CHAPTER 2:

MONEY MARKET
Contents
1 Definition, function and
characteristics of money
market
2Instruments of money market

3Participants in money market

4 Structure of money market

and trading activities
 1. Definition, function and
characteristics of money
market

1.1. Definition of money market

1.2. Function of money market

1.3. Characteristics of money

market
 1.1. Definition of money
market
• In general terms, this is the market
where liquid and short-term borrowing
and lending take place (< 1 year).
• Money market is the market where
Short term instruments are transacted to
meet the short term capital need of
entities in the economy
 1.1. Definition of money
market
• * Note: The term money market is a bit
confusing, because money or currencies are not
actually traded in Money Markets. The goods are
Securities (e.g. treasury bills, government bonds)
that are traded, are short –term and highly liquid,
that is, they are close to being like money and
can easily being converted into money.
1.2. Function of money
market
1.2.1. Create and provide short-term
capital to the economy
1.2.2. Create safe and efficient
investment environment to
participants in the society
1.2.3. Make healthy money circulation
and stabilize value for money
 1.3. Characteristics of
money market
• The Money Markets can be characterised as
having securities that trade in one year or less,
are of large denomination and are very liquid.
• Money market transaction are not taking place
in any one particular locations/building- they
are normally done electronically from various
locations
 1.3. Characteristics of
money market
• Investors in Money Market: Provides a place for
warehousing surplus funds for short periods of time
• Borrowers from money market provide low-cost source
of temporary funds
• Corporations and government use these markets
because the timing of cash inflows and outflows are not
well synchronized. Money markets provide a way to
solve these cash-timing problems.
2. Instruments of money
market
* Characteristics of MM Instruments:
•Initial maturity: less than one year (three months is
quite common); Average residual maturity is very
short
•Liquidity: High liquidity.
•Debt instrument
 2. Instruments of money
market
* Characteristics of MM Instruments:
•Low risk
– Low default risk
– Low interest rate risk
•High liquidity
– Short-term

– Low interest rate risk or small price changes

•MM instruments tend to have similar rates of return which are lower than the
rates that can be earned in other financial markets
2. Instruments of money
market

• 2 types:

(1)Discount Instruments

(2)Yield Instruments (interest

instruments)
 (1)Yield Instruments
 Instruments which pay interest on the amount
invested, where the interest is normally paid to
the holder of the instrument (the lender),
together with the redemption amount at
redemption date. Internal interest payments
may be made in certain cases
These instruments are called interest
instruments
 (2) Discount
Instruments
 Instruments that do not pay interest on
the amount invested but are issued at a
discount to the face value (the
redemption amount)
 These instruments are called discount
instruments
MM instruments
Instruments of money market

MM
Instrumen
ts
 Treasury bills
• Definition: A TB is a government debt
issued by the Government, through the
Treasury State

• In US: Treasury security is a government

debt issued by the United States Department
of the Treasury through the Bureau of the
Public Debt. Treasury securities are the debt
financing instruments of the US federal
government, and they are often referred to
simply as Treasurys
 United States Treasury
Security
 4 types of marketable treasury securities:
 Treasury bills
 Treasury notes
 Treasury bonds
 Treasury Inflation Protected Securities
(TIPS)
 They are very liquid and are heavily
traded on the secondary market
 United States Treasury
Security
• There are several types of non-
marketable treasury securities
including State and Local
Government Series (SLGS),
Government Account Series debt
issued to government-managed trust
funds, and savings bond
 They are issued to subscribers and
cannot be transferred through market
sales
 Treasury Bills
• Definition: Treasury bills (T-Bills) mature
in one year or less (28, 91, 182, and 364
days)
• Discount instrument
• Treasury bills as the least risky
investment available to U.S. investors
 Central bank bills
• Central bank bills (CBBs) are usually short-term (up to
a year) financial instruments issued by a country’s
central bank or monetary authority to commercial
banks.
• CBBs are primarily issued for a range of monetary
policy purposes, exchange rate regulations, and are
also used as a primary means of reducing excess
liquidity (via reserves management).
 Central bank bills
• Central Bank Bills (CBBs) is an indirect monetary
policy tool used by Central Bank to implement
monetary policy through its Open Market Operations.

(Monetary policy is the process by which the Central

Bank controls the supply of money in the economy,
often targeting a rate of interest with the aim of
achieving and/or maintaining price stability and
promoting economic growth)
 Central bank bills
• Features of CBBs are similar to Treasury Bills. It is a
short-term discounted paper with fixed maturities of 28,
63, 91 and 182 days, redeemable at par on maturity.
• The Central Bank has the discretion to set the amount to
be issued/sold together with the terms/maturities.
• Interest rates or yields for CBBs purchased through an
auction are determined by the investors when bidding.
Investing in CBBs is often restricted, to only
Commercial banks and other deposit-taking institutions.
 Certificate of deposit
(CD)
• Definition: A certificate of deposit (CD) is
a time deposit, a financial product
commonly offered to consumers by banks,
thrift institutions, and credit unions
• CDs are similar to savings accounts in
that they are insured and thus virtually
riskfree; they are "money in the bank".
Certificate of deposit
(CD)
• CD different from savings accounts in
that the CD has a specific, fixed term
(often monthly, three months, six
months, or one to five years), and,
usually, a fixed interest rate.
• It is intended that the CD be held until
maturity, at which time the money may
be withdrawn together with the
accrued interest.
 Negotiable certificates
of deposit (NCDs)
• Definition: A negotiable certificate of
deposit is a certificate issued by a bank
for a deposit made at the bank.
• Interest paid together with the face
value at redemption date.
 The NCD will contain the
following information
• Name of the issuing bank
• Date of issue
• Date of redemption (maturity date)
• Amount of the deposit
• Maturity value
• Annual interest rate paid on the deposit
Note: NCDs are bearer documents, which means that the
name of the owner (holder or depositor) does not appear
on the document. The bearer or holder of the document
will receive the maturity value (the amount deposited
plus interest) at maturity date
 Bankers' acceptances -
BA
• Definition: A short-term debt instrument
issued by a firm (non financial firm) that is
guaranteed by a commercial bank
• BA are issued by firms as part of a
commercial transaction
• BA are traded at a discount from face value
on the secondary market, which can be an
advantage because the banker's acceptance
does not need to be held until maturity.
Banker's acceptances are regularly used
financial instruments in international trade
 Bankers' Acceptances -
BA
• BA vary in amount, according to the size of
the commercial transaction. The date of
maturity typically ranges between 30 and
180 days from the date of issue
• However, banks or investors often trade the
instruments on the secondary market
before the acceptances reach maturity
• BA are considered to be relatively safe
investments, since the bank and the
borrower are liable for the amount that is
due when the instrument matures
 Bankers' Acceptances - BA
• BA make a transaction between two
parties who do not know each other more
safe because they allow the parties to
substitute the bank's credit worthiness
for that who owes the payment
• BA used widely in international trade for
payments that are due for a future
shipment of goods and services
 Example of BA
• An importer may draft a BA when it does not
have a close relationship with and cannot obtain
credit from an exporter. Once the importer and
bank have completed an acceptance agreement,
whereby the bank accepts liabilities of the
importer and the importer deposits funds at the
bank (enough for the future payment plus fees),
the importer can issue a time draft to the
exporter for a future payment with the bank's
guarantee.
Note:
• BA are typically sold in multiples of US $100,000
• BA smaller than this amount are referred to as
odd lots
 Commercial Paper
• CP issued (sold) by large corporations to get money to
meet short term debt obligations (ex: payroll), and is
only backed by an issuing bank or corporation's
promise to pay the face amount on the maturity date
specified on the note
• Since it is not backed by collateral, only firms with
excellent credit ratings from a recognized rating agency
will be able to sell their CP at a reasonable price
• In the global money market, CP is an unsecured
promissory note with a fixed maturity of 1 - 270 days
• CP is usually sold at a discount from face value, and
carries higher interest repayment rates than bonds.
Interest rates fluctuate with market conditions, but are
typically lower than banks' rates.
 Advantage of Commercial
Paper
• High credit ratings fetch a lower cost of
capital
• Wide range of maturity provide more
flexibility
• It does not create any lien on asset of the
company
• Tradability of Commercial Paper
provides investors with exit options
Disadvantages of Commercial
Paper

• Its usage is limited to only blue chip

companies
• Issuances of Commercial Paper bring
down the bank credit limits
• A high degree of control is exercised
on issue of Commercial Paper
• Stand-by credit may become necessary
 US Commercial paper types
outstanding at end of each year 2001 -
2007

http://en.wikipedia.org/wiki/Commercial_paper
Total US Commercial paper outstanding
each week

• http://en.wikipedia.org/wiki/Commercial_paper
 Repurchase Agreement
• Also known as a repo, RP is the sale of securities
together with an agreement for the seller to buy
back the securities at a later date
• The repurchase price should be greater than the
original sale price, the difference effectively
representing interest, sometimes called the repo
rate
• The party that originally buys the securities
effectively acts as a lender
• The original seller is effectively acting as a
borrower, using their security as collateral for a
secured cash loan at a fixed rate of interest
 3 types of repo
maturities
• Overnight: refers to a one-day maturity
transaction
• Term: Term refers to a repo with a
specified end date
• Open repo: Open simply has no end
date. Although repos are typically short-
term, it is not unusual to see repos with a
maturity as long as 2 years
 MM instruments
Discount Yield instruments
instruments
•Bank deposits
•Treasury bills
•Certificates of deposit
•Commercial bills
•Repurchase agreements
•Central bank bills (REPO)
 Question

• The longer the maturity on a

note, the higher or lower the
interest rate the issuing
institution must pay?
3. Participants in money market
 Key Participants in the
Money markets
• Governments/Central Banks- For example US
Treasury, Bank of England- Sell
Treasury/Government bills to fund national debts-
Also buy /sell to control money supply.
• Large Businesses- Buy and sell securities( T-
Bills) to manage finance/cash.
• Commercial Banks-Buy/sell (T-Bills) for their
operations and for clients.
Who Participates in the Money
Markets?
4. Structure of money market
and trading activities

4.1 Deposit and lending

market

4.2 Interbank market

4.3 Open market

4.4 Foreign exchange market

 4.1. Deposit and lending
market
• Definition: Currency trading
market between credit institutions
and organizations and individuals
in society
 4.1. Deposit and lending
market
• The deposit market: is a market
for commercial banks and credit
institutions to mobilize capital in
the economy for funding credit
business.
• The lending market: is the market
that provides capital to the
economy on the principle of
repayment and condition.
 4.2. Interbank Market
• Definition: The financial system and trading
of currencies among banks and credit
institutions, excluding retail investors and
smaller trading parties. While some
interbank trading is performed by banks on
behalf of large customers, most interbank
trading takes place from the banks' own
accounts.
• The banks can either deal with one another
directly, or through electronic brokering
platforms
 4.2. Interbank
Market
 Banks borrow short-term funds from other
banks having excess liquidity
• Various interest rates are used in the
interbank market, including the widely used
London Interbank Offered Rate (LIBOR),
Euro Interbank Offered Rate (EURIBOR),
Tokyo Interbank Offered Rate (TIBOR)
• The interbank market is watched closely to
assess credit risk and measure the state of
the economy
4.3. Open Market
 Open market operation -
OMO
• Definition: OMO is an activity by a central bank to
buy or sell government bonds on the open market.
• A central bank uses them as the primary means of
implementing monetary policy.
• The usual aim of open market operations is to
control the short term interest rate and the supply
of base money in an economy, and thus indirectly
control the total money supply.
• This involves meeting the demand of base money
at the target interest rate by buying and selling
government securities, or other financial
instruments. Monetary targets, such as inflation,
interest rates, or exchange rates, are used to guide
this implementation
 OMO are the principal tools of
monetary policy-
Expansionary and Contractionary Monetary Policy

 Reserves of
commercial banks,
making it possible for
Central them to expand their
bank loans and investments
buys
securitie  the price of
s on government Encouragi
OMO securities, equivalent ng
to reducing their investme
interest rates nt
If the central bank sells securities, the
effects are reversed
4.4. Foreign exchange
market (Forex)
 4.4. Foreign exchange market
(Forex)
• In a typical foreign exchange transaction, a
party purchases a quantity of one currency by
paying a quantity of another currency.
• The modern foreign exchange market began
forming during the 1970s after three decades of
government restrictions on foreign exchange
transactions (the Bretton Woods system of
monetary management established the rules for
commercial and financial relations among the
world's major industrial states after World War
II), when countries gradually switched to
floating exchange rates from the previous
exchange rate regime, which remained fixed as
per the Bretton Woods system
 Forex
• Definition: The foreign exchange market
(FX, or currency market) is a form of
exchange for the global decentralized
trading of international currencies.
Financial centers around the world
function as anchors of trading between a
wide range of different types of buyers and
sellers around the clock, with the exception
of weekends. The foreign exchange market
determines the relative values of different
currencies
 The foreign exchange
market is unique because
of
• Its huge trading volume representing the largest
asset class in the world leading to high liquidity
• Its geographical dispersion
• Tts continuous operation: 24 hours a day except
weekends, i.e. trading from 20:15 GMT on
Sunday until 22:00 GMT Friday
• The variety of factors that affect exchange rates
• The low margins of relative profit compared
with other markets of fixed income
• The use of leverage to enhance profit and loss
margins and with respect to account size
Traders in Forex
• Large banks
• Central banks
• Institutional investors
• Currency speculators
• Corporations
• Governments
• Other financia institutions
• Retail investors
 SIMPLE INTEREST
• Signify that the calculation of
interest is based only on the initial
principal of an investment, or the
amount borrowed.
 SIMPLE INTEREST
Simple interest accumulation
12% 12% 12%

A 100 100 100 100

I 12 12 12
 SIMPLE INTEREST
Present value with simple interest
12% 12% 12%

PV S
 SIMPLE INTEREST
Present value with simple interest
A company discounts (sells) a commercial bill with a
face value of $100 000, a term to maturity of 180 days
and a yield of 7.85% per annum. After the bill has been
held for 50 days it is sold as a yield of 7.35% per
annum.
1. How much will the company receive when it sell the
bill?
2. How much will the holder receive when he sells the
bill on day 50?
 COMPOUND INTEREST
• Interest applied to a loan or an
investment was calculated on the
ACCUMULATED principle amount.
• Interest is added to the principle
 COMPOUND INTEREST
Compound interest accumulation
12% 12% 12%

A 100 112
I 12
 COMPOUND INTEREST
Present value with compound
interest 12% 12% 12%

PV S
 COMPOUND INTEREST
Present value with an annuity
12% 12% 12%

PV 100 100 100

The present value of a 100$ annuity received

annually, for 3 years, it funds could be invested
today at 12% p.a. compounded annually
 COMPOUND INTEREST
Present value with compound interest
A bond has a face value of $1,000, a
coupon rate of 4% and a maturity of
four years. The bond makes annual
coupon payments. If the yield to
maturity is 4%
What is the bond’s present value?