Three Basic Characteristics

MONEY MARKETS
1. Low default risk
● the probability of non-payment is little to none so, we
Money Markets would also expect low returns knowing the
Markets where debt securities or instruments with maturities relationship between risk and returns.
of less than one year are traded ● Default risk is low because cash lent in the money
markets must be available for quick return to the
Money Markets vs Capital Markets lender.
● Money market instruments, therefore, are issued by
high-quality borrowers with outstanding credit ratings

2. Sold in large denominations

● This market denominates the securities in large sums
that is in millions
● This is to make the most of the transaction costs that
will be incurred again considering that the returns
here are usually low
● It practically prohibits individual investors from
participating in the primary issue of securities; rather,
their transactions are mostly done in the secondary
Why is it important? market.
Cash collection and cash disbursement patterns do not
necessarily coincide with each other. There will be times of 3. Short term maturity
deficit of cash and times of excess cash ● this is a market for instruments with short-term
maturities, lenders intend to get their money back in a
● As such there are times where a business would need short period
to borrow for a short time, and there are times where ● the borrowers intend to settle them in the same length
they would be interested in lending for a short time. In ● Since money markets have maturities of one year or
either case they can go to the money markets. less, changes in the value of the security is deemed
insignificant due to less risk involving changes in
Keeping unneeded cash as cash is costly because it incurs a short term interest rates.
lot of opportunity cost
● Opportunity cost is the foregone benefit of choosing Yields on money market securities
one alternative over another What is a yield?
● In this instance, if you leave cash as it is instead of ● A yield refers to the earnings generated and realized
investing it in the money markets, you are foregoing on an investment over a particular period of time,
the interest you could have earned from investing in expressed as a percentage based on the face value of
such instruments. the security or its purchase price.

Why invest in money markets? What are the different yields on money market securities?
● For users of funds, immediate cash needs of ● Since money market securities have maturities of one
individuals, corporations, and governments do not year or less, the issuer rarely pays interest directly to
necessarily coincide with their receipts of cash. the investor at a specified time.
● For suppliers of funds, excessive holdings of cash ● Yields received are based on different terms (e.g. 30
balance involve an opportunity cost. However, they days, 60 days, 120 days). Hence, it is difficult to
want to invest in financial securities that can be compare it with other debt instruments.
quickly converted into cash with insignificant loss in ● Annual yields are also computed based on different
value, and with minimal transaction costs. conventions (e.g. based on a 365-day year, based on a
● Money markets address the needs of both parties. 360-day year)
● Yields on money market instruments can either be
There are different money markets deducted in advance once these instruments are
● A market where the government is the debtor – the acquired (acquisition at a discount) or be paid in full
treasury bill market at maturity date, together with the related principal
● markets where businesses borrow – commercial (single payment).
paper markets ● However, in order to compare different money market
instruments with different yields and conventions,

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 their yield rates are converted into the bond
equivalent yield.
Relevant Calculations
Bond equivalent yield (BEY) 365 days
● simple rate of return stated on an annual basis (the
effect of compounding is not accounted here).
● 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. Bond equivalent yield vs discount yield
What are the differences between the bond equivalent yield
and the discount yield?

Effective annual return (EAR) 365 days

● considers the effect of compounding i.e. the
compounded annual rate of return
● The EAR is the true annual rate earned on the
CASE 1
investment.
Suppose you can purchase a total of P1 million in a Treasury
bill (T-bill) that is currently selling on a discount basis (i.e.,
with no explicit interest payments) at 98 percent of its face
value. The T-bill is 210 days from maturity (when the P1
million will be paid).

Example: Computing for the EAR

Converting id to ibe
To do an appropriate comparison of interest rates on discount
Discount yield (DY) 360 days and non-discount securities, adjusting for both base price and
● Instead of directly receiving interest payments from annual periods, the discount yield is converted to its bond
the issuer, the return on the security results from the equivalent yield as follows:
purchase of the security at a discount, which is the 𝑃𝑓 365
difference between the security’s face value (Pf) and 𝑖𝑏𝑒 = 𝑖𝑑𝑥 𝑃0
𝑥 360
its purchase price (P0 )
● the return expressed as a percentage discount of the Example: Converting id to ibe
face value (annual basis)
○ For securities that are sold on a discount
basis, there is no explicit interest rate
○ interest is hidden or imputed in the face
value since they are issued at below face
value amount
○ the difference would be your interest

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 Converting isp to ibe
Note: The effective annual return (EAR) is computed based
The single payment yield also uses the purchase price of the
on the bond equivalent yield (ibe)
security (P0 ) as the denominator in computing the annualized
interest rate. However, it is based on a 360-day period. The
It is important that in comparing the returns of each marketable single payment yield is converted to its bond equivalent yield
security, we ensure that we use a consistent basis for as follows:
comparison.
● Bond equivalent yield to bond equivalent deal or
discount yield to discount yield

Single payment yield — there are also securities with explicit

interest rates because this is a short-term security, interest is
paid once and only at the time of maturity Example 3: Converting isp to ibe

Single Payment Yield (SPY) 365

● For securities with an explicit interest rate
● This is a simple rate of return stated on an annual
basis (the effects of compounding is not accounted
for here).
○ this is just the same as the bond equivalent
yield except that we would use a convention
of 360 days instead
● The terminal payment consists of the interest plus the Note: The effective annual return (EAR) is computed based
face value of the security on the bond equivalent yield (ibe)

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).

CASE 2 Treasury Bills (T-Bills)

Suppose you can purchase a total of P1 million negotiable ● T-Bills are short-term debt obligations issued by the
certificate of deposit which is now 90 days from maturity. U.S. government.
The negotiable certificate of deposit has a quoted annual ● T-bills are virtually default risk free, are highly liquid,
interest rate of 3.50 percent for a 360-day year. 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”)

T-bill auctions
● 91-day, 182-day, and 364-day Treasury bills are offered
Effective annual return: by the Bureau of Treasury (BoTr) through an
● assume that the interest would also earn interest announcement every Monday.
● the effect of compounding should be incorporated ● Bids are submitted by government securities dealers,
financial and nonfinancial corporations, and
Remember, these securities are issued with low default risk, individuals.
short-term maturity less than one and denominated in a large ● Deadline for the submission of bids is the next
sum Monday, 1:00 PM.
● Delivery of securities to the awarded bids is every
Wednesday following the announcement of auction
results.

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Bids can be competitive or noncompetitive.
Example: Computing T-bill yield
● 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.

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. Example: Computing T-bill price
● Any bids with yields higher than the stop-out yield (or A Treasury bill’s price can be calculated from the yield
with lower bid prices) will be rejected. previously computed by rearranging the yield equation.
● 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.

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.

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.
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.
However, to do an appropriate comparison of interest rates
between T-bills and other treasury securities like Treasury Federal funds yields
bonds, the discount yield is converted to its bond equivalent Federal funds are single-payment loans as they pay interest
yield as follows: only once, at maturity.
𝑃𝑓 365
𝑖𝑏𝑒 = 𝑖𝑑𝑥 𝑃0
𝑥 360

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 ● Normally, the securities are repurchased by the
borrower of the loan at a higher price, the difference
representing interest on the funds borrowed.

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.
However, to do an appropriate comparison of interest rates ● The difference is called the ‘haircut’ which is used to
between fed funds and other treasury securities like Treasury protect the repo buyer from any market risk, or
bonds, the single payment yield is converted to its bond adverse changes in the market value of the securities
equivalent yield as follows: held as collateral.

Repurchase agreement yields

The yield on repurchase agreements (iRA ) are single payment
yields as follows:

Example: Converting isp to ibe (for federal funds)

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:
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 Example: Converting isp to ibe (for repurchase agreements)
rate?
● In case of contractionary monetary activities, what
should the central bank do on the target fed funds
rate?

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.
Commercial Paper
○ Funds may be transferred over FedWire
● Commercial Paper (CP) is unsecured short term
system.
corporate debt issued to raise short-term funds (e.g.,
○ If collateralized by risky assets, the repo may
for working capital).
involve a ‘haircut’.
● Generally sold in large denominations (e.g., $100,000
● Typical denominations on repos of one week or less
to $1 million) with maturities between 1 and 270 days.
are $25 million and longer term repos usually have
● CP is usually sold to investors indirectly through
$10 million denominations.
brokers and dealers.
● A reverse repurchase agreement is the purchase of a
● CP is usually held by investors until maturity and has
security with an agreement to sell it back in the future.
no active secondary market.

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 ● CP 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).

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. 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:

Example: Computing NCD yield

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:
𝑃𝑓 365
𝑖𝑏𝑒 = 𝑖𝑑𝑥 𝑃0
𝑥 360

Example: Computing CP yield

Commercial drafts
A commercial draft is a request or demand for payment on
behalf of the seller of the goods or services.

Negotiable certificates of deposit

● A negotiable certificate of deposit (CD) is a
bankissued, fixed maturity, interest-bearing time
deposit that specifies the interest rate and the
maturity date.
● CDs are bearer instruments and thus are salable in the Banker’s Acceptances
secondary market. ● A banker’s acceptance (BA) is a time draft payable to
● Denominations range from $100,000 to $10 million; a seller of goods, with payment guaranteed by a
$1 million being the most common. bank.
● Often purchased by money market mutual funds with ● Used in international trade transactions to finance
pools of funds from individual investors. trade in goods that have yet to be shipped from a
foreign exporter (seller) to a domestic importer
NCD yields (buyer).
The yield on negotiable certificates of deposit are single ● Foreign exporters prefer that banks act as payment
payment yields as follows: guarantors before sending goods to importers.
● Banker’s acceptances are bearer instruments and
thus are salable in secondary markets (meaning, it

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 can be sold by the seller of goods if it is in dire need Hence, the participants from the primary issue also create a
of cash) secondary market for these securities to allow individuals to
invest in smaller denominations.
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 International money markets
value to be received at maturity. ● 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.

However, to do an appropriate comparison of interest rates The London Interbank Offer Rate (LIBOR) is the rate on
between acceptances and other treasury securities like interbank loans between British banks, but it has become a
Treasury bonds, the discount yield is converted to its bond benchmark interest rate at which major global banks lend to
equivalent yield as follows: one another in the international interbank market for
𝑃𝑓 365 short-term loans.
𝑖𝑏𝑒 = 𝑖𝑑𝑥 𝑃0
𝑥 360
It is based on five currencies including the U.S. dollar, the euro,
the British pound, the Japanese yen, and the Swiss franc, and
Summary of yields of different money market securities
serves seven different maturities— overnight/spot next, one
week, and one, two, three, six, and 12 months

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
However, to do an appropriate comparison of interest rates Federal Reserve Bank’s actions as a result of implementing its
between these money market securities and other treasury monetary policy
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.

Money Market Participants

● The U.S. Treasury.
● The Federal Reserve.
● Commercial banks.
● Money market mutual funds.
● Brokers and dealers.
● Corporations.
● Other financial institutions.
● Individuals.

Since primary issues of money market securities are in large

denominations, it prevents individual investors from
participating.

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