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Corporations and government organizations are continually buying and lending money. Often, they borrow money by issuing bonds, but in many cases, they will raise money through money market instruments (aka cash equivalents), which consists of short-term, very low risk securities. The money market is the market for buying and selling short-term loans and securities. The buyer of the money market instrument is the lender of money and the seller is the borrower of money. Capital markets are the other part of the financial markets, which consists of longer term or riskier securities, such as stocks, bonds, currencies, and derivatives.
While money market instruments are diverse, they have several features in common. All have terms of less than 1 year, with most less than 6 months. Many money market instruments have terms of 270 days or less, because any instruments with longer maturities would have to be registered with the SEC under the 1933 Act. They are very low risk securities, and, because of their short terms, they are usually issued at a discount—interest is paid when the holder of the money market instrument is paid par at maturity. Because money market instruments are discounted, their yield is quoted using the bond equivalent yield, which is the yield that is equivalent to the discount, and allows an investor to easily compare yields among different instruments and securities.
Treasury bills are issued by the federal government and have terms of 28, 91, or 182 days, and are virtually free of credit risk. They are the most actively traded money market securities with very low bid/ask spreads due to their liquidity, and they are also except from state or municipal taxes. Retail investors can buy T-bills directly from the Treasury at http://treasurydirect.gov/.
If you bought a 4-week T-bill for $996.50 and receive $1,000 4 weeks later, what is the effective annual compounded interest rate earned?
Solution: To find the effective rate for 4 weeks, you divide the face value of $1,000 divided by the amount that you paid, then subtract 1 for the interest rate over 4 weeks :
$1,000/$996.50 - 1 = 1.0035 -1 = .0035 (rounded) = 0.35%
This is the interest rate for the 4 weeks, but what is the interest rate per year, if compounded (since you can reinvest the money after it matures), so that you can compare it to other investments?
Since there are 13 4-week periods in a year, $1 compounded 13 times would equal: (1.0035)13 - 1 = 1.046 - 1 = 4.6% (rounded)
(See how the future value of a dollar is calculated to understand the reasoning better.)
You can use this formula for calculating the yields of any money market instrument sold at a discount.
The Federal Reserve requires each bank of the Federal Reserve System to maintain a minimum amount of money on deposit at a Federal Reserve bank to insure that the bank has enough reserves to meet customer obligations. Federal funds (aka Fed funds) is the money that banks deposit at the Federal Reserve bank to maintain the amount of deposits required. However, some banks, especially in the large financial centers of major cities like New York, Chicago, and San Francisco, have greater loan requirements than most other banks, and often do not have enough to maintain their reserve requirements. So these banks borrow from other banks that have an excess amount of money over the requirement. Banks will lend their excess reserves to other banks, or borrow $1 million and up, if they are short, paying the federal funds rate of interest, usually for 1 day, since most of these loans are overnight loans. Some banks that are always short on money may borrow for longer terms—from 1 week to 6 months or, in rare cases, longer—from banks that usually have excess reserves. These longer term Fed funds are called term Fed funds. The federal funds rate is extremely volatile, and is regulated by the Federal Reserve to some extent as a means to control the supply and demand of money.
Similar to the Fed funds rate is the LIBOR rate, which is the rate that banks charge to each other in the European market. Many financial instruments and contracts are based on the LIBOR rate.
Repurchase agreements (aka repos) are contracts that are sold, often for 1 day or a few days, with a minimum denomination of $1,000,000, with the stipulation that they will be repurchased for a price that is higher by the amount of the interest, called the repo rate.
Government security dealers typically use repos to finance the purchase of government debt, especially Treasuries. For instance, if a government bond dealer wanted to buy $1 billion worth of Treasuries, he may submit a winning bid for that amount, but pay only $300,000,000 and finance the rest by promising the U.S. Treasury that he will pay for the rest later, after he has customer orders for the rest of the purchase, usually by the next day (an overnight repo). The Treasury will charge daily interest on all issues bid, but not yet paid for. If the bond dealer can sell the Treasuries for more money than he paid, then the dealer makes a profit; if he sells the Treasuries for less, then the dealer will suffer a loss.
In a reverse repo, the dealer buys the securities with the stipulation that the dealer can sell them back for a higher price—the additional interest. The dealer is, in effect, lending the seller money and keeping the securities as collateral.
Term repos have longer maturities of a week to a few months. The market for term repos is larger than the market for overnight repos.
Sometimes a dealer will have an open repo contract with a lender to provide funds on a continuing basis, and that allows the dealer the right of substitution—to substitute securities of equal or greater value for the loans. Either party may cancel the contract at any time.
Repos are considered safer than Fed funds because they are collateralized, so the repo rate ranges from 10 to 200 basis points below the Fed funds rate.
Because repurchase agreements are private agreements between 2 parties, there is no secondary market for repos, especially considering their very short terms of 1 or more days.
A banker’s acceptance is a commercial bank draft requiring the bank to pay the holder of the instrument a specified amount on a specified date, which is typically 90 days from the date of issue, but can range from 1 to 180 days. The banker’s acceptance is issued at a discount, and paid in full when it becomes due—the difference between the value at maturity and the value when issued is the interest. If the banker’s acceptance is presented for payment before the due date, then the amount paid is less by the amount of the interest that would have been earned if held to maturity.
A banker’s acceptance is used for international trade as means of verifying payment. For instance, if an importer wants to import a product from a foreign country, he will often get a letter of credit from his bank and send it to the exporter. The letter of credit is a document issued by a bank that guarantees the payment of the importer’s draft for a specified amount and time. Thus, the exporter can rely on the bank’s credit rather than the importer’s. The exporter presents the shipping documents and the letter of credit to his domestic bank, which pays for the letter of credit at a discount, because the exporter’s bank won’t receive the money from the importer’s bank until later. The domestic bank then sends a time draft to the importer’s bank, which then stamps it “accepted” and, thus, converting the time draft into a banker’s acceptance. This negotiable instrument is backed by the importer’s promise to pay, the imported goods, and the bank’s guarantee of payment.
Creditworthy corporations can borrow from banks for the prime rate of interest, but they may be able to borrow at a lower rate by selling commercial paper to institutional investors and the public—usually banks, pension funds, and other corporations.
Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date, and are issued by corporations with excellent credit instead of borrowing money from a bank. They are issued at a discount, with minimum denominations of $100,000. The main purchasers are other corporations, insurance companies, commercial banks, and mutual funds. Terms range from 1 to 270 days. Commercial paper is the least traded money market instrument in the secondary market.
Finance companies sell 2/3 of the total commercial paper, and sell their issues directly to the public. But corporations that borrow less frequently sell their commercial paper—called industrial paper—to paper dealers, who then sell them at a markup to other investors. A round lot for a paper dealer is $250,000.
Before 1986, the Federal Reserve Board restricted the amount of interest that banks could pay for savings or other time deposits. Often, corporations would have money available for lending, but banks couldn’t compete for this money because of the interest rate restriction. Negotiable CDs were a means around the restrictions.
Negotiable certificates of deposit (aka jumbo certificates of deposits, jumbo CDs) are tradable certificates issued by commercial banks as unsecured time deposits. Terms range from a minimum of 14 days to 1 year or more. Most have terms of 1 to 3 months, but some can have maturities of 3 to 5 years, or longer. They have a minimum denomination of $100,000, but usually are issued in denominations of $1,000,000 or more. Most CDs have a fixed rate of interest, although there are some that pay a variable rate of interest. CDs are actively traded in the secondary market in round lots of $5,000,000.
Broker’s loans are loans from commercial banks to brokers so that the broker’s customers can finance stock purchases. The broker uses the stocks, held in street name, for collateral for the loans.
Time notes are loans that must be paid by a specific date for a specified interest rate, with terms of 6 months or less. A demand note (aka call loan) is a loan that is payable on demand the next day at 1 day’s interest. If the note is not demanded, then the term is extended by another day, and so on, up to 90 days. The interest rate for each day varies with the prevailing interest rate.
Eurodollars usually refers to U.S. dollars deposited in banks outside of the United States. Eurocurrency is a more general term that can refer to any currency that is deposited in banks whose domestic currency is different from the deposited currency, and it can involve any country, including the Far East and the Cayman Islands. Eurodollars or Eurocurrency does not necessarily involve either Europe or the Euro. Multi-national corporations deposit their domestic currency in foreign banks because they can often get better terms trading their currency with the locals than by exchanging domestic currency for foreign currency at a bank. The interest paid on these deposits is usually equal to the London Interbank Offer Rate (LIBOR), which is slightly higher than the yield for 3-month Treasuries.
| This is a sample of key money rates that were published in the Wall Street Journal on April 20, 2007. Note that because many of these rates are negotiated between private parties, and the rates fluctuate throughout the day, these rates are mostly averages that do not necessarily reflect individual transactions. Note also how the yields of the various money market instruments compare with the key interest rates. |
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| Source: Wall Street Journal, April 20, 2007. |
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