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PART-III Powered By Docstoc
					Tarheel Consultancy
      Manipal, Karnataka

Corporate Training and

Course on Fixed Income

     XIM -Bhubaneshwar


      2003-2005 Batch
Term-V: September-December

   Basics of Money Market Securities

   There are fundamental differences between
    Money and Capital markets.
   The same borrower may tap both markets to
    fulfill different needs.
       For instance, a corporate borrower may issue long
        term bonds in the capital market to raise funds to
        build a factory.
       The same borrower may issue commercial paper
        in the money market to finance his inventories.

Introduction (Cont…)
   The purpose for which funds are
    borrowed therefore differs from
    borrower to borrower and often in the
    case of the same borrower from
    transaction to transaction.
       The different motives for borrowing lead to
        the creation of different instruments with
        unique risk and return features.

   Money market securities by definition
    have an original maturity of one year or
       The term original maturity refers to the
        maturity at the time of issue of the
       The maturity of the instrument at a
        subsequent point of time is called its actual

Why Money Markets?
   From the standpoint of both business
    entities as well as the government,
    inflows and outflows will rarely match.
   Consequently at certain points in time,
    an enterprise may be in need of funds,
    while at other times, it may have a

Why? (Cont…)
   Take the case of a government.
   It will collect revenues primarily by way of
       Such revenues tend to arrive in lumps during
        certain months of the year.
   However the government has to incur
    expenses throughout the year, both on
    account of developmental works as well as on
    account of wages and salaries.
Why? (Cont…)
   Consequently during most of the year
    the government will be a borrower, and
    will issue T-bills to meet its short-term
   However at certain points in time when
    it is flush with tax revenues, it may turn
    a net lender for short periods and may
    buy back T-bills.
Why? (Cont…)
   The same it true for a business.
   The balance in a current account will
    constantly fluctuate.
   If surplus funds are available a business may
    temporarily park its funds in money market
   Else if there is a deficit it will issue
    instruments like commercial paper to raise
    short-term funds.

Perishable Money
   Money is an extremely perishable
   The longer money remains idle, the
    greater is the lost income.
   And income that is lost can never be
   We will give an illustration.

   Assume that a corporation has a surplus
    of 12 MM USD that can be invested at
    12% per annum.
   The year we will assume has 360 days,
    which is a standard assumption in
    money markets.
   What will be the lost income if money
    remains idle for a day?

Illustration (Cont…)
   Interest for a day:
    12,000,000 x 0.12 x 1/360 = $ 4,000.
   Loss of income if money lies idle for a
    week = $ 28,000

Borrowers & Lenders
   It is a difficult task to characterize an
    entity as a borrower or a lender.
   An enterprise that is a borrower at one
    point in time may turn a net lender
   Certain institutions tend to be on both
    sides of the market at the same time.

Borrowers & Lenders (Cont…)
   Take an organization like a commercial
   It may borrow short term in the money
    market by issuing negotiable certificates
    of deposit.
   It may at the same time extend working
    capital loans to its clients.

Borrowers & Lenders (Cont…)
   Governments inevitably are borrowers.
   At any point in time, the U.S. Treasury
    is the largest borrower in the global
    money market.

   Investors are primarily concerned with safety
    and liquidity.
   Liquidity is important because most
    investments are for very short periods of
   The global money market has a lot of depth
    and can absorb large issues of securities as
    well as redemptions without a significant
    price impact.
Characteristics (Cont…)
   The market is an OTC network of
    securities dealers, banks, and funds
    brokers, who are linked by telephones
    and computers.
   The market as a whole is supervised by
    the Federal Reserve and other central

Characteristics (Cont…)
   Speed is of the essence.
       Transactions are sealed and executed in a
        matter of minutes or even less.
   Traders are constantly looking for
    arbitrage opportunities and will
    routinely move funds from one part of
    the globe to another.

Characteristics (Cont…)
   National money markets may be
    securities dominated or bank
   Securities dominated markets are
    characterized primarily by the buying
    and selling of marketable securities.
       Examples include the U.S., U.K. and
        Canadian markets.
Characteristics (Cont…)
   In bank dominated markets most of the
    activity is in the form of inter-bank and
    bank-client deals.
       Examples include Japan, China, and Korea.

Features of The Market
   It is a wholesale market.
       Not for small investors.
            However they can participate indirectly through MMMFs.
   The money market facilitates large scale
    transfer of funds.
       For most banks except the Bank of America, fund
        requirements usually exceed deposits.
       For smaller state and local banks, deposits usually
        exceed fund requirements.

The Federal Reserve
    The Federal Reserve is the central bank
     of the United States.
    It is a key component of the money
        It consists of 12 member banks located in
         the following cities.

The Federal Reserve System
   Boston            Chicago
   New York          St. Louis
   Philadelphia      Minneapolis
   Cleveland         Kansas City
   Richmond          Dallas
   Atlanta           San Francisco

Open Market Operations
   The money market is where the Federal
    Reserve carries out open-market
       The term refers to the buying and selling
        of Treasury securities by the FED in the
        secondary market.
       This is done to regulate the money supply
        and influence interest rates.

Open Market Operations
    In order to increase the money supply, the
     FED will buy Treasury securities.
    To decrease the money supply, it will sell
     Treasury securities.
    The decision to undertake such operations
     is taken by the Federal Open Market
     Committee (FOMC).
    It is implemented by the Federal Reserve
     of New York.

Features of Trading
   Because of the large volumes involved, skill
    and expertise in trading are of the utmost
       Most traders specialize in narrow segments of the
       The market is bound by a strict code of honour.
       Billions of dollars worth of business is conducted
        over the phone, and no one reneges.
       The market is relatively unregulated and therefore
        highly innovative.

Types of Instruments
   The most transactions in the global money
    markets take the form of:
       T-bills
       Federal agency securities
       Dealer loans
       Repurchase agreements
       Bankers’ acceptances
       Commercial paper
       Eurocurrency deposits
       Federal funds

   As of 1998 over 700 billion worth of T-
    bills were outstanding constituting
    about 13% of the Federal government’s
   Large (over $100,000) face value CDs
    were outstanding to the extent of about
    500 billion.

Volumes (Cont…)
   Agency securities and commercial paper
    were outstanding to the extent of over
    1 trillion dollars.
   Bankers’ acceptances totaled about 15
   And Eurocurrency deposits exceeded 2
    trillion dollars.

Benchmark Rates
   The rates on various instruments
    revolve around the prevailing T-bill
   T-bills are devoid of default risk and
    have a deep and active secondary
   Consequently they have the lowest

Benchmark Rates (Cont…)
   Federal agency securities are perceived
    to be virtually riskless since it is unlikely
    that the government will permit them to
   However the market for such securities
    is less liquid.
   Consequently the rate on such
    securities will be slightly higher.

Benchmark Rates (Cont…)
   Federal funds which are low risk inter-
    bank loans also have rates which are
    fairly close to T-bill rates.
   For instance the average T-bill rate in
    1999 was about 4.40% where the Fed
    Funds rate was fairly close to 5%.

Treasury Bills
   These are a direct obligation of the U.S.
   By law these must have an original
    maturity of one year or less.
   Which explains why the Treasury does
    not issue zero coupon instruments with
    a maturity exceeding one year.

T-bills (Cont…)
   The financial year for the U.S. government
    runs from 1 October till 30 September.
   However most of its income by way of taxes
    arises in April.
   Consequently even when the government is
    running a surplus budget, it tends to have a
    shortfall during most of the year.
   These temporary deficits are bridged by
    issuing T-bills.

T-bills (Cont…)
   The Treasury issues several types of T-
   Regular-series bills are issued at fixed
    intervals by way of competitive
   13 and 26 week bills are issued every
   52 week bills are issued once a month.

T-bills (Cont…)
   Irregular series bills are issued only
    when a special need arises.
   These take on two forms:
       Strip bills
       Cash management bills.
   A strip bill is essentially a series of bills
    with different maturities.
       Lenders have to buy the strip as a whole.

T-bills (Cont…)
   Cash management bills are a re-opening of
    an existing issue.
   What is a re-opening?
   Consider a six month bill that was issued two
    months ago?
   It will have four months to maturity today.
   So if new four month bills are issued they will
    essentially add to the size of the existing
       This is the meaning of reopening a maturity.

   The Treasury sells T-bills via an auction
   That is, the price is determined by the
    market based on competitive bidding,
    and is not set by the Treasury.
   13-week and 26-week bills are issued
    every week.
   52 week bills are issued once a month.

Auctions (Cont…)
   In the case of 13-week and 26-week
    bills the auction is announced on
   If Thursday were to be a holiday then it
    will be announced on the next business
   Bidders have until 1 P.M. EST on the
    following Monday to submit their bids.

Auctions (Cont…)
   An investor can submit multiple bids.
       That is he can bid at different yields.
       For instance an investor may bid for $500,000
        worth of bids at a yield of 5.01% and for an
        additional $500,000 at a yield of 5%.
   Bids have to be submitted at one of the 37
    Federal Reserve banks and their branches or
    at the Treasury’s bureau of public debt.

Auctions (Cont…)
   Bids may be submitted by person or by mail,
    or may be submitted electronically through a
    securities dealer.
   Online bidding is also possible at
   Most dealers do not charge commissions for
    T-bills bought at auctions, but they may levy
    a processing fee.

Auctions (Cont…)
   For bids that are filed directly with the
    Treasury or through Federal Reserve banks
    obviously no commissions are payable.
   Investors may choose to hold a Treasury
    Direct account.
   For such account holders interest payments
    and principal repayments can be credited
    directly to their bank accounts.

Auctions (Cont…)
   Instructions can be given by such
    account holders to have the proceeds
    from maturing issues to be
    automatically reinvested in new issues.
   There is no service charge for accounts
    with a face value of less than $100,000.
   For higher balances there is a small
    maintenance fee.

Auctions (Cont…)
   The Treasury permits both competitive
    as well as non-competitive bids.
   Most individual bidders submit non-
    competitive bids.
   Such bidders indicate only the quantity
    sought and agree to accept the yield
    that is determined by the auction

Auctions (Cont…)
   Institutional investors however submit
    competitive bids by indicating both the
    quantity sought and the minimum yield that
    they are prepared to accept.
   Non-competitive bids cannot be for more
    than $1,000,000 per bidder in the case of T-
    bills, and for $5,000,000 per bidder in the
    case of T-notes and bonds.

Auctions (Cont…)
   The Treasury generally accepts all non-
    competitive bids.
   Once the bids are received, the amount
    sought by non-competitive bidders is
    first subtracted from the total issue
   All competitive bids are then ranked.

Auctions (Cont…)
   In a price based auction bids will be ranked in
    descending order of price.
   In a yield based auction they will be ranked in
    ascending order of yield.
   All bids are required to be submitted to three
    decimal places.
   In principle the Treasury can conduct a
    uniform price/yield auction or a discriminatory
    price/yield auction.

Auctions (Cont…)
   Of late the Treasury has been
    conducting only single yield auctions.
   In a uniform yield auction, all successful
    bidders get the bills at the market
    clearing yield.
   In a discriminatory yield auction, all
    successful bidders get the bids at the
    yield that they bid.

   Assume that the Treasury has
    announced an issue of $500,000,000.
   Non-competitive bidders have bid $75
   So $425 MM will be offered to the
    competitive bidders.
   Assume that the following bids have
    been received.

Example (Cont…)
Bidder            Yield   Quantity
ABC Investments 5.010     25,000,000
XYZ Investments   5.070   75,000,000
Merrill Lynch     5.035   150,000,000
GE                5.050   100,000,000
Morgan Stanley    5.035   200,000,000
Orange County     5.080   125,000,000
Bank of Japan     5.025   120,000,000

Example (Cont…)
   The bids will be ranked in ascending
    order of yield, and the aggregate
    demand will be determined.

     Example (Cont…)
Bidder          Yield   Quantity      Aggregate
ABC             5.010   25,000,000    25,000,000
Bank of Japan   5.025   120,000,000   145,000,000

Merrill Lynch   5.035   150,000,000   295,000,000

Morgan Stanley 5.035    200,000,000   495,000,000

GE              5.050   100,000,000   595,000,000

XYZ             5.070   75,000,000    670,000,000
Orange County   5.080   125,000,000   795,000,000
Example (Cont…)
   Allocation will begin from the top.
   ABC Investments will receive 25 MM.
   That will leave 400 MM.
   Bank of Japan will get 120 MM.
   That will leave 280 MM.
   Both Merrill Lynch and Morgan Stanley
    have bid 5.035.
Example (Cont…)
   Their total bid is for 350 MM.
   Since only 280 MM is available, pro-rata
    allocation will take place.
   Merrill Lynch will get 3/7 of 280 MM,
    while Morgan Stanley will get 4/7.
   So Merrill Lynch will get 120 MM and
    Morgan Stanley will get 160 MM.

Example (Cont…)
   The remaining bidders will get nothing.
   They are said to be shut-out.
   The market clearing yield of 5.035 is
    called the stop-out yield.
   All non-competitive bidders will get the
    quantities that they asked for at this

Example (Cont…)
   Although the remaining bidders have
    been shut-out they can always buy in
    the secondary market after the auction.

Discriminatory Yield Auction
   What if the above auction had been
    conducted on a discriminatory yield basis?
   ABC would get 25 MM at 5.010.
   Bank of Japan would get 120 MM at 5.025.
   Merrill Lynch and Morgan Stanley would get
    120 MM and 160 MM respectively at 5.035.
   The remaining bidders would be shut-out.

Discriminatory (Cont…)
 All non-competitive bidders would get the
  quantities sought by them at a weighted
  average of the successful bids.
 The average in this case would be:

  25 x 5.010+120 x 5.025+280 x 5.035
  ___           ___         ____
  425           425          425
= 5.0307

   These days all bills are issued in book entry
   The minimum denomination is $1,000.
   They trade in multiples of $1,000 thereafter.
   They are zero coupon instruments.
   The income for an investor is equal to the
    difference between the price and the face

   As per Federal law the income is
    treated as ordinary income and not as
    capital gains.
   Income is subject to Federal taxes but
    is exempt from state and local taxes.

Calculation of The Discount
   For all calculations involving money
    market instruments the year is assumed
    to have 360 days.
   Let us use the following symbols:
       V = Face Value
       Tm = Days to Maturity
       d = Quoted Yield

Price Calculation
  Dollar Discount:
  D = d x V x
Price = P = V - D

    A bill with a face value of $1,000,000
     has 80 days to maturity.
    The quoted yield is 8%.
    D = 1,000,000x.08 x 360
= 177,77.78
P = 1,000,000 – 177,77.78
Rate of Return
   The rate of return if the bill is
    purchased at this price will be greater
    than the quoted yield.
               1,000 ,000  982 ,222 .22 x 360
   R.O.R =                                80
                    982 ,222 .22
        = 8.1448%


Primary Dealers
   Who is a primary dealer?
   A primary dealer is one who is authorized to
    deal directly with the Federal Reserve Bank of
    New York.
   To qualify as a Primary Dealer the dealer
    must agree to make a market in government
    securities at all times and is required to post
    a capital of 50 MM USD.

Primary Dealers (Cont…)
   More than one-third of all primary
    dealers are controlled by corporation
    outside the U.S – in Canada, the U.K.
    Switzerland, Hong Kong, and Japan.
   By getting primary dealer status, these
    dealers get a solid foothold in the U.S.
   There are currently 30 primary dealers.

Primary Dealers (Cont…)
   In addition to these dealers there are
    more than 1500 other dealers who
    perform a variety of dealing and market
    making functions in the Treasury
   The primary dealer system was
    established by the Federal Reserve.

Primary Dealers (Cont…)
   What is the advantage of having primary
   It enables the central bank to conduct its
    monetary policy efficiently with a small group
    of well capitalized dealers.
   These dealers are expected to participate in
    Treasury auctions, to distribute Treasury
    issues, and to make a market in them.

   A Repo or a repurchase agreement is
    an arrangement that facilitates the
    borrowing of funds by a dealer.
   Under this arrangement the dealer will
    sell the securities to another party with
    a simultaneous commitment to buy it
    back later at a fixed price plus interest.

Repos (Cont…)
   Thus a repo is a temporary extension of
    credit that is collateralized by
    marketable securities.
   Dealers routinely take positions in debt
   If a dealer anticipates that interest rates
    will fall he will take a long position.

Repos (Cont…)
   He will either hold the security as an
    investment or else will wait for a client
    to come along.
   The question is, how will he finance this
   After all a dealer’s capital is limited and
    dealers often hold positions that are as
    high as 40 times their capital in value.

Repos (Cont…)
   This is where repos come in.
   Take the case of a dealer who is looking
    for a 30 day loan and is willing to
    pledge T-notes as collateral.

Repos (Cont…)
   Assume that the accrued interest is
   The quoted price per $100 of face value
    is $100.9375.
   The repo is for 30 days.
   The rate of interest is 9% per annum.
   The haircut is 0.005 price points.

Repos (Cont…)
   What is this haircut?
   The lender has to protect himself
    against the risk that the market value of
    the collateral may decline.
   Hence he will not lend the full value of
    the collateral but will apply a discount.
   This discount is called a haircut.

Repos (Cont…)
   The amount that can be borrowed
    against the securities is:
      5,000,000(1.009375 - .005) + 205,700
      = $5,227,575
    The amount due at maturity is this principal
      plus interest.          30
    Interest = 5,227,575x.09x
        = $39,206.81                               78
Repos (Cont…)
   Notice that the haircut is applied to the clean
    price and not to the accrued interest.
   This is because the accrued interest is not a
    function of yield.
   During these 30 days there will be
    fluctuations in the value of the collateral.
   These must be regularly monitored to ensure
    adequate collateralization.

Types of Repos
    Most repos are done on an overnight basis.
    Typically a dealer will locate a corporation
     or MMMF which has funds to invest
    Some dealers may also undertake long
     term speculative positions, which
     consequently need to be financed for
     longer periods.
         Such repos are called Term Repos and carry a
          higher rate of interest.

Types of Repos (Cont…)
   Some Repos are known as Continuing
   They have no explicit maturity date but
    may be terminated at short notice by
    either party.
   These days repos with bells and
    whistles are available.

Types of Repos (Cont…)
   In the case of a Dollar repo the
    borrower can ask for a security that is
    similar to what was sold a the outset,
    but is not necessarily the same.
   In a Flex repo the lender can take back
    a part of the loan whenever required.
   Thus it is like a bank account.

Collateral for Repos
     Most repos are collateralized by
      government securities.
     Sometimes other money market
      instruments like commercial paper and BAs
      may be used.

Credit Risk
   In practice both the borrower and the
    lender are subject to credit risk.
       If interest rates rise sharply, the value of
        the collateral will decline and the lender
        will be vulnerable.
            In this case, if the borrower were to go
             bankrupt, the lender will be left with assets
             which may be worth less than the loan amount.

Credit Risk
     If interest rates decline the value of the
      collateral will rise.
          Now if the lender goes bankrupt, the borrower
           will be left with an amount that is less than the
           market value of the securities.
     There is no strategy which will reduce the
      risk for both the parties.
          Increasing protection for one means enhanced
           risk for the other.

Credit Risk
   The lender can ask for margin.
       What this means is that he can lend less than the
        market value of the assets.
       But this will increase the risk for the borrower.
   The borrower can ask for reverse margin.
       That is, he can ask the lender to lend more than
        the market value of the securities.
       But this will increase the risk for the lender.

Credit Risk
   In practice it is the lenders who receive
       This is because they are parting with cash
        which is the more liquid of the two assets.
   Thus the market value of the collateral
    will exceed the loan amount.
       The excess is called a Haircut.

   The size of the haircut would depend
       The maturity of the collateral.
       Its liquidity.
       Its price volatility.
       The term to maturity of the repo,
       Creditworthiness of the borrower.

Market Risk and Marking to
   Market risk is the risk that the value of
    the collateral may decline.
       To reduce market risk, the collateral must
        be periodically marked to market.
            That is the market value of the security should
             be checked to see if it is adequately in excess
             of the loan amount.
                     If not more collateral should be asked for.
                     Or else a partial return of cash must be

Repos (Cont…)
   In the case of an ordinary repo there
    will be a single interest rate that is
    applicable for the duration of the loan.
   In the case of a continuing contract the
    rate will change from day to day.
   The interest will be calculated on a daily
    basis but will be collected at the end.

Repos (Cont…)
   Such transactions offer a convenient
    route for lenders to park excess funds
    for short periods.
   From the perspective of the lender such
    an arrangement is called a reverse
    repurchase agreement or a reverse

Repos (Cont…)
   Thus every repo must be matched by a
    reverse repo.
   Thus a dealer looking to borrow funds
    will do a repo.
   A dealer looking to place funds will do a
    reverse repo.

Repos (Cont…)
   Who will do a reverse repo?
   A repo will be done by a person who
    wants to finance a long position.
   That is he will buy the security and do a
    repo thereby getting the funds to pay
    for the long position.
   He will have to pay interest on the
    funds borrowed.

Repos (Cont…)
   However he will be entitled to any coupons
    and accrued interest from the underlying
   A dealer who wishes to go short in a debt
    security will borrow and sell it, and will
    pledge the cash proceeds as collateral.
   This will be an example of a reverse repo

Repos (Cont…)
   In this case the short seller will earn the
    reverse repo rate on the cash proceeds.
   But will be eligible to pay any coupon or
    accrued interest for the period for which
    he is short.

Matched Book
   Some dealers will do a repo for one
    maturity with a party and a reverse
    repo for another maturity with another
   They hope to profit from the interest
    rate differential.
   Such dealers are said to be maintaining
    a matched book.

Repos (Cont…)
   Most government securities can be bought at
    a rate called the general collateral rate.
   Thus most securities are close substitutes for
    each other.
   But sometimes a security may be in high
   If so the lender may charge a lower rate.
   Such rates are called special repo rates.

Banker’s Acceptances (BAs)
   In international trade when goods are
    exported the exporter will draw up a
    Draft or a Bill of Exchange.
       A Draft is an instrument that instructs the
        importer to pay the amount mentioned
        upon presentation.
       A Draft may be a Sight Draft or a Time

Sight Drafts
     In such cases the importer has to pay for
      the goods on sight of the draft.
     His bank will not release the shipping
      document until he pays.
     Such transactions are known as
      Documents Against Payment transactions.

Time Drafts
    These are also known as Usance Drafts.
    The bank will release the shipping
     documents in such cases as soon as the
     importer accepts the draft by signing on it.
    The importer need not pay immediately.
    In other words the exporter is offering him
     credit for a period.
    When the importer accepts a draft it
     becomes a Trade Acceptance.

Letters of Credit (LCs)
   Most international transactions are
    backed by LCs.
       An LC is a written guarantee given by the
        importer’s bank to honour any drafts or
        claims for payment presented by the
            LC based transactions are more secure.
            Shipments under an LC can be on the basis of
             a sight draft or a time draft.
LC Based Transactions
   In the case of a sight draft the importer’s
    bank will pay on presentation.
   In the case of a time draft it will accept it by
    signing on it.
   A draft that is accepted by a bank is called a
    Banker’s Acceptance.
       It is obviously more marketable than a trade

The Market for BAs
   In the U.S. there is an active secondary
    market for BAs.
       They are short term zero coupon assets
        which are redeemed at the face value on
       BAs with a face value of 5MM USD are
        considered to constitute a round lot.

The Market for BAs
    Once a BA is issued the exporter can get it
     discounted by the accepting bank.
         That is he can sell it for its discounted value.
    Or he can sell it to someone else in the
     secondary market.

The Market for BAs
   The credit risk involved in holding a BA
    is minimal.
       This is because it represents an obligation
        on the part of the accepting bank.
       In addition it is also a contingent obligation
        on the part of the exporter.
            That is if the bank fails to pay, the holder has
             recourse to the exporter who is the drawer of
             the draft
Negotiable Certificates of
   A CD is an instrument issued by a bank in
    return for a time deposit.
       The term negotiable indicates that there is an
        active secondary market where these deposit
        receipts can be bought and sold.
       As per Federal law a CD must have a minimum
        maturity of 7days. There is no ceiling on the
       Most CDs have maturities ranging from one to
        three months.

CDs (Cont…)
   A CD must be issued at par.
   In practice banks issue many types of
   A true money market CD must be
    negotiable, and have a denomination of
   CDs usually trade in market lots of 1
    MM dollars.

CDs (Cont…)
   Rates are set by negotiations between
    borrowers and lenders and are a reflection of
    prevailing market conditions.
   The concept started in 1961 when Citibank
    started offering this to large corporate
    customers and organized a group of dealers
    to make a secondary market.

CDs (Cont…)
   The motivation was the following.
   Over a period of time, corporate
    Treasury managers had found that
    instruments like T-bills and repos were
    excellent short term investments.
   Thus banks which were losing business
    came up with this innovative

   CDs may be issued in registered form or
    bearer form.
   Those issued in bearer form are more
    easily tradeable.
   Denominations range from $25,000 to
    $10 MM. Most traded CDs have
    denominations of $1,000,000.

CDs (Cont…)
   Maturities can be as long as 18 months.
   Most traded CDs have a maturity of 6
    months or less.
   CDs with maturities in excess of one
    year are called Term CDs.

CDs (Cont…)
   CDs issued by large, financially sound
    banks are called Prime CDs.
   Those issued by smaller and less sound
    banks are called Non Prime CDs.
   CDs are insured up to $100,000.
   Buyers include banks, corporations,
    foreign central banks and governments,
    HNIs and institutions.

   Insurance companies. Pensions funds,
    insurance companies, and MMMFs are
    large buyers.
   They find CDs to be attractive because
    they are liquid, carry low risk and can
    be issued for any desired maturity.

CDs (Cont…)
   These days floating rate CDs with up to
    5 years to maturity are available.
   Interest is reset every 30, 90 or 180
   The gap between reset rates is called
    the leg or roll period.

    CDs are interest bearing instruments and
     not discount instruments.
         So to get a certificate with a face value of
          $100,000 one has to actually deposit $100,000.
    CDs pay interest on an Actual/360 basis.

   Assume that you deposit 1MM USD for
    270 days at a rate of 10% per annum.
       At maturity you will receive the
       principal plus interest equal to:
       1,000,000x.10x 270
                        ------- = $ 75,000

Yields on CDs
    These are a function of demand and
         CDs are not riskless because the issuing bank
          could fail.
         For the issuing bank, the effective cost of the
          CD is greater than the quoted rate of interest
          because of reserve requirements and insurance

   A bank is quoting 8% per annum on a 3
    month deposit.
   Reserves are 5% and are non-interest
   So effectively $8 of interest is being
    offered on $95 of usable funds.
                  =
    Effective rate 95 = 8.42%

   The insurance premium is 8.33b.p.
   So the effective cost is
   8.42 + .0833 = 8.5033%

Commercial Paper (CP)
   Commercial Paper is a short term
    unsecured promissory note.
       Unsecured means that the loan is not not
        backed by a pledge of assets.
       Thus it is backed only by the liquidity and
        earning power of the borrower.
       CP markets are wholesale because the
        denominations are large.

Commercial Paper
    For a large credit worthy issuer CP issues
     offer low cost alternatives to a bank loan.
    Unlike T-Bills CPs carry a risk of default.
         Consequently investors demand higher yields.

Sale of Paper
   Most paper is sold through dealers who buy it
    from the issuer and resell it mainly to banks.
       They get a fee for this.
       Dealers also provide advice on what rate to offer
        on newly issued paper.
       Dealers also undertake to buy unsold paper.
   Large and regular issuers of paper often
    employ their own sales force.

Rating of Commercial Paper
   Paper is rated by one or more of the
    following main rating agencies in the
       Moody’s
       Standard and Poor
       Duff and Phelps
       Fitch

   Summary of the Rating
Company   Higher     Lower      Speculative   Defaulted
          A/ Prime   A/ Prime   Below

Moody’s P-1          P-2,P-3    NP            NP
S&P       A-1+,      A-2, A-3 B, C            D
Duff &    Duff-1+,   Duff-2,    Duff-4        Duff-5
Phelps    Duff-1,    Duff-3
Fitch     F-1+,F-    F-2,F-3    F-5           D
Credit Rating
   We will illustrate using S&P’s rating
       A-1= strong degree of safety for timely
       A-2 = satisfactory degree of safety
       A-3 = adequate safety
       B,C = risky or speculative
       D = default history
Credit Rating
   Agencies are paid by the issuers of paper.
   A good rating makes it easier and cheaper to
   However rating agencies always look at the
    issue from the perspective of a potential
       This is because their credibility is based on their
        track record from the standpoint of accuracy.

Evaluation Criteria
   Rating agencies use the following
       Strong management.
       Good position for the company in a well
        established industry.
       Good earnings record.
       Adequate liquidity.
       Ability to borrow to meet both anticipated
        and unanticipated needs.