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
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.
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
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.
Those firms that issue commercial paper may decide to establish a department that can directly place
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
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?
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Chapter 6: Money Markets 2
ANSWER: Investors are less interested in commercial paper during a recession because the
7. Negotiable CDs. How can small investors participate in investments in negotiable certificates of
deposits (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
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
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
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
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?
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.
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Chapter 6: Money Markets 3
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
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
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
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: This question is open-ended. It requires students to apply the concepts that were presented
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
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Chapter 6: Money Markets 4
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
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
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
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)
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
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.”
b. “Until conditions are more favorable, investors are staying on the sidelines.”
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Chapter 6: Money Markets 5
c. “My portfolio is overinvested in stocks because of the low money market rates.”
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
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
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
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
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Chapter 6: Money Markets 6
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
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?
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Chapter 6: Money Markets 7
ANSWER:
Y
SP –
PP
SP
365
n
$9,100 – $9,000
$9,000
365
90
4.51%
t
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.
Chapter 6: Money Markets 8
Repo rate
=
SP
PP
PP
360
n
$5,000,000 – $4,900,000
$4,900,000
360
40
18.37%
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)
T-bill discount = (Par – PP/Par)(360 / n)
1 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)
2 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:
3 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.
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Chapter 6: Money Markets 9
ANSWER:
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.
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.
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.
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 $45,000 in interest. What is Phil’s
return on the NCD?
%.
,$
,$,$,,$
PP
PPSP
636
000980
000450009800000001
Interest
Yield
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:
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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.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.