Chapter Five

Money Markets

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Money Markets vs Capital Markets

MONEY MARKETS CAPITAL MARKETS

Primary and secondary markets Primary and secondary markets
for debt instruments with for debt instruments with
maturities of one year or less. maturities of more than one year,
and equity instruments.
Suppliers of funds can Suppliers of funds can invest
temporarily invest excess cash funds for a longer time horizon,
while maintaining its desired which involves its permanent
liquidity position. level of current assets.
Users of funds can gain access to Users of funds can gain access to
short-term credit for short-term long-term credit (often at a
financial planning (e.g. working significant amount) to raise
Ch. 1 2
capital management) money for business expansion.

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Why invest in money markets?
• For users of funds, immediate cash needs of
individuals, corporations, and governments do not
necessarily coincide with their receipts of cash.

• For suppliers of funds, excessive holdings of cash

balance involve an opportunity cost. However, they
want to invest in financial securities that can be
quickly converted into cash with insignificant loss in
value, and with minimal transaction costs.

Ch. 1 3
• Money markets address the needs of both parties.
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Characteristics of money markets
• Generally, sold in large denominations.

• Primary issues of money market instruments are often

denominated in large amounts ($1 million to $10
million).
• It practically prohibits individual investors from
participating in the primary issue of securities; rather,
their transactions are mostly done in the secondary
market.
• Primary markets (e.g. commercial banks) create a
secondary market for these money market instruments.
Ch. 1 4

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Characteristics of money markets
• Money market instruments have low default
risks.

• Default risk refers to the inability of the borrower to pay

its outstanding obligation (principal plus interest) at
maturity date.
• Default risk is low because cash lent in the money
markets must be available for quick return to the
lender.
• Money market instruments, therefore, are issued by
high-quality borrowers with outstanding credit ratings.
Ch. 1 5

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Characteristics of money markets

• Money market instruments have maturities of

one year or less.

• The longer the term, the greater the fluctuations in the

price of a security due to changes in interest rates.
• Since money markets have maturities of one year or
less, changes in the value of the security is deemed
insignificant due to less risk involving changes in short-
term interest rates.
Ch. 1 6

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Yields on money market securities

• What is a yield?

• A yield refers to the earnings generated and realized on

an investment over a particular period of time,
expressed as a percentage based on the face value of the
security or its purchase price.

Ch. 1 7

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Yields on money market securities
• What are the different yields on money market
securities?

• Since money market securities have maturities of one year or less,

the issuer rarely pays interest directly to the investor at a specified
time.

• Yields received are based on different terms (e.g. 30 days, 60 days,

120 days). Hence, it is difficult to compare it with other debt
instruments.

• Annual yields are also computed based on different conventions (e.g.

based on a 365-day year, based on a 360-day year) Ch. 1 8

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Yields on money market securities

• What are the different yields on money market securities?

• Yields on money market instruments can either be deducted

in advance once these instruments are acquired (acquisition at
a discount) or be paid in full at maturity date, together with
the related principal (single payment).

• However, in order to compare different money market

instruments with different yields and conventions, their yield
rates are converted into the bond equivalent yield.
Ch. 1 9

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Bond equivalent yield
• The bond equivalent yield (ibe), is the quoted nominal, or
stated yield on a security.

• It is the rate used to determine the present value of the

investment.

(Pf  P0 ) 365
ibe  
P0 n
Pf = the face value of the security
P0 = the purchase price of the security Ch. 1 10
n = the number of days until maturity
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Effective annual return
• The bond equivalent yield did not consider the impact of
compounding of interest during a less than a year
investment horizon.

• The EAR is the true annual rate earned on the investment.

365
  n
 ibe 
EAR   1  1
365 
 
 n 
Ch. 1 11

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Example 1: Computing for the EAR

Ch. 1 12

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Discount yields
• Instead of directly receiving interest payments from the
issuer, the return on the security results from the purchase
of the security at a discount, which is the difference
between the security’s face value (Pf) and its purchase price
(P0).

(Pf  P0 ) 360
id  
Pf n
Pf = the face value of the security
P0 = the purchase price of the security
n = the number of days until maturity Ch. 1 13

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Bond equivalent yield vs discount yield

• What are the differences between the bond equivalent yield

and the discount yield?

BOND EQUIVALENT YIELD DISCOUNT YIELD

Uses the purchase price of the Uses the face value of the
security (P0) as the denominator security (Pf) as the denominator
in computing the annualized in computing the annualized
interest rate. interest rate.
Uses a 365-day annual period. Uses a 360-day annual period.
A generally-used tool to compare
different types of debt
instruments. Ch. 1 14

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Converting id to ibe

• To do an appropriate comparison of interest rates on

discount and non-discount securities, adjusting for both
base price and annual periods, the discount yield is
converted to its bond equivalent yield as follows:

Ch. 1 15

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Example 2: Converting id to ibe

Ch. 1 16
Note: The effective annual return (EAR) is computed based on the bond equivalent
yield (ibe)
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Single payment yields
• Some money market instruments pay interest only once
during their lives: at maturity date.

• The terminal payment consists of the interest plus the face

value of the security.

(Pf  P0 ) 360
isp  
P0 n
Pf = the face value of the security
P0 = the purchase price of the security Ch. 1 17
n = the number of days until maturity
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Converting isp to ibe

• The single payment yield also uses the purchase price of

the security (P0) as the denominator in computing the
annualized interest rate. However, it is based on a 360-day
period. The single payment yield is converted to its bond
equivalent yield as follows:

 365 
ibe  isp  
 360 
Ch. 1 18

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Example 3: Converting isp to ibe

Ch. 1 19
Note: The effective annual return (EAR) is computed based on the bond equivalent
yield (ibe)
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 Types of money market instruments

• Treasury bills (T-bills).

• Federal funds (fed funds).
• Repurchase agreements (repos or R P).
• Commercial paper (C P).
• Negotiable certificates of deposit (C D).
• Banker’s acceptances (B A).

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 Treasury Bills (T-Bills)

• T-Bills are short-term debt obligations issued by the

U.S. government.
• T-bills are virtually default risk free, are highly liquid,
and have little interest rate risk.
• The Federal Reserve buys and sells T-bills to
implement monetary policy, through their open
market operations.
• Strong international demand for T-bills as safe haven
investment, especially after the 2008 global financial
crisis (“capital flight”)

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 T-bill auctions

• 91-day, 182-day, and 364-day Treasury bills are offered by the

Bureau of Treasury (BoTr) through an announcement every
Monday.

• Bids are submitted by government securities dealers,

financial and nonfinancial corporations, and individuals.

• Deadline for the submission of bids is the next Monday, 1:00

PM.

• Delivery of securities to the awarded bids is every Wednesday

following the announcement of auction results.

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 T-bill auctions

• Bids can be competitive or noncompetitive.

• Competitive bids specify the amount of par value of

bills desired and the discount yield, rather than the
price.
• The lower the yield, the higher the price (and vice-versa)
• Those with lower yields have superior bids. Why?

• Non-competitive bids accept the yield as determined

in the auction.

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 T-bill auctions

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 T-bill auctions

• What is the competitive bid stop-out yield?

• The stop-out yield is the highest accepted discount yield (or

the lowest accepted price) for the T-bills.
• Any bids with yields higher than the stop-out yield (or with
lower bid prices) will be rejected.
• Any bids with yields lower than the stop-out yield (or with
higher bid prices) will receive full allocation as specified in
their bids but at the stop-out price.
• Any bids with yields equal to the stop-out rate shall be
given proportional allocation after allotting full value on
superior bids.

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 T-bill auctions

• What is the competitive bid stop-out yield?

• The stop-out yield is the highest accepted discount yield (or

the lowest accepted price) for the T-bills.
• Any bids with yields higher than the stop-out yield (or with
lower bid prices) will be rejected.
• Any bids with yields lower than the stop-out yield (or with
higher bid prices) will receive full allocation as specified in
their bids but at the stop-out price.
• Any bids with yields equal to the stop-out rate shall be
given proportional allocation after allotting full value on
superior bids.

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 T-bill markets

• What are the different markets for T-bills?

• Primary dealers create a secondary market for T-bills by

buying and selling securities on their own account and by
trading for their customers.

• Secondary market T-bill transactions between government

securities dealers are conducted over the Federal Reserve’s
wire transfer service.

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 Treasury bill yields
• Treasury bills are sold on a discount basis.

• The return comes from the difference between the purchase

price paid for the T-Bill and the face value to be received at
maturity.

(Pf  P0 ) 360
id  
Pf n
Pf = the face value of the security
P0 = the purchase price of the security
n = the number of days until maturity

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 Treasury bill yields

• However, to do an appropriate comparison of interest rates

between T-bills and other treasury securities like Treasury
bonds, the discount yield is converted to its bond
equivalent yield as follows:

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 Example 4: Computing T-bill yield

Additional questions:

1. What is the bond equivalent yield? 0.258%

2. What is the effective annual return? 0.259%
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 Example 5: Computing T-bill price

• A Treasury bill’s price can be calculated from the yield

previously computed by rearranging the yield equation.

• If the price is based on the discount yield?

• If the price is based on the bond equivalent yield?

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 Example 5: Computing T-bill price

• Using the answers provided in Example 4:

• Discount yield = 0.255%

• Bond equivalent yield = 0.258%

Compute for the price of the T-bill:

• If based on the discount yield? $9,991.36

• If based on the bond equivalent yield? $9,991.38

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 Federal funds

• The federal funds (fed funds) rate is the target rate

in the conduct of monetary policy.
• Fed fund transactions are short-term (mostly
overnight) unsecured loans.
• Banks with excess reserves lend fed funds, while
banks with deficient reserves borrow fed funds.
• Multimillion dollar loans may be arranged in a
matter of minutes.

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 Federal funds yields

• Federal funds are single-payment loans as they pay

interest only once, at maturity.

(Pf  P0 ) 360
isp  
P0 n

Pf = the face value of the security

P0 = the purchase price of the security
n = the number of days until maturity

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 Federal funds yields

• However, to do an appropriate comparison of interest

rates between fed funds and other treasury securities
like Treasury bonds, the single payment yield is
converted to its bond equivalent yield as follows:

 365 
ibe  isp  
 360 

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 Example 6: Converting isp to ibe
(for federal funds)

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 How federal funds rate affect
monetary policy?

• One of the tools available for central banks to implement

its monetary policies is the discount rate, which is the
target federal funds rate.

• In case of expansionary monetary activities, what should

the central bank do on the target fed funds rate?

• In case of contractionary monetary activities, what should

the central bank do on the target fed funds rate?

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 Repurchase agreement

• A repurchase agreement (repo or RP) is the sale of a

security with an agreement to buy the security back
at a set price in the future.

• Repos are short-term collateralized loans (typical

collateral is U.S. Treasury securities).
• Similar to a fed fund loan, but collateralized.
• Funds may be transferred over FedWire system.
• If collateralized by risky assets, the repo may involve a
‘haircut’.

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 Repurchase agreement

• Typical denominations on repos of one week or less are $25

million and longer term repos usually have $10 million
denominations.

• A reverse repurchase agreement is the purchase of a

security with an agreement to sell it back in the future.

• Normally, the securities are repurchased by the borrower of

the loan at a higher price, the difference representing
interest on the funds borrowed.

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 Repurchase agreement

J.P. Morgan Bank of

Chase America

• Repo buyer • Repo seller

• Buyer of • Seller of
securities securities

• Lender in • Borrower in
the loan the loan
transaction transaction

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 How do “haircuts” work?

• Typically, in a repo agreement, the amount of loan

to be extended by the repo buyer (lender of funds)
to the repo seller (borrower of funds) is less than
the market value of the securities sold to the repo
buyer.

• The difference is called the ‘haircut’ which is used

to protect the repo buyer from any market risk, or
adverse changes in the market value of the
securities held as collateral.

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 Repurchase agreement yields

The yield on repurchase agreements (iRA) are

single payment yields as follows:

(Pf  P0 ) 360
irepo ,sp  
P0 n

Pf = the repurchase price of the security

P0 = the selling price of the security
n = the number of days until the repo matures

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 Repurchase agreement yields

• However, to do an appropriate comparison of interest

rates between repos and other treasury securities
like Treasury bonds, the single payment yield is
converted to its bond equivalent yield as follows:

 365 
ibe  isp  
 360 

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 Example 7: Converting isp to ibe
(for repurchase agreements)

Note: This is the nominal yield received or earned by the repo buyer, which is also the
buyer of the securities and the lender in the loan transaction.

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 Commercial Paper

• Commercial Paper (C P) is unsecured short-

term corporate debt issued to raise short-term
funds (e.g., for working capital).

• Generally sold in large denominations (e.g.,

$100,000 to $1 million) with maturities
between 1 and 270 days.

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 Commercial Paper

• C P is usually sold to investors indirectly

through brokers and dealers.

• C P is usually held by investors until maturity

and has no active secondary market.

• C P issued by firms with lower than prime

credit ratings often back their commercial
papers with letters of credit from its
commercial bank (serving as a guarantee for
the loan).
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 Commercial paper yields
• Commercial papers are sold on a discount basis.

• The return comes from the difference between the purchase

price paid for the commercial paper and the face value to
be received at maturity.

(Pf  P0 ) 360
id  
Pf n
Pf = the face value of the security
P0 = the purchase price of the security
n = the number of days until maturity

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 Commercial paper yields

• However, to do an appropriate comparison of interest rates

between commercial papers and other treasury securities
like Treasury bonds, the discount yield is converted to its
bond equivalent yield as follows:

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 Example 8: Computing CP yield

Note: The effective annual return (EAR) is computed based on the bond equivalent
yield (ibe)
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 Negotiable certificates of deposit

• A negotiable certificate of deposit (C D) is a bank-

issued, fixed maturity, interest-bearing time
deposit that specifies the interest rate and the
maturity date.
• C Ds are bearer instruments and thus are salable
in the secondary market.
• Denominations range from $100,000 to $10 million;
$1 million being the most common.
• Often purchased by money market mutual funds
with pools of funds from individual investors.

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 N C D yields

• The yield on negotiable certificates of deposit are

single payment yields as follows:

(Pf  P0 ) 360
isp  
P0 n

Pf = the face value of the security

P0 = the purchase price of the security
n = the number of days until maturity

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 N C D yields

• However, to do an appropriate comparison of interest

rates between NCDs and other treasury securities
like Treasury bonds, the single payment yield is
converted to its bond equivalent yield as follows:

 365 
ibe  isp  
 360 

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 Example 9: Computing NCD yield

Note: The effective annual return (EAR) is computed based on the bond equivalent
yield (ibe)
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 Commercial drafts

• A commercial draft is a request or demand for

payment on behalf of the seller of the goods or
services.
BASED ON TIME OF PAYMENT BASED ON WHO ACCEPTS
THE DRAFT
Sight draft – if the commercial Trade acceptance – if the buyer of
draft demands immediate the goods and services accepted
payment of goods and services. the commercial draft.
Time draft – if the commercial Banker’s acceptance – if the bank
draft specifies some future time accepted the commercial draft.
when the goods and services are
to be paid.

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 Banker’s Acceptances

• A banker’s acceptance (B A) is a time draft payable to a

seller of goods, with payment guaranteed by a bank.
• Used in international trade transactions to finance trade
in goods that have yet to be shipped from a foreign
exporter (seller) to a domestic importer (buyer).
• Foreign exporters prefer that banks act as payment
guarantors before sending goods to importers.
• Banker’s acceptances are bearer instruments and thus
are salable in secondary markets (meaning, it can be
sold by the seller of goods if it is in dire need of cash)

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 Banker’s acceptance yields
• Banker’s acceptances are sold on a discount basis.

• The return comes from the difference between the purchase

price paid for the acceptance and the face value to be
received at maturity.

(Pf  P0 ) 360
id  
Pf n
Pf = the face value of the security
P0 = the purchase price of the security
n = the number of days until maturity

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 Banker’s acceptance yields

• However, to do an appropriate comparison of interest rates

between acceptances and other treasury securities like
Treasury bonds, the discount yield is converted to its bond
equivalent yield as follows:

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 Summary of yields of different
money market securities
Money market security Type of yield
Treasury bills (T-bills) Discount yield
Federal funds (Fed funds) Single payment yield
Repurchase agreements (Repos) Single payment yield
Commercial papers (C P) Discount yield
Negotiable certificates of deposit Single payment yield
(N C D)
Banker’s acceptances (B A) Discount yield

• However, to do an appropriate comparison of interest rates between these

money market securities and other treasury securities like Treasury
bonds, the above yields are converted to its bond equivalent yield.

• The effective annual return is based on the bond equivalent yield.

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 Money Market Participants

• The U.S. Treasury.

• The Federal Reserve.
• Commercial banks.
• Money market mutual funds.
• Brokers and dealers.
• Corporations.
• Other financial institutions.
• Individuals.
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 Money Market Participants

• Since primary issues of money market

securities are in large denominations, it
prevents individual investors from
participating.

• Hence, the participants from the primary

issue also create a secondary market for
these securities to allow individuals to invest
in smaller denominations.

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 International money markets

• U.S. dollars held outside the U.S. (or called

Eurodollars) are tracked among multinational banks
in the Eurodollar market.
• The rate offered for sale on Eurodollar funds is the
London Interbank Offered Rate (L I B O R).
• Eurodollar Certificates of Deposit are U.S. dollar-
denominated CDs held in foreign banks.
• Eurocommercial paper (Euro-C P) is issued in Europe
and can be in local currencies or U.S. dollars.

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 International money markets

• The London Interbank Offer Rate (LIBOR) is the rate

on interbank loans between British banks, but it has
become a benchmark interest rate at which major
global banks lend to one another in the international
interbank market for short-term loans.

• It is based on five currencies including the U.S. dollar,

the euro, the British pound, the Japanese yen, and the
Swiss franc, and serves seven different maturities—
overnight/spot next, one week, and one, two, three, six,
and 12 months

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 International money markets

• The LIBOR and the US Fed funds rate are very closely
related as both are close substitutes for overnight
funding by banks around the world.

• However, Fed funds are generally lower than the

LIBOR because of two factors: (1) risks associated with
U.S. bank deposits are relatively lower; and (2) it is
affected by the Federal Reserve Bank’s actions as a
result of implementing its monetary policy.

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