Money Market vs. Capital Market
Maturity of 1 year or less vs. maturity of more than 1 year at time of issue
Money Market Instruments
Currently 1-month, 3-month and 6-months
Notes that banks write on themselves.
Under $100,000 are generally non-negotiable
Over $100,000 are often available for trading OTC
Alternative to borrowing from a bank
Majority is issued by financial companies – GMAC is the biggest
Non-financial companies will issue on an irregular basis.
Typically backed by a line of credit at a major bank, but lines of credit are not legally
The usual maturity is < 45 days. It is eligible as collateral at the Fed’s discount window if
the maturity is < 90 days.
Don’t need to register with the SEC if maturity is < 9 mo.
Little secondary market due to heterogeneity
Usually sold in units of $100,000.
LOC paper = Letter of credit commercial paper. Bank will pay-off the paper if the
Sold by issuing firm to investors without an intermediary.
Uses an underwriter
Usually used with transfer of goods from one country to another.
Importer in U.S. and Exporter in Japan.
Exporter wants to send goods to U.S. and receive payment in 90 days.
Exporter may not know credit-worthiness of importer
Importer intends to sell the goods within 90 days to raise the money needed to pay the
Legal remedies in case of default are difficult internationally.
Importer obtains commercial letter of credit from his bank in the U.S. – The U.S. bank
guarantees payment in 90 days. – Importer pays bank a fee to write the letter and intends
to place the money in the bank after he sells the goods in 90 days.
Letter of credit is sent to exporter’s bank in Japan
Exporter ships goods and endorses the shipping documents.
He presents the documents to his bank in Japan.
Japanese bank sends the documents to U.S. bank which “accepts” them.
We now have a B.A.
U.S. bank pays Japanese bank the PV of the purchase price.
Japanese bank pays the exporter.
U.S. bank holds the acceptance and is paid by the importer in 90 days
U.S. bank sells the acceptance on the open market
The sale is on a discount basis.
Purchaser buys a guarantee that the bank will pay money on the 90th day.
The U.S. bank is liable even if the importer defaults on his debt.
B.A. has credit risk of bank and less liquidity than Treasuries.
How do Bond Dealers finance their positions?
Repo = Repurchase agreement = RP
Repo – initiating party wants to borrow funds (sell and repurchase)
Reverse Repo – initiating party wants to obtain collateral
General – any collateral (treasuries) will do
Special – specific collateral desired – rate is lower
Collateral = security used
Haircut = Margin = Difference between market value of collateral and funds delivered to
A initiates a repo and sells T-bonds to B with a forward contract to repurchase them from
B in 2 days at a higher price
The haircut protects B (buyer/lender) because if the value of the T-bonds fall while B has
them, A might refuse to buy them back.
Since repo rate is short-term lending, and the yield curve is usually upward sloping, the
interest earned on the security is usually > the interest paid on the repo, so the bond
dealer has a positive carry.
Coupon Rate on bond = 7.25%
3-day Repo Rate = 6.00%
Dealer buys bond and delivers it to repo dealer
Repo dealer takes bond as collateral and lends cash at repo rate
T-bond price is 94.16 + .5122 accrued interest = 94.6722
Repo dealer takes haircut of 50 basis points of market value = .473361
Amount borrowed is 94.198839
Dealer takes back T-Bond and sells it for 96.78 + accrued interest of .5713 = 97.3513
Dealer pays repo dealer the 94.198839 borrowed plus 6% interest for 3 days
94.198839 (1 + [.06 (3/360)]) = 94.24594
Cash on hand and on deposit at the Fed by commercial banks.
No interest is earned by the banks on this money
Required Reserves = the level the Fed requires banks to hold
Based as a % of deposits
Progressive scale based on time and demand deposits
Excess Reserves = any reserves a bank has above the required level
Total Reserves = Required Reserves + Excess Reserves
A higher required reserve ratio means less money the bank has to lend and a decrease in
the money supply.
Reserve Requirements are based on deposits over a 14-day period called the Computation
Period. Reserves held are based on reserves over the 14-day period starting 2 days after
the start of the computation period. This is called the Maintenance Period.
This means the bank has 2 days at the end of the Maintenance Period to make final
adjustments in its reserves. It can borrow excess reserves from other banks at the Fed
Funds rate or from the Fed itself through the discount window at the Discount Rate.
Discount Rate = the interest rate charged by the Fed to banks that wish to borrow reserves
from the Fed’s discount window.
Banks generally don’t borrow from the Fed unless necessary since it invites an increase
in Fed monitoring, so they usually borrow reserves from other banks. That’s what Fed
Funds are, and the interest rate charged on these loans is the Fed Fund Rate.
The Federal Reserve sets a target for the Fed Funds rate and seeks to control it through
the supply of and demand for money in the banking system.
U.S. dollar deposits in foreign banks outside the U.S. or deposited in foreign branches of
Many banks have branches outside the U.S. (Caymen Islands, Bahamas, etc.). These
branches are not subject to the same regulations, so they can operate at a lower cost.
Dollars deposited there are Eurodollars.
Eurodollars are not subject to reserve requirements.
Interest earned is not reported to the IRS
Treasury Notes and Bonds
Currently 2-yr, 5-yr, and 10-yr
30-yr bond is set to return in 2006
Usually denominated in dollars
Issued outside the jurisdiction of any country to avoid regulations
Underwritten by international syndicate
Offered to investors in several countries
Bearer bonds – unregistered (Die Hard Movie)
Issuers are usually very financially sound– can include governments
Coupon payments made annually
Dual Currency Issues:
Coupon payments in one currency
Principal payment in another currency
Note the exchange rate risk – particularly if principal payment isn’t in your currency and
it is many years off. – But may appeal to investors who feel XR will move a certain way.
Bond Indenture = legal document specifying the terms of the issue including call features,
coupon payments, and restrictive covenants.
Corporate Trustee = Third party who represents the interests of the bondholders.
Mortgage Bonds = bondholders are granted a lien against pledged assets
Lien = legal right to sell mortgaged property to satisfy unpaid obligations.
This rarely happens, but gives bondholders a strong bargaining position in financial
Collateral Trust Bonds = Financial assets such as stocks or bonds are pledged as security
rather than a real asset.
Debenture Bond = No specific asset pledged
Claim on all assets not specifically pledged elsewhere
Subordinated Debenture Bond = Junior debt to a senior debenture bond.
Guaranteed Bond = Guaranteed by a third party.
How financially strong is the third party?
Convertible Bond = Call option on common stock of issuer
Exchangeable Bond = Call option on stock of another company
Warrant = a call option that can be separated from the bond and exercised or sold without
redeeming the bond.
Putable Bond = Bondholder can sell the bond back to the issuer for par on specified
dates. This is good if interest rates go up.
Floating-Rate Bonds = variable coupon rate. It’s tied to some benchmark like a 1yr. T-
Interest is exempt from Fed. Tax
State Tax as well if you live in the state (a few exceptions).
Primary purchasers are banks, P&C Insurance companies, and individuals.
GO = General Obligation Bond
Secured by general taxing power
Limited-tax GO may be subject to a max property tax millage. 1 mill = 10 basis pts.
Example: millage = 6 mills
House has appraised value of $100,000
Property tax = (.006) (100,000) = $600
The revenue of the project will pay the principal and interest.
Example is a toll road.
Commercial insurance company promises to pay principal and interest if any is missed.
Effectively substitutes rating of insur. Co. for rating of municipality
About 50% of munis are insured
Refunded (Prerefunded) Bonds:
Escrow account is established by issuer and is funded by U.S. Treasary securities
sufficient to pay remaining principal and interest payments.
Allows any restrictive covenants to be removed.
This works because Treasuries will sell at a lower price (have a higher yield) than tax-
Serial Bond = Part of principal is retired each year
Term Bond = Sinking fund (usually) with principal repaid entirely at maturity.
Private placement or public offering
Secondary Market: Traded OTC
Odd Lot < $25,000 for retail customers and < $100,000 for institutional customers.
Unlike Treasuries and Corporate bonds, the price is quoted in terms of yield to maturity
(BEY) or yield to call.
AAA Municipals have a term structure and yield curve just like Treasuries.
Expectations about tax rates will influence its shape.
Priced as a perpetuity: P = C/r
Traded like common stock
Dividends are not guaranteed
Usually purchased by corporations because 70% of dividends is exempt from Federal
The ratings companies rate preferred stock just as they do bonds.