Chapter 5 - Money Markets

Question 1

Money Market Participants

Answer 1

(1) Issuers: sells / issues securities to borrow short term funds e.g. govt, securities dealers, commercial banks, corporations

(2) Investor: buys securities as an investment for excess cash / manage short term surplus cash because of the relative liquidity of the instruments and the assumed security of principal

Question 2

Government Sponsored Enterprises (GSEs)

Answer 2

private companies that act as financial intermediaries to provide funds for loans made in the housing, education, and agriculture sectors

e.g. Federal National Mortgage Association (FNMA aka Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC aka Freddie Mac)
GSEs do NOT have explicit credit backing of the US govt but their importance to public welfare has motivated federal govt to intervene in past crises”

Question 3

Central Banks

Answer 3

central banks play an important role in money markets including
(1) managing initial sale and settlement of most book-entry US Treasury security sales / purchases
(2) implement monetary policy through FOMC via purchase / sale of Treasury securities in secondary markets (often using repos)
(3) buys, sells, and redeems Treasury securities in its role as fiscal agent for the US Treasury

Question 4

Intermediaries in the money market

Answer 4

(1) broker dealers: place majority of new issues in the primary market and provide secondary markets with the necessary liquidity for outstanding issues
(2) asset managers: manage a client’s cash / investment activities
(3) central securities depositories (CSDs): hold securities for book entry transfer of securities, provide trade matching (match sales details to purchase details), and provide clearing and settlement

Question 5

Central Securities Depositories

Answer 5

companies that hold securities to enable book entry transfer of securities, provide trade matching, as well as clearing and settlement which increases the liquidity of the money market
(1) international CSDs: settle trades in int’l securities
(2) national CSDs: settles trades in domestic securities

Question 6

Two primary entities that process and clear most money market instruments

Answer 6

(1) Commercial Book Entry System (CBES): processes US Treasury securities
(2) Depository Trust & Clearing Corporation (DTCC): processes all forms of book-entry securities

Question 7

Commercial Book-Entry System (CBES)

Answer 7

is a multi-tiered automated system for purchasing, holding, and transferring marketable treasury securities
it is a delivery system that simultaneously transfer securities against settlement of funds

(1) top tier - National Book-Entry System (NBES) operated by the Fed in its capacity as the fiscal agent for the US Treasury, maintain book entry accounts for depository institutions, US Treasury, foreign central banks, and most GSEs
(2) middle tier - depository institutions hold book-entry accounts for customers (e.g. broker dealer, institutional investor)
(3) lower tier - each broker, dealer, FI maintain book entry accounts for individual customers, corporations, etc.

Question 8

Depository Trust & Clearing Corporation (DTCC)

Answer 8

owned by member FIs

is a corporation that provides clearing, settlement, and info services for equities, corporate & muni bonds, govt securities, mortgage backed securities, money market instruments, and OTC derivatives

brings significant efficiency to the market clearing process by acting as a legal depository (holding place) for most stock / bond certificates and nets transactions among brokers, dealers, funds, etc.
also provides custody and asset servicing for millions of securities issues

operate on an at-cost basis, charging transaction fees for services and returning any excess revenue to members

Question 9

Commercial Paper

Answer 9

tradable promissory notes that represent an unsecured obligation or debt of the issuer

• usually does NOT pay interest
• is issued at a discount and face value is paid at maturity
• dollar discount and yield is influenced by credit rating of issuer and credit rating of specific issue
• CP are purchased for a specific maturity and held to term but can be traded in the secondary market prior to maturity

Question 10

CP Pros and Cons

Answer 10

Advantages:
- range of available maturities so investors can pick their desired maturity
- investment grade CP are highly liquidx
- can diversify risk with CPs from different industries and sectors

Disadvantages:
- not secured against particular asset
- commonly issued with credit enhancement - backup line of credit or SBLC

Question 11

Asset-Backed Commercial Paper (ABCP)

Answer 11

secured against specific assets - typically short term trade receivables from one company (single seller) or multiple companies (multi-seller)
issued through a sponsoring FI vs. directly though an issuing company

Question 12

ABCP Pros and Cons

Answer 12

Advantages:
- more security than standard CP
- credit enhancement from sponsoring bank is designed to facilitate timely repayment at maturity
- investors tend to be rewarded for extra complexity with a moderately higher rate of return than standard CP

Disadvantages:
- complex structure of ABCP makes it harder to appraise overall risk of security and may require third party credit monitoring
- ABCP market is smaller than standard CP market which increases liquidity risk

Question 13

Maturity for CPs

Answer 13

US:
- maturity can range from overnight to 270 days for publicly traded CP
- up to 397 days for private-placement CP
- most CP matures in less than 45 days

UK:
- max maturity of 364 days

Question 14

Bank Obligations (aka bank paper)

Answer 14

banks raise funds in the money markets through time deposits, banker’s acceptances, and repurchase agreements - collectively referred to as bank obligations

Question 15

Examples of Time Deposits

Answer 15

(1) savings accounts
(2) negotiable CDs
(3) non-negotiable CDs (retail CDs)

Question 16

Negotiable CDs

Answer 16

high value time deposits issued by banks and other Fis that are bought and sold on the open market
usually traded in multiples of 100,000 o rmore

Question 17

Non-Negotiable (retail) CDs

Answer 17

issued in many different denominations to consumers and businesses

CONS:
- no secondary marketx
- cannot redeem prior to maturity (penalty for early redemption)

Question 18

Eurodollar Deposits

Answer 18

used by non-US banks and foreign branches of US banks to raise funds in the global money markets
-USD denominated deposits held in FI’s outside the US
- may be issued as negotiable Eurodollar CDs or non-negotiable Eurodollar time deposits - both are interest bearing
- many MNCs invest in these foreign bank issues because they allow the ability to invest in USD based securities that have historically had a higher rate of interest than comparable US bank securities due to fewer reguations and lack of US reserve requirement

Question 19

Yankee CDs

Answer 19

USD denominated CDs sold by US branches (NY branch hence name Yankee) of non-US banks

• minimum investment of $100k
• higher rate of interest than comparable US bank securities due to differences in regulation and no US reserve requirement
• rate differential have mostly gone away but investors stil use Yankee CDs to provide geographical diversification

Question 20

Deposit Insurance on cash investments

Answer 20

private companies (e.g. American Deposit Management Co and IntraFi Network Deposits) can provide service enabling investors to receive full FDIC coverage on cash investments up to $50mm by distributing funds among CDs issued by a network of banks
similarly, FDIC coverage can be obtained for other money market products such as MMDAs by distributing cash across a network of banks

Question 21

Banker’s Acceptance

Answer 21

a time draft that is issued by a purchaser of goods to pay a supplier and the draft has been accepted by the bank on which the draft is drawn

• BA represents the bank’s unconditional promise to pay the time draft at maturity
• beneficiary can either wait until maturity to receive payment in full or sell the BA prior to maturity at a discount

Question 22

Government Paper

Answer 22

govt agencies raise funds in the money market by issuing short-term promissory notes called govt paper

-govt paper are issued in a wide range of maturities but only those with a maturity less than 1 year are considered money market instruments
- variety of maturities let investors to closely match liqudity requirements
- govt paper is issed on a discount relative to their par value
- yield on govt paper tends to be lower than yield of comparable instruments due to lower default risk and lower liquidity risk

Question 23

US Govt Paper

Answer 23

US T-Bills are money market instruments sold at a discount relative to their par value at maturity with original maturities of less than one year
- newly issued T-bills are sold through a multiple price, sealed-bid auction
- T-bills can be purchaed on either a competitive or noncompetive basis

(1) competitive bids - bids are accepted starting with the highest price offered(aka lowest yield for the investor) down to the lowest price necessary to sell the entire issue
(2) non-competitive bids - guarantees the bidder to receive the desired amount of T-bills at the average price from the competitive bid process

Question 24

Dealer’s Bid-Ask Discount

Answer 24

(1) bid discount > ask discount (always) - higher discount = lower price
(2) bid discount - discount at which dealer is willing to buy a security
(3) ask discount - discount at which dealer is willing to sell a security

Question 25

Municipal Bonds (munis)

Answer 25

many muni bonds are exempt from federal income taxes and / or state income taxes in the state of issuance which makes them attractive to investors seeking tax-free income
- dealers provide an active secondary market for these short term muni obligations
- maturities of 3 months to 1 year
- used by local govts to provide interim financing for general obligation bond projects or to provide short term capital in anticipation of future tax revenues

Question 26

Variable Rate Demand Obligations (VRDOs)

Answer 26

issued as long term bonds that carry a short term liquidity feature or put

• put option allows investors to sell the instrument back to the issuer at par, which allows for weekly or monthly liquidation
• typically supported by a credit facility such as a bank letter of credit

Question 27

Floatring Rate Notes (FRNs)

Answer 27

“firms, banks, and central govts raise short term funds via FRNs
- maturities typically 1 year or longer
- pay regular coupon with return of face value at maturity
- traded on the secondary market at a discount
- return / margin on FRN is combo of coupon rate and capital gain / loss on purchase / sale of the FRN
- interest rate is reset periodically based on a reference rate
- FRNs are sold at a quoted spread over the stated reference rate
- can include special features such as min / max coupon rates

PROS:
- variable rate is appealing in uncertain rate enviroments, as to not be locked into a fixed rate
- offer relatively attractive yields
- regular rest of coupon means less capital volatility than fixed interest securities
- creditworthiness is easy to determine - published credit ratings
- issued with credit enhancements to improve marketability
- may be secured by collateral pledged by borrowers

CONS:
- capital value can fluctuate in time between interest rate rests that bring the yield in lin with the rest of the market
- bid-offer spreads tend to be wider
- regular trading can erod any yield advantage pretty quickly
- fairly large minimum investments
- hard for small investors to acheive sufficient counterparty diversification by buying FRNs individually

Question 28

Repurchase Agreements

Answer 28

the owner (typically a bank or securities dealer) of a security (typically government debt securities) will sell the security instrument to an investor and then agree to repurchase the same instrument back form the investor at a later date and at a slightly higher price

• original owner of the security is effectively entering a short term borrowing arrangement
• from the investor perspective they are entering a reverse repo agreements and is able to use the agreement to invest short term cash

Question 29

Classification of Repo (3)

Answer 29

(1) overnight repo
(2) term repo - two days or longer and may have any maturity agreed to by both parties but rarely for periods of more than a year
(3) open repo - have no maturity date but either party can terminate the agreement on a day-by-day basis

Question 30

Benefits of a Repo

Answer 30

(1) each repo is negotiated individually between two parties, therefore the maturity and yield can be tailored to each party’s requirements
(2) taking legal possesion of the underlying security also provides the investor a high degree of comfort
(3) repo can be sold if the selling counterparty defaults on the agreement (sell the underlying security)
(4) repo transactions are generally overcollateralized - to mitigate settlement risk; value of the securities exceed the amount of the repo

Question 31

Two Ways to Structure a Repo Transaction

Answer 31

(1) bilateral repo - collateral and funds are exchanged directly between the two paties
(2) tri-party repo - collateral is held by and funds are exchanged through a broker dealer
- safest method to secure the repo
- security is usually held in a third party agent’s custodian account
- agent will value the security and manage any additional collateral calls by the investor

Question 32

Reserve Primary Fund “broke the buck”

Answer 32

due to contraction of credit triggered by the 2007-2009 global financial crisis, the Reserve Primary Fund (one of the world’s largest MMFs) “broke the buck” aka NAV fell to below $1.00 per share

• occurred due to drop in value in the underlying securities and the fund ran short on cash due to excess investor redemptions
• as a result, 2a-7 was revised to include liquidity requirements (daily / weekly) and restricts ability of fund to purchase illiquid assets

Question 33

Money Market Fund (MMF) Rules / Requirements

Answer 33

MMFs are subject to regulation by the relevant authority (e.g. SEC in the US, ESMA in the EU)

(1) permitted investment: funds may be limited to holding ONLY money market securities with certain characteristics (e.g. a fund must hold govt securities in order to qualify as govt fund)
(2) diversification rules: funds are also subject to counterparty limits to achieve fund diversification
(3) portfolio rules: MMF portfolios are subject to max weighted average maturity (WAM) and max weighted average life (WAL) rules
(4) liquidity requirements: required to hold a specified minimum proportion of assets that mature overnight and mature within a week
(5) fund pricing: funds are allowed to value to a floating NV (FNAV funds) and goverment funds (and funds for retail investors) are allowed to value to a constant NAV (CNAV), in the EU funds can calue to a low volatility NAV (LVNAV) which allows the fundto price to a constant NAV as long as the mark-to-market valuation of the assets remain within 0.20% of the constant price

Question 34

Money Market Fund (MMF) Regulation / Legislation

Answer 34

MMFs are regulated by the SEC under Rule 2a-7 of the Investment Company Act of 1940

(1) ruling places stipulations on MMFs with the goal of ensuring adequate diversification

(2) updated rule post 2007-2009 global financial crises imposed (a) minimum liquidity requirements (2) daily liquidity requirements (3) weekly liquidity requirements and restricts funds from purchasing illiquid and lower quality securities

(3) 2016 revision included (a) floating NAV (b) liquidity fees if weekly liquid assetss fall below certain threshold and (c) ability to suspend redemptions for up to 10 business days

Question 35

5 Common Types of US MMFs

Answer 35

(1) US Treasury Funds: US Treasury securities only

(2) Government Funds: minimum of 99.5% of total assets must be invested in cash, govt securities and repos collateralized by govt securities

(3) Institutional Prime Funds: CP, CDs, govt securities, repos, other short term instruments

(4) Institutional Muni / Tax-Exempt Funds: tax-exempt securities issued by state and local govts

(5) Retail Funds: funds offered ot individuals, institutional investors are restricted from investing in retail money market funds

Question 36

EU Money Market Fund Definition

Answer 36

(1) short term MMF: max WAM of 60 days, max WAL of 120 days, include public debt CAN funds, LVNAV funds, and VNAV funds
(2) standard MMF: max WAM of 6 months, max WAL of one year, all funds are VNAV funds
EU funds that do not meet either definition are not allowed to be designated as an MMF

Question 37

Treasury Benefits of MMFs

Answer 37

(1) security of principal: historically stable and secure, especially during periods of interest rate volatility (e.g. MMF managers extend maturities when rates fall to lock in yields, allowing investors to receive greater return and enjoy liqudity and stability of principal)

(2) access to daily liquidity: investors can make daily redemptions, making MMFs just as liquid as overnight deposits

(3) diversification: small minimum investments allow organizations to tailor their short term portfolio to meet diversification and maturity requirements

(4) benefits of economies of scale: low transaction costs ensure yield do not erode due to active management of the underlying portfolio

Question 38

Duration

Answer 38

is a measurement of a portfolio’s sensitivity to interest changes

Question 39

Short Duration Mutual Funds

Answer 39

invest in securities with average maturity of 1-3 years
- majority of holdings in specific types of instruments such as govt issue, CDs, or CP
- longer investment maturity offer potential for higher return but also increases price volatility risk
- short duration mutual funds do not have fixed unit currency value
- may be used by investors to implement a strategy that matches investments with forecasted cash flow needs