Prepared for Financial Markets and Institutions (TCHE401/TCH401E) – FTU 2024

In its 2016 annual report, Alphabet (Google) listed $58 billion in short-term securities on its balance sheet, plus
$14 billion in actual cash equivalents. Apple does not keep this in its local bank. But where?
This is, of course, this topic of chapter 11—Money Markets.
We review the money markets and the securities that are traded there. In addition, we discuss why the money
markets are important in our financial system. Topics include:
The Money Markets Defined
The Purpose of Money Markets
Who Participates in Money Markets?
Money Market Instruments
Comparing Money Market Securities
The term “money market” is a misnomer. Money (currency) is not actually traded in the money markets.
The securities in the money market are short term with high liquidity; therefore, they are close to being money.
Money Markets Defined
Usually sold in large denominations ($1,000,000 or more)
Low default risk
Mature in one year or less from their issue date, although most mature in less than 120 days
The banking industry should handle the needs for short-term.
Banks have an information advantage.
Banks, however, are heavily regulated.
Creates a distinct cost advantage for money markets over banks.
Reserve requirements create additional expense for banks that money markets do not have
Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets
When interest rates rose, depositors moved their money from banks to money markets.
The cost structure of banks limits their competitiveness to situations where their informational advantages
outweighs their regulatory costs.
Limits on interest banks could offer was not relevant until the 1950s. In the decades that followed, the problem became
apparent.
Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time
Borrowers from money market provide low-cost source of temporary funds
Corporations and U.S. government use these markets because the timing of cash inflows and outflows are not well
synchronized.
Money markets provide a way to solve these cash-timing problems.
Instrument Interest Rate (%)

Prime rate 3.50

Federal funds 0.37

Commercial Paper 0.55

London interbank offer rate 0.44

Eurodollar 0.48

Treasury bills (4 week) 0.24

We will discuss, in turn, each of the major borrowers and lenders in the money market.
First, let’s examine some of the current rates offered in the U.S. money markets.
Participant Role

U.S. Treasury Department Sells U.S. Treasury securities to

fund the national debt

Federal Reserve System Buys and sells U.S. Treasury

securities as its primary method
of controlling interest rates

Commercial banks Buy U.S. Treasury securities; sell

certificates of deposit and make
short-term loans; offer
individual investors accounts
that invest in money market
securities
Participant Role
Businesses Buy and sell various short-term
securities as a regular part of
their cash management
Investment companies (brokerage Trade on behalf of commercial
firms) accounts

Finance companies (commercial Lend funds to individuals

leasing companies)
Insurance companies (property and Maintain liquidity needed to
casualty insurance companies) meet unexpected
demands
Participant Role
Pension funds Sells U.S. Treasury securities to
fund the national debt

Individuals Buys and sells U.S. Treasury

securities as its primary method
of controlling interest rates

Money market mutual funds Allow small investors to

participate in the money market
by aggregating their funds to
invest in large-denomination
money market securities
We will examine each of these in the following slides:
Treasury Bills
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper
Banker’s Acceptance
Eurodollars
T-bills have 28-day maturities through 12- month maturities.
Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in
price provides a return. This is common to short-term securities because they often mature before the issuer can
mail out interest checks.
You pay $999.813 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate?
idiscount = (1,000 − 996.73) / 1,000 × 360/28
= 4.665%
You pay $999.813 for a 28-day T-bill. It is worth $1,000 at maturity. What is its investment rate?
iyt = (1,000 − 996.73) / 996.73 × 365/28 = 4.76%
Security Issue Maturity Discount Investment Price per CUSIP
Term Date Date Rate Rate $100

28 day 5/19/201 6/16/2016 0.240 0.243 99.981333 912796HX0

6
91 day 5/19/201 8/18/2016 0.275 0.279 99.930486 912796HA0
6

182 day 5/19/201 11/17/201 0.370 0.376 99.812944 912796JU4

6 6

28 day 5/19/201 6/9/2016 0.245 0.248 99.980944 912796HW2

6

91 day 5/19/201 8/11/2016 0.240 0.243 99.939333 912796JF7

6
T-bills are auctioned to the dealers every Thursday.
The Treasury may accept both competitive and noncompetitive bids, and the price everyone pays is the highest
yield paid to any accepted bid.
 The Treasury auctioned $2.5 billion par value
91-day T-bills, the following bids were received:

Bidder Bid Amount Bid Price

1 $500 million $0.9940
2 $750 million $0.9901
3 $1.5 billion $0.9925
4 $1 billion $0.9936
5 $600 million $0.9939

The Treasury also received $750 million in noncompetitive bids. Who

will receive T-bills, what quantity, and at what price?
 The Treasury accepts the following bids:

Bidder Bid Amount Bid Price

1 $500 million $0.9940
5 $600 million $0.9939
4 $650 million $0.9936

Both the competitive and noncompetitive bidders pay the highest

yield—based on the price of 0.9936:
In 1991, Salomon Smith Barney violated Treasury auction rules to corner the auction on an $11 billion issue.
Several top Salomon officials were forced to retire (or fired) as a result of the incident.
The Treasury also changed the auction rules to ensure a competitive auction.
Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day.
Used by banks to meet short-term needs to meet reserve requirements.
The next slide shows actual fed funds rates and T-bill rates 1990 through 2016.
Notice that the two rates track fairly closely. What does this suggest about the market for T-bills and the market for
fed funds?
These work similar to the market for fed funds, but nonbanks can participate.
A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a
certain price.
This set-up makes a repo agreements essentially a short-term collateralized loan.
This is one market the Fed may use to conduct its monetary policy, whereby the Fed purchases/sells Treasury
securities in the repo market.
A bank-issued security that documents a deposit and specifies the interest rate and the maturity date
Denominations range from $100,000 to $10 million
Unsecured promissory notes, issued by corporations, that mature in no more than
270 days.
The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.
Commercial paper volume:
fell significantly during the recent economic recession
annual market is still large, at well over $0.85 trillion outstanding
A special type of commercial paper, known as asset-backed commercial paper (ABCP)
played a key role in the financial crisis in 2008 backed by securitized mortgages
often difficult to understand
accounted for about $1 trillion

When the poor quality of the underlying assets was exposed, a run on ABCP began. Because ABCP was held by
many money market mutual funds (MMMFs), these funds also experienced a run. The government eventually had
to step in to prevent the collapse of the MMMF market.
An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually
delivery of promised goods.
These are often used when buyers / sellers of expensive goods live in different countries.
Exporter paid immediately
Exporter shielded from foreign exchange risk
Exporter does not have to assess the financial security of the importer
Importer’s bank guarantees payment
Crucial to international trade
As seen, banker’s acceptances avoid the need to establish the credit-worthiness of a customer living abroad.
There is also an active secondary market for banker’s acceptances until they mature. The terms of note indicate
that the bearer, whoever that is, will be paid upon maturity.
Eurodollars represent Dollar denominated deposits held in foreign banks.
The market is essential since many foreign contracts call for payment is U.S. dollars due to the stability of the
dollar, relative to other currencies.
The Eurodollar market has continued to grow rapidly because depositors receive a higher rate of return on a dollar
deposit in the Eurodollar market than in the domestic market.
Multinational banks are not subject to the same regulations restricting U.S. banks and because they are willing to
accept narrower spreads between the interest paid on deposits and the interest earned on loans.
London interbank bid rate (LIBID)
The rate paid by banks buying funds
London interbank offer rate (LIBOR)
The rate offered for sale of the funds
Time deposits with fixed maturities
Largest short term security in the world
The Eurodollar market is one of the most important financial markets, but oddly enough, it was fathered by the
Soviet Union.
In the 1950s, the USSR had accumulated large dollar deposits, but all were in US banks. They feared the US
might seize them, but still wanted dollars. So, the USSR transferred the dollars to European banks, creating the
Eurodollar market.
Liquidity is also an important feature, which is closely tied to the depth of the secondary market for the various
instruments.
Money Market Issuer Buyer Usual Maturity Secondary
Security Market
Treasury bills U.S. government Consumers and 4, 13, 26, and 52 Excellent
companies weeks
Federal funds Banks Banks 1 to 7 days None
Repurchase Businesses and Businesses and 1 to 15 days Good
agreements banks banks
Negotiable CDs Large money Businesses 14 to 120 days Good
center banks
Commercial Finance Businesses 1 to 270 days Poor
paper companies and
businesses
Banker’s Banks Businesses 30 to 180 days Good
acceptances
Eurodollar Non-U.S. banks Businesses, 1 day to 1 year Poor
deposits governments, and
banks
The Money Markets Defined
Short-term instruments
Most have a low default probability
The Purpose of Money Markets
Used to “warehouse” funds
Returns are low because of low risk and high liquidity
Who Participates in Money Markets?
U.S. Treasury
Commercial banks
Businesses
Individuals (through mutual funds)
Money Market Instruments
Include T-bills, fed funds, etc.
Comparing Money Market Securities
Issuers range from the US government to banks to large corporations
Mature in as little as 1 day to as long as 1 year
The secondary market liquidity varies substantially