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Chapter 6
Money Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline

Money market securities

Institutional use of money markets

Valuation of money market securities

Risk of money market securities

Interaction among money market yields

Globalization of money markets
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Money Market Securities

Money market securities:

Have maturities within one year

Are issued by corporations and governments to
obtain short-term funds

Are commonly purchased by corporations and
government agencies that have funds available for a


Other financial institutions in case cash outflows exceed
cash inflows

Individuals with substantial savings for liquidity purposes

Corporations to have easy access to funding for
unanticipated(dung truoc, huong truoc) expenses
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Money Market Securities (cont’d)

Treasury bills (cont’d)

Pricing Treasury bills

The price is dependent on the investor’s required rate of
return:

Treasury bills do not pay interest

To price a T-bill with a maturity less than one year, the
annualized return can be reduced by the fraction of the
year in which funds would be invested
n
m
kP )1/(Par +=
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Computing the Price of a
Treasury Bill
A one-year Treasury bill has a par value of

Payments to the Treasury are withdrawn electronically from the
account

Payments received from the Treasury are deposited into the
account
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Money Market Securities (cont’d)

Treasury bills (cont’d)

Treasury bill auction (cont’d)

Weekly auctions include 13-week and 26-week T-bills

4-week T-bills are offered when the Treasury anticipates a
short-term cash deficiency

Cash management bills are also occasionally offered

Investors can submit competitive or noncompetitive bids

The bids of noncompetitive bidders are accepted

The highest competitive bids are accepted

Any bids below the cutoff are not accepted

Since 1998, the lowest competitive bid is the price applied to
all competitive and noncompetitive bids
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T
365
×
−
=
n
PP 360
Par
Par
discount bill-T ×
−
=
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Computing the Yield of a
Treasury Bill
An investor purchases a 91-day T-bill for $9,782. If
the T-bill is held to maturity, what is the yield
the investor would earn?
%94.8
91
365
782,9
782,9000,10
365
=
×
−
=
×
−

Commercial paper:

Is a short-term debt instrument issued by well-known,
creditworthy firms

Is typically unsecured

Is issued to provide liquidity to finance a firm’s investment in
inventory and accounts receivable

Is an alternative to short-term bank loans

Has a minimum denomination of $100,000

Has a typical maturity between 20 and 270 days

Is issued by financial institutions such as finance companies and
bank holding companies

Has no active secondary market

Is typically not purchased directly by individual investors
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Money Market Securities (cont’d)

Commercial paper (cont’d)

Ratings

The risk of default depends on the issuer’s financial condition


Commercial paper (cont’d)

Backing commercial paper

Issuers typically maintain a backup line of credit

Allows the company the right to borrow a specified maximum
amount of funds over a specified period of time

Involves a fee in the form of a direct percentage or in the form
of required compensating balances

Estimating the yield

The yield on commercial paper is slightly higher than on a T-
bill

The nominal return is the difference between the price paid
and the par value
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Estimating the Commercial
Paper Yield
An investor purchases 120-day commercial paper
with a par value of $300,000 for a price of
$289,000. What is the annualized commercial
paper yield?
%42.11
120
360

Negotiable certificates of deposit (NCDs):

Are issued by large commercial banks and other
depository institutions as a short-term source of funds

Have a minimum denomination of $100,000

Are often purchased by nonfinancial corporations

Are sometimes purchased by money market funds

Have a typical maturity between two weeks and one
year

Have a secondary market
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Money Market Securities (cont’d)

Negotiable certificates of deposit (NCDs)
(cont’d)

Placement

Directly

Through a correspondent institution

Through securities dealers

Premium

from another with an agreement to sell them

Bank, S&Ls, and money market funds often participate in repos

Transactions amounts are usually for $10 million or more

Common maturities are from 1 day to 15 days and for one,
three, and six months

There is no secondary market for repos
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Money Market Securities (cont’d)

Repurchase agreements (cont’d)

Placement

Repo transactions are negotiated through a
telecommunications network with dealers and repo brokers

When a borrowing firm can find a counterparty to a repo
transaction, it avoids the transaction fee

Some companies use in-house departments

Estimating the yield

The repo yield is determined by the difference between the
initial selling price and the repurchase price, annualized with
a 360-day year