Answers to Chapter 5
Questions:
1. First, money market instruments are generally sold in large denominations (often in units of $1 million to $10
million). Most money market participants want or need to borrow large amounts of cash so that transactions costs
Second, money market securities have low default risk; the risk of late or nonpayment of principal and/or interest is
generally small. Since cash lent in the money markets must be available for a quick return to the lender, money
market instruments can generally be issued only by high quality borrowers with little risk of default.
Finally, money market securities must have an original maturity of one year or less. Recall from Chapter 3 that the
longer the maturity of a debt security, the greater is its interest rate risk and the higher its required rate of return (the
2. The discount yield differs from a bond equivalent yield for two reasons: i) the base price used is the face value of
the security and not the purchase price of the security and ii) a 360-day year is used. The bond equivalent yield uses
a 365-day year and the purchase price, rather than the face value of the security, is used as the base price. Treasury
bills are quoted on a discount yield basis.
3. There are several features of a discount yield that prohibit it from being compared to yields on other
(nondiscount) securities. Specifically, the discount yield uses the terminal price (or face value) as the base price in
ibe = id (Pf/Po)(365/360)
Finally, neither of these yields considers the compounding of interest rates during the (less than one year) investment
horizon. The EAR on a discount security would be calculated by applying the bond equivalent yield for the discount
security to the EAR equation.
4. Single-payment securities pay interest only once, at maturity. Quoted interest rates on single-payment securities
5. The U.S. Treasury has a formal process by which it sells new issues of Treasury bills through its regular Treasury
bill auctions. Every week (usually on a Thursday) the amount of new 91-day and 182-day T-bills the Treasury will
6. Submitted bids can be either competitive bids or noncompetitive bids. Competitive bids specify the amount of
par value of bills desired (the minimum is $100) and the discount yield (in increments of 0.005%), rather than the
competitive bids at the stop-out yield exceeds the amount of bills remaining to be allocated after the superior bids
have been allocated, the bids at the stop-out rate are distributed on a pro-rata basis. For example, if the bids at the
stop-out yield total $5 billion of par value, but there is only $3 billion of par value remaining after satisfying
Noncompetitive bids are limited to $5 million; they specify only the desired amount of the face value of the bills.
Noncompetitive bids usually represent a small portion of total Treasury bills auctioned. If the amount of
noncompetitive bids exceeds the amount of bills auctioned, all noncompetitive bids would be satisfied on a pro-rata
market price.
7. The secondary market for T-bills is the largest of any U.S. money market security. At the heart of this market are
those securities dealers designated as primary government securities dealers by the Federal Reserve Bank of New
York (consisting of 21 financial institutions) who purchase the majority of the T-bills sold competitively at auction
and who create an active secondary market. In addition, there are many (approximately 500) smaller dealers who
EST.
Secondary market T-bill transactions between primary government securities dealers are conducted over the Federal
Reserve’s wire transfer service and are recorded via the Federal Reserve’s book-entry system. A bank or broker that
8. Federal funds are not formal securities. Rather, fed funds are short term loans between financial institutions,
usually for a period of one day. The institution that borrows fed funds incurs a liability on its balance sheet, “federal
funds purchased,” while the institutions that lends the fed funds records an asset, “federal funds sold.”
9. Two forms of federal funds transactions are commonly used: i) negotiations between two commercial banks often
takes place directly over the telephone between the “money dealers” of the banks involved or ii) the transaction may
occur through a fed funds broker. Figure 5-3 illustrates the two methods through which a fed funds transaction can
occur. For example, a bank that finds itself with $75 million in excess reserves can call its correspondent banks to
see if they need overnight reserves. The bank will then sell its excess reserves to those correspondent banks that
offer the highest rates for these fed funds. When a transaction is agreed upon, the lending bank instructs its district
funds loan, the borrowing bank’s fed fund demand deposit account at the lending bank is debited for the total value
of the loan and the lending bank pays the borrowing bank an interest payment for the use of the fed funds.
10. One of the primary risks of the interbank lending system is that the borrowing bank does not have to pledge
collateral for the funds it receives, which are usually in millions of dollars. While the Fed has the ability to use open
market operations to influence the interest rates banks charge each other and can introduce new capital to encourage
banks to lend, the interbank loans are conducted with little scrutiny between parties. The financial crisis of
2008‐2009 produced unprecedented and persistent strains in interbank lending and exposed problems produced by
banks that were heavily leveraged with fed funds. The financial crisis created a huge demand for liquid assets across
11. A repurchase agreement (repos or RPs) is an agreement involving the sale of securities by one party to another
with a promise to repurchase the securities at a specified price and on a specified date in the future. Thus, a
12. Repurchase agreements are arranged either directly between two parties or with the help of brokers and dealers.
Figure 5–4 illustrates a $75 million repurchase agreement of Treasury bonds arranged directly between two parties
Once the transaction is agreed upon, the repo buyer, J.P. Morgan Chase, instructs its district Federal Reserve Bank
(the FRBNY) to transfer $75 million in excess reserves, via Fedwire, to the repo seller’s reserve account. The repo
13. This 270 day maximum is due to a Securities and Exchange Commission (SEC) rule that securities with a
14. Because commercial paper is not actively traded and because it is also unsecured debt, the credit rating of the
issuing company is of particular importance in determining the marketability of a commercial paper issue. Credit
ratings provide potential investors with information regarding the ability of the issuing firm to repay the borrowed
15. One reason for the growth of the commercial paper markets is that companies with strong credit ratings can
generally borrow money at a lower interest rate by issuing commercial paper than by directly borrowing (via loans)
from banks. Indeed, although business loans were the major asset on bank balance sheets between 1965 and 1990,
they have dropped in importance since 1990. Companies have replaced this bank debt with commercial paper. This
trend reflects the growth of the commercial paper market.
In the early 2000s, the slowdown in the U.S. economy resulted in ratings downgrades for some of the largest
commercial paper issuers. For example, the downgrade of General Motors and Ford from a tier-one to tier–two
commercial paper issuer had a huge impact on the commercial paper markets. The result is that these commercial
paper issuers were forced to give up the cost advantage of commercial paper and to move to the long-term debt
markets to ensure they would have access to cash. The decrease in the number of eligible commercial paper issuers
In addition, on September 16, 2008 (one day after Lehman Brothers filed for bankruptcy), Reserve Primary Fund,
the oldest money market fund in the United States saw its shares fall to 97 cents (below the $1.00 book value) after
writing off debt issued by Lehman Brothers. Resulting investor anxiety about Reserve Primary Fund spread to other
Even as markets stabilized after the financial crisis, outstanding values of financial and non-financial commercial
paper continued to fall: from over $2.16 trillion at its peak in July 2007, the commercial paper market has fallen to
$1.76 trillion in July 2008, $1.21 trillion in July 2009, and just $0.99 trillion in July 2013. Reasons for this include a
borrowings can be.
16. The bank and the CD investor directly negotiate a rate, the maturity and, the size of the CD. Once this is done,
the issuing bank delivers the CD to a “custodian” bank specified by the investor. The custodian bank verifies the
that banks act as guarantors for payment before sending goods to domestic importers, particularly when the foreign
supplier has not previously done business with the domestic importer on a regular basis. The U.S. bank ensures the
international transaction by stamping “Accepted” on a trade draft between the exporter and the importer, signifying
acceptance on maturity.
18. The major money market participants are the U.S. Treasury, the Federal Reserve, commercial banks, money
market mutual funds, brokers and dealers, corporations, other financial institutions, such as insurance companies,
The Federal Reserve is a key participant in the money markets. The Federal Reserve holds T-bills (as well as T-notes
and T-bonds) to conduct open market transactions: purchasing T-bills when it wants to increase the money supply
and selling T-bills when it wants to decrease the money supply. The Federal Reserve often uses repurchase
Commercial banks are the most diverse group of participants in the money markets. Banks participate as issuers
and/or investors of almost all money market instruments. For example, banks are the major issuers of negotiable
CDs, banker’s acceptances, federal funds, and repurchase agreements. The importance of banks in the money
markets is driven in part by their need to meet regulatory imposed reserve requirements. For example, during
Money market mutual funds purchase large amounts of money market securities and sell shares in these pools based
on the value of their underlying (money market) securities. In doing so, money market mutual funds allow small
investors to invest in money market instruments. Money market mutual funds provide an alternative investment
opportunity to interest-bearing deposits at commercial banks.
Brokers and dealers services are important to the smooth functioning of money markets. We have alluded to various
categories of brokers and dealers in the chapter. First, are the 30 primary government security dealers. This group of
participants plays a key role in marketing new issues of Treasury bills (and other Treasury securities). Primary
government securities dealers also make the market in Treasury bills; buying securities from the Federal Reserve
when they are issued and selling them in the secondary market. Secondary market transactions in the T-bill markets
Nonfinancial and financial corporations raise large amounts of funds in the money markets, primarily in the form of
commercial paper. The volume of commercial paper issued by corporations has been so large that there is now more
commercial paper outstanding than any other type of money market security. Because corporate cash inflows rarely
equal their cash outflows, they often invest their excess cash funds in money market securities, especially T-bills,
repos, commercial paper, negotiable CDs, and banker’s acceptances.
Because their liability payments are relatively unpredictable, property-casualty (PC) insurance companies, and to a
lesser extent life insurance companies, must maintain large balances of liquid assets. To accomplish this insurance
companies invest heavily in highly liquid money market securities, especially T-bills, repos, commercial paper and
Individual investors participate in the money markets through direct investments in these securities (e.g., negotiable
CDs) or through investments in money market mutual funds, which contain a mix of all types of money market
securities.
19. One of the more grievous actions by some global investment banks during the financial crisis was the
manipulation of the LIBOR. LIBOR is the average of the interest rates submitted by major banks in the United
States, Europe, and the United Kingdom in a variety of major currencies such as the dollar, euro, and yen. The
scandal arose when it was discovered that banks had been manipulating the LIBOR rate so as to make either profits
Concerns were also raised about the failure of British and U.S. regulators to stop the manipulation of LIBOR when
there was evidence that both were aware of it. In July 2012, a former trader stated that LIBOR manipulation had
been occurring since at least 1991. In July 2012, the Federal Reserve Bank of New York released documents dated
as far back as 2007 showing that they knew that banks were misreporting their borrowing costs when setting
LIBOR. Yet, no action was taken. Similarly, documents from the Bank of England indicated that the bank knew as
Since its inception in the 1980s, LIBOR was managed by the British Bankers’ Association (a London-based trade
group whose members are some of the world’s biggest banks). As a result of the LIBOR scandal, British authorities
started looking for a new owner for LIBOR in 2012. In July 2013, the British government announced that LIBOR
would be sold to NYSE Euronext. Further, while ownership of LIBOR would be based in the U.S., responsibility for
regulating it would remain in the U.K.
20. Eurodollar certificates of deposits (CDs) are U.S. dollar denominated CDs in foreign banks. Maturities on
Eurodollar CDs are less than one year and most have a maturity of one week to six months. Because these securities
Problems:
1. Discount yield: iT-bill, d = (($1m. – $973,750)/$1m.)(360/65) = 14.538%
2. Discount yield: icp, d = (($5m. – 0.98625($5m.))/$5m.)(360/136) = 3.640%
3. The nominal bond equivalent yield is calculated as:
The EAR on the CD is calculated as:
4. The nominal bond equivalent yield is calculated as:
The EAR on the CD is calculated as:
b. The T-bill’s bond equivalent yield is calculated as
$10,000 95
b. The T-bill’s bond equivalent yield is calculated as
$9,965 95
c. The T-bill’s bond EAR is calculated as
360
b. The T-bill bid price is calculated as
360
9. EXCEL Problem: Bid Price = $9,993.81
Bid Price = $9,984.51
10. a. iT-bill, d = ($100,000-$95,850)/$100,000) x (360/225) = 6.64%
b. iT-bill, d = ($100,000-$95,850)/$100,000) x (360/300) = 4.98%
11. EXCEL Problem: Yield = 4.014%
Yield = 1.606%
Remembering that fed funds are generally lent for one day, The EAR on the fed funds can then be calculated as:
14. a. The yield on this repo to the bank is calculated as follows
$24,950,000 7
b. The yield on this repo to the bank is calculated as follows
$24,950,000 21
b. irepo, be = 3.44%(365/360) = 3.48%
16. The discount yield on the commercial paper is calculated as
icp, d = $500,000 – $495,000 x 360 = 8.00%
$500,000 45
And the bond equivalent yield is:
$495,000 45
17. The discount yield on the commercial paper is calculated as:
$1,000,000 125
And the bond equivalent yield is:
$995,235 125
Finally, the EAR on the commercial paper is:
c. $2,005,279/(1 + iCD, be/2)) = $1,998,750 => iCD, be = 0.6533%
and the EAR becomes: EAR = [1 + 0.006533/2]2 – 1 = 0.6544%
b. FV = $5m. (1 + 0.003552/2) = $5,008,879
in four months in exchange for $500,000 deposited in the bank today. Immediately after the market rate on the CD
rises to 6 percent, the CD value decreases to