Lecture # 8The Money Markets

Presented by Dr. Zeeshan Atiq

Preview

• Annual report of Microsoft of 2009 reveals that it contained over $6bn in cash and equivalents.

• $25 bn in short-term securities. $30 bn in highly liquid short-term securities.

• These all investments Microsoft made in Money Markets. Money markets are short-term, low risk and very liquid.

• These all characteristics near them to money in nature.

• The money markets are on rise since 1970s.

• In this chapter we discuss why the money markets are important to our financial systems.

The Money Market

• The money market is traditionally defined as the market for financial assets that have original maturities of one year or less.

• In essence, it is the market for short-term debt instruments.

• The term money market is actually a misnomer. Money—currency—is not traded in the money markets.

• The securities that are traded there are short-term and highly liquid, however, they are close to being money.

Money Market: Definition

• Characteristics:• Low default risk

• Maturity period of one or less than one year.

• Sold in large denominations.

The Money Market

• The scope of the money market has expanded in recent years to include securitized products such mortgage-backed and asset-backed securities with short average lives.

Money Market: Definition

• Money Market is a financial market in which only short-term debt instruments (maturity less than one year) are traded. MM is for transactions in wholesale short term loans and deposits and for trading short term financial instruments.

• Money market transactions do not take place in any one particular location or building. Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically.

Why Do We Need the Money Markets?• The banking industry exists primarily to provide

short-term loans and to accept short-term deposits.

• Banks should have an efficiency advantage in gathering information, an advantage that should eliminate the need for the money markets.

• Furthermore, short-term securities offered for sale in the money markets are neither as liquid nor as safe as deposits placed in banks.

• Given the advantages that banks have, why do the money markets exist at all?

Why Do We Need the Money Markets?

• The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service.

• However, the banking industry is subject to more regulations and governmental costs than are the money markets.

• In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds.

The Purpose of the Money Markets• The well-developed secondary market for money

market instruments makes the money market an ideal place for a firm or financial institution to “warehouse” surplus funds until they are needed.

• Similarly, the money markets provide a low-cost source of funds to firms, the government, and intermediaries that need a short-term infusion of funds.

Who Participates in the Money Markets?• Central Bank (State Bank of Pakistan).

• Commercial Banks,

• Co-operative Banks and Primary Dealers are allowed to borrow and lend.

• Specified Pakistani Financial Institutions, Mutual Funds, and certain specified entities are allowed to access to Call/Notice money market only as lenders.

• Individuals, firms, companies, corporate bodies, trusts and institutions can purchase the treasury bills, CPs and CDs.

Money Market Instruments

• Treasury Bills

• Certificate of Deposit

• Commercial Paper

• Call Deposit

• Term Deposit

Treasury Bills

• Treasury bills, commonly referred to as T-Bills are issued by Government of Pakistan against their short term borrowing requirements.

• Zero coupon bonds issued at discount to face value by SBP through PDs (Primary Dealers) via opening of IPS (investment policy statement) account for 3,6 and 12 months – Issued in multiples of Rs.5000-Risk free as borrower is GoP so no need of colleteral-Accepted as colleteral by Banks-

• T-Bills are the most marketable money market security due to its simplicity.

• Their standard maturity periods are 4, 13, 26 or 52 weeks(1, 3, 6, 12 months)

• T-Bills are considered to be the safest investment.

• They are considered to be risk free as they are backed by the government.

Short term certificate of deposit: Short term saving certificate

Short term certificate of deposit: Short term saving certificate• The Government of Pakistan launched Short Term

Savings Certificates (STSCs) scheme on July 1, 2012.

• The scheme has been specifically designed to meet the short term financial requirements of the depositors.

• STSCs is pledge-able and having 3-month, 6-month and 1-year maturity scheme.

Who can purchase

• All Pakistani Nationals as well as Foreign Nationals can purchase STSCs.

• An adult can also purchase STSCs on behalf of a single minor, two minors jointly or as a joint with a minor.

• Institutions may also invest their employees related funds such as pension, gratuity, superannuation, contributory provident fund and trusty fund etc.

How to purchase

• STSC can be purchased from any National Savings Centre (NSC) by filling in the SC-1 (Application form), available free of cost from all NSCs.

Commercial Papers

• Commercial paper is an unsecured, short term loan issued by a corporation, typically for financing Accounts Receivables and Inventories.

• Maturities on Commercial Papers are no longer than nine months, with maturities of between one and two months being the average.

• Commercial Paper is a very safe investment because the financial situation of a company can easily be predicted over a few months.

Commercial Papers in Pakistan

• Commercial paper, as an SECP source explained, is a short-term promissory note issued by corporations with a minimum credit rating of A- for long-term and A2 in short-term arrangements.

• These instruments are typically used for financing working capital requirements.

Commercial Papers in Pakistan

• The maturity period of a Commercial Paper range from as short a duration as 30 days and as long as one year.

• This would, however, be subject to the condition that the equity of the issuing company would be not less than Rs100 million as per its latest audited balance sheet.

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T-Bill Auctions in Pakistan• Treasury bills are sold through auction system

• The cut off yield is determined by the Auction Committee, keeping inview monetary targets, prevailing economic and financial conditions andexpected market response. The Six months’ T-bill is considered the mostimportant benchmark by the money market and is considered to be thesignaling tool of SBP for interest rate movements.

T-Bills Main Characteristics

• Issued in tenors of 3, 6 and 12 months;

• Denominated in multiples of PKR 5,000;

• A 10% withholding tax is deducted at source by SBP upon maturity;

• Non-paper instrument;

• Negotiable instruments and have an active secondary market;

• Redemption of the face value upon maturity is guaranteed by GoP.

Discounting of T-bills

Repurchase Agreements

• Repurchase agreements (repos) work much the same as fed funds except that nonbanks can participate.

• A firm can sell Treasury securities in a repurchase agreement whereby the firm agrees to buy back the securities at a specified future date.

• Most repos have a very short term, the most common being for 3 to 14 days.

• There is a market, however, for one- to three-month repos.

Repurchase Agreements

• Repurchase Agreement

• There is no Secondary market for REPOs.

• REPO transactions are negotiated through telecommunications network.

• Dealers & Brokers perform the role of financial mkt. & receive commission for such services.

• Mkt. Participants:-Central Bank financial institutions & non-financial institutions.

Glossary

• Repurchase/ Repo: A repurchase agreement is the sale of a security with a commitment by the seller to buy the security back from the purchaser at a specified price at a designated future date. Basically a repurchase agreement is a collateralized loan, where the collateral is a security.

• Reverse Repurchase/ Reverse Repo: A Reverse Repurchase is an agreement to purchase and resale of a security at a specific price and a specific future date. It is the mirror image of a Repo transaction. Provider of funds does Reverse Repo transaction.

• Overnight Money Market Repo Rate: The rate at which overnight repo deals are transacted in the money market.

• Call Money: Funds placed with a financial institution without a fixed maturity date. The money can be “called” (withdrawn) at any time. It is a form of clean borrowing / lending in the MM for short term requirements without collateral.

• Delivery Versus Payment (DVP): Clearing and settlement of transactions in money market instruments (MMIs) is through book-entry system of transferring ownership with delivery of the securities against payment i.e. Delivery Versus Payment (DVP).

• Over The Counter (OTC): A secondary market in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “ over the counter ” to anyone who comes to them and is willing to accept their prices.

• Interbank market: A market for wholesale loans and deposits traded between banks.

• Bid: A bid rate is the rate that a bank will wish to pay on any borrowing it makes.

• Offer: Offer rate is the rate that a bank will want to receive on any lending it makes.

• Primary Market: The market in which new issues of financial instruments/ securities are sold initially.

• Secondary Market: A market for buying and selling securities in the period between their issue and maturity. A liquid secondary market enhances the attractiveness of financial instruments/securities to investors.