05 The Money Markets

  • Define the Money Markets

  • Understand the purpose of Money Markets

  • Identify the participants in Money Markets

  • Describe Money Market Instruments

  • Compare Money Market Securities

The Money Markets Defined

  • Definition: The money market is where short-term funds are raised and invested; actual currency is not traded here.

  • Characteristics:

    • Securities are sold in large denominations (typically $1,000,000 or more).

    • They exhibit low default risk.

    • Maturity period is one year or less from the issue date.

Purpose of Money Markets

  1. Warehousing of Surplus Funds: Keeps surplus funds for short durations for investors.

  2. Temporary Funds for Borrowers: Provides a cost-efficient source of temporary funds for firms, government, and other borrowers.

  3. Cash-Timing Solutions: Addresses mismatches in the timing of cash inflows and outflows for corporations and governments.

Role of Banks in Money Markets

  • Banks are expected to handle short-term loans and deposits but face governmental regulations that can disadvantage them.

  • Money markets provide a cost advantage over banks due to less stringent regulations and reserve requirements.

Participants in the Money Markets

Key Instruments:

  1. Treasury Bills

  2. Federal Funds

  3. Repurchase Agreements (Repo)

  4. Negotiable Certificates of Deposit (NCD)

  5. Commercial Paper

  6. Banker’s Acceptances

  7. Eurodollars

Treasury Bills

  • Characteristics:

    • Short-term securities maturing in one year or less.

    • Sold at a discount from face value; at maturity, the investor receives the face value.

    • Example Calculation: For a $1,000 26-week T-bill at a 3.80% discount rate, the purchase price is calculated as:

      • P = F [1 - i x(t/360)], P = $1000 [1 - 0.0380 x (182/360)] = $980.79.

Discount Rate and Investment Rate Calculations

  1. Discount Rate: Calculated based on purchase price and face value.

  2. Investment Rate: Different from discount rate; uses actual days to maturity for accurate yield representations.

Auctioning Process for Treasury Bills

  • T-bills are auctioned weekly; bids can be competitive (specifying price and amount) or non-competitive (specifying only amount).

  • All bidders receive the same yield based on the highest yield accepted.

Other Money Market Instruments

  • Federal Funds: Short-term loans between banks, often overnight, ensuring reserve requirements are met.

  • Repurchase Agreements: A short-term collateralized loan where securities are sold with an agreement to repurchase them later.

  • Negotiable Certificates of Deposit (NCD): Bank-issued securities specifying interest rates and maturity, considered term securities.

  • Commercial Paper (CP): Unsecured promissory notes from large corporations, reflecting the firm’s creditworthiness and maturing in no more than 270 days.

  • Banker’s Acceptances: Used to guarantee payment in international trade; banks substitute their creditworthiness for that of buyers.

  • Eurodollars: US dollar-denominated deposits held in foreign banks, important due to the dollar’s stability.

Comparison of Money Market Securities

  • Rates for various money market instruments move closely together, indicating similar risks and characteristics.

  • Liquidity: Vital feature along with the depth of the secondary market.

Money Markets in Hong Kong

  • Focuses on the interbank market; HIBOR reflects supply and demand for short-term funds.