Money Markets. Lecture 10

Lecture 10.
Money Markets
Murodullo Bazarov
[email protected]
ATB205
office hours: Tues 11:00-13:00

Lecture Outline
The Money Markets Defined
The Purpose of Money Markets
Who Participates in Money Markets?
Money Market Instruments
Comparing Money Market Securities

The Money Markets Defined
The term “money market” is a misnomer. Money (currency) is not actually traded in the money markets.
The securities in the money market are short term with high liquidity; therefore, they are close to being money.
Money Markets Defined
Usually sold in large denominations ($1,000,000 or more)
Low default risk
Mature in one year or less from their issue date, although most mature in less than 120 days

Why Do We Need Money Markets?
The banking industry should handle the needs for short-term funding
Banks have an information advantage.
Banks, however, are heavily regulated, which creates a distinct cost advantage for money markets over banks.

Cost Advantages of Money Markets
Reserve requirements create additional expense for banks that money markets do not have
Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets, especially in the 1970s and 1980s.
When interest rates rose, depositors moved their money from banks to money markets.
The cost structure of banks limits their competitiveness to situations where their informational advantages outweighs their regulatory costs.
Limits on interest banks could offer was not relevant until the 1950s. In the decades that followed, the problem became apparent.

3-month T-bill rates and Interest Rate Ceilings

The Purpose of Money Markets
Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time
Borrowers from money market provide low-cost source of temporary funds
Corporations and U.S. government use these markets because the timing of cash inflows and outflows are not well synchronized.
Money markets provide a way to solve these cash-timing problems.

Sample rates from the Federal Reserve
Sample Money Market Rates, May 15, 2013

Who Participates in the Money Markets?

Money Market Instruments
Treasury Bills
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper
Banker’s Acceptance
Eurodollars

Money Market Instruments: Treasury Bills
T-bills have 28-day maturities through 12- month maturities.
Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks
You pay $996.73 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate?
What is its annualized yield?

Money Market Instruments: Treasury Bills
T-bills are auctioned to the dealers every Thursday.
The Treasury may accept both competitive and noncompetitive bids, and the price everyone pays is the highest yield paid to any accepted bid.
The Treasury auctioned $2.5 billion par value 91-day T-bills, the following bids were received:
Bidder Bid Amount Bid Price
1 $500 million $0.9940
2 $750 million $0.9901
3 $1.5 billion $0.9925
4 $1 billion $0.9936
5 $600 million $0.9939
The Treasury also received $750 million in noncompetitive bids. Who will receive T-bills, what quantity, and at what price?

Money Market Instruments: Treasury Bills
The Treasury accepts the following bids:
Bidder Bid Amount Bid Price
1 $500 million $0.9940
5 $600 million $0.9939
4 $650 million $0.9936
Both the competitive and noncompetitive bidders pay the highest yield—based on the price of 0.9936:

Money Market Instruments: Treasury Bills

Money Market Instruments: Fed Funds
Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day.
Used by banks to meet short-term needs to meet reserve requirements.

Money Market Instruments: Fed Funds
Federal Funds and Treasury Bill Interest Rates, January 1990–January 2013

Money Market Instruments:
Repurchase Agreements
These work similar to the market for fed funds, but nonbanks can participate.
A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price.
This set-up makes a repo agreements essentially a short-term collateralized loan.
This is one market the Fed may use to conduct its monetary policy, whereby the Fed purchases/sells Treasury securities in the repo market.

Money Market Instruments: Negotiable Certificates of Deposit
A bank-issued security that documents a deposit and specifies the interest rate and the maturity date
Denominations range from $100,000
to $10 million

Money Market Instruments: Negotiable Certificates of Deposit Rates
Interest Rates on Negotiable Certificates of Deposit and on Treasury Bills, January 1990–January 2013

Money Market Instruments:
Commercial Paper
Unsecured promissory notes, issued by corporations, that mature in no more than 270 days.
The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.

Money Market Instruments: Commercial Paper Rates
Return on Commercial Paper and the Prime Rate, 1990–2013

Money Market Instruments: Commercial Paper Volume
Volume of Commercial Paper Outstanding

Money Market Instruments:
Banker’s Acceptances
An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods. These are often used when buyers / sellers of expensive goods live in different countries.
Advantages:
Exporter paid immediately
Exporter shielded from foreign exchange risk
Exporter does not have to assess the financial security of the importer
Importer’s bank guarantees payment
Crucial to international trade

Money Market Instruments: Eurodollars
Eurodollars represent Dollar denominated deposits held in foreign banks.
The market is essential since many foreign contracts call for payment is U.S. dollars due to the stability of the dollar, relative to other currencies.
The Eurodollar market has continued to grow rapidly because depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market.

Money Market Instruments: Eurodollars Rates
London interbank bid rate (LIBID)
The rate paid by banks buying funds
London interbank offer rate (LIBOR)
The rate offered for sale of the funds
Time deposits with fixed maturities
Largest short term security in the world

Global: Birth of the Eurodollar
The Eurodollar market is one of the most important financial markets, but oddly enough, it was fathered by the Soviet Union.
In the 1950s, the USSR had accumulated large dollar deposits, but all were in US banks. They feared the US might seize them, but still wanted dollars. So, the USSR transferred the dollars to European banks, creating the Eurodollar market.

Comparing Money Market Securities : a comparison of rates (1990-2013)

Comparing Money Market Securities: Money Market Securities and Their Depth