12

Chapte
r Money Market Instruments:
Commercial Paper, Federal Agency
Securities, Bankers’ Acceptances, and
Eurocurrency Deposits

Money and Capital Markets

Financial Institutions and Instruments in a
Global Marketplace
Eighth Edition
Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

 12 - 2

 Learning Objectives 

 To discover the important roles that large

corporations, government agencies and banks
play in the money market.
 To explore the nature and characteristics of
commercial paper.
 To learn how federal agencies aid various
economic sectors in finding low-cost credit.

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 12 - 3

 Learning Objectives 

 To see the trend toward the

internationalization of the money market, and
examine how bankers’ acceptances and
Eurodeposits are employed in aiding both
domestic and international trade.
 To understand how the transfers of money
from one spending unit to another across
international boundaries can impact a nation’s
economy.
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 12 - 4

Commercial Paper

 Commercial paper consists of short-term,

unsecured promissory notes issued by well-
known and financially strong companies.
 Commercial paper is traded mainly in the
primary market. Opportunities for resale in the
secondary market are more limited.
 Commercial paper is rated prime, desirable, or
satisfactory, depending on the credit standing
of the issuing company.
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Types of Commercial Paper

 There are two major types of commercial

paper.
 Direct paper is issued mainly by large finance
companies and bank holding companies
directly to the investor.
 Dealer paper, or industrial paper, is issued by
security dealers on behalf of their corporate
customers (mainly nonfinancial companies and
smaller financial companies).
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 12 - 6

Structure of the Commercial Paper Market

Supply Side Demand Side

Investors in
commercial paper
Issuers of
commercial paper Money market
Direct or finance funds
Finance paper Banks
companies
Bank holding Insurance
companies companies
Paper Pension funds
Nonfinancial dealer
firms Industrial
Dealer or houses companies
industrial
paper Other investors

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 12 - 7

Maturities & Rate of Return

 Maturities of U.S. commercial paper range from three

days (“weekend paper”) to nine months.
 Most commercial paper is issued at a discount from par,
and yields to the investor are calculated by the bank
discount method, just like Treasury bills.

DR= Par value – Purchase price × 360 .

Par value Days to maturity

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 12 - 8

Growth of Commercial Paper

 The volume of commercial paper has grown

rapidly due to its relatively low cost and high
quality, as well as the expanding use of credit
enhancements.
Outstanding Volume
Year of Paper in the U.S.
1960 $ 4.5 billion
1970 33.4
1980 124.4
1990 562.7
Effect of
2000 1,615.3 weaker economy
2001 1,438.8 & terrorism
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 12 - 9

Market Yields on Commercial Paper

%
9

5
Federal Funds
4 Commercial Paper
Bankers' Acceptances
3 Bank Prime Loans
Treasury Bills
2
1991 1993 1995 1997 1999 2001
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 12 - 10

Commercial Paper

Advantages
 Relatively low interest rates
 Flexible interest rates - choice of dealer or
direct paper
 Large amounts may be borrowed conveniently
 The ability to issue paper gives considerable
leverage when negotiating with banks

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 12 - 11

Commercial Paper

Disadvantages
 Risk of alienating banks whose loans may be
needed when an emergency develops
 May be difficult to raise funds in the paper
market at times
 Commercial paper must generally remain
outstanding until maturity - does not permit
early retirement without penalty

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 12 - 12

Continuing Innovation in the Paper Market

 Innovations and extensions of the paper

market include:
 Master note – the investing firm agrees to take
some paper each day up to an agreed-upon
maximum amount
 Medium-term notes – 9-month to 10-year notes

 Asset-backed commercial paper – loans or credit

receivables are pooled and paper is then issued as a

claim against that pool

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 12 - 13

Federal Agency Securities

 Certain sectors of the economy, such as

agriculture, housing, small businesses, and
college students, appear to have an unusually
difficult time raising funds in the money and
capital markets.
 Beginning in 1916, the U.S. federal
government created special agencies to make
direct loans or guarantee private loans to these
“disadvantaged” borrowers.
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 12 - 14

Types of Federal Credit Agencies

 Government-sponsored agencies are federally

chartered but privately owned. Their
borrowing and lending activities are not
reflected in the federal government’s budget.
 Examples:
 Federal Farm Credit Banks (FFCB)
 Federal Home Loan Mortgage Corp (Freddie Mac)

 Student Loan Marketing Association (Sallie Mae)

 Financing Assistance Corporation (FAC)

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 12 - 15

Types of Federal Credit Agencies

 Federal agencies are legally a part of the

government structure, and their borrowing and
lending activities are included in the federal
budget.
 Examples:
 Export-Import Bank (EXIM)
 Farmers Home Administration (FMHA)

 Government National Mortgage Association

(Ginnie Mae)
 Federal Deposit Insurance Corporation (FDIC)

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 12 - 16

The Roles of Federal Credit Agencies

Performing the Roles of a Financial Intermediary

Granting loans to
Borrowing funds disadvantaged
from the open sectors
market and from
other government Federal &
government- Guaranteeing
agencies loans made by
sponsored
credit other lenders
agencies
Buying loans
from the
secondary market

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 12 - 17

Federal Agency Securities

 The agency market has soared in recent years,

with the volume of outstanding securities
climbing from about $2 billion during the
1950s to almost $2 trillion today.
 Agency securities are generally short to
medium term in maturity (running out to about
10 years).

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 12 - 18

The Marketing of Agency Issues

 The most active buyers of agency securities

include banks, state and local governments,
government trust funds, and the Federal
Reserve System.
 The Federal Reserve is authorized to conduct
open market operations in agency IOUs.
 Major securities dealers who handle U.S.
government securities also generally trade in
agency issues.
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 12 - 19

Bankers’ Acceptances

 A bankers’ acceptance is a time draft drawn

on and endorsed by an importer’s bank.
 Acceptances are used in international trade
because most exporters are uncertain of the
credit standing of their importers.
 The issuing bank unconditionally guarantees
to pay the face value of the acceptance when it
matures, thus shielding exporters and investors
in international markets from default risk.
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 12 - 20

Bankers’ Acceptances

 Acceptances carry maturities ranging from 30

to 270 days, with 90 days being the most
common.
 They are traded among financial institutions,
industrial corporations, and securities dealers
as a high-quality investment and source of
ready cash.

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 12 - 21

How Acceptances Arise

Importer applies for line of credit

Importer’s bank issues letter of credit in favor of exporter

Letter of credit authorizes the drawing of a time draft

Importer’s bank accepts time draft from exporter’s bank

Importer’s bank pays exporter’s bank discounted value of

bankers’ acceptance, and then holds or sells it

Bankers’ acceptance is redeemed at maturity

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 12 - 22

The Growth and Decline of Acceptance Financing

 The volume of US$ acceptances outstanding

grew rapidly, from less than $400 million in
1950, to slightly more than $7 billion in 1970,
and almost $80 billion in 1984.
 Then the volume declined sharply to $10
billion in 2000, as several leading export
nations entered a recession, as economic
problems developed in Asia, and as businesses
turn to other payment and financing methods.
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 12 - 23

Acceptance Rates

 Acceptances do not carry a fixed rate of

interest, but are sold at a discount in the open
market like Treasury bills.
 The yield on acceptances is usually only
slightly higher than the yield on Treasury bills,
and close to the negotiable CD rates offered by
major banks, because of the high credit quality
of the banks that issue the acceptances and
CDs.
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 12 - 24

Acceptance Rates
%
6.5

5.5

4.5

4 Commercial Paper
Bankers' Acceptances
3.5 Treasury Bills
Certificates of Deposit
3
1991 1993 1995 1997 1999 2001
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Data Source:  2003 byReserve
Board of Governors of the Federal SystemCompanies, Inc. All rights reser
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 12 - 25

Investors in Acceptances

 Investors in acceptances include banks,

industrial corporations, money market mutual
funds, local governments, federal agencies,
and insurance companies.
 To many investors, acceptances are a close
substitute for Treasury bills, negotiable CDs,
or commercial paper in terms of quality,
although the acceptance market is far smaller
in terms of the volume of trading.
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 12 - 26

Eurocurrency Deposits

 The Eurocurrency market has arisen because

of the tremendous need worldwide for funds
denominated in dollars, Euros, pounds, and
other relatively stable currencies.
 The Eurocurrency market represents the
largest of all money markets worldwide, with
total funds probably in excess of $4 trillion.

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 12 - 27

Eurocurrency Deposits

 Eurodollars are deposits of U.S. dollars in

banks located outside the U.S.
 The large majority of Eurodollar deposits are
held in Europe, although Europe’s share of the
total is declining.

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 12 - 28

Eurocurrency Deposits

 Eurodollars and other Eurocurrency deposits

are continually on the move in the form of
loans.
 They are employed to finance the import and
export of goods, to supplement government
tax revenues, to provide working capital for
the foreign operations of multinational
corporations, and to provide liquid reserves for
the largest banks.
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 12 - 29

Eurocurrency Deposits

 When a dollar deposit is moved to a bank

located outside the U.S., that bank then holds
claim to the original dollar deposit in the U.S.
 When a Eurodollar loan is made, the borrower
receives a claim against dollars deposited in
U.S. banks.
⇒ Funds are merely passed from one U.S. bank
to another. The total amount of dollar deposits
and U.S. bank reserves remains unchanged.
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 12 - 30

Eurocurrency Maturities and Risks

 Most Eurocurrency deposits are short-term

deposits ranging from overnight to one year,
although a small percentage are long-term time
deposits.
 Eurocurrency deposits are known to be volatile
and highly sensitive to fluctuations in interest
rates and currency prices. They also carry
political risk and default risk.

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 12 - 31

The Supply of Eurocurrency Deposits

 Eurocurrency deposits come from …

 foreign investment
 tourism

 balance of payments (trade) settlements

 interbank funds

 government funds

 large corporations’ cash balances

 central banks supplying or absorbing funds from

the banking system

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 12 - 32

Eurodollars in U.S. Domestic Bank Operations

 Since the late 1960s, U.S. banks have drawn

heavily on Eurodollar deposits as a means of
adjusting their domestic reserve positions.
 Eurodollars usually carry higher reported
interest rates than many other sources of bank
reserves. However, there are fewer legal
restrictions on the borrowing of Eurodollars.
 U.S. banks also aid their customers in
acquiring Eurocurrency deposits and loans.
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 12 - 33

Interest Rates on Eurodollar Deposits

%
6.5

5.5

4.5

4 Treasury Bills
Certificates of Deposit
3.5 Federal Funds
Eurodollar Deposits (London)
3
1991 1993 1995 1997 1999 2001
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 12 - 34

Benefits and Costs of the Eurocurrency Markets

Benefits
 Makes possible an efficient mobilization of
funds around the globe.
 Encourages international cooperation among
nations.
 Creates a cash-management source to aid the
financial operations of corporations and
governments around the globe.

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 12 - 35

Benefits and Costs of the Eurocurrency Markets

Costs
 The capacity to mobilize massive amounts of
funds may contribute to instability in currency
values.
 Monetary and fiscal policies designed to cure
domestic economic problems may not achieve
their desired impact.

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 12 - 36

Money and Capital Markets in Cyberspace

 More information about the various money

market instruments can be found at:
 http://www.investopedia.com/university/
moneymarket/
 http://www.ny.frb.org/pihome/fedpoint/
 http://www.federalreserve.gov/releases/
 http://www.fanniemae.com/
 http://www.freddiemac.com/
 http://www.bis.org/publ/
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 12 - 37

Chapter Review

 Commercial Paper
 What Is Commercial Paper?
 Types of Commercial Paper

 Structure of the Commercial Paper Market

 Maturities & Rate of Return on Commercial Paper

 Growth of Commercial Paper

 Market Yields on Commercial Paper

 Advantages & Disadvantages

 Continuing Innovation in the Paper Market

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 12 - 38

Chapter Review

 Federal Agency Securities

 Types of Federal Credit Agencies
 The Roles of Federal Credit Agencies

 Growth of the Agency Market

 Terms on Agency Securities

 The Marketing of Agency Issues

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 12 - 39

Chapter Review

 Bankers’ Acceptances
 Why Acceptances Are Used in International Trade
 How Acceptances Arise

 The Growth and Decline of Acceptance Financing

 Acceptance Rates

 Investors in Acceptances

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 12 - 40

Chapter Review

 Eurocurrency Deposits
 What is a Eurodollar?
 The Creation of Eurocurrency Deposits

 Eurocurrency Maturities and Risks

 The Supply of Eurocurrency Deposits

 Eurodollars in U.S. Domestic Bank Operations

 Benefits and Costs of the Eurocurrency Markets

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