Chapter 6 : Money Markets

Transcription

1 1 Chapter 6 : Money Markets Chapter Objectives Provide a background on money market securities Explain how institutional investors use money markets Explain the globalization of money markets 2 Why so many different securities? Why so many different (m-m) securities? Why isn t one or two enough? These are the questions that try men s souls. Introduction All the transactions carried out in the financial markets seem to be basically the same: borrowers issue securities that lenders buy. However, the different purposes for which money is borrowed can result in the creation of different kinds of financial assets having different maturities, risks, etc. For instance, the money market is the market for shortterm (one year or less) credit. Characteristics of the Money Market The money market is the mechanism through which holders of temporary cash surpluses meet holders of temporary cash deficits. The money market arises because for most individuals and institutions, cash inflows and outflows are rarely in perfect harmony with each other, and the holding of idle surplus cash is expensive. 3 4 Borrowers and Lenders in the Money Market 5 Government Treasuries (borrowing and redeeming securities) Corporate Borrowers & Cash-Management Customers Needing to Invest Cash Surpluses Security Dealers & Brokers Money Center Banks Nonbank Financial Institutions (mutual funds, insurers, etc.) Central Banks (supplying funds and information and promoting market stability) 6 Maturity of a year or less Debt securities issued by corporations and governments that need short-term funds Large primary market focus Purchased by corporations and financial institutions Secondary market for securities 1

2 Characteristics of the Money Market Money market investors seek mainly safety and liquidity, plus the opportunity to earn some interest income. Because funds invested in the money market represent only temporary cash surpluses and are usually needed in the near future, money market investors are especially sensitive to risk. Marketability and Liquidity Marketability Can an asset be sold quickly? Marketability is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield. Liquidity A liquid financial asset is readily marketable. Moreover, its price tends to be stable and reversible. 7 8 Types of Investment Risk Types of Investment Risk Market risk The risk that the market value of an asset will decline, resulting in a capital loss when sold. Also called interest rate risk. Reinvestment risk The risk that an investor will be forced to place earnings from a security into a lower-yielding investment because interest rates have fallen. Default risk The probability that a borrower fails to meet one or more promised principal or interest payments on a security. Inflation risk The risk that increases in the general price level will reduce the purchasing power of earnings from the investment. Currency risk The risk that adverse movements in the price of a currency will reduce the net rate of return from a foreign investment. Also called exchange rate risk. Political risk The probability that changes in government laws or regulations will reduce the expected return from an investment Characteristics of the Money Market Banks in the Money Market 11 The money market is extremely broad and deep. It can absorb a large volume of transactions with only small effects on security prices and interest rates. The money market is also very efficient. Securities dealers, major banks, and funds brokers maintain constant contact with one another through a vast telephone and computer network and are hence alert to any bargains. 12 Principal channel for payments for loans, securities & other transactions Agents in trust for property management on behalf of bank customers Direct lenders to money market borrowers Banks Money Market Roles Guarantors of performance & payment Custody agents for safekeeping securities owned by market participants and pledged as collateral for loans Channel for government money & credit policy 2

3 Money Market Participants Treasury Bills Commercial paper Negotiable certificates of deposits Repurchase agreements Federal funds Banker s acceptances Instrument Treasury bills Federal funds Repurchase agreement Commercial Paper Negotiable CDs Banker s acceptances Principal Issuer U.S. Treasury Commercial banks FRS, Comm banks Other Fis Comm banks Other FIs, Corps Commercial banks Commercial banks Principal Investor FRS, Comm banks Other FIs, Corps Commercial banks FRS, Comm banks Other FIs, Corps Corporations Corps, Other FIs Comm banks, Corps The Money Market Instrument Typical Maturities Principal Borrowers Secondary Market Treasury bills 3 to 12 months U.S. government Very active Negotiable CDs 1 to 6 months Depository institutions Modest activity Commercial paper 1 to 270 days Financial and business firms Moderately active Bankers acceptances 90 days Financial and business firms Limited Repurchase agreements 1 day, and 2 days Banks, securities dealers, None, but very to 3 months typical; other owners of securities, active primary 6 months less typical nonfinancial firms, market for short governments maturities Fed funds Chiefly 1 business day Depository institutions Active brokers market Eurodollars Overnight, 1 week, Banks None 1 to 6 months, and longer 16 Market Makers Assist in raising funds to finance deficits by marketing a borrower s new securities in the primary market Advise potential buyers and sellers of securities on the course of action likely to minimize costs and maximize returns MARKET MAKERS Stand ready to buy or sell outstanding securities in the secondary market Treasury bills Issued to meet the short-term needs of the U.S. government Attractive to investors Minimal default risk backed by Federal Government Excellent liquidity for investors Short-term maturity Very good secondary market Competitive Bidding Treasury bill auction (fill bids in amount determined by Treasury borrowing needs) Bid process used to sell T-bills Bids submitted to Federal Reserve banks by the deadline Bid process Accepts highest bids Accepts bids until Treasury needs generated

4 19 Noncompetitive Bidding Treasury bill auction noncompetitive bids ($1 million limit) May be used to make sure bid is accepted Price is the weighted average of the accepted competitive bids Investors do not know the price in advance so they submit check for full par value After the auction, investor receives check from the Treasury covering the difference between par and the actual price 20 Estimating T-bill yield No coupon payments Par or face value received at maturity Yield at issue is the difference between the selling price and par or face value adjusted for time If sold prior to maturity in secondary market Yield based on the difference between price paid for T-bill and selling price adjusted for time Calculating the Yield on Bills T-bills do not carry a promised interest rate. Instead, they are sold at a discount from their par or face value. Bill yields are determined by the bank discount method, which does not compound interest rates and uses a 360-day year for simplicity. The bank discount rate (DR) on T-bills Calculating T-Bill Annualized Yield SP PP Y T = PP 365 n Y T = The annualized yield from investing in a T-bill SP = Selling price PP = Purchase price n = number of days of the investment (holding period) = Par value Purchase price 360. Par value Days to maturity T-bill yield for a newly issued security Par PP T-bill discount = PP 360 n T-bill discount = percent discount of the purchase price from par Par = Face value of the T-bills at maturity PP = Purchase price n = number of days to maturity Short-term debt instrument Alternative to bank loan Dealer placed vs. directly placed Used only by well-known and creditworthy firms Unsecured Commercial Paper Minimum denominations of $100,000 Not a large secondary market

5 Commercial paper Unsecured, short-term promissory notes as alternative to: Short-term bank loans Other forms of borrowing Primary benefit to largest & most creditworthy issuers is: Cost of borrowing is lower than at a commercial bank Structure of the Commercial Paper Market Supply Side Issuers of commercial paper Finance companies Bank holding companies Nonfinancial firms Direct or finance paper Dealer or industrial paper Paper dealer houses Demand Side Investors in commercial paper Money market funds Banks Insurance companies Pension funds Industrial companies Other investors Commercial paper backed by bank lines of credit Bank line used if company loses credit rating Bank lends to pay off commercial paper Bank charges fees for guaranteed line of credit Estimating commercial paper yields Y CP Par PP = PP 360 n Y CP = Commercial paper yield Par = Face value at maturity PP = Purchase price n = number of days to maturity Negotiable Certificates of Deposits Negotiable Certificates of Deposit (NCD) Issued by large commercial banks Minimum denomination of $100,000 but $1 million more common Purchased by nonfinancial corporations or money market funds Secondary markets supported by dealers in security A bank-issued time deposit that specifies an interest rate and maturity date and is is negotiable in in the secondary market Bearer Instrument whoever holds the the CD when it it matures receives the the principal and interest Denominations that range from $100,000 to to $10 million, $1 million being the most common Often purchased by money market mutual funds with pools of of funds from individual investors

6 31 NCD placement Direct placement Use a correspondent institution specializing in placement Sell to securities dealers who resell Sell direct to investors at a higher price NCD premiums Rate above T-bill rate to compensate for lower liquidity and safety DR = Par value Purchase price 360. Par value days to maturity Negotiable Certificates of Deposit 32 CD interest rates are computed as a yield to maturity (ytm) on a 360-day basis. Interest = term in days deposit promised income 360 principal ytm In secondary market trading, the bank discount rate (DR) is used as a measure of CD yields. Negotiable Certificates of Deposit The Market Structure for Negotiable CDs The principal buyers of negotiable CDs include corporations, state and local governments, foreign central banks and governments, wealthy individuals, and a variety of financial institutions. Most buyers hold CDs until they mature. However, prime-rate CDs are actively traded in the secondary market. Money center banks Issue primary market CDs Funds raised to meet legal reserve requirements and other bank cash needs Redemption of CDs at maturity Sale of negotiable CDs Large depositors (corporations & other customers) Immediately available funds Buyers in the secondary CD market Negotiable Certificates of Deposit Bankers are becoming increasingly innovative in packaging CDs to meet the needs of customers. New types of CDs include variable-rate CDs, rollover or rolypoly CDs, jumbo CDs, Yankee CDs, brokered CDs, bear and bull CDs, installment CDs, rising-rate CDs, and foreign index CDs. Repurchase Agreements Sell a security with the agreement to repurchase it at a specified date and price Borrower defaults, lender has security Reverse repo name for transaction from lender Negotiated over telecommunications network Dealers and brokers used or direct placement No secondary market

7 Estimating repurchase agreement yields Repo Rate SP PP = PP 360 n Repo Rate = Yield on the repurchase agreement SP = Selling price PP = Purchase price n = number of days to maturity Federal Funds Interbank lending and borrowing Federal funds rate usually slightly higher than T-bill rate Fed district bank debits and credits accounts for purchase (borrowing) and sale (lending) Federal funds brokers may match up buyers and sellers using telecommunications network Usually $5 million or more Exhibit 6.5 L/C (Letter of Credit) Application 2 Importer 1 Purchase Order 5 Shipment of Goods 3 L/C L/C Notification 4 Exporter Shipping Documents & Time Draft 6 Bankers Acceptance A bank takes responsibility for a future payment of trade bill of exchange Used mostly in international transactions Exporters send goods to a foreign destination and want payment assurance before sending Bank stamps a time draft from the importer ACCEPTED and obligates the bank to make good on the payment at a specific time American Bank (Importer s Bank) 7 Shipping Documents & Time Draft Draft Accepted (B/ACreated) Japanese Bank (Exporter s Bank) Bankers Acceptance porter can hold until the date or sell before maturity If sold to get the cash before maturity, price received is a discount from draft s total Return is based on calculations for other discount securities Similar to the commercial paper example Major Participants in Money Market Participants Commercial banks Finance, industrial, and service companies Federal and state governments Money market mutual funds All other financial institutions (investing) Short-term investing for income and liquidity Short-term financing for short and permanent needs Large transaction size and telecommunication network

8 Valuation of Exhibit 6.7 Present value of future cash flows at maturity (zero coupon) Value (price) inversely related to discount rate or yield Money market security prices more stable than longer term bonds Yields = risk-free rate + default risk premium International Economic Conditions U.S. Fiscal Policy U.S. Monetary Policy Short-Term Risk-Free Interest Rate (T-bill Rate) U.S. Economic Conditions Issuer s Issuer s Industry Unique Conditions Conditions Risk Premium of Issuer Required Return on the Money Market Security Price of the Money Market Security Interaction Among Money Market Yields Securities are close investment substitutes Investors trade to maintain yield differentials T-Bill is the benchmark yield in money market Yield changes in T-bills quickly impacts other securities via dealer trading Yield differentials determined by risk differences between securities Default risk premiums vary inversely with economic conditions Money market rates vary by country Segmented markets Tax differences Estimated exchange rates Government barriers to capital flows Deregulation Improves Financial Integration Capital Flows To Highest Rate of Return Eurodollar deposits and Euronotes Dollar deposits in banks outside the U.S. Increased because of international trade growth and U.S. trade deficits over time No reserve requirements at banks outside U.S. Eurodollar Loans Channel funds to other multinationals that need short-term financing Euro-commercial paper Issued without the backing of a banking syndicate Maturity tailored to investors Dealers that place paper create a secondary market Rates range between 50 and 100 basis points above the LIBOR rate

9 Performance of international securities Effective yield for international securities has two components The yield earned on the investment denominated in the currency of the investment The exchange rate effect Performance of international securities Yield for an international investment Y f = SP f PP f PP f Y f = Foreign investment s yield SP f = Investment s foreign currency selling price PP f = Investment s foreign currency purchase Chapter Concepts Summary 51 The exchange rate effect (%) S )measures the percentage change in the spot during the investment period Y = ( 1 + Y ) ( 1 + % S ) 1 e f % ) S measures the expected percent change in the currency Currency appreciated, % ) S is positive and adds to net yield Currency depreciated, % ) S is negative and reduces net yield 52 Surplus units channel investments to securities issued by deficit units Debt securities markets Money Market Capital Market Money market securities Short-term High quality Very good liquidity International Aspects of Money Markets While U.S. money markets are the largest, the international market is is growing U.S. securities bought/sold by foreign investors foreign money market securities Euro money market instruments Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP London Interbank Offered Rate (LIOR) 53 the rate paid on Eurodollars 9