Fixed Income Securities

1
Part-04A
The Money Market
2
Introduction
3
Debt Markets
Money markets are a key segment of the debt
market
Why do we have debt markets?
So that those in need of funds can interact with
those who have a surplus
4
Introduction
All debt markets have a common feature

On one hand we have
parties ready to borrow by
issuing securities
On the other hand we have
parties willing to lend in the
process of acquiring
securities
5
All security for cash transactions are not identical
A 30 year mortgage loan
vs.
3 month loan to meet a corporations working capital
needs
Introduction
Purpose of borrowing
The purpose for which money is borrowed
differs from
borrower-to-borrower
transaction-to-transaction
1. A corporation may issue long term bonds to
finance the construction of a building
2. It may issue short-term promissory notes to fund
the acquisition of raw materials.
6
Introduction
Types of financial assets
Money is borrowed to create different
kinds of financial assets with
different maturities
different risk profiles
different size
7
Introduction
Term to maturity
Loans in the money market have an original
term to maturity of <1 year
Original term to
maturity
Actual term to maturity
The OTM of a security is its
term to maturity at the time
of issue
The ATM is the current term
to maturity of the security
It cannot change once a
security is issued
It will keep declining with
the passage of time
8
Introduction
Money Markets
Money market securities have to be debt
securities
Since equity shares have no maturity date.
Money market consists of transactions to
meet short-term cash needs
Meant for current account, not for capital account
It is a mechanism by which holders of
temporary cash surpluses interact with those
with temporary cash deficits
The nature of transactions range from overnight to
1 year

9
Introduction
Why?
Why do we need money markets?
For most individuals / institutions inflows &
outflows of cash will rarely match.
Inflows may happen at a time different from
when outflows are required to be met

10
Introduction
Why the attention?
Why are we so concerned about short-term
transactions?
Money is an extremely perishable commodity
When idle cash is not invested there is an
opportunity cost - interest income is foregone
Income that is lost is lost forever
When large amounts are involved, the lost
income even a day can be substantial
11
Introduction
Example
A firm has 12MM dollars available overnight.
Assume interest rate @ 3.60% p.a.
Assume the year has 360 days
A common assumption in many money markets
If money is kept idle overnight the lost income
will be:
12,000,000 x 0.036 x (1/360) = $1,200
If the money were to remain idle for a week
the income foregone will be $8,400

12
Introduction
Analogies
We can give similar examples from the travel
and hotel industries
If the New York Hilton has 20 unoccupied rooms
on a day the revenue is lost forever
You cannot put two guests in a room on a subsequent
night
If British Airways were to fly from New York to
London with 10 empty seats
The income is lost forever
We cannot put 2 people per seat on a subsequent flight
13
Borrowers & Lenders
It is very difficult to classify an economic entity
as a borrower or a lender.
The same institutions frequently operate on both
sides of the market
E.g. Citibank
Borrower Lender
It will borrow regularly in
the money market by way
of Certificates of Deposit,
borrowings of Federal
Funds etc.
At the same time it will be
making short term loans to
corporate borrowers
14
Introduction
What do investors want?
Investors in the market primarily seek
Safety and liquidity
An opportunity to earn some extra income
Liquidity is paramount because participants
may seek to enter and exit in an unanticipated
fashion.
15
Introduction
Liquidity
A liquid market is characterized by a large
number of buyers and sellers
What would happen if the market were to
be illiquid?
If there is excess demand large buy orders will
send prices shooting up
If there is excess supply large sell orders will
send prices crashing down.
16
Introduction
Liquid market
In a liquid market large trades can be
executed without a major price impact
Liquid markets are characterized by low bid-ask
spreads
Since transactions are frequent dealers can
afford to operate with a smaller profit per
round trip transaction
Bid the price at which the dealer buys from
the public
Ask the price at which the dealer sells to the
public
Round trip a purchase followed by a
subsequent sale
17
Introduction
Liquidity & Impact Costs
Let us define the fair price of a security as a
simple average of the bid and the ask
If the market is very liquid
Large orders on both sides can be executed at an
average price that is close to the fair price
18
Impact Costs (Cont)
The impact cost of a trade is the percentage
mark up for an order of a certain size, with
respect to the fair price
The cost depends on whether we are buying or
selling
It also depends on the size of the transaction
19
Impact Costs (Cont)
20
Example
21
The spread is Rs 2.00
The fair price is Rs 99
Niharika issues a buy order for 1,000 shares
It will get executed at prices ranging from 100.00
to 102.25.
The weighted average price is:
Example (Cont)
The impact cost may be computed as:
(Weighted Average Trade Price Fair Price)
Fair Price
In this case it is:
(101.47 99.00)
_________________ x 100 = 2.49%
99.00
22
Example
23
Consider the same Limit Order Book
Mukul places a sell order for 1,000 shares
It will be executed at prices ranging from 98.00 to
95.45.
The weighted average price is:

Example (Cont)
The impact cost may be computed as:
(Fair Price Weighted Average Trade Price)
Fair Price
In this case it is:
99.00 96.245
_________________ x 100 = 2.78%
99.00
24
Example
25
Assume that Niharika observes the LOB and
issues a buy order for 2,000 shares
It will be executed at prices ranging from 100.00
to 104.50.
The weighted average price is:

Example (Cont)
26
The impact cost is:

Central Banks
The market is overseen by the Federal Reserve Bank in the
U.S. and by the central banks of other countries. These
are:
U.K. Bank of England
Canada The Bank of Canada
Switzerland The Swiss National Bank
Japan Bank of Japan
Europe European central bank
Germany Bundesbank
Australia Reserve Bank of Australia
27
Introduction
Features (Cont)
There is no central trading arena.
It is a market connected by telephones and
computers
Speed is of the essence since money is perishable.
Transactions are conducted in a matter of seconds
and payments are made instantaneously
28
Introduction
Global Money Markets
29
National / Intl. Money Markets
Every nation has its own money market
Some are poorly developed.
Others like that of the U.S extend beyond the
borders of a country or a continent.
National money markets may be
Security markets dominated
Bank dominated
30
Global Money Mkts
Types of National Money Markets
Securities dominated market most
transactions are through open market trading
of financial instruments.
Western markets are largely securities dominated.
Bank dominated market bank borrowing
and lending is at the centre of most
transactions.
Asian markets tend to be largely bank dominated.
These markets have a potential weakness - they
yield more easily to government pressures
resulting in bad loans
31
Global Money Mkts
International Money Markets
International money market ties all domestic
markets together.
At its heart is the Eurocurrency market.
Here large bank deposits are traded outside the
boundaries of the country where the particular
currency is issued.

32
Global Money Mkts
Key Dates in Cash Market
Instruments
33
Key Dates
Transaction date
Value date
Maturity Date
34
Key Dates
Transaction Date
Date on which terms and conditions of a
financial instrument are agreed upon
Date on which parties enter into a contract
Also known as Trade date, Dealing date, Done
date
35
Key Dates
Value Date
Date on which instrument starts to earn or
accrue a return
This date may/may not be same as transaction
date
36
Key Dates
Types of Value Dates
Value Date
Same Day Value
Or
Value Today
Next Day Value
Or
Value Tomorrow
Spot Value
37
Key Dates
Value Date =
Transaction Date
Value Date =
Transaction Date
+ 1
Value Date =
Transaction Date
+ 2
Maturity Date
The date on which the instrument ceases to
accrue a return
Maturity date is often not a date
It is a term to maturity which is a whole number of
weeks/months after the value date
Date of maturity follows two conventions
The Modified Following Business Day Convention
The End/End Rule
38
Key Dates
The Modified Following Business Day
Convention
This convention consists of the following three
rules
1. Maturity is set for the same date as the value
date
If the value date is 21 March
The one month maturity will be 21 April
The two month maturity will be 21 May
2. If the maturity as per rule 1 is a non-business
day, then it is moved to the following business day
39
Modified(Cont)
3. If the following business day according to rule 2
falls in the next calendar month
Then the maturity date is moved back to the last
business day of the calendar month.
40
Illustration
Consider a 3-M deposit with a value date of 21
June 20XX
The maturity date should be 21 September
20XX
But if 21 September is a Sunday
The maturity date will be Monday 22 September
Assuming it is not a holiday
41
Illustration-2
A 1-M deposit was made on 31 July 20XX
The maturity date will be 31 August 20XX
If 31 August is a Sunday
Then the maturity will be fixed for Friday 29
August
42
The End/End Rule
If the value date is the last business day of the
current calendar month
Then the maturity date will be the last business
day of the relevant calendar month.
Consider a one month deposit with a value
date of 31 May.
It will mature on 30 June if it is a business day.
Consider a one month deposit with a value
date of 30 June
It will mature on 31 July if it is a business day
43
The End/End Rule (Cont)
Consider a one month deposit with a value date
of 31 January
It will mature on 28 or 29 February
Consider a one month deposit with a value date
of 28 or 29 February
It will mature on 31 March
If the maturity date as per this rule were to be a
holiday then
The modified following business day convention
would apply.
44
Interbank Market
45
Interbank Market
It is a market for large or wholesale loans
and deposits
It is an arena for transactions between
commercial banks
Borrowing / lending is for periods <= 12
months
Participants
Commercial banks
Insurance companies
Pension funds
46
Interbank Mkt
Need for Interbank Market
All commercial banks are required to
maintain an account with the central bank
Banks with surplus lend to banks with
deficit
The lending bank earns some interest
The bank with a deficit covers its deficit

47
Interbank Mkt
Types of Loans
1. Overnight money: Money lent on a given day
is scheduled to be repaid on next banking day
2. Day to Day money: The deposit is for an
unspecified time. Funds can be called back at
any time and will be repaid on same day
Also called money at call
48
Interbank Mkt
Types of Loans
3. Notice money: Money lent with a short
notice of withdrawal
E.g. 2 days or 7 days notice
4. Fixed money: Money lent for a fixed period
E.g. 1 week or 1 month
5. Intra day money: Money lent and repaid on
same day
49
Interbank Mkt
LIBOR
LIBOR London Interbank Offer Rate
Rate at which bank with high credit rating is prepared to lend
to a similar bank
LIBOR is quoted for different tenors
Each bank quotes its own indicative LIBOR rate
50
Interbank Mkt
ICE LIBOR
ICE Inter-Continental Exchange
It is the most widely used benchmark for
short term interest rates
ICE maintains a panel of banks
For the US Dollar there are 18 banks
These banks submit rates which are then
combined

51
Interbank Mkt
ICE LIBOR (Cont)
Banks are required to submit rates in answer to
the following question:
At what rate could you borrow funds, were you to do so
by asking for and then accepting inter-bank offers in a
reasonable market size just prior to 11 A.M.
The LIBOR is computed using a trimmed
arithmetic mean
For the USD the top 4 and bottom 4 quotes are
excluded
The remaining 10 are averaged

52
ICE LIBOR is Provided for 5 Currencies
53
USD
GBP
EUR
JPY
CHF
ICE LIBOR (Cont)
There are 7 different maturities for each
currency
Shortest maturity is overnight O/N
The maximum maturity is 12 months
54
Quoting Panel for the USD
Bank of America
Bank of Tokyo-Mitsubishi
Barclays Bank
BNP Paribas
Citibank
Credit Agricole
Credit Suisse
Deutsche Bank
HSBC
JP Morgan Chase
Lloyds Bank
UBS
Rabobank
Royal Bank of Canada
Norinchukin
Societe Generale
Sumitomo Mitsui
Royal Bank of Scotland

55
LIBID
LIBID London Interbank Bid Rate
It is rate at which a London bank with good
credit rating will pay on funds deposited with
it by another top rated bank
LIBID is quoted for different tenors
56
Interbank Mkt
EURIBOR
It is a benchmark rate used by international
market for the Euro
Produced by European Banking Federation
Brussels
Euribor is reported at 11 a.m. Brussels time
everday
The rates are spot rates
Interest is computed on Actual/360 basis
Maturities are 1-w; 2-w; 1-m; 2-m; 3-m; 6-m;
9-m; 12-m
57
Interbank Mkt
Interest Computation Methods
For inter-bank loans and some money market
securities interest is paid on the principal value
of the instrument
It is paid at the end of the loan period along with the
principal
However securities like T-bills and commercial
paper are discount securities
They are issued at a discount to the principal and pay
the principal at maturity
They are analogous to ZCBs
58
Interest (Cont)
For inter-bank loans interest is computed and
paid with the principal
The method of computation depends on the
currency
For most currencies including USD and EUR an
ACT/360 method is used
For the GBP an ACT/365 convention is used
The Indian market uses an ACT/365 convention
59
Calculating Interest
Interest payable on assumption of a 360 day
year

P x (r/100) x (T/360)

P Principal
T No. of days
r Rate of interest
60
Interbank Mkt
Illustration-1
A bank makes a loan of 10MM Euros from 15
July 15 October
Interest rate is 5.75% per annum
# of days = 16+31+30+15 = 92
Interest = 10,000,000x 5.75 x 92
________
100 x 360
= EUR 146,944.44
61
Illustration-2
Bank makes a loan = $7.5 MM
Period: 1 year (365 days)
Interest rate = 5.25% p.a.

Interest = 7,500,000 x (5.25/100) x (365/360)
= $ 399,218.75
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Interbank Mkt
Illustration-3
A bank makes a loan of GBP 7.5MM for 180
days at 4.95% per annum
Interest = 7,500,000x4.95x180
_________
100x365
= GBP 183,082.19
63
Fed Funds & Clearinghouse Funds
How do funds move so fast in the money
market?
Money market traders usually trade in Federal
Funds.
What are Federal Funds?
Deposit balances of commercial banks held at
the regional Federal Reserve Banks or at large
correspondent banks.
64
Fed Funds
Federal Funds
They are the principal means of making
payments in the money market.
Definition The term Federal Funds refers to
money that is available for immediate
payment.
Transferred from one depository institution to
another by simple book-keeping entries
65
Fed Funds
Federal Funds (Cont)
Banks must keep a reserves equivalent to a
certain percentage of their deposits
Includes vault cash
Reserves held at the Fed
An increase in deposits leads to a greater
availability of funds
Increase in loans made and securities
purchased leads to a depletion of funds
66
Federal Funds (Cont)
Frequently some banks hold more legal reserves
than what the law requires
Excess reserves yield nil returns
So banks with a surplus lend to those with a deficit
Most loans are overnight
Availability of excess reserves varies on a daily basis
and in an unpredictable way
The lending of such funds is termed a SALE
The borrowing of such funds is termed as a PURCHASE

67
Fed Funds loans features
Most Fed Funds loans are
Overnight transactions
Continuing contracts with no specific maturity date
Continuing contracts can be terminated without advance
notice by either party

68
Fed Funds
Clearing House Funds
Method of payment in the capital markets
for transactions involving businesses and
households
Most large transactions are paid for by check
or by issue of a check following a payment by a
credit card
Funds transferred by check are called
Clearinghouse Funds.
69
Fed Funds
Funds availability
Clearinghouse funds are not accepted in money markets
For money market transactions these transactions are far
too slow and risky
Federal Funds Clearinghouse funds
Money is available on
same day and hence
interest can be earned on
the same
Compared to Federal Funds it
takes at least a day to clear
local checks and 2-3 days for
outstation checks
Money is transferred safely Funds have an element of risk
since check may be returned
70
Fed Funds
Illustration of an Inter-State Payment
An IT firm in Chicago sells software worth
$100,000 to a party in Boston
It receives a check drawn on a Boston bank
It will deposit the check with its bank in
Chicago
The bank will send the check to the Chicago FED
The Chicago FED will send the check to the
Boston FED
The Boston FED will send it to the drawers bank
71
Illustration (Cont)
The bank in Boston will debit the drawers
account
It will either remit the funds to the Boston FED
Or else authorize it to debit its reserve account
The Boston FED will transfer funds to the Chicago
FED
The Chicago FED will credit the reserve account of
the drawees bank
The drawees bank will credit the drawees
account
72
Illustration (Cont)
The net result is the transfer of $100,000 from
a party in Boston to a party in Chicago
Checks collected and cleared through the
Federal Reserve system must be paid in full by
the drawers bank
No deduction of fees
Payable at PAR
But the drawees bank can levy collection charges
from the drawee
73
Inter-District Fund Transfers
How do funds move from one Federal Reserve
Bank to another
To facilitate transfers the 12 banks maintain a
fund in Washington DC called
The Inter-District Settlement Fund
Each district bank has a share
74
Correspondent Banks
It is a common practice for banks to maintain
accounts with other banks
Banks in small towns and cities have relationships
with larger banks in money centers
Foreign banks have accounts with banks in the
US
Such relationships are referred to as
correspondent banking relationships.
75
Correspondent Banks (Cont)
The bank which maintains an account is called
the RESPONDENT Bank
The bank offering the account maintenance
facility is called the CORRESPONDENT Bank
Correspondent banks facilitate
Check clearing and collection
Foreign exchange transactions
They also participate in loan syndication

76
Correspondent Banks (Cont)
A NOSTRO is its account of its money being
held by another bank
VOSTRO is its account of the money of
another bank being held by it
Barclays is holding an account with Citibank
in NYC
Barclays would refer to is as its Nostro
Citi would term it a Vostro account
77
Correspondent Banks (Cont)
A nostro with a credit balance is an asset
It will show up on the asset side of Barclays
balance sheet
From the perspective of the other bank a credit
balance in a Vostro account is a liability
A Vostro with a debit balance would signify that a
loan has been made
It is consequently an asset
78
Payment Systems
There are two networks for large value fund
transfers in the US
One is Fedwire Funds Service
Operated by the Federal Reserve
It not only facilitates inter-bank payments but also
enables safekeeping and transfer of government
and other securities
The other network is Clearing House Inter-
bank Payments System (CHIPS)

79
FEDWIRE
Fedwire is an RTGS
It facilitates transfers between two institutions on
a real time and gross basis
It is the fastest possible channel for transfers of
money through the banking system
Real time means that there is no waiting period for
the payee
Gross settlement means that it is settled on a one-
on-one basis
Payments over Fedwire are final and irrevocable
80
CHIPS
It is a privately owned real time payments
system
It continuously matches nets and settles
payment orders
To settle position on a real time basis CHIPS
requires up to two rounds of pre-funding
All members have to maintain a pre-funded
account with the New York Fed
81
T-Bills
82
Treasury Bills
Purchases / Sales of T-bills often represent
the largest volume of daily transactions in the
money market.
Interest rates on such bills are the benchmark for
all other money market rates.
What are the important features of T-bills?
a. Zero default risk
b. Ready marketability
c. High liquidity
83
T-Bills
Regular Series Bills
Regular series bills are issued routinely every
week or month by way of competitive
auctions.
4-week, 3 and 6 month bills are issued every week
1 year bills are issued every month
Of the above maturities 6 month bills provide
the maximum revenue for the Treasury.
84
T-Bills
Irregular Series Bills
Irregular series bills are issued only when
the Treasury has a special need
Cash management bills are issued when the
Treasury has a special need for funds
They have maturities ranging from a few days
to as long as 6 months
They offer flexibility for they can be issued as
and when required
85
T-Bills
On / Off the run securities
On the run securities Off the run securities
Newly issued securities for
a given maturity
Securities for the same
maturity that were issued
earlier
E.g. a 3 month bill issued
recently
E.g. a 2 year note issued
21 months ago
Have 3 months to maturity,
but are more liquid
Have 3 months to maturity
but are less liquid
86
T-Bills
On-the-run bills more liquid
Why are on-the-run bills more liquid?
For a short period after issue, securities tend to
be very actively traded
Thereafter, most securities pass into the hands
of investors who are quite content to hold
them till maturity.
Thus compared to on-the-run securities, off-
the-run securities tend to be less liquid.
87
T-Bills
T-Bills selling process
T-bills are sold by an auction process.
Prices and yields are determined by the market
and not by the Treasury.
The auction schedule for the coming year is
announced in advance
88
T-Bills
Competitive & Non-Competitive bids
The Treasury entertains 2 types of bids.
Competitive bids typically are submitted by
large investors including banks and securities
dealers.
Non-competitive bids submitted by small
investors who agree to accept the price set at
the auction.
The Treasury generally fills all non-competitive bids.
89
T-Bills
Pricing at auctions
All prices are expressed on a $100 basis
The minimum denomination for bills is $100
And they are issued in multiples of $100
thereafter.
90
T-Bills
Re-openings
Every T-bill issue has a unique CUSIP number
Committee on Uniform Securities Identification
Procedures
Some are however re-openings of existing issues
Re-opened securities are given the same CUSIP
number
If a cash management bill were to mature on the
same day as a regular bill, which is usually a
Thursday, it is said to be ON-CYCLE
In this case the CUSIP is the same
For OFF-CYCLE bills the CUSIP number will be different
91
Yields
The quoted yield for T-bills is a discount
yield.

DR = Face Value Price 360
________________ x _____
Face Value T
m

DR quoted discount rate
Tm number of days till maturity
92
T-Bills - Yields
Example 1
Assume that a T-bill with
Face value = $100
90 days to maturity
Selling price = $97.50

DR = 100 97.50 360
____________ x _____ = 10%
100 90
93
T-Bills - Yields
Example (Cont)
In the market the price will not be quoted
as 97.50
The dealer will quote the yields as 10%
An investor must use the yield to calculate the
price.
94
T-Bills - Yields
Example Investment Rate
Rate of return for an investor who buys a bill at a discount
rate of DR will always be higher than the quoted yield
Investment rate

IR = Face Value Price 365
________________ x ____
Price T
m



= 100 97.50 365
___________ x _______ = 10.40%

97.50 90
95
T-Bills - Yields
Example (Cont)
A bill with 90 days to maturity has a face value
of $1,000,000
The quoted yield is 4.80%
D = $12,000
Price = $988,000
96
Example (Cont)
A 364 day bill has been issued at a yield of
5.4%
D = $54,600
P - $945,400
97
BEY
The Bond Equivalent Yield is also known as the
Coupon Equivalent Yield
It facilitates comparisons with capital market
debt instruments like coupon paying bonds
The method of computation depends on
whether the security has more or less than
6M to maturity
98
Less than 6M
The BEY for a bill with less than 182 days to
maturity is
The return on a simple interest basis assuming
that the year has 365 days
99
Less than 6M (Cont)
A bill has a face value of $1,000,000
It has 90 days to maturity
Yield is 4.50%
P = 988,125
BEY = 11,875/988,125 x (365/90) = 4.8738%
100
Less than 6M
The BEY can be converted to a Money market
Yield by multiplying by 360/365
Face value = 1,000,000
Time = 90 days
Discount rate = 4.75%
Money Market Yield = 4.8071%
101
More than 6M
A coupon bond with more than 182 days to
maturity will pay a coupon before maturing
To compare the yield on a T-bill with the YTM
the bill must be treated as if it will pay interest
after 6 months
That is interest is paid on the intermediate
interest for the remaining term to maturity
102
More than 6M
103
More than 6M
104
Holding Period Return
A bill is bought at a rate d1 with Tm1 days left
to maturity
And sold at a rate d2 with Tm2 days left to
maturity
105
HPR (Cont)
106
HPR (Cont)
107
HPR (Cont)
A bill with 180 days to maturity is bought at a
yield of 6%
It is sold after 30 days at 5.80%
108
HPR (Cont)
109
Value of an 01
Participants want to know the price sensitivity
of a security wrt yield
How much will the price change if the yield
changes by 1bp
P01 = 0.0001xVxTm/360
110
Value of an 01 (Cont)
A bill has 90 days to maturity
It is quoting at 5%
P01 = 0.0001x1,000,000x90/360 = $25
111
Carry
What is Carry
`It is the interest income received on the
security being financed minus the interest
expense incurred in financing the security
Carry may be positive or negative
112
Tail
What is a tail.
`calculating the yield at which a future money
market security is purchased
when the future security is created by buying an
existing instrument and financing the initial
portion of its life with a Term Repo
113
Tail (Cont)
A brokerage house is funding the purchase of a
108 day bill using a 45 day term repo
The quoted rate is 4.8%
The repo rate is 4.56%
The initial cost of the bill is $985,600
The funding cost is
985,600x0.0456x45/360 = 5,617.92
At the end of 45 days it will be holding a 63 day bill
114
Tail (Cont)
The cost of this bill is
985,600 + 5,617.92 = 991,217.92
The dollar discount is $8782.08
The corresponding discount rate is 5.0183%
The transaction is attractive if the firm
believes that the 63 day bill can be sold 45
days later at a lower discount rate
115