Chapter 05 – Money Markets 6th Edition
d.Commercial Paper
Commercial paper is a short term unsecured promissory note issued by large,
creditworthy corporations and financial institutions. Because the notes are unsecured and
are not very liquid, commercial paper is rated by ratings agencies. The paper rating
strongly affects the cost of financing with commercial paper. Low quality paper is often
secured by bank lines of credit to obtain a better rating. In normal times the spread
between prime grade and medium grade paper averages about 22 basis points per year.
The maximum maturity is 270 days (most are less) because the SEC requires formal
registration of securities with maturities greater than 270 days. For this reason some of
the paper issued is commonly rolled over at maturity. Commercial paper comprised
about 20% of total money market securities in 2013, down from 26% in 2007, but
starting to recover from the crisis.
Commercial paper is a discount instrument and uses discount quotes similar to T–bills.
The commercial paper market has developed to provide corporations with an alternative
to short term bank loans. Commercial paper outstanding grew tremendously in the 1990s
because large, creditworthy paper issuers were able to obtain lower cost financing by
issuing paper rather than borrowing from banks. Commercial paper is issued in
denominations ranging from $100,000 to $1 million, with the most common maturities in
the 20 to 45 day range. About 22% of issuers directly market their own paper, but the
bulk is sold through brokers and dealers. Brokered paper is more expensive. There is no
active secondary market for commercial paper, partly because commercial paper dealers
will redeem paper from the buyers if the buyer needs the money prior to maturity. In
2007 the market for asset backed commercial paper seized up as lenders refused to roll
over maturing paper that was backed by mortgages. Asset backed commercial paper
(ABCP) is paper backed by assets of the issuing firms. This market grew dramatically
before the crisis, peaking at $2.16 trillion. Many of the assets backing the paper were
mortgage related however and when the crisis began liquidity dried up in the market and
it collapsed. Much of the investment in ABCP came from money market funds, which
were having their own problems and reduced investments in all risky assets including
ABCP. In June 2010 there were just $391 billion of ABCP outstanding even though the
Fed created a Commercial Paper Funding Facility to provide liquidity to borrowers in the
market.
As a result of problems in the paper market spreads between prime grade and medium
grade paper increased from only a few basis points to 160 basis points in 2007 and 395
basis points in 2008 before peaking at an incredible 615 basis points after the Lehman
collapse. Spreads have returned to more normal levels but the market has not yet
recovered its former size.
a. Negotiable Certificates of Deposit
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A negotiable certificate of deposit (hereafter CD) is a bearer certificate indicating that a
time deposit has been made at the issuing bank which the bearer can collect at maturity.
Large CDs are negotiable instruments. Negotiable CDs have a minimum denomination
of $100,000, but denominations of $1 million are the most common. Typical maturities
range from 1, 2, 3 and 6 months out to 1 year. Negotiable CD rates are add on rates
(single-payment loans) quoted using the 360 day convention.1 They comprised about
27% of money market securities in 2013; the absolute amount of CDs outstanding fell
from 2007 to 2010 as bank credit deteriorated and has yet to recover. Normally, large
well known banks, particularly New York banks, often can pay lower interest rates on
their CDs than other lesser well known institutions. About 15 dealers make a secondary
market in CDs, although it is not very active. CDs are required to have ‘substantial
interest penalties for early withdrawal.’ The secondary market eliminates the problem of
the interest penalty, and has increased bank’s ability to draw funds that would otherwise
be invested in non-bank money market securities.
b. Banker’s Acceptances (BAs)
Drafts are often used to facilitate international trade in goods and services. The seller of
the goods writes either a time draft or a sight draft payable by the buyer of the goods or
services. A sight draft is a claim that becomes due and payable upon presentation to the
purchaser. A time draft is a claim that becomes due and payable at a certain future date
specified on the draft. Because the seller normally will not know the creditworthiness of
the buyer (and credit investigation costs can be quite high), the seller may be reluctant to
ship the goods unless payment can be guaranteed by a third party. Banker’s acceptances
are a certain kind of time draft where a bank has agreed to pay the seller of the goods the
amount owed if the buyer cannot or will not pay on the date due. The draft is backed by
a letter of credit drawn on the buyer’s bank, ensuring that the bank will “accept” the draft
drawn up by the seller. Once the seller can prove that the goods have been shipped in
accordance with the contract and the proper paperwork has been presented to the buyer,
the time draft can be sold as a discount instrument. The seller of the goods can wait until
maturity to receive payment, or can discount the note to the bank and receive the
discounted face amount immediately. The bank can then hold the acceptance or sell it.
BAs are bearer instruments and are fairly actively traded. Maturities range from 30 to
270 days and BAs are bundled into round lots of $100,000 and $500,000.
The amount of BAs outstanding is quite small compared to the other money market
instruments (less than 1% of the total money market securities outstanding) and has been
steadily declining. Users of BAs are primarily firms involved in export and import and
foreign banks financing non-U.S. international trade.2 Commercial paper
(non-collateralized and asset backed), Euro CP and bank loans compete with BAs. Thus
BAs continue to decline in relative importance due to growth in the asset backed
commercial paper and Euro commercial paper markets and because spreads between
1CDs with maturity greater than one year are not bullet or single payment loans, rather
they usually pay interest semiannually.
2See for instance, LaRoche, R. Bankers Acceptances, Federal Reserve Bank of
Richmond, Economic Quarterly, (79) 1, Winter 1993.
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Eurodollar deposits and BAs have fallen. Acceptances actually began declining in 1990
when the Fed removed reserve requirements on non-personal time deposits. As a result
the favorable treatment of BAs, (certain BAs have no reserve requirements) no longer
existed. A schematic of how a BA is created is provided in Appendix 5B available on
Connect.
c. Comparison of Money Market Securities
Most money market securities have high denominations, or high round lots, low default
risk, low interest rates and short maturities. The different instruments have evolved to fill
certain niches or needs. The securities’ secondary markets show more variation. T-bills
are the most actively traded money market security. CDs and BAs are less actively
traded, in part because money market mutual funds and other buyers have been using a
buy and hold strategy for these securities. Commercial paper is usually redeemed by the
seller upon the buyer’s request so no secondary market is needed. Fed funds and repos
tend to be short term so no secondary market has developed for these instruments.
2. Money Market Participants
a. The U.S. Treasury
The Treasury issues T-bills to provide funds throughout the year. The bulk of individual
income tax receipts occur in the spring and corporations and self-employed individuals
generally pay taxes quarterly. Government expenditures however occur throughout the
year and the Treasury uses T-bills to provide financing over the intervening periods when
income is not received.
b. The Federal Reserve
The Fed is a major participant in the money market. The Fed’s open market operations
are conducted using T-bills, T-notes and T-bonds, and Fed policy often involves
repurchase agreements. Moreover, the Fed currently targets the fed funds rate and
actively intervenes in money markets to manipulate this rate.
c. Commercial Banks
Banks both issue and invest in CDs, fed funds, BAs and repos. Banks use the money
markets to manage and minimize their excess reserves position and to meet short term
deficits in reserves.
d. Money Market Mutual Funds
Money market mutual funds (MMMFs) pool investors’ funds and purchase money
market securities. Because most money market securities are high denomination, the
MMMFs allow the small investor to participate in a variety of money market securities
that would otherwise be too expensive for the typical individual. Investors in MMMFs
may earn slightly higher rates than on bank accounts but must forego bank deposit
insurance. Most MMMFs allow limited check writing, low cost investment and free
movement of funds between funds in the same family. There are many different funds
with differing investment strategies. Some are only available for institutional investors
and some are available for individual investors.
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e. Brokers and Dealers
Major brokers and dealers include:
The twenty–one government securities dealers who make a market in T-bills assist the
Treasury by purchasing its securities and assist the Fed in implementing open market
operations.
Cantor, Fitzgerald Securities, Garban-Intercapital or ICAP, Liberty, Prebon, and
Hilliard Farber are money and security brokers. They are major players in the
secondary market for government securities and they serve as brokers in the fed funds
market. They do not trade for their own account and maintain anonymity of the
principals in trades they broker.
Thousands of brokers and dealers who link buyers and sellers.
f. Corporations
Non-financial corporations raise large amounts of money in the commercial paper
markets and invest in other money market securities.
g. Other Financial Institutions
Insurance firms, particularly property and casualty insurers, maintain large liquidity
balances. Money market mutual funds invest in these securities and finance companies
must raise large amounts of funds in the commercial paper market because they cannot
accept deposits.
3. International Aspects of Money Markets
Text Table 5-7 indicates the level of foreign investment in U.S. money market securities
by type of instrument. Investments in Treasury securities comprise the largest segment.
Text Figure 5-8 shows money market instruments outstanding in selected
countries/regions for selected instruments. Notice the growing prevalence of the euro as
the currency of denomination. During the financial crisis, foreign investment in money
markets grew only in Treasury investments (recall that Treasuries are a safe haven
investment). U.S. rates were increasingly unfavorable in comparison to foreign interest
rates so investors seeking yield invested elsewhere. In particular the Fed kept the fed
funds rate low while LIBOR jumped and Euro CD rates also rose well above U.S. rates.
a. Euro Money Markets
Eurocurrency deposits are deposits of currency held outside the home country. Hence,
Eurodollar deposits are dollar denominated deposits held outside the United States.3
Eurodollar deposits are not subject to U.S. bank regulations. The Eurodollar market has
evolved as a source of overnight funding for international banks, and plays a role similar
to fed funds loans in the U.S. The rate offered to lend these funds is the London
InterBank Offer Rate (LIBOR).4 The LIBOR rate is closely related to the U.S. fed funds
rate and the two rates appear to be converging more closely in recent years, but LIBOR
tends to be slightly higher because regulatory costs on Eurodollar accounts are lower than
on domestic deposits. LIBOR also tends to be higher because international bank deposits
3In reality, the money may never leave the country, but for accounting purposes the
money is considered ‘offshore.’
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are perceived as slightly riskier than U.S. deposits, perhaps in part because the U.S. has
not allowed its large banks to fail. During the crisis LIBOR rose from 2.57% in
September 2008 to an all-time high of 6.88% in September 2009. Because the Fed kept
the fed funds rate low LIBOR and the fed funds rate diverged.
Teaching Tip: Until recently the British Banker’s Association (BBA) published daily
estimates of LIBOR based on loan rate data supplied by participating banks. In early
2008 some banks indicated to the BBA a concern that the reported LIBOR did not truly
represent bank borrowing costs. LIBOR had increased sharply with the credit crunch;
nevertheless, some banks apparently felt that others were underreporting true borrowing
costs, fearing that higher LIBOR would indicate a potential problem obtaining funding.
This eventually blew up into the LIBOR manipulation scandal as it was revealed that
banks manipulated LIBOR to profit on derivatives positions and/or to appear less risky
during the crisis. Bank profits from misquoting LIBOR may have exceeded $75 billion.
Details of how this was accomplished may be found in the Wall Street Journal Online
article of 5/2/13: Clubby London Trading Scene Fostered Libor Rate-Fixing Scandal
http://online.wsj.com/article/SB10001424127887323296504578396670651342096.html?
mod=WSJ_hp_LEFTWhatsNewsCollection.
UBS was fined $1.52 billion, RBS $612 million and Barclays $450 million. J. P. Morgan
and Deutsche-Bank are now facing fines from European Union regulators. As a result of
the scandal the BBA is no longer allowed to publish LIBOR. ICE now publishes LIBOR.
LIBOR is available in various maturities for the following currencies: USD, CHF (Swiss
franc), GBP, JPY, CAD, Euro, AUD, DKK (Danish krone), NZD, and the SEK (Swedish
krona). More disturbingly, The Federal Reserve Bank of New York and the Bank of
England may have known of the manipulation as early as 2007 and a trader alleges that
manipulation has occurred since 1991. This is one more instance of the need to
emphasize ethics in business. LIBOR is the base rate on literally trillions of dollars of
derivatives. LIBOR also is the base rate for many loans, including adjustable rate loans.
Some of the major euro securities include:
Eurodollar CDs: Dollar denominated deposits held outside the U.S. The maturity is
typically less than one year. Rates on Eurodollar CDs are sometimes higher than
domestic CD rates because of the lack of explicit deposit insurance and lower
regulatory costs.
4The rate at which a bank will pay to obtain these funds is called, not surprisingly,
LIBID. According to the text the spread between LIBOR and LIBID is narrow, usually
no more than 12.5 basis points.
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Eurocommercial paper issued by commercial paper dealers: Technically, the term
means commercial paper issued outside the borrower’s country of origin, but in their
home currency. The term is coming to mean securities issued in Europe without
involving a bank.
With the introduction of the euro currency net issuance of international debt denominated
in euros has grown rapidly. It is likely that money markets denominated in euros will
continue to grow in importance.
Euro money markets were strongly affected by the 2013 debt crisis in Cypress. Short
term euro market activity declined rapidly as fears of contagion spread. The European
Central Bank was forced to lend over $1 trillion to prevent a banking crisis in the EU. As
a result Euro commercial paper rates climbed significantly above U.S. commercial paper
rates and dollar denominated paper was substituted for euro commercial paper.
Appendix 5A: Single versus Discriminating Price Auctions (available in Connect or
from your McGraw-Hill representative)
In the Treasury single price auction the lowest bid price accepted becomes the price that
all winning bidders pay. There are two purported advantages of a single price auction
over a discriminating auction:
1. A greater number of bidders have their bids filled and
2. More aggressive bidding occurs under the single price format resulting in a higher
average price paid by investors.
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Purchase order sent by U.S. buyer to Chinese seller
Chinese seller requests a leer of credit
Nocaon of leer of credit and dra authorizaon
Order shipped
Time dra and shipping papers sent to Chinese seller’s bank
Time dra and shipping papers sent to U.S. bank; banker’s
acceptance created
Payments sent to foreign bank (immediately if Chinese
seller wishes to discount the dra and collect immediately,
at maturity if not)
Payments sent to Chinese seller (see #7)
Payment to U.S. bank by U.S. buyer at maturity, paid in full
Shipping papers delivered
Chapter 05 – Money Markets 6th Edition
Appendix 5B: Creation of a Banker’s Acceptance ((available in Connect or from
your McGraw-Hill representative)
A schematic of the creation of a Banker’s Acceptance (BA) with a brief explanation is
provided at the website. A slightly modified copy is reproduced below:
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1.1.1.1 VI. Web Links
http://www.federalreserve.gov/ Website of the Board of Governors of the Federal
Reserve
http://www.americanbanker.com/ American Banker’s Association Website
http://www.ustreas.gov/ Website of the U.S. Treasury.
http://www.ft.com/ Financial Times, won two Espy awards for best new
site and best non U.S. news site. Coverage of
global events and markets.
http://www.moodys.com/ A leading provider of independent credit ratings,
research and financial information to the capital
markets.
http://www.standardandpoors.com/ A leading provider of independent credit ratings,
research and financial information to the capital
markets, although little of the information is free.
1.1.1.1.1.1 http://www.ny.frb.org/ Federal Reserve Bank of New York website, complete
with research, links to the Treasury Direct program
and job opportunities.
http://www.bloomberg.com/ The website provides current market data on many
instruments, including stocks, bonds and money
market securities.
1.1.1.1.1.2 VII. Student Learning Activities
1. Go to the Treasury Direct webpage:
http://www.treasurydirect.gov/indiv/myaccount/myaccount.htm and read about the
Treasury Direct program. What is the program for and how can it benefit investors?
Describe the three ways that individuals can buy Treasury securities. Which one is
being phased out? What are the advantages and disadvantages of each?
2. Compare current rates on fed funds loans, T-bills, commercial paper and banker’s
acceptances. Are the rates similar? Why do they differ? Calculate the effective
annual rates for each type instrument. Keep the terms as similar as possible.
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Chapter 05 – Money Markets 6th Edition
3. Using the Web, find the highest three or four negotiable CD rates in the country
offered by banks for a one year maturity. (Hint: The Wall Street Journal or BankRate
websites can help.) Why do the rates differ? Should an investor automatically
choose the highest rate? Why or why not?
4. You are the Assistant Treasurer for ABC Corporation. Your firm has $10 million in
excess cash it does not plan on needing for the next three months. These funds
however do include some contingency funds that are kept if unexpected funds needs
arise. Your boss has asked you to recommend a money market investment for the
firm. Prepare a two page memo to your boss explaining the different types of money
market investments available and the pros and cons of investing in each.
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