Chapter 6 Money Markets Outline Money Market Securities Treasury Bills Commercial Paper Negotiable Certificates of Deposit (NCDs) Repurchase Agreements Federal Funds Banker’s Acceptances Institutional Use of Money Markets Valuation of Money Market Securities Impact of Changes in Credit Risk Interest Rate Risk Globalization of Money Markets Eurodollar Securities International Interbank Market Performance of Foreign Money Market Securities Key Concepts 1. Explain the main role of money market securities. 2. Identify the more popular money market securities, and elaborate where necessary. 3. Explain how financial institutions participate in money markets. POINT/COUNTER-POINT: Should Firms Invest in Money Market Securities? POINT: No. Firms are supposed to use money in a manner that generates an adequate return to shareholders. Money market securities provide a return that is less than that required by shareholders. Thus, firms should not be using shareholder funds to invest in money market securities. If firms need liquidity, they can rely on the money markets for short-term borrowing. COUNTER-POINT: Yes. Firms need money markets for liquidity. If they do not hold any money market securities, they will frequently be forced to borrow to cover unanticipated cash needs. The lenders may charge higher risk premiums when lending so frequently to these firms. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Firms should not hold an excessive amount of money in the form of money market securities. But they should invest in money market securities so that they have access to funds before being forced to rely on short-term loans. Questions 1. Primary Market. Explain how the Treasury uses the primary market to obtain adequate funding. ANSWER: The Treasury issues Treasury bills through a weekly auction. Investors can submit competitive bids, where the Treasury will accept the highest bids first. Alternatively, investors can submit noncompetitive bids, which will automatically be accepted. The price to be paid by noncompetitive bidders is the weighted average price of accepted bids. 2. T-bill Auction. How can investors using the primary T-bill market be assured that their bid will be accepted? Why do large corporations typically make competitive bids rather than noncompetitive bids for T-bills? ANSWER: Noncompetitive bids in the Treasury auction ensure acceptance by the Treasury. Large corporations make competitive bids because noncompetitive bidders are limited to the size of noncompetitive bids. 3. Secondary Market for T-bills. Describe the activity in the secondary T-bill market. How can this degree of activity benefit investors in T-bills? Why might a financial institution sometimes consider T-bills as a potential source of funds? ANSWER: The secondary market for Treasury bills is very active, which makes Treasury bills more attractive because it enhances their liquidity. Financial institutions that have previously purchased Treasury bills can sell these securities in the secondary market whenever they need cash. 4. Commercial Paper. Who issues commercial paper? What types of financial institutions issue commercial paper? Why do some firms create a department that can directly place commercial paper? What criteria affect the decision to create such a department? ANSWER: Commercial paper is normally issued by well-known, creditworthy firms. Bank holding companies and finance companies commonly issue commercial paper. Those firms that issue commercial paper may decide to establish a department that can directly place the paper. In this way, the firms can avoid the transactions costs incurred when commercial paper dealers issue commercial paper. Such a strategy is only worthwhile if the firms continuously issue commercial paper. 5. Commercial Paper Ratings. Why do ratings agencies assign ratings to commercial paper? ANSWER: Ratings are assigned to designate the degree of default risk associated with commercial paper. Companies issuing commercial paper pay rating services in order to have their paper rated. 6. Commercial Paper Rates. Explain how investors’ preferences for commercial paper change during a recession. How should this reaction affect the difference between commercial paper rates and T-bill rates during recessionary periods? ANSWER: Investors are less interested in commercial paper during a recession because the probability of default increases. Consequently, issuers of commercial paper must offer a higher premium above the prevailing risk-free rate in order to make the paper attractive to investors. 7. Negotiable CDs. How can small investors participate in investments in negotiable certificates of deposits (NCDs)? ANSWER: Money market funds can pool invested funds by individual investors and purchase NCDs. In this way, small investors can invest in NCDs. 8. Repurchase Agreements. Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Why? ANSWER: Repurchase agreements with a similar maturity as commercial paper would likely have a slightly lower yield, since they are typically backed by Treasury securities. 9. Banker’s Acceptances. Explain how each of the following would use banker’s acceptances: (a) exporting firms, (b) importing firms, (c) commercial banks, and (d) investors. ANSWER: A banker’s acceptance can (a) protect an exporter from the risk of nonpayment by the importer, (b) protect importing firms from the risk of paying for goods without ever receiving them, (c) enable banks to offer exporters and importers a service for which it charges a fee, and (d) offer investors an investment instrument (when exporters sell the acceptance in the secondary market). 10. Foreign Money Market Yield. Explain how the yield on a foreign money market security would be affected if the foreign currency denominating that security declined to a greater degree. ANSWER: The foreign money market yield would be reduced if the foreign currency denominating the security depreciates to a greater degree, since the U.S. investors would have to pay a higher exchange rate for the currency than the exchange rate at which the currency is converted back to dollars. 11. Motive to Issue Commercial Paper. The maximum maturity of commercial paper is 270 days. Why would a firm issue commercial paper instead of longer-term securities, even if it needs funds for a long period of time? ANSWER: The firm may be unwilling to lock in the prevailing long-term yield on bonds, perhaps because it expects that long-term interest rates (and yields offered on new bonds) will decline in the near future. 12. Risk and Return of Commercial Paper. You have the choice of investing in top-rated commercial paper or commercial paper that has a lower risk rating. How do you think the risk and return performances of the two investments differ? ANSWER: The commercial paper with the lower rating should have a higher rate of return and also a higher degree of default risk. 13. Commercial Paper Yield Curve. How do you think the shape of the yield curve for commercial paper and other money market instruments compares to the yield curve for Treasury securities? Explain your logic. ANSWER: The shape of the commercial paper yield curve is generally upward sloping but it only applies up to a 270-day (9-month) maturity. The yields on commercial paper are normally slightly higher than yields on T-bills with the same maturity, so the yield curve on commercial paper would be very similar to the yield curve of Treasury bills up to the 9-month maturity, except that it would be slightly higher. Advanced Questions 14. Influence of Money Market Activity on Working Capital. Assume that interest rates for most maturities are unusually high. Also assume that the net working capital (defined as current assets minus current liabilities) levels of many corporations are relatively low in this period. Explain how the money markets play a role in this relationship between the interest rates and the level of net working capital. ANSWER: When interest rates are relatively high, corporations are unwilling to issue long-term debt because they do not want to lock in long-term interest rates. Therefore, they use more short-term financing until interest rates decline. Their increase in short-term debt results in a reduction in their net working capital. 15. Applying Term Structure Theories to Commercial Paper. Apply the term structure of interest rate theories that were discussed in Chapter 3 to explain the shape of the existing commercial paper yield curve. ANSWER: The yields offered on commercial paper can vary because of liquidity differences, segmented maturity markets, or interest rate expectations. Other things being equal, longer-term commercial paper should have a slightly higher annualized yield because it is less liquid (longer time until maturity). If firms need funds for a particular short-term period (such as a one-month period) at a given point in time, the yield for that specific maturity should be higher than other maturities of commercial paper. If interest rates are expected to risk, shorter-term commercial paper will have lower annualized yields because investors will prefer shorter-term maturities under these conditions and firms will prefer to issue longer-term commercial paper under these conditions. If interest rates are expected to decrease, the opposite forces would occur. 16. How Money Market Rates Should Respond to Prevailing Conditions. How have money market rates changes since the beginning of the semester? Consider the existing economic conditions. Do you think money market rates will increase or decrease during the semester? Offer some logic to support your answer. ANSWER: Money market rates typically respond to prevailing economic conditions, including factors such as inflation, economic growth, central bank policy, and market demand for short-term funds. Let's analyze the situation and forecast the likely direction of money market rates during the semester: 1. Existing Economic Conditions : Currently, the economy is experiencing a period of recovery from the impacts of the COVID-19 pandemic. Economic indicators such as GDP growth, employment levels, and consumer spending are showing signs of improvement. However, inflationary pressures have also increased, driven by factors such as supply chain disruptions, pent-up demand, and fiscal stimulus measures. 2. Central Bank Policy : The central bank (e.g., the Federal Reserve) plays a significant role in shaping money market rates through its monetary policy decisions. If the central bank perceives inflationary pressures as transitory and temporary, it may maintain its accommodative stance by keeping short-term interest rates low. Conversely, if inflationary pressures persist and pose risks to price stability, the central bank may signal a shift towards tightening monetary policy by raising interest rates. 3. Market Demand and Sentiment : Market demand for short-term funds can also influence money market rates. Strong demand for credit from businesses and consumers may exert upward pressure on money market rates, especially if supply is limited. Conversely, if market sentiment becomes risk-averse due to uncertainty or external shocks, investors may seek the safety of short-term assets, driving money market rates lower. Considering these factors, here's a forecast for money market rates during the semester: • Likely Direction : Money market rates are likely to experience upward pressure during the semester, reflecting a combination of factors such as improving economic conditions, inflationary pressures, and potential shifts in central bank policy towards tightening. However, the pace and magnitude of rate increases may depend on the central bank's assessment of inflation dynamics and its approach to monetary policy normalization. • Logic to Support Forecast : With the economy recovering and inflation rising, the central bank may face increasing pressure to address inflationary risks by adjusting monetary policy settings, including raising short-term interest rates. Higher interest rates would likely be passed on to money market rates, as banks and financial institutions adjust their lending and borrowing rates accordingly. Additionally, strong demand for credit amid economic growth could contribute to upward pressure on money market rates. In summary, while the exact trajectory of money market rates depends on various factors and uncertainties, the prevailing economic conditions suggest a potential for upward movement in rates during the semester, driven by factors such as inflation, economic growth, and central bank policy decisions. 17. Impact of Lehman Brothers Failure. Explain how the bankruptcy of Lehman Brothers (a large securities firm) reduced the liquidity of the commercial paper market. ANSWER: In September 2008, Lehman Brothers (a large securities firm) defaulted on its commercial paper, which temporarily scared many investors away from the commercial paper market. 18. Bear Stearns and the Repo Market. Explain the lesson to be learned about the repo market based on the experience of Bear Stearns. ANSWER: The repo market funding requires collateral that is trusted by investors, and when economic conditions are weak, some securities may not serve as adequate collateral to obtain funding. 19. Impact of Credit Crisis on Liquidity. Explain why the credit crisis affected the ability of financial institutions to access short-term financing in the money markets. ANSWER: The credit crisis of 2008 had a major impact on the perceived credit risk of money market securities. Given the financial problems of some financial institutions in this period (government bailout of Bear Stearns in March 2008 and bankruptcy of Lehman Brothers in September 2008), it was difficult for financial institutions to raise funds in this market. 20. Impact of Credit Crisis on Risk Premiums. Explain how the credit crisis affected the credit risk premium in the commercial paper market. ANSWER: During the credit crisis, some institutional investors avoided commercial paper issued by financial institutions because of the financial problems they were experiencing. Thus, the premium that some financial institutions had to pay when issuing commercial paper increased. 21. Systemic Risk. Explain how systemic risk is related to the commercial paper market. That is, why did problems in the market for mortgage-backed securities affect the commercial paper market? ANSWER: Some issuers of asset-backed commercial paper used mortgage-backed securities (MBS) as collateral. As the value of MBS declined during the credit crisis, institutional investors were no longer willing to invest in commercial paper secured by MBS. Thus, some financial institutions that were heavily invested in MBS could no longer issue commercial paper because they had no other assets available to post as collateral. 22. Commercial Paper Credit Guarantees. Explain why investors that provided guarantees on commercial paper were exposed to much risk during the credit crisis. ANSWER: During the credit crisis, the financial institutions providing credit guarantees were also exposed to high risk because they provided guarantees for issuers that had excessive exposure to mortgages. The guarantors would incur substantial costs on their credit guarantees if issuers of commercial paper default due to the mortgages and other assets they were holding. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Money markets are not used to get rich, but to avoid being poor.” Money markets provide a low return, but have low risk. Investors maintain investments in money market securities for safety and liquidity. b. “Until conditions are more favorable, investors are staying on the sidelines.” Investors are investing in money market securities, waiting to move their funds into stocks or bonds once conditions are more promising. c. “My portfolio is overinvested in stocks because of the low money market rates.” Portfolio managers may invest more funds in stocks than they prefer if yields on money market securities are very low. Managing in Financial Markets As a treasurer of a corporation, one of your jobs is to maintain investment in liquid securities such as Treasury securities and commercial paper. Your goal is to earn as high a return as possible, but without taking much of a risk. a. The yield curve is currently upward sloping, such that 10-year Treasury bonds have an annualized yield 3 percentage points above the annualized yield of three-month T-bills. Should you consider using some of your funds to invest in 10-year Treasury securities? No, unless you are willing to bear the risk. Ten-year Treasury bonds are subject to a high degree of interest rate risk. If interest rates rise, the value of the bonds will decline. If you have to liquidate the Treasury securities after their value has declined, you may have to take a loss on your investment. Even though these securities are free from default risk, they can still generate significant losses, especially when a Treasurer may need to liquidate them on short notice. b. Assume that you have substantially more cash than you would possibly need for any liquidity problems. Your boss suggests that you consider investing the excess funds in some money market securities that have a higher return than short-term Treasury securities, such as negotiable certificates of deposit (NCDs). Even though NCDs are less liquid, this would not cause a problem if you have more funds than you need. Given the situation, what use of the excess funds would benefit the firm the most? The excess funds should not be invested in money market securities. If these funds are not needed for liquidity purposes, they should be used to support the firm’s operations (and therefore reduce the amount of funds that have to be borrowed). c. Assume that commercial paper is presently offering an annualized yield of 7.5 percent, while Treasury securities are offering an annualized yield of 7 percent. Economic conditions have been stable, and you expect conditions to be very favorable over the next six months. Given this situation, would you prefer to hold T-bills or a diversified portfolio of commercial paper issued by various corporations? Given that economic conditions are favorable, commercial paper would be a good investment. It provides a .5 percent premium over Treasury bills, and the probability of default is low given your expectations of the economy. d. Assume that commercial paper typically offers a premium of 0.5 percent above the T-bill rate. Given that your firm typically maintains about $10 million in liquid funds, how much extra will you generate per year by investing in commercial paper versus T-bills? Is this extra return worth the risk that the commercial paper could default? Given an extra .5 percent per year, you would generate an extra $50,000 per year, as long as the commercial paper did not default. There will be mixed opinions about whether the extra return is worth the risk. Consider that some Treasurers may simply invest in Treasury bills because there is not much reward for earning a slightly higher return. Also, a default on an investment could result in some form of a penalty to the Treasurer. Those Treasurers who are encouraged to take some risk when making their decisions are more willing to invest in the commercial paper. The decision will also depend on the Treasurer’s view of the probability that the commercial paper may default. Problems 1. T-bill Yield. Assume an investor purchased a six-month T-bill with a $10,000 par value for $9,000 and sold it ninety days later for $9,100. What is the yield? ANSWER: 2. T-bill Discount. Newly issued three-month T-bills with a par value of $10,000 sold for $9,700. Compute the T-bill discount. ANSWER: Commercial Paper Yield. Assume an investor purchased six-month commercial paper with a face value of $1,000,000 for $940,000. What is the yield? ANSWER: 4. Repurchase Agreement. Stanford Corporation arranged a repurchase agreement in which it purchased securities for $4,900,000 and will sell the securities back for $5,000,000 in 40 days. What is the yield (or repo rate) to Stanford Corporation? ANSWER: 5. T-bill Yield. You paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until maturity, what is the T-bill yield? What is the T-bill discount? ANSWER: T-bill yield YT = (SP – PP/PP)(365 / n) YT = [(100,000 – 98,000)/(98,000)] x (365/120) = 6.2% T-bill discount = (Par – PP/Par)(360 / n) T-bill discount = (100,000 – 98,000)/100,000 x (360/120) T-bill discount = 0.06 = 6%. T-bill Yield. The Treasury is selling 91-day T-bills with a face value of $10,000 for $9,900. If the investor holds them until maturity, calculate the yield. ANSWER: YT = [(SP – PP)/PP)](365/n) YT = [(10,000 – 9,900)/(9,900)] x (365/91) = 4.05% Required Rate of Return. A money market security that has a par value of $10,000 sells for $8,816.60. Given that the security has a maturity of two years, what is the investor’s required rate of return? ANSWER: $8,816.6 = 10,000/(1 + r)2 $8,816.6 (1 + r)2 = 10,000 (1 + r)2 = 1.1342 (1 + r) = 1.0649 r = 0.0649 = 6.49% Effective Yield. A U.S. investor obtains British pounds when the pound is worth $1.50 and invests in a one-year money market security that provides a yield of 5 percent (in pounds). At the end of one year, the investor converts the proceeds from the investment back to dollars at the prevailing spot rate of $1.52 per pound. Calculate the effective yield. ANSWER: % change in S = 1.52 – 1.50/1.50 = 0.0133 = 1.33% Ye = (1 + Yf)(1 + % change in S) – 1 Ye = (1.05)(1.0133) – 1 = 0.064 = 6.4% 9. T-bill Yield. a. Determine how the annualized yield of a T-bill would be affected if the purchase price were lower. Explain the logic of this relationship. ANSWER: The annualized Treasury bill yield is increased if the purchase price is lower, because the amount returned to the investor would represent a larger gain relative to a smaller investment. b. Determine how the annualized yield of a T-bill would be affected if the selling price were lower. Explain the logic of this relationship. ANSWER: The annualized Treasury bill yield is reduced if the selling price is lower, because the amount returned to the investor would represent a smaller gain relative to the investment. c. Determine how the annualized yield of a T-bill would be affected if the number of days were reduced, holding the purchase price and selling price constant. Explain the logic of this relationship. ANSWER: The annualized Treasury bill yield is increased if the number of days of the investment is shorter, because the amount returned to the investor is earned over a shorter amount of time. 10. Return on NCDs. Phil purchased an NCD a year ago in the secondary market for $980,000. The NCD matures today at a price of $1,000,000, and Phil received $45,000 in interest. What is Phil’s return on the NCD? ANSWER: 11. Return on T-bills. Current Treasury-bill yields are approximately 2 percent. Assume an investor considering the purchase of a newly-issued three-month Treasury bill expects interest rates to increase within the next three months and has a required rate of return of 2.5 percent. Based on this information, how much is this investor willing to pay for a three-month Treasury bill? ANSWER: Flow of Funds Exercise Financing in the Money Markets Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. It has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It previously purchased Treasury securities that it could sell if it experiences any liquidity problems. If the economy continues to be strong, Carson may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering the issuance of stock or bonds to raise funds in the next year. The prevailing commercial paper rate on paper issued by large publicly traded firms is lower than the rate Carson would pay when using a line of credit. Do you think that Carson could issue commercial paper at this prevailing market rate? No. Carson has a large amount of debt, and would not be able issue commercial paper. It relies on debt to obtain additional funds and would probably need to go public (issue stock) before it would be able to issue commercial paper. b. Should Carson obtain funds to cover payments for supplies by selling its holdings of Treasury securities or by using its credit line? Which alternative has a lower cost? Explain. Carson should consider selling its holdings of Treasury securities, because the cost of forgoing the return on these securities is lower than the cost incurred when using a line of credit. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
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