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CHAPTER 4

THE MONEY MARKET

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Learning Objectives Describe the money market. Know the different types of financial instruments

available in the money market. Know what a banker's acceptance is. Know what a treasury bill is. Know what a certificate of deposit is. Know what a commercial paper is. Know what Eurodollars are. Know what a repurchase agreement or repo is.

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MONEY MARKET: WHAT IS IT? Borrowers issue highly liquid and short-term financial

instruments such as bankers' acceptances, treasury bills, certificates of deposit, commercial paper and Eurodollars

Short term means a maturity period of less than one year Money market securities are essentially IOUs issued by

governments, financial institutions and large organizations for their short-term cash requirements.

These instruments are very liquid and considered extraordinarily safe.

Money market securities offer significantly lower returns than most other securities because the financial instruments issuers are extremely conservative

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INSTRUMENTS IN THE MONEY MARKET

Bankers’ Acceptances (BA)These instruments are very liquid and considered extraordinarily safe

Treasury Bills (TB)Certificates Of Deposit (CD)Commercial PaperEurodollarsRepurchase Agreements (Repo)

INSTRUMENTS IN THE MONEY MARKET – BANKERS’ ACCEPTANCE (BA) Bankers’ Acceptance is a negotiable instrument or time draft

drawn on and accepted by a bank. Before acceptance, the draft is not an obligation of the bank,

it is merely an order by the drawer to the bank to pay a specified sum of money on a specified date to a named person or to the bearer of the draft.

Upon acceptance, which occurs when an authorized bank accepts and signs it, the draft becomes a primary and unconditional liability of the bank.

If the bank is well known and enjoys a good reputation, the expected draft may be readily sold in an active market.

A banker’s acceptance is also a money market instrument – a short-term discount instrument that usually arises in the course of international trade.

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INSTRUMENTS IN THE MONEY MARKET – BANKERS’ ACCEPTANCE (BA)

A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within six months.

At this stage, it is like a postdated check. When the bank endorses the order for payment as

“accepted”, it assumes responsibility for ultimate payment to the holder of the acceptance.

At this point, the acceptance may be traded in secondary markets much like any other claim on the bank.

Bankers’ acceptance are considered very safe assets, as they allow traders to substitute the bank’s credit standing for their own.

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INSTRUMENTS IN THE MONEY MARKET – BANKERS’ ACCEPTANCE (BA)

Bankers’ Acceptance is a short-term credit investment created by non-financial companies and guaranteed by a bank to make a specified payment when it is due.

Arises most often in connection with international trade.An exporter draws a draft on a specific bank in order to

obtain payment for goods shipped to a customer in another country.

A negotiable time draft for financing imports, exports or other transactions in goods.

Especially useful when the creditworthiness of a foreign trade partner is unknown.

The maturities on acceptances normally range from 30 to 180 days

A banker's acceptance needs to be held until maturity.

BANKERS’ ACCEPTANCES (BA)

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Acceptances are traded at discounts from their face value in the secondary market, for example: Face value of banker's acceptance RM1,000,000 Minus 2% per annum commission for one year RM20,000 Amount received by exporter in one year RM980,000

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Treasury bills (TB)

Treasury bills or T-bills are another type of marketable money market security.

Issued by government when it wants to borrow money to meet its short-term cash needs.

They are issued with three-month, six-month and one-year maturities.

They are issued at a discount from the face value.

When the TBs mature, the government pays the holder the full face value.

Treasury bills (TB)

Bank Negara Malaysia facilitates the sale of treasury bills through competitive auction.

Malaysian treasury bills are issued on a weekly basis and auction is held one day before the issue date.

The successful bidders are determined according to the most competitive yield offered.

The standard trading amount is RM5 million. Treasury bills are actively traded in the

secondary market.

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Certificate of Deposit CD is a form of savings certificate. The bearer of a CD is entitled to receive interest. CDs can be issued in any denomination. Interest rate on CDs is fixed over their stated maturity. Maturity term of a CD generally ranges from one month

to five years. The certificate can be purchased directly from

commercial banks or savings and loan institutions. The certificate is a non-tradable security. CDs are not traded on any exchange. CDs are relatively low-risk debt instrument

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Commercial Paper Commercial paper is unsecured, It is short-term loan or promissory note . It is issued by large companies. The proceeds of commercial paper sales used to finance

working capital. Issued at a discount, Based on current market interest rates. Average maturity of commercial paper is between one and

two months. Maturities on commercial paper are usually no longer

than nine months. Commercial paper is issued by a wide variety of domestic

and foreign firms, including finance companies, banks and industrial firms.

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Eurodollars Eurodollars are deposits denominated in U.S. dollars

deposited in banks outside the borders of the U.S. International investors buy U.S. dollars and deposit them

in a bank outside the U.S. and then use these dollars to buy goods in the world markets.

It has become convenient to businessmen to use Eurodollars .

The term Eurodollars originated in Europe (specifically London)

Eurodollars have very little to do with the euro or European countries.

Eurodollars

The average Eurodollar deposit is very large (in the millions) and they have a maturity period of up to about one year.

The U.S. and foreign companies borrow Eurodollars to pay for imports from U.S. and to invest in the U.S. securities markets.

Eurodollars are also used as an international currency, or international medium of exchanged.

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Repurchase agreement (repo) Repurchase agreement (or repo) is a legal contract

between a borrower and a lender. Repo transactions involve sale of securities at a particular

price by a repo seller to a repo buyer, whereby the repo seller gives a commitment on his part to repurchase the equivalent securities from the repo buyer

The repo buyer also gives a corresponding commitment to sell the equivalent securities back to the repo seller on a certain date and at a certain price plus a stated interest charge.

Both the date and the contract price of the same transaction are fixed for the duration of the transaction.

Repurchase agreement (repo) There are two major reasons why companies with

surplus cash prefer repos to marketable securities: The adjustable maturity provision embedded in repos.

The original repos’ maturity period can be adjusted to suit the needs of investing companies. Therefore, funds can be productively employed for a very short period of time.

Repos are protected against price fluctuations throughout the contract period and therefore any risk involved in the liquidation process is removed. Thus, companies can invest any surplus cash for a few days. E.g. Mutual funds will buy repos as a way to “park” excess cash flows for only very short periods.

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