SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 14)

The Determinants of Interest Rates

by

Charles Lamson

In the previous articles, I have emphasized the role of the financial system in coordinating and channeling the flow of funds from surplus spending units (SSUs or households) to deficit spending units (DSUs or firms). The interest rate is of paramount importance in this process for the following reasons: (1) Since it is the reward for lending and the cost of borrowing and lending, that is, the behavior of DSUs and SSUs; and (2) conversely, the borrowing and lending behavior of DSUs and SSUs influences the interest rate. In the market for loanable funds, as in other markets, supply and demand are the key to determining interest rates. This means, of course, that any change in interest rates will be the result of changes in supply and/or demand.

The demand for loanable funds originates from the household, business, government, and foreign DSUs who borrow because they are spending more than their current income. The downward-sloping demand curve indicates that DSUs are willing to borrow more at lower rates, ceteris paribus (all things remaining equal). Businesses borrow more at lower interest rates because more investment projects become profitable, ceteris paribus. Projects that would be unprofitable if the business had to pay 12 percent to borrow the funds become quite profitable if the funds can be had for only 2 percent. Consumers borrow more at lower interest rates, ceteris paribus, for such things as automobiles and other consumer durables.

The total supply of loanable funds originates from two basic sources: (1) the household, business, government, and foreign SSUs who are prepared to lend because they are spending less than their current income, and (2) the Fed, which, in its ongoing attempts to manage the economy's performance, supplies reserves to the financial system that lead to increases in the growth rate of money (and loans). We shall assume that the Fed's supply of funds is fixed at a particular amount for the time being. Adding the funds that SSUs are willing to supply to the Fed's supply of funds produces a supply curve for loanable funds that is upward sloping. This indicates that SSUs are willing to supply more funds at higher rates, ceteris paribus. as Exhibit 1 shows, the quantity of funds supplied equals the quantity of funds demanded at point E1. The equilibrium interest rate in the market for loanable funds is 6 percent, and the equilibrium quantity of funds borrowed and lent is $500 billion.

The interest rate is measured on the vertical axis, while the quantity of loanable funds is measured on the horizontal axis. At E1, the quantity is equal to the quantity supplied, and the market is in equilibrium. The supply of and demand for loanable funds determines the interest rate.

***

From the point of view of our portfolio manager, it is not sufficient to know the equilibrium or current interest rate. What is really of concern is the potential for future changes in interest rates and the capital gains (increases in bond prices) or capital losses (decreases in bond prices) that will accompany such changes. Since any change in interest rates will be the result of a change in either the supply of or demand for funds, let us take a close look at the major factors that can shift either of the curves.

Changes in the Demand for Loanable Funds

On the demand side, research has shown that movements in gross domestic product (GDP) are a major determinant in shifts in the demand for funds. In particular, when GDP rises, ceteris paribus, for example, both firms and households become more willing and able to borrow. Firms are more willing because the rise in GDP has improved the business outlook, encouraging them to expand planned inventories and engage in more investment spending, such as purchases of plant and equipment. Households are more willing to borrow because the rise the rise in GDP has increased their incomes and/or improved the employment outlook. These factors encourage them to increase their purchases of goods and services, particularly autos, other durable goods, and houses, which often require some financing. Both firms and households are more able to borrow because the improved economic outlook and the rise in incomes will make it easier to make the interest and principal payments on any new debt. Another factor that affects the demand for loanable funds is an increase in the anticipated productivity of capital investments. Anticipated increases in productivity lead to a greater demand for capital investments and hence increase the demand for loanable funds.

The effect of an increase in the demand for funds resulting from a rise in income or an anticipated increase in productivity of capital investment is shown in Exhibit 2. The demand for funds shifts from DD to D1. Previously, the quantity of funds supplied was equal to the quantity of funds demanded at point E1: the equilibrium interest rate prevailing in the market was 6 percent, and the quantity of funds borrowed was $500 billion. When the demand curve shifts to the right, ceteris paribus, a disequilibrium develops in the market. More specifically, at the prevailing 6 percent rate, the quantity of funds demanded exceeds the quantity supplied. Given the excess demand, the interest rate rises. The higher interest rate induces SSUs to increase the quantity of loanable funds they are willing to supply (a movement along the supply curve). Such changes in plans help to close the gap between quantity demanded and quantity supplied, and a new equilibrium is essentially established at point E2 where the interest rate is 8 percent and the quantity of funds borrowed and lent is $600 billion. To sum up, we start with an equilibrium, demand increases, ceteris paribus, creating a disequilibrium, the interest rate goes up, and a new equilibrium is established.

Changes in the Supply of Funds

On the supply side, as you already know, one of the factors determining supply of loanable funds is monetary policy. In particular, the Fed's ability to alter the growth rate of money in the economy. It means it can have a direct effect on the cost and availability of funds. To illustrate, a Fed-engineered increase in the supply, as shown in Exhibit 3, shifts the supply curve from SS to S1, ceteris paribus. This creates a disequilibrium: the quantity supplied of funds exceeds the quantity demanded of funds at the prevailing 6 percent interest rate. The excess quantity supplied puts downward pressure on interest rates. As interest rates fall, DSUs and SSUs revise their borrowing and lending plans. For example, as the cost of borrowing falls, DSUs will be induced to borrow a larger quantity (a movement along a demand curve). Such actions, which serve to narrow the gap between quantity supplied and quantity demanded, will continue until a new equilibrium is established at point E2. The result is a fall in the interest rate from 6 percent to 4 percent and an increase in the quantity demanded from $500 billion to $550 billion. In sum, the money growth supply rate and the interest rate are inversely related, ceteris paribus. Holding other things constant, an increase in the money supply will lower the interest rate, while a decrease in the money supply will raise the interest rate via the effect of changes in the growth rate of the money supply on the supply of loanable funds.

The graphical analysis illustrates the relationship between changes in the supply of loanable funds and interest rates. However, graphs by themselves explain little and prove nothing. If the illustration is really going to aid your understanding, you need to be able to breath some life into the picture by knowing how and why the interest rate changes; that is, what is the mechanism or process that produces this result? The answer in this case is quite simple. Visualize financial intermediaries in the economy, particularly depository institutions, as having more funds to lend as a result of the Fed's action increasing the money supply. In general, the intermediaries will use these funds to acquire interest-earning assets---securities and loans, in particular. If they demand more securities (bonds), this will raise the price and lower the yield to maturity on outstanding bonds, ceteris paribus. If the intermediaries want to extend loans, they will have to induce households and firms to borrow more than they are currently borrowing or planning to borrow. How can this be accomplished? If you said, "Lower the rates charged on loans," you are correct. Thus, the movement from E1 to E2 in Exhibit 3 is not a sterile hop to be memorized and reproduced in response to some exam questions. It depicts a process and a series of transactions, including the acquisition of securities, extension of loans, and accompanying changes in interest rates that are at the heart of the operations of the financial system and its role in the economy.

Recap

The demand for loanable funds originates from DSUs. The quantity demanded is inversely related to the interest rate. The supply of loanable funds originates from SSUs and from the Fed, which supplies reserves to the banking system. The quantity supplied is directly related to the interest rate. If incomes increase, the demand for loanable funds increases. If the money supply increases, the supply of loanable funds increases and the interest rate falls.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 136-140*

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SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 13)

Interest Rates, Bond Prices, and Present Values

by

Charles Lamson

Although bonds issued by corporations and governments differ in a variety of ways, they really share the following character: they have an original maturity greater than ten years; they have a face or par value (F) of $1,000 per bond, and the issuer (borrower) agrees to make equal periodic interest payments over the term to maturity of the instrument and to repay the face value at maturity. The periodic payments are called coupon payments (C) and are equal to the coupon rate on a bond multiplied by the face value of the bond. As we shall see in a moment, the coupon rate, which usually appears on the bond itself, is not the same thing as the interest rate. The distinction between the coupon rate and the coupon payment and between the coupon rate and the interest rate is often a source of considerable confusion.

So, for example, you buy a bond for Jane for $981.48, you would receive $60 of interest at maturity ($1,000) plus a capital gain of $18.53; the gain is equal to the par value you get back at maturity ($1,000) minus the price you pay at the time of purchase ($981.48). Together the interest and the capital gain ($60 + $1,852 = $78.52). Thus, in this example, you buy the bond at a price below its par value. This is called a discount from par and raises yield on the bond, called the yield to maturity, from 6 to 8 percent. In sum, as the market interest rate rises, the price of existing bonds falls. The lower yield to maturity on existing bonds is unattractive to potential purchasers who can purchase newly issued bonds with higher yields to maturity. Therefore, the yield to maturity on previously issued bonds must somehow rise to remain competitive with the new higher level of prevailing interest rates. The yield on existing bonds rises when their prices fall. 

Suppose that instead of rising from 6 percent to 8 percent the day after Jane buys the bond. The interest rate in the market falls to 4 percent. Jane's bond will rise to $1,019.23. What does this represent?If any of us bought Jane's bond for $1,019.23, we would be paying a price above the par value. This is called a premium above par. At maturity we would get $60 minus a capital loss of $19.23; the loss is equal to what we pay at the time of purchase minus the par value we receive at maturity ($1019.23 - $1,000 = $19.23). The $40.77 ($60 - $19.23 = $40.77) represents a 4 percent yield over the year ($40.77/$1019.23 = .04). Thus, as the market interest rate falls, the prices of existing bonds rise. The reason is that the higher yield to maturity on existing bonds is attractive to potential investors, and as they buy existing bonds, the bond prices rise, reducing their yield to maturity.

In general, then, there is an inverse relationship between the price of outstanding bonds trading in the secondary market and the prevailing level of market interest rates. As a result one can say that if bond prices are rising, then interest rates are falling, and vice versa. These are different ways of saying the same thing, and we need not resort to the formalities of discounting and present value analysis to see the bare essentials of this relationship

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003,  MAUREEN BURTON & RAY LOMBRA, PGS.  

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SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 12)

INTEREST RATES AND BOND PRICES

by

Charles Lamson

Change must be measured from a known baseline.

     ---Evan Schwiit

The Present Versus the Future

State University currently charges students $5,000 a year for tuition. Following the appointment of an innovative financial officer. it offers enrolling freshmen a new way to pay four years tuition---pay $18,000 today, rather than $5,000 per year for four years. Would you participate in the plan? Following her third box office smash, a Hollywood sensation has just signed a multipicture contract. As Compensation, the star has been offered either $6 million today or $7.5 in five years. You are her financial adviser; what should she do and why? You win a million-dollar lottery and learn that the million dollars will be paid out in equal installments of $50,000 per year, over the next 20 years. Would you be willing to trade this stream of future income for one payment today? How large would that payment have to be?

The Time Value of Money

The interest rate is the cost to borrowers of obtaining credit, and the reward to lending for surplus funds. Thus, just as rent is the cost to apartment dwellers and the return to the landlord, the interest rate is the rental rate paid by borrowers and received by lenders when money is "rented out."

The central point to remember from this discussion, is the role the interest rate plays in linking the present with the future. Lending in the present enables spending in the future the sum of what is lent, plus the interest earned. Borrowing in the present enables spending in the present, but requires paying back in the future, what I borrowed plus interest. Since the interest rate is the return on lending, and the cost, of borrowing; it plays a pivotal role in spending, saving, borrowing, and lending decisions made in the present and bearing on the future. The concept I have been describing is called time value of money. Simply put, the interest rate represents the time value of money, because it specifies the terms upon which one can trade off. present purchasing power for future purchasing power. This is one of the most important and fundamental concepts in economics and finance.

Compounding and Discounting

Compounding: Futures

Compounding is a method used to answer a simple question: What is the future value of money lent or borrowed today? As is illustrated in Exhibit 1. the question is forward looking; we stand in the present today, and ask a question about the future.

1. Compounding: The Future Value of Money Lent Today

Click to enlarge.

Suppose Joseph A. Student agrees to lend a friend $1,000 for one year, the friend gives Joe an IOU for $1,000 and agrees to repay the $1,000 interest in a year. The amount that is originally lent is the principal---in this case $1,000. If the agreed interest rate is 6 percent, then the friend will pay  total of $1,060 ($1,00 + $60).

Imagine now that Joe's friend borrows for two years instead of one year and makes no payments to Joe until two years pass. Here, is where compounding comes into play. Literally, compounding means to combine, add to, or increase. In the financial world, it refers to the increase in the value of funds that results from earning interest on interest. More specifically, interest earned after the first year is added to the original principal; the second year's interest calculation is based on this total. The funds to be received at the end of two years.

Discounting: Present Values

Compounding is forward looking. It addresses the question: What is the future value of money lent (or borrowed) today? As we shall see, understanding compounding is of money (lent) or borrowed (or borrowed) today? As we shall see understanding compounding is the key to really understanding what often seems to be a more difficult concept to grasp---discounting.

In effect, as shown in Exhibit 2, discounting is backward looking. It addresses this question: What is the present value of money to be received (or paid) in the future?

2. Discounting the Present Value of Money to Be Received in the Future

Recap

Compounding is finding the future value of a present sum. Discounting is finding the present value of a future sum.

*SOURCE:  THE FINANCIAL SYSTEM AND THE ECONOMY, 3RD ED., 2003,  MAUREEN BURTON & RAY LOMBRA, PGS. 130-133* 

END

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SUNNY SIDE OF THE STREET:: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 11)

Financial Markets Instruments and Market Makers (part B)

by

Charles Lamson

Why Market Makers Make Markets

The willingness of a market maker to make a market for any particular security will be a function of the expected profits and risks associated with buying, selling, and holding that type of security. The profits earned by a market maker flow mainly from the revenue generated by the price it charges for conducting a transaction. the number it charges for conducting a transaction. the number of transactions engaged in, and any capitol gains or losses associated with the market makers inventories of securities. Generally, a market maker charges a brokerage fee or commission for each transaction. The fee may be part item, such as 10 cents per share on stock, or a specified percentage of the total value of the trade, such as, 1 percent of the total proceeds from the sale of bonds. Market makers also collect a fee in some markets by buying a particular security at one price---the bid price---and selling the security at a slightly higher price---the "offer," or asked price. In this case, the revenue received by a market maker is a function of the spread between the bid, and asked prices, and the number of transactions in which the market maker and the public engage. Competition among market makers tends to minimize transaction costs to market participants.

1. Market Makers

Market Making and Liquidity

The quality and cost of services provided by market makers affect the transactions costs associated with buying or selling various securities, the costs and convenience associated with buying or selling liquidity affect portfolio decisions, the market-making function influences, in turn, affect the liquidity of these securities. because transactions costs and liquidity affect portfolio decisions, the market-making function influences the allocation of financial resources in our economy. Some markets, such as the TR-bill market are characterized by high quality secondary markets. The large volume of outstanding securities encourages many firms to make markets in Treasury securities, and the volume of trading and competition among market makers, produces a spread between the dealer "bid," and asked "prices" of only 0.1 to 0.2 percent, well below the spread of 0.3125 to 0.5 percent associated with transaction in less actively traded, longer term government securities.

Substitutability, Market Making, and Market Integration

Market makers play another important, but less obvious, role in helping to integrate the various financial markets. Market makers such as Merrill Lynch and Solomon Smith Barney make markets in numerous financial instruments. In general, the trading floor of the typical market maker is a busy place on the floor of the trading room, the specialist in T-bills sits near the specialist in corporate bonds, who in turn, is only 20 feet from the specialist in mortgage-backed securities. Assuming that these people talk to one another, the activity in one market is known to those operating in other markets. With each specialist disseminating information to consumers via telephone, and continually monitoring computer display terminals, a noticeable change in the T-bills market (say a half percentage point decline in interest rates on T-bills), will quickly become known to buyers and sellers in other markets. Such information will, in turn, influence training decisions in these other markets, and thus, affect interest rates on other securities.

*SOURCE: THE FINANCIAL SYSTEM &THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 118-121*

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SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 11)

The Role of Market Makers

by 

Charles Lamson

The participants in financial markets are the buyers and sellers, and market makers. The market makers function as coordinators who link up buyers and sellers of financial instruments. The link involves arranging and executing trades between buyers and sellers. Market makers may make markets in only one type of security, say, Treasury bills, or in several different types of securities including stocks and corporate and government bonds. Who are these market makers? Where are they located? Why do they exist? What does"making a market" entail. These are some of the questions to which we now turn.

You probably have heard of large Wall Street firms such as Merrill Lynch, Solomon Smith Barney (part of Citigroup) Morgan Stanley, Dean Witter, and Goldman Sachs---five leaders of finance. The main offices of these five financial firms are in New York City, the financial capitol of the United States. These offices are linked by telephone and telex to other major cities in the United States and the rest of the world, where branch offices and regular customers are located. Like most enterprises, these firms are in business to earn profits. In this industry, profits are earned by providing financial services to the public. These services include giving advice to potential traders, conducting trades for the buyers and sellers of securities in the secondary market, and providing advice and marketing services to issuers of new securities in the primary market.

To better understand the role of market makers, it will be helpful to distinguish between brokers and dealers. A broker simply arranges trades between buyers and sellers. A dealer, in addition to arranging trades between buyers and sellers, stands ready to be a principal in a transaction, more specifically, a dealer stands ready to purchase and hold securities sold by investors. The dealer carries an inventory of securities and then sells them to other investors. When we refer to market makers in this next series of posts, we will be referring to dealers, the market makers.   

As a key player in financial markets, the market maker has an important role in our financial system. In particular, a market maker helps to maintain a smoothly functioning, orderly financial market. market makers stand ready to buy and sell and adjust prices---literally making a market. Let us assume that there are 100,000 shares of stock for sale at a particular price. If buyers take only 80,000 shares at that price, what happens to the remaining 20,000 shares? When such a short-term imbalance occurs, rather than making inconsistent changes in prices the market takes a position (buy) and holds shares over a period of time to keep the price from falling erratically, or the market maker may altar the prices until all (or most) of the shares are sold. Thus, in the short-term market makers facilitate the ongoing shuffling and rearranging of portfolios by standing ready to increase or decrease their inventory position. If there is not a buyer for every seller or a seller for every buyer, These actions enhance market efficiency and contribute to an orderly, smoothly functioning financial system.

Market makers also receive, process, interpret and disseminate information to potential buyers and sellers. Such information includes the outlook for monetary and fiscal policy; unemployment, newly published data on inflation, unemployment and output; fresh assessments of international economic conditions; information on the profits of individual firms; and analysis of trends and market shares in various industries. As holders of outstanding securities and potential issuers of new securities digest all this information, they may take actions that bring about a change in current interest rates and prices of stocks and bonds.

To illustrate, assume the political situation in the Middle East deteriorates, and experts believe a prolonged war which would disrupt the flow of oil to the rest of the world is likely. Analysts, employed by the market makers, would assess the probable impact on the price of oil, the effect on U.S. oil companies' profits, and so forth. Such information would be disseminated to and digested by financial investors, and lead some of them to buy (demand) or sell (supply) particular securities.

In general, when something affects the supply or demand for a good, the price of that good will be affected. in the financial markets when something affects the supply of, or demand for, a security, its prices will move to a new equilibrium and the market maker will facilitate the adjustment. Securities prices change almost every day. Because of the activity of market makers, these changes usually occur in an orderly and efficient manner. 

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, BURTON & LOMBRA, PGS. 116-118*

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SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 10)

Control Market Instruments
by
Charles Lamson

The capital market is extremely important because it raises the funds needed by deficit spending units (DSUs) to carry out their spending and investment plans. A smoothly functioning capital market influences how fast the economy grows.


Stocks

Stocks are equity claims representing ownership of the net income and the assets of a corporation. The income that stockholders receive for their ownership is called dividends. Preferred stock pays a fixed dividend, and in the event of bankruptcy of the corporation, the owners of preferred stock are entitled to be paid first, after the corporation's other creditors. Common stock pays a variable dividend, depending on the profits that are left over after preferred stockholders have been paid and retained earnings set aside. The largest secondary market for outstanding shares of stock is the New York Stock Exchange. Several stock indexes measure the overall movement of common stock prices; the Dow Jones Industrial Average, perhaps the best known, is based on the prices of only 30 stocks while the Standard & Poor's 500 Stock Index is based in the prices of 500 stocks. The amount of new stock issues in any given year is typically quite small relative to the total value of shares outstanding.

Mortgages

Mortgages are loans to purchase single (or multiple) family residential housing, land or other real structures, with the structure or land serving as collateral for the loan. In the event the borrower fails to make the scheduled payments, the lender can repossess the property. Mortgages are usually made for up to 30 years, and the repayment of the principal is generally spread out over the life of the loan. Some mortgages charge a fixed interest rate that remains the same over the life of the loan; others charge a variable interest rate, that is adjusted periodically to reflect changing market conditions. Savings and loan associations and mutual savings banks are the primary leaders in the residential mortgage market, although commercial banks are now also active lenders in this market.

Corporate Bonds

Corporate Bonds are long-term bonds issued by usually (although not always) with excellent credit ratings. Maturities range from 2 to 30 years. The owner receives an interest payment twice a year and the principal at maturity. Because the outstanding amount of bonds for any given corporation is small, corporate bonds are not nearly as liquid as other securities such as U.S. government bonds. However, an active secondary market has been created by dealers who are willing to buy and sell corporate bounds. The principle buyers of corporate bonds are life insurance companies, pension funds, households, commercial banks, and foreign investors.

U.S. Government Securities

U.S. government securities are long-term debt instruments with maturities of 2 to 30 years issued by the U.S. Treasury to finance the deficits of the federal government. They pay semiannual dividends and return the principal at maturity. An active secondary market exists, although it is not as active as the secondary market for T-bills. Despite this, because of the ease with which they are traded, government securities are still the most liquid security traded in the capital market. The principal holders of government securities are the Federal Reserve, financial intermediaries, securities, dealers, households, and foreign investors.

U.S. Government Agency Securities

U.S. government agency securities are long-term bonds issued by various government agencies, including those that support commercial, residential and agricultural, real estate, lending, and student loans. Some of these securities are guaranteed by the federal government, and some are not, even though all of the agencies are federally sponsored. Active secondary markets exist for most agency securities. Those that are guaranteed by the federal government function much like U.S. government bonds, and tend to be held by the same parties that hold government securities.

State and Local Government Bonds (Municipals)

State and local government bonds (municipals) are long-term instruments issued by state and local governments to finance expenditures on schools, roads, college dorms, and the like. An important attribute of municipals is that their interest payments are exempt from federal income taxes and from state taxes for investors living in the issuing state. Because of their tax status, state and local governments can issue debt at yields that are usually below those of taxable bonds of similar maturity. they carry some risk that the issuer will not be able to make scheduled interest or principal payments. Payments are generally secured in one of two ways. Revenue bonds are used to finance specific projects, and the proceeds of those projects are used to pay off the bondholders. General obligation bonds are backed by the full faith and credit of the issuer; taxes can be raised to pay the interest and principal on general obligation bonds.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED.,2003, MAUREEN BBURTON & RAY LOMBRA, PGS.  114-117* 

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SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 9)

Major Financial Market Instruments
by
Charles Lamson

Financial markets perform the important role of channeling funds from SSUs to DSUs. Since the action in financial markets involves the trading of financial instruments, in effect, IOUs issued by DSUs, understanding the action requires us to be familiar with what is being traded. We first examine the instruments trading in the money market and then look at those traded in the capital market.


Money Market Instruments

U.S. Treasury Bills

U.S. Treasury bills (T-bills) are short-term debt instruments of the U.S. government with typical maturity of 3 to 12 months. They pay a set amount at maturity and have no explicit interest payments. In reality, they pay interest by initially selling at a discount---that is, at a price lower than the amount paid at maturity. For instance, in April 2013, $9,470 to buy a 1-year Treasury bill that can be redeemed for $10,000 in April 2014; thus, the bill effectively pays $530 in interest. The yield on such a bill is 5.6 percent or $530/$9,470 [(interest amount)/(purchase price)].

U.S. Treasury bills are the most liquid of all the money market instruments, because they have an active secondary market (where investors buy and sell securities they already own, what most people typically think of as the "stock market") and relatively short terms to maturity. They also are the safest of all money market instruments because there is no possibility that the government will fail to pay back the amount owed when the security matures. The federal government is always able to meet its financial commitments because of its ability to increase taxes or to issue currency in fulfillment of its scheduled payments. The Cracking the Code Feature explains how to interpret the information about T-bills reported on the financial pages of major newspapers.


Negotiable Certificates of Deposit (CDs)

A certificate of deposit (CD) is a debt instrument sold by a depository institution that pays annual interest payments equal to a fixed position of the original purchase price is also paid back. Most CDs have a maturity of 1 to 12 months. Prior to 1961, most CDs were not negotiable; that is, they could not be sold to someone else and could not be redeemed from the bank before maturity without paying a significant penalty. In 1961, with the goal of making CDs more liquid and more attractive to investors, Citibank introduced the first negotiable certificates of deposit (CDs). Such negotiable CDs could be resold in a secondary market, which Citibank created. Negotiable CDs have a minimum denomination of $100,000, but in practice the minimum denomination to trade in the secondary market is $2,000,000. Most large commercial banks and many large savings and loans now issue CDs. In addition, smaller banks are able to borrow in the market by using brokers.

Commercial Paper

Commercial paper is a short-term debt instrument issued by corporations such as General Motors, AT&T, and other less well known domestic and foreign enterprises. Most commercial paper is supported by a backup line of bank credit. Prior to the 1960s, corporations usually borrowed short-term funds from banks. Since then corporations have come to depend on selling commercial paper to other financial intermediaries and other lenders for their immediate short-term borrowing needs.The growth of the commercial paper market, since 1960, has been impressive, and is partially due to the increase in commercial paper issued by non-financial firms. Initially, only large corporations had access to the commercial paper market, but in the late 1980s and early 1990s, medium and small firms found ways to enter this market. In addition, some financial intermediaries also get funds to invest and lend by issuing commercial paper.


Bankers Acceptances

Bankers acceptances are money market instruments created in the course of financing international trade. Banks were first authorized to issue bankers' acceptances to finance the international and domestic trade of their customers by the Federal Reserve Act of 1913. Exhibit 1 depicts how bankers' acceptances work. A bankers acceptance is a bank draft (a guarantee of payment similar to a check) issued by a firm and payable on some future date. For a fee, the bank on which the draft is drawn stamps it as "accepted," thereby guaranteeing that the draft will be paid even in the event of default by the firm. If the firm fails to deposit the funds into its account to cover the draft by the future due date, the bank's guarantee means that the bank is obligated to pay the draft. The bank's creditworthiness is substituted for that of the firm issuing the acceptance, making the draft more likely to be accepted when it is used to purchase goods abroad. The foreign exporter knows that even if the company purchasing the goods goes bankrupt. the bank draft will still be paid off. The party that accepts the draft (often another bank) can then resell the draft in a secondary market at a discount before the due date, or it can hold the draft in its portfolio as an investment. Bankers' acceptances that trade in secondary markets are similar to Treasury bills in that they are short-term and sell at a discount. The amount of bankers' acceptances increased by nearly 4,000 percent ($2 billion to $75 billion) between 1960 and 1984, however, the acceptance market has declined due to the growth of other financing alternatives and the increased trade in currencies other than the dollar. 

1. Bankers' Acceptances

Click to enlarge.

Repurchase Agreements

Repurchase agreements are short-term agreements in which the seller sells a government security to a buyer and simultaneously agrees to buy the government security back on a later date at a higher price. In effect, the seller has borrowed funds for a short-term, and the buyer ostensibly has made a secured loan for which the government security serves as collateral. If the seller (borrower) fails to pay back the loan, the buyer (lender) keeps the government security. For example, assume that a large corporation such as IBM finds it has excess funds in its checking account it does not want to sit idly when interest can be earned. IBM uses these excess funds to buy a repurchase agreement from a bank. In the agreement the bank sells government securities, while at the same time agreeing to repurchase the government securities the next morning (or in a few days) at a higher price than the original selling price. The difference between the original selling price and the higher price the securities are bought back for is, in reality, interest. The effect of this agreement is that IBM has made a secured loan to a bank that holds the government securities as collateral, until the bank repurchases them when it pays off the loan. Repurchase agreements were created in 1969. Outstanding repurchase agreements are now an important source of funds to banks.


Federal (Fed) Funds

Federal (Fed) funds are typically overnight loans between depository institutions of their deposits at the Fed. This is effectively the market for excess reserves. A depository institution might borrow in the federal funds market if it finds that its reserve assets do not meet the amount required by law. It can borrow reserve deposits from another depository institution that has excess reserve deposits, and choose to lend them to earn interest. The reserve deposit balances are transferred between the borrowing and lending institutions using the Fed's wire transfer system. In recent years, many large depository institutions have used this market as a permanent source of funds to lend, not just when there is a temporary shortage of required reserve assets. Financial market participants watch the federal funds rate closely to judge the tightness of credit in the financial system. When the Fed funds rate is high, relative to other short-term rates, it indicates that reserves are in short supply. When it is relatively low, the credit need of depository institutions are also low.

Eurodollars

Eurodollars are dollar-denominated deposits held in banks outside the United States. For example, an American makes a deposit denominated in U.S. dollars in a bank in England, or some other foreign country, that is a Eurodollar deposit. Eurodollar deposits are not subject to domestic regulations, and are not covered by deposit insurance. The Eurodollar market started in the 1950s, when Soviet Bloc governments put dollar-denominated deposits into London banks. The funds were deposited in London because the governments were afraid that if the deposits were in the United States, they would be frozen in the event of a flare up of Cold War tensions. Despite the easing of tensions, the Eurodollar market continues to thrive. Today many corporations and investors hold Eurodollar deposits in a foreign country, if they have trade-related dollar transactions in that country. U.S. banks can also borrow Eurodollar deposits from foreign banks, or their own foreign branches, when they need funds to lend and invest. 

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD EDITION, 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 108-114*

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SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 8)

The Fed's Major Policy Tools

by

Charles Lamson

When someone is suffering from a back ailment, physicians usually have several therapeutic approaches available, including rest, traction braces, muscle relaxers, and surgery. These "tools," which can be used in combination, are all designed to relieve pain and restore the patient's health. Since policy makers are similarly equipped and motivated. let us examine the Fed's major policy tools

Open Market Operations

Open market operations are the most important monetary policy tool at the Fed's disposal. These operations which are executed by the Federal Reserve Bank of New York, under the guidance and direction of the FOMC, involve the buying or selling of U.S. government securities by the Fed. When the Fed buys securities, reserves fall. These operations are important because they have a direct effect on the reserves that are available to depository institutions. Depository institutions are required to hold reserve assets equal to a certain proportion of outstanding deposit liabilities. Changes in reserves, in turn, affect the ability of depository institutions to make loans and to extend credit. When banks or other depository institutions to make loans, they create checkable deposits. Thus, changes in reserves also affect the money supply. Consequently, when reserves change, the money supply and credit extension also change.

The Discount Rate and Discount Rate Policy

Because the Fed controls the amount of required reserve assets that depository institutions must hold, it also operates a lending facility called the discount window, through which depository institutions, caught short of reserves, can borrow from the Fed. The discount rate is the interest rate the Fed charges depository institutions that borrow reserves directly from the Fed. The discount rate is a highly visible, but less important, Fed policy tool. We say that it is "visible" because changes in the discount rate are often well-publicized, for example, on the evening news broadcast. 

Reserve Requirements

The major item on the liability side of depository institutions' balance sheets is deposits. The Fed requires depository institutions to hold required reserves equal to a proportion of the checkable deposit liabilities. The Fed specifies the required reserve ratio, which is the fraction that must be held. For example, if the required reserve ratio on checkable deposits is 10 percent, then for each $1.00 in checkable deposit liabilities outstanding, a depository must hold $.10 in reserve assets.

Recap

The Fed's main tools for implementing monetary policy are open market operations and setting the required reserve ratio and the discount rate. Open market operations are the most widely used tool.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD EDITION, 2003,  MAUREEN BURTON & RAY LOMBRA, PGS. 90-94

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