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Financial Markets and Institutions Overview

Introduction

  • Reference: Financial Markets and Institutions, Abridged 11th Edition by Jeff Madura.
  • All rights reserved. No reproduction without permission.

Chapter Objectives

  • Describe the features of the most popular money market securities.
  • Explain how money markets are used by institutional investors.
  • Explain the valuation and risk of money market securities.
  • Explain how money markets have become globally integrated.

Money Market Securities

Definition

  • Money market securities are debt securities with a maturity of one year or less.
  • Issues occur in the primary market through telecommunications networks by the U.S. Treasury, corporations, and financial intermediaries seeking short-term financing.
  • Common purchasers include households, corporations, and governments with short-term funding needs.
  • Money market securities are liquid, meaning they can be sold in the secondary market.

Types of Money Market Securities

  • Treasury Bills (T-bills)
  • Commercial Paper
  • Negotiable Certificates of Deposit (NCDs)
  • Repurchase Agreements (Repos)
  • Federal Funds
  • Banker's Acceptances

Treasury Bills (T-bills)

Overview

  • Issued by the U.S. government to borrow funds.
  • Maturities: 4-week, 13-week, and 26-week issued weekly.
  • Historical par value: minimum was $10,000; now $1,000 is the minimum with multiples.
  • Sold at a discount from par value; gain = par value - purchase price.
  • Backed by the federal government; virtually credit (default) risk-free.
  • Highly liquid due to short maturity and strong secondary market presence.

Investors in Treasury Bills

  • Depository Institutions: Retain liquid assets.
  • Financial Institutions: Invest for managing cash flows.
  • Individuals: Invest indirectly through money market funds.
  • Corporations: Use T-bills for unexpected expenses.

Pricing and Yield

  • T-bills are priced at a discount; the value is calculated via present value.
  • Example: For a par value of $10,000 and a required rate of return of 4%, the price is:
    P = \frac{10,000}{1.04} = 9615.38

Estimating the Yield

  • Yield is the return derived from T-bills.

Auction Process

  • Investors bid for new T-bills online at www.treasurydirect.gov.
  • Two bidding options: competitive and non-competitive.

Commercial Paper

Overview

  • Short-term debt instrument from creditworthy firms, generally unsecured.
  • Commonly issued to manage liquidity or finance inventory/accounts receivable.
  • Minimum denomination: normally $100,000.
  • Maturities usually range from 1 day to 270 days.

Credit Risk

  • Subject to issuer's financial condition and cash flow; risk influenced by the issuer's stability.

Credit Ratings

  • Assigned by agencies like Moody’s, Standard & Poor’s, and Fitch to indicate default risk potential.
  • Higher credit ratings result in lower expected default risk.

Placement and Backing

  • Issuers place commercial paper directly or through dealers.
  • Some backed by assets, which yield lower returns than unsecured forms.
  • Typical issuers maintain backup lines of credit.

Yield Estimation and Curve

  • Commercial paper is priced at a discount, providing a yield higher than T-bills due to credit risk and less liquidity.
  • Commercial paper yield curve is influenced by similar factors impacting Treasury yield curves but for shorter maturities.

Negotiable Certificates of Deposit (NCDs)

Definition

  • Issued by large commercial banks as a short-term funds source; minimum value: $100,000.
  • Maturity terms: 2 weeks to 1 year.
  • Available secondary market enhances liquidity.

Placement and Yield

  • Issuers either place NCDs directly or via correspondent institutions.
  • Yield forms through interest earned plus capital gains from differences in purchase and redemption prices.

Repurchase Agreements (Repos)

Overview

  • Involves one party selling securities to another with an agreement for repurchase.
  • Functions as a loan secured by the underlying securities, often involving financial institutions.
  • Market size approximates $4.5 trillion; transactions typically commence at $10 million.
  • Common maturities include 1 day to 15 days, and one, three, and six months.

Placement

  • Transactions occur via telecommunications networks, facilitated by dealers and repo brokers as intermediaries.

Federal Funds

Purpose

  • Allows depository institutions to borrow/lend short-term funds at the federal funds rate.
  • The Federal Reserve controls the supply affecting this rate; generally, it is slightly higher than the T-bill rate.

Banker’s Acceptances

Definition

  • A bank's commitment to a future payment, mainly for international trades.
  • Exporters can retain acceptances until payment but often sell them at a discount for immediate cash.

Market Dynamics

  • A secondary market exists for these acceptances due to their potential for discounting.

Institutional Use of Money Markets

Purpose

  • Financial institutions purchase money market securities for return while ensuring adequate liquidity.
  • Securities enhance liquidity through:
    • Cash generation from newly issued securities.
    • Cash from liquidated money market securities.
  • Institutions act as creditors in these transactions.

Valuation and Risk of Money Market Securities

Impact of Credit Risk Changes

  • Post-Lehman’s default, investors became wary of commercial paper, affecting funding availability.
  • The Emergency Economic Stabilization Act of 2008 stabilized markets, with the Fed buying commercial paper to bolster liquidity.
  • Risk premiums rise during uncertainty, leading to a flight to quality toward safer investments like T-bills.

Interest Rate Risk

  • If short-term interest rates rise, the required return on money market securities increases while their prices decrease.
  • Money market securities are less affected by interest rate changes than longer-term bonds.

Measuring Interest Rate Risk

  • Sensitivity analysis can help assess potential value changes in response to interest rate movements.

Globalization of Money Markets

Development

  • Money markets evolved internationally with increasing trade and financing in regions including Europe, Asia, and South America.
  • Fund flow between countries heightened due to tax differences, speculation on exchange rates, and reduced barriers for foreign investments.

Eurodollar Securities

  • Involves dollar deposits in Europe, including:
    • Eurodollar CDs: large dollar-denominated deposits accepted by banks in Europe.
    • Euronotes: short-term, bearer-form securities with common maturities (1, 3, 6 months).
    • Euro-commercial paper: issued without banking support, with tailored maturities.

International Interbank Market

  • Facilitates funds transfer between banks with differing liquidity situations.
  • The LIBOR Scandal of 2012 illustrates issues in rate reporting by banks in the interbank market.

Performance Measurement

  • Foreign money market securities are appraised by the effective yield, adjusted for exchange rate effects.

Additional Resources

  • Exhibits referenced throughout the chapter provide visual aids to support explanations and data interpretation regarding securities and market trends.