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Part 5 Markets Chapter 15 Money markets What you will learn in this chapter: n The major instruments which are created and traded in the money markets n The characteristics of those instruments and how they are priced n The main participants in the money markets n The size, growth and recent development of these markets n The use of money markets by the authorities for policy purposes 290 CHAPTER 15 MONEY MARKETS 15.1 Introduction characteristics. Repurchase agreements involve a sale of securities with an agreement to buy them back in the Financial markets can be classified in many different ways. One very simple and very common classifica-tion distinguishes between money markets and capital markets. The distinction is based upon the length of the loan when it is first made (that is, on the ‘initial maturity’). In money markets, funds are borrowed and lent for a maximum of one year. However, many loans are for less than one year when they are initially made (many are ‘overnight’). This, combined with the fact that many existing one-year loans were made some time ago, means that the average maturity of outstand-ing debt in money markets is much shorter. Within this two-part classification there are further possibilities. We can distinguish (money) markets for several differ-ent instruments; or we can distinguish by the way in which they are traded; or we can distinguish by the identity of the borrower. Table 15.1 provides a list of money markets distinguished largely by instrument. The table begins with those markets where the borrowing/ lending is carried out through the issue of securities which can be bought and sold in a secondary market. These are the discount market itself, and the markets for commercial paper (CP) and certificates of deposit (CDs). We then subdivide the discount market by borrower, noting that it trades bills issued by three distinct classes of borrower. By contrast, the inter-bank market is a ‘market’ for deposits that cannot be traded. Money market deposits have much the same Table 15.1 Money markets near future for a price that determines the cost of the funds obtained. One consequence that follows from this variety of short-term instruments is that they are priced (or ‘quoted’) in two different ways. Some are quoted on a yield basis, while others are quoted on a discount basis. We note this distinction in the table (by y and d respectively) and explain it in the next section. Finally, we need to bear in mind that most of these markets exist for instruments issued in the domestic currency, and also, increasingly, for instru-ments denominated in a currency other than that of the country in which they are traded. Such instruments are identified by the prefix ‘Euro-’, though this is strictly a misnomer since the currency can be any currency (US or Hong Kong dollars, or Yen, for example). Hence, most financial centres trading CDs and commercial paper will also trade Euro-CDs (ECDs) and ECP. Although Table 15.1 shows an apparently wide variety of instruments available to short-term lenders and borrowers, the fact that they are all short-term instruments makes them very close substitutes for one another. This in turn means that price movements (for money market securities) and movements in rates of return (for all money market instruments) are very highly correlated. It also means that differentials between the returns on different instruments are usually very small. This is reinforced by the fact that money markets are usually dominated by large traders – banks, savings institutions, government and corpor-ate treasury departments – to whom small differences in yield can still mean large differences in profit or loss. One consequence of this is the need for a convenient The discount market Treasury bills d Local authority/utility bills d Commercial bills d The market for commercial paper d The certificate of deposit market y The interbank market y Money market deposits y Repurchase agreements y form for expressing fractions of yields or interest rates. This is done by quoting basis points (or bps) where one basis point equals 1/100 of 1 per cent. Basis points have become an internationally recognized standard. Of course, it follows equally that some method is needed for quoting small changes in price. Alas, these methods are not universal. In the UK and USA the smallest unit of price change is 1/32 while in continental Europe the unit is 0.01.1 For some reason, both units have come to be known as ticks in everyday use. But saying in d quoted on a discount basis; y quoted on a yield basis London that UK treasury bills are ‘up three ticks’ sug-gests a larger price change than a similar remark about Schatzwechsel in Frankfurt. 1 We have used decimals rather than fractions in all illustrations and exercises. 15.2 MONEY MARKET INSTRUMENTS: CHARACTERISTICS AND YIELDS 291 Distinguishing financial markets into markets for ‘short-’ and ‘long-term’ loans is common practice, and useful since instruments within each category 15.2 Money market instruments: characteristics and yields are close substitutes for each other. But, while some institutions have a particular need to lend or borrow short term while others specialize in long-term lending or borrowing, most lenders and borrowers use both groups of markets at some time. For example, remem-ber what we said in Section 10.4.1 about the effect of interest rate expectations on lenders’ decisions. Imagine a lender who normally prefers to lend for a short period (in the money markets). If he thinks that short-term rates are likely to fall in the very near future, he might prefer on this occasion to lock into current rates for a longer period (via the capital markets). Equally, firms who think that interest rates will be lower in future might decide to borrow short on a temporary basis in spite of their normal pref-erence for long-term borrowing. As a source of short-term finance, the money markets are, naturally, important to a wide range of institutions. They are important also for another reason which takes us back to Chapter 9 ‘The level of interest rates’ and Chapter 12 ‘Bank lending and the money supply’. This is that central banks exer-cise their influence over short-term interest rates, via the money markets (either the discount market or interbank market in practice). Money markets are the focus for this official activity for a combination of reasons. Firstly, as we all know, banks offer a guarantee to their clients that their deposits can be converted on demand into cash and therefore banks need to hold the necessary liquid reserves. Secondly, because these reserves (generally) pay no interest, banks hold the minimum quantity; their demand for reserves is highly interest-inelastic. Thirdly, since banks must make settlement on a day-to-day basis, short-ages of reserves must be relieved by immediate (that is, very short-term) funds. Finally, in a system-wide shortage of funds the central bank becomes the sole supplier. We shall see how this works, in a little more detail, in Section 15.4. In the next section, we explain the character-istics of each of the instruments being traded in the money markets. In Section 15.3 we look at the use and characteristics of the markets themselves in each of several European centres; in Section 15.5 we note the rapid growth of Eurocurrency markets and the causes and consequences of this growth. Section 15.6 summarizes. 15.2.1 The discount market This is a market in which short-term securities are issued and traded. Bills are usually issued with initial matur-ities of from one to three months, six months, and, less usually, 12 months. For this reason, it would be incon-venient and expensive to set up the arrangements for paying interest in the normal way, for securities which would attract at most one interest payment, and so the practice is to issue the bills at a discount to their par or maturity value. Thus a three-month bill with a par value of £250,000 might be issued for £240,000, a discount of £10,000. Clearly it is essential that the amount by which the bill is discounted should be con-vertible into a rate in order to allow comparison with the return on other financial instruments. The simplest way to do this is to calculate the return as a rate of discount, d. The formula for the rate of discount is: d = M×nsP (15.1) where P is the price, M is the par or redemption or maturity value and nsm is the period to redemption (that is, from settlement of purchase to maturity) expressed as a fraction of a year. In the UK, a year is reckoned as 365 days while in the US markets and in continental Europe it is taken to be 360 days. In our example, therefore, the discount of £10,000 is equivalent to a rate of discount of: d = (250,000 − 240,000)/(250,000 ´ 0.25) = 16% Notice that as the bill approaches maturity, the value of nsm, and thus the value of the denominator, falls. If nothing else changed, therefore, the return on the bill would increase as it approached maturity. To prevent this from happening, it is the bill’s price that rises as it approaches maturity. By rearranging Equation 15.1, it is quite easy to find the price at which a bill must be sold in order to yield a given rate of discount. Suppose, for example, that we wish to lend for two months at a rate of 10 per cent. Then: P = M − d(M·nsm) (15.2) and thus: P = 250,000 − 0.1(250,000 ´ 0.166) = 245,835 ... - tailieumienphi.vn
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