Lecture 6 Money Markets
Page 1: Overview
Lecture Title: LECTURE 6 RFN 301: Financial Markets, Institutions and Instruments
Topic: Money Markets and Instruments
Page 2: Expected Learning Outcomes
At the end of the session, learners should be able to:
Explain the meaning, purpose, and participants of the money markets.
Understand the importance of money markets in the financial system.
Explain different money market instruments.
Understand how money market instruments are traded.
Page 3: The Money Markets Defined
Misnomer: "Money market" is misleading as actual currency is not traded.
Definition: A market for trading short-term securities with high liquidity.
Characteristics: Securities are close to being cash due to their short-term nature.
Page 4: Money Market Instruments
Features:
Denominations: Usually sold in large amounts ($1,000,000 or more).
Risk: Have low default risk.
Maturity: Typically mature in one year or less; most under 120 days.
Page 5: The Purpose of Money Markets
Short-term investments: Acts as a safe haven for surplus funds.
Short-term finance: Provides low-cost temporary funds for borrowers.
Cash flow management: Helps businesses synchronize cash inflows and outflows.
Page 6: Advantages of Money Markets
Cost advantages:
Less regulated than banks, minimizing costs for savers and borrowers.
Regulatory costs for banks stem from non-interest earning reserves.
Higher investment return: Offers better short-term returns than banks due to lesser regulation on interest rates.
Page 7: Money Markets Participants
Participants and Roles: ○
U.S. Treasury Department: Sells securities to fund national debt.
Federal Reserve System: Regulates money supply via buying and selling U.S. Treasury securities.
Commercial banks: Buy securities, sell CDs, make short-term loans.
Businesses: Regularly buy/sell short-term securities.
Investment companies: Trade for commercial accounts.
Finance companies & Insurance companies: Lend funds, maintain liquidity.
Pension funds: Hold money market instruments for future investments.
Individuals: Invest in money market mutual funds.
Money market mutual funds: Allow small investors to participate by pooling their funds.
Page 8: National Participants
National Treasury: Issues Treasury bills as the main money market instrument.
Central Bank of Kenya: Engages in open market operations to control money supply.
Banks: Buy securities, issue deposits, and provide short-term loans.
Page 9: Business and Individual Participants
Business firms: Engage in buying/selling short-term securities for cash management.
Individuals: Purchase money market mutual funds.
Investment companies and brokers: Execute trades on behalf of investors.
Insurance companies: Maintain liquidity for claims.
Page 10: Pension and Finance Participants
Pension funds & Life insurance companies: Hold money market assets awaiting capital market investments.
Finance companies: Provide short-term loans to businesses and individuals.
Money market mutual funds: Pool funds from small investors to buy large securities.
Page 11: Treasury Bills
Maturity: T-bills range from 28 days up to 12 months (91, 182, and 364 days in Kenya).
Discounting: Investors buy below face value, with returns realized at maturity.
Page 12: Treasury Bill Auctions
Auction Timing: Held every Thursday.
Bid Types:
Competitive bids: Investors quote yield; successful bids pay that yield.
Non-competitive bids: Investors accept the weighted average yield.
Page 13: Pricing T-bills Example
Example Calculation: If a 28-day T-bill costs $996.37 with a maturity value of $1,000, what is the discount rate?
Page 14: Treasury Bills Yield Example
Annualized Yield Calculation: Example involves purchasing a 28-day T-bill for $996.37, worth $1,000 at maturity.
Page 15: Interbank Lending
Definition: Short-term funds lent between financial institutions, typically overnight.
Purpose: Helps banks meet reserve requirements.
Page 16: Repurchase Agreements (Repos)
Function: Nonbanks can participate; involves selling Treasury securities with terms to repurchase later.
Policy Tool: Central banks use repos for monetary policy management.
Page 17: Negotiable Certificates of Deposit (CDs)
Definition: Bank-issued securities documenting a deposit with specified interest and maturity dates.
Denominations: Range from $100,000 to $10 million, closely tracking T-bill rates.
Page 18: CD Rates Over Time
Figure: Comparison of interest rates on Negotiable CDs and Treasury Bills from January 1990 - January 2010.
Page 19: Commercial Paper
Definition: Unsecured promissory notes issued by corporations with maturities up to one year.
Market Note: In Kenya, the CP market is smaller than bank loans, though rates are nearly 2% below average bank rates.
Page 20: Commercial Paper Rates Over Time
Figure: Return on Commercial Paper compared with the Prime Rate (1990-2010).
Page 21: Banker’s Acceptances
Definition: Orders to pay a certain amount at a specified date upon conditions being met, often in international trade.
Page 22: Advantages of Banker’s Acceptances
Benefits:
Immediate payment to exporters.
Protection from foreign exchange risks.
No credit assessment required for importers.
Backed by banks, crucial for international trade.
Page 23: Secondary Market for Banker’s Acceptances
Feature: An active secondary market exists for banker’s acceptances until maturity, ensuring liquidity.
Page 24: Eurodollars
Definition: Dollar-denominated deposits in foreign banks, crucial for international contracts requiring U.S. dollars.
Page 25: Growth of Eurodollars
Market Growth: Rapid growth due to higher return rates in the Eurodollar market compared to domestic banks.
Industry Dynamics: Multinational banks often subject to less regulation than U.S. banks.
Page 26: Eurodollar Rates
Key Rates:
LIBID: Rate paid by banks buying funds.
LIBOR: Rate offered for the sale of funds.
Market Note: Most significant short-term security globally.
Page 27: Historical Context of Eurodollars
Origins: Created in the 1950s when the USSR transferred dollar deposits to European banks to avoid U.S. risk.
Page 28: Comparing Money Market Securities
Liquidity: Key feature closely linked to the depth of the secondary market for various money market instruments.
Page 29: Money Market Securities Overview
Table Summary: Includes issuers, buyers, maturity, and liquidity characteristics of various money market securities such as Treasury Bills, Commercial Paper, etc.
Page 30: Lecture Summary
Defined Money Markets: Characterized by short-term instruments with low default risk.
Page 31: Participants
Who Participates?
U.S. Treasury, Commercial banks, Businesses, Individuals (through mutual funds).
Page 32: Summary of Money Market Securities
Diversity: Issuers from government, banks to corporations; maturity varies significantly; liquidity differs.