Money Market Securities

Money Market Securities

n     Maturity of a year or less

n     Debt securities issued by corporations and governments that need short-term funds

n     Large primary market focus

n     Purchased by corporations and financial institutions

Money Market Securities

n     Treasury Bills

n     Commercial paper

n     Negotiable certificates of deposits

n     Repurchase agreements

n     Federal funds

n     Banker’s acceptances

Money Market Securities

n     Treasury bills

l      Issued to meet the short-term needs of the U.S. government

l      Attractive to investors

u   Minimal default risk—backed by Federal Government

u   Very good secondary market, hence excellent liquidity for investors

Money Market Securities

n     Treasury bill auction (fill bids in amount determined by Treasury borrowing needs)

l      Bid process used to sell T-bills

l      Bids submitted to Federal Reserve banks by the deadline

l      Bid process

u   Accepts highest bids

u   Accepts bids until Treasury needs generated

Money Market Securities

n     Treasury bill auction—noncompetitive bids

($5 million limit)

l      May be used to make sure bid is accepted

l      Price is the weighted average of the accepted competitive bids

l      Investors do not know the price in advance so they submit check for full par value

l      After the auction, investor receives check from the Treasury covering the difference between par and the actual price

Money Market Securities

n     Estimating T-bill yield

l      No coupon payments

l      Par or face value received at maturity

l      Yield at issue is the difference between the selling price and par or face value adjusted for time

l      If sold prior to maturity in secondary market

u   Yield based on the difference between price paid for   T-bill and selling price adjusted for time

Money Market Securities

n     No coupon payments

n     Calculating T-Bill Annualized Yield:

Money Market Securities

l      Short-term debt instrument

l      Major issuers are financial institutions

l      Unsecured

u   Used only by well-known and creditworthy firms

l      Minimum denominations of $100,000

l      Maturities vary from 1 day to 270 days

l      Not a large secondary market

Money Market Securities

l      Issued by large commercial banks

l      Purchased by nonfinancial corporations or money market funds

l      Pays interest to holder

l      Minimum denomination of $100,000 but $1 million more common

l      Maturities range from two weeks to 1 year

l      Not a large secondary market

Money Market Securities

l      Sell a security with the agreement to repurchase it at a specified date and price

l      Borrower defaults, lender has security

l      Reverse repo from lender’s perspective

l      Negotiated over telecommunications network

l      Dealers and brokers used or direct placement

l      No secondary market

Money Market Securities

l      Interbank lending and borrowing

l      Federal funds rate usually slightly higher than T-bill rate

l      The Fed debits reserve accounts for borrowing, and credits for lending

Money Market Securities

l      A bank takes responsibility for a future payment of trade bill of exchange

l      Used mostly in international transactions

l      Exporters send goods to a foreign destination and want payment assurance before sending

Money Market Securities

l      Exporter can hold until the date or sell before maturity

l      If sold to get the cash before maturity, price received is a discount from draft’s total

l      Return is based on calculations for other discount securities

Major Participants in Money Market

n     Participants

l      Commercial banks

l      Finance, industrial, and service companies

l      Federal and state governments

l      Money market mutual funds

l      All other financial institutions (investing)

n     Short-term investing for income and liquidity

n     Short-term financing for short and permanent needs

n     Large transaction size and telecommunication network

Valuation of Money Market Securities

n     Present value of future cash flows at maturity (zero coupon)

n     Value (price) inversely related to discount rate or yield

n     Money market security prices more stable than longer term bonds

n     Yields = risk-free rate + default risk premium

l      Yield differentials determined by risk differences between securities

Interaction Among Money Market Yields

n     Securities are close investment substitutes

n     Investors trade to maintain yield differentials

n     T-Bill is the benchmark yield in money market

Globalization of Money Markets

n     Money market rates vary by country

l      Segmented markets

l      Tax differences

l      Estimated exchange rates

l      Government barriers to capital flows

n     Deregulation Improves Financial Integration

n     Capital Flows To Highest Rate of Return

Globalization of Money Markets

n     Effective yield for international securities has two components

l      The yield earned on the investment denominated in the currency of the investment

l      The exchange rate effect