2- Money Markets

trade debt securities or instruments with maturity less than a year

= ISSUED BY agents that REQUIRE short term funds
= PURCHASED BY agents that HAVE short term excess of funds

forgone interest cost from the holding of cash balances

- generate higher rate of interest than holding cash
- is very liquid
- low default risk (short maturity)
- efficient, as it enables large transfer of moeny from suppliers to users of funds quickly and at low cost

1. large denomination
- low transaction/trading costs relative to interest paid
- size of initial transaction allows indirect individuals investment (money market mutual funds)

2. short maturities
- less than a year, - interest rate risk = - return
- lower price movements, low price risk

3. low default risk
- short maturity
- issued only by high quality borrowers (little risk of default)

used to caculate present value of an investment
= (face value - purchase price)/purchase price x 365/number of days until maturity

annual interest rate when interest is paid/compounded more than once a year
= 1 - bond equivalent yield/(365/number of days until maturity)^ 365/n -1

interest rate of security that is sold at a discount (Tbills, CP, BA)
= (face value - purchase price)/face value x 365/n

interest rate for instruments that pay interest only 1x at maturity
year = 360 days
bond equivalent yield = single payment yield x 365/360

short term obligations issued by US Gov
- issued to cover gov budget deficits or refinance gov debt

PROS: default risk free + highly liquid + little interest rate risk
RISK: exchange rate risk + inflation risk

- bought/sold by the federal reserve to implement monetary policy
- in primary market can be bought by 24 dealers, in secondary market they are traded with other investors

- registered instrument = electronic certificate of ownership on fedwire
- bearer instrument = physical certificate of ownership

short term, overnight unsecured loans
- transaction between 2 commercial banks to satisfy minimum required reserves
- banks with excess reserves lend fed funds to banks with deficient reserves

PROS: highly liquid, flexible source of funding for commercial banks
Uncollateralize (unsecured) because low risk

Fed funds rate = interest rate for borrowing fed funds (target rate in monetary policy to build all interest rates)

bank with reciprocal accounts and agreement
- bank will sell its excess reserves to correspondent banks that offer highest rates for fed funds

sale of securitiy with agreement to buy it back at fixed price (higher) on specified date in future

collateralized loans = secured with collaterol = us treasury securities

PROS: low credit riskt, lower interest rates than fed funds

- real sale, title passes for the term of agreement
- if collateralized by risky assets may involve "haircut" meaning loan is smaller than market value of secruities pledged to reflect the risk of the collateral

the purchase of a security with the agreement to sell it back in the future

unsecured, short term promissory note issued by a company to raise short term funds
- created directly (uses issuers own sales force) then sold to investors indirectly (through brokers)
- usually hled to maturity (no secondary market)
- only by major corporations with high credit rating and low risk of default

paper backed by assets of the issuing firm

bank issued, fix maturity, interest bearing deposit that specifies interset rate and maturity date

bearer instruments = holder at maturity recives principal + interest (has secondary market)

purchased often by money market mutual funds (pools of funds by individual investors)

trading process: banks try to sell them to investors likely to hold them rather than sell on SM

time draft payable to a seller of goods with payment guaranteed by a bank

- used in international trade to finance trade goods from foreign exporter to domestic importer
- bearer instruments, sell in SM
- low risk of default = low intrest rate

issues T bills to raise money to meet unavoidable short term expenditure needs prior to receiving tax revenues

most important participant in money markets

t bills - to affect money supply

repurchase agreements - to smooth interest rates and money supply

targets federal fund rates, affecting money market rates
opperates as discount window influencing the supply of bank reserves to commercial banks

issuers and investors
- need to meet reserve requirements imposed by regulation

in economic expansion - reserve deficiencies and loan demand --> borrow fed funds, repo, cs, or cps
in contractionary period - excess of reserve --> purchase treasury securities, trade fed funds

purchase large amount of money market securities and sell shares in pools based on the value of their underlying money market securities
- allows small investors to invest in money market instruments
- alternative to interest bearing deposits at commercial banks

rise funds primarily in the form of commerical paper and invest excess cash in money market

- 24 primary government securities dealers who play key role in new issues of t bills, they sell in secondary market
- money and security brokers never trade for their own
- brokers and dealers also for smaller investors

- invest in highly liquid money market securities
- liability payments are unpredictable, must have large balance of liquid assets
- can not issue deposits, raise funds through MM especially through CP