Maturity)

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