Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Steven V. Mann, Ph.D.

Professor of Finance The Moore School of Business University of South Carolina

Moorad Choudhry

Senior Fellow Centre for Mathematical Trading and Finance City University Business School

The money market is the market for financial instruments that have a maturity of one year or less. The financial instruments traded in this market include securities issued by the U.S. Department of the Treasury (specifically, Treasury bills), U.S. federal agency securities (discount note and various “bill” products), depository institutions (negotiable certificates of deposit, federal funds, and bankers acceptances), insurance companies (funding agreements), commercial paper, medium-term notes, repurchase agreements, short-term municipal securities, short-term mortgage-backed securities, and asset-backed securities. In this chapter we cover all but the last three financial instruments.

U.S. TREASURY BILLS

The U.S. Treasury is the largest single borrower in the world. Treasury bills are short-term discount instruments with original maturities of less than one year. All Treasury securities are backed by the full faith and credit of the U.S. government. This fact, combined with their volume (in terms of dollars outstanding) and liquidity, afford Treasury bills a central place in the money market. Indeed, interest rates on Treasury bills serve as benchmark short-term rates throughout the U.S. economy as well as in international money markets.

Treasury bills are issued at a discount to par value, have no coupon rate, and mature at par value. The Treasury currently issues on a regular basis bills with original maturities of 4 weeks, 13 weeks (3 months) and 26 weeks (6 months), as well as cash-management bills with various maturities.

Cash management bills are offered from time to time with various maturities. The time between the announcement of an issue, auction, and issuance is usually a week or less. Cash management bills are issued to bridge seasonal fluctuations in the Treasury’s cash position. Owing to their variable issuance and maturity, cash management bills can mature on any business day.

All Treasury securities are sold and transferable in increments of $1,000. Previously, Treasury bills were available in minimum purchase amounts of $10,000. Treasury bills are issued in book-entry form. This means that the investor receives only a receipt as evidence of ownership instead of a paper certificate. The primary advantage of book entry is ease in transferring ownership of the security. Interest income from Treasury securities is subject to federal income taxes but is exempt from state and local income taxes.

The U.S. Department of the Treasury maintains a regular and predictable schedule for their security offerings. The current auction cycle for Treasury bills is weekly. With the exception of holidays and special circumstances, the offering is announced on Thursday and is auctioned the following Monday. The issue/settlement day is the Thursday following the auction. Because of holidays, the maturities may be either longer or shorter by one day. The auction process and the determination of the winning bidders is explained in Chapter 7.

Between the auction’s announcement and the actual issuance of the securities, trading of bills takes place in the when-issued or wi market. Essentially, this when-issued market is nothing more than an active forward market in the bills. Many dealers enter a Treasury bill auction with large short positions and hope to cover these positions with bills obtained at the auction. Dealers make commitments with their customers and other dealers to make/take delivery of bills for an agreed upon price with settlement occurring after the bills are issued. In fact, all deliveries on when-issued trades occur on the issue day of the security traded. When-issued yields serve as important indicators for yields that will prevail at the auction.

Price Quotes for Treasury Bills

The convention for quoting bids and offers in the secondary market is different for Treasury bills and Treasury coupon securities. Bids/offers on bills are quoted in a special way. Unlike bonds that pay coupon interest, Treasury bill values are quoted on a bank discount basis, not on a price basis. The yield on a bank discount basis is computed as follows:

where:

For example, Exhibit 6.1 presents the PX1 Governments screen from Bloomberg. Data for the most recently issued bills appear in the upper lefthand corner. The first and second columns indicate the security and its maturity date. In the third column, there is an arrow indicating an up or down tick for the last trade. The fourth column indicates the current bid/ask rates. A bond-equivalent yield (discussed later) using the ask yield/price is contained in column 5. The last column contains the change in bank discount yields based on the previous day’s closing rates as of the time posted.

Source: Bloomberg Financial Markets

Exhibit 6.2 presents the same information for all outstanding bills (page PX2). Other important market indicators are contained in the lower left-hand corner of the screen.

Source: Bloomberg Financial Markets

As an example using the information in Exhibit 6.1, consider a Treasury bill with 91 days to maturity and a face value of $1,000. Suppose this bill is trading at 995.854444. The dollar discount, D, is computed as follows:

D = $1,000 − 995.854444 = $4.145556

Therefore,

Given the yield on a bank discount basis, the price of a Treasury bill is found by first solving the formula for Y_d given the dollar discount (D), as follows:

The price is then

Using the information in Exhibit 6.1, for the current 91-day bill with a face value of $1,000, if the yield on bank discount basis is quoted as 1.64%, D is equal to

Therefore,

The quoted yield on a bank discount basis is not a meaningful measure of the return from holding a Treasury bill, for two reasons. First, the measure is based on a face-value investment rather than on the actual dollar amount invested. Second, the yield is annualized according to a 360-day rather than a 365-day year, making it difficult to compare Treasury bill yields with Treasury notes and bonds, which pay interest on a 365-day basis. The use of 360 days for a year is a money market convention for some money market instruments, however. Despite its shortcomings as a measure of return, this is the method that dealers have adopted to quote Treasury bills. Many dealer quote sheets and some other reporting services provide two other yield measures that attempt to make the quoted yield comparable to that for a coupon bond and other money market instruments.

CD Equivalent Yield

The CD equivalent yield (also called the money market equivalent yield) makes the quoted yield on a Treasury bill more comparable to yield quotations on other money market instruments that pay interest on a 360-day basis. It does this by taking into consideration the price of the Treasury bill (i.e., the amount invested) rather than its face value. The formula for the CD equivalent yield is

For example, using the data from Exhibit 6.1 for the 91-day bill that matured on April 11, 2002, the ask rate on a bank discount basis is 1.64%. The CD equivalent yield is computed as follows:

Bond-Equivalent Yield

The measure that seeks to make the Treasury bill quote comparable to coupon Treasuries is called the bond-equivalent yield. This yield measure makes the quoted yield on a Treasury bill more comparable to yields on Treasury notes and bonds that use an actual/actual day count convention. In order to convert the yield on a bank discount to a bond-equivalent yield, the following formula is used:

where T is the actual number of days in the calendar year (i.e., 365 or 366).

As an example, using the same Treasury bill with 91 days to maturity and a face value of $1,000 that would be quoted at 1.64% on a bank discount basis, the bond-equivalent yield is calculated as follows:

This number matches the bond-equivalent yield given by the Bloomberg screen in Exhibit 6.1.

GOVERNMENT SPONSORED AGENCY INSTRUMENTS

U.S. government agency securities can be classified by the type of issuer—those issued by federal agencies and those issued by government sponsored enterprises. Federal agencies are fully owned by the U.S. government and have been authorized to issue securities directly in the marketplace. They include the Export-Import Bank of the United States, the Tennessee Valley Authority (TVA), the Commodity Credit Corporation, the Farmers Housing Administration, the General Services Administration, the Government National Mortgage Association, the Maritime Administration, the Private Export Funding Corporation, the Rural Electrification Administration, the Rural Telephone Bank, the Small Business Administration, and the Washington Metropolitan Area Transit Authority. The only federal agency that is an active issuer of short-term debt obligations is the TVA. With the exception of securities of the Tennessee Valley Authority and the Private Export Funding Corporation, the securities are backed by the full faith and credit of the United States government. Interest income on securities issued by federally related institutions is exempt from state and local income taxes.

Government sponsored enterprises (GSEs) are privately owned, publicly chartered entities. They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance. The entities in these privileged sectors include farmers, homeowners, and students. GSEs issue securities directly in the marketplace. Today there are six GSEs that currently issue debentures: Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Federal Agricultural Mortgage Corporation, Federal Farm Credit System, Federal Home Loan Bank System, and Student Loan Marketing Association. The interest earned on obligations of the Federal Home Loan Bank System, the Federal Farm Credit System, and the Student Loan Marketing Association are exempt from state and local income taxes.

Although there are differences between federal agencies and GSEs, it is common to refer to the securities issued by these entities as U.S. agency securities or, simply, agency securities. In this chapter we will discuss the short-term debt obligations issued by the six GSEs and the TVA. Chapter 9 provides information about each of these agencies and other securities that are covered. All of the securities issued by these entities expose an investor to credit risk. Consequently, agency securities offer a higher yield than comparable maturity Treasury securities.

Fannie Mae

Fannie Mae issues short-term debt in the form of discount notes. Discount notes are unsecured general obligations issued at a discount from their face value and mature at their face value. They are issued in book-entry form through the Federal Reserve banks and have original maturities that range from overnight to 360 days with the exception of 3-month, 6-month, and 1-year maturities. These maturities are available through Fannie Mae’s Benchmark Bills program, discussed shortly.

Discount notes are offered every business day via daily posting by Fannie Mae’s selling group of discount note dealers. These dealer firms make a market in these discount notes and the secondary market is well-developed. Investors may choose among cash-, regular-, or skip-day settlements.

Fannie Mae introduced the Benchmark Bills program in early November 1999 as an important component of its discount note program. Benchmark Bills, like discount notes, are unsecured general obligations issued in book-entry form as discount instruments and are payable at par on their maturity date. However, unlike discount notes, Benchmark Bills are issued at regularly scheduled weekly auctions where the size of the issuance is announced in advance. When the program was launched, Benchmark Bills were issued in two maturities—3-month and 6-month. In October 2000, Fannie Mae introduced a 1-year (360 days) that are auctioned every two weeks.

Fannie Mae announces the size of each weekly auction on Tuesday sometime during mid-morning Eastern time. Exhibit 6.3 presents a Bloomberg news report from September 18, 2001 of a Fannie Mae auction announcement of 3- and 6-month Benchmark Bills. The auction itself is conducted on Wednesdays. Fannie Mae accepts bids from a subset of eight of the dealers from its Selling Group of Discount Note Dealers. These eight dealers (called ACCESS dealers) can submit bids on their own account or on behalf of their customers. The bids may be either competitive or non-competitive. The minimum bid size is $50,000 with additional increments of $1,000. Moreover, bidding dealers are subject to a 35% takedown rule. A takedown rule limits the amount a single buyer can bid on or hold to 35% of the total auction amount.

Source: Bloomberg Financial Markets

Bids are submitted in the form of yields on a bank discount basis out to three decimal points and are accepted between 8:30 a.m. and 9:30 a.m Eastern time. The submitted bids are ranked from lowest to the highest. As noted previously, this is equivalent to arranging the bids from highest price to the lowest price. Starting from the lowest yield bid, all competitive bids are accepted until the amount to be distributed to the competitive bidders is completely allocated. The highest accepted bid is called the stop out discount rate and all accepted bids are filled at this price (i.e., a single price auction). Exhibit 6.4 presents a Bloomberg news report of the results of a September 19, 2001 auction of 3-month and 6-month Benchmark Bills. Non-competitive bids are also executed at the stop out discount rate and are allocated on the basis of when the bids were received (i.e., first-come, first-served). The minimum face value is $1,000. The day count convention—like virtually every security discussed in this chapter—is Actual/360.

Source: Bloomberg Financial Markets

Although the Benchmark Bills program is a subset of their well-established discount notes program, Fannie Mae has taken steps such that the two programs do not interfere with one another. Specifically, Fannie Mae does not issue discount notes in any given week with a maturity date within one week on either side of a Benchmark Bill’s maturity date. For example, in a particular week, Fannie Mae will not issue a discount note with a maturity between two months, three weeks to three months, or one week. The maturity lockout is in effect for 6-month and 1-year Benchmark Bills as well. However, the two programs are also complementary in that a 3-month Benchmark Bill with two months until maturity may be “reopened” as a 2-month discount note with the same maturity date and CUSIP as the bill.

Benchmark Bills trade at a spread over comparable maturity U.S. Treasury Bills due to the modicum of credit risk to which Fannie Mae debt investors are exposed. Exhibit 6.5 presents some summary statistics of daily 3-month, 6-month, and 1-year Benchmark Bill yield spreads versus comparable maturity U.S. Treasury Bills for the period August 1, 2000 through July 20, 2001.

Source: Fannie Mae

Federal Home Loan Mortgage Corporation

Federal Home Loan Mortgage Corporation (Freddie Mac) issues discount notes and Reference Bills. While at issuance discount notes can range in maturity from overnight to 365 days, half of these notes have maturities of three days or less. The most popular maturities are one month and three months. Freddie Mac discount notes are offered for sale continuously with rates posted 24 hours a day (business days) through a group of investment banks that belong to the Freddie Mac dealer group. These notes are issued in book entry form through the Federal Reserve Bank of New York and have a minimum face value of $1,000 with increments of $1,000 thereafter. The pricing conventions are the same as U.S. Treasury bills.

Freddie Mac’s Reference Bills program is similar in structure to Fannie Mae’s Benchmark Bills. One important difference between the two is that Reference Bills are offered in more maturities namely, one month (28 days), two months (56 days), three months (91 days), six months (182 days), and one year (364 days).

Like U.S. Treasury bills and Benchmark Bills, Reference Bills are sold weekly using a Dutch auction. 1-month and 2-month Reference Bills are auctioned each week on Monday, while 3-month maturities are auctioned weekly on Tuesday. The 6-month and 1-year Reference Bills are auctioned every four weeks on Tuesday on an alternating schedule such that every two weeks either a 6-month or a 1-year maturity will be auctioned. In order to give their investors flexibility, Freddie Mac offers multiple settlement dates. For Reference bills auctioned on Mondays, investors may choose between cash and regular settlement dates. For those auctioned on Tuesdays, investors may choose between cash, regular, and skip-day settlement dates. Auctions of Reference Bills are announced on Thursday for the following week and have a minimum size of $1 billion.

Federal Home Loan Bank System

The Federal Home Loan Bank System (“FHLBank System”) issues discount notes. Like the other discount notes discussed earlier, these securities are unsecured general obligations sold at a discount from par and mature at their face value. Minimum face values are $100,000 with additional increments of $1,000. The maturities range from overnight to 360 days. FHLBank System discount notes are generally offered for sale on a continuous basis generally by one or more of the following ways: (1) auction; (2) sale to dealers as principal; and (3) allocation to selected dealers as agent in accordance with FHLBank System procedures for reoffering the notes to investors.

Federal Farm Credit System

The Federal Farm Credit System (FFCS) issues discount notes that are unsecured, joint obligations of the FFCS. Maturities range from overnight to 365 days with the majority having maturities of less than 90 days. Minimum face values are $5,000 and with $1,000 increments. All discount notes have cash settlement.

The FFCS also issues short-term securities with maturities less than one year that are issued at par and pay interest at maturity. Exhibit 6.6 presents a Bloomberg DES (Security Description) screen for an interest at maturity security that looks much like the certificates of deposits discussed later in this chapter. This security was issued by the FFCS on August 1, 2001 and matured on November 1, 2001. Note that unlike most of securities in the money market, the day count convention is 30/360.

Source: Bloomberg Financial Markets

On the issuance date of August 1, 2001, the yield on this security was 3.52% as can be seen from the upper left-hand side of the screen. Accordingly, the interest at maturity is determined by multiplying the face value, the yield at issuance, and the fraction of a year using a 30/360 day count convention. With the 30/360 day count, all months are assumed to have 30 days and all years are assumed to have 360 days. There are 90 days between August 1, 2001 and November 1, 2001 using a 30/360 day count convention.

The interest at maturity is computed as follows assuming a $1 million face value:

Exhibit 6.7 presents a Bloomberg Yield Analysis (YA) screen for this security. Suppose a $1,000,000 face value is purchased with a settlement day of September 21, 2001 for the full price (i.e., flat price plus accrued interest) of $1,006,150.03 as can be seen from the “PAYMENT INVOICE” box on the right-hand side of the screen. We know the investor receives $1,008,800 at maturity, so the if buyer holds the security until maturity, she will receive the difference of $2,649.97. This calculation agrees with the “GROSS PROFIT” on the right-hand side of the screen.

A yield calculation which may require some explanation is labeled “DISCOUNT EQUIVALENT” in Exhibit 6.7. This security is similar to a discount security in that the security does not pay a cash flow until maturity. The discount equivalent yield puts discount notes which are quoted on a bank discount basis and interest at maturity securities on the same basis. Namely, suppose the face value of the security is $1,008,800 and the security full price’s is $1,006,150.03, what is the yield on the bank discount basis? To see this, recall the formula for the dollar discount (D):

where

Source: Bloomberg Financial Markets

In this case, the face value is $1,008,800, the dollar discount is $2,649.97, and the actual number of days until maturity is 41 since discount securities use an Actual/360 day count convention. Inserting these numbers into the formula gives us:

Solving for Y_d gives us:

The calculation agrees with the yield calculation displayed in the “YIELD CALCULATIONS” box on the left-hand side of the screen in Exhibit 6.7.

Federal Agricultural Mortgage Corporation

The Federal Agricultural Mortgage Corporation (“Farmer Mac”) issues discount notes with maturities that range from overnight to 365 days and are offered on a continuous basis. Farmer Mac discount notes are available with cash-, regular-, and skip-day settlement dates. Exhibit 6.8 presents a Bloomberg DES (Security Description) for a Farmer Mac discount note that was issued on October 24, 2000 and matures on October 24, 2001. The maturity for Farmer Mac discount notes will always fall on a business day. As can be seen in the “ISSUE SIZE” box in bottom center of the screen, the minimum face value is $1,000 with additional increments of $1,000 thereafter.

Source: Bloomberg Financial Markets

Exhibit 6.9 is a Bloomberg YA (Yield Analysis) screen for the same Farmer Mac discount note. From this screen, we see that the discount yield is 2.28516% that corresponds to a price of 99.784179 (per $100 of face value) with settlement on September 20, 2001. From the “CASH-FLOW ANALYSIS” box on the right-hand side of the screen, it can be seen that an investor can purchase a $1 million face value package of notes that mature on October 24, 2001 for $997,841.79. The interest income of $2,158.21 is fully taxable at the federal, state, and local levels.

Source: Bloomberg Financial Markets

Student Loan Marketing Association

The Student Loan Marketing Association (“Sallie Mae”) issues floating-rate debt either tied to the 91-day U.S. Treasury bill rate or, to a lesser extent, 3-month LIBOR, discount notes, and short-term interest at maturity securities that are callable. Exhibit 6.10 presents a Bloomberg DES screen for a Sallie Mae interest at maturity security that was issued on August 2, 2001 and matures on July 23, 2002. The security is callable at par on October 23, 2001, approximately three months after issuance.

Source: Bloomberg Financial Markets

Tennessee Valley Authority

The Tennessee Valley Authority’s discount note program is structured similarly to those described previously. There are two differences nonetheless. First, the face value of TVA’s discount notes is $100,000 with additional increments of $1,000 thereafter. Second, interest on these securities is exempt from state and local taxes except estate, inheritance, and gift taxes.

COMMERCIAL PAPER

Commercial paper is a short-term promissory note issued in the open market as an obligation of the issuing entity. Commercial paper is sold at a discount and pays face value at maturity. The discount represents interest to the investor in the period to maturity. Although some issues are in registered form, commercial paper is typically issued in bearer form. Commercial paper is the largest segment of money market exceeding even U.S. Treasury bills with just over $1.5 billion in commercial paper outstanding at the end of April 2001.

The maturity of commercial paper is typically less than 270 days; a typical issue matures in less than 45 days. Naturally, there are reasons for this. First, the Securities and Exchange Act of 1933 requires that securities be registered with the Securities and Exchange Commission (SEC). Special provisions in the 1933 act exempt commercial paper from these registration requirements so long as the maturity does not exceed 270 days. To avoid the costs associated with registering issues with the SEC, issuers rarely issue commercial paper with a maturity exceeding 270 days. In Europe, commercial paper maturities range between 2–365 days. To pay off holders of maturing paper, issuers generally “rollover” outstanding issues; that is, they issue new paper to pay off maturing paper.

Another consideration in determining the maturity is whether the paper would be eligible collateral by a bank if it wanted to borrow from the Federal Reserve Bank’s discount window. In order to be eligible, the paper’s maturity may not exceed 90 days. Because eligible paper trades at a lower cost than paper that is ineligible, issuers prefer to sell paper whose maturity does not exceed 90 days.

The combination of its short maturity and low credit risk make commercial paper an ideal investment vehicle for short-term funds. Most investors in commercial paper are institutional investors. Money market mutual funds are the largest single investor of commercial paper. Pension funds, commercial bank trust departments, state and local governments, and nonfinancial corporations seeking short-term investments comprise most of the balance.

The market for commercial paper is a wholesale market and transactions are typically sizeable. The minimum round-lot transaction is $100,000. Some issuers will sell commercial paper in denominations of $25,000.

Although commercial paper is the largest sector of the money market, there is relatively little trading in the secondary market, the reason being that most investors in commercial paper follow a “buy and hold” strategy. This is to be expected because investors purchase commercial paper that matches their specific maturity requirements. Any secondary market trading is usually concentrated among institutional investors in a few large, highly rated issues. If investors wish to sell their commercial paper, they can usually sell it back to the original seller—either the dealer or the issuer.

Direct Paper versus Dealer Paper

Commercial paper is classified as either direct paper or dealer paper. Direct paper is sold by an issuing firm directly to investors without using a securities dealer as an intermediary. The vast majority of the issuers of direct paper are financial firms. Because financial firms require a continuous source of funds in order to provide loans to customers, they find it cost effective to have a sales force to sell their commercial paper directly to investors. Direct issuers post rates at which they are willing to sell commercial paper with financial information vendors such as Bloomberg, Reuters, and Telerate.

Although commercial paper is a short-term security, it is issued within a longer term program, usually for three to five years for European firms: U.S. commercial paper programs are often open-ended. For example, a company might establish a 5-year commercial paper program with a limit of $100 million. Once the program is established, the company can issue commercial paper up to this amount. The program is continuous and new paper can be issued at any time, daily if required.

In the case of dealer placed commercial paper, the issuer uses the services of a securities firm to sell its paper. Commercial paper sold in this manner is referred to as dealer paper.

Commercial Paper Credit Ratings

All investors in commercial paper are exposed to credit risk. Credit risk is the possibility the investor will not receive the timely payment of interest and principal at maturity. While some institutional investors do their own credit analysis, most investors assess a commercial paper’s credit risk using ratings by nationally recognized statistical rating organizations (NRSROs). The SEC currently designates only Fitch, Moody’s, and Standard & Poor’s as NRSROs for rating U.S. corporate debt obligations. Exhibit 6.11 presents the commercial paper ratings from the NRSROs.

The risk that the investor faces is that the borrower will be unable to issue new paper at maturity. This risk is referred to as rollover risk. As a safeguard against rollover risk, commercial paper issuers secure backup lines of credit sometimes called “liquidity enhancement.” Most commercial issuers maintain 100% backing because the NRSROs that rate commercial paper usually require a bank line of credit as a precondition for a rating. However, some large issues carry less than 100% backing. Backup lines of credit typically contain a “material adverse change” provision that allows the bank to cancel the credit line if the financial condition of the issuing firm deteriorates substantially.

The commercial paper market is divided into tiers according to credit risk ratings. The “top top tier” consists of paper rated A1+/P1/F1+. “Top tier” is paper rated A1/P1, F1. Next, “split tier” issues are rated either A1/P2 or A2/P1. The “second tier” issues are rated A2/P2/F2. Finally, “third tier” issues are rated A3/P3/F3.

Yields on Commercial Paper

Like Treasury bills, commercial paper is a discount instrument. In other words, it is sold at a price less than its maturity value. The difference between the maturity value and the price paid is the interest earned by the investor, although some commercial paper is issued as an interest-bearing instrument.

As an example, consider some commercial paper issued by GE Capital. Exhibit 6.12 presents Bloomberg’s Money Market Security screen for this security that was issued on October 25, 2001 that matures in 45 days. From Bloomberg’s Yield Analysis (YA) screen in Exhibit 6.13, we see that commercial paper has a discount yield of 2.27% at the upper left-hand side of the screen. The day count convention in the United States and most European commercial paper markets is Actual/360 with the notable exception being the UK which uses Actual/365. Given the yield on a bank discount basis, the price is found the same way as the price of a Treasury bill described earlier in this chapter, by first solving for the dollar discount (D) as follows:

where

Yd	=	discount yield
F	=	face value
t	=	number of days until maturity

The price is then

Source: Bloomberg Financial Markets

With a settlement day of October 25, 2001, the GE Capital commercial paper has 45 days to maturity. Assuming a face value of $100 and a yield on a bank discount basis of 2.27%, D is equal to

Source: Bloomberg Financial Markets

Therefore,

This calculation agrees with the price displayed in the box on the upper left-hand side of the screen in Exhibit 6.13.

The yield on commercial paper is higher than that on Treasury bill yields. There are three reasons for this relationship. First, the investor in commercial paper is exposed to credit risk. Second, interest earned from investing in Treasury bills is exempt from state and local income taxes. As a result, commercial paper has to offer a higher yield to offset this tax advantage offered by Treasury bills. Finally, commercial paper is far less liquid than Treasury bills. The liquidity premium demanded is probably small, however, because commercial paper investors typically follow a buy-and-hold strategy and so are usually less concerned with liquidity.

ASSET-BACKED COMMERCIAL PAPER

Asset-backed securities are discussed in several chapters in this book. Here we will briefly describe asset-backed commercial paper (hereafter, “ABC paper”) which is commercial paper issued by either corporations or large financial institutions through a bankruptcy-remote special purpose corporation.

ABC paper is usually issued to finance the purchase of receivables and other similar assets. Some examples of assets underlying these securities include trade receivables (i.e., business-to-business receivables), credit card receivables, equipment loans, automobile loans, health care receivables, tax liens, consumer loans, and manufacturing-housing loans.

According to Moody’s, an investor in ABC paper is exposed to three major risks.¹ First, the investor is exposed to credit risk because some portion of the receivables being financed through the issue of ABC paper will default, resulting in losses. Obviously, there will always be defaults so the risk faced by investors is that the losses will be in excess of the credit enhancement. Second is liquidity risk which is the risk that collections on the receivables will not occur quickly enough to make principal and interest payments to investors. Finally, there is structural risk that involves the possibility that the ABC paper conduit may become embroiled in a bankruptcy proceeding, which disrupts payments on maturing commercial paper.

MEDIUM-TERM NOTES

A medium-term note (MTN) is a corporate debt instrument with a characteristic akin to commercial paper in that notes are offered continuously to investors by an agent of the issuer. Investors can select from several maturity ranges: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and so on up to any number of years. Medium-term notes issued in the United States are registered with the Securities and Exchange Commission under Rule 415 (i.e., the shelf registration rule) which gives a corporation the maximum flexibility for issuing securities on a continuous basis. MTNs are also issued by non-U.S. corporations, federal agencies, supranational institutions, and sovereign governments. The MTN market is primarily institutional with individual investors being of little import.

The label “medium-term note” is a misnomer. Traditionally, the term “note” or “medium-term” was used to refer to debt issues with a maturity greater than 1 year but less than 15 years. Certainly this is not descriptive of MTNs since they have been issued with maturities from 9 months to 30 years, and even longer. The focus here is on short-term MTNs with maturities of one year or less. MTNs are discussed further in Chapter 11.

Borrowers have flexibility in designing MTNs to satisfy their own needs. They can issue fixed- or floating-rate debt. The coupon payments for MTNs can be denominated in U.S. dollars or in another currency.

A corporation that desires an MTN program will file a shelf registration with the SEC for the offering of securities. While the SEC registration for MTN offerings are between $100 million and $1 billion, once the total is sold, the issuer can file another shelf registration. The registration will include a list of the investment banking firms, usually two to four, that the corporation has arranged to act as agents to distribute the MTNs. The large New York-based investment banking firms dominate the distribution market for MTNs. As an illustration, Exhibit 6.14 presents a Bloomberg Money Market Program Description screen for Amgen Inc. MTN program. There are three things to note. First, across the bottom of the screen, it indicates this a $400 million program. Second, as listed on the left-hand side of the screen, the MTNs issued under this program are denominated in multiple currencies. Third, as can be seen at the bottom of the “PROGRAM INFORMATION” box, two investment banking firms—Bear Stearns (BEAR) and Goldman Sachs (GS)—will distribute the issue. Not all MTNs are sold on an agency basis; some have been underwritten.

Source: Bloomberg Financial Markets

An issuer with an active MTN program will post rates for the maturity ranges it wishes to sell. Fixed-rate interest payments are typically on a semiannual basis with the same interest payment dates applicable to all of the notes of a particular series of an issuer. Of course, the final interest payment is made at maturity. Floating-rate MTNs may have more frequent coupon payments. If interest rates are volatile, posted rates may change, sometimes more than once per day. The notes are priced at par which appeals to many investors because they do not have to be concerned with either amortizing premiums or accreting discounts. Any change in new rates will not affect the rates on previously issued notes.

The purchaser may usually set the maturity as any business day with the offered maturity range, subject to the borrower’s approval. This is a very important benefit of MTNs as it enables a lender to match maturities with its very own specific requirements. As they are continuously offered, an investor can enter the market when portfolio needs require and will usually find suitable investment opportunities. With underwritten issues, the available supply—both in the new issue and secondary markets—might be unsatisfactory for the portfolio’s needs. A particular series of MTNs may have many different maturities but all will be issued under the same indenture. The bulk of the notes sold have maturities of less than five years.

LARGE-DENOMINATION NEGOTIABLE CDS

A certificate of deposit (CD) is a financial asset issued by a depository institution that indicates a specified sum of money that has been deposited with them. Depository institutions issue CDs to raise funds for financing their business activities. A CD bears a maturity date and a specified interest rate or floating-rate formula. While CDs can be issued in any denomination, only CDs in amounts of $100,000 or less are insured by the Federal Deposit Insurance Corporation. There is no limit on the maximum maturity but Federal Reserve regulations stipulate that CDs cannot have a maturity of less than seven days.

A CD may be either nonnegotiable or negotiable. If nonnegotiable, the initial depositor must wait until the CD’s maturity date for the return of their deposits plus interest. An early withdrawal penalty is imposed if the depositor chooses to withdraw the funds prior to the maturity date. In contrast, a negotiable CD allows the initial depositor (or any subsequent owner of the CD) to sell the CD in the open market prior to the maturity date.

There are two types of negotiable CDs. The first is the large-denomination CD, usually issued in denominations of $1 million or more. The second type is the small-denomination CD (less than $100,000) which is a retail-oriented product. Our focus here is on the large-denomination negotiable CD with maturities of one year or less and we refer to them as simply CDs throughout the chapter.

CD Issuers

CDs whose cash flows are denominated in U.S. dollars can be classified into four types according to the issuing institution. First are the CDs issued by domestic banks. Second are CDs that are denominated in U.S. dollars but are issued outside the United States. These CDs are called Eurodollar CDs or Euro CDs. A third type of CD is called a Yankee CD which is a CD denominated in U.S. dollars and issued by a non-U.S. bank with a branch in the United States. Finally, thrift CDs are those issued by savings and loans and savings banks.

Money center banks and large regional banks are the primary issuers of domestic CDs. Most CDs are issued with a maturity of less than one year. Those issued with a maturity greater than one year are called term CDs.

Unlike the discount instruments discussed in this chapter, yields on domestic CDs are quoted on an interest-bearing basis. CDs with a maturity of one year or less pay interest at maturity (i.e., simple interest). The day count convention is Actual/360. Domestic CDs issued in the United Kingdom denominated in pounds sterling are quoted the same way except the day count convention is Actual/365.

Eurodollar CDs are U.S. dollar-denominated CDs issued primarily in London by U.S., Canadian, European, and Japanese banks. The CDs earn a fixed rate of interest related to dollar LIBOR. The term LIBOR comes from the London Interbank Offered Rate and is the interest rate at which one London bank offers funds to another London bank of acceptable credit quality in the form of a cash deposit. The rate is “fixed” by the British Bankers Association every business morning by the average of the rates supplied by member banks. The LIBID is the market’s “bid” rate—the rate at which banks pay for funds in the London market. The quote spread for a selected maturity is therefore the difference between LIBOR and LIBID.

CD Yields

The yield 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 CD’s maturity as this will be considered relative to the money market yield curve. As CDs are issued by depository institutions as part of their short-term funding and liquidity requirement, issue volumes are driven by the demand for loans and availability of alternative sources for potential borrowers. However, the credit quality of the issuing bank is the primary consideration. In the U.S. market, “prime” CDs—issued by highly rated domestic banks—trade at a lower yield than “non-prime” CDs. Similarly, in the U.K. market, the lowest yield is paid by “clearer” CDs which are issued by the clearing banks (e.g., RBS NatWest plc, HSBC and Barclays plc). In both markets, CDs issued by foreign financial institutions such as French or Japanese banks will trade at higher yields.

CD yields are higher than yields on Treasury securities of like maturity. The spread is due primarily to the credit risk that a CD investor is exposed to and the fact that CDs offer less liquidity. The spread due to credit risk will vary with both economic conditions in general and confidence in the banking system in particular, increasing in times when the market’s risk aversion is high or when there is a crisis in the banking system.

Eurodollar CDs offer a higher yield than U.S. domestic CDs on average. There are three reasons that account for this. First, there are reserve requirements imposed by the Federal Reserve on CDs issued by U.S. banks in the United States that do not apply to issuers of Eurodollar CDs. The reserve requirement effectively raises the cost of funds to the issuing bank because it cannot invest all the proceeds it receives from the issuance of the CD and the amount that must be kept as reserves will not earn a return for the bank. Because it will earn less on funds raised by selling domestic CDs, the domestic issuing bank will pay less on its domestic CD than on a Euro CD. Second, the bank issuing the CD must pay an insurance premium to the FDIC, which again raises the cost of funds. Finally, Euro CDs are dollar obligations that are payable by an entity operating under a foreign jurisdiction, exposing the holders to a risk (called sovereign risk) that their claim may not be enforced by the foreign jurisdiction. As a result, a portion of the spread between the yield offered on Euro CDs and domestic CDs reflects what can be thought of as a sovereign risk premium. This premium varies with the degree of confidence in the international banking system.

FEDERAL FUNDS

Depository institutions are required to hold reserves to meet their reserve requirements. The level of the reserves that a depository institution must maintain is based on its average daily deposits over the previous 14 days. To meet these requirements, depository institutions hold reserves at their district Federal Reserve Bank. These reserves are called federal funds.

Because no interest is earned on federal funds, a depository institution that maintains federal funds in excess of the amount required incurs an opportunity cost of the interest forgone on the excess reserves. Correspondingly, there are also depository institutions whose federal funds are short of the amount required. The federal funds market is where depository institutions buy and sell federal funds to address this imbalance. Typically, smaller depository institutions (e.g., smaller commercial banks, some thrifts, and credit unions) almost always have excess reserves while money center banks usually find themselves short of reserves and must make up the deficit. The supply of federal funds is controlled by the Federal Reserve through its daily open market operations.

Most transactions involving federal funds last for only one night; that is, a depository institution with insufficient reserves that borrows excess reserves from another financial institution will typically do so for the period of one full day. Because these reserves are loaned for only a short time, federal funds are often referred to as “overnight money.”

One way that depository institutions with a required reserves deficit can bring reserves to the required level is to enter into a repurchase agreement (as described later) with a counterparty other than a financial institution. The repurchase agreement (which consists of the sale of a security and an agreement to repurchase it later) will provide funds for a short period of time, after which the bank buys back the security as previously agreed. Of course, an alternative to the repo is for the bank to borrow federal funds from a depository institution that holds excess reserves.

Thus, depository institutions view the repo market and the federal funds market as close substitutes.

Federal Funds Rate

The interest rate at which federal funds are bought (borrowed) by depository institutions that need these funds and sold (lent) by depository institutions that have excess federal funds is called the federal funds rate. The federal funds is a benchmark short-term interest rate. Indeed, other short-term interest rates (e.,g, Treasury bills) often move in tandem with movements in the federal funds rate. The rate most often cited for the federal funds market is known as the effective federal funds rate. The daily effective federal funds rate is a volume-weighted average of rates for federal fund trades arranged through the major New York brokers.

Although the term of most federal funds transactions is overnight, there are longer-term transactions that range from one week to one year. Trading typically takes place directly between buyer and seller, usually between a large bank and one of its correspondent banks. Some federal funds transactions require the use of a broker. The broker stays in constant touch with prospective buyers/sellers, arranging deals between them for a commission. Brokers provide another service to this market in (normally) unsecured loans because they often can give lenders credit analyses of borrowers if the lenders have not done business with them previously.

BANKERS ACCEPTANCES

A bankers acceptance is a written promise issued by a borrower to a bank to repay borrowed funds. The lending bank lends funds and in return accepts the ultimate responsibility to repay the loan to its holder, hence the name—bankers acceptance. The acceptance is negotiable and can be sold in the secondary market. The investor who buys the acceptance can collect the loan on the day repayment is due. If the borrower defaults, the investor has legal recourse to the bank that made the first acceptance. Bankers acceptances are also known as bills of exchange, bank bills, trade bills, or commercial bills.

Essentially, bankers acceptances are instruments created to facilitate commercial trade transactions. The use of bankers acceptances to finance commercial transactions is known as acceptance financing. The transactions in which acceptances are created include the import and export of goods, the storage and shipping of goods between two overseas countries where neither the importer nor the exporter is based in the home country, and the storage and shipping of goods between two entities based at home.

Bankers acceptances are sold on a discounted basis just like Treasury bills and commercial paper. The rate that a bank charges a customer for issuing a bankers acceptance is a function of the rate at which the bank believes it will be able to sell it in the secondary market. A commission is added to this rate. The major investors in bankers acceptances are money market mutual funds and municipal entities.

Bankers acceptances have declined in importance in recent years in favor of other forms of financing. There are several reasons that account for this decline. First, the rise in financial disintermediation has reduced corporations’ dependence on bank financing in that they now have access to a wider range of funding options (e.g., commercial paper). Second is the vicious circle of low liquidity which leads to less issuance and so on. Third, in July 1984, the Federal Reserve discontinued the use of bankers acceptances as collateral for repurchase agreements when conducting open market operations.

The Creation of a Bankers Acceptance

The most efficient way to explain the creation of a bankers acceptance is by an illustration. The following fictitious parties are involved in this process:

• PCs For Less plc, a firm in London that sells a wide variety of information appliances;
• Kameto Ltd., a manufacturer of personal computers based in Japan
• ABC Bank plc, a clearing bank based in London
• Samurai Bank, a bank based in Japan
• Palmerston Bank plc, another bank based in London
• Adam Smith Investors plc, a money market fund based in Edinburgh

PCs For Less and Kameto Ltd. are preparing to enter into a deal in which PCs For Less will import a consignment of personal computers (PCs) with a transaction value of ₤1 million. However, Kameto Ltd. is concerned about the ability of PCs For Less to make payment on the PCs when they are delivered. To circumvent this uncertainty, both parties decided to fund the transaction using bankers acceptance financing. The terms of the transaction are that payment must be made by PCs For Less within 60 days after the PCs have been shipped to the United Kingdom. In determining whether it is willing to accept the ₤1 million, Kameto Ltd. must calculate the present value of the amount because it will not be receiving this sum until 60 days after shipment. Therefore, both parties agree to the following terms:

• PCs For Less arranges with its banker, ABC Bank plc, to issue a letter of credit (LOC, also known as a time draft). The LOC states that ABC Bank plc will guarantee the payment of ₤1 million that PCs For Less must make to Kameto 60 days from shipment. The LOC is sent by ABC Bank to Kameto’s bankers who are Samurai Bank. On the receipt of the LOC, Samurai Bank notifies Kameto, who will then ship the PCs. After the PCs are shipped, Kameto presents the shipping documents to Samurai and receives the present value of ₤1 million. This completes the transaction for Kameto Ltd.
• Samurai Bank presents the LOC and the shipping documents to ABC Bank plc. The latter will stamp the LOC as “accepted”, thus creating a bankers acceptance. This means that ABC Bank plc agrees to pay the holder of the bankers acceptance the sum of ₤1 million on the acceptance’s maturity date. PCs For Less will receive the shipping documents so that it can then take delivery of the PCs once it signs a note or some other financing arrangement with ABC Bank plc.

At this point, the holder of the bankers acceptance is Samurai Bank and it has the following two choices available: (1) the bank may retain the bankers acceptance in its loan portfolio or (2) it may request that ABC Bank plc make a payment of the present value of ₤1 million. Let’s assume that Samurai Bank elects to request payment of the present value of ₤1 million. Now the holder of the bankers acceptance is ABC Bank plc. It also has two choices that it can make: (1) it may retain the bankers acceptance as an investment or (2) it may sell it to another investor. Once again, assume it chooses the latter, and one of its clients, Adam Smith Investors, is interested in a high-quality security with same maturity as the bankers acceptance. Accordingly, ABC Bank plc sells the acceptance to Adam Smith Investors at the present value of ₤1 million calculated using the relevant discount rate for paper of that maturity and credit quality. Alternatively, it may have sold the acceptance to another bank, such as Palmerston Bank plc that also creates bankers acceptances. In either case, on the maturity of the bankers acceptance, its holder presents it to ABC Bank plc and receives the maturity value of ₤1 million, which the bank in turn recovers from PCs For Less plc.

The holder of the bankers acceptance is exposed to credit risk on two fronts: the risk that the original borrower is unable to pay the face value of the acceptance and the risk that the accepting bank will not be able to redeem the paper. For this reason, the rate paid on a bankers acceptance will trade at a spread over the comparable maturity risk-free benchmark security (e.g., U.S. Treasury bills). Investors in acceptances will need to know the identity and credit risk of the original borrower as well as the accepting bank.

Eligible Bankers Acceptances

An accepting bank that chooses to retain a bankers acceptance in its portfolio may be able to use it as collateral for a loan obtained from the central bank during open market operations, for example, the Federal Reserve in the United States and the Bank of England in the United Kingdom. Not all acceptances are eligible to be used as collateral in this manner, as the acceptances must meet certain criteria as specified by the central bank. The main requirements for eligibility are that the acceptance’s maturity must not exceed a certain maturity (a maximum of six months in the United States and three months in the United Kingdom) and that it must have been created to finance a self-liquidating commercial transaction. In the United States, eligibility is also important because the Federal Reserve imposes a reserve requirement on funds raised via bankers acceptances that are ineligible. Bankers acceptances sold by an accepting bank are potential liabilities of the bank but reserve requirements impose a limit on the amount of eligible bankers acceptances that a bank may issue. Acceptances eligible for deposit at a central bank offer a lower discount rate than ineligible ones and also act as a benchmark for prices in the secondary market.

FUNDING AGREEMENTS

Funding agreements (FAs) are short-term debt instruments issued by insurance companies. Specifically, a funding agreement is a contract issued by an insurance company that provides the policyholder the right to receive the coupon payments as scheduled and the principal on the maturity date. These contracts are guaranteed by the insurer’s general account or a separate account. FAs are not publicly traded and therefore are less liquid than other money market instruments such as commercial paper. In recent years, medium-term notes (U.S. MTNs and Global MTNs) have become increasingly popular. These are securitizations whose cash flows are backed by a portfolio of FAs.

Coupon rates may be either fixed or floating. Reference rates have included U.S. Treasury rates, LIBOR, commercial paper rates, the federal funds rate, and the prime rate. The unique feature of FAs is that the holder of this security has an embedded put option with a 7-, 30-, 90-, 180-day or 1-year expiration. Therefore, FAs are putable back to the issuer at par. Yields offered on FAs depend on the credit quality of issuing insurer, the structure of the embedded put option, and the term to maturity.

The major investors in FAs are money market mutual funds. Short-dated putable FAs are structured to qualify as 2a-7 eligible money market mutual fund investments because they are illiquid investments since, as we noted earlier, they are not publicly traded.² A study by Moody’s investigated the reasons why money market mutual funds invest in FAs. The following reasons were cited:

1. FAs are attractive short-term investments.
2. FAs are highly rated and are “stable value”-type products
3. Investors like FAs as an established product.

REPURCHASE AGREEMENTS

One of the largest segments of the money markets worldwide is the market in repurchase agreements or repo. A most efficient mechanism by which to finance bond positions, repo transactions enable market makers to take long and short positions in a flexible manner, buying and selling according to customer demand on a relatively small capital base. Repo is also a flexible and relatively safe investment opportunity for short-term investors.

A repurchase agreement or “repo” is the sale of security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. For example, a dealer who owns a 10-year U.S. Treasury note might agree to sell this security (the “seller”) to a mutual fund (the “buyer”) for cash today while simultaneously agreeing to buy the same 10-year note back at a certain date in the future (or in some cases on demand) for a predetermined price. The price at which the seller must subsequently repurchase the security is called the repurchase price and the date that the security must be repurchased is called the repurchase date. Simply put, a repurchase agreement is a collateralized loan where the collateral is the security that is sold and subsequently repurchased. One party (the “seller”) is borrowing money and providing collateral for the loan; the other party (the ‘buyer’) is lending money and accepting a security as collateral for the loan. To the borrower, the advantage of a repurchase agreement is that the short-term borrowing rate is lower than the cost of bank financing, as we will see shortly. To the lender, the repo market offers an attractive yield on a short-term secured transaction that is highly liquid. This latter aspect is the focus of the discussion to come. In particular, we will focus on the U.S. repo market.³

The Basics

Suppose a government securities dealer purchases a 5% coupon Treasury note that matures on August 15, 2011 with a settlement date of Thursday, November 15, 2001. The face amount of the position is $1 million and the note’s full price (i.e., flat price plus accrued interest) is $1,044,843.75. Further, suppose the dealer wants to hold the position until the end of the next business day which is Thursday, November 16, 2001. Where does the dealer obtain the funds to finance this position?

Of course, the dealer can finance the position with its own funds or by borrowing from a bank. Typically, the dealer uses a repurchase agreement or “repo” market to obtain financing. In the repo market, the dealer can use the purchased Treasury note as collateral for a loan. The term of the loan and the interest rate a dealer agrees to pay are specified. The interest rate is called the repo rate. When the term of a repo is one day, it is called an overnight repo. Conversely, a loan for more than one day is called a term repo. The transaction is referred to as a repurchase agreement because it calls for the security’s sale and its repurchase at a future date. Both the sale price and the purchase price are specified in the agreement. The difference between the purchase (repurchase) price and the sale price is the loan’s dollar interest cost.

Let us return now to the dealer who needs to finance the Treasury note that it purchased and plans to hold it overnight. We will illustrate this transaction using Bloomberg’s Repo/Reverse Repo Analysis screen (RRRA) that appears in Exhibit 6.15. The settlement date is the day that the collateral must be delivered and the money lent to initiate the transaction. Likewise, the termination date of the repo agreement is November 16, 2001 and appears in the lower left-hand corner. At this point we need to ask, who is the dealer’s counterparty (i.e., the lender of funds)? Suppose that one of the dealer’s customers has excess funds in the amount of $1,044,843.75 called the “SETTLEMENT MONEY” and is the amount of money loaned in the repo agreement. On November 15, 2001, the dealer would agree to deliver (“sell”) $1,044,843.75 worth of Treasury notes to the customer and buy the same Treasury security for an amount determined by the repo rate the next day on November 16, 2001.

Suppose the repo rate in this transaction is 1.83%—see the upper right-hand corner of the screen. Then, as will be explained shortly, the dealer would agree to deliver the Treasury notes for $1,044,843.75 and repurchase the same securities for $1,044,896.86 the next day. The $53.11 difference between the “sale” price of $1,044,843.75 and the repurchase price of $1,044,896.86 is the dollar interest on the financing.

Source: Bloomberg Financial Markets

Repo Interest

The following formula is used to calculate the dollar interest on a repo transaction:

Notice that the interest is computed using a day count convention of Actual/360 like most money market instruments. In our illustration, using a repo rate of 1.83% and a repo term of one day, the dollar interest is $53.11 as shown below:

This calculation agrees with repo interest as calculated in the lower right-hand corner of Exhibit 6.15.

The advantage to the dealer of using the repo market for borrowing on a short-term basis is that the rate is lower than the cost of bank financing for reasons explained shortly. From the customer’s perspective (i.e., the lender), the repo market offers an attractive yield on a short-term secured transaction that is highly liquid.

Reverse Repo and Market Jargon

In the illustration presented above, the dealer is using the repo market to obtain financing for a long position. Dealers can also use the repo market to cover a short position. For example, suppose a government dealer established a short position in the 30-year Treasury bond three days ago and must now cover the position—namely, deliver the securities. The dealer accomplishes this task by engaging in a reverse repo. In a reverse repo, the dealer agrees to buy securities at a specified price with a commitment to sell them back at a later date for another specified price. In this case, the dealer is making collateralized loan to its customer. The customer is lending securities and borrowing funds obtained from the collateralized loan to create leverage.

There is a great deal of Wall Street jargon surrounding repo transactions. In order to decipher the terminology, remember that one party is lending money and accepting a security as collateral for the loan; the other party is borrowing money and providing collateral to borrow the money. By convention, whether the transaction is called a repo or a reverse repo is determined by viewing the transaction from the dealer’s perspective. If the dealer is borrowing money from a customer and providing securities as collateral, the transaction is called a repo. If the dealer is borrowing securities (which serve as collateral) and lends money to a customer, the transaction is called a reverse repo.

Types of Collateral

While in our illustration, we use a Treasury security as collateral, the collateral in a repo is not limited to government securities. Money market instruments, federal agency securities, and mortgage-backed securities are also used. In some specialized markets, even whole loans are used as collateral.

Documentation

Most repo market participants in the United States use the Master Repurchase Agreement published by the Bond Market Association (BMA). In Europe, the Global Master Repurchase Agreement published by the BMA and the International Securities Market Association has become widely accepted.⁴

Credit Risks

Just as in any borrowing/lending agreement, both parties in a repo transaction are exposed to credit risk. This is true even though there may be high-quality collateral underlying the repo transaction. Consider our initial example in Exhibit 6.15 where the dealer uses U.S. Treasuries as collateral to borrow funds. Let us examine under which circumstances each counter-party is exposed to credit risk.

Suppose the dealer (i.e., the borrower) defaults such that the Treasuries are not repurchased on the repurchase date. The investor gains control over the collateral and retains any income owed to the borrower. The risk is that Treasury yields have risen subsequent to the repo transaction such that the market value of the collateral is worth less than the unpaid repurchase price. Conversely, suppose the investor (i.e., the lender) defaults such that the investor fails to deliver the Treasuries on the repurchase date. The risk is that Treasury yields have fallen over the agreement’s life such the dealer now holds an amount of dollars worth less than the market value of the collateral. In this instance, the investor is liable for any excess of the price paid by the dealer for replacement securities over the repurchase price.

Repo Margin

While both parties are exposed to credit risk in a repo transaction, the lender of funds is usually in the more vulnerable position. Accordingly, the repo is structured to reduce the lender’s credit risk. Specifically, the amount lent should be less than the market value of the security used as collateral, thereby providing the lender some cushion should the collateral’s market value decline. The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin or “haircut.” Repo margins vary from transaction to transaction and are negotiated between the counterparties based on factors such as the following: term of the repo agreement, quality of the collateral, creditworthiness of the counterparties, and the availability of the collateral. Minimum repo margins are set differently across firms and are based on models and/or guidelines created by their credit departments. Repo margin is generally between 1% and 3%. For borrowers of lower credit worthiness and/or when less liquid securities are used as collateral, the repo margin can be 10% or more.⁵

To illustrate the role of a haircut in a repurchase agreement, let us once again return to the government securities dealer who purchases a 5% coupon, 10-year Treasury note and needs financing overnight. Recall, the face amount of the position is $1 million and the note’s full price (i.e., flat price plus accrued interest) is $1,044,843.75. As before, we will use Bloomberg’s RRRA screen to illustrate the transaction in Exhibit 6.16.

Source: Bloomberg Financial Markets

When a haircut is included, the amount the customer is willing to lend is reduced by a given percentage of the security’s market value. In this case, the collateral is 102% of the amount being lent. This percentage appears in the box labeled “COLLATERAL” in the upper left-hand corner of the screen. Accordingly, to determine the amount being lent, we divide the note’s full price of $1,044,843.75 by 1.02 to obtain $1,024,356.62 which is labeled “SETTLEMENT MONEY” located on the right-hand side of the screen. Suppose the repo rate in this transaction is 1.83%. Then, the dealer would agree to deliver the Treasury notes for $1,024,356.62 and repurchase the same securities for $1,024,408.69 the next day. The $52.07 difference between the “sale” price of $1,024,356.62 and the repurchase price of $1,024,408.69 is the dollar interest on the financing. Using a repo rate of 1.83% and a repo term of 1 day, the dollar interest is calculated as shown below:

This calculation agrees with the repo interest as calculated in the lower right-hand corner of Exhibit 6.16.

Marking the Collateral to Market

Another practice to limit credit risk is to mark the collateral to market on a regular basis. Marking a position to market means simply recording the position’s value at its market value. When the market value changes by a certain percentage, the repo position is adjusted accordingly. The decline in market value below a specified amount will result in a margin deficit. The Master Repurchase Agreement gives the “seller” (the dealer/borrower in our example) the option to remedy the margin deficit by either providing additional cash or by transferring additional securities that are reasonably acceptable to the buyer (the investor/lender in our example). Conversely, if the market value rises above the amount required by margin, this results in margin excess. If this occurs, the “buyer” will remedy the excess by either transferring cash equal to the amount of the excess or returning a portion of the collateral to the “seller.”

Delivery of the Collateral

One concern in structuring a repurchase agreement is delivery of the collateral to the lender. The most obvious procedure is for the borrower to actually deliver the collateral to the lender or to the cash lender’s clearing agent. If this procedure is followed, the collateral is said to be “delivered out.” At the end of the repo term, the lender returns collateral to the borrower in exchange for the repurchase price (i.e., the amount borrowed plus interest).

The drawback of this procedure is that it may be too expensive, particularly for short-term repos (e.g., overnight) owing to the costs associated with delivering the collateral. Indeed, the cost of delivery is factored into the repo rate of the transaction in that if delivery is required this translates into a lower repo rate paid by the borrower. If delivery of collateral is not required, an otherwise higher repo rate is paid. The risk to the lender of not taking actual possession of the collateral is that the borrower may sell the security or use the same security as collateral for a repo with another counterparty.

As an alternative to delivering out the collateral, the lender may agree to allow the borrower to hold the security in a segregated customer account. The lender still must bear the risk that the borrower may use the collateral fraudulently by offering it as collateral for another repo transaction. If the borrower of the cash does not deliver out the collateral, but instead holds it, then the transaction is called a hold-in-custody repo (HIC repo). Despite the credit risk associated with a HIC repo, it is used in some transactions when the collateral is difficult to deliver (e.g., whole loans) or the transaction amount is relatively small and the lender of the funds is comfortable with the borrower’s reputation.

Investors participating in a HIC repo must ensure: (1) they transact only with dealers of good credit quality since a HIC repo may be perceived as an unsecured transaction and (2) the investor (i.e., the lender of cash) receives a higher rate in order to compensate them for the higher credit risk involved. In the U.S. market, there have been cases where dealer firms that went into bankruptcy and defaulted on loans were found to have pledged the same collateral for multiple HIC transactions.

Another method for handling the collateral is for the borrower to deliver the collateral to the lender’s custodial account at the borrower’s clearing bank. The custodian then has possession of the collateral that it holds on the lender’s behalf. This method reduces the cost of delivery because it is merely a transfer within the borrower’s clearing bank. If, for example, a dealer enters into an overnight repo with Customer A, the next day the collateral is transferred back to the dealer. The dealer can then enter into a repo with Customer B for, say, five days without having to redeliver the collateral. The clearing bank simply establishes a custodian account for Customer B and holds the collateral in that account. In this type of repo transaction, the clearing bank is an agent to both parties. This specialized type of repo arrangement is called a tri-party repo.

Determinants of the Repo Rate

Just as there is no single interest rate, there is not one repo rate. The repo rate varies from transaction to transaction depending on a number of factors: quality of the collateral, term of the repo, delivery requirement, availability of the collateral, and the prevailing federal funds rate. Panel A of Exhibit 6.17 presents a Bloomberg screen (MMR) that contains repo and reverse repo rates for maturities of 1 day, 1 week, 2 weeks, 3 weeks, 1 month, 2 months, and 3 months using U.S. Treasuries as collateral on November 15, 2001. Panel B presents repo and reverse repo rates with agency securities as collateral. Note how the rates differ by maturity and type of collateral. For example, the repo rates are higher when agency securities are used as collateral versus governments. Moreover, the rates generally decrease with maturity that mirrors the inverted Treasury yield curve on that date.

Another pattern evident in these data is that repo rates are lower than the reverse repo rates when matched by collateral type and maturity. These repo (reverse repo) rates can be viewed as the rates at which the dealer will borrow (lend) funds. Alternatively, repo (reverse repo) rates are prices at which dealers are willing to buy (sell) collateral. While a dealer firm primarily uses the repo market as a vehicle for financing its inventory and covering short positions, it will also use the repo market to run a “matched book.” A dealer runs a matched book by simultaneously entering into a repo and a reverse repo for the same collateral with the same maturity. The dealer does so to capture the spread at which it enters into a repurchase agreement (i.e., an agreement to borrow funds) and a reverse repurchase agreement (i.e., an agreement to lend funds). For example, suppose that a dealer enters into a term repo for one month with a money market mutual fund and a reverse repo with a corporate credit union for one month for which the collateral is identical. In this arrangement, the dealer is borrowing funds from the money market mutual fund and lending funds to the corporate credit union. From Panel A in Exhibit 6.17, we find that the repo rate for a one-month repurchase agreement is 1.90% and repo rate for a one-month reverse repurchase agreement is 1.97%. If these two positions are established simultaneously, then the dealer is borrowing at 1.90% and lending at 1.97% thereby locking in a spread of seven basis points. The term matched book is something of a misnomer in that most matched books are deliberately mismatched to take advantage of a trader’s expectation of the short-term yield curve. Traders engage in positions to take advantage of (1) short-term interest rate movements and (2) anticipated demand and supply in the underlying bond.

The delivery requirement for collateral also affects the level of the repo rate. If delivery of the collateral to the lender is required, the repo rate will be lower. Conversely, if the collateral can be deposited with the bank of the borrower, a higher repo rate will be paid. For example, on November 15, 2001, Bloomberg reports that the general collateral rate (repos backed by non-specific collateral) is 2.10% if delivery of the collateral is required. For a tri-party repo discussed earlier, the general collateral rate is 2.13%.

The more difficult it is to obtain the collateral, the lower the repo rate. To understand why this is so, remember that the borrower (or equivalently the seller of the collateral) has a security that lenders of cash want for whatever reason. Such collateral is said to be “on special.” Collateral that does not share this characteristic is referred to as “general collateral.” The party that needs collateral that is “on special” will be willing to lend funds at a lower repo rate in order to obtain the collateral. For example, on November 14, 2001, Bloomberg reports the on-the-run 5-year Treasury note (3.5% coupon maturing November 15, 2006) was “on special” such that the overnight repo rate was 0.65%. At the time, the general collateral rate was 2.13%.

While these factors determine the repo rate on a particular transaction, the federal funds rate discussed earlier determines the general level of repo rates. The repo rate generally will trade lower than the federal funds rate, because a repo involves collateralized borrowing while a federal funds transaction is unsecured borrowing. For example, for the period October 2, 2000 to April 6, 2001 (129 observations) the overnight repo rate was, on average, 8.17 basis points below the federal funds rate.

Panel B: Agency Securities

Source: Bloomberg Financial Markets

Callable Repo

In a callable repo arrangement, the lender of cash in a term fixed-rate repo has the option to terminate the repo early. In other words, the repo transaction has an embedded interest rate option which benefits the lender of cash if rates rise during the repo’s term. If rates rise, the lender may exercise his or her option to call back the cash and reinvest at a higher rate. For this reason, a callable repo will trade at a lower repo rate than an otherwise identical conventional repo.