A security is an instrument that represents ownership in an asset or debt obligation. Securities are classified as either money market securities, capital market securities, or derivative securities.
Money market securities are short-term indebtedness. By “short term” we usually imply an original maturity of one year or less. The most common money market securities are Treasury bills, commercial paper, negotiable certificates of deposit, and bankers acceptances. [6, p.44]
Treasury bills (T-bills) are short-term securities issued by the U.S. government; they have original maturities of either four weeks, three months, or six months. [6, p.44] Unlike other money market securities, T-bills carry no stated interest rate. Instead, they are sold on a discountedbasis: Investors obtain a return on their investment by buying these securities for less than their face value and then receiving the face value at maturity. T-Bills are sold in $10,000 denominations; that is, the T-Bill has a face value of $10,000.
Commercial paper is a promissory note—a written promise to pay—issued by a large, creditworthy corporation. These securities have original maturities ranging from one day to 270 days and usually trade in units of $100,000. [6, p.45] Most commercial paper is backed by bank lines of credit, which means that a bank is standing by ready to pay the obligation if the issuer is unable to. Commercial paper may be either interest – bearing or sold on a discounted basis.
Certificates of deposit (CDs) are written promises by a bank to pay a depositor. Nowadays they have original maturities from six months to three years. [6, p.45] Negotiable certificates of deposit are CDs issued by large commercial banks that can be bought and sold among investors. Negotiable CDs typically have original maturities between one month and one year and are sold in denominations of $100,000 or more. Negotiable certificates of deposit are sold to investors at their face value and carry a fixed interest rate. On the maturity date, the investor is repaid the amount borrowed, plus interest.
Eurodollar certificates of deposit are CDs issued by foreign branches of U.S. banks, and Yankee certificates of deposit are CDs issued by foreign banks located in the United States. [6, p.45] Both Eurodollar CDs and Yankee CDs are denominated in U.S. dollars. In other words, interest payments and the repayment of principal are both in U.S. dollars.
Bankers’ acceptances are short-term loans, usually to importers and exporters, made by banks to finance specific transactions. An acceptance is created when a draft (a promise to pay) is written by a bank’s customer and the bank “accepts” it, promising to pay. [6, p.46] The bank’s acceptance of the draft is a promise to pay the face amount of the draft to whoever presents it for payment. The bank’s customer then uses the draft to finance a transaction, giving this draft to her supplier in exchange for goods. Since acceptances arise from specific transactions, they are available in a wide variety of principal amounts. Typically, bankers’ acceptances have maturities of less than 180 days. Bankers’ acceptances are sold at a discount from their face value, and the face value is paid at maturity. Since acceptances are backed by both the issuing bank and the purchaser of goods, the likelihood of default is very small.
Money market securities are backed solely by the issuer’s ability to pay. With money market securities, there is no collateral; that is, no item of value (such as real estate) is designated by the issuer to ensure repayment. The investor relies primarily on the reputation and repayment history of the issuer in expecting that he or she will be repaid.
Markets in the United States [6, p.53-57]:
1. Equity Markets
In the United States, there are two national stock exchanges: (1) the New York Stock Exchange (NYSE), commonly called the “Big Board,” and (2) the American Stock Exchange (AMEX or ASE), also called the “Curb.” National stock exchanges trade stocks of not only U.S. corporations but also non-U.S. corporations.
2. Stock Exchanges
The regional stock exchanges compete with the NYSE for the execution of smaller trades.
3. OTC Market
The OTC market is called the market for unlisted stocks. As explained previously, technically while there are listing requirements for exchanges, there are also listing requirements for the Nasdaq National and Small Capitalization OTC markets. There are three parts to the OTC market: two under the aegis of NASD (the Nasdaq markets) and a third market for truly unlisted stocks, the non-Nasdaq OTC markets.
4. Stock Market Indicators
The most commonly quoted stock market indicator is the Dow Jones Industrial Average (DJIA). Other stock market indicators cited in the financial press are the Standard & Poor’s 500 Composite (S&P 500), the New York Stock Exchange Composite Index (NYSE Composite), the Nasdaq Composite Index, and the Value Line Composite Average (VLCA).
5. Bond Markets
The bond trading that does take place on exchanges consists primarily of small orders, whereas bond trading in the OTC market is for larger—sometimes huge—blocks of bonds, purchased by institutional investors. The three broad-based bond market indexes most commonly used by institutional investors are the Lehman Brothers U.S. Aggregate Index, the Salomon Smith Barney (SSB) Broad Investment- Grade Bond Index (BIG), and the Merrill Lynch Domestic Market Index.
6. Options and Futures Markets
The first formal options market was the Chicago Board Options Exchange (CBOE). Soon after, several exchanges introduced optionscontracts to their “product lines.” Now options are traded on suchexchanges as the CBOE, the Chicago Board of Trade (CBOT), the PacificStock Exchange, the Philadelphia Stock Exchange, and the AmericanStock Exchange.
7. Money Markets
Money market securities are not traded in a physical location; rather these securities are traded over-the-counter through banks and dealers that are networked together by telephone and computer lines. These intermediaries bring together buyers and sellers from around the world. In the United States, most trading is centered on large banks (called money center banks) located in the major financial centers of the country. Many banks and dealers specialize in specific instruments, such as commercial paper or bankers’ acceptances.
The United States has a central monetary authority known as the Federal Reserve System. The Federal Reserve System (often referred to as the “Fed”) acts as the U.S. central bank, much like the Bank of England and the Bank of France are central banks in their respective countries.
The role of a central bank is to carry out monetary policy that serves the best interests of the country’s economic well-being. Monetary policy is the set of tools that a central bank can use to control the availability of loanable funds. These tools can be used to achieve goals for the nation’s economy. Along with the U.S. Treasury, the Fed determines policies that affect employment and prices.
The Federal Reserve System is comprised of 12 district banks, with the Federal Reserve Board of Governors overseeing the activities of the district banks. The members of the Board are appointed by the President of the United States and confirmed by the U.S. Senate, and each serves a term of 14 years, with terms staggered through time. The president also appoints the chairman of the board from among the members on the board. The chairman serves in this capacity for a term of four years. [6, p.64]
The Federal Reserve District Banks are not-for-profit institutions. Their responsibilities include (1) handling the vast majority of checkclearing in the United States, (2) issuing money, and (3) acting as the bankers’ bank, accepting deposits from other financial institutions. [6, p.65] Financial managers and investors are interested in the supply and demand for money because it is the interaction of supply and demand that ultimately affects the interest rates paid to borrow funds and the amount of interest earned on investing funds. The demand for money is determined by the availability of investment opportunities. The supply of money is determined, in large part, by the actions of a nation’s central bank.
The decisions of the Fed affect the money supply of the United States. The money supply consists of cash and cash-like items. In fact, there are different definitions of the money supply, depending on the cash-like items you include. For example, the most basic definition of money supply, M1, consists of [6, p.66]:
·cash (currency and bills) in circulation,
·demand deposits (non-interest earning deposits at banking institutions
·that can be withdrawn on demand),
·other deposits that can be readily withdrawn using checks, and
·travelers’ checks.
A broader definition of money supply is M2, which consists of everything in M1, plus [6, p.66]:
·savings deposits,
·small denomination time deposits,
·money market mutual funds, and
·money market deposit accounts.
A still broader definition of money supply is M3, which consists of everything in M2, plus [6, p.67]:
·large denomination time deposits,
·term repurchase agreements issued by commercial banks and thrift institutions, term Eurodollars held by U.S. residents, and
·institution-owned balances in money market funds.
Thus, the money market is a market in which the cash requirements of market participants who are long cash are met along with the requirements of those that are short cash. The money market is traditionally defined as the market for financial assets that have original maturities of one year or less. In essence, it is the market for short-term debt instruments. Financial assets traded in this market include such instruments as U.S. Treasury bills, commercial paper, some medium-term notes, bankers acceptances, federal agency discount paper, most certificates of deposit, repurchase agreements, floating-rate agreements, and federal funds.
There are three types of money market funds: (1) general money market funds; (2) U.S. government short-term funds; and (3) short-term municipal funds. A money market exists in virtually every country in the world, and all such markets exhibit the characteristics we described in this chapter to some extent. In the UK money market, unit trusts typically invest in deposits, with a relatively small share of funds placed in money market paper such as government bills or certificates of deposit. Economies such as Japan and Germany are based more on banking relationships, with banks providing a large proportion of corporate finance.
Money market securities are short-term indebtedness. These are treasury bills (T-bills), commercial paper, certificates of deposit (CDs), Eurodollar certificates of deposit, bankers’ acceptances.
U.S. financial sector divided on: equity markets, stock exchanges, OTC market, stock market indicators, bond markets, options and futures markets, money markets. The United States has a central monetary authority known as the Federal Reserve System.
Monetary policy is the set of tools that a central bank can use to control the availability of loanable funds. These tools can be used to achieve goals for the nation’s economy. Along with the U.S. Treasury, the Fed determines policies that affect employment and prices.
Chapter 3
Money Management. Cash Management for Finance Managers
Any firm can deal in government securities, but when the Federal Reserve engages in trades of Treasuries in order to implement monetary policy, the New York Fed’s Open Market Desk will deal directly only with dealers that it designates as primary or recognized dealers. The primary dealer system was established in 1960 and is designed to ensure that firms requesting status as primary dealers have adequate capital relative to positions assumed in Treasury securities and that their trading volume in Treasury securities is at a reasonable level. The Federal Reserve requires primary dealers to participate in both open market operations and Treasury auctions. In addition, primary dealers provide market information and analysis which may be useful to the Open Market Desk in the implementation of monetary policy. Primary dealers include diversified and specialized firms, money center banks, and foreign-owned financial entities. [5, p.44]
Primary dealers trade with the investing public and with other dealer firms. When they trade with each other, it is through intermediaries known as interdealer brokers. Dealers leave firm bids and offers with interdealer brokers who display the highest bid and the lowest offer in a computer network tied to each trading desk and displayed on a monitor.
The dealer responding to a bid or offer by “hitting” or “taking” pays a commission to the interdealer broker. [5, p.45] The size and prices of these transactions are visible to all dealers at once. The fees charged are negotiable and vary depending on transaction volume.
Six interdealer brokers handle the bulk of daily trading volume. They include Cantor, Fitzgerald Securities, Inc.; Garban Ltd.; Liberty Brokerage Inc.; RMJ Securities Corp.; Hilliard Farber & Co. Inc.; and Tullett & Tokyo Securities Inc. These six firms serve the primary government dealers and approximately a dozen other large government dealers aspiring to be primary dealers. [5, p.46]
Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished. With the exception of Cantor, Fitzgerald Securities Inc., interdealer brokers do not trade for their own account, and they keep the names of the dealers involved in trades confidential. The quotes provided on the government dealer screens represent prices in the “inside” or “interdealer” market.
We have already learned U.S. Treasury bills are very important instruments in the money market, there is some evidence which suggests that bill yields no longer serve as benchmark instruments from which other money market instruments are priced. LIBOR is the interest rate which major international banks offer each other on Eurodollar certificates of deposit (CD) with given maturities. The maturities range from overnight to five years. So, references to “3-month LIBOR” indicate the interest rate that major international banks are offering to pay to other such banks on a CD that matures in three months. Eurodollar CDs pay simple interest at maturity on an ACT/360 basis. [5, p.35] LIBOR serves as a pricing reference for a number of widely traded financial products and derivatives (e.g., floaters, swaps, structured notes, etc.).
Because of LIBOR’s importance in the global money markets, it is instructive to examine the relationship between Treasury bill yields and LIBOR. We expect LIBOR rates to be higher than the yields on bills of the same maturity because investors in Eurodollars CDs are exposed to default risk.
U.S. Treasury securities and the U.S. dollar are considered “safe havens” in times of crisis, regardless of their underlying causes. During times of turmoil, the resulting “flight to quality” widens the spread between LIBOR rates and T-bill rates.
U.S. money market is managed by U.S. government agencies. [5, p.54] U.S. government agency securities can be classified by the type of issuer—those issued by federal agencies and those issued by government sponsored enterprises. Moreover, U.S. government agencies that provide credit for the housing market issue two types of securities: debentures and mortgage-backed/asset-backed securities.
Federal agencies are fully owned by the U.S. government and have been authorized to issue securities directly in the marketplace. Government sponsored enterprises (GSEs) are privately owned, publicly chartered entities. [5, p.56] They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance. The entities in these privileged sectors include farmers, homeowners, and students. GSEs issue securities directly in the marketplace.
The Federal National Mortgage Association (“Fannie Mae”) is a GSE chartered by the Congress of the United States in 1938 to develop a secondary market for residential mortgages. [5, p.70] Fannie Mae buys home loans from banks and other mortgage lenders in the primary market and either holds the mortgages until they mature or issues securities backed by pools of these mortgages. Fannie Mae’s housing mission is overseen by the U.S. Department of Housing and Urban Development (HUD), and its safety and soundness is overseen by the Office of Federal Housing Enterprise Oversight (OFHEO). Although it is controversial, Fannie Mae maintains a direct line of credit with the U.S. Treasury.
If a corporation needs short-term funds, it may attempt to acquire funds via bank borrowing. One close substitute to bank borrowing for larger corporations with strong credit ratings is commercial paper. Commercial paper is a short-term promissory note issued in the open market as an obligation of the issuing entity. [2, p.40] Commercial paper is sold at a discount and pays face value at maturity. The discount represents interest to the investor in the period to maturity. Although some issues are in registered form, commercial paper is typically issued in bearer form.