The Money Markets PDF

PART 5 FINANCIAL MARKETS 11 CHAPTER...

PART 5 FINANCIAL MARKETS 11 CHAPTER The Money Markets PREVIEW If you were to review the annual report of Alphabet have become much more important since 1970, (holding company for Google) for 2016, you would when interest rates rose above historic levels. In find that the company had over $14 billion in fact, the rise in short-term rates, coupled with a cash. The firm also listed $58 billion in short-term regulated ceiling on the rate that banks could pay securities. The firm chose to hold over $72 billion for deposits, resulted in a rapid outflow of funds in highly liquid short-term assets in order to be from financial institutions in the late 1970s and ready to take advantage of investment opportunities early 1980s. This outflow caused many banks and and to avoid the risks associated with other types savings and loans to fail. The industry regained of investments. Alphabet will have much of these its health only after massive changes were made funds invested in the money markets. Recall that to bank regulations with regard to money market money market securities are short-term, low-risk, interest rates. and very liquid. Because of the high degree of This chapter carefully reviews the money mar- safety and liquidity these securities exhibit, they are kets and the securities that are traded there. In close to being money, hence their name. The money addition, we discuss why the money markets are markets have been active since the early 1800s but important to our financial system. 285 M11_MISH5006_09_GE_C11.indd 285 17/10/17 2:25 PM  286 PART 5 Financial Markets The Money Markets Defined The term money market is actually a misnomer. Money—currency—is not traded in the money markets. Because the securities that do trade there are short-term and highly liquid, however, they are close to being money. Money market securities, which are discussed in detail here, have three basic characteristics in common: They are usually sold in large denominations. They have low default risk. They mature in one year or less from their original issue date. Most money market instruments mature in less than 120 days. Money market transactions do not take place in any one particular location or building. Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically. Because of this characteristic, money market securities usually have an active secondary market. This means that after the security has been sold initially, it is relatively easy to find buyers who will purchase it in the future. An active secondary market makes money market securities very flexible instruments to use to fill short-term financial needs. For example, Microsoft’s annual report states, “We consider all highly liquid interest-earning invest- ments with a maturity of 3 months or less at date of purchase to be cash equivalents.”* Another characteristic of the money markets is that they are wholesale markets. This means that most transactions are very large, usually in excess of $1 million. The size of these transactions prevents most individual investors from par- ticipating directly in the money markets. Instead, dealers and brokers, operating in the trading rooms of large banks and brokerage houses, bring customers together. These traders will buy or sell $50 or $100 million in mere seconds—certainly not a job for the faint of heart! As you may recall from Chapter 2, flexibility and innovation are two important characteristics of any financial market, and the money markets are no exception. Despite the wholesale nature of the money market, innovative securities and trading methods have been developed to give small investors access to money market secu- rities. We will discuss these securities and their characteristics later in the chapter, and again in Chapter 20, where we show how they are used by the mutual fund industry. Why Do We Need the Money Markets? In a totally unregulated world, the money markets should not be needed. The bank- ing industry exists primarily to provide short-term loans and to accept short-term deposits. Banks should have an efficiency advantage in gathering information, an advantage that should eliminate the need for the money markets. Thanks to con- tinuing relationships with customers, banks should be able to offer loans more cheaply than diversified markets, which must evaluate each borrower every time a new security is offered. Furthermore, short-term securities offered for sale in the money markets are neither as liquid nor as safe as deposits placed in banks and thrifts. Given the advantages that banks have, why do the money markets exist at all? * Excerpt from Accounting Policies, Microsoft Corporation 2012 Annual Report. Published by Microsoft Corporation, © 2012. M11_MISH5006_09_GE_C11.indd 286 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 287 The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service. However, the banking industry is subject to more regulations and governmental costs than are the money markets. In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds. Money Market Cost Advantages Interest-rate regulations were a competitive obstacle for banks. One of the principal purposes of the banking regulations of the 1930s was to reduce competition among banks. Regulators felt that with less competition banks were less likely to fail. The cost to consumers of the greater profits banks earned because of the lack of free market competition was justified by the greater economic stability that a healthy banking system would provide. One way that banking profits were ensured was by regulations that set a ceiling on the rate of interest that banks could pay for funds, known as Regulation Q. The Glass-Steagall Act of 1933 prohibited payment of interest on checking accounts and limited the interest that could be paid on time deposits. The limits on interest rates were not particularly relevant until the late 1950s. Figure 11.1 shows that the limits became especially troublesome to banks in the late 1970s and early 1980s when inflation pushed short-term interest rates above the level that banks could Percent 16 3-Month Treasury Bill Rate 14 12 10 8 6 Ceiling Rate on Savings Deposits at Commercial Banks 4 2 0 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 Year FIGURE 11.1 T  hree-Month Treasury Bill Rate and Ceiling Rate on Savings Deposits at Commercial Banks, 1933 to 1986 Source: http://www.stlouisfed.org/default.cfm.  288 PART 5 Financial Markets legally pay. Investors pulled their money out of banks and put it into money market security accounts offered by many brokerage firms. These new investors caused the money markets to grow rapidly. Commercial bank interest-rate ceilings were removed in March 1986, but by then the retail money markets were well estab- lished. Banks continue to provide valuable intermediation, as we will see in several later chapters. In some situations, however, the cost structure of the banking indus- try makes it unable to compete effectively in the market for short-term funds against the less restricted money markets. The Purpose of the Money Markets The well-developed secondary market for money market instruments makes the money market an ideal place for a firm or financial institution to “warehouse” sur- plus funds until they are needed. Similarly, the money markets provide a low-cost source of funds to firms, the government, and intermediaries that need a short-term infusion of funds. The goal of most investors in the money market who are temporarily warehous- ing funds is not to earn particularly high returns on their funds. Rather, they use the money market as an interim investment that provides a higher return than holding cash or money in banks. They may feel that market conditions are not right to war- rant the purchase of additional stock, or they may expect interest rates to rise and hence not want to purchase bonds. It is important to keep in mind that holding idle surplus cash is expensive for an investor because cash balances earn no income for the owner. Idle cash represents an opportunity cost in terms of lost interest income. Recall from Chapter 4 that an asset’s opportunity cost is the amount of interest sacrificed by not holding an alternative asset. The money markets provide a means to invest idle funds and to reduce this opportunity cost. Investment advisers often hold some funds in the money market so that they will be able to act quickly to take advantage of investment opportunities they might identify. Most investment funds and financial intermediaries also hold money mar- ket securities to meet investment or deposit outflows. The sellers of money market securities find that the money market provides a low-cost source of temporary funds. Table 11.1 shows the interest rates available on a variety of money market instruments sold by different firms and institutions. For example, banks may borrow excess reserves (we will define the money market secu- rities later in this chapter) to obtain funds in the money market to meet short-term reserve requirement shortages. The government funds a large portion of the U.S. debt with Treasury bills. Finance companies like GMAC (General Motors Acceptance Company) may enter the money market to raise the funds that it uses to make car loans.1 Why do corporations and the U.S. government sometimes need to get their hands on funds quickly? The primary reason is that cash inflows and outflows are rarely synchronized. Government tax revenues, for example, usually come only at certain times of the year, but expenses are incurred all year long. The government can borrow short-term funds that it will pay back when it receives tax revenues. 1 GMAC was once a wholly owned subsidiary of General Motors that provided financing options exclu- sively for GM car buyers. In December 2008 it became an independent bank holding company. M11_MISH5006_09_GE_C11.indd 288 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 289 TABLE 11.1 Sample Money Market Rates, May 13, 2016 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 Source: Federal Reserve Statistical Bulletin, http://www.federalreserve.gov/releases/h15/data.htm and Libor: http://www.fedprimerate.com/libor/libor_rates_history.htm. Businesses also face problems caused by revenues and expenses occurring at differ- ent times. The money markets provide an efficient, low-cost way of solving these problems. Who Participates in the Money Markets? An obvious way to discuss the players in the money market would be to list those who borrow and those who lend. The problem with this approach is that most money market participants operate on both sides of the market. For example, any large bank will borrow aggressively in the money market by selling large commercial CDs. At the same time, it will lend short-term funds to businesses through its commercial lending departments. Nevertheless, we can identify the primary money market players—the U.S. Treasury, the Federal Reserve System, commercial banks, busi- nesses, investments and securities firms, and individuals—and discuss their roles (summarized in Table 11.2). U.S. Treasury Department The U.S. Treasury Department is unique because it is always a demander of money market funds and never a supplier. The U.S. Treasury is the largest of all money market borrowers worldwide. It issues Treasury bills (often called T-bills) and other securities that are popular with other money market participants. Short-term issues enable the government to raise funds until tax revenues are received. The Treasury also issues T-bills to replace maturing issues. Federal Reserve System The Fed holds vast quantities of Treasury securities that it sells if it believes interest rates should be raised. Similarly, the Fed will purchase Treasury securities if it believes interest rates should be lowered. The Fed’s responsibility for interest rates makes it the most influential participant in the U.S. money market. The Federal Reserve’s role in controlling the economy through open market operations was dis- cussed in detail in Chapters 9 and 10.  290 PART 5 Financial Markets TABLE 11.2 Money Market Participants 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 Businesses Buy and sell various short-term securities as a regular part of their cash management Investment companies (brokerage Trade on behalf of commercial accounts firms) Finance companies (commercial Lend funds to individuals leasing companies) Insurance companies (property and Maintain liquidity needed to meet unexpected casualty insurance companies) demands Pension funds Maintain funds in money market instruments in readiness for investment in stocks and bonds Individuals Buy money market mutual funds 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 Commercial Banks Commercial banks hold a percentage of U.S. government securities second only to pension funds. This is partly because of regulations that limit the investment opportunities available to banks. Specifically, banks are prohibited from owning risky securities, such as stocks or corporate bonds. There are no restrictions against holding Treasury securities because of their low risk and high liquidity. Banks are also the major issuer of negotiable certificates of deposit (CDs), bank- er’s acceptances, federal funds, and repurchase agreements (we will discuss these securities in the next section). In addition to using money market securities to help manage their own liquidity, many banks trade on behalf of their customers. Not all commercial banks deal in the secondary money market for their custom- ers. The ones that do are among the largest in the country and are often referred to as money center banks. The biggest money center banks include Citigroup, Bank of America, J.P. Morgan, and Wells Fargo. Businesses Many businesses buy and sell securities in the money markets. Such activity is usually limited to major corporations because of the large dollar amounts involved. M11_MISH5006_09_GE_C11.indd 290 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 291 As discussed earlier, the money markets are used extensively by businesses both to warehouse surplus funds and to raise short-term funds. We will discuss the specific money market securities that businesses issue later in this chapter. Investment and Securities Firms The other financial institutions that participate in the money markets are listed in Table 11.2. Investment Companies Large diversified brokerage firms are active in the money markets. The largest of these include Bank of America, Merrill Lynch, Barclays Capital, Credit Suisse, and Goldman Sachs. The primary function of these dealers is to “make a market” for money market securities by maintaining an inventory from which to buy or sell. These firms are very important to the liquidity of the money market because they ensure that sellers can readily market their securities. We discuss investment companies in Chapter 22. Finance Companies Finance companies raise funds in the money markets primarily by selling commercial paper. They then lend the funds to consumers for the purchase of durable goods such as cars, boats, and home improvements. Finance companies and related firms are discussed in Chapter 27 (on the Web at www.pearsonglobaleditions.com/Mishkin). Insurance Companies Property and casualty insurance companies must maintain liquidity because of their unpredictable need for funds. For example, when tornadoes and flooding hit the Midwest in December 2015, more than 1,000 homes were destroyed and 50 lives lost. Insurance companies paid out over a billion dollars in benefits to policyholders. To meet this demand for funds, the insurance companies sold some of their money market securities to raise cash. Insurance companies are discussed in Chapter 21. Pension Funds Pension funds invest a portion of their cash in the money markets so that they can take advantage of investment opportunities that they may identify in the stock or bond markets. Like insurance companies, pension funds must have sufficient liquidity to meet their obligations. However, because their obligations are reasonably predictable, large money market security holdings are unnecessary. Pension funds are discussed in Chapter 21. Individuals When inflation rose in the late 1970s, the interest rates that banks were offering on deposits became unattractive to individual investors. At this same time, brokerage houses began promoting money market mutual funds, which paid much higher rates. Due to regulations that capped the rate they could pay on deposits, banks could not stop large amounts of cash from moving to mutual funds. To combat this flight of money from banks, the authorities revised the regulations. Banks quickly raised rates in an attempt to recapture individual investors’ dollars. This halted the rapid movement of funds, but money market mutual funds remain a popular individual investment option. The advantage of mutual funds is that they give investors with relatively small amounts of cash access to large-denomination securities.  292 PART 5 Financial Markets Money Market Instruments A variety of money market instruments are available to meet the diverse needs of market participants. One security will be perfect for one investor; a different secu- rity may be best for another. In this section we gain a greater understanding of money market security characteristics and how money market participants use them to manage their cash. Treasury Bills To finance the national debt, the U.S. Treasury Department issues a variety of debt securities. The most widely held and most liquid security is the Treasury bill. Treasury bills are sold with 4-, 13-, 26-, and 52-week maturities. The Treasury bill had a minimum denomination of $1,000 until 2008, at which time new $100 denom- inations became available. The Federal Reserve is the Treasury’s agent for the dis- tribution of all government securities. It has set up a direct purchase option that individuals may use to purchase Treasury bills over the Internet. First available in September 1998, this method of buying securities represented an effort to make Treasury securities more widely available. The government does not actually pay interest on Treasury bills. Instead, they are issued at a discount from par (their value at maturity). The investor’s yield comes from the increase in the value of the security between the time it was pur- chased and the time it matures. CASE Discounting the Price of Treasury Securities to Pay the Interest Most money market securities do not pay interest. Instead, the investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is called discounting and is common to short-term securities because it simplifies the distribution at maturity. (We discussed discounting in Chapter 3.) Table 11.3 shows the results of a typical Treasury bill auction as reported on the Treasury direct web site. If we look at the first listing we see that the 28-day Treasury bill sold for $99.981333 per $100. This means that a $1,000 bill was discounted to $999.81. The table also reports the discount rate and the investment rate. The dis- count rate is computed as F - P 360 idiscount = * (1) F n where idiscount = annualized discount rate P = purchase price F = face or maturity value n = number of days until maturity Notice a few features about this equation. First, the return is computed using the face amount in the denominator. You will actually pay less than the face amount, since this is sold as a discount instrument, so the return is underestimated. Second, M11_MISH5006_09_GE_C11.indd 292 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 293 TABLE 11.3 Recent Bill Auction Results Security Issue Maturity Discount Investment Price per Term Date Date Rate Rate $100 CUSIP 28 day 5/19/2016 6/16/2016 0.240 0.243 99.981333 912796HX0 91 day 5/19/2016 8/18/2016 0.275 0.279 99.930486 912796HA0 182 day 5/19/2016 11/17/2016 0.370 0.376 99.812944 912796JU4 28 day 5/12/2016 6/9/2016 0.245 0.248 99.980944 912796HW2 91 day 5/12/2016 8/11/2016 0.240 0.243 99.939333 912796JF7 Source: http://www.treasurydirect.gov/RI/OFBills. a 360-day year (30 * 12) is used when annualizing the return. This also underesti- mates the return when compared to using a 365-day year. The investment rate is computed as F - P 365 iinvestment = * (2) P n The investment rate is a more accurate representation of what an investor will earn, since it uses the actual number of days per year and the true initial investment in its calculation. Note that when computing the investment rate the Treasury uses the actual number of days in the following year. This means that there are 366 days in leap years. EXAMPLE 11.1 Discount and You submit a noncompetitive bid to purchase a 28-day $1,000 Treasury bill, and Investment you find that you are buying the bond for $999.81333. What are the discount rate and the investment rate? Rate Percent Calculations Solution Discount rate $1000 - $999.81333 360 idiscount = * $1000 28 idiscount =.00240 =.240% Investment rate $1000 - $999.81333 365 iinvestment = * 999.81333 28 iinvestment =.00243 =.243% These solutions for the discount rate and the investment rate match those reported by Treasury direct for the first Treasury bill in Table 11.3.  294 PART 5 Financial Markets GO Risk Treasury bills have virtually zero default risk because even if the government ONLINE ran out of money, it could simply print more to redeem them when they mature. The Access www.treasurydirect risk of unexpected changes in inflation is also low because of the short term to.gov. Visit this site to study how Treasury securities are maturity. The market for Treasury bills is extremely deep and liquid. A deep market auctioned. is one with many different buyers and sellers. A liquid market is one in which securities can be bought and sold quickly and with low transaction costs. Investors in markets that are deep and liquid have little risk that they will not be able to sell their securities when they want to. On a historical note, the budget debates in 1978, 1996, and again in 2013 caused the government to temporarily shut down, nearly leading to default on its debt, despite the long-held belief that such a thing could not happen. If the stale- mates had lasted much longer, we would have witnessed the first-ever U.S. govern- ment security default. We can only speculate what the long-term effect on interest rates will be if the market decides to add a default risk premium to all government securities. Treasury Bill Auctions Each week the Treasury announces how many and what kind of Treasury bills it will offer for sale. The Treasury accepts the bids offering the highest price. The Treasury accepts competitive bids in ascending order of yield until the accepted bids reach the offering amount. Each accepted bid is then awarded at the highest yield paid to any accepted bid. As an alternative to the competitive bidding procedure just outlined, the Treasury also permits noncompetitive bidding. When competitive bids are offered, investors state both the amount of securities desired and the price they are willing to pay. By contrast, noncompetitive bids include only the amount of securities the investor wants. The Treasury accepts all noncompetitive bids. The price is set as the highest yield paid to any accepted competitive bid. Thus, non- competitive bidders pay the same price paid by competitive bidders. The signifi- cant difference between the two methods is that competitive bidders may or may not end up buying securities, whereas the noncompetitive bidders are guaranteed to do so. In 1976 the Treasury switched the entire marketable portion of the federal debt over to book entry securities, replacing engraved pieces of paper. In a book entry system, ownership of Treasury securities is documented only in the Fed’s computer: Essentially, a ledger entry replaces the actual security. This procedure reduces the cost of issuing Treasury securities as well as the cost of transferring them as they are bought and sold in the secondary market. The Treasury auction of securities is supposed to be highly competitive and fair. To ensure proper levels of competition, no one dealer is allowed to purchase more than 35% of any one issue. About 40 primary dealers regularly participate in the auction. Salomon Smith Barney was caught violating the limits on the percentage of one issue a dealer may purchase, with serious consequences. (See the Mini-Case box “Treasury Bill Auctions Go Haywire.”) Treasury Bill Interest Rates Treasury bills are very close to being risk-free. As expected for a risk-free security, the interest rate earned on Treasury bill securities is among the lowest in the economy. Investors in Treasury bills have found that in some years their earnings did not even compensate them for changes in purchasing power due to inflation. Figure 11.2 shows the interest rate on Treasury bills and the inflation rate over the period 1973–2016. As discussed in Chapter 3, the real  CHAPTER 11 The Money Markets 295 MINI-CASE Treasury Bill Auctions Go Haywire Every Thursday the Treasury announces how many own name by submitting a relatively high bid. It then 28-day, 91-day, and 182-day Treasury bills it will offer bought additional securities in the names of its cus- for sale. Buyers must submit bids by the following tomers, often without their knowledge or consent. Salo- Monday, and awards are made the next morning. The mon then bought the securities from the customers. Treasury accepts the bids offering the highest price. As a result of these transactions, Salomon cornered The Treasury auction of securities is supposed to the market and was able to charge a monopoly-like be highly competitive and fair. To ensure proper levels premium. The investigation of Salomon Smith Barney of competition, no one dealer is allowed to purchase revealed that during one auction in May 1991, the more than 35% of any one issue. About 40 primary brokerage managed to gain control of 94% of an $11 dealers regularly participate in the auction. billion issue. During the scandal that followed this In 1991 the disclosure that Salomon Smith Barney disclosure, John Gutfreund, the firm’s chairman, and had broken the rules to corner the market cast the several other top executives with Salomon retired. The fairness of the auction in doubt. Salomon Smith Treasury has instituted new rules since then to ensure Barney purchased 35% of the Treasury securities in its that the market remains competitive. rate of interest has occasionally been less than zero. Several times since 1973 the inflation rate matched or exceeded the earnings on T-bills. Clearly, the T-bill is not an investment to be used for anything but temporary storage of excess funds because it may not even keep up with inflation. Rate (%) 16 T-Bill Interest Rate 14 12 10 8 6 4 Inflation Rate 2 0 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017 FIGURE 11.2 T  reasury Bill Interest Rate and the Inflation Rate, January 1973–January 2016 Source: http://www.federalreserve.gov/releases and CPI: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.  296 PART 5 Financial Markets Federal Funds Federal funds are short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. The term federal funds (or fed funds) is misleading. Fed funds really have nothing to do with the federal govern- ment. The term comes from the fact that these funds are held at the Federal Reserve bank. The fed funds market began in the 1920s when banks with excess reserves loaned them to banks that needed them. The interest rate for borrowing these funds was close to the rate that the Federal Reserve charged on discount loans. Purpose of Fed Funds The Federal Reserve has set minimum reserve requirements that all banks must maintain. To meet these reserve requirements, banks must keep a certain percentage of their total deposits with the Federal Reserve. The main purpose for fed funds is to provide banks with an immediate infusion of reserves. Banks can borrow directly from the Federal Reserve, but the Fed actively discourages banks from regularly borrowing from it. One indication of the popularity of fed funds is that on a typical day a quarter of a trillion dollars in fed funds will change hands. Terms for Fed Funds Fed funds are usually overnight investments. Banks analyze their reserve position on a daily basis and either borrow or invest in fed funds, depending on whether they have deficit or excess reserves. Suppose that a bank finds that it has $50 million in excess reserves. It will call its correspondent banks (banks that have reciprocal accounts) to see if they need reserves that day. The bank will sell its excess funds to the bank that offers the highest rate. Once an agreement has been reached, the bank with excess funds will communicate to the Federal Reserve bank instructions to take funds out of its account at the Fed and deposit the funds in the borrower’s account. The next day, the funds are transferred back, and the process begins again. Most fed funds borrowings are unsecured. Typically, the entire agreement is established by direct communication between buyer and seller. Federal Funds Interest Rates The forces of supply and demand set the fed funds interest rate. This is a competitive market that analysts watch closely for indications of what is happening to short-term rates. The fed funds rate reported by the press is known as the effective rate, which is defined in the Federal Reserve Bulletin as the weighted average of rates on trades through New York brokers. The Federal Reserve cannot directly control fed funds rates. It can and does indirectly influence them by adjusting the level of reserves available to banks in the system. The Fed can increase the amount of money in the financial system by buy- ing securities, as was demonstrated in Chapter 10. When investors sell securities to the Fed, the proceeds are deposited in their banks’ accounts at the Federal Reserve. These deposits increase the supply of reserves in the financial system and lower interest rates. If the Fed removes reserves by selling securities, fed funds rates will increase. The Fed, through its open market committee (FOMC), will often announce its intention to raise or lower the fed funds rate in advance. Though these rates directly affect few businesses or consumers, analysts consider them an important indicator of the direction in which the Federal Reserve wants the economy to move. Figure 11.3 compares the fed funds rate with the T-bill rate over the period January 1990 to April 2016. Clearly, the two track together. M11_MISH5006_09_GE_C11.indd 296 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 297 Interest Rate (%) 9 8 7 Federal Funds 6 5 4 3 2 Treasury Bills 1 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 FIGURE 11.3 Federal Funds and Treasury Bill Interest Rates, January 1990–April 2016 Source: http://www.federalreserve.gov/releases/h15/data.htm. Repurchase Agreements Repurchase agreements (repos) work much the same as fed funds except that non- banks can participate. A firm can sell Treasury securities in a repurchase agreement whereby the firm agrees to buy back the securities at a specified future date. Most repos have a very short term, the most common being for 3 to 14 days. There is a market, however, for one- to three-month repos. The Use of Repurchase Agreements Government securities dealers frequently engage in repos. The dealer may sell the securities to a bank with the promise to buy the securities back the next day. This makes the repo essentially a short-term collateralized loan. Securities dealers use the repo to manage their liquidity and to take advantage of anticipated changes in interest rates. The Federal Reserve also uses repos in conducting monetary policy. We pre- sented the details of monetary policy in Chapter 10. Recall that the conduct of monetary policy typically requires that the Fed adjust bank reserves on a tempo- rary basis. To accomplish this adjustment, the Fed will buy or sell Treasury securi- ties in the repo market. The maturities of Federal Reserve repos never exceed 15 days. Interest Rate on Repos Because repos are collateralized with Treasury securities, they are usually low-risk investments and therefore have low interest rates. Though  298 PART 5 Financial Markets rare, losses have occurred in these markets. For example, in 1985 ESM Government Securities and Bevill, Bresler & Schulman declared bankruptcy. These firms had used the same securities as collateral for more than one loan. The resulting losses to municipalities that had purchased the repos exceeded $500 million. Such losses also caused the failure of the state-insured thrift insurance system in Ohio. More recently, the financial crisis of 2007–2008 impacted the repo market when the value of the securitizing collateral came under scrutiny. The ability of borrowers to issue short-term debt was rapidly curtailed and the market collapsed for a period of time. Negotiable Certificates of Deposit A negotiable certificate of deposit is a bank-issued security that documents a deposit and specifies the interest rate and the maturity date. Because a maturity date is specified, a CD is a term security as opposed to a demand deposit: Term securi- ties have a specified maturity date; demand deposits can be withdrawn at any time. A negotiable CD is also called a bearer instrument. This means that whoever holds the instrument at maturity receives the principal and interest. The CD can be bought and sold until maturity. Terms of Negotiable Certificates of Deposit The denominations of negotiable certificates of deposit range from $100,000 to $10 million. Few negotiable CDs are denominated less than $1 million. The reason that these instruments are so large is that dealers have established the round lot size to be $1 million. A round lot is the minimum quantity that can be traded without incurring higher than normal brokerage fees. Negotiable CDs typically have a maturity of one to four months. Some have six- month maturities, but there is little demand for ones with longer maturities. History of the CD Citibank issued the first large certificates of deposit in 1961. The bank offered the CD to counter the long-term trend of declining demand deposits at large banks. Corporate treasurers were minimizing their cash balances and investing their excess funds in safe, income-generating money market instruments such as T-bills. The attraction of the CD was that it paid a market interest rate. There was a problem, however. The rate of interest that banks could pay on CDs was restricted by Regulation Q. As long as interest rates on most securities were low, this regulation did not affect demand. But when interest rates rose above the level permitted by Regulation Q, the market for these certificates of deposit evaporated. In response, banks began offering the certificates overseas, where they were exempt from Regulation Q limits. In 1970 Congress amended Regulation Q to exempt certificates of deposit over $100,000. By 1972 the CD represented approximately 40% of all bank deposits. The certificate of deposit is now the second most popular money market instrument, behind only the T-bill. Interest Rate on CDs The rates paid on negotiable CDs are negotiated between the bank and the customer. They are similar to the rate paid on other money market instruments because the level of risk is relatively low. Large money center banks can offer rates a little lower than other banks because many investors in the market believe that the government would never allow one of the nation’s largest banks to fail. This belief makes these banks’ obligations less risky. M11_MISH5006_09_GE_C11.indd 298 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 299 GO Commercial Paper ONLINE Access www.federalreserve Commercial paper securities are unsecured promissory notes, issued by corpora-.gov/releases/CP/. Find tions, that mature in no more than 270 days. Because these securities are unse- detailed information on cured, only the largest and most creditworthy corporations issue commercial paper. commercial paper, including criteria used for calculating The interest rate the corporation is charged reflects the firm’s level of risk. commercial paper interest rates, outstanding volume, Terms and Issuance Commercial paper always has an original maturity of less and historical discount rates. than 270 days. This is to avoid the need to register the security issue with the Securities and Exchange Commission. (To be exempt from SEC registration, the issue must have an original maturity of less than 270 days and be intended for current transactions.) Most commercial paper actually matures in 20 to 45 days. Like T-bills, most commercial paper is issued on a discounted basis. About 60% of commercial paper is sold directly by the issuer to the buyer. The balance is sold by dealers in the commercial paper market. A strong secondary mar- ket for commercial paper does not exist. A dealer will redeem commercial paper if a purchaser has a dire need for cash, though this is generally not necessary. History of Commercial Paper Commercial paper has been used in various forms since the 1920s. In 1969 a tight-money environment caused bank holding companies to issue commercial paper to finance new loans. In response, to keep control over the money supply, the Federal Reserve imposed reserve requirements on bank-issued commercial paper in 1970. These reserve requirements removed the major advantage to banks of using commercial paper. Bank holding companies still use commercial paper to fund leasing and consumer finance. The use of commercial paper increased substantially in the early 1980s because of the rising cost of bank loans. Figure 11.4 graphs the interest rate on commercial paper against the bank prime rate for the period January 1990–April 2016. Commercial paper has become an important alternative to bank loans primarily because of its lower cost. Market for Commercial Paper Nonbank corporations use commercial paper extensively to finance the loans that they extend to their customers. For example, General Motors Acceptance Corporation (GMAC) borrows money by issuing commercial paper and uses the money to make loans to consumers. Similarly, GE Capital and Chrysler Credit use commercial paper to fund loans made to consumers. The total number of firms issuing commercial paper varies between 600 and 800, depending on the level of interest rates. Most of these firms use one of about 30 commercial paper dealers who match up buyers and sellers. The large New York City money center banks are very active in this market. Some of the larger issuers of commercial paper choose to distribute their securities with direct placements. In a direct placement, the issuer bypasses the dealer and sells directly to the end investor. The advantage of this method is that the issuer saves the 0.125% commission that the dealer charges. Most issuers of commercial paper back up their paper with a line of credit at a bank. This means that in the event the issuer cannot pay off or roll over the matur- ing paper, the bank will lend the firm funds for this purpose. The line of credit reduces the risk to the purchasers of the paper and so lowers the interest rate. The bank that provides the backup line of credit agrees in advance to make a loan to the issuer if needed to pay off the outstanding paper. The bank charges a fee of 0.5% to 300 PART 5 Financial Markets Rate (%) 11 Prime Rate 10 9 8 7 6 5 4 Return on Commercial 3 Paper 2 1 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 FIGURE 11.4 Return on Commercial Paper and the Prime Rate, 1990–April 2016 Source: http://www.federalreserve.gov/releases/h15/data/Monthly/H15_PRIME_NA.txt. 1% for this commitment. Issuers pay this fee because they are able to save more than this in lowered interest costs by having the line of credit. Commercial banks were the original purchasers of commercial paper. Today the market has greatly expanded to include large insurance companies, nonfinancial businesses, bank trust departments, and government pension funds. These firms are attracted by the relatively low default risk, short maturity, and somewhat higher yields these securities offer. In 2016 there was about $1 trillion in commercial paper outstanding (see Figure 11.5). The Role of Asset-Backed Commercial Paper in the Financial Crisis A special type of commercial paper known as asset-backed commercial paper, or ABCPs, comprises short-term securities with more than half having maturities of 1 to 4 days. The average maturity is 30 days. ABCPs differ from conventional commercial paper in that they are backed (secured) by some bundle of assets. In 2004–2007 these assets were mostly securitized mortgages. The majority of the sponsors of the ABCP programs had credit ratings from major rating agencies; however, the quality of the pledged assets was usually poorly understood. The size of the ABCP market nearly doubled between 2004 and 2007 to about $1 trillion as the securitized mortgage market exploded. When the poor quality of the subprime mortgages used to secure ABCP was exposed in 2007–2008, a run on ABCPs began. Unlike commercial bank deposits, there was no deposit insurance backing these investments. Investors attempted to sell them into a saturated market. The problems extended to money market mutual  CHAPTER 11 The Money Markets 301 Amount Outstanding ($ trillions) 2.5 2.0 Volume of Commercial Paper 1.5 1.0 0.5 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2011 2012 2013 2014 2015 FIGURE 11.5 Volume of Commercial Paper Outstanding, 1990 to 2016 Source: http://www.federalreserve.gov/releases/cp/yrend.htm. funds, which found that the issuers of ABCP had exercised their option to extend the maturities at low rates. Withdrawals from money market mutual funds threat- ened to cause them to “break the buck,” where a dollar held in the fund can be redeemed only at something less than a dollar, say, 90 cents. In September 2008 the Federal Reserve set up a guarantee program to prevent the collapse of the money market mutual fund market and to allow for an orderly liquidation of their ABCP holdings.2 Banker’s Acceptances A banker’s acceptance is an order to pay a specified amount of money to the bearer on a given date. Banker’s acceptances have been in use since the twelfth century. However, they were not major money market securities until the volume of interna- tional trade ballooned in the 1960s. They are used to finance goods that have not yet been transferred from the seller to the buyer. For example, suppose that Builtwell Construction Company wants to buy a bulldozer from Komatsu in Japan. Komatsu does not want to ship the bulldozer without being paid because Komatsu has never heard of Builtwell and realizes that it would be difficult to collect if payment were not forthcoming. Similarly, Builtwell is reluctant to send money to Japan before receiving the equipment. A bank can intervene in this standoff by issuing a banker’s 2 For more detail on ABCPs and their role in the subprime crisis, see “The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market,” by Daniel Covitz, Nellie Liang, and Gustavo Suarez, working paper from the Federal Reserve Board.  302 PART 5 Financial Markets acceptance whereby the bank in essence substitutes its creditworthiness for that of the purchaser. Because banker’s acceptances are payable to the bearer, they can be bought and sold until they mature. They are sold on a discounted basis like commercial paper and T-bills. Dealers in this market match up firms that want to discount a banker’s acceptance (sell it for immediate payment) with companies wishing to invest in banker’s acceptances. Interest rates on banker’s acceptances are low because the risk of default is very low. Eurodollars Many contracts around the world call for payment in U.S. dollars due to the dollar’s stability. For this reason, many foreign companies and governments choose to hold dollars. Prior to World War II, most of these deposits were held in New York money center banks. However, as a result of the Cold War that followed, there was fear that deposits held on U.S. soil could be expropriated. Some large London banks responded to this opportunity by offering to hold dollar-denominated deposits in British banks. These deposits were dubbed Eurodollars (see the following Global box). The Eurodollar market has continued to grow rapidly. The primary reason is that depositors often receive a higher rate of return on a dollar deposit in the Eurodollar market than in their domestic market. At the same time the borrower is often able to receive a more favorable rate in the Eurodollar market than in their domestic market. This is because multinational banks are not subject to the same regulations restrict- ing U.S. banks and because they are willing and able to accept narrower spreads between the interest paid on deposits and the interest earned on loans. London Interbank Market Some large London banks act as brokers in the interbank Eurodollar market. Recall that fed funds are used by banks to make up temporary shortfalls in their reserves. Eurodollars are an alternative to fed funds. Banks from around the world buy and sell overnight funds in this market. The rate paid by banks buying funds is the London interbank bid rate (LIBID). Funds are offered for sale in this market at the London interbank offer rate (LIBOR). Because many banks participate in this market, it is extremely competitive. The spread between the bid and the offer rate seldom exceeds 0.125%. Eurodollar deposits are time deposits, which means that they cannot be withdrawn for a specified period of GLOBAL Ironic Birth of the Eurodollar Market One of capitalism’s great ironies is that the Eurodollar they would be safe from expropriation. (This fear was market, one of the most important financial markets not unjustified—consider the U.S. freeze on Iranian used by capitalists, was fathered by the Soviet Union. assets in 1979 and Iraqi assets in 1990.) However, In the early 1950s, during the height of the Cold War, they also wanted to keep the deposits in dollars so that the Soviets had accumulated a substantial amount of they could be used in their international transactions. dollar balances held by banks in the United States. The solution was to transfer the deposits to European Because the Russians feared that the U.S. govern- banks but to keep the deposits denominated in dollars. ment might freeze these assets in the United States, When the Soviets did this, the Eurodollar was born. they wanted to move the deposits to Europe, where M11_MISH5006_09_GE_C11.indd 302 17/10/17 2:25 PM  CHAPTER 11 The Money Markets 303 time. Although the most common time period is overnight, different maturities are available. Each maturity has a different rate. The overnight LIBOR and the fed funds rate tend to be very close to each other. This is because they are near-perfect substitutes. Suppose that the fed funds rate exceeds the overnight LIBOR. Banks that need to borrow funds will borrow overnight Eurodollars, thus tending to raise rates, and banks with funds to lend will lend fed funds, thus tending to lower rates. The demand-and-supply pressure will cause a rapid adjustment that will drive the two rates together. At one time, most short-term loans with adjustable interest rates were tied to the Treasury bill rate. However, the market for Eurodollars is so broad and deep that it has recently become the standard rate against which others are compared. For example, the U.S. commercial paper market now quotes rates as a spread over LIBOR rather than over the T-bill rate. The Eurodollar market is not limited to London banks anymore. The primary brokers in this market maintain offices in all of the major financial centers world- wide. Eurodollar Certificates of Deposit Because Eurodollars are time deposits with fixed maturities, they are to a certain extent illiquid. As usual, the financial markets created new types of securities to combat this problem. These new securities were transferable negotiable certificates of deposit (negotiable CDs). Because most Eurodollar deposits have a relatively short term to begin with, the market for Eurodollar negotiable CDs is relatively limited, constituting less than 10% of the amount of regular Eurodollar deposits. The market for the negotiable CDs is still thin. Other Eurocurrencies The Eurodollar market is by far the largest short-term security market in the world. This is due to the international popularity of the U.S. dollar for trade. However, the market is not limited to dollars. It is possible to have an account denominated in Japanese yen held in a London or New York bank. Such an account would be termed a Euroyen account. Other Euro currencies are possible as well. Keep in mind that if market participants have a need for a particular security and are willing to pay for it, the financial markets stand ready and willing to create it. Comparing Money Market Securities Although money market securities share many characteristics, such as liquidity, safety, and short maturities, they all differ in some aspects. Interest Rates Figure 11.6 compares the interest rates on many of the money market instruments we have discussed. The most notable feature of this graph is that all of the money market instruments appear to move very closely together over time. This is because all have very low risk and a short term. They all have deep markets and so are priced competitively. In addition, because these instruments have so many of the same risk and term characteristics, they are close substitutes. Consequently, if one rate should temporarily depart from the others, market supply-and-demand forces would soon cause a correction. It is also noteworthy how rapidly these rates responded to the M11_MISH5006_09_GE_C11.indd 303 17/10/17 2:25 PM  304 PART 5 Financial Markets Interest Rate (%) 9 Fed funds 8 Treasury bills 7 Certificates of deposit 6 Commercial paper 5 4 3 2 1 0 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 FIGURE 11.6 Interest Rates on Money Market Securities, 1990–2016 Source: http://www.federalreserve.gov/releases/h15/data.htm. global recession that followed the 2007–2008 financial crisis. Money market rates were still at historic lows years later. Liquidity As we discussed in Chapter 4, the liquidity of a security refers to how quickly, eas- ily, and cheaply it can be converted into cash. Typically, the depth of the secondary market where the security can be resold determines its liquidity. For example, the secondary market for Treasury bills is extensive and well developed. As a result, Treasury bills can be converted into cash quickly and with little cost. By contrast, there is no well-developed secondary market for commercial paper. Most holders of commercial paper hold the securities until maturity. In the event that a commercial paper investor needed to sell the securities to raise cash, it is likely that brokers would charge relatively high fees. In some ways, the depth of the secondary market is not as critical for money market securities as it is for long-term securities such as stocks and bonds. This is because money market securities are short-term to start with. Nevertheless, many investors desire liquidity intervention: They seek an intermediary to provide liquidity where it did not previously exist. This is one function of money market mutual funds (discussed in Chapter 20). Table 11.4 summarizes the types of money market securities and the depth of the secondary market.  CHAPTER 11 The Money Markets 305 TABLE 11.4 Money Market Securities and Their Markets Money Market Secondary Security Issuer Buyer Usual Maturity Market Treasury bills U.S. Consumers and 4, 13, 26, and Excellent government companies 52 weeks Federal funds Banks Banks 1 to 7 days None Repurchase Businesses and Businesses and 1 to 15 days Good agreements banks banks Negotiable Large money Businesses 14 to 120 days Good certificates center banks of deposit Commercial Finance Businesses 1 to 270 days Poor paper companies and businesses Banker’s Banks Businesses 30 to 180 days Good acceptance Eurodollar Non-U.S. banks Businesses, 1 day to 1 year Poor deposits governments, and banks How Money Market Securities Are Valued Suppose that you work for Merrill Lynch and that it is your job to submit the bid for Treasury bills this week. How would you know what price to submit? Your first step would be to determine the yield that you require. Let us assume that, based on your understanding of interest rates learned in Chapters 3 and 4, you decide you need a 2% return. To simplify our calculations, let us also assume we are bidding on securities with a one-year maturity. We know that our Treasury bill will pay $1,000 when it matures, so to compute how much we will pay today we find the present value of $1,000. The process of computing a present value was discussed in Example 1 in Chapter 3. The formula is FV PV = (1 + i)n In this example FV = $1000, the interest rate = 0.02, and the period until matu- rity is 1, so $1,000 Price = = $980.39 (1 + 0.02) Note what happens to the price of the security as interest rates rise. Since we are dividing by a larger number, the current price will decrease. For example, if interest rates rise to 3%, the value of the security would fall to $970.87 [$1,000/ (1.03) = $970.87]. This method of discounting the future maturity value back to the present is the method used to price most money market securities. M11_MISH5006_09_GE_C11.indd 305 17/10/17 2:25 PM  306 PART 5 Financial Markets SUMMARY 1. Money market securities are short-term instruments 3. Many participants in the money markets both buy and with an original maturity of less than one year. These sell money market securities. The U.S. Treasury, com- securities include Treasury bills, commercial paper, mercial banks, businesses, and individuals all benefit federal funds, repurchase agreements, negotiable by having access to low-risk short-term investments. certificates of deposit, banker’s acceptances, and 4. Interest rates on all money market securities tend Eurodollars. to follow one another closely over time. Treasury 2. Money market securities are used to “warehouse” bill returns are the lowest because they are virtu- funds until needed. The returns earned on these ally devoid of default risk. Banker’s acceptances and investments are low due to their low risk and high negotiable certificates of deposit are next lowest liquidity. because they are backed by the creditworthiness of large money center banks. KEY TERMS asset-backed commercial paper demand deposit, p. 298 London interbank offer rate (LIBOR), (ABCP), p. 300 direct placements, p. 299 p. 302 bearer instrument, p. 298 discounting, p. 292 noncompetitive bidding, p. 294 book entry, p. 294 liquid market, p. 294 term security, p. 298 competitive bidding, p. 294 London interbank bid rate (LIBID), wholesale markets, p. 286 deep market, p. 294 p. 302 QUESTIONS 1. What is the main characteristic of money market of a separate, less-regulated market. Why did the transactions which enables it to have active second- Eurodollar market grow so rapidly? ary market? 9. What is meant by the Eurodollar market? Why is it an 2. If a 15-year bond is supposed to mature in the next important source of financing? Discuss. three months, is it considered to be a money market 10. How are interest rates usually settled for negotiable instrument? CDs? 3. What cost advantages does the money market have 11. How can you characterize the Treasury bill’s inter- over the banking sector? est rates? How are investment rates different from 4. What are the main purposes of money markets? Why mentioned interest rates? is there a need for money markets? 12. What are the terms of federal funds? Why are these 5. How did asset-backed commercial papers contribute terms often misleading? to the financial crises of 2007-2008? 13. How does the Federal Reserve control interest rates 6. Why are T-Bills a favorable money market instrument on Fed funds? How are interest rates settled on Fed for the U.S. government? For investors? funds? 7. Why do businesses use the money markets? 14. Why do commercial paper securities mature within 8. The Eurodollar market dates back to the period 270 days or less? after World War II, when started with the circula- 15. Why is the banker’s acceptance form of financing tion of dollars overseas followed by the development ideal for foreign transactions? M11_MISH5006_09_GE_C11.indd 306 06/11/17 10:54 AM  CHAPTER 11 The Money Markets 307 Q U A N T I TAT I V E P R O B L E M S 1. Calculate the annualized discount rate and annu- 9. A commercial paper’s annualized discount rate is alized investment rate on the purchase of 91-day 4.85%. Its face value is $18,000,000, and it matures T-bill, if the face value is $3,000 and purchase price in 72 days. What would its price be? What would its is $2,900. price be if it matures in 125 days? 2. What would be the annualized discount rate % and 10. The annualized yield is 4.5% for a 91-day T-bill and the annualized investment rate % if a Treasury bill 5% for a 182 day T-bill. What is the expected rate for was purchased for $9,360 maturing in 270 days for 91 T-bill from now? $10,000? 11. In a Treasury auction of $2.1 billion par value 91-day 3. Suppose you want to earn an annualized discount T-bills, the following bids were submitted: rate of 2.5%. What would be the most you would pay for a 182-day Treasury bill that pays $10,000 at Bid Amount Price per maturity? Bidder ($ million) $100 4. What is the minimum discount rate you will accept if you want to earn at least a 0.25% annualized invest- 1 500.0 99.40 ment rate on a 182-day $1,000 T-bill? 2 750.0 99.01 5. The price of a 145-day commercial paper is $4,525. If 3 1.5 99.25 the annualized discount rate is 5.25%, what will the 4 1.0 99.36 commercial paper will pay at the day of maturity? 5 600.0 99.39 6. Your minimum discount rate bid of 0.35% for a $10,000 T-bill that matures in 91 days has been accepted. Calculate your annualized investment rate. If only these competitive bids are received, who will receive T-bills, in what quantity, and at what price? 7. The price of $8,000 face value commercial paper is $7,930. If the annualized discount rate is 4%, when 12. If the Treasury also received $750 million in non- will the paper mature? If the annualized investment competitive bids, who will receive T-bills, in what rate is 4%, when will the paper mature? quantity, and at what price? (Refer to the table in problem 11.) 8. Calculate the price of a 180-day T-bill purchased at a 5% discount rate if the T-bill has a face value of $5,000. WEB EXERCISES The Money Markets Compare the rates for items a–c to those reported in 1. Up-to-date interest rates are available from the Table 11.1. Have short-term rates generally increased Federal Reserve at http://www.federalreserve.gov/ or decreased? releases. Locate the current rate on the following 2. The Treasury conducts auctions of money market securities: treasury securities at regular intervals. Go to http:// a. Prime rate treasurydirect.gov/instit/instit.htm?upcoming and locate the schedule of auctions. When is the next b. Federal funds auction of 4-week bills? When is the next auction of c. Commercial paper (financial) 13- and 26-week bills? How often are these securities d. Certificates of deposit auctioned? e. Discount rate f. One-month Eurodollar deposits