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Money markets provide an alternative for the management of opportunity cost funds.
(a) Describe the term "opportunity cost" as it relates to funds.
(b) Explain how money markets meet an investor's needs for these funds.
(a) The forgone interest cost from the excessive holding of cash balances.
(b) It provides an investment that can be quickly and relatively costlessly converted back to cash when needed in the short term.
Money market instruments are generally sold in large denominations. Describe the other two basic characteristics of money market instruments.
- Money market instruments have a low default risk.
- Money market securities must have an original maturity of one year or less.
Corporations and government units issue various types of money market securities. One of these instruments is a repurchase agreement. Describe how a repurchase agreement operates in the sale of securities from one party to another.
- One party sells securities to a second party with a promise to repurchase
- At a specified date
- At a specified price
What are three reasons why the U.S. Government sells Treasury bills (T-bills)?
- To cover budget deficits
- To refinance maturing government debt
- To conduct monetary policy
Treasury bill (T-bill) auctions are held weekly.
(a) Explain why the highest bidders at auctions may pay less than the amount they bid.
(b) Explain what advantage the highest bidder has.
(a) All successful bidders receive T-bills at the lowest price accepted at the auction.
(b) The highest bidder receives the first allocation.
Treasury bill auctions have both competitive and noncompetitive bids. Distinguish between these two types of bids.
- A competitive bid specifies the desired quantity of T-bills and the bid price.
- A noncompetitive bid specifies the desired quantity of T-bills and agrees to pay the lowest price of the winning competitive bids.
Describe the structure and operation of the secondary market for T-bills in the United States.
- It is the largest of any U.S. money market security.
- The Federal Reserve Bank (of New York) designates primary government securities dealers
- Multiple smaller dealers deal directly in the secondary market.
- The market is decentralized (with telephone trading).
- Primary dealers conduct business with the Fed by wire transfer.
- T-bill dealers keep records of T-bill ownership.
- Individuals and businesses must purchase through the primary or smaller dealers.
ABC Bank is considering entering into a reverse repurchasing agreement, whereby it will agree to buy T-bills from one of the primary government securities dealers for $1,000,000. ABC's plan is to hold the securities for 20 days and sell them back for $1,010,000 at the end of the 20-day period. Calculate the yield to ABC on this repurchase agreement.
[($1,010,000 - $1,000,000) / $1,000,000] x (360 / 20) = .18 or 18% Score 1 point for ($1,010,000 - $1,000,000) / $1,000,000Score 1 point for 360 / 20Score 3 points for 18%, maximum 3 points.
Various issuers and investors participate in the different money markets. Identify three of these participants.
- U.S. treasury
- Federal Reserve
- Commercial banks
- Money market traders (brokers and dealers)
- Other financial institutions (such as mutual funds)
The U.S. Treasury is a participant in money markets. Describe the role of the U.S. Treasury in money market activities.
It raises money through the sale of T-bills.
Eurodollar deposits are dollar-dominated deposits in non-U.S. banks.
(a) Identify the source of the interest rate at which these funds are offered for sale.
(b) Explain why the U.S. fed funds rate is generally lower than the Eurodollar funds rate.
(a) LIBOR (London Interbank Offered Rate)
(b) The rate for U.S. bank funds is generally lower because of their low-risk nature, versus that of foreign bank deposits.
Eurodollar certificates of deposit have several characteristics. Describe two characteristics of the Eurodollar certificate of deposit.
- They are U.S. dollar-denominated CDs in foreign banks.
- Maturities are less than one year.
- Most have a maturity of one week to six months.
- They are not subject to reserve requirements in the same manner as U.S. deposits.
(a) Define LIBOR.
(b) Explain why the fed funds rate is generally slightly lower than the LIBOR.
(a) LIBOR—London Interbank Offered Rate, which is an interbank Eurodollar market organized by large banks in London as an alternate overnight source of funding to the U.S. federal funds rate.
(b) The fed funds rate is generally lower than LIBOR because of the low-risk nature of U.S. bank deposits versus foreign bank deposits. U.S. bank deposits are covered by deposit insurance up to certain levels.
National Bank has some excess funds, and State Bank wants to borrow part of these funds for one day.
(a) Identify the resulting asset for National Bank.
(b) Identify the resulting liability for State Bank.
- (a) National Bank will have an asset called "federal funds sold."
- (b) State Bank will have a liability called "federal funds purchased."
ABC Bank has the opportunity to purchase a 180-day T-bill with a face value of $10,000 for a price of $9,000. Calculate the T-bill's discount yield rate.
[($10,000 - $9,000) / $10,000] x (360 / 180) = .20 or 20% Score 1 point for ($10,000 - $9,000) / $10,000Score 1 point for 360 / 180Score 3 points for 20 percent
John has the opportunity to purchase a 90-day unsecured promissory note issued by a company to raise short-term funds to finance some working capital requirements. The par value of the note is $100,000, and John can purchase it for $95,000. Calculate the discount yield that John will receive for this promissory note.
[($100,000 - $95,000) / $100,000] x 360 / 90 = .20 or 20%