Money Market PDF

MONEY MARKET The money market refers to a segment of the financial system where short-term borrowing, lending, and trading of financial instruments occur. It is a segment of the financial market where short-term debt instruments are traded. These instruments typically have a maturity...

MONEY MARKET The money market refers to a segment of the financial system where short-term borrowing, lending, and trading of financial instruments occur. It is a segment of the financial market where short-term debt instruments are traded. These instruments typically have a maturity of less than a year. Investors and borrowers use the money market to meet short-term financing needs. One of the primary functions of the money market is to facilitate liquidity in the financial system, allowing institutions to balance their cash flows efficiently. For example, banks may lend excess reserves overnight in the money market, while companies may issue commercial paper to finance their short-term operational expenses. The purpose of the money market is to provide liquidity and meet the short-term financing needs of governments, businesses, and banks. By facilitating the quick exchange of cash, the money market helps keep the economy running smoothly, ensuring that participants can obtain or lend money efficiently over short time periods. The instruments in the money market include various financial products with maturities typically lasting less than a year. Examples include Treasury Bills (T-Bills), Commercial Papers (CPs), Certificates of Deposit (CDs), Repurchase Agreements (Repos), and Bankers’ Acceptances (BAs). These instruments are highly liquid, allowing participants to meet their short-term needs meaning they can be easily converted into cash. This is because they have short maturities and are actively traded in the market. CLASSES OF MONEY IN THE PHILIPPINES: Treasury Bills (T-Bills): Issued by the Bureau of Treasury. Considered to be one of the safest investments. Mature in a short period, usually less than a year. Investors earn interest, but it's typically lower than other investments. Commercial Papers (CPs): Issued by large, creditworthy corporations. Used to fund short-term needs like inventory purchases or payroll. Mature in a short period, often less than a year. Interest rates are usually slightly higher than T-Bills. Certificates of Deposit (CDs): Issued by banks. Similar to savings accounts but offer higher interest rates for a fixed term. Can be issued for various terms, but often less than a year. Investors are typically penalized for early withdrawal. Repurchase Agreements (Repos): A type of short-term loan where one party sells a security to another with an agreement to buy it back at a slightly higher price at a later date. Often used by banks to raise short-term funds. The difference in price is essentially the interest earned. Bankers' Acceptances (BAs): A type of time draft issued by a bank. Used to finance international trade. The bank guarantees payment of the draft. Investors earn interest on the face value of the BA. INTEREST RATES - is the cost of borrowing money or the return on investment for lending money, usually expressed as an annual percentage. TYPES OF INTEREST RATES: Simple Interest Rate Definition: Interest calculated only on the principal amount, or on that portion of the principal amount which remains unpaid. Formula: Simple Interest = Principal × Rate × Time Example: Student A obtains a simple interest loan to pay for one year of college tuition. The loan amount is ₱18,000. The annual interest rate on the loan is 6%. The term of the loan is three years. Solution: $18,000×0.06×3=$3,240 Therefore, the total amount of principal and interest paid to the lender is: $18,000+$3,240=$21,240$18,000+$3,240=$21,240 Compound Interest Rate Definition: Interest calculated on both the initial principal and the accumulated interest from previous periods. Example: Ben takes out a three-year loan of $10,000 at an interest rate of 5%, which compounds annually. In the end, as worked out in the calculation below, he pays $1,576.25 in interest on the loan. Solution: $10,000 [(1 + 0.05)³– 1] = $10,000 [1.157625 – 1] = $1,576.25 How Interest Rates are Determined? 1. Central Banks - set key interest rates that influence the overall level of interest rates in the economy. 2. Inflation - interest rates often reflect expectations about inflation. Higher inflation usually leads to higher interest rates. 3. Economic Growth - interest rates are adjusted based on the state of the economy. Impact of Interest Rates on the Economy 1. Consumer Spending - lower interest rates reduce the cost of borrowing, which can lead to increased consumer spending on big-ticket items like homes and cars. 2. Exchange Rates - interest rates can influence currency value. Higher rates can attract foreign investment, strengthening the currency, while lower rates might weaken it. 3. Financial Stability - interest rates also play a role in financial stability. Very low rates for extended periods can lead to excessive risk-taking by investors and borrowers, potentially leading to financial bubbles. YIELD CURVE – is a graphical representation of the interest rates of bonds with different maturities. It is also made up by graphing the plots of the yields of bonds of similar quality or risk class against their maturities, ranging from shortest to longest term. TYPES OF YIELD CURVE: Normal yield curve - is the most common shape, where longer-term bonds have higher interest rates than shorter-term bonds. This often indicates economic growth and expansion. Inverted yield curve – occurs when longer-term bonds have lower interest rates than shorter-term bonds.This occurs when longer-term bonds have lower interest rates than shorter-term bonds. It’s often seen as a signal of an impending economic recession. Flat yield curve – happens when interest rates across different maturities are relatively equal. It can suggest economic uncertainty or a transition between growth and recession. RISK in finance refers to the potential for financial loss or gain. In the context of investments, it encompasses the uncertainty associated with future returns. TYPES OF RISK Market risk - risk that the overall market will decline, affecting the value of investments. Credit risk - risk that the issuer of a debt security will default on their obligations. Liquidity risk - risk that an asset cannot be easily bought or sold without affecting its price. Interest rate risk - risk that changes in interest rates will affect the value of an investment. Currency risk - risk of loss due to fluctuations in exchange rates. TERM STRUCTURE refers to the relationship between the yield (or interest rate) of a debt security and its time to maturity. It's often visualized as a yield curve. TERM STRUCTURE OF INTEREST RATES Expectations Theory - is also called the “Pure Expectations Theory”. This theory says that the long rates are a tool to help forecast future short rates. So, you would get the same return if you invest in a two year bond as you would in two one year bonds (a one year bond today and rolling it over in a one year bond after one year). Liquidity Preference Theory - the investor requires a yield premium relative to short term bonds for he mentioned risk to be incentivized to hold long term bonds. If liquidity is tight, rates would go up and if it's loose, rates would go down or stay flat. Demand for Money Time Preference Theory Market Segmentation Theory - no relationship between the markets for bonds with different maturity lengths and that interest rates affect the supply and demand of bonds. The supply and demand for short-term government and corporate bonds depend on the business demand for short-term assets such as accounts receivable and inventories. Preferred Habitat Theory - if the expected returns on longer-term bonds exceed the expectations for shorter- term bonds, investors who normally buy only short-term bonds will shift to longer maturities to realize increased returns. INTERBANK MARKET - is a global network used by financial institutions to trade currencies and other currency derivatives directly between themselves. The interbank market is a decentralized market. KEY FEATURES OF INTERBANK MARKET Participants - primarily large banks and other financial institutions. Types of Transactions – interbank lending, Foreign Exchange (Forex) Trading, Repo (Repurchase Agreements). Interest Rates - Interbank Offered Rates - the interest rates at which banks lend to each other that serve as benchmarks for many other financial products, including loans and mortgages. How it works: Quotation - banks provide bids and ask prices for different currencies. Matching - a bank with a buy order matches with another bank with a sell order. Transaction - the trade is executed at the agreed-upon price and quantity. Interest Rates - the interest rates at which banks are willing to lend to each other. Settlement - currency is exchanged between the two banks. Purpose and Importance: The interbank market is vital for maintaining liquidity, enabling efficient currency exchange, and supporting the implementation of monetary policy. It ensures that banks can meet their financial obligations, contributing to overall financial stability. Key points to remember about Interbank Market: Decentralized - no central exchange or regulator. Large-scale - transactions are typically very large. Influential - impacts currency exchange rates and interest rates. Risk management - used by banks to manage risk. COMMERCIAL PAPER – is a short-term, unsecured promissory note issued by a corporation to raise funds. Purpose: is to meet short-term financial needs, such as inventory purchases, payroll, or debt repayment. KEY FEATURES Unsecured: Does not require collateral. Short-term: Typically matures within 270 days. Issued at a Discount: Sold at a price below its face value, and the difference is the interest earned by the investor. Creditworthiness: Issuers must have a strong credit rating to attract investors. Issuers (borrower)  Corporations: Large, financially sound companies. Financial Institutions: Banks, insurance companies, and investment firms. Government Entities: In some cases. Investors (lender) Individuals: High-net-worth individuals seeking short-term returns. Corporations: Other corporations looking for a safe place to invest excess cash. Money Market Funds: Mutual funds that invest in short-term debt securities. ADVANTAGES OF COMMERCIAL PAPER Lower Interest Rates: Typically offers lower interest rates than bank loans. Flexibility: Can be issued in various denominations and maturities to meet specific needs. Efficient: A relatively quick and efficient way to raise funds. DISADVANTAGES OF COMMERCIAL PAPER Credit Risk: Investors face the risk of the issuer defaulting on the debt. Liquidity Risk: In times of economic uncertainty, it can be difficult to sell commercial paper before maturity. REPURCHASE AGREEMENT (REPO) - is a short-term loan arrangement where one party sells a security to another party with an agreement to repurchase it at a specified price at a designated future date. How does a Repurchase Agreement work? Participants in Repurchase Agreement The party “selling” in a repurchase agreement: This party is selling the security to the opposing party and receiving cash. Eventually, this party repurchases the same security at a future date at a specified price. The party “purchasing” in a repurchase agreement: This party is buying the security from the opposing party through lending cash. Eventually, this party resells the same security back to the opposing party at a future date at a specified price. Tenor of a Repurchase Agreement Fixed Repo Tenor has a fixed start and end date. Fixed tenors can be overnight, 1, 2, or 3-months, or even up to 1 or 2 years. Open Repo Tenor does not have a fixed start and end date. Repos with an open tenor can be terminated on any business day in the future provided that there is sufficient notice by either party. TYPES OF LEGS Near Leg – also called ‘start leg’. The point of initial sale. Far Leg – also called ‘close leg’. The point of repurchase of the sold asset. Repo Rate – it is the interest rate charged to the borrower in a repurchase agreement. Solving for required Interest Payment: Example: A company enters into a repo agreement, borrowing $1,000,000 at a repo rate of 3%. The agreement has a tenor of 5 days. Calculate the required interest payment.