FIN301_8 Money Markets PDF

Money Markets  We review the money markets and the securities that are traded. Topics include: ─ The Money Markets Defined ─ The Purpose of Money Markets ─ Who Participates in Money Markets? ─ Money Market Instruments ─ C...

Money Markets  We review the money markets and the securities that are traded. Topics include: ─ The Money Markets Defined ─ The Purpose of Money Markets ─ Who Participates in Money Markets? ─ Money Market Instruments ─ Comparing Money Market Securities © 2012 Pearson Education. All rights reserved. 11-1  The Money Markets Defined  Money Markets Defined 1. Money market securities are usually sold in large denominations 2. They have low default risk 3. They mature in one year or less from their issue date, although most mature in less than 120 days Note: Money(currency) is not traded, securities are short term, thus close to being money. © 2012 Pearson Education. All rights reserved. 11-2  Why Do We Need Money Markets? In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits. Banks also have an information advantage on the credit-worthiness of participants. Banks do mediate between savers and borrowers; however, they are heavily regulated. This creates a distinct cost advantage for money markets over banks. © 2012 Pearson Education. All rights reserved. 11-3  Cost Advantages  Reserve requirements create additional expense for banks that money markets do not have  Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets, especially in the 1970s and 1980s.  When interest rates rose, depositors moved their money from banks to money markets to earn a higher interest rate. © 2012 Pearson Education. All rights reserved. 11-4  Cost Advantages  Even today, the cost structure of banks limits their competitiveness to situations where their informational advantages outweighs their regulatory costs.  Figure 11.1 shows that limits on interest banks could offer was not relevant until the 1950s. But in the decades that followed, the problem became apparent. © 2012 Pearson Education. All rights reserved. 11-5  3-month T-bill rates and Interest Rate Ceilings © 2012 Pearson Education. All rights reserved. 11-6  The Purpose of Money Markets  Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time  Borrowers from money market provide low-cost source of temporary funds  Corporations and governments use these markets because the timing of cash inflows and outflows are not well synchronized. Money markets provide a way to solve these cash-timing problems © 2012 Pearson Education. All rights reserved. 11-7  Who Participates in the Money Markets? © 2012 Pearson Education. All rights reserved. 11-8  Money Market Instruments: 1. Treasury Bills  T-bills have 28-day maturities through 12- month maturities.  Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return.  This is common to short-term securities because they often mature before the issuer can mail out interest checks. © 2012 Pearson Education. All rights reserved. 11-9  Money Market Instruments: Treasury Bills Discounting Example  You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? © 2012 Pearson Education. All rights reserved. 11-10  Money Market Instruments: Treasury Bill Auctions  T-bills are auctioned to the dealers  The Treasury may accept both competitive and noncompetitive bids, and the price everyone pays is the highest yield paid to any accepted bid. © 2012 Pearson Education. All rights reserved. 11-11  Money Market Instruments: 2. Fed Funds  Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day.  Used by banks to meet short-term needs to meet reserve requirements.  Fed funds and T-Bills rates track fairly closely © 2012 Pearson Education. All rights reserved. 11-12  Money Market Instruments: 3.Repurchase Agreements  These work similar to the market for fed funds, but nonbanks can participate.  A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price.  This set-up makes a repo agreements essentially a short- term collateralized loan.  This is one market the Fed may use to conduct its monetary policy, whereby the Fed purchases/sells Treasury securities in the repo market. © 2012 Pearson Education. All rights reserved. 11-13  Money Market Instruments: 4. Negotiable Certificates of Deposit  A bank-issued security that documents a deposit and specifies the interest rate and the maturity date  Denominations range from $100,000 to $10 million  They are known as fixed deposits in Botswana © 2012 Pearson Education. All rights reserved. 11-14  Money Market Instruments: 5. Commercial Paper  Unsecured promissory notes, issued by corporations, that mature in no more than 270 days.  The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.  Only BTC has issued commercial paper in Botswana © 2012 Pearson Education. All rights reserved. 11-15  Money Market Instruments: Commercial Paper Rates Although the two track closely in terms of movements, notice that difference between the two remains roughly 200 basis points(2%). What could account for this difference? © 2012 Pearson Education. All rights reserved. 11-16  Money Market Instruments: 5. Banker’s Acceptances  An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods.  These are often used when buyers / sellers of expensive goods live in different countries.  There is also an active secondary market for banker’s acceptances until they mature. The terms of note indicate that the bearer, whoever that is, will be paid upon maturity © 2012 Pearson Education. All rights reserved. 11-17  Money Market Instruments: Banker’s Acceptances Advantages 1. Exporter paid immediately 2. Exporter shielded from foreign exchange risk 3. Exporter does not have to assess the financial security of the importer 4. Importer’s bank guarantees payment 5. Crucial to international trade © 2012 Pearson Education. All rights reserved. 11-18  Money Market Instruments: 6.Eurodollars  The Eurodollar market has continued to grow rapidly because depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market.  Discuss what Eurodollars are and their examples.  How did they evolve? © 2012 Pearson Education. All rights reserved. 11-19  Comparing Money Market Securities: Money Market Securities and Their Depth © 2012 Pearson Education. All rights reserved. 11-20  Exercise  Explain how the government of Botswana can use the money market to influence its monetary policy.  What is the economic role of money markets?  Give an example of how an importer in Botswana can use a bankers acceptance to facilitate his/her transactions with foreign parties..  Explain why money market instrument have relatively lower interest rates. © 2012 Pearson Education. All rights reserved. 11-21