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
Chapter 6: Money Markets ❖ 2
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?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Primary Market. Explain how the Treasury uses the primary market to obtain adequate funding.
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?
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?
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?
5. Commercial Paper Ratings. Why do ratings agencies assign ratings to commercial paper?
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?
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?
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.
Chapter 6: Money Markets ❖ 4
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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.
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?
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.
ANSWER: The shape of the commercial paper yield curve is generally upward sloping but it only
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.
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.
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.
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.
18. Bear Stearns and the Repo Market. Explain the lesson to be learned about the repo market based
on the experience of Bear Stearns.
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.
20. Impact of Credit Crisis on Risk Premiums. Explain how the credit crisis affected the credit
risk premium in the commercial paper market.
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?
22. Commercial Paper Credit Guarantees. Explain why investors that provided guarantees
on commercial paper were exposed to much risk during the credit crisis.
CRITICAL THINKING QUESTION
Money Market Funding During a Credit Crisis. Many financial institutions borrow heavily in the
money markets using mortgages and mortgage-backed securities as collateral. Write a short essay about
the lessons of the credit crisis to the deficit units and the surplus units who participate in the money
markets? Should money markets be regulated to a greater degree to ensure proper collateral in money
markets?
ANSWER
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.”
Chapter 6: Money Markets ❖ 7
b. “Until conditions are more favorable, investors are staying on the sidelines.”
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?
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?
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?
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
Chapter 6: Money Markets ❖ 8
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?
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:
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.
ANSWER:
Chapter 6: Money Markets ❖ 9
3. 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:
Chapter 6: Money Markets ❖ 10
ANSWER:
8. 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:
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 $45,000 in interest. What is Phil’s
return on the NCD?
ANSWER:
%63.6
000,980$
000,45$000,980$000,000,1$
Interest
Yield
=
+−
=
+−
=PP
PPSP
Chapter 6: Money Markets ❖ 11
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:
89.937,9$
)12/3(%)5.21/(000,10$
=
+=P
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.
a. 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?
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.