125.220 Topic 6: Money Markets

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  1. What are the money markets
    Money markets deal in loans & instruments by which Govt, financial institutions & companies raise S/T debt finance for working capital & investments from overnight to up to a year
  2. Short-term Debt Financing instruments
    - How do firms obtain debt funding?
    - What types are traded?
    •The securities are ranked by type of issuer, their creditworthiness & general risk associated with investment

    • Trade credit (non-marketable part of MM markets)
    • – by suppliers of good & services Intercompany loans (non-marketable part of MM markets)
    • – by insurance, finance companies & banks (called Interbank market) - part for their urgent S/T needs
    • Bank overdrafts = indirect finance
    • – major source especially for small companies
    • Short-term bank loans
    • – loan drawn down at time of approval
    • – regular payment schedule
    • commercial bills or bills of exchange = direct financing
    • – Bank bills
    • – Non-bank bills
  3. Two Types of Short term Money Markets in NZ
    1. Official S/T money market
    Trades in govt. securities
  4. 1. Official S/T money market
    - Treasury bills
    • Used for funding government expenditure
    • • Treasury bills first issued in 1969. Originally sold on tap by NZRB but after 1984, sold weekly by tender by NZDMO. “Ontap” - govt quoted interest rate - you ordered what you wanted.
    • • Maturity dates - between 1 month & 1 year. Most are 3m, 6m or 1 year. Now market sets rates by tendering at auction, but NZ DMO has right to reject any offers.
    • • T-bills issued directly in money markets as discount (zerocoupon) instrument as interest included with nominal value (par value) repaid at maturity. Min. denomination of $1m & multiples of $1m thereafter
    • • Large % held by non-residents.
    • • T-bill interest rate regarded as benchmark interest rate
  5. Treasury formula Settlement Price/$N
    • chart?chf=bg,s,00000000&cht=tx&chl=Par%20%3D%20%5Cfrac%7BN%7D%7B1%2B(i%20%5Ctimes%20%5Cfrac%7Bn%7D%7B365%7D)%7D&chs=252x90
    • Where
    • N = par (principal) of T-bill
    • i = yield divided by 100
    • n = number of full days from settlement date to maturity
  6. 2. Non-Govt short/term money market
    • • Deals with flows of money in private sector.
    • • Banks, merchant banks, & brokers channel surplus funds to companies & individuals requiring funding.
    • • An important function of money market- smoothing out cash flows for banks & corporates
    • • Securities in S/T debt markets - mostly discount ones.
  7. Key S/T Debt Instruments- Bills of Exchange
    • • Used by Greeks (4th century BC).
    • • Growth in 18th & 19th Centuries with expansion of international trade
    • Bill of exchange: defined as a negotiable instrument maturing within a given time period (usually 1-6 months), sold at a discount to face value which market believes to be the obligation (debt) of a good credit-worthy name.
    • • Bills of exchange (Commercial bills) in Australasia:
    • – bank (accepted) bills (most of activity) & non-bank bills.
    • – trade bills
    • • Other names for bills: CDs, commercial paper (CP), P-notes
  8. Characteristics of Bank bill finance in Australasia
    • • Borrower e.g. Large company goes to major bank
    • • Assessment made of borrower’s credit risk
    • • Credit rating of borrower affects size of discount
    • – Higher the credit rating ⇒ the bill may be discounted at lower yield ( reflecting a low risk premium)
    • • Maturity usually 30, 60, 90,120 or 180 days
    • • Minimum face value usually $100,000
  9. Four parties involved (potentially) in Bank bill issue
    • (a) Drawer
    • (b) Acceptor
    • (c) Payee
    • (d) Discounter
    • (e) Endorser
  10. (a) Drawer
    • – Issuer of the bill = company (draws up the bill)
    • – Wants to borrow the funds= company financing
    • – Secondary liability for repayment of the bill (after the acceptor)
  11. Four parties involved (potentially) in Bank bill issue
    (b) Acceptor
    • – Undertakes to repay the face value to the holder of the bill at maturity
    • – Acceptor usually a bank or sometimes investment bank
    • – Gives the bill a high credit status ⇒ easier to sell & at lower yield
    • – In case of bank, it quickly is repaid funds by drawer
  12. Four parties involved (potentially) in Bank bill issue
    (c) Payee
    • – The party to whom the bill is specified to be paid
    • – Usually the drawer, but drawer could select other party as payee e.g. subsidiary
  13. Four parties involved (potentially) in Bank bill issue
    (d) Discounter
    • – The party that purchases the bill in primary money market (supplies the funds)
    • – Discounts the face value & buys the bill
    • – The lender of the money
    • – May also be the acceptor of the bill
  14. Four parties involved (potentially) in Bank bill issue
    (e) Endorser
    • Any previous holder of bill but has sold it.
    • Has a contingent liability
    • • Once the bill has been drawn up by issuer & accepted by a bank, it can be sold in the market place to the discounter who provides the funds.
    • • S/T money market – liquid secondary market in bank accepted bills (BAB)
    • • Basic tenet when a bill is "acquired in good faith ..." the buyer has good title to the bill.
    • • Chain of legal ownership for liability of payment
  15. Advantage of Bills
    • • Lower cost than other S/T borrowing forms (i.e. overdraft, fully drawn advances = indirect finance)
    • •Lower as direct finance avoids the cost of intermediation
    • • Borrowing cost (yield) determined at issue date (not affected by subsequent changes in interest rates)
    • • Term of loan may be extended by ‘roll-over’ at maturity- at new prevailing interest rate
  16. Discount Securities—Calculating Price
    Discount Securities Formula from textbook
    • chart?chf=bg,s,00000000&cht=tx&chl=Price%20%3D%20%5Cfrac%7BFV%20%5Ctimes%20DIY%7D%7BDIY%2B(%5Cfrac%7Byield%7D%7B100%7D)%20%5Ctimes%20DTM)&chs=432x102
    • Where:
    • FV = face value
    • DIY = Days in year
    • DTM = Days to maturity
    • Yield = not expressed as decimal
  17. Discount Securities—Calculating Price
    Example 1: A company issues a 90-day bill with face value $100,000 yielding 8.75% p.a.
    What initial amount will the company raise with this issue?
    • chart?chf=bg,s,00000000&cht=tx&chl=Price%20%3D%20%5Cfrac%7B100%2C000%20%5Ctimes365%7D%7B365%2B(%5Cfrac%7B8.75%7D%7B100%7D)%20%5Ctimes90)&chs=342x102
    • Price = $97,888.03
  18. Discount Securities
    Example 2: A company needs ongoing S/T funds (1.5M) & a bank agrees to arrange a bank bill facility & issue 90-day bills at current market yields of 7% + 325 basis points for issuing fees.
    How much will the company raise by issuing directly a bank bill?

    • Initial funds for firm = chart?chf=bg,s,00000000&cht=tx&chl=%5Cfrac%7B1%2C500%2C000%20%5Ctimes%20365%7D%7B365%2B(0.1025%5Ctimes90)&chs=234x82
    • Initial funds for firm = $1,463,023
  19. Discount Securities—Rediscounting
    Example 3: A discounter initially buys a 180 day bill with face value $100,000. The bill now has 90 days to maturity & current
    90-day bill yields are 7.80% p.a. Calculate the rediscount price(selling price).
    • chart?chf=bg,s,00000000&cht=tx&chl=Price%20%3D%20%5Cfrac%7B100%2C000%20%5Ctimes%20365%7D%7B365%20%2B%20(%5Cfrac%7B7.80%7D%7B100%7D%5Ctimes%2090)%7D&chs=336x102
    • Price = $98,113.01
  20. Discount Securities—Calculating Face Value
    A company may need to raise a specific amount of funds from a bill issue.
    Face Value = chart?chf=bg,s,00000000&cht=tx&chl=Price%20%5Ctimes%20%5B%5Cfrac%7B365%2B(%7B%5Cfrac%7Byield%7D%7B100%7D%20%5Ctimes%20DTM)%7D%7D%7B365%7D%5D&chs=408x100
  21. Discount Securities—Calculating Face Value
    Example 4: Company needs to raise $500,000 from issue of 60-day bill rollover facility, at a yield of 8.50%.
    At what face value will the bill have to be drawn?
    • Face Value = chart?chf=bg,s,00000000&cht=tx&chl=500%2C000%5Ctimes%5B%5Cfrac%7B365%2B(%5Cfrac%7B8.50%7D%7B100%7D%5Ctimes60)%7D%7B365%7D%5D&chs=360x94
    • Face Value = $506,986.30
  22. Discount Securities—Calculating Yield + 1st formula for calculation
    • Yield is the rate of interest on the amount outlaid to purchase the bill (or other discount instrument)
    • Yield = chart?chf=bg,s,00000000&cht=tx&chl=%5B%5Cfrac%7BFaceV%20-%20CurrentP%7D%7BCurrentP%7D%5D%5Ctimes%5B%5Cfrac%7BDIY%5Ctimes100%7D%7BDTM%7D%5D&chs=480x70
  23. Discount Securities—Calculating Yield using 2nd formula
  24. Factors influencing bill rates
    • • On any day the AUS & NZ money markets will set bill rates.
    • • Note bank bills at slightly higher yield than T-bills - About 20 basis points above T-bills
    • • Expectation of interest rate movements over term of the bill.
    • • The demand & supply of bills in the market.
    • • The maturity of bills offered.
    • • The names of the parties of the bill & their status.
  25. Commercial Paper
    • An unsecured, short-term debt instrument issued by a corporation (S&P BBB &
    • higher), typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates
    • • Calculation—use discount securities formula
  26. For Underwritten Issues
    • • Underwriting guarantees the full issue of notes is sold
    • • Underwriter usually a commercial bank, investment bank or merchant bank
    • • Underwritten issue can incorporate a roll-over facility, effectively extending borrower’s line of credit beyond short-term life of CP-note issue
    • • Borrowers - S&P investment grade BBB & above
    • • With a roll-over facility, issuers usually refinance repayment of maturing commercial paper with newly issued commercial paper
  27. Negotiable Certificates of Deposit (CDs)
    • • Short-term discount security issued by banks
    • • Maturities range up to 180 days (does vary with country)
    • • Bearer form
    • • Issue them to manage their liabilities & liquidity
    • • Usually issued to international institutional investors in wholesale money markets
    • • The S/T money market has an active secondary market in CDs (in USA- increase in spreads in CD & CP market quickly revealed financial crisis in 2007)
    • • Calculation—use discount securities formula
  28. Investment Bank Cash Advance Facility
    • • Made to large corporations
    • • Generally for a term for a number of years but also available short-term
    • • Priced at a margin above a reference rate
    • • Reference rate fixed for short-term loans (up to 180 days) but may be periodically revised for longer-term loans
  29. Factoring
    • • Company sells its accounts receivable to a factoring company
    • • Converts a future cash flow (receivables) into a current cash flow
    • • Recourse arrangement: factor has a claim against vendor if a receivable is not paid
    • • Non-recourse arrangement: factor has no claim against vendor company
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125.220 Topic 6: Money Markets
money & capital markets
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