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