Chapter 11: The Money Markets

Defining Money Markets

1. Usually sold in large denominations

2. Usually have low default risk

3. Mature in 1 year or less from their original issue date, usually under 120 days

MM is something of a misnomer; money isn’t being traded, money-like securities are traded (highly liquid)

MM is a type of wholesale funding market: transaction volumes are extremely large ($1 mn+)

Too big for retail investors, broker-dealers bring institutional customers together; they rely on MM because banks are highly regulated and comes at a cost (or lower return), and asymmetric info problems may not be severe for well-known institutional borrowers

What’s the purpose of money markets?

Lenders: market for firms or financial institutions to temporarily “warehouse” surplus funds until they are needed

• Opportunity cost to holding cash

• Typically earn a higher interest rate than at a bank

• Useful t o have liquid short-term assets, e.g., taking advantage of new investment opportunities

Borrowers: low-cost source of funds to firms, governments, and financial intermediaries that need short-term funds

• For governments and firms, cash inflows and outflows are often mismatched, e.g., tax revenues are higher in April, lower in February

• Some non-depository financial institutions have relied on money markets for short-term funding, but it’s a less stable source than deposits

Who participates in the money markets?

Major participants, and why:

• U.S. treasury department: selling to fund budget deficits, roll over existing debt (largest supplier in U.S.)

• NY Fed: Buying/selling to conduct open market operations, control short-term interest rates (Ch. 10)

• Commercial banks: sell certificates of deposit, make short-term loans, buy T-bills (limits on asset holdings)

• Finance companies: borrow to fund loans to individuals

• Insurance companies: maintain liquid assets for unanticipated payouts (e.g., natural disasters)

• Pension funds: maintain liquid assets for investment purposes (mostly invest in long-term assets)

• Non-financial corporations: buy/sell for cash management

• Money market mutual funds: buy large-denomination securities, sell shares of money market mutual funds to retail customers

• Individuals: buy money market mutual funds, e.g., Cheryl

Money market instruments: 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

• Note: Previously using N = years to maturity (Ch. 3 - 5)

Money market instruments: 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

Money market instruments: T-bill auctions

Each week the Treasury announces how many and what kind of Treasury bills it will offer for sale…

Competitive bidding:

• Investors submit bids stating both quantity of securities desired and price they are willing to pay

• The Treasury accepts competitive bids in ascending order of yield until the accepted bids reach the offering amount

• Each accepted bid is then awarded at the highest yield paid to any accepted bid

Noncompetitive bidding:

• Treasury accepts (guaranteed) purchase orders, investors state quantity of securities desired regardless of the price

• Price is set as the highest yield paid to competitive bids

Comparing money market securities

MM securities generally share similar features in terms of liquidity, maturity, and safety, but…

• Liquidity: less of a concern since all are short-term, often held to maturity, but some of these securities have liquid secondary markets (e.g., T-bills), others have no secondary market (e.g., CP)

• Risk: T-bills are considered risk-free, collateralized repo-lending or asset-backed CP is safe (unless collateral loses value, e.g., 2008), unsecured securities are riskier…

Run on money market funds in 2008

1. Lehman brothers goes bankrupt on 9/15/2008

2. Reserve primary fund, the original money market firm created in 1971, was holding $785 mn (~1.2% of assets) in commercial paper (CP) issued by Lehman, declared worthless the next day

3. Lehman’s failure sparks a “run,” investors racing for redemptions, kills demand for CP because higher perceived risk

4. Reserve Primary Fund “breaks the buck” on 9/16: net asset value falls to $0.97 per share (assets < liabilities)

5. No deposit insurance! MM funds aren’t as safe as bank accounts → $350 bn in fund redemptions within a week

6. Fed launches an Asset-Backed Commercial paper (ABCP) Money Market Fund Liquidity Facility (AMLF), making cheap collateralized loans to banks for purchases of ABCP from money market funds (helping to meet redemptions, support liquidity)

7. U.S. Treasury rolls out a Temporary Guarantee Program for MM Funds (Reserve primary fund doesn’t qualify)