Introduction to the Money Market

• The money market involves the buying and selling of short-term financial assets that mature in less than a year
• The money market focuses on liquidity and short-term financing.
• Capital markets deal with long-term investments, like stocks and bonds, unlike money markets.

Real-World Significance

• The money market enables businesses, governments, and financial institutions to manage short-term funding.
• It helps make sure there is liquidity in the financial system and impacts interest rates
• It is an important part of monetary policy
• Manage Daily Liquidity: Banks use the market to manage day-to-day liquidity needs
• Finance Budget Deficits: Governments issue treasury bills to finance budget deficits
• Working Capital: Corporations issue commercial paper to raise capital for operations

Key Segments of the Money Market

• The money market contains different segments, for serving specific needs

Deposits Market

• Banks and financial institutions lend to and borrow from each other for very short periods of time (overnight to a few months)
• Interbank interest rates, such as LIBOR and SARON (for CHF), are determined in the deposit market
• Example: A Swiss bank needing CHF 50 million overnight to meet withdrawal requests borrows from another bank at a rate that is negotiated

Government Short-Term Debt Market

• Governments issue treasury bills (T-bills) as short-term instruments to raise money
• Treasury bills are considered risk-free because governments back them
• Investors purchase T-bills at a discount and receive the full face value when they mature
• Example: An investor pays CHF 98,000 for a 3-month T-bill and receives CHF 100,000 at maturity, earning CHF 2,000

Repurchase Agreements (Repo Market)

• Repos are short-term loans where securities are sold with a promise to repurchase them later
• Repos are used by banks and financial institutions to manage short-term liquidity
• Repo rate is the interest that the lender earns
• Example: A Swiss bank sells CHF 1 million in bonds to another bank, agreeing to buy them back in 7 days for CHF 1.001 million; the interest is the extra CHF 1,000

Commercial Paper (CP) Market

• Large corporations issue commercial paper, a short-term debt, to fund operations
• Receivables back asset-backed commercial paper (ABCP)
• Unlike government securities, these instruments carry a higher risk
• Example: Nestle raises CHF 10 million for operational expenses by issuing a 90-day commercial paper with a 2% yield

Commercial Paper Historical Context

• The ABCP market collapsed during the 2007-08 financial crisis; institutions lost confidence in these securities, causing liquidity shortages

Secondary Market for Bonds

• Bonds that will mature in <1 year are traded
• Investors trade off their expectations of interest rates

Foreign Exchange Market (FX Market)

• Currency transactions with short maturities are parts of the FX money market
• A Swiss company may use the FX market to hedge against exchange rate fluctuations while waiting for USD payments next month

Special Types of Deposits in the Money Market

• Deposits Market includes Escrow and Dual Currency Deposits

Escrow (Fiduciary Deposit)

• Fixed-term deposits placed by Swiss banks for a client with a foreign bank
• Swiss tax authorities treat Escrow Deposits differently from domestic bank deposits

Escrow: Risk Consideration

• Clients bear the risk involved with counterparty (defaulting of foreign bank)
• Clients bear risk of fund being unable to transfer fund

Escrow Example

• A Swiss client deposits CHF 1 million in a German bank using a Swiss fiduciary arrangement

Dual Currency Deposit (DCD)

• Deposits in one currency where principal and interest may be repaid in another currency at a pre-agreed exchange rate

DCD: High Interest Rate

• This compensates for exchange rate risk

DCD: Investment Structure

• Customer cash flow is similar to having a fixed deposit and sells a foreign exchange
• The bank has the right to repay in either currency

DCD: Example

• A client deposits USD 100,000 in a DCD at a 5% interest rate; bank repays CHF instead of USD at maturity based on which rate is more favorable to the bank

Economic Role of the Money Market

• Serves two primary economic function

For Issuers (Borrowers)

• Money Market has a quick and cost-effective source of funding for the short term (less than 1 year)
• Used by banks, governments, and corporations to manage liquidity and operational expenses
• A Swiss corporation issues commercial paper for 3 months to help finance working capital

Investors (Lenders)

• Low-risk investment options that has a short-term maturity
• Provides liquidity while idle cash earns interest
• Bank invests in treasury bills for 90 days to safely store excess cash

Interest Calculation Conventions

• Interest on money market instruments Formula:
  • Interest Over t Days = Nominal * Rnom * (t / day Count Convention)
• Nominal = Loan or Deposit Amount
• Rnom = Annual interest rate
• T = Loan duration in Days
• Day Count Convention = 360 or 365, depending on currency

Day Count Conventions by Currency

• act/360 uses in EUR, USD, CHF, SEK, DKK, NOK, HUF, CZK
• act/365 uses in GBP, HKD, AUD, CAD, SGD, TWD, MYR, ZAR
• JPY uses act/365 for domestic transactions and act/360 for European markets

Example: USD Investment

• Investment Amount: USD 1,000,000; term: 6 months (182 days), interest rate: 2% and Act/360.
• Mr. Weber earns USD 10,111.11 interest over 6 months with Capital appreciation rate of 1.011% over 182 days

Benchmark Interest Rates Overview

• Benchmark interest rates are reference rates that are reflective of borrowing costs in the money market, and they are used to

  • Price financial contracts (mortgages, bonds, swaps and other derivatives)
  • Guide monetary policy as central banks adjust instruments to influence short-term benchmarks impacting the whole economy

• These are reported daily reflecting actual transactions, market quotes or a combination of the two

Why Benchmark Rates Matter

• They define the cost of money, where adjustments to the rates may impact trillions of loans globally
• They serve as monetary policy tools, adjustments signify changes to the key interest rates
• They reflect market conditions, as seen with rising LIBOR leading to shortages in liquidity

Categorizing Benchmark Rates

• How they are calculated
  • Transactions-based (SOFR, Federal Funds Rate, €STR)
  • Quotes-based (LIBOR, Euribor historically)
  • Mixed (SAR)
• Type of Loan
  • Secured (backed by Collateral: SOFR, SARON)
  • Unsecured (No Collateral: LIBOR, Euribor, Federal Funds)

LIBOR (London Interbank Offered Rate) - What It Is

• LIBOR was average interest rate leading banks used when borrowing from each other on an unsecured basis in 5 currencies with multiple maturities (1 Week, 1 Month, etc.)

LIBOR Calculation Methods

• Submission made from a panel of banks that would borrow at
• Data collected from Thomson Reuters

LIBOR Scandal and Phase Out

• 2008 LIBOR Scandal - Banks manipulated quotes to profit from derivatives
• This led to Reforms such as Waterfall Methodology that included:
  • Level 1 using Real transactions(VMAP)
  • Level 2 using Interpreted or Adjusted Historical Data
  • Level 3 Expert Judgement - if no data exists

LIBOR Timeline:

• Discontinued after 2021: EUR, CHF, JPY, GBP, and USD (1W and 2M)
• Discontinued after June 30, 2023: Remaining USD LIBORs
  • LIBOR was the reference rate for over $200 trillion across mortgages to corporate loans

EURIBOR (Euro Interbank Offered Rate)

• Like LIBOR, but specific to the Eurozone
• Reflects the rate at which banks lend each other Euros without collateral
  • Calculations gather quotes from an Active Eurozone bank
  • Calculation removes the Top/Bottom 15% and uses the average of middle rates
  • Similar to LIBOR it uses a Waterfall Approach
• Still in use as is the go-to reference for Euro-denominated floating rate Loans

Federal Funds Rate- What is is

• The average rate at which U.S Banks lend excess reserves to each other overnight and is

  • Unsecured Lending
  • Based on real transactions
  • Published by the Federal Reserve

• Used by the FED as primary monetary policy tool

• Influences by opening market operations, reserve requirements, and interest on reserves

SOFR (Secured Overnight Financing Rate) - What is it

• Transaction-based, secured benchmark that reflects the cost of overnight borrowing, collateralized w/U.S Treasury securities
  • Published daily by the New York Fed at 8:00 A.M
  • Based on Actual Repo Transactions
  • Main USD replacement for LIBOR due to transparency, trillions in daily repo activity and is harder to manipulate

Cons: No term structure, derivatives and Loans need more compounding formulas

Swiss Average Rates (SAR / SARON)

• Rates reflect secured borrowing in CHF, from real time repo transactions and quotes on SIX Repo LTD.
  • SARON = Swiss Average Rate Overnight
  • Collateral = Fixed income securities accepted by SNB
• Heavily Used as the benchmark for mortgages, floating rates and derivatives

Compound SARON Rate

• Interest calculated in arrears base on compounded daily SARON
• Formula includes daily SARON values and the amount of days applied

ΕΟΝΙΑ & €STR (Eurozone)

• EONIA stands ofr Euro Overnight Index Average and is
  • Based on overnight Unsecured interbank loans
  • Phased out in favor of €STR Volume-weighted average
  • Phased out in favor of €STR due to limited volume and quote-based issues

Euro Short-Term Rate

• Based exclusively on transactions, not quotes
• Published by ECB
• Volume-weighted trimmed mean (removes top/bottom 25% Volume
• Robust, Manipulation-resistant alternative to EONIA

Key Benchmarks: secured vs. unsecured, active vs. discontinued

• LIBOR: Unsecured; Discontinued
• EURIBOR: Unsecured; Active
• Fed Funds: Unsecured; Active
• SOFR: Secured; Replacing USD LIBOR
• SARON: Secured; Key CHF benchmark
• €STR: Unsecured; Replaced EONIA

Volume-Weighted Average Price (VWAP) What is is

• Volume Weighted Average Price - way to calculate the Average price of of assets or rates over a time frame giving heavier volume of prices that are involved.
• LIBOR Waterfall is used to determine the benchmark rate from a set of real transactions
• Formula: VWAP = Σ(ri * vi) / Σvi
  • Where ri is the rate of all transactions and vi is the volumes in each transaction

SARON Compounded Rate Formula

• Because SARON is an Overnight Rate, when lending or borrowing for longer periods, needs compounded rates to reflect the time value of money to make it more accurate
• Formula: SARON Compound Rate Where:
  • r i ​ = daily SARON rate for day i
  • a i ​ = # of calendar days for which r i ​
  • B d ​ = # of business days in the observation window
  • n = total # of calendar days in the observation window
• Formula: SARON Compound Rate= (1+ri*ai/360) ^ 360/n - 1

Act/360 for Calculations

• Most Money market conventions (CHF, USD, EUR) and act/360 standardizes calculations accross different months

Euro STR Trimmed Mean

• Process for removing outliers:
  1. Order all reported transaction rates
  2. Trim the top and bottom 25% by Volume
  3. Average the remaining 50 to get the heart of the market

Price Quotations

• Money Market are Mostly zero coupon meaning they dont pay periodic interest
• Instead they are at a discount in face value and repaid in full maturity

Quoting Conventions

• Discount Yield Quotation - US T-Bills
• Price Quotation - Swiss Confederation Registered Claims
  • These show the return of rates to price

Discount Yield Quotation

• Expresses as the the Face Value not amount invested

Price Quotation from Discount Yield

• Price quotation of investments pay up front by subtracting the discount

Investment Yield or Bond Equivalent Yield

• is the actual return value earned relative to amount invested to face value creating an accurate comparisson
• This is used when instruments are deeply discounted and time periods are short

Term Yields

• Instruments are deeply discounted when undersating discount yield
• Discount is based on face value by dealers and issuers

Remember: Ask price > bid price and Ask yield < Bid yield and learn to convert between Yield and price using the given formulas, also, For instruments less than 1 year, use 360

Repurchase Agreements (Repo)

• Repos is short term collateralized loan disguised as 2 legal transactions: spot and foward.

Spot Leg

• One party sells security for cash

Forward Leg

• Seller buys back securities later at a higher price
• The person buying earns interest in repo rate
  • Secured loan or spot sale with forward repurchase of the security

Repos Benefits and Risks

Collateral is not pledged it is transferred. Collateral receivers benefit from dividends

Reverse Repo

From buyers perspective, transaction is the same as reverse repo. Lender provides cash and earns cash back plus plus interest

Bond Collateral Info

• Clean vs Dirty price, value the buyer must pay if the bond is trading mid coupon period.

1. Bond collateral info,

   • Clean: 101.5%
   • Coupon: 2.5%
   • Accrued: 0.625% aka 2.5% * 90/360
   • Dirty: 101.5+0.625 = 102.125%

2. Determine Nominal Number of Bonds:

   • One has collateral of dirty price which receives 979,192

3. Apply Haircut

   • to protect against market volatility; used for if there is 2% then required number
   • 979192 * 1+0.02 = 998, 775 rounding to nearest being 999,000

4. Interest on the Reverse Repo: if one is earning interest on the loan

   • 1,000,000 * (1+0.015 *30 /360) = 1.001,250

Repos Daily Collateral Valuation

• Bond price can fluctuate in 2 forms with daily collateral revaluation
  1. Fall Below: Margin Calls
  2. Rise Above: Margin Call for Buyer
  • Ensures loan is secured

Types of Collateral in the Repo Market

1. General Collateral- liquid high quality securities
2. Specific Collateral Agreement by Buyer and Seller on what bonded is named
3. Special collateral-Bond in high demand. Trades might pay to be able to loan that given bond in a repo

Key repo rates

• Repo = Secured loan in disguise,
• Haircuts Protect the lender,
• GC vs SC influences rates significantly
• Clean Price = accured interest

Market Organization (Primary Markets, Secondary Markets)

• Transactions use the Act/360 convention and repos equal secured loan with collateral secured at maturity. 1.8 Org:
  1. Primary-New instruments introduced, issuers include the
  • Governments: T-bill and action via agents
  • Corporations: commercial paper being brokered by other agencies
  • Repos: banks OTC bilateral agencies

Order Submissions

• Auctions via limit orders expressed 1.As Discounts

2. As Face Prices

CP (commercial Paper)

• Have high min denominations: only for well connected institutional groups
• Repo agreements are under GMRA 1.7 Secondary Market: the issued money markets
  1. Govt: t bills etc trade on OTC spots
  2. Liquidity -instrument and jurisdiction

Calculation and Payment of Interest

Instrument Calculations

• Periodic Accrual, Periodic Agreed

Taxation of the Repo

1)Zero coupon bought at par. 2) Interest price base in rate deposits and Repos 3) Repos for collateral: value fluctuates and need margin calls

• At begin, instrument - cash placed at 2:00, subscription placed etc
• TOM Next

1. reverse or t + 1
2. During- notice periods periodic or reversed periodic
3. During sales with bills

Key Notes About Repo

1. Settlements are vital
2. Market depends a lot on flow and access to cash

Investment Constraints and Risks

4.7 model between client financial institutions. Client profile and understanding - investor stays in the mandate. Legal for low vs ethical . Disclosure and understand constraints.

A. Risks

1. Credit/issuer risk: failure to to deliver as promised
2. Collateral Risk, - that the collateral doesn't actually cover the underlying risks, - Legal Risk = risk of getting sued

Key Terms to Know

1. Reverse repos: require marginal calls
2. Repo has no stem duty
3. All risk types: maximum loss-structuring collateral

• Max loss varies and DCD is short based currency and SIV /ABCP in context

4. Tax risk, liquidity , Legal
5. Country Risk blends all the risk types