Fin 4319-Chapter 5

Question 1

What are money markets?

Answer 1

Short term debt instruments (original maturity of one year or less) are issued by economic agents that require short-term funds and are purchased by economic agents that have excess short-term funds

Question 2

What is opportunity cost?

Answer 2

Excessive holdings of cash balances involve a cost in the form of forgone interest

Question 3

What is default risk?

Answer 3

The risk of late or nonpayment of principal and/or interest

Question 4

What is the formula for bond equivalent yields?

Answer 4

i_bey = ( P_f - P₀)/P₀

P_f == Face value

P₀= Purchase price of the security

h = Number of days until maturity

Question 5

What is the Effective annual Return formula?

Answer 5

EAR = ( 1 + i_bey/ (365/h) )^365/h - 1

Question 6

What is he discount yields formula?

Question 7

What are treasury bills?

Answer 7

short-term obligations issued by the US Treasury

Question 8

What are federal funds?

Answer 8

short-term funds transferred between financial institutions usually for no more than one day

For example, commerical bank maybe short of reserves, requiring it to borrow excess reserves from another bank that has a surplus. The banks trade fed funds in the form of excess reserves held at their local Federal Reserve Bank.

Question 9

What are repurchase agreements?

Answer 9

agreements involving the sale of securities by one party to another with a promise to repurchase the securities at a specified date and price

Question 10

What is commercial paper?

Answer 10

An unsecured short-term promissory notes issued by a company to raise short-term cash, often to finance working capital requirements.

Question 11

What is negotiable certificates of deposit?

Answer 11

bank-issued time deposit that specifies an interest rate and maturity date and is negotiable (salable on a secondary market).

Question 12

What is Banker’s acceptances?

Answer 12

time drafts payable to a seller of goods, with payment guaranteed by a bank

Question 13

What are Treasury bill auctions?

Answer 13

The US Treasury formal process by which it sells new issues of Treasury bills

Question 14

What is the federal funds rate?

Answer 14

The overnight (or one day) interest rate for borrowing fed funds

Question 15

What are correspondent banks?

Answer 15

Banks with which it has reciporocal accounts and agreements

Question 16

What is a reverse repurchase agreement?

Answer 16

A reverse repo is an agreemnt involving the purchase (buying) of securties by one party from another with the promise to sell them back at a given date in the future

Question 17

What is a bearer instrument?

Answer 17

A negotiable CD is a bearer instrument. That means whoever holds the CD when it matures receives the principal and interest.

Question 18

What is the Eurodollar market?

Answer 18

The place where they trade dollar denominated deposits held offshore in US bank branches overseas and in other (foreign) banks

Question 19

What is the London Interbank Offered Rate (LIBOR)?

Answer 19

The rate offered for sale on Eurodollar funds

Question 20

What are eurodollar certificates of deposit (CD)?

Answer 20

US dollar deonominated CDs in foreign banks. Maturities on Eurodollar CDs are less than one year, and most have a maturity of one week to 6 months.

Question 21

What is Eurocommerical paper (Euro-CP)?

Answer 21

Euro-CP is issued in Europe by dealers of commericial paper without involving a bank. Eurocommercial paper rate is generally about one-half to 1 percent above the LIBOR rate.

Question 22

What are the 3 characteristics common to money market securities?

Answer 22

1. sold in large denominations ($1 mil to $10 million)
2. have low default risk (risk of late or nonpayment)
3. original maturity of one year or less

Question 23

Why is it difficult for individual investors to be involved in the initial sale of a money market security?

Answer 23

The size of these initial transactions ($1 mil to $10 million)

Question 24

What characteristics of a discount yield prevent in from being directly compared to a bond equivalent yield?

Answer 24

1. Discount yield use the terminal price, or the security’s face value (P_f) as the base price in calculating an annualized interest rate. But bond equivalent yields are based on the purchase price (P₀) of the security
2. Discount yields generally use a 360-day year instead of 365 day year to compute interest returns.

Question 25

Do you understand, How Treasury bills are first issued?

Answer 25

Every week, usually on a Thursday, the amout of new 13 wk and 26 wk T-bills the Treasury will offer for sale is announced. Bids maybe submitted by government securities dealers, financial, and non financial corporations, and individuals and must be r eceived by a Federal Reserve Bank (or TreasuryDirect on the internet), by the deadline of 1 PM on the Monday following the auction announcement. Allocations and prices are announced the following morning (Tuesday), and the T-bills are delivered on the Thursday following the auction.

Question 26

In Treasury bill auctions, what are competitve bids?

Answer 26

Competitive bids specify the desired quantity of T-bills and the bid price. The highest bidder receives the first allocation of T-bills and subsequent bids are filled in decreasing order of the bid until all T-bills auctioned that week are distributed. Pthe price pad by all bidders is then the lowest price of the accepted competitive bidders. No bidder can legally receive more than 35% of the T-bills involved in any auction.

Question 27

In Treasury bill auctions, what are non competitive bids?

Answer 27

With noncompetitive bids, the bidder indicates the quantity of T-bills he or she wants to buy and agrees to pay the lowest price of the winning competitive bids. Noncompeitive bidders get a preferential allocation which means all these bids are met before the remaining T-bills are allocated to the competitive bidders. Thus the noncompetitive bidder agrees to accept the discount rate determined at auction and is guarenteed to receive the full amount of the bid. Noncompetitive bids are limited to $1 million or less. This allows small investors to participate in the T-bill auction market without incurring large risks.

Question 28

What 2 types of federal funds transactions?

Answer 28

The federal fund transactions can be initiated by either the lending or the borrowing bank with negotiations between any pair of commercial banks taking place directly over the telephone

Alternatively trades can be arranged through fed funds brokers who charge a small fee for bring the two parties to the fed funs transaction together.

Question 29

What securities are mainly used as collateral in repurchase agreements?

Answer 29

US Treasury securities (like T-bills) and gonverment agency securities (like Fannie Mae).

Question 30

Why was the negotiable CD market was created?

Answer 30

Rising interest rates in the 1950’s and significant interest rate penalties charged on the early withdrawl of funds invested in CDs, large CDs became unattractive to deposite holders. The result was a big drop in deposits at banks. They created negotiable CD’s to get bank deposits back.

They are attractive because you can sell it on a secondary market.

Question 31

What the process is by which a banker’s acceptance is created?

Answer 31

The US bank insures the international transaction by stamping “Accepted” on a time draft written against the letter of credit between the exporter and importer, signifying its obligation to pay the foreign exporter (or its bank) on a specified date should the importer fail to pay for the goods.

Question 32

Who is the principal issuer of Treasury Bills?

Answer 32

US Treasury

Question 33

Who are the principal investors in Treasury bills?

Answer 33

Investors are Federal Reserve System, Commericial Banks, Mutual Funds, Brokers and Dealers, Other financial instituations, Corporations, Individuals

Question 34

Who are the principal issuers of Federal funds repurchase agreements?

Answer 34

Commercial banks, Federal Reserve System, Brokers and dealers, Other financial institutions

Question 35

Who are the principal investors of Federal Funds / Repurchase agreements?

Answer 35

Commercial banks, Federal Reserve system, Mutual funds, Brokers and dealers, Other financial institutions, Corporations

Question 36

Who are the principal issuers of Commercial Paper?

Answer 36

Commercial banks, Other financial instituations, Corporations

Question 37

Who are the principal investors of Commercial paper?

Answer 37

Everyone except Federal reserve system and Commericial banks

Question 38

Who’s the principal issuer of Negotiable CDs and Banker’s acceptances?

Answer 38

Commercial Banks

Question 39

Who are the principal investors of Negotiable CD’s?

Answer 39

Everyone but Federal Reserve System and Commercial Banks.

Question 40

Who are the principal investors of Banker’s acceptances?

Answer 40

Commercial banks, Brokers and dealers, Corporations

Question 41

Do you understand what services brokers and dealers provide for money market participants?

Answer 41

1) The 18 primary government security dealers provide key role in marketing new issues of Treasury bills (and other Treasury securities). They also make the market by buying from Federal Reserve and selling them on secondary market.
2) There are 5 major money and security brokers which play a major role in linking buyers and sellers in the fed funs market and assist in secondary trading in other money market securties.
3) Thousands of brokers and dealers by linking smaller investors

Question 42

Do you understand what the major US money market securities held by foreign investors are?

Answer 42

In 2010, 3,936b in Treasury securities

630b in Repurchase agreements

219b in Negotiable CDs

192b in Open market paper

Question 43

Do you understand which currencies most international money market instruments are issued in?

Answer 43

US dollar

Question 44

Do you understand what the differences are between a Eurodollar CD and Eurocommercial paper?

Answer 44

Eurodollar CD’s are issued by non-US banks

Eurocommercial paper (euro-cp) are issued in Europe by dealers of commercial paper without involving a bank and can use other currencies

Question 45

Do you understand what the relation is between the federal funds rate and the LIBOR?

Answer 45

The federal funds rate applies to the US banks, and the LIBOR rate applies to banks outside of the US. The LIBOR is usually slightly higher than the federal funds rate because no reserve requirements and more risk of banks outside the US.

Question 46

Why do commercial paper issuers almost always obtain a rating of their issues?

Answer 46

Commercial paper is held by investors from time of issue until maturity, there is no active secondary market for commercial paper. Because it’s not actively traded and because it is also unsecured debt, the credit rating of the issuing company is important. The credit rating provide potential investors with information regarding the ability of the issuing firm to repay the borrowed funds.