Chapter 14 The Money Market Contents The Nature of the Money Market Money Market Instruments Money Market Calculations Yield and Risk Analysis Page 248 Chapter 14 - Page 249 Answers to Questions: 1. Knowing the available investment options and how to evaluate them is important for three major reasons. First, improved cash management and forecasting ability has its payoff in increased interest income or reduced interest expense. Second, even where the company is a net borrower during much of the year, it still needs a liquidity reserve. Third, the corporate treasurer must understand the money markets because each investment represents someone else's borrowing. Learning about potential investments implies understanding when and how each security could be used as a way to borrow funds. Ignorance regarding money market concepts might result in potential risks and returns being improperly appraised, but more typically the opportunity cost is losing the chance to have a greater return. 2. Securities with an original maturity sold in the primary market or a current maturity of one year or less bought on the secondary market are considered to be part of the money market. It is in the primary market that investment bankers arrange for the marketing and pricing of new issues of money market securities. The secondary market, even more so than the primary market, is best thought of as a global network of telecommunication hook-ups between all potential buyers and sellers. Primary and secondary markets are inter-related because the larger the volume on the resale market, the less risk involved with buying the security on the primary market. 3. Interest rates on money market securities typically move in unison. 4. Dealers typically "take a position" in the security instrument(s) they trade, meaning they hold an inventory of securities. Independent securities dealers, investment banks, and large commercial banks commonly have individuals that perform the dealer role. Brokers are also middlemen, but they do not inventory the securities they arrange transactions. When receiving an order, they check around for the security; when located, the brokers execute the trade. They are paid a commission for their services. 5. a. Default risk is the possibility that the issuer will not meet contractual obligations to pay interest or repay principal. b. Liquidity risk is tied to the marketability of a security--the ability to sell quickly at or very near the current market price. c. Reinvestment rate risk is the possibility that the investor will have to invest cash proceeds at a lower interest rate for the remainder of the predetermined investment horizon. d. Interest rate risk is the possibility that interest rates will increase, causing the prices of existing fixed-income securities to drop. Chapter 14 - Page 250 e. Prepayment risk refers to a return of principal whenever a mortgage in the pool is paid off due to homeowner relocation or to a drop in general interest rates, which trigger refinancing. 6. Eurodollar deposits are not assessed an FDIC premium, nor are they required to have reserves held against them. The lower costs to issuers imply higher yields than domestic CDs for the investor. 7. The high-quality issuers that have always been able to issue commercial paper have been joined by medium-quality issuers offering credit enhancement in the form of collateral or a backup line of credit from their banks. While default risks are measurably higher for either type of commercial paper issuer, the default rates are still extremely low. 8. Dividend capture simply means buying a common or preferred stock shortly before it pays its dividend, or buying a preferred stock having an adjustable dividend payment. The major risk is a decline in the stock price during the holding period. 9. Agencies are securities issued by governmental agencies and several private financing institutions that have governmental backing. For a slightly higher default risk and less liquidity investors gain higher yields on federal agency securities than on Treasury securities with similar maturities. 10. The variable rate demand note reset interest rate is a function of supply and demand factors in this specialized market. If investors do not like the new rate, they can still sell ("put") the security back to the issuer for par value. 11. The advantage of pooling monies before investing are: professional money management, as professional money managers make the investment decisions and oversee the securities in the funds; diversification of default risk by including many issuers' securities, and possibly even securities from issuers in various countries; higher yields due to investing in much larger denominations than would be possible for any single investor; enhanced liquidity because as some investors withdraw funds others are reinvesting, and individual securities do not have to be sold to fund withdrawals; and greater flexibility in the sense that any combination of securities can be assembled--by maturity, issuer type, issuer geographic location, or other mixes investors might desire. Chapter 14 - Page 251 12. A repurchase agreement (RP, or "repo") is the sale of a portfolio of securities with a prearranged buyback one or several days later. As the sale price is less than the repurchase price, the difference constitutes the interest return. Sweep accounts are those in which excess funds are automatically or at the cash manager's request transferred ("swept") from the demand deposit account into an interest-bearing overnight investment. 13. Sweep accounts are those in which excess funds are automatically or at the cash manager's request transferred ("swept") from the demand deposit account into an interest-bearing overnight investment. Banks offer the convenience of "one-stop" shopping, automatic transfers of amounts above the compensating balance level, choices of several pooled investments to select from, and perhaps even an optional credit line paydown instead of investing the surplus. The bank merely makes a bookkeeping entry--no wire transfer is made--and the transaction can be fully automated by stipulating that any balances above some preset amount will be swept out nightly. 14. Discount securities do not pay coupon interest, meaning they are bought at a price below their face or par value and the investor receives face value at maturity. Coupon securities are bought at a given face value, on which the periodic interest is calculated. Interest may be added to the account within the holding period or at the end of that period. 15. Here are the coupon-equivalent rates (right column): Item Maturity Coupon-Equivalent Yield 3-month Treasury bills 91 days 4.82% 6-month Treasury bills 182 days 4.70% This coincides with the yield curve graphed in Exhibit 14-11, an inverted or “falling” (actually bowed) yield curve. Considering the various yield curves in Exhibit 14-12, this fits best with the Feb. 1981 falling yield curve. There could be market segmentation, yields expected to fall but then rise later on, there may be a liquidity premium as one gets out further on the yield curve (which is biased expectations). We cannot be more certain because the numerical data from the auction comprises only a small segment of the yield curve, however. 16. Coupon-equivalent yield is calculated based on a 365-day year instead of 360 days which is the case for discount yield. It also bases the return on the amount invested, not the face value. 17. The oldest explanation and first in importance is the unbiased expectations hypothesis. This theory posits that the prevailing yield curve is mathematically derived from the present short-term rate and expectations for rates that will exist Chapter 14 - Page 252 at various points in time in the future. Existing interest rates in today's markets are called spot rates; rates that the market collectively forecast today for future years are called forward rates. Combining the shortest-term spot rates with the forward rates being forecasted by the market, we can derive today's spot rates for medium-term and long-term securities. The second explanation for a yield curve's shape is the liquidity preference hypothesis. Higher yields are viewed as necessary to induce investors to tie their funds up for long time periods (in other words, to be illiquid) in light of the increasing interest rate risk. Preference for liquidity is thought to characterize enough investors that the yield curve (in the absence of expectations or other influences on other than the shortest-term securities) should slope upward from left to right. The longer the maturity, the larger the liquidity premium that must be offered to attract investors. The market segmentation hypothesis contends that instead of being close substitutes, securities with short, medium, and long maturities are seen by investors (funds suppliers) and issuers (funds demanders) as quite different. Supply and demand in each maturity spectrum determines the prevailing interest rate in that spectrum, and market participants do not arbitrage disparities across spectrums. The fourth hypothesis merges unbiased expectations and liquidity preference in the biased expectations hypothesis. Basically this is merely expectations modified by some degree of liquidity preference. Many market observers find the biased expectations hypothesis the most plausible of the four explanations. Chapter 14 - Page 253 Solutions to Problems: Chapter 14 1. Security selection and tax considerations. ASSUMPTIONS: Security Term (Yr.) Yield Tax Rate CD 1 6% 39% Muni 1 4% 0% After-tax rate on CD = 6 % * (1 - 0.39) = 3.66% After-tax return on municipal = 4.25% Reggie should select the municipal security, assuming equal default risk. 2. Tax Equivalent Yields a.) Comparing taxable and non-taxable securities To make a proper comparison, the yields must be compared on an after-tax basis by comparing the municipal yield to the yield on taxable securities time (1 - T). b.) Calculating tax equivalent yields Muni yield 5% Tax rate 39% tax-equivalent yield = 5 % / (1 - 0.39) = 8.20% Jacqui should only buy a fully taxable security yielding more than 8.20% if she wants to beat the muni's 5% yield. 3. Dividend (capture) yield vs. commercial paper yield. Dividend yield 8% Tax rate 35% a.) Calculating the dividend capture yield Assume Heather holds the stock at least 46 days and 70% of the dividend is tax exempt. (100 % - (30 % * 34 %)) = 89.80% retained effective yield = 8 % * 89.80 % = 7.184% Chapter 14 - Page 254 b.) Equivalent taxable yield 7.184 % = r * (1 - 0.34) r = 7.184/(1 - 0.34) = 11.05% c.) Types of risk and return possibilities Price risk and event risk. The latter was very relevant in the U.S. in the late '90s, as electrical utilities were facing new competition due to interstate selling of power. Extra return could come from a stock price increase due to the industry coming into favor or getting favorable regulatory rulings. Most cash managers would shy away from the risk with core liquidity holdings. 4. T-bill yield calculations. ASSUMPTIONS: At Treasury bill auction, price was 97.569 % of par on $10,000 T-bills with maturity of 91 days. a.) Discount yield on T-bills Price = 97.569% or 0.97569 of $10,000 face value = $9,756.90 T-bill discount yield = (10,000 - 9,756.90) / 10,000 * 360/91 = 9.62% b.) Coupon-equivalent yield on T-bills (10,000 - 9,756.90) / 9,756.90 * 365/91 = 9.99% c.) Calculating annual effective yields effective yield = (1 + (10,000 - 9,756.90)/9,756.90)^(365/91) -1 effective yield = 10.37% d.) Relationship between effective yield, coupon-equivalent yield, and discount yield. E.Y. > C.-E. Y. > D.Y. It may surprise someone doing this for the first time that the true (effective) yield is so much higher, on an annual basis, than the widely-quoted discount yield on a 13-week security. 5. Commercial paper nominal yield calculation. Teaching notes: 1. This is essentially identical to a T-bill coupon-equivalent yield calculation, but the yield is called "commercial paper nominal yield" by market participants. 2. This material is not presented in the chapter text, which explains the inclusion in the problem (and below) of the formula. CPNY = (Dollar discount / Purchase price) * (365 / Days to maturity) where Dollar discount = Face value - Purchase price Chapter 14 - Page 255 a.) Finding the nominal yields on commercial paper ASSUMPTIONS: A commercial paper issue has these characteristics: Maturity 45 days Face value $100,000.00 Selling price $98,950.00 First, note that the selling price is equivalent to the purchase price. Substituting, CPNY = (100,000-98950 / 98950) * (365 / 45) CPNY = 8.61% b.) Finding the nominal yields on commercial paper A commercial paper issue with these characteristics: Maturity 30 days Face value $1,000,000.00 Selling price $990,450.00 First, note that selling price is equivalent to purchase price. Substituting, CPNY = (1,000,000-990,450 / 990,450) * (365 / 30) CPNY = 11.73% 6. Implied forward rates and investing strategy. ASSUMPTIONS: The 1-year T-bill coupon-equivalent yield = 5.25%, and the 2-year T-bill is yielding 5.95%. a.) Calculating the implied one-year forward rate Using Equation 14-8 (in Term Structure Theories section of chapter): tR2 is 5.95%, tR1 is 5.25%, and t+1r1, t is the unknown we are after. (1 + 0.0595) = [(1 + 0.0525(1 + r)]^1/2 1.0595 = [(1 + 0.0525(1+r)]^1/2 Squaring both sides to simplify, we have: 1.12254 = (1 + 0.525)(1 + r) Dividing both sides by 1.0525 to simplify, we have: 1.066547 = (1 + r) Subtracting 1 from both sides, r =0.066547, or 6.65%. Chapter 14 - Page 256 b.) To roll or not to roll ASSUMPTIONS: The forecasted one-year forward rate is 7%. Since the two-year rate implies a year 2 forward one-year rate of 6.65% (our solution in part a), one would be better off rolling over the consecutive one-year securities if the 7% year-two forecast is correct.