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 security may be best for another. In this text 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 liquid security is the Treasury bill. Treasury bills have 91-day, 182-day, or 12-month maturities.

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 purchased and the time it matures.

Treasury bills have virtually zero default risk because even if the government ran out of money, it could simply print more to redeem them when they mature. The risk of unexpected changes in inflation is also low because of the short term to maturity. The market for Treasury bills is extremely deep and liquid. A deep market 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.

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 government. The term is a holdover from when the fed funds market began in the 1920s and 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.

The Federal Reserve has set minimum reserve requirements that all banks must maintain to ensure that they have adequate liquidity. To meet these reserve requirements, banks must maintain 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 should they be short. Banks can borrow directly from the Federal Reserve, but many prefer to borrow from other banks so that they do not alert the Fed to any liquidity problems.

Repurchase agreements (repos) work much the same as fed funds except thatnonbanks 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.

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.

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 securities 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.

Commercial paper securities are unsecured promissory notes, issued by corporations, that mature in no more than 270 days. Because these securities are unsecured, only the largest and most creditworthy corporations issue commercial paper. The interest rate the corporation is charged reflects the firm's level of risk.

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 international trade ballooned in the 1960s. They are used to finance goods that have not yet been transferred from the seller to the buyer.

Eurodollars.Many contracts around the world call for payment in U.S. dollars due to the dollar's stability. For this reason, many 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

The Eurodollar market has continued to grow rapidly. The primary reason is that depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market. At the same time, the borrower is able to receive a more favorable rate in the Eurodollar market than in the domestic market. This is because multinational banks are not subject to the same regulations restricting 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.

Date: 2015-12-24; view: 1112