The Money MarketThe Money Market
Chapter 9
© 2003 South-Western/Thomson Learning
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Learning ObjectivesLearning Objectives Primary participants and instruments of
money markets
How money markets are used by various
participants
Recent trends in money market instruments
How money markets have become
international in scope
What money market mutual funds are and
why they have become important
intermediaries
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Money MarketMoney Market
Short-term credit market: where debt securities having original maturities of 1 year or less are traded
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Money Market CharacteristicsMoney Market Characteristics Issued in large denominations
Usually $1 million or more Money market instruments have short
maturities Less than 3 months Ranging from 1 day to 1 year
Money market instruments characterized by: Low liquidity Default risk
Does not occupy one particular geographic location or trading floor
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Money Market BenefitsMoney Market Benefits
More efficient source of credit for largest: Financial institutions Nonfinancial corporations Governmental bodies
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Money Market BenefitsMoney Market Benefits
Advantages over bank borrowing Banks required to hold noninterest-
bearing required reserves: As vault cash On deposit at Fed
only 90-97% of banks’ domestic transactions deposits can be lent out
Banks face regulatory constraints on: size of loan they can make to one particular
borrower Particular types of assets they are allowed
to hold on their balance sheet
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Money Market ParticipantsMoney Market Participants
Commercial banks and savings associations
GSEs The Federal Reserve Corporations and finance companies Pension funds and insurance
companies Brokers and dealers MMMFs and individuals
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Commercial Banks and Savings AssociationsCommercial Banks and Savings Associations
Play five important roles: Borrow in money market:
To meet their reserve needs To make loans to their commercial or
household customers
Hold significant levels of Treasury securities on asset side of their balance sheets
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Commercial Banks and Savings AssociationsCommercial Banks and Savings Associations
3. Assist other participants by: Providing credit enhancements for a fee to
those issuing commercial paper and bankers’ acceptances
5. Serve as agents and underwriters in commercial paper market
6. Serve as primary dealers of U.S. government securities Enables them to trade money market
securities on behalf of their corporate customers
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GSEsGSEs Governments & Government-Sponsored
Enterprises (GSEs): U.S. Treasury is world’s single largest
borrower Issues U.S. Treasury bills (T-bills) Treasury notes and bonds that have longer maturities
Privately owned GSEs: Federal National Mortgage Association (Fannie
Mae) Federal Farm Credit Banks Funding
Corporation (FFCBFC) Student Loan Marketing Association (Sallie
Mae)
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Privately-owned GSEsPrivately-owned GSEs
Engaged in assisting with finance of: Housing Agriculture Education
State and municipal (local governments and special districts) governments issue short-term municipal notes to finance: Their own expenditures Expenditures of local schools, hospitals
and private firms
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The Federal ReserveThe Federal Reserve
Fed controls level of reserves available to depository institutions open market purchase and sale of T-
bills repurchase agreements
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Corporations/Finance CompaniesCorporations/Finance Companies
Use money markets to raise funds store funds
Issue large amounts of commercial paper as primary source of funds which they lend to consumers and firms use to make up for temporary shortfalls of
cash
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Pension Funds and Insurance CompaniesPension Funds and Insurance Companies
Both use money market for cash management to provide needed liquidity
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Brokers and DealersBrokers and Dealers
Ensure the regular functioning of the money market
Market new issues of securities Repurchase securities Establish secondary market Act as intermediaries in the RP market Match buyers and sellers
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The Broker’s Role in the Federal Funds Market
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Money Market InstrumentsMoney Market Instruments
Commercial paper Unsecured, short-term promissory notes
as alternative to: Short-term bank loans Other forms of borrowing
Primary benefit to largest & most creditworthy issuers is: Cost of borrowing is lower than at a
commercial bank
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Money Market InstrumentsMoney Market Instruments Commercial paper
Characteristics largely defined by legislation and issuers’ attempt to avoid costly disclosure requirements mandated for other types of securities
Expensive requirements avoided if these are met: Paper issued must mature in less than 270 days Paper must be issued in large denomination so
that it is not typically purchased directly by public
Proceeds must be used to fund current transactions
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Money Market InstrumentsMoney Market Instruments
Commercial paper Financial companies (specifically nonbank
financial companies responsible for issuing majority: Domestic paper Foreign paper
Companies choose to issue paper: Through a dealer Engage in direct placements
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Money Market InstrumentsMoney Market Instruments Federal (Fed) Funds
When institutions anticipate insufficient reserves, they often turn to Federal (fed) funds market.
Here they can borrow reserves from other institutions on an overnight basis.
Institutions with excess reserves can turn to the fed funds market to loan these reserves and earn interest.
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Money Market InstrumentsMoney Market Instruments
Fed Funds Fed funds are lent:
on an overnight basis in denominations of $5 million or more
Fed Funds Rate: Interest rate charged on overnight loans of
reserves among commercial banks
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Money Market InstrumentsMoney Market Instruments
Repurchase Agreements Short-term contract in which seller agrees to:
Sell government security to a buyer Buy it back on a later date at a higher price
Reverse Repurchase Agreements or
Matched Sale-Purchase (MSP) Agreement Repurchase agreement viewed from
perspective of initial buyer Short-term agreements in which:
Buyer buys a government security from seller Agrees to sell it back on a later date at a higher price
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Money Market InstrumentsMoney Market Instruments
Most money market instruments are sold at a discount.
days of number360
price purchace
price purchace - price selling ratePR
360
days of number rate RP invested funds earnedInterest
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Money Market InstrumentsMoney Market Instruments CERTIFICATES of DEPOSIT (CDs)
Debt instruments issued by commercial banks with: Minimum denomination of $100,000 Fixed interest rate Return the principal at maturity
Debt instruments issued by commercial banks that may be: Negotiable (tradable) Non-negotiable (not tradable)
Thrift CDs Certificates of deposit issued by:
Savings associations Credit unions
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Money Market InstrumentsMoney Market Instruments CERTIFICATES of DEPOSIT (CDs)
Interest rates on negotiable CDs tend to be higher than T-bill rates: CD holders exposed to default risk - only a portion of
deposit is insured Unlike T-bills, earnings on CDs subject to state/local
income taxes Secondary market for CDs much thinner than T-bills,
making negotiable CDs less liquid than T-bills
Euro CDs Certificates of deposit issued by foreign branches
of commercial banks but denominated in currency of the branch’s home country
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Money Market InstrumentsMoney Market Instruments
Foreign CDs Certificates of deposit issued by the
foreign branches of commercial banks but denominated in currency of the branch’s host country
Yankee CDs Certificate of deposit issued by a
foreign bank in a foreign currency, but sold in the United States
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Money Market InstrumentsMoney Market Instruments
U.S. TREASURY BILLS Sold to a variety of different types of
buyers with: Low minimum denominations
$10,000
Short maturities
Sold on a discount basis Sold at price below its face, or par, value Original issues are sold at regularly
scheduled auctions
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Money Market InstrumentsMoney Market Instruments U.S. Treasury Bills – Auction Methods
Multiple-Price Method Seller accepts bids prior to selling securities
Sales awarded beginning with highest bidder Buyers end up paying different prices for same securities
based upon their respective bids
Treasury discontinued this method in November 1998
Stop-Out Yield Lowest accepted bid price or yield in securities auction
Uniform Price Method Seller accepts bids prior to selling securities
Sales awarded beginning with highest bidder Buyers pay same price for securities based on stop-out yield
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Money Market InstrumentsMoney Market Instruments EURODOLLARS
Dollar-denominated deposit liabilities exempt from U.S. banking regulations
International Banking Facilities (IBFs) Financial institutions in U.S. Cater to needs of foreign individuals, corporation,
and/or governments Allow non-U.S. residents to hold unregulated Eurodollar
deposits London Interbank Bid Rate (LIBID)
Interest rate London banks are willing to borrow Eurodollar balances
London Interbank Offered Rate (LIBOR) Interest rate London banks are willing to loan Eurodollar
balances
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The Anatomy of Eurodollar Borrowing
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Money Market InstrumentsMoney Market Instruments
BANKERS’ ACCEPTANCES (BAs) Allow bank to “accept” responsibility or
guarantee payment of one of its customers
Important in international trade when export company may not know or easily determine the credit-worthiness of foreign company
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Money Market InstrumentsMoney Market Instruments
MONEY MARKET MUTUAL FUNDS (MMMFs) Short-term investment pools use
proceeds they raise from selling shares to invest in various money market instruments
Disintermediation Reversal of financial intermediation process
whereby funds are: Pulled from financial intermediaries Moved directly into open market instruments