Short term Lending and borrowing instruments

Question 1

Money market is

Answer 1

not a physical location;
it is a virtual market place made up of
electronic communications 
between banks, 
dealers and 
major corporations.

Question 2

Basis upon which Money market operates:

Answer 2

a “wholesale” level,
with individual transactions of tens or hundreds of million pounds sterling.
mostly discounted quotes

Question 3

also collective investment vehicles (“money market funds”)

Answer 3

offering access to the money market for individuals and small companies.

Question 4

three basic ways for investors to access the money markets:

Answer 4

1. directly on their own account –
   ⁃ most suitable for large financial firms 

2. hire a professional investment management firm –
   ⁃ suitable for investors who will make transactions of large amounts
   ⁃ but who don’t have the expertise to deal in the market themselves 

3. via a money market fund –
   ⁃ these provide a diversified holding
   ⁃ of money market instruments
   ⁃ and are most suitable for smaller investors.

Question 5

Distinction is often made between domestic and international money markets.

Answer 5

The latter consists of funds
in a particular currency deposited in banks that are located outside that currency’s domestic market
(and are therefore not subject to the regulation and taxation that governs the domestic market).

Question 6

Quoting MM instruments:

Answer 6

In the UK, 
money market interest rates 
are often quoted 
relative to LIBOR 
(the London Inter Bank Offered Rate). 

is true of currencies other than just sterling,

eg a US bank may be prepared to lend to a US company at “1.5% over LIBOR”.

Question 7

List the money market instruments introduced in Subjects A201 and A103.

Answer 7

1 Treasury bills 

2 local authority bills 

3 bills of exchange 

4 certificates of deposit (CDs) 

5 commercial paper 

6 term deposits 

7 call deposits.

Question 8

Factors influencing the spreads of money market rates will include :

Answer 8

1. default risk and

2. market liquidity.

Question 9

Most money market securities operate on a

Answer 9

discount basis; 
do not pay explicit interest but 
rather generate returns by 
the difference between 
the purchase price and 
the maturity proceeds.

Question 10

return is in the form of

Answer 10

a capital gain and

there is no explicit income payment.

Question 11

taxation authorities

Answer 11

will generally
regard the returns as income,
and tax it accordingly.

Question 12

Give 2 reasons why the risk of default is generally less for money market instruments issued by a company than for corporate bonds issued by the same company.

Answer 12

Reasons are:
1 The short-term future is more certain than the long-term future.
Investors can be more confident that a particular company
will survive a few weeks than they can
that it will survive the next twenty years. 


2 Only the more reliable companies
⁃ can borrow using short-term instruments
⁃ such as commercial paper.

Question 13

Example of MM instrument

Answer 13

A 3-month Treasury bill is being issued at an annual (simple) discount rate of 4%. Therefore, an investor would pay $99 at issue for each $100 nominal.

Question 14

Lending in money markets

Answer 14

money markets provide a means for institutions (or individuals)
with excess short- term cash to
make a return on that cash.

Question 15

The institutions involved in short term lending include :

Answer 15

banks, 
companies and 
national and 
local governments and 
government agencies.

Question 16

The available investments for short term lending are:

Answer 16

1 Treasury bills 

2 commercial paper 

3 repos 

4 government agency securities 

5 bank time deposits and certificates of deposit 

6 bankers’ acceptances and eligible bills.

Question 17

major forms of money market investment in most markets are:

Answer 17

1 Treasury bills,
2 commercial paper and
3 repo agreements

Question 18

Treasury bills

Answer 18

most economies 
major issuer of money market instruments is 
national government. Bills issued by the government are 
usually known as Treasury bills and 
are typically issued in 
3-month (91-day), 
6-month (182-day) and 
one-year forms.

Question 19

Treasury bills issue is by

Answer 19

auction, 
where competitive and non-competitive bids may be entered – 
latter are then filled at 
the average price of 
the successful competitive bids.

Question 20

In a UK Treasury bill auction:

Answer 20

all bids must be on a competitive basis.

Question 21

In a US Treasury bill auction,

Answer 21

investors must choose whether to bid competitively or non-competitively;

they cannot do both in the same auction.

If bidding competitively,
the investor submits a tender specifying the discount rate he requires (eg 0.51%).
If the specified discount rate is too high,
the investor may not receive any bills or
may not receive their full allocation bid. 

With a non-competitive bid,
the investor is guaranteed to receive the full amount of bills requested.
The price the investor pays will be
the average price determined from the successful competitive bids.
The upper limits on how much each investor can bid for
are lower for non-competitive bids than for competitive ones.

Question 22

Secondary Market for T-bills is

Answer 22

deep and liquid

Question 23

Commercial paper is

Answer 23

Short-term
unsecured notes
issued directly by a company
(overriding the need for financial intermediation)

issued at a discount, 
usually for a term of a few months, 
but can typically be presented 
to the issuer (or to a dealer) 
for repurchase.

Question 24

The main features of commercial paper:

Answer 24

1 a bearer document. 

2 Terms at vary from a few days up to several months
⁃ with terms up to two months being the most common. 


3 single-name instrument,
⁃ the security is provided
⁃ only by the company issuing the paper,
⁃ ie borrowing the money. 


4 Companies who wish to raise finance by issuing commercial paper have to
⁃ meet certain minimum standards. 


5 The effective rate of interest paid will be
⁃ slightly higher than the equivalent rate
⁃ on a risk-free investment (such as a Treasury bill).
⁃ The size of the “margin” over the risk-free rate of interest
⁃ will depend on the company’s credit rating. 


6 Rating agencies such as Moody’s and Standard and Poor’s publish ratings for commercial paper.

Question 25

A repo is

Answer 25

an agreement whereby one party sells stock to another with a simultaneous agreement to repurchase it at a later date at an agreed price.

Question 26

Usage of repos

Answer 26

``` Holders of government bonds and other high quality assets can use repos as a short-term financing tool, whilst maintaining their underlying economic exposure to these assets. Repo stock usually used is The “stock” involved is usually either Government bonds or Treasury bills. ```

Question 27

Repo interest rate is:

Answer 27

The difference between the repurchase price and the selling price is quoted as the repo interest rate.

Question 28

Overnight repos

Answer 28

are very common and | so they are a very liquid instrument.

Question 29

Open repos

Answer 29

``` also available. ave no fixed maturity date and either side can withdraw after giving the specified notice, usually 1 day. ``` For example, the investor can give notice and get the return on his cash (ie the agreed price for the Treasury bill) in return for handing back the bill.

Question 30

A “reverse repo” is

Answer 30

``` the opposite side of the agreement. This is a form of secured lending as cash is being lent for the duration of the repo by the party buying the stock, with the security as collateral. ```

Question 31

Other money market instruments include:

Answer 31

1  government agency securities 
 2  interbank deposits 
 3  bankers’ acceptances and eligible bills.

Question 32

Government agencies

Answer 32

issue and trade securities hat are almost as risk-free and liquid as Treasury bills.

Question 33

Typical examples of government agencies are

Answer 33

``` nationalised industries and local authorities (in the UK) or Federal Mortgage Associations, states and counties and school boards (in the US). ```

Question 34

Similarity of Gov Agency securities to

Answer 34

The securities (“notes”) issued are similar to Treasury bills, and a liquid secondary market typically exists in such bills and notes.

Question 35

reason for the slightly higher interest rate on government agency securities.

Answer 35

Marketability of Gov agency securities Although is a liquid secondary market not quite as marketable as Treasury bills The second reason relates to a slightly higher level of risk – the risk is that the national government would allow the agency to default. Investors may decide that this is extremely unlikely to happen, particularly for certain government agencies, in which case the risk margin over Treasury bills will be very small. Like Treasury bills, government agency bills are issued at a discount and redeemed at par.

Question 36

Bank activity in money markets

Answer 36

major providers of funds to the markets as well as being borrowers (when faced with a shortage of funds due to clearing activities).

Question 37

typical securities involved by banks for short term lending

Answer 37

Interest-bearing inter-bank overnight borrowing and | Certificates of Deposit (1 to 3 months) t

Question 38

Certificate of Deposit (CD)

Answer 38

a negotiable term deposit. If the investor wants to realise his investment before the maturity date, he can sell the CD to another investor.

Question 39

The main features of CDs are:

Answer 39

1  They are bearer documents – ⁃ the bank pays time deposit payment ⁃ to whoever presents the CD at maturity. 
 2  A secondary market exists but ⁃ it is far less liquid than that for Treasury bills and ⁃ government agency securities. 
 3  Typical maturity terms range from ⁃ 1 to 3 months. 
 4  Domestic and international CDs exist ⁃ in many currencies.

Question 40

Bankers’ acceptances and eligible bills are

Answer 40

a form of tradable IOUs, whereby a company that has supplied goods or services to a client will have the invoice “accepted” by a bank (who thereby guarantees payment at the due date). The bill can then be traded in a secondary market to raise immediate cash, at a discount. referred to as bills of exchange in Subject A103.

Question 41

What is a bank time deposit?

Answer 41

``` is a bank deposit that has a specified term. If the investor wants to access their investment before the maturity date they may be allowed to do so, but a penalty will be imposed, eg the interest rate might be reduced. ```

Question 42

other ways in which companies can borrow short-term mainly including banks include:

Answer 42

1  term loans 
 2  evergreen credit ⁃ (permission to borrow up to a specified limit, ⁃ with no fixed maturity) ⁃ just like an overdraft facility, ⁃ although it does involve the potential borrower ⁃ paying a commitment fee to the bank ⁃ for the option to borrow when it wants to. ⁃ Even with such an agreed line of evergreen credit, ⁃ the bank may require the borrower ⁃ to repay all outstanding amounts ⁃ periodically ⁃ to prevent what is intended to be a short-term form of borrowing ⁃ becoming a long-term (or permanent) fixture. 
 3  revolving credit ⁃ (similar to evergreen credit, ⁃ but with a fixed maturity of up to 3 years) ⁃ normal to have to pay a commitment fee ⁃ on the full agreed amount of borrowing, ⁃ whether or not it is all used. ⁃ Interest is only payable ⁃ on the amount actually borrowed. 
 ``` 4  bridging loans ⁃ (advances to be repaid ⁃ from specified income) ⁃ A bridging loan is used to ⁃ pay for a specific item ⁃ (eg new machinery, ⁃ investment in a new project) ⁃ in the interim period ⁃ before long-term finance is obtained. 
 ``` 5   international bank loans ⁃ As an alternative to borrowing from a domestic bank, ⁃ a company may choose to borrow international currency ⁃ from a bank overseas. ⁃ This may be from a single bank or ⁃ possibly, especially if large amounts are to be borrowed, ⁃ from a syndicate.

Question 43

Describe factoring.

Answer 43

two types of factoring: non-recourse and recourse (or invoice discounting). 1. Non-recourse factoring is ⁃ where the supplier sells on its trade debts ⁃ to a factor in order to ⁃ obtain cash payment of the accounts ⁃ before their actual due date. ⁃ The factor takes the credit risk ⁃ and also responsibility for credit analysis ⁃ of new accounts and payment collection. 
 2. recourse factoring, ⁃ a copy of the invoice is sent to the factor ⁃ who then gives the supplying company the money up front ⁃ equal to a percentage of the invoices it sends out. ⁃ The credit risk remains with the supplying company ⁃ who is still responsible for collecting its debts. ⁃ When the supplying company eventually gets paid by a customer, ⁃ it passes the money on to the factor. ⁃ Effectively, recourse factoring is a loan ⁃ which is secured against the invoices.

Question 44

Issues that differentiate between different types of loan include:

Answer 44

1  Commitment – ⁃ whether there is prior commitment by the lender ⁃ to advance funds when required ⁃ (often requiring payment of a commitment fee to the lender). ⁃ Companies may just approach a bank for a loan ⁃ “as and when” they need the cash. ⁃ It is more usual, however, to ⁃ pre-arrange a line of credit, ie ⁃ to get a commitment from the bank ⁃ on an amount up to which it will lend. ⁃ This can be on an evergreen or a revolving basis. ⁃ A commitment fee is usually payable to the bank. 
 2  Maturity – ⁃ the term for which the lending is made. 
 ``` 3  Rate of interest – ⁃ this may be either fixed or floating. ⁃ Very short-term loans may be ⁃ at a fixed rate of interest. ⁃ Most loans are ⁃ at a floating rate, ⁃ ie linked to the general level of interest rates, ⁃ eg a fixed margin above LIBOR. 
 ``` 4  Security – ⁃ whether the loan is ⁃ to be secured against assets ⁃ (either fixed or liquid assets).

Question 45

What are liquid assets for trading companies?

Answer 45

Liquid assets are current assets, | eg stocks and debtors.