Money markets by RodneySooialo


Money Markets and
Financial Institutions
  Prof. Greg Duffee
  Haas School of Business
  Fall 2004
Money markets
   Common features
     Markets  for borrowing and lending at short
      maturities (one year or less)
     Very large wholesale markets (large $ transactions)
     Near zero default risk
   Our discussion will also introduce concepts of
     Primary and secondary markets
     Brokers and dealers
     Money market yield conventions

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The commercial paper market

   CP is issued by                    Outstanding CP in U.S.,
    major financial and                  2004:Q1 ($ billion)
                                            190   95.5
   For former, an                                           Nonfinancial
    important source of                                      Financial
    funding                                                  corporations
   Maturities average
    about 30 days; max
   Unsecured IOUs

                          Duffee, MBA 232                             3

   Two main uses
     Long-term  financing (rolling over maturing CP)
     Matching fluctuating demands for cash

   Purchasers
     MM  mutual funds, insurance companies, pension
          Advantage as an investment vehicle is very low risk

                              Duffee, MBA 232                    4
CP markets

   Two types of primary markets (initial issuance of IOUs)
     Dealer market: investment banks buy CP from issuer, market
      to investors
     Direct placements: issuer sells directly to investors (bilateral
     Roughly equal in size; nonfinancial CP typically uses dealer

   Minimal secondary market (subsequent trading of
    IOUs before maturity)

                              Duffee, MBA 232                        5
Economics of the CP market
   Facts about the market
       About 500 firms in US issue CP
            All have their CP rated by credit rating agencies
       Market effectively requires high rating to issue CP
            At least medium investment-grade
       For issuers, CP financing is cheaper than longer-term debt

   Questions
       Why can’t lower-quality borrowers use the CP market (―junk‖
       Why is it so cheap for issuers?
       How do issuers deal with rollover risk?

                                    Duffee, MBA 232                   6
   Answers
     Moral   hazard limits issuance of unrestricted IOUs
          Covenants required for lower-quality firms

     Short maturity of CP means that high-quality firms do
      not have enough time to get into trouble; low credit

     CP issuers have backup lines of credit from
      commercial banks (with covenants)

                              Duffee, MBA 232               7
Recent trends in CP

   Amount outstanding                Yield spread between two CP

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Themes to remember

   Nature of the market is strongly affected by
     Asymmetric  information
     Transaction costs

   Temporary supply/demand fluctuations can
    produce sharp, short-run variations in rates
     Notas obvious as simple economic principles might
      suggest – financial instruments are typically highly

                          Duffee, MBA 232                    9
CP yield conventions

   CP yields are quoted on a 360 day discount basis
       Assumes a year is 360 days
       Interest is figured as a fraction of amount paid back, not amount

                                  days 
                     P  F 1  Yd      ,
                                   360 
                          F  P  360 
                     Yd          days 
                                       
                             F         

                                Duffee, MBA 232                         10
   GE issues CP with a face value of $100, payable in 30
    days. It sells today for $99.85. What is the yield quoted
    in the CP market? What is the bond-equivalent yield?

                  100  99 .85  360 
             Yd                      0.0180
                      100       30 

                           Duffee, MBA 232                  11
Treasury bills
   ZCB with maturities 1 year or less

   Yield convention same as CP – 360-day discount

   $900+ billion outstanding
      About ¼ of Fed debt

   Uses the same as CP: Long-term financing by rolling
    over, matching fluctuating demands for cash

                           Duffee, MBA 232                12
Treasury bills

   Investors
     Foreign central banks
     The Fed (open market operations)
     Wholesale investors: MM mutual funds,      insurance
      companies, pension funds, banks
     Individuals
   Lowest interest rates among all taxable
     Strong   demand for zero default risk, low interest-rate

                            Duffee, MBA 232                  13
Markets for Treasury bills

   Originally sold at auction (primary market)
   Secondary market
     Inter-dealer market is a broker market
         Brokers have computer systems on which dealers post
          prices, quantities to buy/sell with other dealers
     Rest of market is a dealer market
         Individuals, companies call a dealer to get price, make trade

     Wholesale (inter-dealer) market is a broker market
   Separate markets is a common feature of
    secondary trading in financial instruments

                              Duffee, MBA 232                         14
The primary market for Treasury bills

   $60+ billion auctioned each week
       Currently, weekly auctions of 26-week, 13-week, and 4-week
       Occasional ―cash management‖ bills
   Purchasers are
       Dealers (―competitive‖ bidders)
       Individual investors (―competitive‖ bidding through dealers or
       Foreign governments, the Fed (noncompetitive)
   Amounts auctioned determined by Treasury based on
    funding requirements and perceived demand
   Auctions are run by the Fed

                                Duffee, MBA 232                          15
Auction mechanics
   The bidders
     Competitive     – qualified dealers, on own account or for
          Each can bid for up to 35% of entire amount auctioned
          Small number of big players; mostly major investment banks
     Noncompetitive      – others
   The bids
     Competitive bids are pairs of quantity       and yield
        Example: $10 million at 1.8%

        Noncompetitive bids are quantities only

   Sealed-bid method used

                              Duffee, MBA 232                       16
Auction mechanics

   Treasury announces amount a few days in advance
       Example: Thursday, June 24, announce $17 billion of 13-week
        bills and $15 billion of 26-week bills to be sold on Monday, June
        28 (plus whatever the Fed buys)
   Single-price (aka uniform-price) system is used
       All winning bidders pay same price
       All noncompetitive bids are added up and subtracted first
       Bids at highest yield (stop-out yield) are prorated so total amount
        of bids equals issuance amount)
       Stop-out yield determines the bond’s price

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Hypothetical bidding example

   Auction of $11.5 billion in 182-day notes
   $500 million in competitive bids

                     Bidder and Amount
Yield Bid A          B         C       D             E         Totals
  5.475%       0.5         0.5       0           0         0           1
  5.480%         1         0.5       1           1       0.5           4
  5.485%       1.2         1.1       1         1.2         1         5.5
  5.490%       1.5           2       2         1.4         2         8.9
               4.2         4.1       4         3.6       3.5        19.4

                             Duffee, MBA 232                            18
Duffee, MBA 232   19
More about Treasury auctions

   With slight modifications, same procedure is used to
    issue longer-term Treasury securities
   Auctions used to be multiple-price auctions
       Winning bidders paid the yield they bid
   Why the change?
       Holding bids constant, single-price auctions raise less money
       But bidding patterns cannot be held constant – winner’s curse
       Single-price bids are more aggressive
   Economic theory leans towards single-price; empirical
    evidence is mixed

                                Duffee, MBA 232                         20
Secondary markets for Treasury bills

   Trading activity is very heavy
       Combined trades of most active participants is about 10%
   Reasons for trading
       Continual rebalancing of portfolios
            Nonfinancial corporations sweeping spare funds into treasuries
            Mutual funds adjusting to redemptions or new funds
       Speculation/hedging
            Positions can be used to bet on direction of short-term rates
            Common use – hedge much interest-rate risk in other securities
   More discussion when we consider longer-term Treasury

                                   Duffee, MBA 232                            21
The Fed funds market

   Used primarily by commercial banks to borrow and lend
    bank reserves
       Banks keep funds on account at the Fed
       Banks with excess funds lend to those with insufficient funds
        (based on withdrawals, reserve requirements)
       Lending takes place in this market
   Maturity – primarily, same-day borrowing of reserves
       Term Fed funds exists
   Trade size about $25MM, daily volume $100+ billion
   Brokers usually arrange trades (thousands of banks)

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Fed funds

   No collateral
   Interest rates vary from transaction to transaction
    (supply/demand, not credit risk, which is small)
   Most commonly seen rate: ―effective‖ Fed funds rate
       Volume-weighted average of daily rates
   Rates can fluctuate dramatically because of market
       Same-day funds are hard to come by
   The Federal Reserve defines monetary policy in terms of
    a ―target‖ effective Fed funds rate

                               Duffee, MBA 232            23
Fed funds yield convention
    Fed funds quoted on a ―360-day add-on‖ basis
       Also called ―money market‖ basis
    Simple interest calculation, 360-day year

                 days                     F  P 360
    F  P1  Ymm                Ymm     
                 360                        P days
    Example: Borrow $10 million overnight at 2%. What is paid back?

                                      1 
          F  $10 ,000 ,000 1  0.02       $10 ,000 ,556
                                     360 

                               Duffee, MBA 232                         24
Yield conventions

   For the same economic transaction, rank the following
    rates: 360-day discount, 360-day add-on, simple interest
    with 365-day year
   Lowest is 360-day discount: Interest figured off of higher
    base amount
   Middle is 360-day add-on
   Highest is simple interest with 365-day year. The period
    over which you are borrowing is a larger fraction of a
    `year’ when a 360-day year is used, so rate is smaller.

                           Duffee, MBA 232                   25
General principles of yield conventions

   Money-market rates are used when the transaction is
    like a loan of $X.
   Discount rates are used when the transaction is like the
    sale of a security with face value of $X.

                           Duffee, MBA 232                     26
Eurodollar deposits

   Eurodollars are $-denominated time deposits in banks
    outside of the US
   Maturity from one day and up
   Interest received is ―Eurodollar deposit rate‖
    (competitive; depends on bank)

   Eurocurrencies are deposits denominated in a currency
    that is not the home currency of the bank
   Multinational corporations use Euro$ deposits to simplify
    payment systems

                           Duffee, MBA 232                  27
The market for Eurodollar deposits

   Major banks use Euro$ deposit market heavily to borrow
    and lend funds (borrow and lend deposits)
   Primary market is a broker/dealer market
       Potential borrowers/lenders contact brokers or major banks in
        London (center of market) directly
       Deposit rate is negotiated with dealer
   Primary market is liquid for maturities ranging from day
    to year
   No collateral for borrowed deposits
       Small amount of credit risk, priced into the rate

                                 Duffee, MBA 232                        28
The Eurodollar market

   Secondary market is small (Eurodollar CDs)

   Average rate of interest charged by London banks to
    lend deposits to other (A-rated) banks is called LIBOR –
    London Interbank Offered Rate
      Term structure of LIBOR

                           Duffee, MBA 232                 29
The importance of LIBOR
   LIBOR is the baseline for pricing interest-rate
    instruments: floating-rate debt, interest rate swaps, caps,
    floors. Priced at spread to LIBOR

   Why?
       LIBOR is less responsive to idiosyncratic supply/demand
        fluctuations that affect other markets
       With issuers limited in number (Treasury), in ability to react
        quickly (Treasury, CP), or with institutional restrictions on trading
        (Fed funds), idiosyncratic demand shocks move rates
       With Eurodollars, major financial institutions can be on either
        side, no institutional restrictions to slow their reaction

                                 Duffee, MBA 232                           30
The RP (repo) market

   A market for short-term collateralized borrowing and
   Used by financial institutions, Gov organizations. Very
    large market ($4+ trillion outstanding/day)
   Mechanics
       Primary market only – a dealer market
       Funds usually borrowed for next-day delivery
       Market liquid for maturities ranging from one day to many
        months (term repo)
       Collateral is usually Treasury securities, but other publicly-traded
        securities can be used

                                 Duffee, MBA 232                          31
The RP market

   Legally, RP is a matched sale-repurchase
       Buy security for $10MM today
       Simultaneously agree to forward contract—sell security back for
        $10MM + one day’s interest tomorrow
       Therefore for one day, lender of funds has unrestricted use of
        security (contrast with borrowing to buy car/house)
       Can think of RP as borrowing money or borrowing a security
   Terminology
       To repo (borrow money), to do repo (lend money), to reverse in
        securities (borrow securities), to reverse out securities (lend

                                Duffee, MBA 232                           32
Credit risk in repo

   Low and two-way
     Credit  risk for party that reverses in the security is
      created by the possibility that the security’s price falls
      and the counterparty defaults
     Haircuts apply to collateral (maybe $0.25 for $100 in
      bills, 1% to 3% for longer-term bonds)
     Haircuts reduce this risk
     Credit risk for the party that reverses out the security
      is created by the possibility of a price increase
      coupled with a counterparty default
     Haircuts raise this risk

                            Duffee, MBA 232                    33
The RP market

   One-day RP rate closely tracks Fed funds rate
     Funds rate typically higher – credit risk

   The Fed conducts monetary policy through the RP

   The RP market is used extensively by investment banks
    to fund positions they take in securities markets

   Also popular with non-financial institutions that want to
    store funds in liquid, collateralized form

                            Duffee, MBA 232                     34
Financing Treasurys in the RP market
   Speculating without much cash
       To go long, buy, reverse out the security – no money down
       To go short, sell, and reverse in to deliver
   Short example – a CP dealer buys $50MM (face) of 6-
    month CP on Wednesday, will sell entire amount to
    customers on Monday. Goal is to hedge general market
    interest rate risk of position
       Desired hedge: short-sell $50MM of 6-month T-bills at
        Wednesday’s rate, close out short position at Monday’s rate.
       But short-selling Treasurys is equivalent to borrowing at the
        Treasury rate—no one will lend to the CP dealer at that rate w/o
       More generally – shorts must deliver!

                                Duffee, MBA 232                        35
RPs and shorts

   The CP dealer can hedge using repos
   Key intuition: with repos, lender of cash (reversing in
    securities) has temporary ownership of securities but
    does not face price risk of securities
       Hands securities back at future date at price fixed today
   Application
       Short-sell Treasury bills
       Lend proceeds in RP market, taking same bills as collateral
       Hand over bills to counterparty in short position
       Close out RP position when hedge is no longer needed
            Buy bills in cash market, hand over to close out RP position;
             returned principal plus interest in repo loan pays for bills

                                    Duffee, MBA 232                          36
RPs and shorts

   Short-sellers demand for securities is a major reason for
    heavy use of repo market

   We will return to this use of the repo market later in the

                            Duffee, MBA 232                      37
Observations on money markets (1)

   Money market instruments impose no restrictions on
    borrowers (other than obligation to pay back the loan)
   Borrowing without restrictions is limited to financially
    secure firms over short time horizons
      If same firms want to borrow long term, or if lower-
       quality firms want to borrow short or long term,
       restrictions are always imposed on the borrower
      Only default-free entities have easy access to long-
       term borrowing without restrictions

                           Duffee, MBA 232                     38
Observations on money markets (2)

   Rates on mm instruments are linked because
    they are close substitutes for many investors
    and borrowers
     Commercial  banks can borrow unsecured funds in
      Fed funds, Eurodollar markets
     Large investors who want extremely low risk
      investments can buy Treasury bills or lend in repo
     Large investors willing to accept slightly more risk can
      buy CP or deposit money in Eurodollars

                           Duffee, MBA 232                  39
Observations on money markets (3)

   Primary markets are structured to minimize transaction
    costs in linking buyers and sellers
      Methods include direct search, brokers, dealers, and
       auctions—we will deal with these more systematically

   Secondary markets range from extremely active to non-
      No technological barriers to trading CP, Eurodollars in
       secondary markets, but too little demand to justify
       expense of market

                           Duffee, MBA 232                  40
Appendix: Explicit example of short-
selling and RPs
    CP dealer buys $50MM (face) of 6-month CP on
    Wednesday, will sell entire amount to customers on
    Monday. Goal is to hedge general market interest rate
    risk of position.

                          Duffee, MBA 232                   41
   Wednesday
       Sell $50MM (face) of newly-issued 6-month T-bills for delivery on
        Thursday at yield 1.75%
       Next-day overnight repo: reverse out bills at 1.75% (determines
        price), repo rate of 1.90%

   Thursday
       Receive $50MM(1-0.0175)(182/360)=$49,557,639 for T-bills
       Hand over cash to RP counterparty, receive the bills
       Deliver the bills to counterpart of short position
       Arrange another next-day overnight repo at (assumed
        unchanged) Treasury yield of 1.75%, repo rate of 1.90%

                                Duffee, MBA 232                        42
   Friday
       Close out original RP transaction
          Receive principal plus interest of $49,557,639(1+0.0190/360)
           = $49,560,255
          Return T-bills

       Perform under 2nd RP transaction
          Lend $50MM(1 – 0.0175(181/360))=$49,560,069

          Receive T-bills as collateral

          Pocket $186 from T-bill – RP spread

       Arrange another next-day overnight repo at (assumed
        unchanged) Treasury yield of 1.75%, repo rate of 1.9%

                               Duffee, MBA 232                       43
   Monday
       Close out 2nd RP transaction
          Receive principal plus 3 days interest of $49,560,069(1 +
          Return T-bills
       Perform under 3rd RP transaction
          Lend $50MM(1 – 0.0175(178/360))=$49,567,361

          Receive T-bills as collateral

          Pocket $555 from T-bill – RP spread

       Buy T-bills for next-day delivery at (assumed higher) yield of 2%

                                 Duffee, MBA 232                        44
   Tuesday
       Close out 3rd RP transaction
            Receive principal plus interest of
            Deliver T-bills
       Perform under cash transaction
            Pocket difference of $59,644 as profit from short position in T-bills

            Buy T-bills at $50MM(1 – 0.02(177/360))=$49,508,333

                                      Duffee, MBA 232                                45

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