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 ar...
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