60 Questions
What are the characteristics of securities in money markets?
High liquidity, large denominations, low default risk, and short time to maturity
Why do money markets have a distinct cost advantage over banks?
Banks have reserve requirements and interest rate regulations
What is the purpose of money markets for investors?
A place for warehousing surplus funds for short periods of time
Why do corporations and the US use money markets?
To solve cash-timing problems due to unsynchronized cash inflows and outflows
What was the trend of the 3-month T-bill rate in the 40s and 50s?
Very low
What happened to people's behavior when interest rates rose?
They moved to money markets for higher returns
What are the characteristics of borrowers from money markets?
They seek low-cost temporary funds
Which money market instrument involves bank-issued securities documenting a deposit and specifying the interest rate and maturity date?
Negotiable certificates of deposit
What is the typical range of maturities for Treasury bills?
28 days to 12 months
Which entity controls interest rates through open-market operations?
Federal Reserve System
What is the primary function of federal funds in the money market?
To meet reserve requirements for banks
What does expansionary monetary policy involve?
Buying government securities in the bond/money market
What was the primary factor influencing the collapse of Lehman Brothers?
High repo haircuts
What did the LIBOR scandal impact?
The cost of mortgages and loans
What is the primary function of Commercial Paper?
To provide short-term financing for corporations
What was the role of Asset-backed commercial paper (ABCP) in the 2008 financial crisis?
It led to a run on ABCPs and played a key role in the crisis
What is the main purpose of securitization?
To turn non-tradable financial contracts into tradable instruments
What is the primary function of Commercial Mortgage Backed Securities (CMBS)?
To allow banks to earn money by pooling mortgages and selling them to SPVs
What is maturity transformation, and why is it considered risky?
It involves using short-term deposits for long-term loans, posing risk due to potential mismatch in interest rates
What was the outcome of Money Market Mutual Funds (MMMFs) investing in ABCPs during the 2008 crisis?
It led to liquidity problems when the housing market trust decreased
What is the significance of Banker's Acceptances in international trade?
They are important for international trade, allowing for contingent payments and an active secondary market until maturity
What is the main purpose of money markets?
To provide a low-cost source of funds for short-term funding.
Why are Eurodollars considered short-term financing instruments?
They have maturities ranging from 1 day to 1 year.
What is the formula for calculating the annualized discount rate for a T-bill purchased for $10,000 maturing in 270 days and sold for $9,360?
$\left(\frac{F-P}{F}\right) \times \frac{360}{n}$
What is the main advantage of negotiable certificates of deposit for businesses?
High liquidity and easy buy/sell options.
In a T-bill auction with a par value of $2.1 billion for 91-day T-bills, who will get the bills if only competitive bids are accepted?
Bidders offering the highest price (lowest yield).
Why are banker's acceptances considered ideal for foreign transactions?
They provide assurance of payment from reputable banks.
What is the London Interbank Offered Rate (LIBOR) based on?
Estimates submitted by leading banks in London.
What is the primary reason for the creation of the Eurodollar market?
To prevent potential seizure of US dollar deposits by the US government.
What makes commercial paper a short-term financing option for businesses and finance companies?
It has maturities of up to 207 days.
What is the typical maturity range for securities in money markets?
1 year or less
What creates additional expenses for banks in handling short-term loans and deposits?
Reserve requirements
Why did people move to money markets in the 70s and 80s when interest rates rose?
For higher return
What is the primary purpose of money markets for investors?
Warehousing surplus funds for short periods
What are the characteristics of borrowers from money markets?
Low-cost source of temporary funds
What was the trend of the 3-month T-bill rate in the 40s and 50s?
Very low
Why do corporations and the US use money markets?
For timing of cash inflows and outflows
What is the primary function of Asset-backed commercial paper (ABCP) in the money market?
Providing short-term financing for companies
What is the main purpose of securitization in the context of money markets?
Turning non-tradable financial contracts into tradable instruments
What was the outcome of Money Market Mutual Funds (MMMFs) investing in ABCPs during the 2008 crisis?
Liquidity problems when the housing market trust decreased
What is the typical range of maturities for Treasury bills?
28 days to 12 months
What is the significance of Banker's Acceptances in international trade?
Allowing for contingent payments and an active secondary market until maturity
What is the primary function of repurchase agreements in the money market?
Conducting monetary policy by buying/selling Treasuries
What is the primary function of Commercial Paper in the money market?
Providing short-term financing for companies
What was the main impact of the LIBOR scandal?
Influencing the cost of mortgages and loans
What was the role of Commercial Mortgage Backed Securities (CMBS) in the 2008 financial crisis?
Another way for banks to earn money by pooling mortgages and selling them to SPVs
What is the primary reason for the collapse of Lehman Brothers?
High repo haircuts
What is the primary reason for the lack of trust in Money Market Mutual Funds (MMMFs) after the 2008 crisis?
The Reserve Primary Fund breaking the buck in 2008
What is the primary function of negotiable certificates of deposit in the money market?
Documenting a deposit and specifying the interest rate and maturity date
What is the main purpose of federal funds in the money market?
Short-term funds transferred between financial institutions
What is the key function of the Federal Reserve in controlling interest rates?
Open-market operations
Which of the following money market securities is issued by non-US banks?
Negotiable Certificates of Deposits
What is the main advantage of negotiable certificates of deposit for businesses?
Easy to buy and sell
What is the typical range of maturities for Eurodollars?
Up to 1 year
What is the formula for calculating the annualized discount rate for a T-bill purchased for $10,000 maturing in 270 days and sold for $9,360?
$\frac{(F-P)}{F} \times \frac{360}{n}$
What is the main purpose of money markets for investors?
Low-risk, short-term investment options
What is the primary function of Commercial Paper in the money market?
Short-term financing for businesses and finance companies
What is the main reason for the creation of the Eurodollar market?
To avoid US regulations on interest rates
What was the trend of the 3-month T-bill rate in the 40s and 50s?
Steadily decreasing
What is the main advantage of Banker's Acceptances for foreign transactions?
Reduced risk of non-payment in international trade
Study Notes
Money Market Instruments and the 2008 Financial Crisis
- Libor rates were manipulated by banks, including Barclays, with encouragement from the Bank of England
- Commercial Paper is unsecured short-term debt sold directly to investors, with a significant increase in use in the early 1980s
- Asset-backed commercial paper played a key role in the 2008 financial crisis, leading to a run on ABCPs
- Securitization involves turning non-tradable financial contracts into tradable instruments, such as ABCPs
- Commercial Mortgage Backed Securities (CMBS) is another way for banks to earn money by pooling mortgages and selling them to SPVs
- Maturity transformation, the act of banks using short-term deposits for long-term loans, is risky and was a factor in the 2008 crisis
- Diversification did not work well after 2008, as the complexity and lack of understanding led to a run on ABCPs
- Banks issued bad loans and made money with fees, transferring risk to investors
- The 2008 crisis was caused by bad loans, maturity transformation, wrong pricing models, and the failure of diversification
- Money Market Mutual Funds invested in ABCPs, leading to liquidity problems when the housing market trust decreased
- The Reserve Primary Fund breaking the buck in 2008 led to a lack of trust in MMMFs and problems for the real economy
- Banker's Acceptances are important for international trade, allowing for contingent payments, and an active secondary market until maturity
Money Market Instruments and Functions
- Money market instruments include stocks, bonds, cash, and short-term instruments like Treasury bills, federal funds, commercial paper, LIBOR, Eurodollar, and repurchase agreements
- Key participants in money markets include the US Treasury Department, the Federal Reserve System, commercial banks, businesses, investment companies, finance companies, and insurance companies
- The Federal Reserve controls interest rates through open-market operations, with the current target interest rate around 5.25-5.5%
- Expansionary monetary policy involves the Fed buying government securities in the bond/money market, increasing the money supply and lowering interest rates
- Treasury bills have maturities ranging from 28 days to 12 months and are commonly discounted, providing a return through capital appreciation
- Treasury bills are auctioned to dealers every Thursday, with both competitive and non-competitive bids influencing the price paid, and the interest rate on T-bills is typically close to the inflation rate
- Federal funds are short-term funds transferred between financial institutions, usually for one day, and are used by banks to meet reserve requirements
- Repurchase agreements are similar to the federal funds market but involve nonbanks, with the Fed using this market to conduct monetary policy by buying/selling Treasuries
- The collapse of Lehman Brothers was influenced by high repo haircuts, which resulted in the firm not being able to get enough cash
- Negotiable certificates of deposit are bank-issued securities that document a deposit and specify the interest rate and maturity date, with maturities typically between 1 and 4 months
- The LIBOR scandal involved banks estimating how much interest they would have to pay to borrow cash, impacting the cost of mortgages and loans
- The LIBOR scandal led to government intervention to save banks and revealed the impact of borrowing costs on the financial sector
Test your knowledge of money market instruments and their role in the 2008 financial crisis with this quiz. Explore concepts such as Libor rates, commercial paper, asset-backed commercial paper, securitization, commercial mortgage backed securities, maturity transformation, diversification, bad loans, money market mutual funds, and banker's acceptances.
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