Chapter Two

Money Markets

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Money Markets

⚫ Money markets trade debt securities or instruments

with maturities of less than one year
⚫ Once issued, money market instruments trade in active
secondary markets
⚫ Need for money markets arises because the immediate cash
needs of individuals, corporations, and governments do not
necessarily coincide with their receipts of cash
⚫ Money market instruments share basic characteristics:
1. Generally sold in large denominations ($1m to $10m units)
2. Low default risk, the risk of late or nonpayment of principal
and/or interest
3. Must have an original maturity of one year or less

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Yields on Money Market Securities

⚫ The bond equivalent yield is the quoted nominal, or

stated, yield on a security

⚫ Bond equivalent yield on money market securities with

a maturity of less than one year can be converted to
an effective annual interest return (EAR):

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 Yields on Money Market
Securities: Discount Yields
⚫ Some money market instruments (e.g., T-bills and
commercial paper) are bought and sold on a discount basis
⚫ Yields on these securities use a 360-day year
⚫ Return on these securities results from the purchase of the security
at a discount from its face value (P0) and the receipt of face value
(Pf) at maturity

⚫ Interest rates on discount securities, or discount yields, are

quoted on a discount basis using the following equation:

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Yields on Money Market
Securities: Discount Yields
(Continued)
⚫ Several features of a discount yield make it difficult to
compare with bond equivalent yields on other
(nondiscount) securities
⚫ Discount yields use the terminal price, or the security’s face
value, as the base price in calculating an annualized interest
rate, whereas bond equivalent yields are based on the
purchase price of a security
⚫ Discount yields use a 360-day year rather than a 365-day year
to compute interest returns
⚫ Discount yield can be converted into a bond equivalent
yield in the following manner:

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Yields on Money Market
Securities: Single-Payment Yields

⚫ Some money market securities (e.g., negotiable CDs

and fed funds) pay interest only once during their lives:
at maturity
⚫ Quoted nominal interest rates on single-payment securities
normally assume a 360-year.
⚫ To compare interest rates against securities that pay interest
based on a 365-day year, the nominal interest rate must be
converted to a bond equivalent yield in the following manner:

⚫ The EAR for single-payment securities must utilize the

bond equivalent yield as follows:

or
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Money Market Instruments

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Money Market Instruments
Outstanding

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Treasury Bills (T-Bills)

⚫ T-Bills are short-term debt obligations issued by the

U.S. government to cover government budget deficits
and to refinance maturing government debt
⚫ Main tool used by the Federal Reserve to implement monetary
policy
⚫ Original maturities are 4, 13, 26, and 52 weeks
⚫ Issued in denominations of multiples of $100
⚫ Existing T-bills can be bought and sold in an active secondary
market through government securities dealers who purchase T-
bills from the U.S. government and resell them to investors
⚫ Virtually default risk free, with little interest rate or liquidity risk

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The New Issue and Secondary
Market Trading Process for T-Bills
⚫ A treasury bill auction is the formal process by
which the U.S. Treasury sells news issues of T-bills
⚫ Bids are submitted by government securities dealers,
financial and nonfinancial corporations, and individuals
⚫ Bids may be competitive or noncompetitive
⚫ Competitive bids specify the amount of par value of bills
desired and the discount yield, rather than the price
⚫ Generally used by large investors and government securities
dealers and make up most of the auction market
⚫ Noncompetitive bids are limited to $5m for a single bidder;
they specify only the desired amount of the face value of
the bills
⚫ Usually represent a small portion of total T-bills auctioned, but
allow small investors to participate in the T-bill auction market
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Treasury Auction Results,
Dec. 16, 2019

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Treasury Auction Results

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 Secondary Market for T-Bills

⚫ Secondary market for T-bills is the largest of any U.S.

money market security
⚫ 24 FIs are designated as ‘primary government securities
dealers’ and purchase most of the T-bills sold
competitively at auction, creating an active secondary
market
⚫ Around 500 smaller dealers directly trade in this secondary market
⚫ Primary dealers “make a market” for T-bills by buying and selling
securities for their own account and by trading for their customers
⚫ Secondary market T-bill transactions between primary government
securities dealers are conducted over the Federal Reserve’s wire
transfer service — Fedwire

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Secondary Market T-Bill Transaction

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T-Bill Yields

⚫ Discount yield on a T-bill is calculated as follows:

⚫ The formula for a bond equivalent yield on a T-bill is:

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T-Bill Yield: Example 5-4

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T-Bill Yields (Continued)

⚫ For the asked discount yield, the required market ask

price would be:

⚫ For the bond equivalent yield, the required market ask

price would be:

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 Federal Funds

⚫ Federal funds (fed funds) are short-term funds

transferred between financial institutions, usually for a
period of one day
⚫ Commercial banks trade fed funds in the form of excess
reserves held at their local Federal Reserve Bank
⚫ Fed funds rate is the interest rate for borrowing fed funds
⚫ Function of the supply and demand for federal funds among
financial institutions and the effects of the Federal Reserve’s
trading through the FOMC
⚫ Primary risk of interbank lending system is that the
borrowing bank does not have to pledge collateral for the
funds it receives, which are usually in the millions
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 Trading in the Federal Funds
Market
⚫ Fed funds market is a highly liquid and flexible source of
funding for commercial banks and savings banks
⚫ Commercial banks, especially the largest commercial banks,
conduct most transactions in the fed funds market
⚫ Correspondent banks are those with reciprocal accounts
and agreements
⚫ Banks with excess reserves call correspondent banks to see if
they need overnight reserves, selling the excess reserves to the
correspondent banks that offer the highest rates for the fed funds
⚫ Overnight fed funds loans will likely be based on an oral
agreement between the two parties and are generally unsecured
loans

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Repurchase Agreements

⚫ A repurchase agreement (repo or RP) is an

agreement involving the sale of securities by one party
to another with a promise to repurchase the securities
at a specified price and on a specified date
⚫ Most repos are collateralized, with the seller holding securities
to back the transaction
⚫ Collateral has a “haircut” applied, meaning the loan is slightly
smaller than the market value of securities pledged
⚫ One-day maturity repos are called overnight repos, while repos
with longer maturities are called term repos
⚫ A reverse repurchase agreement (reverse repo)
involves the purchase of securities by one party from
another with the promise to sell them back
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 Repurchase Agreements
(Continued)
⚫ Repurchase agreements are arranged directly between
two parties or with the help of brokers and dealers
⚫ The yield on repos is calculated as the annualized
percentage difference between the initial selling price of
the securities and the contracted (re)purchase price,
using a 360-day year

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 Commercial Paper

⚫ Commercial paper is an unsecured short-term

promissory note issued by a company to raise short-
term cash, often to finance working capital requirements
⚫ One of the largest (in terms of dollar value outstanding) of the
money market instruments, with nearly $1.1 trillion outstanding
as of December 2019
⚫ Companies with strong credit ratings can generally borrow
money at a lower interest rate by issuing commercial paper
than by directly borrowing (via loans) from banks
⚫ Generally sold in denominations of $100,000, $250,000,
$500,000, and $1 million
⚫ Maturities generally range from 1 to 270 days—the most
common maturities are between 20 and 45 days
⚫ Generally held by investors from the time of issue until maturity
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 Asset-Backed Commercial Paper
(ABCP)
⚫ Mid-2000s saw a huge rise in the use of ABCP
⚫ In July 2007, $1.19 trillion of the total $2.16 trillion commercial
paper outstanding was ABCP
⚫ ABCP is collateralized by other financial assets of issuer
⚫ The financial assets are typically a mix of many different assets
that are jointly judged to have a low risk of bankruptcy by a ratings
agency
⚫ In the mid-2000s, the collateralized assets were mainly mortgage-
backed securities
⚫ Billions of dollars of asset-backed commercial paper were tainted
because some of the proceeds were used to buy investments tied
to U.S. subprime mortgages
⚫ Even as markets stabilized after the financial crisis,
outstanding values of commercial paper continued to fall
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 Commercial Paper (Continued)

⚫ Commercial paper is sold to investors either directly

using the issuer’s own sales force or indirectly through
brokers and dealers
⚫ Commercial paper underwritten and issued through brokers and
dealers is more expensive to the issuer
⚫ Like Treasury bills, yields on commercial paper are
quoted on a discount basis

⚫ To convert to a bond equivalent yield, the following

applies:

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Negotiable Certificates of Deposit

⚫ A negotiable certificate of deposit (CD) is a bank-

issued, fixed maturity, interest-bearing time deposit
that specifies an interest rate and maturity date and is
negotiable
⚫ Bearer instruments, meaning whoever holds the CD
when it matures receives the principal and interest
⚫ May be traded any number of times in the secondary
market
⚫ Denominations range from $100,000 to $10 million;
$1 million being the most common
⚫ Often purchased by money market mutual funds with
pools of funds from individual investors
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Negotiable Certificates of Deposit
(Continued)
⚫ Trading process
⚫ Banks issuing negotiable CDs post a daily set of rates for the
most popular maturities of their negotiable CDs, normally 1,
2, 3, 6, and 12 months
⚫ Subject to its funding needs, the bank then tries to sell as
many CDs to investors who are likely to hold them as
investments rather than sell them to the secondary market
⚫ Negotiable CD rates are negotiated between the bank
and the CD buyer
⚫ Large, well-known banks can offer CDs at slightly lower rates
than smaller, less well-known banks
⚫ Negotiable CDs are single-payment securities
⚫ Interest rates are generally quoted using a 360-day year

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Banker’s Acceptances

⚫ A banker’s acceptance (BA) is a time draft payable to

a seller of goods, with payment guaranteed by a bank
⚫ Make up an increasingly small part of the money markets
⚫ Beginning in June 2002, banker's acceptance levels are
included in the commercial paper levels and no longer
differentiated from commercial paper
⚫ Many BAs arise from international trade transactions
⚫ Payable to the bearer at maturity
⚫ Traded in secondary markets
⚫ Denominations determined by the size of the original
transaction, but often trade in secondary markets in
round lots of $100,000 and $500,000
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Money Market Participants

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 International Aspects of Money
Markets
⚫ U.S. money markets are the largest and most active in the
world, but money markets across the world have been
growing in size and importance
⚫ Two forms of growth include the following:
1. U.S. money market securities bought and sold by foreign
investors
2. Foreign money market securities

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 Euro Money Markets

⚫ Eurodollar market is the market in which Eurodollars trade

⚫ Foreign governments and businesses have historically held a store
of funds (deposits) denominated in dollars outside of the U.S., and
these deposits are called Eurodollar deposits
⚫ Eurodollars may be held by governments, corporations, and
individuals from anywhere in the world and are not directly subject to
U.S. bank regulations
⚫ Rate paid on Eurodollar CDs is generally higher than that paid on
U.S.– domiciled CDs
⚫ As an alternative to the Eurodollar market, companies can
also obtain short-term funding by issuing Eurocommercial
paper
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 Eurodollar Market

⚫ Eurodollar market is used by banks around the world as a

source of overnight funding
⚫ Rate offered for sale on Eurodollar funds is known as the
London Interbank Offered Rate (LIBOR)
⚫ Funds traded in the Eurodollar market are often used as an
alternative to fed funds as a source of overnight funding for banks
⚫ During the financial crisis, the LIBOR rate spiked significantly, while
the fed funds rate did not
⚫ Banks manipulated the LIBOR rate for profit
⚫ In 2017, Secured Overnight Financing Rate (SOFR) was
selected as a successor to USD LIBOR
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Eurodollar Certificates of Deposit

⚫ Eurodollar certificates of deposits (CDs) are U.S.

dollar-denominated CDs in foreign banks
⚫ Maturities are less than one year, and most have a
maturity of one week to six months
⚫ Because these securities are deposited in non-U.S.
banks, they are not subject to reserve requirements in
the same manner as U.S. deposits

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Eurocommercial Paper

⚫ Eurocommercial paper (Euro-CP) is an unsecured,

short-term loan issued by a bank or corporation in the
international money market, denominated in a currency
that differs from the domestic currency of the market
where the paper is issued
⚫ Example: Eurodollar commercial paper denominated in U.S.
dollars but issued in the Japanese debt market with a short
time remaining until maturity
⚫ $523.2 billion Eurocommercial paper outstanding and $435.9
billion Eurodollar CDs outstanding as of December 31, 2019
⚫ Eurocommercial paper rate is generally benchmarked
to the Euro Overnight Index Average (EONIA)
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