Module 2.1 Flashcards
Money Market Securities (1 of 18)
Money market securities are debt securities with a maturity of one year or less.
Issued in the primary market through a telecommunications network by the Treasury, corporations, and financial intermediaries that wish to obtain short-term financing.
Are commonly purchased by households, corporations, and governments that have funds available for a short time period.
Can be sold in the secondary market and are liquid.
The more popular money market securities are
Treasury bills (T-bills) Commercial paper Negotiable certificates of deposit Repurchase agreements Federal funds Banker’s acceptances
Treasury Bills
Issued when the U.S. government needs to borrow funds.
The Treasury issues T-bills with 4-week, 13-week, and 26-week maturities on a weekly basis.
The par value (amount received by investors at maturity) of T-bills was historically a minimum of $10,000, but now it is $1,000 and multiples of $1,000.
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.
Investors in Treasury Bills
Depository institutions retain a portion of their funds in assets that can be easily liquidated to accommodate withdrawals.
Other financial institutions invest in T-bills in case cash outflows exceed cash inflows.
Individuals with substantial savings invest indirectly through money market funds.
Corporations invest in T-bills to cover unanticipated expenses.
Credit Risk — Backed by federal government, virtually free of credit (default) risk
Liquidity — high liquidity due to short maturity and strong secondary market.
Pricing Treasury Bills
Priced at a discount from their par value
Price depends on the investor’s required rate of return
Value of a T-bill is the present value of the par value
Example: If investors require a 4% 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
Treasury Bill Auction
Investors can submit bids online for newly issued T-bills at www.treasurydirect.gov.
Investors have the option of bidding competitively or noncompetitively.
Commercial Paper
Short-term debt instrument issued by well-known, creditworthy firms; typically unsecured
Normally issued to provide liquidity or to finance a firm’s investment in inventory and accounts receivable
The minimum denomination of commercial paper is usually $100,000.
Maturities are normally between 20 and 45 days but can be as short as 1 day or as long as 270 days.
Commercial Paper Denomination and Credit Risk
Denomination
The minimum denomination of commercial paper is usually $100,000.
Maturities are normally between 20 and 45 days but can be as short as 1 day or as long as 270 days.
Credit Risk
Issued by corporations susceptible to failure, therefore subject to failure.
Risk is affected by issuer’s financial condition and cash flow.
Commercial Paper Credit Risk Rating
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. (Exhibit 6.2)
Commercial Paper Placement, Backing, and Yield
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 offer lower yield than unsecured commercial paper.
Issuers of commercial paper typically maintain backup lines of credit.
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
Commercial Paper Yield Curve
Commercial Paper (cont.)
Commercial Paper Yield Curve
Represents the yield offered on commercial paper at various maturities.
The same factors that affect the Treasury yield curve affect the commercial paper yield curve, but they are applied to very short-term horizons.
Commercial Paper Rate Over Time
Highly correlated with the T-bill rate with the same maturity. (Exhibit 6.3)
Negotiable Certificates of Deposit
Certificates issued by large commercial banks and other depository institutions as a short-term source of funds.
The minimum denomination is $100,000.
Maturities on NCDs normally range from two weeks to one year.
A secondary market for NCDs exists, providing investors with some liquidity.
Negotiable CD’s Placement and Yield
Placement
Some issuers place their NCDs directly; others use a correspondent institution that specializes in placing NCDs.
Yield
Provide a return in the form of interest along with the difference between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase price.
Offer a premium above the T-bill yield in order to compensate for less liquidity and safety.
Repurchase Agreements
With a repurchase agreement (repo), one party sells securities to another with an agreement to repurchase the securities at a specified date and price.
A reverse repo is the purchase of securities by one party with an agreement to sell them.
A repurchase agreement (or repo) represents a loan backed by the securities.
Financial institutions often participate in repos.
The size of the repo market is about $4.5 trillion. Transaction amounts are usually for $10 million or more.
The most common maturities are from 1 day to 15 days and for one, three, and six months.
Repo Agreements Placement, Impact on Credit Crisis
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.
Impact of the Credit Crisis
Many financial institutions that relied on the market for funding were not able to obtain funds.
Investors became more concerned about the securities that were posted as collateral.
Estimating the Yield
Federal Funds
Enable depository institutions to lend or borrow short-term funds from each other at the federal funds rate.
The Federal Reserve adjusts the amount of funds in depository institutions in order to influence the federal funds.
The rate is normally slightly higher than the T-bill rate at any given time.
Commercial banks are the most active participants.
The volume of interbank loans on commercial bank balance sheets over time is an indication of the importance of lending between depository institutions.
Banker’s Acceptances
Indicate that a bank accepts responsibility for a future payment.
Commonly used for international trade transactions.
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
Institutional Use of Money Markets
Financial institutions purchase money market securities in order to earn a return while maintaining adequate liquidity.(Exhibit 6.6)
Money market securities can be 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
Valuation of Money Market Securities
Market Price of Money Market Security (Pm)
A change in Pm can be modeled as:
Impact of Changes in Credit Risk
Institutional investors were less willing to invest in commercial paper because of concerns that other firms might default. As a result, many firms were no longer able to rely on the commercial paper market for short-term funding.
The Emergency Economic Stabilization Act of 2008 was enacted, which helped to stabilize the money markets.
In November 2008, the Fed began to purchase commercial paper issued by highly rated firms to increase liquidity in the commercial paper market. (Exhibit 6.8).
Risk premiums following Lehman’s default
During periods of heightened uncertainty, investors shift from risky money market securities to Treasury securities in a flight to quality.
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. (Exhibit 6.9).
Globalization of Money Markets
As international trade and financing have grown, money markets have developed in Europe, Asia, and South America.
The flow of funds between countries has increased as a result of tax differences among countries, speculation on exchange rate movements, and a reduction in government barriers that were previously imposed on foreign investment in securities. (Exhibit 6.10)
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. Maturities can be tailored to satisfy investors.
International Interbank Market — facilitates the transfer of funds from banks with excess funds to those with deficient funds.
LIBOR Scandal — In 2012, some banks falsely reported their rates that they periodically report in the interbank market.
Performance of Foreign Money Market Securities
Measured by the effective yield
(yield adjusted for the exchange rate)
