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Flashcards in Short term Lending and borrowing instruments Deck (45):

Money market is

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


Basis upon which Money market operates:

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


also collective investment vehicles (“money market funds”)

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


three basic ways for investors to access the money markets:

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.


Distinction is often made between domestic and international money markets.

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).


Quoting MM instruments:

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”.


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

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.


Factors influencing the spreads of money market rates will include :

1. default risk and
2. market liquidity.


Most money market securities operate on a

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


return is in the form of

a capital gain and
there is no explicit income payment.


taxation authorities

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


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.

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.


Example of MM instrument

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.


Lending in money markets

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


The institutions involved in short term lending include :

companies and
national and
local governments and
government agencies.


The available investments for short term lending are:

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.


major forms of money market investment in most markets are:

1 Treasury bills,
2 commercial paper and
3 repo agreements


Treasury bills

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.


Treasury bills issue is by

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


In a UK Treasury bill auction:

all bids must be on a competitive basis.


In a US Treasury bill auction,

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.


Secondary Market for T-bills is

deep and liquid


Commercial paper is

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.


The main features of commercial paper:

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.


A repo is

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


Usage of repos

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.


Repo interest rate is:

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


Overnight repos

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


Open repos

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.


A “reverse repo” is

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.


Other money market instruments include:

1  government agency securities 

2  interbank deposits 

3  bankers’ acceptances and eligible bills.


Government agencies

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


Typical examples of government agencies are

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


Similarity of Gov Agency securities to

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


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

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.


Bank activity in money markets

major providers of funds to the markets

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


typical securities involved by banks for short term lending

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


Certificate of Deposit (CD)

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


The main features of CDs are:

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.


Bankers’ acceptances and eligible bills are

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.


What is a bank time deposit?

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.


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

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.


Describe factoring.

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.


Issues that differentiate between different types of loan include:

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).


What are liquid assets for trading companies?

Liquid assets are current assets,
eg stocks and debtors.