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*
END
No comments:
Post a Comment