Which One Of The Following Is The Best Definition Of A Money Market Instrument?

Money Markets, Bond Markets, and Mortgage Markets

Rajesh Kumar , in Strategies of Banks and Other Financial Institutions, 2014

4.2.2.2.4 Euro medium-term notes

Euro medium-term notes (EMTNs) are directly issued to markets with maturities of less than five years and are offered continuously rather than all at once, as with a bond issue. There is no underwriting syndicate for typical EMTNs issues. EMTNs are noncallable, unsecured senior debt securities. In structured EMTNs, a borrower issues EMTNs and simultaneously enters into one or more derivative agreements to transform the cash payments. For example, a borrower who issues floating-rate EMTNs along with a swap agreement can create synthetically a fixed note because floating rate payments can be swapped for a fixed rate payment.

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Market Background: The Money Markets

Moorad Choudhry , in The Repo Handbook (Second Edition), 2010

4.2.2 Certificates of Deposit

Certificates of Deposit (CDs) are receipts from banks for deposits that have been placed with them. They were first introduced in the sterling market in 1958. The deposits themselves carry a fixed rate of interest related to LIBOR and have a fixed term to maturity, so cannot be withdrawn before maturity. However, the certificates themselves can be traded in a secondary market, that is, they are negotiable. ³ CDs are therefore very similar to negotiable money market deposits, although the yields are about 0.15% below the equivalent deposit rates because of the added benefit of liquidity. Most CDs issued are of between one and three months maturity, although they do trade in maturities of one to five years. Interest is paid on maturity except for CDs lasting longer than one year, where interest is paid annually or, occasionally, semi-annually.

Banks, merchant banks and building societies issue CDs to raise funds to finance their business activities. A CD will have a stated interest rate and fixed maturity date and can be issued in any denomination. On issue a CD is sold for face value, so the settlement proceeds of a CD on issue always equal its nominal value. The interest is paid, together with the face amount, on maturity. The interest rate is sometimes called the coupon, but unless the CD is held to maturity this will not equal the yield, which is of course, the current rate available in the market and varies over time. In the United States CDs are available in smaller denomination amounts to retail investors. ⁴ The largest group of CD investors are banks themselves, money market funds, corporates and local authority treasurers.

Unlike coupons on bonds, which are paid in rounded amounts, CD coupon is calculated to the exact day.

CD yields. The coupon quoted on a CD is a function of the credit quality of the issuing bank, its expected liquidity level in the market, and of course the maturity of the CD, as this will be considered relative to the money market yield curve. As CDs are issued by banks as part of their short-term funding and liquidity requirement, issue volumes are driven by the demand for bank loans and the availability of alternative sources of funds for bank customers. The credit quality of the issuing bank is the primary consideration; in the sterling market the lowest yield is paid by "clearer" CDs, which are CDs issued by the clearing banks such as RBS NatWest, HSBC and Barclays plc. In the US market "prime" CDs, issued by highly-rated domestic banks, trade at a lower yield than non-prime CDs. In both markets CDs issued by foreign banks, such as French or Japanese banks, will trade at higher yields.

Euro-CDs, which are CDs issued in a different currency to the home currency, also trade at higher yields, in the US because of reserve and deposit insurance restrictions.

If the current market price of the CD, including accrued interest, is P and the current quoted yield is r, the yield can be calculated (given the price) using (4.2).

(4.2) $r = (\frac{M}{P} \times (1 + C (\frac{N_{i m}}{B})) - 1) \times (\frac{B}{N_{s m}}) .$

Given the yield, the price can be calculated using (4.3).

(4.3) $\begin{array}{l} P & = & M \times \frac{(1 + C (N_{i m} / B))}{(1 + r (N_{s m} / B))} \\ = & F / (1 + r (N_{s m} / B)) \end{array}$

where

C is the quoted coupon on the CD;

M is the face value of the CD;

B is the year day-basis (365 or 360);

F is the maturity value of the CD;

N_im is the number of days between issue and maturity;

N_sm is the number of days between settlement and maturity;

N_is is the number of days between issue and settlement.

After issue a CD can be traded in the secondary market. The secondary market in CDs in the UK is very liquid, and CDs will trade at the rate prevalent at the time, which will invariably be different from the coupon rate on the CD at issue. When a CD is traded in the secondary market, the settlement proceeds will need to take into account interest that has accrued on the paper and the different rate at which the CD has now been dealt. The formula for calculating the settlement figure is given by (4.4), which applies to the sterling market and its 365-day count basis.

(4.4) $Proceeds = \frac{M \times tenor \times C \times 100 + 36500}{days remaining \times r \times 100 + 36500}$

The tenor of a CD is the life of the CD in days, while days remaining is the number of days left to maturity from the time of trade.

The return on holding a CD is given by (4.5).

(4.5) $\begin{array}{l} Re turn & = & (\frac{1 + purchase yield \times (days from purchase to maturity / B)}{1 + sale yield \times (days from sale to maturity / B)} - 1) \\ \times \frac{B}{days held} \end{array}$

Example 4.1

CD Calculations

•

A three-month CD is issued on 6 September 1999 and matures on 6 December 1999 (maturity of 91 days). It has a face value of £20,000,000 and a coupon of 5.45%. What are the total maturity proceeds?

$Proceeds = 20 million \times (1 + 0 .0545 \times \frac{91}{365}) = £ 20, 271, 753.42.$

•

What is the secondary market price on 11 October if the yield for short 60-day paper is 5.60%?

$P = \frac{20.271 m}{(1 + 0.056 \times \frac{56}{365})} = £ 20,099,066.64.$

•

On 18 November the yield on short three-week paper is 5.215%. What rate of return is earned from holding the CD for the 38 days from 11 October to 18 November?

$R = (\frac{1 + 0.0560 \times (56 / 365)}{1 + 0.05215 \times (38 / 365)} - 1) \times \frac{365}{38} = 9.6355 % .$

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The Money Markets

Moorad Choudhry , in The Bond & Money Markets, 2001

31.2.2 Certificates of Deposit

Certificates of Deposit (CDs) are receipts from banks for deposits that have been placed with them. They were first introduced in the sterling market in 1958. The deposits themselves carry a fixed rate of interest related to LIBOR and have a fixed term to maturity, so cannot be withdrawn before maturity. However the certificates themselves can be traded in a secondary market, that is, they are negotiable. ² CDs are therefore very similar to negotiable money market deposits, although the yields are about 0.15% below the equivalent deposit rates because of the added benefit of liquidity. Most CDs issued are of between one and three months' maturity, although they do trade in maturities of one to five years. Interest is paid on maturity except for CDs lasting longer than one year, where interest is paid annually or occasionally, semi-annually.

Banks, merchant banks and building societies issue CDs to raise funds to finance their business activities. A CD will have a stated interest rate and fixed maturity date and can be issued in any denomination. On issue a CD is sold for face value, so the settlement proceeds of a CD on issue are always equal to its nominal value. The interest is paid, together with the face amount, on maturity. The interest rate is sometimes called the coupon, but unless the CD is held to maturity this will not equal the yield, which is of course the current rate available in the market and varies over time. In the United States CDs are available in smaller denomination amounts to retail investors. ³ The largest group of CD investors however are banks themselves, money market funds, corporates and local authority treasurers.

Unlike coupons on bonds, which are paid in rounded amounts, CD coupon is calculated to the exact day.

CD yields

The coupon quoted on a CD is a function of the credit quality of the issuing bank, and its expected liquidity level in the market, and of course the maturity of the CD, as this will be considered relative to the money market yield curve. As CDs are issued by banks as part of their short-term funding and liquidity requirement, issue volumes are driven by the demand for bank loans and the availability of alternative sources of funds for bank customers. The credit quality of the issuing bank is the primary consideration however; in the sterling market the lowest yield is paid by "clearer" CDs, which are CDs issued by the clearing banks such as RBS NatWest plc, HSBC and Barclays plc. In the US market "prime" CDs, issued by highly-rated domestic banks, trade at a lower yield than non-prime CDs. In both markets CDs issued by foreign banks such as French or Japanese banks will trade at higher yields.

Euro-CDs, which are CDs issued in a different currency to the home currency, also trade at higher yields, in the US because of reserve and deposit insurance restrictions.

If the current market price of the CD including accrued interest is P and the current quoted yield is r, the yield can be calculated given the price, using (31.2):

(31.2) $r = (\frac{M}{P} \times (1 + C (\frac{N_{i m}}{B})) - 1) \times (\frac{B}{N_{s m}}) .$

The price can be calculated given the yield using (31.3):

(31.3) $\underset{= F / (1 + r (\frac{N_{s m}}{B}))}{P = M \times (1 + C (\frac{N_{i m}}{B}))} / 1 + r (\frac{N_{s m}}{B})$

where

C	is the quoted coupon on the CD
M	is the face value of the CD
B	is the year day-basis (365 or 360)
F	is the maturity value of the CD
N_im	is the number of days between issue and maturity
N_sm	is the number of days between settlement and maturity
N_is	is the number of days between issue and settlement.

After issue a CD can be traded in the secondary market. The secondary market in CDs in the UK is very liquid, and CDs will trade at the rate prevalent at the time, which will invariably be different from the coupon rate on the CD at issue. When a CD is traded in the secondary market, the settlement proceeds will need to take into account interest that has accrued on the paper and the different rate at which the CD has now been dealt. The formula for calculating the settlement figure is given at (31.4) which applies to the sterling market and its 365-day count basis.

(31.4) $Proceeds = \frac{M \times Tenor \times C \times 100 + 36500}{Days remaining \times r \times 100 + 36500} .$

The tenor of a CD is the life of the CD in days, while days remaining is the number of days left to maturity from the time of trade.

The return on holding a CD is given by (31.5):

(31.5) $R = (\frac{(1 + undefined purchase yield \times (days from purchase to maturity / B))}{1 + sale yield \times (days from sale to maturity / B)} - 1) \times \frac{B}{days held} .$

Example 31.2

■ A three-month CD is issued on 6 September 1999 and matures on 6 December 1999 (maturity of 91 days). It has a face value of £20,000,000 and a coupon of 5.45%. What are the total maturity proceeds?

$Proceeds = 20 million \times (1 + 0.0545 \times \frac{91}{365}) = £ 20, 271, 753.42.$

■ What is the secondary market proceeds on 11 October if the yield for short 60-day paper is 5.60%?

$P = \frac{20.27 lm}{(1 + 0.056 \times \frac{56}{365})} = £ 20.099, 066.64.$

■ On 18 November the yield on short three-week paper is 5.215%. What rate of return is earned from holding the CD for the 38 days from 11 October to 18 November?

$R = (\frac{1 + 0.0560 \times \frac{56}{365}}{1 + 0.05215 \times \frac{38}{365}} - 1) \times \frac{365}{38} = 9.6355 % .$

CDs issued with more than one coupon

CDs issued for a maturity of greater than one year pay interest on an annual basis. The longest-dated CDs are issued with a maturity of five years. The price of a CD paying more than one coupon therefore depends on all the intervening coupons before maturity, valued at the current yield. Consider a CD that has four more coupons remaining to be paid, the last of which will be paid on maturity together with the face value of the CD. The value of this last coupon will be:

(31.6) $M \times C \times \frac{n_{3 - 4}}{B}$

where n ₃₋₄ is the number of days between the third and fourth (last) coupon dates and C is the coupon rate on the CD. The maturity proceeds of the CD are therefore:

(31.7) $M \times (1 + C \times \frac{n_{3 - 4}}{B}) .$

The present value of this amount to the date of the second coupon payment is therefore its discounted value using the current yield r is given by (31.8):

(31.8) $P_{2} = \frac{M \times (1 + C \times \frac{n_{3 - 4}}{B})}{1 + r \times \frac{n_{3 - 4}}{B}} .$

This value is then added to the actual cash flow received on the same date, that is, the second coupon date, which is given by:

(31.9) $M \times C \times \frac{n_{2 - 3}}{B} .$

The total of these two amounts is given by (31.10):

(31.10) $P_{1} = M \times (\frac{(1 + C \times \frac{n_{3 - 4}}{B})}{(1 + r \times \frac{n_{3 - 4}}{B})} + C \times \frac{n_{2 - 3}}{B}) .$

This amount is then discounted again to obtain the present value on the first coupon date at the current yield r, and added to the total cash flow. This process is repeated so that the final total amount can be discounted to the purchase date, at the current yield.

In general for a CD with N coupon payments remaining the price is given by (31.11):

(31.11) $P = M \times (\frac{1}{A_{N}} + (\frac{C}{B} \times Σ_{k = 1}^{N} (\frac{n_{k - 1; k}}{A_{k}})))$

where

$A_{k} = (1 + r \times \frac{n_{p 1}}{B}) (1 + r \times \frac{n_{1 - 2}}{B}) (1 + r \times \frac{n_{2 - 3}}{B}) \dots (1 + r \times \frac{n_{k - 1; k}}{B})$

n_k _-1;k	is the number of days between the (k−1)th coupon and the kth coupon
n_p ₁	is the number of days between purchase date and the first coupon.

An example of the way CDs and time deposits are quoted on screen is shown at Figure 31.2, which shows one of the rates screens displayed by Garban ICAP, money brokers in London, on a Telerate screen. Essentially the same screen is displayed on Reuters. The screen has been reproduced with permission from Garban ICAP and Dow-Jones Telerate. The screen displays sterling interbank and CD bid and offer rates for maturities up to one year as at 8 December 1999, together with FRA rates and repo rates (in fact, there were no repo quotes at that time). The maturity marked "O/N" is the over-night rate, which at that time was 5.0625–4.9375. Rates for cash instruments in the sterling market, except for repo, are quoted in 32nds, so a spread of one thirty-second is 0.03125. The maturity marked "T/N" is "tom-next", or "tomorrow-to-the-next", which is the over-night rate for deposits commencing tomorrow. As we noted earlier, the liquidity of CDs means that they trade at a lower yield to deposits, and this can be seen from Figure 31.2. The bid-offer convention in sterling is that the lending rate – the rate at which funds are lent – placed on the left. This is the same for both CDs and deposits, so a six-month CD rate would be purchased at 6.125%, which means that funds are lent at 6.125%, while a six-month time deposit is lent at 6.15625%.

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Medium-term Notes

Moorad Choudhry , in The Bond & Money Markets, 2001

21.2 The primary market

MTN issues are arranged within a programme. A continuous MTN programme is established with a specified issue limit, and sizes can vary from $100 million to $5,000 million or more. Within the programme MTNs can be issued at any time, daily if required. The programme is similar to a revolving loan facility; as maturing notes are redeemed, new notes can be issued. The issuer usually specifies the maturity of each note issue within a programme, but cannot exceed the total limit of the programme.

Example 21.1

ABC plc

■ ABC plc establishes a five-year $200 million MTN programme and immediately issues the following notes:

$50 million of notes with a one-year maturity

$70 million of notes with a five-year maturity

ABC plc can still issue a further $80 million of notes; however in one year's time when $50 million of notes mature, it will be able to issue a further $50 million if required. The total amount in issue at any one time never rises above $200 million.

The first step for the borrower is to arrange shelf registration with the SEC. This ensures the widest possible market for the programme; there are also no re-sale or transfer restrictions on the bonds themselves. The shelf registration identifies the investment bank or banks that will be acting as agents for the programme and who will distribute the paper to the market. A domestic programme may have only one agent bank, although two to four banks are typical. Global and Euro-MTN programmes usually have more agent banks. Once registration is complete the borrower issues a prospectus supplement detailing the terms and conditions of the programme. Often a draft prospectus is issued first, and only issued in final once the issuing bank has gauged market reaction. A draft prospectus is known as a red herring. Within a programme a borrower may also issue conventional corporate bonds, underwritten by an investment bank, but there is none of the flexibility available compared to an MTN issue, which can be arranged at very short notice, so conventional bond offerings within a programme are rare.

The agent banks sometimes publicise the maturities and yield spreads that are to be offered as part of the programme; a typical example for an hypothetical programme in the sterling market is given at Table 21.2.

Table 21.2. MTN programme offer, October 1999.

Maturity	Yield spread (bps)	Benchmark bond	Current yield
9 months	20	13% 2000	5.80
12 – 24 months	25	7% 2001	6.25
2 – 3 years	35	7% 2002	6.37
3 – 4 years	45	6.5% 2003	6.38
4 – 5 years	50	6.75% 2004	6.34
5 – 6 years	55	8.5% 2005	6.36
9 – 11 years	50	5.75% 2009	5.77
15 – 20 years	30	8% 2021	5.02

The exact date of a particular maturity issue is not always known at the time the programme is announced, so yields are often given as a spread over the equivalent maturity government bond. If the borrower has a particular interest to tap the market at specific points of the yield curve, the spread offered at that point is increased in order to attract investors. Once the required funds have been raised, offer spreads are usually reduced. If the full amount stated in the registration details is raised, US domestic market borrowers need to file a new registration with the SEC. The size of individual issues within a programme varies with the funding strategy of the borrower. Certain companies have a preference to raise large amounts at once, say $100 to $200 million, and raise funds using fewer issues. This also maintains a "scarcity value" for their paper compared to borrowers who tap the market more frequently. Other companies adopt the opposite approach, with small size issues of between $5 to $10 million spread over more dates.

Domestic market MTNs are primarily offered on an agency basis, although issues within a programme are sometimes sold using other methods. Agent banks sometimes acquire the paper for their own book, trading it later in the secondary market. Specific issues may be underwritten by an agent bank, or sold directly to investors by the corporate treasury arm of the borrowing company.

The main issuers of MTNs in the US market are:

■: general finance companies, including automobile finance companies, business credit institutions and securities houses;
■: banks, both domestic and foreign;
■: governments and government agencies;
■: supranational bodies such as the World Bank;
■: domestic industrial and commercial companies, primarily motor car and other industrial manufacturing companies, telecommunications companies and other utilities;
■: savings and loan institutions.

During the 1980s the MTN market was dominated by financial institutions, accounting for over 90% of issue volume. This share was reduced to approximately 70% by 1992 (Crabbe 1992), the remainder of the issues being accounted for by other categories of borrower.

There is a large investor demand in the US for high-quality corporate paper, much more so than in Europe where the majority of bonds are issued by financial companies. This demand is particularly great at the short- to medium-term maturity end. As the market has a large number of issuers, investors are able to select issues that meet precisely their requirements for maturity and credit rating. The main investors are:

■: investment companies;
■: insurance companies;
■: banks;
■: savings and loan institutions;
■: corporate treasury departments;
■: state institutions.

It can be seen that the investor base is very similar to the issuer base!

All the main US investment banks make markets in MTNs, including Merrill Lynch, Goldman Sachs, Morgan Stanley, CSFB and Salomon Smith Barney. In the UK active market makers in MTNs include RBS Financial Markets and Barclays Capital.

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The Day-to-Day Operation of a Fund

David Loader , in Fund Custody and Administration, 2016

Certificates of deposit

A popular security type used as collateral is a Certificate of Deposit. CDs are certificates, which give ownership of a deposit at a bank and for which there is an established market.

The advantages of using CDs as collateral:

•: Considered to be of high quality and "near-cash" they are guaranteed by the banks on which they are drawn. The lender is able to specify the creditworthiness of the banks by only accepting paper with a rating of, say, "A" or better.
•: CDs are straightforward to sell should the need arise.

The disadvantages of CDs as collateral:

•: The nominal amount of CDs tends to be in shapes of £1,000,000 or $1,000,000 and this makes it difficult to ensure that the margined collateral value matches the value of outstanding loans.
•: CDs have a limited lifespan and borrowers must ensure that CDs are substituted as old CDs mature.

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The Valuation of Securities

S.J. Garrett , in Introduction to the Mathematics of Finance (Second Edition), 2013

Certificates of Deposit

Certificates of deposit are certificates stating that some money has been deposited, usually issued by banks and building societies. They are short-dated securities, and terms to redemption are usually in the range of 28 days to 6 months. Interest is payable on maturity. The degree of security and marketability will depend on the issuing bank.

The valuation of these various types of fixed-interest securities is the topic of much of this chapter. There are also stocks with a coupon rate that varies according to changes in a standard rate of interest, such as the rate on Treasury Bills. These stocks, and the index-linked securities mentioned previously, are not fixed-interest securities in the strict sense, but have more in common with ordinary shares, which we briefly discuss in the following section.

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The Repo Markets

Moorad Choudhry , in The Bond & Money Markets, 2001

34.11.2 Gilt repo and other sterling money markets

Gilt repo has developed alongside growth in the existing unsecured money markets. There has been a visible shift in short term money market trading patterns from unsecured to secured money. According to the Bank of England (BoE) market participants estimate that gilt repo now accounts for about half of all overnight transactions in the sterling money markets. The repo general collateral (GC) rate tends to trade below the interbank rate, on average about 10–15 basis points below, reflecting its status as government credit. The gap is less obvious at very short maturities, due to the lower value of such credit over the short term and also reflecting the higher demand for short term funding through repo by securities houses that may not have access to unsecured money.

The Certificate of Deposit (CD) market has grown substantially, partly because the growth of the gilt repo and stock lending market has contributed to demand for CDs for use as collateral in stock loans. One effect of gilt repo on the money market is a possible association with a reduction in the volatility of overnight unsecured rates. Fluctuations in the overnight unsecured market have been reduced since the start of an open repo market, although the evidence is not conclusive. This may be due to repo providing an alternative funding method for market participants, which may have reduced pressure on the unsecured market in overnight funds. It may also have enhanced the ability of financial intermediaries to distribute liquidity.

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Financial markets: bonds

John Hill , in Environmental, Social, and Governance (ESG) Investing, 2020

Types of debt instruments: money market instruments

Money market instruments are financial instruments which are issued with a maturity of one year or less. They provide a market for investors to earn a return on liquid assets; borrowers who need short-term liquidity have access to these funds; and they provide the Fed with a means to effect monetary policy. The money markets include the following different types of instruments, each with different purposes. Banks lend to each other in what is called the "interbank funding (or lending) market." Unsecured lending takes place through the federal funds market while secured lending occurs in the repo market. The rate at which banks borrow from each other is the "fed funds rate." In London, the rate at which banks borrow from each other is the London InterBank Offered Rate or LIBOR. LIBOR has become the underlying reference rate for a huge amount of floating rate debt. Roughly $400 trillion dollars of financial instruments are based on LIBOR.

A repurchase agreement (repo) is a short-term sale of a security with a promise to buy it back, usually the next day. The agreement from the buyer's perspective is called a reverse repo: the purchase of a security with an agreement to sell it back. The security that's exchanged stands as collateral for the loan advanced to the seller. The seller, usually a dealer, thereby has access to lower cost funds, while the buyer can earn a return on a liquid, secured transaction. Collateral are most often Treasuries and agency securities but can include mortgage-backed securities, other asset-backed securities (ABS), and pools of loans.

Commercial paper (CP) is an alternative to bank borrowing by corporations with high credit ratings. Most CP matures within 90 days but can extend further. When the CP expires, it is usually replaced with a new issue, in a process called "rolling over." Some CP is issued by nonfinancial companies, but financial companies with large funding needs have come to dominate this market. The volume of CP outstanding prior to the Global Financial Crisis totaled over $2 trillion. Since the GFC, volumes have been barely half that level.

Certificates of Deposit are issued by banks and have a term and denomination. The large denomination CDs are $10 million and over. CDs may be nonnegotiable, requiring the owner to wait until the maturity date to redeem, or negotiable, in which case the owner can sell the CD on the open market at any time.

Banker's Acceptances are financing agreements, guaranteed by the issuing bank, which are created for use in transactions involving imports and exports as well as storing and shipping goods within the United States. An importing business, for example, can provide a banker's acceptance to an exporting business thereby limiting the risk to the shipper of nonpayment. The banker's acceptance substitutes the financial institution's credit standing for that of the importing business.

A Funding Agreement is a life insurance contract providing a guaranteed return of principal and interest to the buyer. There are a number of different variations which provide for a fixed or floating rate of interest, maturities of 3–13 months and there may be a put provision, which allows the investor to demand early repayment.

Money Market Funds have approximately $3 trillion in assets. They are invested in short-term financial instruments with an objective of obtaining the highest return subject to certain restrictions and a mandate to maintain a net asset value of $1 or more. Money market funds were created in the 1970s in part to provide a return on funds that were in checking accounts and were prohibited from earning interest. A net asset value of less than $1 is called "breaking the buck" and was of great concern during the Global Financial Crisis. In September 2008 Lehman Bros. filed for bankruptcy. At the time the Reserve Primary Fund took losses on Lehman debt and its net asset value dropped to 97 cents. Investors were concerned that other money market funds might have similar issues and a large net capital outflow ensued. Actions by the U.S. Department of the Treasury to temporarily insure these funds prevented what might have become a run on money market funds and freezing the ability of firms to fund short-term needs. Fig. 7.4 shows the level of total financial assets in money market mutual funds over time.

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Cash Instruments

R."Tee" Williams , in An Introduction to Trading in the Financial Markets: Trading, Markets, Instruments, and Processes, 2011

Fixed-Income Participants

The nature of money-market instruments, notes, and bonds makes fixed-income instruments ideal for some investors and unattractive to others (see Figure 3.1.2.4). The determining characteristics of fixed-income instruments include

•: predictable cash flows;
•: certainty of the return of invested capital;
•: limited risk;
•: high required initial investment;
•: a ceiling on possible price appreciation; and
•: homogeneous characteristics of instruments within risk categories.

When market conditions cause these expected characteristics to be unrealized, the turmoil in the fixed-income markets is usually much higher than occurs when equities fail to meet expectations.

Investors

In general, fixed-income instruments are not well suited for most individuals because of the high required investment and the limitations on returns. Individuals requiring the safety and security of fixed income can meet those needs by investing in packaged instruments that invest in bonds.

Among institutional investors, almost all invest a portion of their portfolios in bonds and other fixed-income securities except for those funds dedicated to equities or other instruments. Insurance companies and companies that manage pensions and annuities are heavy users of fixed-income instruments. These types of investment products have both predictable cash contributions to the portfolio and known or predictable future payments because of actuarial predictions of death rates, retirement withdrawals, or planned payments to beneficiaries. This certainty of receipts and payments from fixed-income instruments makes it possible for portfolio managers to plan their cash needs with precision and in turn invest so that the fixed- income instruments mature when the cash is needed.

The investment demands of insurance, pensions, and annuities fit neatly with the financing needs of companies that raise funds frequently. Companies with strong credit ratings that regularly need to borrow are able to sell bonds directly to these investors either without investment bankers or with substantially lower fees for the issues. These direct or private placements can occur at substantially lower costs for both the issuing company and for ultimate investors.

Intermediaries

The fixed-income market is largely dealer based. We distinguish two types of dealers (refer to Figure 3.1.2.4)—that is, important categories of intermediaries:

Fixed-income intermediaries provide the capabilities for investors and principals to find others willing to trade and, when necessary, provide immediacy as dealers.

Fixed-income quote management provides a facility for dealers to publish quotes that can attract prospective traders and may provide the ability to execute automatically against a dealer's inventory.

Major Dealers

Fixed-income trading demands large quantities of capital. A dealer must stand ready to buy large quantities of fixed-income instruments from major customers, and the dealer must then hold those positions in inventory until a buyer can be found. Therefore, most fixed-income markets are dominated by very large dealers, which are often divisions of large investment banks or universal banks.

Large dealers cannot spare the time required to sell to and to service smaller customers. Moreover, smaller customers often cannot afford expensive market-data services on which dealers make markets. (These market-data systems are described in Book 3.) The advent of the Internet has created an economic opportunity for major dealers to service smaller customers without excessive use of the dealer's employees or expensive vendor market-data systems. The Internet also provides smaller customers access to more liquidity.

For most fixed-income market sectors, the term "major dealer" is simply descriptive. However, in some markets such as the U.S. government's markets, there is a formal designation of primary dealers . The New York Federal Reserve Bank (N.Y. Fed), which manages the sale of U.S. Treasury securities and helps to control the U.S. money supply (see the "Control of Money Supply" sidebar later), designates a number of very large banks and broker/dealers as primary dealers. Primary dealers are permitted to trade directly with the N.Y. Fed and participate in U.S. Treasury auctions.

Minor Dealers

As implied in the previous section, smaller dealers evolved to fill a void left by large dealers unable or unwilling to service smaller customers. Small dealers act almost as agents, rarely carrying positions. They acquire instruments for customers' purchase orders from major dealers and quickly liquidate positions they acquire. Smaller dealers are threatened by the capacity of the Internet to provide a low-cost delivery mechanism for larger dealers.

Interdealer Brokers

Interdealer brokers were described in Book 1. In the fixed-income market, IDBs provide the facility for major dealers to lay off positions with one another without revealing their own identity to the counterparty. Both dealers see the IDB as the other side of their trade and do not know the identity of the other principal.

Quote management

The fixed-income market does not typically trade on exchanges and other trading venues because most trading takes place among dealers, and trades are often too large to be accommodated in normal execution processes. However, most markets have some form of quote distribution so prospective traders can find dealers providing attractive quotes (refer to Figure 3.1.2.4). Some of these systems are beginning to provide execution capabilities, but most executions are against dealers' inventories.

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Cash Flow Engineering in Foreign Exchange Markets

Robert L. Kosowski , Salih N. Neftci , in Principles of Financial Engineering (Third Edition), 2015

6.2.2.1 A money market synthetic

The first synthetic is obtained using money market instruments. To do this, we need a brief review of money market instruments. The following lists some important money market instruments, along with the corresponding quote, registration, settlement, and other conventions that will have cash flow patterns similar to Figure 6.2d and e. The list is not comprehensive.

Example

Deposits/loans. These mature in less than 1 year. They are denominated in domestic and Eurocurrency units. Settlement is on the same day for domestic deposits and in 2 business days for Eurocurrency deposits. There is no registration process involved and they are not negotiable.

Certificates of deposit (CD). Generally these mature in up to 1 year. They pay a coupon and are sometimes sold in discount form. They are quoted on a yield basis, and exist both in domestic and Eurocurrency forms. Settlement is on the same day for domestic deposits and in 2 working days for Eurocurrency deposits. They are usually bearer securities and are negotiable.

Treasury bills. These are issued at 13-, 26-, and 52-week maturities. In France, they can also mature in 4–7 weeks; in the United Kingdom, also in 13 weeks. They are sold on a discount basis (United States, United Kingdom). In other countries, they are quoted on a yield basis. Issued in domestic currency, they are bearer securities and are negotiable.

Commercial paper (CP). Their maturities are 1–270 days. They are very short-term securities, issued on a discount basis. The settlement is on the same day; they are bearer securities and are negotiable.

Euro-CP. The maturities range from 2 to 365 days but most have 30- or 180-day maturities. Issued on a discount basis, they are quoted on a yield basis. They can be issued in any Eurocurrency, but in general they are in Eurodollars. Settlement is in 2 business days, and they are negotiable.

How can we use these money market instruments to interpret the synthetic for the FX forward as shown in Figure 6.2?

One money market interpretation is as follows. The cash flow shown in Figure 6.2e involves making a payment of $C_{t_{0}}^{USD}$ at time t ₀, to receive USD100 at a later date, t ₁. Clearly, an interbank deposit will generate exactly this cash flow pattern. Then, the $C_{t_{0}}^{USD}$ will be the present value of USD100, where the discount factor can be obtained through the relevant Eurodeposit rate.

(6.1) $C_{t_{0}}^{USD} = \frac{100}{1 + L_{t_{0}}^{USD} ((t_{1} - t_{0}) / 360)}$

Note that we are using an ACT/360-day basis for the deposit rate $L_{t_{0}}^{USD}$ , since the cash flow is in Eurodollars. Also, we are using money market conventions for the interest rate. ³ Given the observed value of $L_{t_{0}}^{USD}$ , we can numerically determine the $C_{t_{0}}^{USD}$ by using this equation.

How about the cash flows shown in Figure 6.2d? This can be interpreted as a loan obtained in interbank markets. One receives $C_{t_{0}}^{EUR}$ at time t ₀ and makes a euro-denominated payment of $100 / F_{t_{0}}$ at the later date t ₁. The value of this cash flow will be given by

(6.2) $C_{t_{0}}^{EUR} = \frac{100 / F_{t_{0}}}{1 + L_{t_{0}}^{EUR} ((t_{1} - t_{0}) / 360)}$

where $C_{t_{0}}^{EUR}$ is the relevant interest rate in euros.

Finally, we need to interpret the last diagram shown in Figure 6.2f. These cash flows represent an exchange of $C_{t_{0}}^{USD}$ against $C_{t_{0}}^{EUR}$ at time t ₀. Thus, what we have here is a spot purchase of dollars at the rate $e_{t_{0}}$ .

The synthetic is now fully described:

•: Take an interbank loan in euros (Figure 6.2d).
•: Using these euro funds, buy spot dollars (Figure 6.2f).
•: Deposit these dollars in the interbank market (Figure 6.2f).

This portfolio would exactly replicate the currency forward, since by adding the cash flows in Figure 6.2d–f, we recover exactly the cash flows generated by a currency forward as shown in Figure 6.2a.

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