Money Markets

Question 1

What is the money market? (4)

Answer 1

• Market for short term borrowing and lending (short term credit, commercial paper, notes/certificates, loans, deposits with maturities less than a year)
• Institutions can borrow funds if they have cash flow problems or deposit funds if they have a surplus
• Deposit rate from overnight to 12 months
• Exist in most major economies - most active is London

Question 2

What is the interbank market? (3)

Answer 2

• Banks have borrowing/lending markets amongst themselves called the inter bank market
• Raises the shortfalls and lay off the surpluses generated in each period by their customers activities
• Min transaction size is £500,000 - arrangements are unsecured

Question 3

What are the 2 rates for interbank markets? (3)

Answer 3

• SONIA - Sterling Overnight Index Average - published by BoE for unsecured transactions whether negotiated via a broker or directly with a counterparty - look at what the borrowing rates were the previous night (backward looking). Not open to manipulation
• SOFR - Secured Overnight Financing Rate - released by US FED reflects the cost of borrowing through treasury securities
• LIBOR was removed as a result of the scandal - manipulation.

Question 4

What are T bills? (7)

Answer 4

• Government borrows money on the money market - ‘I owe you’ (IOU) Treasury Bills - open market operations - injecting or withdrawing cash from the banking system
• Issued with a life of less than a year
• No interest or coupon
• T bills are issued at a discount and redeemed at their face value or par
• Minimum denomination is £25,000 nominal value
• Administered by the DMO
• Yield is based on the actual/365 convention in UK. 30/360 in the US

Question 5

What is commercial paper? (4)

Answer 5

• Companies issue unsecured short dated debt
• Investors need to take into account the risk of default
• Like T Bills, CPs carry no coupon - they are issued at a discount and redeemed in full
• CPs may have maturities of between 7 days and 12 months

Question 6

What are certificates of deposits (CDs)? (8)

Answer 6

• Can be used by any bank or building society with a UK banking licence
• Issued when an investor placed some money (£100k min) for a given term with a bank at an agreed interest rate
• CDs can each represent denominations of £10,000 and are freely tradable
• CDs represent a deposit and not a loan
• CDs pay interest whereas bills and CPs do not
• CDs are typically issued with a life between 1 month and 1 year but can be issued with a life up to 5 years
• Only default risk is the bank defaulting
• In the US, CD holders are protected by the Federal Deposit Insurance Corporation up to $250,000