Ch. 11: The Money Markets

Defining Money Markets

Sold in large amounts, low default risk, mature in ≤1 year from issue date (usually <120 days)

Money isn’t traded - highly liquid money-like securities are

Wholesale funding market: transaction volumes large ($1M)

Retail investors can't afford big investments, so broker-dealers connect institutional investors instead. They use MM bc banks are expensive and heavily regulated, and big, well-known borrowers don't have as many trust issues.

What’s the purpose of Money Markets?

MM lets lenders (firms & institutions) store surplus funds temporarily and earn higher interest than bank while maintaining liquidity for future decisions.

Borrowers (firms & gov) use as low-cost way to cover ST funding (especially when inflows and outflows misalign).

However, MM for ST funding can be less stable than deposits

Who Participates in the Money Markets?

U.S. Treasury: sell securities to fund deficits and refinance debt (largest supplier)

NY Fed: manages open market ops and controls ST rates

Commercial banks: issue CDs, make loans, buy T-bills

Finance companies: borrow to fund consumer loans

Insurance companies: hold liquid assets for unexpected payouts

Pension funds: maintain liquidity for investments, though main focus LT assets

Non-financial corps: use market to manage CF

MM mutual funds: buy large securities and sell funds to retail customers

Individuals: invest in MM mutual funds for liquidity and safety

Pricing T-bill returns: Discount Rate

i_discount = (F - P)/F * 360/n

• i_discount is the annualized discount rate

• F is the face value

• P is the purchase price

• n is the number of days to maturity

Pricing T-bill returns: Investment Rate

i_investment = (F - P)/P * 365/n

• i_investment is the annualized investment rate

• F is the face value

• P is the purchase price

• n is the number of days to maturity

• Use 366 days for leap years, not 365

T-bill auctions

Competitive: investors specify how much they want and price (yield) willing to accept. Treasury accepts bids from lowest to highest until total amount is sold. All accepted bids get highest yield among them

Noncompetitive: investors state how much they want to buy, and purchase is guaranteed. They accept price set by highest yield from competitive bids

Varying liquidity and risk across money market securities

T-bills are most liquid with highly liquid secondary markets. CP lack secondary markets an are HTM

T-bills are risk-free. Collateralized securities (repos or asset-backed CP) are generally safe, but riskier if collateral loses value (2008). Unsecured securities (some CP) riskier bc no collateral

The run on the money market funds in 2008

When Lehman Brothers went bankrupt on 9/15/2008, the Reserve Primary Fund, holding $785 million in Lehman-issued commercial paper, declared it worthless. This caused a “run” on MM funds, triggering a sharp drop in demand for CP and leading the Reserve Primary Fund to “break the buck” on 9/16, with its net asset value falling below $1 per share. With no deposit insurance, $350 billion was withdrawn from MM funds. In response, the Fed introduced the ABCP MM Fund Liquidity Facility to support liquidity, while the U.S. Treasury launched a temporary guarantee program for MM funds.