CHAPTER 11. The Money Markets

Transcription

1 CHAPTER 11 The Money Markets

2 Now that s a lot! In its 2009 annual report, Microsoft listed $25 billion in short-term securities on its balance sheet, plus $6 billion in actual cash equivalents. Microsoft does not keep this in its local bank. But where? This is, of course, this topic of chapter 11 Money Markets. 11-2

3 Chapter Preview We review the money markets and the securities that are traded there. In addition, we discuss why the money markets are important in our financial system. Topics include: The Money Markets Defined The Purpose of Money Markets Who Participates in Money Markets? Money Market Instruments Comparing Money Market Securities 11-3

4 The Money Markets Defined The term money market is a misnomer. Money (currency) is not actually traded in the money markets. The securities in the money market are short term with high liquidity; therefore, they are close to being money. 11-4

5 Definition of Money Markets According to Crowther, "The money market is a name given to the various firms and institutions that deal in the various grades of near money." According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government." 11-5

6 The Money Markets Defined A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos). History: The money market developed because there are parties that had surplus funds, while others needed cash. [3 Today it comprises cash instruments as well. 11-6

7 The Money Markets Defined Money Markets Defined 1. Money market securities are usually sold in large denominations ($1,000,000 or more) 2. They have low default risk 3. They mature in one year or less from their issue date, although most mature in less than 120 days 11-7

8 The Money Markets Defined: Why Do We Need Money Markets? In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits. Banks also have an information advantage on the credit-worthiness of participants. Banks do mediate between savers and borrowers; however, they are heavily regulated. This creates a distinct cost advantage for money markets over banks. 11-8

9 Functions of Money Market Money market is an important part of the economy. It plays very significant functions. As mentioned above it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors. The major functions of money market are given below:- To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions. To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc 11-9

10 Functions of Money Market To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry. To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy. To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy

11 Characteristics of Money Markets Money Market have an active secondary market. Money markets is that they are wholesale markets. Flexibility Innovation 11-11

12 The Money Markets Defined: Cost Advantages Reserve requirements create additional expense for banks that money markets do not have Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets, especially in the 1970s and 1980s. When interest rates rose, depositors moved their money from banks to money markets to earn a higher interest rate

13 The Money Markets Defined: Cost Advantages Even today, the cost structure of banks limits their competitiveness to situations where their informational advantages outweighs their regulatory costs. Figure 11.1 shows that limits on interest banks could offer was not relevant until the 1950s. But in the decades that followed, the problem became apparent

14 3-month T-bill rates and Interest Rate Ceilings 11-14

15 The Purpose of Money Markets Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time Borrowers from money market provide lowcost source of temporary funds 11-15

16 The Purpose of Money Markets Corporations and U.S. government use these markets because the timing of cash inflows and outflows are not well synchronized. Money markets provide a way to solve these cash-timing problems

17 The Importance of Money Markets A well-developed money market is essential for a modern economy. Though, historically, money market has developed as a result of industrial and commercial progress, it also has important role to play in the process of industrialization and economic development of a country. Importance of a developed money market and its various functions are discussed below: 1. Financing Trade: Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade

18 The Importance of Money Markets 2. Profitable Investment: Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity

19 The Importance of Money Markets 3. Self-Sufficiency of Commercial Bank: Developed money market helps the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market

20 The Importance of Money Markets 4. Self-Sufficiency of Commercial Bank: Developed money market helps the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market

21 The Importance of Money Markets 5. Financing Industry: Money market contributes to the growth of industries in two ways: (a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc. (b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market

22 The Importance of Money Markets 5. Help to Central Bank: Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank. Money market helps the central bank in two ways: (a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy, (b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy

23 Who Participates in the Money Markets? We will discuss, in turn, each of the major borrowers and lenders in the money market. Before we do that, let s examine some of the current rates offered in the U.S. money markets. Some of these rates have been discussed in previous chapters. Other rates will be explored throughout this chapter

24 Who Participates in the Money Markets?: A Sample from the Wall Street Journal 11-24

25 Who Participates in the Money Markets? 11-25

26 Money Market Instruments We will examine each of these in the following slides: Treasury Bills Federal Funds Repurchase Agreements Negotiable Certificates of Deposit Commercial Paper Eurodollars 11-26

27 Money Market Instruments (cont.) We will examine each of these in the following slides (continued): Commercial Paper Banker s Acceptance Eurodollars 11-27

28 Money Market Instruments: Treasury Bills T-bills have 28-day maturities through 12- month maturities. Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks

29 Money Market Instruments: Treasury Bills Discounting Example You pay $ for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? 11-29

30 Money Market Instruments: Treasury Bills Discounting Example You pay $ for a 28-day T-bill. It is worth $1,000 at maturity. What is its annualized yield? 11-30

31 Money Market Instruments: Treasury Bill Auctions T-bills are auctioned to the dealers every Thursday. The Treasury may accept both competitive and noncompetitive bids, and the price everyone pays is the highest yield paid to any accepted bid

32 Money Market Instruments: Treasury Bill Auctions Example The Treasury auctioned $2.5 billion par value 91-day T-bills, the following bids were received: Bidder Bid Amount Bid Price 1 $500 million $ $750 million $ $1.5 billion $ $1 billion $ $600 million $ The Treasury also received $750 million in noncompetitive bids. Who will receive T-bills, what quantity, and at what price? 11-32

33 Money Market Instruments: Treasury Bill Auctions Example The Treasury accepts the following bids: Bidder Bid Amount Bid Price 1 $500 million $ $600 million $ $650 million $ Both the competitive and noncompetitive bidders pay the highest yield based on the price of : 11-33

34 Money Market Instruments: Treasury Bill Rates The next slide shows the results of several Treasury bill auctions, from It also shows some other data about each auction. Do you know what each term means? 11-34

35 Money Market Instruments: Treasury Bill Auction Results 11-35

36 Money Market Instruments: Treasury Bill Rates The next slide shows actual T-bill rates and the annual rate of inflation from 1973 through Notice that the inflation rate exceeds the rate on T-bills in several on the years. This indicates a negative real return for T-bill investors during these periods

37 Money Market Instruments: Treasury Bills 11-37

38 Mini-Case: Treasury Bill Auctions Go Haywire In 1991, Salomon Smith Barney violated Treasury auction rules to corner the auction on an $11 billion issue. Several top Salomon officials were forced to retire (or fired) as a result of the incident. The Treasury also changed the auction rules to ensure a competitive auction

39 Money Market Instruments: Fed Funds Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. Used by banks to meet short-term needs to meet reserve requirements

40 Money Market Instruments: Fed Funds Rates The next slide shows actual fed funds rates and T-bill rates 1990 through Notice that the two rates track fairly closely. What does this suggest about the market for T-bills and the market for fed funds? 11-40

41 Money Market Instruments: Fed Funds Rates 11-41

42 Chapter Summary The Money Markets Defined Short-term instruments Most have a low default probability The Purpose of Money Markets Used to warehouse funds Returns are low because of low risk and high liquidity 11-42

43 Chapter Summary (cont.) Who Participates in Money Markets? U.S. Treasury Commercial banks Businesses Individuals (through mutual funds) Money Market Instruments Include T-bills, fed funds, etc