Lecture Notes – September 12th

Things to have – websites/slides

Article of the day

http://www.nytimes.com/2012/09/08/business/sorting-out-the-collapse-of-new-rules-for-money-market-funds.html?pagewanted=all

Fed Reserve Data

http://www.federalreserve.gov/datadownload/Chart.aspx?rel=H15&series=80bbf1a069ef10a5f290019ee5e856d4&lastObs=&from=01/01/1990&to=12/01/2012&filetype=spreadsheetml&label=include&layout=seriescolumn&pp=Download

Recent T-Bill auction results

http://www.treasurydirect.gov/RI/OFBills

Lecture topics

1 – Any questions/issues from the reading or the homework?

Reading Assignments

Chapters 4, 5 and 12 in the textbook.

Homework assignment is on the web. The answers to the previous homework assignments are on the web as well.

Today’s topics

Theory of interest rates

First we need to talk about the return on a bond (still chapter 3).

Money Markets

This is a mis-nomer. This market is not about money. It is about short term securities that are highly liquid and thus very much like money.

Main characteristics

·  Usually sold in large denominations

o  Usually in excess of 1m USD

·  Low default risk

·  Mature in 1 year or less from their original issue date. Most money market instruments mature in less than 120 days.

Why do they exist?

·  In theory Banks should be able to fulfill the function of money markets – give short-term loans and accept short-term deposits. The problem is that they are highly regulated. This puts banks at a cost disadvantage for these funds.

·  Investors in Money Market:

o  Provides a place for warehousing surplus funds for short periods of time

o  Generally a strong secondary market.

·  Borrowers from money market provide low-cost source of temporary funds

·  Allows both to manage the timing of inflows and outflows efficiently.

Major Participants

·  US Treasury – issues T-bills

·  Fed Reserve – owns large quantities of treasury securities that it sells if it believes that the money supply should be expanded

·  Commercial Banks – buys treasuries, sells Certificates of deposits and makes short term loans. Offer individual investor accounts that invest in money market securities.

·  Businesses - short term cash needs or excess cash.

·  Investment and security firms

Instruments

Fed funds.

These are short term (usually 1 day) loans between financial institutions. The purpose of these is that the Fed Reserve has set minimum reserve requirements that every bank has to maintain. This allows banks that are short of reserves to borrow “excess” reserves from each other.

These are negotiated between banks. Upon agreement the seller will communicate to the Federal Reserve to take funds out of the seller’s account into the borrower’s account. The next day the funds are transferred back.

The Federal Reserve sets a target interest rate for Fed Funds. It cannot directly control the rate but influences it by adjusting the level of reserves available to banks. For example it can sell securities. This will reduce the cash in the financial system. This puts pressure on reserves and raises rates.

T-Bills

·  The US Treasury Department issues treasury bills. These are the most widely held and liquid money market instruments.

·  These instruments have maturities of 4, 13, 26 and 52 weeks as well as cash management bills with a variable term of a few days.

·  They are discount instruments

·  At maturity they pay $100. Note, in some ways this makes them not like other money market instruments as they are available to purchase in small quantities.

·  They are auctioned weekly by the US treasury. There are two types of bids:

·  Competitive bids where one agrees to purchase an amount of bonds at or above a certain yield. These are limited to 35% of the offering amount

·  Non-competitive bid where one agrees to purchase an amount of bonds at the yield determined at the auction. These are limited to $5m.

·  Bills are issued on the Thursday following the auction.

·  The issue price P = F x (1 – r x t / 360) where

o  F is the face amount, r is the rate, t is the days to maturity

·  On July 3, 2012 the results of the 28 day treasury bill auction were:

o  $30,001,071,200 auctioned

o  $139,002,501,200 tendered for competitive bidding

o  $559,555,000 tendered for non-competitive bidding

o  Final rate 0.075%

o  Issue date July 5, 2012

o  Maturity date August 2, 2012

Commercial Paper

·  Unsecured promisatry note, issued by a corporation that matures in less than 270 days (to be exempt from SEC registration requrements).

·  Most mature in 20-45 days.

·  Mostly issued on a discounted basis.

·  Most issuers of commercial paper back up their paper with a line of credit at a bank. This means that if the issuer cannot pay off or roll over the maturing paper then the bank will lend a firm funds to pay it off. The line of credit reduces the risk to the purchases of the paper. The bank charges a fee of 0.5% to 1% for the commitment.

Why is the line of credit interesting for a bank?

Two thoughts – 1 undercuts the commercial loans part of their business – according to the book – commercial paper is an important alternative to Loans due to their lower cost. 2 – the commitment is generally going to be drawn when the company has a refinancing issue (cannot refinance due to perceived credit risks, market credit risks have increased or otherwise) - this would suggest that the loan commitment is the cheapest version of credit available – means it was possibly mispriced to begin with.

Show graph of Prime rate vs return on commercial paper. Prime rate is the bank loan rate for high quality borrower.

Other types of Money Market Instruments

·  Bankers Acceptances

o  These are used to finance goods that have not yet been transferred from buyer to seller. It is a bearer instrument and is an order to pay a specific amount of money to the bearer on a specific date. It allows one to substitute the credit risk of a counterparty with that of a bank. Used heavily in International Trade (should check this out).

·  Eurodollar contracts

o  Simply a US dollar deposit in a foreign bank. This started initially because there was fear that deposits held in the US of US dollars could be expropriated.

·  Negotiable Certificates of Deposit

o  This is a bearer instrument. Whoever holds the instrument at maturity gets the principal and interest. The CD can be bought and sold until maturity.

o  I like the following quote from the book “Large money center banks can offer rates a little lower than other banks because many investors in the market believe that the government would never allow one of the nation’s largest banks to fail.” It would be interesting to see whether this phrasing was identical in earlier editions of the book….

Money Market Funds and Financial Crisis

In September 2008 The Reserve Fund broke the buck. A money market mutual fund operates generally with a stable NAV and for most investors it is treated like a checking account. The advantage over checking accounts is that the interest rate is higher. Of course you do not get something for nothing. Let’s go back a little in time.

You had problems in some short term assets:

Asset Backed Commercial Paper

·  This is a short term security (average maturity is 30 days) backed by a bundle of assets. From 2004-7 these assets were mostly mortgages. When the quality of these assets were exposed in 2007-8 there was a run on this paper. The paper had been highly rated and short-term. Thus used by money market mutual funds for yield enhancement.

Auction Rate Securities

·  These were short term securities whose rate was determined at auction. These were sold as safe as cash. In Feb 2008 securities or sale exceeded demand and the auction agents refused to take excess supply on their balance sheets. The auctions failed en masse and investors and issuers were stuck.

The following article from December 2007 had BofA and others step in to safeguard the NAV of their money market mutual funds.

Within the article you have some comments about the security of money market funds

http://www.marketwatch.com/story/correct-is-your-money-market-fund-safe?dist=morenews

So large investment firms stepped in to support the money market mutual funds and investors again thought that they were secure.

The Reserve Fund held 1.2% of its assets in Lehman Commercial Paper the day that Lehmans was allowed to fail. Became the second money market fund ever to break the buck.

Consider flows from Prime (higher yielding) money market mutual funds into government.

Caused major selling pressure in higher risk short term assets and buying pressure for low risk.

September 19: The Federal Reserve announced a series of broad initiatives designed to stabilize the market, which had ceased to function even for very short-term, high-credit securities.

·  XXX The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) provided non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance purchases of high-quality asset-backed commercial paper (ABCP) from money market funds.

·  The Commercial Paper Funding Facility (CPFF) provided a backstop to U.S. issuers of commercial paper through a special purpose vehicle that would purchase three-month unsecured commercial paper and ABCP directly from eligible issuers.

XXX September 19: Treasury announced its Temporary Guarantee Program for Money Market Funds, which temporarily guaranteed certain account balances in money market funds that qualified for and elected to participate in the program. The program expired on September 18, 2009. No claims were made on the Guarantee program. Instead, Treasury and, as a result, taxpayers, received an estimated $1.2 billion in fee payments from participating money market funds.

Can I find a graph of risk premiums?

The article

http://www.nytimes.com/2012/09/08/business/sorting-out-the-collapse-of-new-rules-for-money-market-funds.html?pagewanted=all

Return on a bond

I am doing a more general exposition than what is in chapter 3. I think it is important though to think about what is involved in this return analysis.

We are going to consider the return on a bond where we buy it at time t_0 and sell it at time t_1. There is a special case of this analysis where t_1 is the maturity of the bond.

The return on a bond is the determined by

  1. The price paid for the bond
  2. The coupons received on the bond
  3. The interest rate received on the reinvestment of these coupons to the date the bond is sold.
  4. The price of the bond when it is sold. When the bond is held to maturity the assumption is that the “price of the bond” is the Notional plus the coupon paid.

If we assume that all interest rates are the same then we can easily do this calculation. We can work an example:

Let’s look at a 5 year bond paying 4% annual coupons with an interest rate of 7%. Our present value analysis suggests that the fair price for this bond is 87.70. Assume that we buy the bond today at 87.70 and sell the bond in 2.5 years time at 90. We can reinvest the first two coupon payments of 4 for 1.5 years and 0.5 years. Thus the total return in cash terms is 10.87 dollars. The yield on this investment was 10.87/87.70 = 12.39% over 2.5 years. The annual return is 4.78%.

What happened??? If you look at a sale price of 90 for the bond in 2.5 years we can see that this is equivalent to a 9.6% yield to maturity on the bond. Basically interest rates went up and we lost money on the bond. To mak 7% on the investment we would have had to sell the bond at 95.30%.

Important possibly unknown factors in the return analysis are:

  1. Reinvestment interest rate for the coupon payments to the sell date
  2. Yield to maturity from the sell date to the maturity of the bond.

Section 1 – Asset Demand

An asset is a piece of property that is a store of value. In this discussion since we are thinking about interest rates we should think about T-bills, bonds etc..

An investor thinking about buying a specific asset needs to think about 4 considerations:

  1. Wealth – the total wealth of the investor
  2. As the wealth of an investor increases the demand for an asset increases.
  3. Expected return – the return of the specific asset relative to other assets
  4. Risk – the degree of uncertainty of the return w.r.t. the return on other assets
  5. Liquidity – the ease and speed with which this asset can be turned into cash relative to other assets.

Expected Return and Risk are closely related.

Expected Return

Generally one will have a series of possible outcomes for a particular investment. Formally

Re=p1R1+p2R2+…+pNRN

For a discount bond we know what the outcome will be. The return will be the yield to maturity on the bond. For other bonds there are more possible outcomes. In chapter 3 of the book they mention reinvestment risk. For example if I buy a 5 year bond which pays 7% coupons and hold this to maturity I will receive 4 coupons prior to maturity. In order to correctly analyze my return over the period I need decide at what rate I will invest my coupon proceeds. This rate cannot be fixed up front. In addition there may be a probability that the issue of the bond defaults and cannot make part or all of certain coupon payments or return the principal at maturity.