11F 378 Money Market

11F 378 Money Market - THE MONEY MARKETS In times of...

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Unformatted text preview: THE MONEY MARKETS In times of turmoil, some money will exit the stock market. Where would investors park their cash while waiting to reenter the stock market? The answer is the money market. Interestingly, the term “money market” is misleading. Money conventionally means currency. However, money is not traded in the money markets. Instead, securities that do trade there are short ­term and highly liquid; and they are close to being money, hence their name. We have to understand why the money markets are a preferred place to invest temporary and otherwise idle cash. Then, we need to know the characteristics of money market securities. Finally, we want to learn how to calculate the prices and yields of money market securities. These skills are important in the balancing of liquidity and credit risk. Economics Role of the Money Market The economic role of the money market is to facilitate the trading of liquidity. SSUs have excess funds that they are looking to lend (invest) and DSUs have shortages they are looking to cover by borrowing (or raising) capital. Typically, when speaking about lending or investing, the discussion concerns the placing of funds for an extended period of time in a risky investment for the purchase of earning a decent return on the investment. However, in the money markets, issues are a little different. In the money markets, SSUs lend temporary excesses and DSUs borrow to cover temporary shortages. While SSUs’ lending is basically to prevent the funds from being idle, their primary concern is the ability to retrieve all of their cash when they need it. The ability to turn a financial asset into cash quickly without a price concession is referred to as liquidity. Therefore, the money markets are described as the markets for trading liquidity. Often enough, SSUs are called as lenders of liquidity and DSUs are labeled as borrowers of liquidity. The market markets are financial markets for liquidity. Liquidity is what invests ask when they make their funds available in the money markets. To ensure the liquidity of these investments, money markets have been developed around three features: (1) short ­term debt instruments, (2) low default risk and high marketability. First, money market investors only make short ­term loans. Using only short ­term loans ensure that their cash is scheduled to return in a short amount of time (by definition, one year or less). Typically, money market investors pick securities with an initial maturity that matches the period of time that they expect to have excess funds. Second, money market investors have a temporary excess. This means that money market investors expect to need their current excess within next year. Because they expect to need their current excess to meet their own future cash flows obligations, they will only invest these funds in securities with very low default risk. In order words, since the investors expect to have to use their current excess funds in the near future, they are unwilling to place these funds at risk. Third, while money market investors pick initial maturities that match the time they expect to need their cash, they require the ability to sell the securities before maturity without price concession just in case they need cash sooner than originally planned. Therefore, money market investors require that their securities are marketable. To ensure that investors in the money markets receive the liquidity they demand, the money markets have several other common features that support liquidity. First, within each of the seven money markets, the debt contracts are standardized. Standardized contracts mean that all the contracts have the same basic features. This standardization allows traders to understand and value each individual contract quickly, which allows for fast trading of securities. Second, traders are done in immediately available funds. To allow trading in immediately available funds, physically possession of money market securities seldom occurs. Instead, the securities are warehoused in a central location and ownership is recorded electronically, which allows ownership to change hands as rapidly as the funds. Third, many brokers and dealers trade in money market securities. Since numerous outlets exist for trading money market securities, the competition between the brokers and dealers minimizes the transaction costs of a trade. Money market securities usually have an active secondary market. Finally, money markets are wholesale markets. This means that most transactions are very large, usually in excess of $1 million. The size of these transactions prevents most individual investors from participating directly in the money markets. Instead, brokers and dealers, operating in the trading rooms of large banks and brokerage houses, bring customers together. These traders will buy or sell $50 million or $100 million in mere seconds. Almost all lenders and borrowers use the money markets at some point in time to store or borrow liquidity. However, four major players actively participate in the money markets to manage their cash flows. The four players are (1) commercial banks, (2) Bank of Canada, (3) investment and securities firms, and (4) corporations. Most money market participates operate on both sides of the market. For example, any large bank will borrow aggressively in the money market by selling large commercial CDs. At the same time, it will lend short ­term funds to businesses through its commercial lending departments. Participants Role Government of Canada Bank of Canada Sells securities to fund the national debt Buys and sells government securities as its primary method of controlling the money supply Buy government securities; sell certificates of demand and make short ­term loans; offer individual investors accounts that invest in money market securities Buy and sell various short ­term securities as a regular part of their cash management Trade on behalf of commercial accounts Lend funds to individuals Banks and other deposit ­taking institutions Corporations Investment companies (brokerage firms) Finance companies (commercial leasing firms) Insurance companies (P&C insurance companies) Pension funds Individuals Money market mutual funds Maintain liquidity needs to meet unexpected demands Maintain funds in money market instruments in readiness for investment in stocks and bonds Buy money market mutual funds Allow small investors to take part in the money market by aggregating their funds to invest in large ­denomination money market securities Pricing Money Market Securities The price of a money market instruments has two components: (1) the face value (loan principal) and (2) one interest payment. With a face value and one interest payment, two possible cash flow combinations are possible. One combination forms an instrument known as a discount instrument. The cash flow combination for a discount instrument sets the price at face value minus the interest payment and repays the face value. The second cash flow combination forms an add ­on instrument. The cash flow combination for an add ­on instrument sets the price at the face value and repays the face value plus the interest payment. Four of the seven types of money market securities are priced as discount instruments, namely: (1) Treasury bills, (2) short ­term government agency debt, (3) commercial paper, and (4) banker’s acceptances (BAs). The remaining three types, negotiable certificates of deposits (CDs), repurchase agreements (repos), and overnight funds, are sold at face value as add ­on instruments. In principle, the price of a money market discount security is determined by finding the present value of its future cash flows. Since the investor in a discount security is purchasing the right to receive the face value at maturity without intervening interest payment. To calculate the price, use the formula for the present value of a single future cash flow, which is PV = FVt where k is the discount rate. (1 + k ) t In practice, the market convention is to price money market instruments on a bank discount basis. The formula is: price = face value – discount = face value – {face value × r × (t/360)} where r is the current annualized market rate. The interest payment is calculated using the simple interest. In general, the yield on an investment is found by computing the increase in value in the security during its holding period and divided by the amount paid for the security. This yield is converted into an annual yield by multiplying by 365 divided by the number of days until maturity. Use the following formula: i yt = Pt +1 − Pt 365 365 × r or i yt = × 365 − (r × t ) Pt t Worked Example Use the bank discount method to find the price of a six ­month money market discount instrument with a face value (FV) of $1,000 when the annualized market rate(r) is 3.87%. A typical six ­month securities has t = 182 days to maturity. Price = $1,000 – ($1,000 × 0.0387 × 182/360) = $1,000  ­ $19.57 = $980.43. Note that the discount is the amount of simple interest on the face value over the life of the security based on a 360 ­day year. Obviously, 360 days does not make a year, but remember that a 360 ­day year is part of the bank discount basis. ($1,000 − $980.43) 365 × = 0.0395 = 3.95% . Alternatively, $980.43 182 365 × 0.0387 14.1255 i yt = = = 0.0395 = 3.95% . Note that in this money market yield 365 − (0.0387 × 182) 357.9566 The holding period return: HPR = formula r must be entered in decimal form. Worked Example Assume a 3 ­month add ­on instrument with $1,000 face value and 4.65% interest is to be purchased. A typical 3 ­month instrument covers 91 days. The interest payment is $11.75 = $1,000 × 0.0465 × (91/360). For add ­on securities, investors pay face value for the security and receive face value plus a simple interest payment at maturity. Therefore, $1,000 is paid at the time of purchase for the right to receive $1,011.75 in 91 days. The (annualized) holding period return on this instrument becomes ($1.011.75 − $1,000) 365 × = 0.0471 = 4.71% . Note that if use a 360 ­day year, the interest rate and $1,000 91 the return for add ­on security will be the same. Classes of Money Market Securities A variety of money market instruments are available to meet the diverse needs of market participants. One security will be perfect for one investor. A different security may be best for another. We need to know the various characteristics of money market securities and how money market participants use them to manage their cash. (1) Treasury Bills: A T ­bill is a short ­term debt obligation of the Canadian government. It is often described as the ideal money market instrument because it has the lowest default risk and highest marketability of any money market instrument. As of September 18, 1997, every two weeks the Bank of Canada, on behalf of the government of Canada, announces how many treasury bills it will offer for sale. T ­bills are generally issued with maturities of 98 days, 168 0r 182 days and 350 or 364 days, although for cash management purposes the Bank of Canada often issues T ­bills with a maturity of less than 91 days. T ­bills are available in denominations of $1,000, $5,000, $25,000, $100,000 and $1,000,000 and in bearer form. Government securities distributors submit bids, on their own behalf and on behalf of their customers, subject to auction limit of no more than 40% in one issue. The Bank of Canada accepts the bids offering the highest price and makes the awards. The highest bidder is satisfied first. Subsequent bidders are satisfied in the order of their bid amount until the total amount of securities is distributed. Note that this implies not everyone at the auction pays the same price for the securities. In this multiple price auction process, the winner of the auction paid more for the asset than anyone else is was willing to pay, creating concern that the winner ends up paying more than the asset is worth. This is so ­called winner’s curse. Beginning in November 1998, the Bank of Canada switched all auctions to uniform ­price auctions where all bidders pay the same price. Under the uniform price auctions, the Bank of Canada also permits noncompetitive bidding. When competitive bids are offered, investors state both the amount of securities desired and the price they are willing to pay. By contrast, noncompetitive bids include only the amount of securities the investor wants. The price charged to noncompetitive bidders will be determined by the results of the competitive auction process. Individual investors can submit noncompetitive bids, but only the designated Treasury dealers can submit competitive bids. As the close of bidding, all sealed bids are forwarded to the Bank of Canada for processing. As a first step, all noncompetitive bids are accepted automatically and are subtracted from the total issue amount. The cut ­off yield is determined. This is the price at which all competitive bids are sufficient to finance the remaining issue amount. Competitive bids at or above the cut ­off yield are accepted and bids below the cut ­off yield bid are rejected. Worked Example The Bank of Canada announces an offering of Treasury bills with a face value amount of $25 billion. The response is $5 billion of noncompetitive bids, along with the following competitive bids: Bidder A B C D E Price Bid $95,000 $95,500 $96,000 $96,500 $97,000 Quantity Bid $5 billion $5 billion $5 billion $5 billion $5 billion In this auction, Bids E, D, C and B are accepted. The cut ­off yield is $95,500. That is, $95.5 per $100 of Treasury bill is the price paid by each bidder. $23.875 billion = (0.995)×($25 billion) will be raised by the entire offering. Very often banks and other FIs – especially investment banks – enter into commitments to buy and sell securities before issue. This is called when issued (WI) trading. A WI commitment taken on with new T ­ bills can expose an FI to the off ­balance ­sheet risk. The Bank of Canada releases a call for tenders for three ­month, six ­month and one ­year Government of Canada treasury bills on Thursday afternoon and the auction is held the following Thursday afternoon. Secondary trading (the “when ­issued” market) for these bills occurs until the settlement date, which is the day following the auction of the bills. There are nine primary dealers who maintain a market in the securities and 22 government securities distributors who are investment dealers and banks. Normally, primary dealers sell the yet ­to ­be ­issued T ­bills for forward delivery to customers in the secondary market at a small margin above the price they expect to pay at the primary auction. This can be profitable if the primary dealer gets all the bills needed at the auction at the appropriate price to fulfill these forward WI contracts. A primary dealer who makes a mistake regarding the tenor of the auction faces the risk that the commitments entered into deliver T ­ bills in the WI market can be met only at a loss. For example, an overcommitted dealer may have to buy T ­bills from other dealers at a loss right after the auction results are announced to meet the WI T ­bill delivery commitments made to its customers. (2) Government Agency Obligations Government agencies’ job is to provide a dependable supply of credit to their specific disadvantaged groups at the lowest possible cost. The three areas that have received the most focus for agency credit are housing, trading and framing. Some agencies are owned and directed by the federal government and their debt is of course backed by the full faith and credit of the government. Some agencies are federally sponsored but private owned. Examples include Canada Mortgage and Housing Corporation (CMHC), Export Development Canada (EDC) and Farm Credit Canada (FCC). The debt of these agencies is not guaranteed by the federal government. However, it is unlikely the federal government would allow a crown corporation to default on its debt, so these agencies have a de facto government guarantee. The marketability varies from one agency’s securities to another’s securities. Some agencies have well ­ established and active secondary markets; however, none of the agencies’ securities have the marketability of T ­bills. Agency securities trade at a positive spread above the same maturity T ­bills. (3) Commercial Papers Commercial paper (CP) is unsecured corporate debt which is typically issued to finance short ­term working capital. The only backing is the creditworthiness of the issuing firm. Most issuers back up their CP with a line of credit at a bank. The line of credit reduces the risk to the purchasers of the CP and so lowers the interest rate. The bank charges a fee of 0.5% to 1% for this commitment. Issuers pay this fee because they are able to save more than this in lowered interest costs by having the backup line. If the issuing firm has an adverse change in its financial condition to the point where it cannot service its debt obligations, the bank who issued the backup line of credit does not have to loan the firm money. This is common practice in lending because all loan agreements for line of credit allow the bank to deny requests under if the situation becomes unfavorable. However, as money market investors demand low default risk, the CP market is not available to most firms because their default risk is too high. CP is issued as an alternative to short ­term bank credit and is often used because the firms who have access to this market can issue CP at a lower rate than they can borrow from a bank. The interest rate the corporate is charged reflects the firm’s level of risk. In general, CP is cheaper than bank debt because it avoids the middleman (the bank) and thus, the middleman’s markup. About 60% of CP is sold directly by the issuer to the buyer. The balance is sold by dealers in the CP market. A strong secondary market for CP does not exist. A dealer will redeem CP if a purchaser has a need for cash, though this is not necessary. The CP market is a wholesale market with common denominations of $100,000, $250,000, $500,000 and $1 million and with initial maturities ranging from 1 to 365 days. One may think these characteristics, along with the small number of issuers, are restrictive enough to create a relatively small market. However, this is not the case. Banks were the original purchasers of CP. Today, the market has greatly expanded to include large insurance companies, nonfinancial businesses, bank trust departments and government pension funds. These firms are attracted by the relative low default risk, short maturity and high yields these securities offer. The average dollar amount of CP outstanding was $1,346 billion over the last ten years in Canada. (4) Bankers’ Acceptances (BAs) BA begins with an actual business transaction where the seller has difficulty determining the creditworthiness of the buyer and therefore requests special assurances with receiving payments. The special assurance of a BA is that the bank accepts the responsibility to make the payment for the business transaction. That is, when the bank accepts the transaction, payment for the transaction becomes a direct obligation of the bank. Thus, the bank’s creditworthiness replaces the creditworthiness of the buyer. The need for a BA almost always arises in foreign trade. To provide insights into the process for creating a BA and the reason behind the transactions, let us work on a BA for international trade. Primary steps include: (a) The import (buyer) requests that its bank send an irrevocable letter of credit (L/C) to the exporter (seller) to cover the cost of the goods to be purchased. (b) The exporter, on receipt of the L/C, ships the goods and is paid by its own bank when it presents the L/C along with proof the goods were shipped. (c) The exporter’s bank creates a time draft based on the L/C and sends it with proof of shipment to the importer’s bank. (d) The importer’s bank stamps the time draft ACCEPTED. This makes the time draft an obligation of the importer’s bank. The importer’s bank then either returns the accepted time draft to the exporter’s bank (which it can then sell) or pays the exporter’s bank the discounted amount of the face value of the time draft, and (e) The importer’s bank collects funds from the importer to cover the BA when the time draft matures. There are three primary benefits in foreign trade for going through this involved process. The benefits are: (a) The exporter does not have to determine the creditworthiness of the importer. Instead, the importer’s bank guarantees payment. (b) The exporter gets paid immediately, and (c) The exporter is not exposed to foreign exchange risk because it receives payment from its bank in its local currency. Because BAs are payable to the bearer, in principle, they can be bought and sold until they maturity. They are sold on a discounted basis like CP and T ­bill. However, the secondary market for BAs is a dealer market. Currently, about a dozen primary dealers in BAs make the ongoing market. Dealers in this market match up firms that want to discount a BA’s (sell it for immediate payment) with companies looking to invest in BAs. Given BAs are not more risky, the CP spread is usually below the BA spread. Such an observation suggests BAs are less marketable than CPs. Interest rates on BAs are low because the default risk is very low. For example, no investor in BAs in Canada has suffered a loss of principal in more than 60 years. The reason is that only large money center banks are involved in this market. A secondary market exists in which these BAs can be traded should an investor choose not to hold them until maturity, which usually ranges between 30 and 180 days at the time of issue. BAs are relatively safe investments because both the bank and the borrower are liable for the amount due at maturity. (5) Certificates of Deposit (CD): Term Deposits CD is a bank ­issued security that documents a deposit and specifies the interest rate and the maturity date. Because a maturity date is specified, a CD is a term deposit as opposed to a demand deposit. Term securities have a specified maturity date whereas the demand deposits can be withdrawn at any time. Similar term deposits issued trust and mortgage companies in Canada are known as guaranteed investment certificates (GICs). CDs and GICs are often negotiable, meaning that they can be traded and in bearer form (called bearer deposit notes). This means that whoever holds the instrument at maturity receives the principal and interest. The CD can be bought and sold until maturity. Negotiable CDs come in denominations between $100,000 and $10 million. However, negotiable CDs seldom trade in denominations of less than $1 million because $1 million is deemed to be a round lot for trading in this market. Negotiable CDs typically have a maturity of one to four months. Some have six ­ month maturities, but there is little demand for ones with longer maturities. Indeed, negotiable CDs are the least marketable of the money market instrument. The rates paid on CDs are negotiable between the bank and the customer. They are similar to the rate paid on other money market instruments because the level of risk is relatively low. Large money center banks can offer rates a little lower than other banks because investors think the government will never allow large banks to fail. This belief makes these banks’ obligation less risky. Overall, CD rates tend to be slightly above the T ­bill rate because of the slightly greater chance of default. The negotiable CD was started by Citibank in 1961. The purpose was to counter the long ­term trend at large banks of declining demand deposits. This trend is important and troublesome because demand deposits are a primary funding source for a bank’s lending activities. Citibank established the market by getting securities dealers to agree to make a market in negotiable CDs. Canadian banks also issue non ­negotiable CDs. That is, they cannot be sold to someone else and cannot be redeemed from the bank before maturity without paying a substantial penalty. Non ­negotiable CDs are issued in denominations ranging from $5,000 to $100,000 and with maturities of one day to five years. They are also known as term deposit receipts or term notes. Trust and mortgage loan companies issue CDs under a variety of names such as GICs (guaranteed investment certificates), DRs (deposit receipts), GTCs (guaranteed trust certificates) and GIRs (guaranteed investment receipts). (6) Overnight Funds Overnight funds are short ­term funds transferred (loaned or borrowed) among FIs, usually for a period of one day. One reason why a bank might borrow in the overnight funds market is that it does not have enough settlement balances at the Bank of Canada. It can then borrow these balances from another bank with excess settlement balances. The main purpose for the overnight funds is to provide depository institutions with an immediate infusion of reserves should they be short. In principle, depository institutions can borrow directly from the Bank of Canada. But they prefer to borrow from other institutions so that they do not pay the bank rate when they borrow from the Bank of Canada. Similarly, the reason that banks like to lend in the overnight funds market is that money at the Bank of Canada’s standing liquidity facility earns a lower interest rate than in the overnight money market. Overnight funds are usually overnight investments. Banks analyze their reserve position on a daily basis and either borrow or invest in overnight funds, depending on whether they have excess or deficit settlement balances with the Bank of Canada at the end of the day. Suppose that a bank finds it has $50 million in excess settlement balances. It will call its correspondent banks (banks that have reciprocal accounts) to see whether they need reserves that day. The bank will sell its excess funds to the bank that offers the highest rate. Once an agreement has been reached, the bank with excess funds will wire the funds to the borrowing bank. This involves telecommunicating to the Bank of Canada instructions to take funds out of the seller’s accounts at the Bank and deposit the funds in the borrower’s account. The next day, the funds are transferred back, and the process begins again. Most overnight funds borrowings are unsecured. Typically, the entire agreement is supported only by oral communication between buyer and seller. The overnight market is very sensitive to the credit needs of the deposit ­taking institutions, so the interest rate on overnight loans, called the overnight interest rate, is a closely watched barometer of the tightness of credit market conditions in the banking system and the stance of monetary policy. When the overnight interest rate is high, it indicates that the banks are strapped for funds, whereas when it is low, banks’ credit needs are low. The overnight interest rate is the operating target of the Bank of Canada’s monetary policy. The Bank of Canada implements monetary policy by changing the overnight interest rate. Since December 2000, the Bank of Canada has operated under a system of eight fixed dates throughout the year for announcing any changes to the operating band of 50 basis points for the overnight rate, keeping the option of acting between the fixed dates in extraordinary circumstances. Moreover, the Bank of Canada targets the overnight interest rate at the midpoint of the band using repurchase transactions, either SPRA or SRAs. Although changes in the overnight interest rate directly affect few businesses or consumers, they are key indicator of the direction in which the Bank of Canada wants the economy to move. Remember that a secondary market in overnight funds does not exist. Instead, market liquidity is directly related to the maturity of the loan. (7) Repurchase Agreements (Repos) Repos work much the same way as overnight funds except that nonbank can participate. A repo is the sale of securities with the simultaneous agreement to repurchase the securities at an agreed price on agreed future date. The typical securities for a repo are government and agency securities. The length of the repo is negotiable between the buyer and seller at time of the initial sale. Most repos have a very short term of 3 to 14 days. However, there is a market for one ­ to three ­month repos. The repurchase price is the initial sale price plus an interest payment. Thus, repos are add ­on instruments. The yield on a repo is slightly less than the rate that can be obtained from outright purchase of the underlying security. In a repo, cash and securities trade at the initial sale, with the securities and the initial cash amount plus interest returned on the specified future date. This process is the same as a collateral loan, with the securities as collateral. Indeed, repos are most easily understood when they are thought of as a short ­ term loan backed by collateral. The money lender in a repo is subject to the default risk of the borrower. The securities in the repo act as collateral that reduces default risk. The lender does not own the securities but instead has the securities as collateral. During the time covered (the tenor) by the repo, the securities are held for safe keeping by a third party custodian. Therefore, in the case of default, lender must precede with legal procedure to take ownership of the securities. Having a custodian hold the securities provides protection for the lender because the borrower is prevented from pledging the securities as collateral for more than one repo contract. As further protection for the lender, the value of the securities exceeds the dollar value of the loan. (8) Money Market Mutual Funds (MMMFs) The money markets are primarily wholesale markets because the instruments are typically written in large denominations. The larger denominations make the money market as a corporate or institutional market. However, individuals also have interest in investing in money market instruments. MMMFs aggregate the funds of many small investors and purchase money market instruments. The returns on these instruments are passed on to the investors. MMMFs are a substitute for bank deposits for individual investors. However, bank deposits are insured and MMMFs are not. In theory, MMMFs are riskier than bank deposits. In reality, the extra risk is really very small. CP is by far the largest component of the money invested in MMMF, followed by CDs and repos and then by BAs. Since the default risk on these securities is low, the risk of MMMFs is very low. Investors recognize this and so are willing to abandon the safety of their banks. MMMFs have grown rapidly since 1978. INSTITUTIONAL USE OF MONEY MARKETS Securities Issued by Common Investors Common Maturity T ­Bills Federal government Negotiable certificates of deposits (NCDs) Commercial Paper Commercial Banks Households, firms, 13 weeks, 26 financial weeks, 1 year institutions Firms 2 weeks to 1 year Bankers’ Acceptance Overnight Funds Repurchase Agreements Finance Firms companies and other corporations Commercial Banks Firms Depository institutions Firms and Financial Institutions Depository Institutions Firms and FIs Secondary Market Activity High Moderate 1 day to 270 days Low 30 days to 270 days 1 day to 7 days High 1 day to 15 days Nonexistence Nonexistent ...
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This note was uploaded on 10/02/2011 for the course ECON 101 taught by Professor Mikson during the Spring '08 term at Aarhus Universitet.

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