Week 3 Flashcards
Money Markets
Financial market where the securities are short-term with high liquidity
Why is money market better than banking industry?
Money market is cost benefitial in providing short term funds if asymmetric information is NOT severe.
What are the cost advantages of Money Markets comparing to Banks?
- Banking industry requires extra expenses due to reserve requirements
- Lessen regulations on the interests rate for the depositors. (higher interest rates)
- The cost structure of banks in general limit their competitiveness
Advantages of Money Markets
- short term funds
- low-cost source of funds to firms etc
- higher returns than holding cash
- higher liquidity
- low-cost way to solve the cash-timing problems
How does the FED control interest rates?
The FED uses open market operations (i.e. selling and buying government securities) to arrive at the target rate
Money Market instruments: Treasury Bills
T-bills have 28 days maturities through 12-month maturities. The market for Treasury Bills is extremely deep and liquid (i.e. it consists of many sellers and buyers and securitieis can be bought and sold quickly with low transaction costs)
It has zero default risk because government (seller) can print more money to redeem it. Also, government does not pay interest becasue investors buy it at a lower price than its face value when it matures, the increase in price is the return.
You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity.
What is the discount rate?
What is the annualized yield?
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Treasury Bill auctions
There are two main types of Treasury auctions: competitive bidding and non-competitive bidding.
Competitive ones: These bidders specify the price or yield they are willing to accept for the securities.
Non-competitive ones: These bidders agree to accept the yield determined by the auction.
During an auction, all non-competitive bidders are accepted first then come the competitive bidders. The clearing yield (or price) is the highest yield (lowest price offered by the bidders) accepted in the competitive bidding process. This is the rate that determines the price at which all successful bidders (both competitive and non-competitive) will receive their securities.
Process: It starts with the lowest yield or highest offered price
After accepting all bids up to the total bidding amount, the highest yield or lowest price is accepted in the competitive bidding.
Federal Funds
Short term funds transferred (loaned and borrowed) between financial institutions, usually for a period of one day. (e.g. banks with excess reserves are allowed to make loans to banks that need them (i.e. to meet their reserve requirement)) The interest rate charged on these transactions is called the federal funds rate
Federal fund rate
Interest rates charged on transcations made between banks.
FED cannot directly control the rates, but indirectly influences it by adjusting the level of reserves available to banks.
Repurchase aggrement
A repurchase agreement (often called a repo) is a short-term borrowing arrangement where one party sells a security (usually government bonds) to another party with an agreement to repurchase it at a later date, usually the next day or within a few days, at a higher price. (which is essentially also a short term collateralized loan)
Repo haircuts
High repo haircuts as a
result of lower trust in the banking sector result in the collapse of Lehman Brothers
You sell $100 worth of collateral but can only receive $100 × (1 - x) in cash, where x is the haircut (the percentage discount applied to the collateral). The size of the haircut depends on the trustworthiness of the borrower and the quality of the collateral. At the end of the agreement, the borrower must still repay the full amount of cash borrowed (not the discounted value).
Rep 105%
In a Repo 105 transaction, Lehman would sell assets and receive 105% or more of their value in cash. Due to accounting rules, these transactions were classified as sales (not financing), which allowed Lehman to remove the assets from its balance sheet temporarily.
Negotiable Certificates of Deposits
a bank-issued security that documents a deposit and specifies the interest rate and the maturity date. Because a maturity date is specified, a Certificate of Deposit is a term security.
A term security is a financial instrument with a fixed maturity date, and CDs fall under this category because they are issued for a specified term
Commercial paper
unsecured short-term debt issued by corporations that mature in no more than 270 days. They are sold directly to investors with no real secondary market.
Since these papers are unsecured, only the largestr and most creditworthy firms issue commercial papers
