The Money Market

Question 1

What is the money market?

Answer 1

The money market is the market for short-term debt securities

Question 2

What are the roles of the money market?

Answer 2

1. Arranges direct financing through the issue of short-term debt securities and is a low-risk asset class for investors
2. It performs price discovery by identifying short-term benchmark rates
3. It provides the banking system with a source of wholesale funds and a low-risk market for their liquid reserves
4. It enables the RBA to implement monetary policy and so influence the economy

Question 3

What is the money markets contribution to the flow of funds?

Answer 3

The money market enables direct financing in wholesale amounts using low-risk, short-term debt securities
the largest issuers are the banks, who issue negotiable certificates of deposit (NCDs)
banks also help companies borrow from the market through their acceptance of bills (known as bank-accepted bills)
state and Commonwealth governments also use the market

Question 4

What is the money markets contribution to the banking system?

Answer 4

The money market holds the banking system’s liquid reserves
This includes ESA balances, loans to the inter-bank overnight market and securities that can be used in repos with the RBA
The money market is a source of funds for banks
They raise funds through the issue of NCDs, and it enables banks to sell the bills they accept (to investors)

Question 5

What is the BBSW?

Answer 5

The market discovers the price of short-term funds (that is, short-term interest rates)…
…known as the BBSW (the bank-bill swap rate), it is calculated by for a range of terms each business day, from the rates on which the securities of the prime banks trade
The BBSW is used to define the interest rate in floating- rate loans, and in the calculation of the cash settlements for interest rate derivatives

Question 6

What is the new calculation process for the BBSW?

Answer 6

the process for calculating the BBSW was reformed. This firstly involved shifting responsibility for its calculation from AFMA (an industry body) to the ASX, who is seen as having greater independence and experience with benchmark calculations.

Question 7

What is the money markets relationship with the RBA?

Answer 7

The money market is the main channel through which the RBA’s monetary policy is transmitted

Question 8

What are money market securities?

Answer 8

Securities with a term less than a year that make a single payment (their face value) at maturity
They are issued and trade at a discount to their face value
investors earn a return by purchasing them and later reselling for a higher price, or by holding them until they mature and receiving their face value
Money market securities have very low credit risk, even though they are mostly unsecured

Question 9

What securities trade in the money market?

Answer 9

• NCDs – issued by banks
• Treasury notes – issued by the Commonwealth government
• Commercial paper – issued by non-financial companies and state and territory governments
• Asset-backed commercial paper – debt normally secured by residential mortgages and issued by SPVs.

Question 10

What is bill acceptance?

Answer 10

A legal commitment by a third party to stand behind a borrower’s obligation to pay the bill’s face value at the specified future date

Question 11

What is a bill facility?

Answer 11

This is an agreement by the acceptor to rollover bills on their maturity date for an agreed period

Question 12

What are treasury notes?

Answer 12

Short-term securities issued by the Treasury, on behalf of the Commonwealth Government
Issued through a competitive tender, where bids are invited from money market dealers
the lowest bidders are successful, given the bids are expressed as yields
T-notes are considered ‘risk-free’ and so trade below the BBSW

Question 13

What is commercial paper?

Answer 13

Commercial paper
Promissory notes issued by low-risk, non-financial companies
Issues arranged on a best-efforts basis by a dealer panel
Trade at yields around or above the BBSW, depending on the risk of the issuer

Question 14

What is asset-backed commercial paper?

Answer 14

Promissory notes issued by SPVs and secured by specified assets, mainly residential mortgages

Question 15

What is a repurchase agreement?

Answer 15

Interday repos are an arrangement to sell securities
on the basis that they are repurchased at a later
date at an agreed (higher) price

Question 16

What are trading and settlement arrangements?

Answer 16

An OTC market where dealers trade on their own behalf in making a market for wholesale clients
The main dealers are the majors, foreign-owned banks, specialist investment and merchant banks
they trade from their own dealing rooms mostly by phone (some use of ATSs)

Question 17

How do trading and settlement agreements work?

Answer 17

Dealers quote their bid and offer yields as a simple interest yield (to two decimal points)
usually their spread is only a few basis points
yields and prices are inversely related, so they ‘bid high’ and ‘offer low’
the yield is then used to calculate the settlement price
Austraclear is the market’s clearinghouse and arranges RTGS settlement on a same day (T + 0) basis

Question 18

Investment yields

Answer 18

The main component of investment returns is the interest earned – this is implicit, since security prices trend up (over time) to their face value
If the securities are held to maturity, interest is the only return
such investments therefore earn the yield at which the securities were purchased

Question 19

What is the holding period yield?

Answer 19

When securities are sold before maturity, the return to investors will include interest but may also include a capital gain or loss
the risk of capital loss is price risk
Capital gains and losses arise from changes in the market yield
if a security is sold at a lower yield (than the purchase yield) a capital gain is achieved, and vice versa
The actual yield achieved is the holding period yield

Question 20

What is price risk in holding period yields?

Answer 20

Price risk arises from random movements in interest rates, its impact is reflected in a security’s tick value

Question 21

What is tick value?

Answer 21

Tick value is the change in price caused by a one basis point change in yield – it is the smallest change that can arise in the market value of a security

Question 22

What are the influences on short term rates?

Answer 22

The RBA’s monetary policy, including expectations of changes to the cash rate
The economy/business cycle, in particular the demand for funds by business
Changes in risk premiums

Question 23

What is the main objective of monetary policy?

Answer 23

The main objective of monetary policy is low inflation with a target range of 2%–3%, on average, over the medium term
Other objectives are low unemployment and stable economic growth