FACULTY OF COMMERCE

NAMES STUDENT I.D

Christine V Kakomwe N0164522X

NyaradzoN Mpinyuri N0161781J

Takudzwa B Masawi N0161956H

Merlin Mudiwa N0165061M

DEPARTMENT : Insurance and Actuarial Science

LECTURER : Mr Zinyoro

COURSE :Financial Markets, Institutions and Regulation (CIN 4117)

QUESTION

Money Markets
 a. Define money markets and Identify the major types of money market securities

According to Goodfriend (2011), money markets occupy a central place in the modern financial
system, providing monetary services and credit intermediation in the capital market at maturities
of less than a year. This market was named the “money market” as it allow participants to
acquire cash on short notices as well as invest excess funds in easily salable short term
marketable securities. Money marketsare usually used by financial institutions and others to
adjust their liquidity position and maintain a certain balance in their portfoliosMody (1986).
Form these two authors, money markets can therefore be defined as a market where short term
financial securities are traded.

Money market securities are generally sold in large denominations, having maturities of one year
or lesswith a low default risk.They are used mainly to raise funds for the government and they
help in the implementation of monetary policies. Money market securities are also used to
transfer funds from parties with surplus to those with deficit.There are different types of financial
securities that are traded in the money market and these include the following:

Treasury Bills

According to Driessen, (2016), Treasury bills are short term securities sold at a discount from
their face value. The discount from the face value is determined by the interest rate. Saunders
and Cornett (2015),also defined treasury bills as short term obligation of the US government
issued to cover current government budget shortfalls and to refinance maturing government debt
and are deemed to be risk free. They are sold through an auction process and are issued in
denominations of multiples of $100. In this case the minimum allowable denomination of a
treasury bill is $100. Treasury bills can be sold as new issue or as already existing.

Newly issued treasury bills in the United State of Americaare sold through its regular Treasury
bill auction. The amount of newly issued treasury bills is announced on a weekly basis (every
Thursday) and all the bids from different participants should be submitted to the Federal Reserve
Bank before the set deadline. Allocations and prices are then announced the following Monday
morning. T-bills are then delivered on a Thursday following the auction day.
According to Driessen, (2016), auction bids for T-bills are submitted either as competitive or
non-competitive bids. Competitive bids are specific with regards to the amount of par value and
the discount yield for a desired bill. With non-competitive bids the bidder agrees to accept the
discount rate that will be determined at auction and is assured to receive the full amount of the
bid, thus the discount rate is not specified at the time of bid submission. Once the auction closes
all the non-competitive bids are accepted and competitive bid are ranked from the lowestdiscount
yield (high price) to the highest yield(low price). All those competitive bids with rates above the
yield rate also known as the stop out yield or stop out rate set by the auction are rejected
(Saunders and Cornett 2015).

Example

Suppose ABC purchased a $1 million Treasury bill that is currently selling on a discount basis at
97½ percent of its face value. The T-bill is 140 days from maturity. Calculate Discount yield,
Bond equivalent yieldand Effective annual return.

Solution
Bond equivalent yield

ibe = (Pf - P0) * 365

P0 n

= [($1m. - $975,000)/$975,000](365/140)

= 6.68%
Effective annual return

EAR = 1 + [ibe / (365/n) ]365/n - 1

= [1 + 0.0668/(365/140)]365/140 - 1

= 6.82%
Discount yield

Id =Pf - P0* 360

Pf n

= [($1m. - $975,000)/$1m.](360/140)

= 6.43%

Where
⚫ P f = Face value
⚫ P 0 = Purchase price of the security
⚫ n = Number of days until maturity

Commercial Paper

Kacperczyk and Schnabl (2010), defines commercial paper as a short term debt instrument
issued by large corporations as a way of raising cheaply at short term interest rates.Saunders and
Cornett (2015), also defines Commercial paper as an unsecured short term promissory note
issued by a corporations to raise short term cash, often to finance working capital requirement.
Commercial paper offerslightly higher returns as compared to treasury bills as there will be a
minimal credit risks involved. According to Nayar and Rozeff, (1994) Commercial papers are
exempted from Securities and Exchange Commission registration requirements under either (1)
Section 3(a)(3) of the Securities Act of 1933, which exempts notes whose proceeds are to be
used for current transactions and that have maturities less than nine months, (2) Section 3(a)(6),
which exempts securities issued by common or contract carriers, or (3) Section 4(2), which
exempts private placements made to a small number of investors and not to the public.

Instead of taking out loans with high interest rates from the banks, companies with strong credit
ratings can issue a commercial paper with relatively lower interest rates. However companies
with lower credit rating will have to back their commercial paper with a letter of credit obtained
from a commercial bank. The bank will be promising payment upon default of the issuing
company at maturity date. ACommercial paper is generally sold in denominations of $100,000,
$250,000, $500,000 and $1,000,000. There are two types of commercial paper namely the
secured and unsecured commercial paper. Secured commercial papers are collateralised with
other financial assets whilst unsecured do not have collateral security. The discount at which the
commercial paper is issued equals in the investment return of the commercial paper.

A Commercial paper can be sold directly or indirectly through the use of brokers or dealers.
When commercial paper is issued directly from an issuer to a buyer, the company saves the
underwriting cost of the dealer but must find appropriate investors and determine the discount
rate on the paper that will place the complete issue. When the firm decides how much
commercial paper it wants to issue, it posts offering rates to potential buyers based on its own
estimates of investor demand. The firm then monitors the flow of money during the day and
adjusts its commercial paper rates depending oninvestor demand.Those that are sold through a
broker or dealer are usually expensive to the buyer as they include underwriting cost. Brokers or
dealers assist in negotiating specific quantities and maturities to the issue on behalf of the
investor

Certificate of Deposit

According to Saunders and Cornett (2015),Certificate Deposit is a short term security with a
fixed interest rate and maturity date that is issued by a bank to raise funds from the secondary
market and they are negotiable. Their differencing feature is that they can be traded any number
of times in the secondary market, hence the original buyer might not be the owner at maturity.
They have denominations that range from $100,000 to $10,000,000. Their very high
denominations makes it impossible for individuals to purchase them therefore, they are mainly
purchased by money market mutual funds. Maturity ranges from two weeks to one year.

A Certificate of deposit is traded in both the primary and secondary money market. In the
primary market new certificate of deposit are issued whilst in the secondary market only already
exiting CDs are traded. Well known banks can offer relatively lower rates as compared to
smaller banks as a result of perceptions with regards to default risk. CDs are negotiated between
the bank and the buyer in terms of rate, maturity and size. Immediately after negotiations the
bank ought to deliver the CD to a custodian bank for verification. Unlike other securities, CDs
allow for early withdrawals although they come with a penalty which is equal to the amount of
interest.
Banks that issue certificate deposit post a daily set of rate for the most popular maturities of their
CDs. They try to sell as many CDs as possible in the primary market.Soon after they deliver
these CDs to a specified custodian bank that the investor chooses.The custodian bank verifies the
CD, debits the amount to the investor’s account, and credits the amount to the issuing bank.

Repurchase Agreements

Happ(1986), defined Repurchase Agreements as arrangements where the borrower sells

government securities to the lender under commitment to repurchase them at a higher price at a
later date. According to Pickett (n.d) the borrower promises to repurchase the security at fixed
time and price. Repos collateralised fed funds loans, with collateral taking form of securitiessuch
as treasury bills.

There are two types of Repos namely the bilateral and tri-party repo. According to Pickett (n.d),
a bilateral repo the cash lender buys a security from the cash borrower on a condition that the
borrower will purchase a back the security at a specified time and price. At the trade date the
borrower deliver the security to the lender and the lender transfers the loan amount to the
borrower. The same applies at the date of repurchase; lender will have to give back the security
to the borrower whilst the borrower transfers the borrowed funds to the lender with interest.

Unlike the bilateral repo where the borrower and the lender are the only parties involved, tri-
party repos include a third party in their arrangements. In this case a custodian bank acts as an
intermediary between the borrower and the lender being in custody of the security being used as
collateral security by the borrower.

Repurchase agreements are arranged either directly between two parties or with the help of
brokers and dealers. A repo buyer arranges to purchase security for example fed funds from the
repo seller, with an agreement that the seller will repurchase the fed funds within a stated period
of time. The repo is collateralized with T-bonds. In most repurchase agreements, the repo buyer
acquires title to the securities for the term of the agreement.After this the Federal Reserve Bank
transfers the money to the seller’s reserve account as per buyer’s instruction. Upon maturity of
the repo seller transfers the initial amount plus additional funds (interest) from its reserve
account to the reserve account of the repo buyer.
Federal funds
According to Simon D (1990), Federal funds are reserves loaned between banks and other
depository institutions that are required to hold reserves with the Federal Reserve System.
Federal funds are subject to credit risk because they are typically booked without a formal
written contract on an uncollateralized basis. Taking for instance excess reserves held at Federal
Reserve Bank are traded with commercial banks with shortfalls in their reserve. These funds are
referred to as single payment loans as they pay interest once upon maturity. They are short term
money market securities and they are usually unsecured loans, thus there is no collateral security
for the loan.

Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds.
Federal funds transactions can be initiated by either the lending or the borrowing bank, with
negotiations between any pair of commercial banks taking place directly over the telephone.
Alternatively, trades can be arranged through fed funds brokers who charge a small fee for
bringing the two parties to the fed funds transaction together.

a) Understand the major developments in Euro money markets.

● What are euro money markets?

These are international or foreign markets where the trading of debt securities or instruments
with maturities of less than one year takes place. The trading is done with the US dollar as the
base currency. This is because the US dollar remains more significant relative to other
currencies. The US dollar is the major international medium of exchange and 62 percent of the
world’s currency reserves are held in U.S dollars.(Saunders and Cornett 2015) To this, many
contracts require payments to be done in US dollars and this has made several countries to keep
deposits in the US currency.

● What led to the creation of the Euro money markets?

● The major reason for the creation of the Euro money markets was to facilitate
international trading of money market instruments among several countries. U.S
corporations conducting international trade often hold U.S. dollar deposits in foreign
 banks overseas to facilitate expenditures and purchases. Governments, individuals and
corporations can participate in the market for the purpose of international trading. These
dollar-denominated deposits held offshore in U.S. bank branches overseas and in other
(foreign) banks are called Eurodollar deposits and the market in which they trade is called
the Eurodollar market.

● Operations in the market

The market is not directly influenced by the US bank regulations, such as reserve requirements
or deposit insurance premiums. As such, the rates paid on the deposits are generally higher.
Companies make use of the Euro money markets to obtain short term funding through Euro
commercial paper and certificates of deposits. Thus, the market instruments include Euro dollar,
Euro commercial paper and Euro certificates of deposits.

1. Euro dollar market

It is a market in which dollars held outside the US are tracked among multinational banks.
(Saundersand Cornett 2015)This market comprises of several large banks in London and is
used as a way of sourcing short term funds (overnight funding). For example, a company in Italy
needing U.S. dollars for a foreign trade transaction might ask Citigroup’s subsidiary in London
to borrow these dollars on the Eurodollar market. Alternatively, a Greek bank needing U.S.
dollar funding may raise the required funds by issuing a Eurodollar Commercial Deposits.

Most of the transacting takes place in London and the rate used is known as the London
Interbank Offered Rate (LIBOR). The London Interbank Offered Rate (LIBOR) is a widely used
indicator of funding conditions in the interbank market . (Hou and Skeie 2014) The market
has grown enormously to the extent that the LIBOR is now being used as the standard for pricing
short term business loans and thus overtaking the US federal funds rate. Funds traded in the
Eurodollar market are often used as a substitute to federal funds as a source of overnight funding
for banks. Generally, the federal fund rates are lower than the LIBOR due to their low risk in
nature. For instance, the federal fund rates will be subject to regulation eg deposit insurance
unlike LIBOR where there is no much influence from regulation. (Machlup1970). However, the
federal fund rate has sometimes risen over the LIBOR rate.
The LIBOR and U.S. federal funds rate tend to be very closely related. Should rates in one of
these markets (e.g., the LIBOR market) decrease relative to the other (e.g., the fed funds market),
overnight borrowers will borrow in the LIBOR market rather than the fed funds market. As a
result, the LIBOR will increase with this increased demand and the fed funds rate will decrease
with the decline in demand. This will make the difference between the two rates quite small,
although not equal.

2. Eurodollar Certificates of Deposit

These are US dollar denominated certificates of deposits with maturities of less than one year
held in foreign banks. Eurodollar CDs are not subject to reserve requirements in the same
manner as U.S. deposits because these securities are deposited in non-U.S. banks. According to
Federal Reserve Board (2013),prior to the 1990s the Eurodollar CD paid consistently higher
interest rates than U.S. CDs. In October 2008, the Eurodollar CD rate (5.31 percent) was 0.99
percent higher thanthe U.S. CD rate (4.32 percent). This difference was again due to the low-risk
nature of U.S.bank deposits relative to foreign bank deposits.

3. Euro commercial paper

These are Eurosecurities issued in Europe by dealers of commercial paper without involving a
bank.Eurocommercialpaper is issued in local currencies as well as in U.S. dollars. With the
introductionof the European Currency Unit in 1999, Eurocommercial paper denominated ineuro-
area currencies increased significantly. By 2010, 49.7 percent of all Eurocommercial paper
outstanding was denominated in euros. In comparison, U.K. (Britishpound sterling) paper
comprised 13.1 percent of all Eurocommercial paperoutstanding, while U.S dollar–denominated
paper fell to 30.5 percent of the total.(Saundersand Cornett 2015)

Projections are that the Euro money market will only continue to grow. However, theEuropean
crisis resulted in a drop in the amount of Eurocommercial paper denominatedin euro-area
currencies. In 2013, just 32.1 percent of all Eurocommercialpaper outstanding was denominated
in euros, while pound sterling paper comprised 20.7 percent and U.S. dollar-denominated paper
rose to 41.4 percent of the total.
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