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CHAPTER 7 MONEY MARKETS CHAPTER OBJECTIVES 1. Discuss the economic role of money markets and general characteristics of money market instruments. 2. Introduce valuation methods of money market securities; enable students to compute money market yields and prices. 3. Make students familiar with the seven classes of instruments that comprise the money markets, as well as the characteristics of each of these markets. CHANGES FROM THE LAST EDITION 1. All time-sensitive tables and figures have been updated. 2. The section titled “How the money markets work” has been slightly shortened. CHAPTER KEY POINTS 1. This chapter examines the U.S. money markets, which serve as markets for liquidity. The money market is a collection of markets where short-term, marketable obligations with very little credit risk are bought and sold. The money markets are where businesses, government units, financial institutions, and world investors store liquidity, fund liquidity, and adjust liquidity. Also, the money markets are where the Federal Reserve conducts its monetary policy. 2. Emphasize the general characteristics of money market instruments. That is, money market instruments have: (a) low default risk, (b) short-term maturity, and (c) high marketability. Also emphasize the reasons why money market investors desire and require these characteristics. 3. The role of the key players in the money markets should be emphasized. These are: commercial banks, the Federal Reserve System, Treasury Department, dealers and brokers, and corporations. It would be especially useful to discuss the role of primary government security dealers as their role does not get coverage elsewhere in the text. You can also mention the increasing importance of money market mutual funds as players in the money markets. Exhibit 7.12 may help better summarize the roles of different market participants in the money markets for you students. 4. Money market yields are computed differently from capital market yields. In particular, money market yields do not assume compound interest. 1
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5. Discuss the characteristics of each of the money market instruments. They may differ by issuer, maturity, pricing methods (discount vs. add-on instruments), investor clienteles, default risk, and marketability. Make sure that your students understand how these differences are reflected in yields. 6. The close substitutability between money market instruments explains why interest rates on different money market instruments tend to move together over time. 7. Reemphasize the importance of money markets to commercial banks for adjusting their liquidity position and as a source of funds. The U.S. money markets developed, to a great extent, as a regulatory avoidance movement of commercial banks. ANSWERS TO END-OF-CHAPTER QUESTIONS 1. Calculate the bond equivalent yield for a 180-day T-bill that is purchased at a 6% "ask" rate. If the bill has a face value of $10,000, calculate its price.
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