Part-11

Part-11 The Money Market

1

Introduction

2

Introductio n

Introduction 

All debt markets have a common feature

On one hand we have parties ready to borrow by issuing securities



On the other hand we have parties willing to lend in the process of acquiring securities

All security for cash transactions are not identical A 30 year mortgage loan vs.  3 month loan to meet a corporation’s working capital needs 

3

Purpose of borrowing 

Introductio n

The purpose for which money is borrowed differs from 

borrower-to-borrower



transaction-to-transaction 1. A corporation may issue long term bonds to finance the construction of a building 2. It may issue short-term promissory notes to fund the acquisition of raw materials. 4

Types of financial assets 

Introductio n

Money is borrowed to create different kinds of financial assets with 

different maturities



different risk profiles



short-term securities

5

Term to maturity 

Introductio n

Loans in the money market have an original term to maturity of <1 year Original term to maturity

Actual term to maturity

The original term to The actual term to maturity of a security is maturity is the current its term to maturity at the term to maturity of the time of issue security It cannot change once a security is issued

It will obviously keep declining with the passage of time 6

Money Markets 

Money market securities have to be debt securities 



Since equity shares have no maturity date.

Money market consists of transactions to meet short-term cash needs 



Introductio n

Meant for current account, not for capital account

It is the mechanism through which holders of ‘temporary cash surpluses’ interact with parties with ‘temporary cash deficits’ 

The nature of transactions range from overnight to 1 year 7

Why? 

Introductio n

Why do we need money markets? 

For most individuals / institutions inflows & outflows of cash will rarely match.



Inflows may happen at a time different from when outflows are required to be met

8

Example

Example – The Government It collects revenues by way of taxes

Disbursements must be made throughout the year to meet expenses such as Wages, Salaries, Office supplies, Fuel costs

Taxes arrive in lumpy amounts and do not arise uniformly throughout the year

When tax revenues arrive the government will be temporarily flush with funds At such points in time it will enter the money market as a lender 9

Example

Example – The Government However during most months of the year the government will have a cash deficit

When the government has a deficit it will borrow short-term by issuing Treasury Bills

This will be true even if it were to have a budget surplus for the year as a whole During periods of a shortfall of cash the government will enter the money market as a borrower During those months when it has a temporary surplus it will buy back Treasury Bills to reduce its borrowings

10

Example

Example – Business Businesses collect revenues from sales

The points of time at which such revenue is realized may not however coincide with budgeted expenses to cover wages, salaries, and other operational expenses

The checking account of a firm will fluctuate from large surpluses to low or non-existent cash balances During periods when it has a surplus , a firm will enter the money market as a lender The objective is to earn some returns however moderate on idle money 11

Example

Example – Business During periods when it has a cash deficit the business will enter the money market as a borrower

One way is to issue short term unsecured promissory notes called Commercial Paper

12

Why the attention? 

Introductio n

Why are we so concerned about short-term transactions?  

 

Money is an extremely perishable commodity When idle cash is not invested there is an opportunity cost - interest income is foregone Income that is lost is lost forever When large amounts of funds are involved, the income that is lost from not profitably investing idle funds for even a day can be substantial

13

Example

Introductio n



A firm has 12MM dollars available overnight.



Assume interest rate @ 12% p.a.



Assume the year has 360 days 



A common assumption in money markets

If money is kept idle the lost income will be: 12,000,000 x 0.12 x (1/360) = $4,000



If the money were to remain idle for a week the income foregone will be $28,000

14

Introductio n

Borrowers & Lenders 

It is very difficult to classify an economic entity as a borrower or a lender. 



The same institutions frequently operate on both sides of the market

E.g. Citibank

Borrower

Lender

It will borrow regularly in At the same time it will the money market by be making short term way of Certificates of loans to corporate Deposit, borrowings of borrowers Federal Funds etc. 15

Introductio n

Borrowers & Lenders Borrower

Lender

Frequently a corporation will Only to come back into borrow millions of dollars on a the market as a lender a single day few days hence due to a sudden upsurge in cash receipts Institutions that are present on both sides of the market include Large banks, Finance companies, Non-financial corporations, Central Banks of countries One institution that is usually always on the demand side is the government. At any point in time the U.S. Treasury is the largest borrower in the world

16

What do investors want? 



Introductio n

Investors in the market primarily seek 

Safety and liquidity



An opportunity to earn some extra income

Liquidity is of paramount concern because participants may seek to enter and exit the market in a sudden unanticipated fashion.

17

Liquidity

Introductio n



A liquid market is characterized by the presence of a large number of buyers and sellers at all time.



What would happen if the market were to be illiquid? 

If there is excess demand large buy orders will send prices shooting up



If there is excess supply large sell orders will send prices crashing down. 18

Liquid market 





Introductio n

In a liquid market large trades can be executed without a major price impact Liquid markets are characterized by low bid-ask spreads Since transactions are frequent dealers can afford to operate with a smaller profit per round trip transaction 





Bid  the price at which the dealer buys from the public Ask  the price at which the dealer sells to the public Round trip  a purchase followed by a subsequent sale 19

Safety 



Introductio n

Safety is important because 

Investments are made for short periods



Investments may be liquidated at any time

Money market investors are very sensitive to default risk 

Even a hint of trouble regarding the financial condition of a borrower may have a strong impact on the market. 20

Safety - Examples 

1970: Penn Central Transportation Company defaulted on its short-term commercial notes. 





Introductio n

The short-term commercial paper market ground to a halt Investors refused to buy even paper issued by top grade companies

1980s: Continental Illinois Bank had to be propped up by government loans. 



Immediately rates on all short-term bank CDs rose There was a fear that all large bank CDs had 21 become risky

Introductio n

Risks in the Market Risks

Market Risk

Reinvestment Risk

Default Risk

Inflation Risk

Currency Risk

Political Risk

22

Risks in the Market

Introductio n

1. Market risk - the possibility that the value of an existing security will fall when interest rates rise, thereby leading to a capital loss. 2. Reinvestment risk - the possibility of having to reinvest cash flows arising from securities at lower rates, due to a decline in rates. 3. Default risk - the risk that the borrower will fail to make principal or interest payments.

23

Risks…(Cont…)

Introductio n

4. Inflation risk - the risk that the purchasing power of cash flows received from a security could erode. 5. Currency risk - the risk that the domestic currency may appreciate with respect to a foreign currency. 

This will lead to lower cash inflows in terms of domestic currency when foreign currency is converted.

6. Political risk - the risk that changes in regulations may result in reduced returns or even a total loss of invested capital.

24

Risks…(Cont…) 

Introductio n

Money market securities generally offer more protection against such risks as compared to other instruments. 

The prices of such securities tend to be relatively stable over time.



Thus while they may not offer prospects of significant capital gain



There is also a lower possibility of a significant capital loss. 25

Reasons for lower risk

Introductio n

1. Interest rate movements over relatively short periods tend to be usually moderate 2. The impact of a given interest rate change is greater the longer the term to maturity of the cash flow 3. Default risk is also minimal in money markets 



Borrowers have to be well established with impeccable credit ratings. Else their securities will not attract sufficient investor interest. 26

Other Risks 

Introductio n

Money market securities are subject to inflation risk 

But they offer some compensation by way of enhanced liquidity.



Currency and political risks are also less in money markets 

Due to the short-term nature of the investments. 27

Features

Introductio n

1. The money market is broad and deep 

It can absorb large volumes of transactions with minimal impact on security prices and interest rates.

1. Investors can usually sell securities at short notice 

Often in just a matter of minutes

1. The market consists of a wide network of   

Securities dealers Major banks Fund brokers 28

Features (Cont…)

Introductio n

4. Traders are constantly on the look out for arbitrage opportunities. 

Money has no loyalty



It can move from one corner of the globe to another in a matter of minutes in search of higher interest rates.

29

Central Banks 

Introductio n

The market is overseen by the Federal Reserve Bank in the U.S. and by the central banks of other countries. These are: 

U.K. – Bank of England



Japan – Bank of Japan



Europe – European central bank



Germany – Bundesbank



Australia – Reserve Bank of Australia 30

Features (Cont…) 

Introductio n

There is no central trading arena. 

It is a market connected by telephones and computers



Speed is of the essence since money is perishable.



Transactions are conducted in a matter of seconds and payments are made instantaneously

31

Categories of Money Market Instruments

32

Categories of MMI

Categories Money Market Instruments

Cash Instruments

Off-balance-sheet Instruments

Derivative Instruments

33

Categories

Categories of MMI



Cash instruments - A contract for the immediate borrowing or lending of funds



Off-balance-sheet instruments (OBS) Arrangements for borrowing or lending at a future point in time  

The price is fixed in advance This cannot be recorded on the balance sheet of the parties 

Balance sheet can only reflect current borrowing/lending 34

Categories of MMI

Cash Instruments Cash Instruments

Bank bills Deposits & CommerTreasury & Bankers’ cial Bills Loans AcceptPaper ances

Certificates Of Deposit

Euro notes

Repurchase Agreeements

35

Illustration 

Categories of MMI

A bank makes a commitment to make a 3-month loan 6 months from today @ 5 % p.a.

36

Derivative Securities 

Some off-balance-sheet-instruments do not involve future borrowing / lending 



Categories of MMI

They are used for managing risk

Only a return is paid Instruments

Forward Rate Agreements

Money Market Futures

Money Market Interest Rate Swaps

Interest Rate Options 37

Illustration  

Categories of MMI

A bank buys a $50MM FRA @ 5% If 3 month LIBOR 6 months later were higher than 5%  The bank will be paid a return by its counterparty equal to the interest rate differential times $50MM



If 3 month LIBOR 6 months later were lower than 5%  The counterparty will have to be paid a return equal to the differential times $50MM 38

Notional Principal 

Categories of MMI

In the illustration $50MM is not paid or received



It is used for the calculation of return  this is Notional Principal’



It is not recorded on the balance sheets

39

Key Dates in Cash Market Instruments

40

Key Dates

Key Dates 

Transaction date



Value date



Maturity Date

41

Key Dates

Transaction Date 

Date on which terms and conditions of a financial instruments are agreed upon



Date on which parties enter into a contract



Also known as Trade date, Dealing date, Done date

42

Key Dates

Value Date 

Date on which instrument starts to earn or accrue a return



This date may/may not be same as transaction date

43

Key Dates

Types of Value Dates Value Date

Same Day Value Or Value Today

Next Day Value Or Value Tomorrow

Value Date = Transaction Date

Value Date = Transaction Date + 1

Spot Value Value Date = Transaction Date + 2 44

Key Dates

Maturity Date 

The date on which the instrument ceases to accrue a return



Maturity date is often not a date 



It is a term to maturity which is a whole number of weeks/months after the value date

Date of maturity follows two conventions 

The Modified Following Business Day Convention



The End/End Rule

45

The Modified Following Business Day Convention 

This convention consists of the following three rules 

1. Maturity is set for the same date as the value date 

If the value date is 21 March  



The one month maturity will be 21 April The two month maturity will be 21 May

2. If the maturity as per rule 1 is a nonbusiness day, then it is moved to the following business day

46

Modified…(Cont…) 

3. If the following business day according to rule 2 falls in the next calendar month, then the maturity date is moved back to the last business day of the calendar month.

47

The End/End Rule 

If the value date is the last business day of the current calendar month, then the maturity date will be the last business day of the relevant calendar month. 

Consider a one month deposit with a value date of 31 May. 



It will mature on 30 June if it is a business day.

Consider a one month deposit with a value date of 30 June 

It will mature on 31 July if it is a business day

48

The End/End Rule (Cont…) 

Consider a one month deposit with a value date of 31 January 



Consider a one month deposit with a value date of 28 or 29 February 



It will mature on 28 or 29 February

It will mature on 31 March

If the maturity date as per this rule were to be a holiday then the modified following business day convention would apply.

49

Fed Funds & Clearinghouse Funds

50

Fed Funds

Fed Funds & Clearinghouse Funds 

How do funds move so fast in the money market? 

Money market traders usually trade in Federal Funds.



What are Federal Funds? 

Deposit balances of commercial banks held at the regional Federal Reserve Banks or at large correspondent banks. 51

Fed Funds

Fed Funds…(Cont…) When a dealer firm buys securities from a trader…

It will contact its bank and request that funds be transferred from its account to the trader’s account at another bank

These transactions take place via a public or private wire network

The central bank will remove funds from the reserve account of the buyer’s bank and transfer the same to the reserve account of the seller’s bank

The transaction is so quick that the seller of securities has funds available to use on the same day that the trade is carried out or a 52

Fed Funds

Immediately Available Funds 

Federal funds are known as ‘Immediately Available funds’



This is because of the speed with which money moves from one bank’s reserve account to that of another. 53

Fed Funds

Clearing House Funds 

Method of payment in the capital markets for transactions involving businesses and households 

Most large transactions are paid for by check or by issue of a check following a payment by a credit card



Funds transferred by check are called Clearinghouse Funds. 54

Fed Funds

Process The buyer writes a check

It goes to the seller’s bank which forwards that check eventually to the depository institution upon which it was drawn

If the two institutions are in the same community they will exchange bundles of checks drawn against each other every day, through the local clearinghouse 55

Fed Funds

Funds availability 



Clearinghouse funds are not accepted in money markets For money market transactions these transactions are far too slow and risky Federal Funds

Clearinghouse funds

Money is available on same day and hence interest can be earned on the same

Compared to Federal Funds it takes at least a day to clear local checks and 2-3 days for outstation checks

Money is transferred safely

Funds have an element of risk since check may be 56

Global Money Markets

57

Global Money Mkts

Global Money Markets 

Money market throughout the world share certain characteristics a. They support borrowing and lending for periods ranging from 1 day to 1 year b. They help reconcile cash imbalances for  Public / private businesses  Individuals / Institutions

a. They aid governments in financing their deficits (fiscal deficit) b. They help governments manage the growth of money and credit and maintain stability of currency rates (monetary policy) 58

Global Money Mkts

National / Intl. Money Markets 

Every nation has its own money market 

Some are poorly developed.



Others like that of the U.S extend beyond the borders of a country or a continent.



National money markets may be 

Security markets dominated



Bank dominated 59

Types of National MoneyGlobal Money Mkts Markets 

Securities dominated market  most borrowing and lending is through open market trading of financial instruments. 



Western markets are largely securities dominated.

Bank dominated market  bank borrowing and lending is at the centre of most transactions.  

Asian markets tend to be largely bank dominated. These markets have a potential weakness - they yield more easily to government pressures resulting in bad loans

60

Global Money Mkts

International Money Markets 

International money market ties all domestic markets together. 

At its heart is the Eurocurrency market.



Here large bank deposits are traded outside the boundaries of the country where the particular currency is issued.

61

Securities & Relative Volumes

62

Sec & Rel vols

Securities and Relative Volumes 

The principal instruments that are traded in the money market are: a. b. c. d. e. f. g. h. i. j.

T-bills Federal agency securities Dealer loans Repurchase agreements Commercial Certificates of Deposit Federal Funds Commercial paper Bankers’ Acceptances Financial Futures Eurocurrency deposits 63

Sec & Rel vols

Growing Volumes 

The volume of money market securities has grown rapidly in recent years. 1.

One reason is the international economy’s growing need for liquid, readily marketable, and relatively safe securities. 

1.

This is particularly true during periods when bank rates are falling and some currencies are rapidly losing value.

Another factor has been the attractive yields offered to investors. 64

Sec & Rel vols

Money Market Instruments 

Two of the most important money market instruments are 

T-bills and



Negotiable CDs



Even larger in terms of volumes is the market for federal agency securities.



The commercial paper market is also rapidly growing 

Many large corporations have found paper to be a cheaper and more flexible source of funds as compared to bank loans. 65

Difficult to estimate volume 



Sec & Rel vols

The volume of Federal funds transactions is difficult to estimate. 

Thousands of banks are active in this market



All transactions are not reported

The true size of the Eurodollar market is also unknown 

It spans many nations and is relatively unregulated. 66

Interbank Market

67

Interbank Market 







Interbank Mkt

It is a market for large or wholesale loans and deposits It is an arena for transactions between commercial banks Borrowing / lending is for periods <= 12 months Participants   

Commercial banks Insurance companies Pension funds 68

Need for Interbank Market 

Interbank Mkt

All commercial banks are required to maintain an account with the central bank



Banks with surplus lend to banks with deficit 

The lending bank earns some interest



The bank with deficit covers its deficit

69

Interbank Mkt

Features of Interbank Market 

Loans are unsecured



Interest rates are lower



Banks with high credit rating play role of intermediary

70

Types of Loans

Interbank Mkt

1. Overnight money: Money lent on a given day is scheduled to be repaid on next banking day 2. Day to Day money: The deposit is for an unspecified time. Funds can be called back at any time and will be repaid on same day 

Also called ‘money at call’ 71

Types of Loans

Interbank Mkt

3. Notice money: Money lent with a short notice of withdrawal 

E.g. 2 days or 7 days notice

3. Fixed money: Money lent for a fixed period 

E.g. 1 week or 1 month

3. Intra day money: Money lent and repaid on same day 72

Role of Brokers 

Interbank Mkt

Provide up-to-date indicative interest rates to market



They charge a standard commission



Their success depends on: 

Ability to provide good and accurate information



Ability to facilitate quick execution of trades



Ability to maintain confidentiality

73

LIBOR

Interbank Mkt



LIBOR  London Interbank Offer Rate



Rate at which bank with high credit rating is prepared to lend to a similar bank



LIBOR is quoted for different tenors



Each bank quotes its own indicative LIBOR rate

74

BBA LIBOR  



 

Interbank Mkt

BBA  British Bankers’ Association It is the most widely used benchmark for short term interest rates Rate is complied by BBA and Reuters and released after 11 a.m. London time BBA maintains a panel of 8 banks It provides a reference panel which reflects the balance of the market by  

Country Type of institution 75

LIBID

Interbank Mkt



LIBID  London Interbank Bid Rate



It is rate at which a London bank with good credit rating will pay on funds deposited with it by another top rated bank



LIBID is quoted for different tenors

76

Interbank Mkt

LIBID vs. LIBOR LIBID Rate that banks with

LIBOR Rate that banks seeking

surplus funds might haveto borrow might have to to accept on interbank

pay

deposit Rate is lower

Rate is higher

Some banks use LIMEAN, the average, as the agreed upon rate 77

SONIA & EURONIA SONIA (Sterling Overnight Index average)

Interbank Mkt

EURONIA (Euro Overnight Index average)

These indices track actual market overnight funding rates Weighted average to 4

Weighted average to 4

decimal places of all

decimal places of all

unsecured sterling overnight unsecured euro overnight transactions

transactions

Brokered by WMBA between Brokered by WMBA between midnight and 4.15 p.m.

midnight and 4 p.m. 78

EURIBOR 







 

Interbank Mkt

It is a benchmark rate used by international market for the Euro Produced by European Banking Federation – Brussels Quotes are taken from 57 banks in the euro zone countries Euribor is reported at 11 a.m. Brussels time everday The rates are spot rates Interest is computed on Actual/360 basis 79

Calculating 

Interbank Mkt

Interest payable on assumption of a 360 day year P x (r/100) x (T/360) P  Principal T  No. of days r  Rate of interest

80

Illustration   

Interbank Mkt

Bank makes a loan = $7.5 MM Period: 1 year (365 days) Interest rate = 5.25% p.a. Interest = 7,500,00 x (5.25/100) x (365/360) = $ 399,218.75

81

Securities and Relative Interest Rates

82

T-Bills 

Sec & Rel. Int. Rates

The foundation of the market’s structure is the level of yields on T-bills 

These securities have zero default risk



They carry minimal market risk



Secondary market for T-bills is the most active and deep of all securities markets.



Due to combination of low risk and ready marketability T-bills carry the lowest yields 83

Sec & Rel. Int. Rates

Other market securities 

Federal agency securities  One set of yields that stays close to T-bill rates is the yield on federal agency securities.





These are considered to be virtually riskless.



They are less marketable than T-bills.

Federal Funds  The rate on Federal funds also stays fairly close to the T-bill rate

84

Relative Rates (Cont…)

Sec & Rel. Int. Rates

Instrument

Yield

Instrument

Yield

Federal Funds

3.72

6-M CD

4.27

2-M Nonfinancial CP

3.83

1-M ED

3.87

3-M Nonfinancial CP

3.86

3-M ED

4.07

1-M Financial CP

3.82

6-M ED

4.25

2-M Financial CP

3.91

Bank Prime Rate

6.75

3-M Financial CP

4.02

4-week T-bills

3.31

1-M CD

3.89

3-M T-bills

3.65

85

Treasury Bills

86

T-Bills

Treasury Bills 

Purchases / Sales of T-bills often represent the largest volume of daily transactions in the money market. 



Interest rates on such bills are the benchmark for all other money market rates.

What are the important features of T-bills? a. Zero default risk b. Ready marketability c. High liquidity

87

T-Bills

U.S. T-Bills 

U.S T-bills are direct obligations of the U.S. government 



By law T-bills in the U.S must have an original maturity of <1 year The government’s fiscal year runs from 1 Oct to 30 Sep Uptil April

Even in years with a budget surplus the government is likely to have a deficit in most months

April & Post April Income tax, the main source of revenue for the government, is not fully collected till April In April and the months immediately following it will be flush with funds 88

T-Bills

T- Bills for deficits / surplus 

T-bills are ideally suited to manage these deficits / surpluses because a. Their maturities are short b. They are readily marketable c. Their prices adjust quickly to changing market conditions 89

T-Bills

Volumes of U.S. T-Bills 



The volume of U.S. T-bills outstanding grew rapidly in the 1980s and 1990s The main reasons were 1. Record fiscal deficits 2. Occasional recessions that reduced revenues from income tax 3. Rapid expansion of defense programs 4. Extension of welfare subsidies to low income individuals. 5. The global economy had grown rapidly creating a greater need for such liquid assets to aid institutions in the efficient management of their cash positions

90

T-Bills

Regular Series Bills 

Regular series bills are issued routinely every week or month by way of competitive auctions.





3 and 6 month bills are issued every week



1 year bills are issued every month

Of the above maturities 6 month bills provide the maximum revenue for the Treasury. 91

T-Bills

Irregular Series Bills 

Irregular series bills are issued only when the Treasury has a special need a. Strip bills 



A package of a series of bills with different maturities Investors have to bid for the entire series

b. Cash management bills 





Consist of re-opened issues of bills that were issued earlier E.g. assume that 6-months bills were issued 2 months ago. If we were to now issue 4-month bills we would be adding to the amount that is outstanding Normally occurs when there is an unusual or unexpected need for funds. 92

T-Bills

On / Off the run securities On the run securities Off the run securities Newly issued securities

Securities for the same

for a given maturity

maturity that were issued earlier

E.g. a 6 month bill issued E.g. a 3 month bill issued 3 months ago

recently

Have 3 months to

Have 3 months to

maturity, but are more

maturity

liquid 93

T-Bills

On-the-run bills more liquid 

Why are on-the-run bills more liquid? 

For a short period after issue, securities tend to be very actively traded



Thereafter, most securities pass into the hands of investors who are quite content to hold them till maturity.



Thus compared to on-the-run securities, offthe-run securities tend to be less liquid.

94

T-Bills

T-Bills selling process 

T-bills are sold by an auction process. 



Prices and yields are determined by the market and not by the Treasury.

The process: 

Issue of a new regular bill is announced by the Treasury on Thursday of every week



Bids are due on the following Monday before 1:00 P.M. New York time.



The bills are issued on the Thursday following Monday’s auction. 95

T-Bills Competitive & Non-Competitive bids



The Treasury entertains 2 types of bids. 

Competitive bids  typically are submitted by large investors including banks and securities dealers. 



They bid for several million dollars worth of securities at a time.

Non-competitive bids  submitted by small investors who agree to accept the price set at the auction. 

The Treasury generally fills all non-competitive bids. 96

T-Bills

At the auction Bids are arranged in descending order from the highest price or in ascending order from the lowest yield

All competitive bids must be submitted to three decimal places

Lowest price at which at least some bills are awarded is called ‘stop-out’ price

No one bidding < stopout price will receive any bills in an auction

Once bills are acquired by successful bidders, many will be sold right away in the secondary market

All bills are issues only in ‘book-entry’ form, not physical form

97

T-Bills

Illustration Discount Rates Bid

Equivalent Prices

3.540

96.460

3.545

96.455

3.550

96.450

3.555

96.445

3.560

96.440

3.565

96.435

3.570

96.430 98

T-Bills

Pricing at auctions 

All prices are expressed on a $100 basis as though the bills have a face value of $100 

In actual fact the minimum denomination for bills is $1,000



And they are issued in multiples of $1000 thereafter. 99

Yields 

T-Bills Yields

The quoted yield for T-bills is a discount yield. DR = Face Value – Price ________________ x _____ Face Value  

360 Tm

DR  quoted discount rate Tm  number of days till maturity 100

Example 1 

T-Bills Yields

Assume that a T-bill with   

Face value = $100 90 days to maturity Selling price = $97.50

DR = 100 – 97.50 360 ____________ x _____ = 10% 100 90

101

Example (Cont…) 

T-Bills Yields

In the market the price will not be quoted as 97.50 

The dealer will quote the yields as 10%



An investor must use the yield to calculate the price.

102

T-Bills Yields

Example – Investment Rate 

Rate of return for an investor who buys a bill at a discount rate of DR will always be higher than the quoted yield Investment rate IR = Face Value – Price ________________ x ____ Price Tm

365

= 100 – 97.50 365 ___________ x _______ = 10.40% 97.50 90 103

Example (Cont…) 

T-Bills Yields

Both the discount rate and the investment rate are calculated under the assumption that the bill will be held till maturity.



Several other formulas are used by investors for calculating yields on bills that are not held to maturity. 104

Holding Period Return 

T-Bills Yields

One formula is: HPR = P2 – P1 360 _______ x _______ 100 Tm1 -Tm2

=

Tm1 DR1 – Tm2 DR2 _________________ Tm1 – Tm2

105

HPR terms

T-Bills Yields



HPR  holding period return



DR1  discount rate when the bill was purchased with Tm1 days to maturity



DR2  discount rate when the bill is sold with Tm2 days to maturity

106

Example 2   

T-Bills Yields

Assume that an investor buys a 180 day bill at a discount of 6% Sells it 30 days later at a discount of 5.80%

HPR is (180x6.00) – (150x5.80) _______________________ = 7% 180 - 150

107

Yield to Maturity

T-Bills Yields



Calculate the Yield to Maturity of a T-bill that has more than 182 days to maturity



A coupon paying bond with a time to maturity >182 days will make a coupon payment before maturity 

To facilitate a comparison between the yield for a discount instrument with >182 days to maturity & the YTM of a conventional bond, the discount security must be treated as if it too pays a semi-annual coupon. 108

Yields (Cont…) 

T-Bills Yields

Let us denote the bond equivalent yield by y.

109

Yields (Cont…)

T-Bills Yields

110

Example - BEY 

T-Bills Yields

Consider a bill with 184 days to maturity, a quoted yield of 8% and a face value of $1,000,000.



Calculate the Bond Equivalent Yield

111

Yields (Cont…)

T-Bills Yields

P = $959111.11 Therefore:

112

T-Bills

Primary Dealers 

The money market depends heavily on the buying and selling activities of securities dealers.



Primary Dealer 

A dealer firm which is qualified to trade securities directly with the Federal Reserve Bank of New York



The firm must agree to be available to trade securities at all times and post a capital of at least $50m 113

T-Bills

Exclusive Privileges 

Until recently the primary dealers possessed several exclusive privileges in dealing with the U.S. government 1. They held exclusive membership on the Treasury Borrowing Advisory Committee which helps the government decide what kinds of securities to sell at each auction 2. They were the only traders along with banks who could place bids for new government securities on behalf of themselves and their customers without posting the normally required 5% cash deposit on each bid amount. 114

T-Bills

Exclusive Privileges 3. A primary dealer had to agree to share information regularly and freely with the Federal Reserve. 4. They also agreed to meaningfully participate in trading with the FED at any time the FED wishes 5. They agreed to make realistic bids 6. They agreed to trade continuously in the full range of securities 115

T-Bills

Why collude? 

In a large and highly competitive market there was the risk that: a. Primary dealers could overbid thereby eliminating potential profits b. They could underbid which would mean that they would receive no securities at all



Thus dealers had a strong incentive to share information with each other on 

the size of the orders they wished to place



the prices they hoped to bid 116

T-Bills

New rules for auctions 

In the wake of a scandal the Treasury and the New York FED set up new rules for the auction 1. Customers purchasing large amount of securities through dealers are required to verify in writing the amount they bid. 2. Any dealer or broker registered with the SEC could file bids on behalf of customers without putting up a deposit or a guarantee. 117

T-Bills

New Rules (Cont…) 3. The Treasury promised it would stop giving primary dealers an advance look at its borrowing plans before releasing the information to the public 4. It also promised it would automate the bidding process rather than rely on handwritten bids. 5. In 1992 the rule that a dealer must account for at least 1% of total Treasury market trading in order to qualify as a competitive bidder was removed. 118

T-Bills

New Rules (Cont…) 6. The Treasury pledged that it would re-open security issues and issue more securities if it detected that a market squeeze was developing with some dealers being unable to find reasonably priced government securities to satisfy the needs of their customers. 7. The Treasury also switched from a multiple price auction to a single price auction. 119

T-Bills

Winners’ Curse 

Multiple price auctions encouraged dealers to bid high in order to increase the probability of winning. 



Dealers placing higher bids faced a ‘Winners’ Curse’ 



The higher the price bid, the lower the expected profit when securities were sold in the secondary market

They incurred a greater probability of loss when they attempted to resell the securities.

At best the winners’ curse reduced the aggressiveness of bidding and probably resulted in the Treasury getting a lower price. 120

Funding of Dealer Positions

121

Dealer Positions

Funding of Dealer Positions 

Government security dealers supply a large volume of securities to the market 

They depend heavily on the money market for borrowed funds



Most dealers invest very little of their own equity



Ratios of security portfolios held to owners’ capital of even 40:1 are common.



The bulk of their operating capital is borrowed from banks and other financial institutions. 122

Sources of Dealer Funds

Dealer Positions

Most heavily used sources of dealer funds

Demand loans from banks

Repurchase agreements with banks / lenders

123

Demand Loans 



 

Dealer Positions

Every major bank posts rates at which it is willing to make short-term loans to dealers. Generally two rates are quoted 

One for new loans



A lower rate for the renewal of existing loans

A demand loan may be called at any time. Such loans are virtually riskless because they are usually collateralized by U.S. government securities.

124

Repurchase agreements

125

Repurchase Agreements

Repos 



Repurchase agreements are an increasingly popular alternative to demand loans. They represent a temporary extension of credit collateralized by marketable securities

Dealer

Sells securities

Lender

Makes commitment to buy the securities back at a later date

126

Types of Repos 

Repurchase Agreements

Term Repos  Some repos called Term Repos are for a fixed length of time.



Continuing Contracts  Continuing Contracts carry no explicit maturity date but may be terminated at short notice by either party 127

Providers of Repos

Repurchase Agreements

Providers of Repos

Large Banks

NonFinance Cos

State Govts

Local Govts

Insurance Cos

Foreign Financial Institutions

128

Custodial Account 

Securities for the collateral are supposed to be placed in a ‘custodial account’ at a bank. 



When loan is repaid the dealer’s liability is canceled and the securities are returned

There is evidence that this safety feature is not scrupulously followed. 





Repurchase Agreements

If a dealer goes out of business, lender may have difficulty in recovering the securities Dealer firms have collapsed and many S&Ls lost money from inadequately collateralized loans.

Fed authorities have imposed strict reporting guidelines on dealers

129

Types of Repos 





Repurchase Agreements

Term Repos  Contracts for terms longer than overnight e.g. contracts for periods ranging from 1 - 3 months or even longer Dollar repos  They permit the borrower to repurchase securities that are similar to but not necessarily the same as the securities originally sold FLEX repos  They permit lenders to withdraw a part of the loan whenever cash is needed.

130

Value of Collateral

Repurchase Agreements



The interest rate of repos is closely linked to other money market rates.



Usually the collateral is valued at the current market price plus accrued interest less a small discount called a Haircut to reduce the lender’s exposure to market risk. 

The longer the term of the repo, and the riskier and less liquid the security that is pledged, the larger will be the Haircut.

131

Value of Collateral 

Repurchase Agreements

Repos are periodically market to market. 

If the price of the collateral has declined the borrower may need to pledge additional collateral.

132

Example of Repo - 1 



Repurchase Agreements

A party has made an overnight loan of $100 MM to a dealer at 7.2% Thus the interest payable the next day is: 100,000,000 x 0.072 x 1 ___ = $20,000 360

133

Illustration - 2

Repurchase Agreements



Take the case of a dealer who is looking for a 30 day loan and is willing to pledge T-notes as collateral.



Assume accrued interest = $205,700



The quoted price per $100 of face value is $100.9375



The repo is for 30 days



The rate of interest is 9% p.a.



The haircut is 0.005 price points 134

Illustration - 2 (Cont…) 

Repurchase Agreements

The amount that can be borrowed against the securities is:

5,000,000 (1.009375 - 0.005) + 205,700 = $5,227,575 

The amount due at maturity is this principal plus interest.

Interest = 5,227,575 x 0.09 x (30/360) = $39,206.81 135

Illustration - 2 (Cont…) 

Repurchase Agreements

During these 30 days there will be fluctuations in the value of the collateral.



These must be regularly monitored to ensure adequate collateralization. 

Most repos are collateralized by government securities.



Sometimes other money market instruments like commercial paper and BAs may be used. 136

Credit Risk 

Repurchase Agreements

In practice both borrower and lender are subject to credit risk



There is no strategy which will reduce the risk for both the parties. 

Increasing protection for one means enhanced risk for the other.

137

Credit Risk Interest rates rise

Repurchase Agreements

Interest rates decline

If interest rates rise If interest rates decline, sharply, the value of the the value of the collateral will decline collateral will rise. 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.

If the lender goes bankrupt, the borrower will be left with an amount that is less than the market value of the securities. 138

Margins 

Repurchase Agreements

The lender can ask for margin. 

i.e. he can lend less than the market value of the assets.





This will increase the risk for the borrower

The borrower can ask for reverse margin. 

i.e. he can ask the lender to lend more than the market value of the securities.



This will increase the risk for the lender 139

Margins (Cont…) 

Repurchase Agreements

In practice it is the lenders who receive margins. 

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’

140

Reverse Repo 



Repurchase Agreements

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 repo.   

Thus every repo must be matched by a reverse repo. A dealer looking to borrow funds will do a repo. A dealer looking to place funds will do a reverse repo.

141

Matched Book 

Repurchase Agreements

Some dealers will do a repo for one maturity with a party and a reverse repo for another maturity with another party.



They hope to profit from the interest rate differential.



Such dealers are said to be maintaining a ‘matched book’

142

Rates 

General collateral rate  Most government securities can be bought at a rate called the general collateral rate. 



Repurchase Agreements

Thus most securities are close substitutes for each other.

Special repo rates  Sometimes a security may be in high demand and the lender may charge a lower rate. 

Such rates are called special repo rates. 143

Repos (Cont…) 

Repurchase Agreements

To promote a smoothly functioning market the Federal Reserve frequently participates in repos with primary dealers. 

It may buy securities on a short-term basis and then sell them back



It may sell securities with an agreement to buy back

144

Repos (Cont…) 

Repurchase Agreements

By selling securities to dealers the FED temporarily absorbs dealer funds and reduces the ability of the dealers’ banks to make loans.



Thus while dealers use repos to increase their earnings from trading, the FED uses them to steady the money market.

145

Settlement

Repurchase Agreements



Parties will have accounts with the Central Securities Depositories



Sale of securities will be transacted by book entry



Payments will be made by an assured payment system of the CSD



Settlement may take place 1-2 days after the date of the repo transaction agreement

146

Repo Rates 

Bid price  Rate that the dealer is willing to accept in return for purchasing bonds and agreeing to sell them back 



Bid rate is the customer’s repo rate and the dealer's reverse repo rate

Offer rate  Rate that the dealer is willing pay to sell and then repurchase the bonds 



Repurchase Agreements

Offer rate is the customer’s reverse repo rate and the dealer’s repo rate

The Bid will always be higher than the Ask

147

Federal Funds

148

Fed Funds

Federal Funds 

They are the principal means of making payments in the money market.



Definition  The term Federal Funds refers to money that is available for immediate payment. 

Transferred from one depository institution to another by simple book-keeping entries 149

Fed Funds

Federal Funds History

Today

The name federal funds came about because in the earlier years the principal source of immediately available money was the reserve balance that each bank held with the regional Federal Reserve Bank

Today the Fed funds market is far broader in scope than just reserves on deposit with Federal Reserve Banks

If a bank needed to transfer funds to another it needed to only contact the regional FRB and funds would be transferred in a matter of seconds by computers

Virtually all banks maintain deposits with large correspondent banks in major cities. These deposits may be readily transferred from the account of one 150

Fed Funds

Federal Funds Today 

S&Ls, Credit Unions, and Savings Banks maintain deposits with commercial banks or with Federal Reserve Banks that are available for immediate transfer to a customer or to a financial institution.

151

Fed Funds

Borrowers of Fed Funds Borrowers of Fed Funds

Securities dealers

Corporations

State & Local Govts

S & Ls

Insurance Commercial Cos banks

They are the most important of all borrowers since they use Federal Funds a the principal way to adjust their legal 152 reserve account at the district Federal

Mechanics of Federal Funds Trading 

Fed Funds

The mechanics of Fed Funds trading depends on the locations of the borrowing and lending institutions.

153

Fed Funds

Illustration 1 Take for example two banks that are located in New York

The borrower would be handed a check drawn on the lender’s reserve account at the Federal Reserve Bank of New York The lender on the other hand may be given a check drawn on the borrower

This is payable immediately. Fed funds would be transferred to the borrower’s reserve account before the close of business This is one day money because it must pass through the New York Clearinghouse 154

Alternative Mechanism 

The lending bank can simply contact the New York Fed



It can ask it to electronically move funds from the lender’s reserve account to the borrower’s



The transaction can be reversed on the following day.

155

Fed Funds

Illustration 2 If the institutions are not located within the same district the transaction would proceed in the same way except that two Federal Reserve banks would be involved The borrower and the lender agree on the terms of the loan The lending institution directly or indirectly through a correspondent bank contacts the district Federal Reserve bank requesting a wire transfer of funds The reserves are then transferred to the borrowing bank through the Fed’s wire network FEDWIRE

156

Fed Funds

Contact Mechanisms 

Fed Funds borrowers and lenders contact each other using the following mechanisms a. Computer networks b. Telephone c. There are also Fed Funds brokers who indicate by telephone and computer screens what funds are available and at what rate.

157

Fed Funds

Fed Funds loans features 

Most Fed Funds loans are 

Overnight transactions



Continuing contracts with no specific maturity date



Continuing contracts can be terminated without advance notice by either party

158

Fed Funds

Fed Funds loans 

One day loans  They carry a fixed rate of interest but continuing contracts do not



Term Federal Funds  Loans lasting beyond a day. 



They are being supplied by foreign banks and other lenders They are considered as a safe and profitable way to warehouse funds until they are needed for long-term loan commitments

159

Negotiable CDs

160

Nego CDs

What is a CD? 

It is an interest bearing receipt for funds left with a depository institution for short periods of time.



The minimum maturity as per U.S. law is 7 days.



There is no maximum limit.



CDs are issued at par and pay interest explicitly. 

They are not discount instruments.



Payment is made in Fed Funds on the day of maturity.

161

Nego CDs

True Money Market CDs 

True money market CDs are negotiable instruments that can be resold before maturity 

They carry a minimum denomination of $100,000



The round lot for trading is $1,000,000



They may be registered on the books of the issuing banks or else may be issued in bearer form. 

CDs issued in bearer form are more convenient for resale. 162

Nego CDs

Negotiable CDs 

Denominations range from $25,000 to $10MM 

A true money market CD has a minimum denomination of $100,000



Maturities range from a few months to 18 months





Most CDs have a maturity of 6 months or less

Term CDs  CDs with maturities beyond a year are called Term CDs 163

Nego CDs

Non-negotiable Time Deposits vs. Negotiable CDs Time Deposits

CDs

An investor will deposit a The depositor will be sum of money with a

issued a bearer security

bank for a stated period of time Investor is paid interest Investor is entitled to at a specified rate

claim deposit with interest at the end of the period

It cannot be easily

It can be liquidated at

terminated until it

any time at the

164

Nego CDs

Calculations  

Consider a CD with a face value of V. The funds owed on maturity is given by: V + Tm ____ x V x i 360

where: Tm  original term to maturity i  interest rate 165

Nego CDs

Example 

A firm purchases a $100,000 CD



Duration = 6 months



Interest rate @ 7.5%



It would receive: 100,000 x {1 + (0.075 x 180/360)} = $103,750

166

Nego CDs

Calculations (Cont…) 



To convert the yield to a true yield for a 365 day year, multiply the quoted rate by 365/360. Thus YTMCD = i x 365 ____ 360

167

Nego CDs

Example 

i = 0.075



YTM = 0.075 x (365/360) = 7.6%

168

Nego CDs

Yield on CDs 

The yield on CDs is normally higher than the T-bill rate due to 

Greater default risk



A thinner resale market



Tax exemptions granted to T-bills by state and local governments.

169

Nego CDs

Types of CDs 1. Variable or floating rate CDs 2. Rollover or Rolypoly CDs 3. Jumbo CDs 4. Yankee CDs 5. Brokered CDs 6. Deposit notes 7. Bear and Bull CDs 8. Installment CDs 9. Rising rate CDs 10.Foreign-index CDs 170

Nego CDs

1. Floating rate CDs  

They carry a maturity of up to 5 years Interest rate is reset every 30, 90, or 180 days. 



Gap between interest reset dates is known as the Leg or the Roll period. Floating rate is usually tied to movements in the    



The The The The

secondary market yield on fixed-rate CDs prevailing Fed Funds rate prime bank rate going market rate on ED deposits.

This CD gives the investor a higher return than normally would be obtained by continuously renewing short term CDs. 171

Nego CDs

2. Rollover CDs 

In the 1970s the Rollover or Rolypoly CD was introduced. 







6 month CDs are the maximum maturity traded in the secondary markets.

Rollover CDs are longer term CDs with higher rates but in packages composed of a series of 6 month CDs extending for at least 2 years. This promised higher returns plus the ability to retire some components of the package early to meet cash needs. The customer is however obligated to purchase the remaining certificates on each 6 month anniversary date till the contract expires. 172

Nego CDs

Other CDs 3. Jumbo CDs are $100000+ negotiable CDs issued by non-bank thrift institutions such as S&Ls and Savings Banks. 4. Yankee CDs are issued in the U.S by foreign banks. 5. Brokered CDs are sold through brokers or dealers.

173

Nego CDs

6. Deposit notes 

In the 1980s deposit notes appeared.



These are a hybrid financial instrument combining the features of CDs and corporate bonds with maturities reaching out to as long as 10 years.

174

Nego CDs

Other CDs 7. Bear and Bull CDs have returns linked to the performance of the stock market. 8. Installment CDs allow customers to make a small initial deposit and then gradually build up the balance in the account to a target level. 175

Nego CDs

Other CDs 9. Rising rate CDs are longer term deposits whose promised yield increases over time with penalty free withdrawals permitted on selected anniversary dates. 10.Foreign Index CDs offer a return linked to economic developments abroad and to fluctuations in foreign currency values.

176

Nego CDs

Global CD Markets - Canada 

In Canada the big banks issue CDs and bearer deposit notes with maturities ranging from 30 days to 12 months in units of $100000 and higher.



These are usually sold at a discount from par.



Some Canadian bank CDs are available in both USD and CAD. 177

Nego CDs

Global CDs – Japan & Asia 

In Japan CDs have been permitted since the 1980s. 

Gradually restrictions on maturities and minimum account sizes have been relaxed.



Asian dollar CDs are available. 

They carry fixed rates or floating rates linked to SIBOR.



They normally trade in units of 1MM dollars. 178

Nego CDs

Global CDs - Euro 

Eurodollar CDs are negotiable dollar denominated time deposits issued by foreign branches of U.S. banks and foreign owned banks. 

They carry higher rates than comparable domestic CDs due to greater perceived risk.



They can carry maturities in excess of one year and rates are adjusted every 3 to 6 months to match changes in the LIBOR. 179

Nego CDs

Yields on CDs 

These are a function of demand and supply. 

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 premia.

180

Nego CDs

Illustration 







A bank is quoting 8% p.a. on a 3 month deposit Reserves @ 5% and are non-interest bearing Effectively $8 interest is being offered on $95 of usable funds Effective rate = 8 95 = 8.42%

181

Nego CDs

Illustration 

The insurance premium is 8.33 b.p.



Effective cost is 8.42 + 0.0833 = 8.5033%

182

Commercial Paper

183

Commercial Paper 



Unsecured promissory notes are known as commercial paper Large corporations borrow billions of dollars in the money market through these 



Comm Paper

A study in U.S. found that 1000+ corporations were regularly selling commercial paper to money market investors

Such paper consists of short-term unsecured promissory notes issued by well known companies that are financially strong and carry high credit ratings

184

Funds raised for 

Comm Paper

The funds raised are normally used for current transactions such as: 

Purchase of raw materials



Payment of accrued taxes



Meeting of wage and salary obligations



Other short-term obligations rather than for capital account transactions.

185

Bridge Financing 

Comm Paper

These days a substantial number of paper issues are used to provide `bridge financing for long-term projects’ 

Issuing firms usually plan to convert their short-term paper into more permanent financing when the capital market looks more favourable. 186

Comm Paper

Buyers of Commercial Paper 

Paper is generally issued in multiples of $1,000 & in denominations designed to meet the needs of the buyer.



It is traded mainly in the primary market. 



Opportunities for resale in secondary market are limited

Investors are careful to purchase those issues whose maturity matches their planned holding periods. 

Resale has increased in recent years 187

Credit rating 



Comm Paper

Most issuers of paper enjoy a high credit rating. To reduce risk for investors, borrowers usually secure a line of credit at a commercial bank for a small fee or a deposit. 



The line of credit cannot be used to directly guarantee payment if company goes bankrupt. The lender may renege on the credit line if the borrower has had a `material adverse change’ in his condition. 188

Letters of Credit 

Many issuers also take out irrevocable letters of credit prepared by their banks. 





Comm Paper

Such a letter of credit makes a bank unconditionally responsible for repayment if the corporation defaults.

Banks usually charge 50 to 150 b.p. on the amount of the guarantee that is issued. Insurance companies and parent companies of paper issuers also guarantee issues of commercial paper. 189

Types of Commercial Paper 

Comm Paper

There are two major types of commercial paper 

Direct paper



Dealer paper

190

Direct Paper 

The main issuers of direct paper are  





Comm Paper

Large finance companies Bank holding companies

Issuers deal directly with investors rather than use securities dealers as intermediaries. Such companies announce the rates that they are paying on various maturities 



Investors select maturities that closely match their expected holding periods and buy the paper directly from the issuer. Interest rates may be adjusted during the day that the paper is sold to regulate the inflow of investor funds

191

Direct Paper (Cont…) 



Comm Paper

Leading finance companies that borrow in the direct paper market include 

General Motors Acceptance Corporation (GMAC)



General Electric Capital Corporation (GE Capital)

Such firms have 

An ongoing need for short-term money



Possess top credit ratings



Have established working relationships with major institutional investors in order to place new issues regularly.

192

Direct Paper (Cont…) 

Directly placed paper must be sold in large volume to cover the substantial costs of distribution and marketing. 



On an average each direct issuer in the U.S. borrows at least $1bn per month

Issuers of direct paper do not have to pay dealers’ commissions 



Comm Paper

They must maintain a marketing division to maintain constant contact with active investors

Issuers like Citicorp sell paper in weekly auctions in which buyers bid for securities 193

Funds used for 

Comm Paper

Sometimes direct issuers must sell their paper even when they have no need for funds 



 

They have to maintain a good working relationship with active investor groups. They also have to pay fees to banks for supporting lines of credit. They have to pay agencies that rate their issues They have to pay agents like trust companies that collect funds and disburse payments.

194

Industrial Paper 

The other variety of commercial paper is dealer paper that is issued by security dealers on behalf of their corporate customers. 



Comm Paper

Such paper is also known as Industrial Paper.

This is issued mainly by non-financial companies, smaller bank holding companies and financial companies 

These borrow less frequently than companies that issue direct paper. 195

Buyers of Industrial Paper 



Comm Paper

The issuing company may sell the paper directly to the dealer who buys it less a discount and commissions, and then attempts to resell it at the highest possible price in the market. Alternatively the issuing company may bear all the risk with the dealer only agreeing to sell at the best price available less commissions. 

This is referred to as a best efforts transaction.

196

Value of Paper 

Comm Paper

The value of paper outstanding has grown rapidly due to various reasons.



For large well known corporations commercial paper is usually a cost effective substitute for bank loans and other forms of borrowing. 

This is especially true for non-financial firms that issue paper through dealers. 197

Growth of the Market

Comm Paper



The paper market has also grown because of cutbacks in bank lending.



Due to loan quality issues banks have become more cautious.



Another reason for the market’s rapid growth is the high quality of most paper. 

Many investors regard paper as a high quality substitute for T-bills and other money market instruments. 198

Credit Enhancements 

Comm Paper

The expanding use of credit enhancements has also contributed to the growth of the paper market. E.g. 

Standby letters of credit



Indemnity bonds



Other irrevocable payment guarantees

199

Documented notes 

Comm Paper

Such paper often referred to as `documented notes’ usually carries the higher credit rating of the guarantor rather than the lower credit rating of the issuer.



In such cases even after paying the guarantor’s fee the issuer saves on interest costs.

200

Yankee Paper 





Comm Paper

Yankee paper  Foreigners also issue paper in the U.S. market. Issuers can often issue Yankee paper at a cheaper rate than what it would cost them to borrow outside the U.S. Foreign issuers generally pay higher rates than American issuers of comparable credit quality. 

This is to compensate American investors for the difficulty of gathering information on foreign issuers and the lack of name recognition.

201

International Paper - Yen 

Comm Paper

Yen denominated paper was allowed in 1987 after Japanese companies threatened to move their short-term borrowing programs abroad.



In 1988 foreigners were allowed to issue Samurai paper in Japan.

202

Comm Paper

International Paper – Canada 







Like in the U.S. paper issues in Canada must be backed by a bank line of credit in order to catch the attention of the market. The Canadian market has a broader range of maturities ranging from 24 hours to a year. Paper in Canada tends to be issued in large denominations usually $100,000+ Most Canadian paper is therefore purchased by large institutions rather than individual investors.

203

International Paper - Euro 

Comm Paper

The Euro-paper market evolved in the 1980s.



The market sees large volumes because issuers can tap foreign investors.



Many U.S. firms which have had difficulty borrowing at home due to low credit quality have found the Euro market to be less quality conscious. 204

International Paper – Euro (Cont…) 

Large investors in Euro-paper include:   







Comm Paper

International banks Private corporations Foreign central banks

In contrast U.S. paper is bought mainly by money market mutual funds. Euro-paper is priced below the face value and appreciates in value as maturity approaches. The quoted interest rate is a discount rate like in the case of T-bills. 205

Example – Euro (Cont…) 

Comm Paper

Assume that we wish to acquire Euro-paper with a face value of $100MM and a time to maturity of 90 days



If the discount rate is 6%, the price would be 100,000,000 - 100,000,000 x 0.06 x (90/360) = 98,500,000 206

International Paper – Euro (Cont…) 

Comm Paper

There appears to be an active secondary market for Europaper unlike in the case of US paper.



Average maturity of Europaper = 2 times average maturity of US paper.

207

Maturity of US Paper 





Comm Paper

Maturities of US paper range from 3 days (weekend paper) to 270 days Most paper has an original maturity of 60 days or less with an average maturity of 20 to 45 days US paper is generally not issued with a maturity exceeding 270 days 

Because any security with a maturity in excess of 270 days must be registered with the SEC 208

Yield on Commercial Paper 

Comm Paper

Yields are quoted on a discount basis like in the case of T-bills



Most commercial paper is issued in discount form.



Some corporations do sell interest bearing or coupon paper

209

Denomination for Paper 









Comm Paper

The minimum denomination for paper is usually $25,000 Among institutional investors the minimum denomination is usually $1,000,000 Notes are typically issued in bearer form to make resale easier. On maturity, payment is made on presentation to the bank which is designated as the agent. Settlement is made in Federal Funds on the same day. 210

Comm Paper

Advantages with paper market 

Advantages for companies that are able to tap the paper market. a. Generally rates are less than on bank loans. b. The effective rate on bank loans is higher than what is quoted due to the need to keep a compensating deposit.

211

Example 

Comm Paper

Take the case of a firm that borrows $100MM @ 8% with a compensating balance of 20%

The effective rate is 8,000,000 ___________ = 10% 80,000,000 

212

Comm Paper

Advantages with paper market

c. Another advantage of borrowing in the paper market is that rates are often more flexible than bank rates. 





A company in need can quickly raise funds through either dealer paper or direct paper. Dealers maintain close contact with the market and generally know where funds can be found. Notes can be issued and funds raised on the same day.

213

Lending money 

Federal & state regulations limit the amount of money that a bank can lend to a single borrower 



Comm Paper

For nationally chartered banks the maximum unsecured loan that can be granted to a borrower is 15% of the bank’s capital and surplus.

Corporate needs frequently exceed an individual bank’s loan limit. 



A consortium of banks can be assembled - but this takes time. In the paper market it is much easier to arrive at agreements for large issues.

214

Lending Money (Cont…) 

Comm Paper

The ability to issue paper gives a corporation considerable leverage when negotiating with a bank.



A banker who knows that his customer can draw on the paper market is likely to be more receptive and offer more advantageous terms.

215

Risk of Paper 

Comm Paper

One risk of issuing paper is that of alienating banks whose loans may be needed should a real emergency arise. 

It must be remembered that paper cannot be paid off at the issuer’s discretion but must remain outstanding till maturity.



In contrast many bank loans can be paid off prematurely without penalties. 216

Master Note 







Comm Paper

A recent innovation in the direct paper market This is frequently issued to bank trust departments and other permanent investors by finance companies. Under such an arrangement the investing firm agrees to take some paper each day up to an agreed upon maximum amount. Interest is calculated on the daily average balance of paper taken by the investor. 217

Medium Term Note 







Comm Paper

An extension of the paper market is the Medium Term Note. Such notes have maturities ranging from 9 months to 10 years and are issued by investment grade corporations. They carry fixed rates of interest and are generally non-callable unsecured obligations marketed through dealers. Particularly suited for companies with substantial quantities of medium term assets 

E.g. who wish to balance such assets with liabilities that are longer in maturity than conventional commercial paper.

218

Comm Paper

Ratings and Rating Agencies 

Depending on the credit standing of the issuer paper is rated as:   



Prime Desirable or Satisfactory

Firms issuing paper generally seek ratings from multiple issuers.  



It is extremely difficult to market unrated paper. About 75% of the firms that currently sell paper are prime rated. Generally notes bearing ratings from at least two agencies are preferred by investors.

219

Rating Agencies 

Comm Paper

Prominent rating agencies include: 

Moody’s Investors Service



Standard & Poor’s Corporation



Fitch Investor’s Service



Canadian Bond Rating Service



Japanese Bond Rating Institute



Dominion Bond Rating Service



IBCA Ltd.

220

Comm Paper

Summary of the Rating Systems Company

Higher A/ Prime

Lower Speculativ Defaulted e A/ Prime Below Prime

Moody’s

P-1

P-2, P-3

NP

NP

S&P

A-1+, A-1

A-2, A-3

B, C

D

Fitch

F-1+,F-1

F-2,F-3

F-5

D

221

Credit Rating 

Comm Paper

We will illustrate using S&P’s rating scale. 

A-1= strong degree of safety for timely repayment



A-2 = satisfactory degree of safety



A-3 = adequate safety



B,C = risky or speculative



D = default history

222

Credit Rating

Comm Paper



Agencies are paid by the issuers of paper.



A good rating makes it easier and cheaper to borrow



However rating agencies always look at the issue from the perspective of a potential investor. 

Their credibility is based on their track record from the standpoint of accuracy.

223

Evaluation Criteria 

Comm Paper

Rating agencies use the following criteria. 

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.

224

Federal Agency Securities

225

Agencies 

US government attempts to aid disadvantaged sectors e.g.    



Fed Agency Sec

Agriculture Housing Small businesses College students

Government has created special agencies to make loans to these sectors 

These agencies are large enough to complete for funds in the open market 226

Fed Agency Sec

Types of Federal Credit Agencies Government sponsored True Federal Agencies agencies They are federally

They are legally a part of

chartered but privately

the government structure

owned, and are quasiprivate institutions The borrowing and

The borrowing and

lending activities of these lending activities are agencies are not reflectedreflected in the fed in the fed’s budget

budget

227

Types of Federal Credit Agencies…

Fed Agency Sec

Government sponsored True Federal Agencies agencies They are permitted to Securities are fully draw on US Treasury for guaranteed by the credit funds upto specified limit of the US government with approval – but securities are not guaranteed by the fed They have capitalization They operate with less requirements which limit capital per dollar of debt the rate of growth of their 228 debt obligations

Sources of borrowings 

Fed Agency Sec

Money market borrowings are done by: 

Sponsored agencies issue short term coupon securities and variable notes



Long term borrowing is done by issuing debentures

229

Fed Agency Sec

Features of agency securities 

They are subject to fed income taxes 



Exempt from state and local taxes

They are short to medium term with maximum maturity of 10 years 

Longer term have denominations of as less as $1,000



Shorter term are usually sold in denominations of $50,000

230

Solicitation Method A fiscal agent in NY will assemble a group of bankers, dealers, brokers to bring each issue to the market This solicitation group conveys to potential investors the size, denomination, maturity of new issue Investors are not told the price of the new securities but are asked for their views

Fed Agency Sec

This pricing information is conveyed to the fiscal agent The day after the order books are closed, the fiscal agent will price the new securities and deliver them.

Investors do not know the prices/yields until after the sale.

231

Bankers’ Acceptances

232

BAs

What is a bill? 







It is an undertaking to pay a specified amount of money at a future date – upto 12 months in the future It is a form of short-term finance for the debtor Bills can be sold in the money market at any time prior to their maturity date Bills are classified on basis of the entity which gives the undertaking to pay   

T-Bills Bank bills Trade bills 233

BAs

Bills of Exchange 

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



Time Draft 234

BAs

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. 235

BAs

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’. 236

BAs

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 exporter. 

LC based transactions are more secure.



Shipments under an LC can be on the basis of a sight draft or a time draft. 237

BAs

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 acceptance.

238

BAs

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 maturity BAs with a face value of 5MM USD are considered to constitute a round lot. Once a BA is issued the exporter can get it discounted by the accepting bank.  

i.e. he can sell it for its discounted value. he can sell it to someone else in the secondary market.

239

BAs

Credit Risk for BAs 

The credit risk involved in holding a BA is minimal. 

It represents an obligation on the part of the accepting bank.



It is also a contingent obligation on the part of the exporter. 

i.e. if the bank fails to pay, the holder has recourse to the exporter who is the drawer of the draft 240

BAs

Trade Bills 

These are issued by a commercial enterprise



They are bills drawn by one non-bank company on another demanding payment for a trade debt



They may be used for domestic / international trade transactions



Financial institutions will buy only the finest trade bills in the market 241

BAs

Bank Bills 

These are bills of exchange drawn on and payable by a commercial bank



A common form is a bankers’ acceptance

242

BAs

Sterling Acceptance Credits 

These are facilities that provide for the drawing of sterling bills of exchange by a corporate customer on a bank



The bills are immediately discounted and the company receives the sale value less the bank’s commission



An acceptance credit facility will be granted to the company by the bank concerned for a specified credit limit

243

BAs

Advantages for the company 1. It can raise short term finance in the money market 2. It can get a relatively low rate of interest 3. It provides the company with an additional and flexible form of financing

244

BAs

Procedure for Acceptance Credit The client and the bank agree to the establishment of a facility When client wants to draw funds it will inform the bank – the bank will issue the bill

At maturity the bill will be presented to the bank by the holder The bank will debit the client’s account with the amount paid to the holder

The bank will have the bill discounted in the market – the proceeds will be given to the client 245

Buying and Selling Bills Illustration 

BAs

A co. has drawn a bill on HSBC for $5,000,000



Maturity  150 days



The bank accepted it and sold it to Barclays at a discount @ 5.25%



30 days hence Barclays sold the bill to ABN Amro at a discount @ 4.75% 246

BAs

Illustration (Cont…) 

Purchase price: 5,000,000 [1 – (5.25/100) * (150/360)] = $4,890,625



Sale price: 5,000,000 [1 – (4.75/100) * (120/360)] = $4,920,833.33

247

BAs

Illustration (Cont…) 

Profit: $4,920,833.33 - $ 4,890,625 = $ 30,208.33



ROI on a 360-day year basis (30,208.33/4,890,625) * (360/30) = 7.41% 248

Eurocurrency Deposits

249

What is Eurocurrency? 

Eurocurrency Deposits

It is a freely convertible currency deposited outside the country to which it belongs. 

Dollars deposited outside the US are Eurodollars



Yen deposited outside Japan are Euroyen

250

Illustration

Eurocurrency Deposits



A french exporter ships champagne to a New York importer accompanied by a bill for $10,000



The importing firm pays for the champagne by issuing a cheque denominated in dollars and deposits it in a US bank – First American bank – where the French firm has a checking account

251

Eurocurrency Deposits

Illustration (Cont…) 

After the check clears the results are: French Exporter’s Account Assets

Liabilities

Deposit in US Bank = $10,000 First American Bank’s Account Assets

Liabilities Deposit owed to French Exporter = $10,000 252

Illustration (Cont…) 

Eurocurrency Deposits

This is not a Eurodollar deposit since deposit occurs in the US



The French Exporter is offered an attractive rate of return on its dollar deposit by its own local Paris bank 

It moves its dollar deposit there



Paris bank wants to loan these dollars to other customers in the US 253

Eurocurrency Deposits

Illustration (Cont…) 

The 4 transactions will be: French Exporter’s Account Assets

Liabilities

Deposit in US Bank = - $10,000 Deposit in Paris Bank = + $10,000 First American Bank’s Account Assets Reserves transferred to Correspondent Bank = - $10,000

Liabilities Deposit owed to French Exporter = - $10,000 254

Illustration (Cont…)

Eurocurrency Deposits

US Correspondent Bank’s Account Assets

Liabilities

Reserves transferred from Deposit owed to Paris Bank = First American Bank = $10,000 $10,000 Paris Bank’s Account Assets Deposit with US Correspondent Bank = $10,000

Liabilities Deposit owed to French Exporter = $10,000 255

Illustration (Cont…) 

Assume the Paris bank makes a loan of $10,000 to a small oil company in Manchester.



The British company needs US dollars to pay for shipment of petroleum drilling equipment from Texas

256

Eurocurrency Deposits

Illustration (Cont…) Paris Bank’s Account Assets Loan to British company = + $10,000

Liabilities

Deposit in Correspondent Bank = - $10,000 British Oil Company’s Account Assets Deposit with US Correspondent Bank = $10,000

Liabilities Loan from Paris Bank = $10,000 257

Illustration (Cont…)

Eurocurrency Deposits

Paris Bank’s Account Assets Amount owed by British Oil Company = + $10,000

Liabilities Deposit owed to French exporter = $10,000

258