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Chapter 14


									      Chapter 14

 The Money Market


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

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;

       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.

      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

      (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.
      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
      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.
      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
      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.

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