FIN 4140 Financial Markets & Institutions

Transcription

1 FIN 4140 Financial Markets & Institutions Lecture 9-10 Money Market

2 Money Market Securities Securities with maturities within one year are referred to as money market securities. They are issued by corporations and governments to obtain short term funds. Money market securities are commonly purchased by corporations (including FI) and government agencies that have funds available for a short term period. Because money market securities have a short term maturity and can typically be sold in the secondary market, they provide liquidity to investors. The more popular money market securities are: 1) Treasury bills 2) Commercial paper 3) NCD 4) Repo 5) Federal funds 6) Bankers acceptances 2

3 Treasury Bills When govt needs to borrow funds, they frequently issues short term securities known as Treasury bills (T-bills). These are sold weekly through an auction. One year T-bills are issued on a monthly basis. The par value (amount received by investors at maturity) of T-bills are now $1,000 and in multiples of $1,000 thereafter. T-bills are sold at a discount from par value and the gain to an investor holding a T- bill until maturity is the difference between par value and the price paid. T-bills are attractive to investors because they are backed by the Federal government and therefore are virtually free of credit (default) risk. Another attractive feature of T- bills is their liquidity, which is due to their short maturity, and strong secondary market. Investors in T-bills: Depository institutions commonly invest in T-bills so that they can retain a portion of their funds in assets that can easily be liquidated if they suddenly need to accommodate deposit withdrawals. Other FIs also invest in T-bills in the event that they need cash because cash outflows exceed cash inflows. Individuals with substantial savings invest in T-bills for liquidity purposes. Many individuals invest in T-bills indirectly by investing in money market funds, which in turn purchases large amount of T-bills. Corporations invest in T-bills so that they have easy access to funding if they incur sudden unanticipated expenses. 3

4 Treasury Bills Pricing T-bills: The price that an investor will pay for a T-bill with a particular maturity depends on the investor s required rate of return on that T-bill. Price is determined as the present value of the future cash flows (par value) to be received. Since the T-bill does not generate interest payments, the value of a T-bill is the present value of the par value. Example: If investors require a 7% annualized return on a one year T-bill, the price that they will be willing to pay is, P = $1000/1.07 = $ To price a T-bill with a maturity shorter than one year, the annualized return can be reduced by the fraction of the year in which funds will be invested. Example: If investors require a 6% annualized return on a 6 month T-bill, this reflects a 3% semi-annual return over 6 months period. The price that they will be willing to pay is, P= $1000/1.03 = $ The prices paid for six month T-bills are significantly lower than the prices paid for three month T-bills because the investment term is longer. The lower price results in a higher annualized yield that compensates investors for their longer term investment. 4

5 Treasury Bills If an investor purchases a newly issued T-bill and holds it until maturity, the return is based on the difference between the par value and the purchase price. If the T-bill is sold prior to maturity in the secondary market, the return is based on the difference between the selling price and the purchase price. The annualized yield from investing in a T-bill can be determined as: y t SP PP PP 365 x n where, SP= selling price, PP= purchase price, n = no. of days of the investment (holding period) Example: An investor purchases a T-bill with a 6month (182 days) maturity and $1,000 par value for $960. If this T-bill is held to maturity, its yield is, yt x %

6 Treasury Bills If the T-bill is sold after 120 days at the price of $982, the annualized yield is yt x 6.97% Estimating the T-bill discount: The T-bill discount (T-bill rate) represents the percent discount of the purchase price from par value for newly issued T-bills and is computed as: T-bill Discount Par 360 x ParPP n 6

7 Commercial Paper Commercial paper is a short term debt instrument issued only by well known, credit worthy firms and is typically unsecured. It is normally issued to provide liquidity or finance a firm s investment in inventory and accounts receivable. The issuance of commercial paper is an alternative to short term bank loans. Financial institutions such as finance companies and banks are major issuers of commercial paper. The minimum denomination of commercial paper is usually $100,000. The typical denominations are in multiples of $1 million. Maturities are normally between 20 and 45 days but can be as short as one day or as long as 270 days. Because of the high minimum denomination, individual investors rarely purchase commercial paper directly, although they may invest in it indirectly by investing in money market funds that have pooled the funds of many individual investors. Money market funds are major investors in commercial paper. An active secondary market for commercial paper does not exist. However, it is sometimes possible to sell the paper back to the dealer who initially helped to place it. In most cases, investors hold commercial paper until maturity. 7

8 Commercial Paper Example: If an investor purchases a 30-day commercial paper with a par value of $1,000,000 for a price of $990,000, the yield is, Par PP 360 1,000, , yt x x 12.12% PP , When firms sell their commercial paper at a lower (higher) price than projected their cost of raising funds will be higher (lower) than they initially anticipated. Some corporations prefer to issue commercial paper rather than borrow from a bank because it is usually a cheaper source of funds. 8

9 NCD-Negotiable Certificate of Deposit NCDs are certificates that are issued by large commercial banks and other depository institutions as a short term source of funds. The minimum denomination is $100,000, although a $1 million denomination is more common. Non financial corporations often purchase NCDs. Although NCD denominations are too large for individual investors, they can indirectly invest in NCD through investing in money market funds. Maturities on NCDs normally range from two weeks to one year. A secondary market for NCDs exist providing investors with some liquidity. NCDs must offer a premium above the T-bill yield to compensate for less liquidity and safety. NCDs provide a return in the form of interest along with the difference between the price at which the NCD is redeemed (sold in the secondary market) and the purchase price. 9

10 NCD-Negotiable Certificate of Deposit Given that an institution issues an NCD at par value, the annualized yield that it will pay is the annualized interest rate on the NCD. If investors purchase NCD and hold it until maturity, their annualized yield is the interest rate. Example: An investor purchased an NCD a year ago in the secondary market for $970,000. He redeems it today upon maturity and receives $1,000,000. He also receives interest of $40,000. His annualized yield on this investment is, yt SP PP interest 1, 000, , , % PP 970,

11 Repurchase Agreements With a repurchase agreement or repo, one party sells securities to another party with an agreement to repurchase the securities at a specified date and price. In essence, the repo transaction represents a loan backed by the securities. If the borrower default on the loans, the lender has claim on the securities. Reverse repo refers to the purchase of securities by one party from another with an agreement to sell them. Thus a repo and reverse repo can refer to the same transaction but from different perspectives. Financial institutions such as banks, saving and loan associations and money market funds often participate in repurchase agreements. Many non-financial institutions are active participants as well. 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. A secondary market for repo does not exist. An investor initially purchased securities at a price of $9,852,217 with an agreement to sell them back at a price of $10,000,000 at the end of a 60 day period. The yield or repo rate on this transaction is, SP PP , 000, 000 9,852, yt x x 9% PP n 9,852,

12 Federal Funds The federal funds market allows depository institutions to effectively lend or borrow short term funds from each other at the so called federal funds rate. The federal funds rate is influenced by the demand and supply of funds in the federal funds market. Many market participants view changes in the federal funds rate as an indicator of potential changes in other money market rates. The federal funds rate is normally slightly higher than the T-bill rate at any point in time. Most transactions are for $5m or more and usually have 1 to 7 day maturity. 12

13 Banker s Acceptances A banker s acceptance indicates that a bank accepts responsibility for a future payment. Banker s acceptances are commonly used for international trade transactions. An exporter that is sending goods to an importer whose credit rating is not known will often prefer that a bank act as a guarantor. The bank therefore facilitates the transaction by stamping Accepted on a draft, which obligates payment at a specified point in time. In turn, the importer will pay the bank what is owed to the exporter along with a fee to the bank for guaranteeing the payment. Exporters can hold a banker s acceptance until the date at which payment is to be made, but they frequently sell the acceptance before maturity at a discount to obtain cash immediately. The investor who purchases the acceptance then receives the payment guaranteed by the bank in the future. The investor return on a banker s acceptance is derived from the difference between the discounted price paid for the acceptance and the amount to be received in the future. Maturities often ranges from 30 to 270 days and an active secondary market exists for this. 13

14 Institutional Use of Money Markets Type of Financial Institutions Participation in the Money Markets Commercial banks and Savings institutions Bank holding companies issue commercial paper Some banks and savings institutions issue NCDs, borrow or lend funds in the federal funds market, engage in repo, and purchase T-bills. Finance companies Issue large amounts of commercial paper Money market mutual funds Use proceeds from shares sold to invest in T- bills, commercial paper, NCDs, repo, and banker s acceptance. Insurance companies May maintain a portion of their investment portfolio as money market securities for liquidity. Pension funds May maintain a portion of their investment portfolio as money market securities for liquidity. 14