Module #03: Money Market

Money Market
– In money markets, short-term debt instruments (those with an original maturity of
one year or less) are issued by agencies and organizations requiring short-term funds and
is purchased by agencies and organizations with excess short-term funds.
– Once issued, money market instruments will then be actively traded in the secondary
markets.
– It allows the transfer of large sums of money from the suppliers of funds to the users of
funds for short periods of time both quickly and at a minimal cost to the transacting
parties

Primary Market
o Is where securities are being created and sold by firms by (floating) new money
market instruments for the first time
o Market wherein the issuer or the corporation’s capital structure will be affected
because of their involvement in the transaction.
o There will be change in capital structure

Secondary Market
o Is extremely important as it reallocates relatively fixed amounts or liquid funds
in the market over time
o Transaction between existing and prospective investors
o No change in the capital structure

Treasury Bill Rate = Minimum Rate of Return

Why does the money market exist?

– There is an immediate cash need for individuals and companies and governments that
need to be addressed.
– Need does not necessarily coincide with their receipts.
– The reason why economic units hold minimal cash is because having excess, idle cash,
while it is a good buffer for emergencies, there is often an opportunity cost, often in the
form of forgone interest.

Types of Money Market Securities

Below are just some of the common money market securities:
a. Treasury Bills
b. Federal Funds
c. Repurchase agreements
d. Commercial papers
e. Negotiable certificates of deposit (CDs)
f. Banker’s acceptances

Below are just some of the common money market securities in the Philippines:
a. Treasury Bills
o A short term investment, issued by the government, with a maturity period of
one year or less
 b. Commercial Papers
o Securities issued by the corporation, circulated in forms of drafts, checks,
promissory notes, bill of exchange, etc. (can be negotiated).
c. Time Deposits
o From banks, higher interest rates but cannot be withdrawn immediately, cannot
sell to others. There is a transfer of funds from the issuer (bank) and the investor
(depositor).
d. Retail Treasury Bonds and Corporate Bonds
e. Long-Term Negotiable Certificates of Deposit (LTNCD)
o Normally, 5 year period
o A product of the bank wherein the bank issues a CD, which is as good as savings
(covered by PDIC - maximum of 500,000 from the checking account can be
recovered if the bank becomes bankrupt).

For an instrument to be negotiable:

1. Must be in writing and signed by the maker (promissory note) or drawer
(check)
2. Must contain an unconditional promise or order to pay a sum certain in
money
3. Must be payable on demand or at a fixed determinable future time
4. It must be payable to order or bearer
5. Where an instrument is addressed to a drawee, he must be named or
indicated with reasonable certainty

Characteristics of Money Market Securities

– Money market instruments are sold in large denominations
o Because most market participants want or need to borrow large sums of money
to finance their businesses.
o Transaction costs are relatively lower than the interest paid.
o The size of these initial transactions prevents most individual investors from
investing directly in money market securities. Rather, they invest indirectly
through financial institutions such as money market mutual funds.
– These securities have low default risk or the risk of late or non-payment of principal or
interest
o Because money being lent must be available for a quick return to the lender
(usually must be repaid within one year or less)
 Money market instruments can only be issued by high-quality borrowers with little risk
of default.

– The securities sold in the money market must have an original maturity of one year or
less.
o Because the maturity of these money market instruments are short, it helps
lower the interest rate risk that affects market value and price of the security.

Money Market Participants

Who are the money market players and other parties involved
A. The Bureau of Treasury
o As principal custodian of government funds, the Bureau of the Treasury (BTr) is
responsible for ensuring the sufficiency of Government financial resources
including the active management and investment of excess funds. (from the BTr
ISO Certification)
 o They are also the agency responsible for the issuance of the money market
securities in the Philippines

B. Commercial Banks
o They participate as issuers and or investors of almost all money market
instruments.
o This is because in part, they need to meet reserve requirements imposed by the
Central Bank.
o Every amount deposited has a portion reserved and remitted to the Bangko
Sentral ng Pilipinas (BSP).

C. Money Market Mutual Funds

o These pooled funds purchase large amounts of money market securities and sell
them based on the instrument's underlying value.
o Money market mutual funds allow individuals and other small investors to invest
in money market securities.

D. Brokers and Dealers

o Brokers and dealers play a key role in marketing new issues of treasury bills and
other securities.
o They link buyers and sellers in the fed funds market and assist in secondary
trading in other money market securities as well.
o Brokers and dealers also act as intermediaries by linking buyers and sellers of
money market instruments, usually for smaller investors who do not have
sufficient funds to invest in primary issues of money market securities or those
who simply would like to invest in money market securities.

E. Corporations
o Financial and other non-financial corporations raise large amount of funds in the
money market because their cash inflows rarely equal their business needs, they
will often invest their excess cash in money market securities or borrow from
other parties in the money market to raise cash to meet their short-term needs.

F. Other Financial Institutions

o Other financial institutions, such as insurance companies are players in the
money market, because of the unpredictable nature of their liabilities. They are
therefore required to maintain a large amount of liquid assets. To achieve this,
they invest in money market securities.

G. Individuals
o Individual investors participate in the money markets through direct and indirect
investments in money market securities via banks or money market mutual
funds.

Yields on Money Market Securities

– Returns on Money market securities are measured and quoted in a manner that does not
allow them to be evaluated using the time value of money equations because some
securities interest rates are based on a 360-day year while others are based on a 365-day
year.
– It is inappropriate to compare annual interest rates on various money market securities,
other short-term securities and long-term securities without accounting for these
differences.
– it becomes necessary to adjust these interest rates for differences in the securities
characteristics.
– Income of the investor, expense of the issuer

A. Bond Equivalent Yield

o Does not consider the effects of compounding of interest in an investment
horizon of less than 1 year.
o If interest paid is paid or compounded more than once per year, the true annual
rate earned can be calculated using the effective annual return.
o [ t ] is the nominal or stated rate earned on a security over a one-year period. It is
used to calculate the present value of an investment. The formula for bond
equivalent yield is as follows:

Where:
Pf = Face value
P0 = Purchase price of the security
n = number of days until maturity

B. Effective Annual Return

o EAR is used when the investment horizon or the maturity on a security is less
than a year. This accounts for the compounding of interest for certain money
market securities.

Where:
ibe = bond equivalent yield
N = number of days until maturity

C. Discount Yield
o Some money market securities such as treasury bills and commercial papers are
bought at a discount.
o Buying the security at less than face value at the time of purchase.
o The discount is then considered yield or a return for investing.
o The calculation of the returns on discount securities such as T-Bills and CDs are
on a 360-day basis rather than a 365-day basis
o This is used to calculate the interest rates on discount securities.

o To properly compare returns of discount and nondiscount securities, the yield on

the discount securities can be adjusted to reflect its Bond Equivalent Yield by
using the formula below:
 365
360
o Further you will also notice that the discount yield is calculated using the face
value and not the purchase price. This was easier and quicker, thus, it became
the convention for calculating the discount yield even though it meant that the
discount yield is an inaccurate measurement of return.

Discount Yield, Bond Equivalent Yield and Effective Annual Return a Comparison

Suppose you can purchase P 1Million Treasury Bill that is currently selling on a discount
basis at 98.5% of its face value. The T-Bill is 140 days from maturity.

To compute for the discount yield, we use the formula below:

To compute for the bond equivalent yield, we use the formula below:

To compute for the effective annual return, we use the formula below:

Single-Payment Yields
– This is used to calculate returns on money market securities that pay interest only at
maturity. Securities that have single payment yields will receive a final payment at
maturity consisting of interest plus face value of the security.
– Single payment securities normally assume a 360-day year.
 – To properly compare the interest rates on single-pay securities with other types that pay
using a 365- day year, the interest received on single pay securities should be converted
to the bond equivalent yield as follows:

Types of Money Market Securities

A. Treasury Bills
o These are short-term, negotiable and transferable fixed income securities issued
by the Bureau of Treasury in behalf of the Philippine government.
o This is often used by the Philippine government to finance public expenditures
such as:
 Construction of buildings, roads, bridges, schools
 Benefits for the 4 Ps
 Senior Citizen Assistance
 Other expenditures supporting the general public welfare, etc.
o In the Philippines, T-Bills have 3 different tenors: 91-day, 182-day and 364-day
T-Bills
o Often sold at a discount and redeemed at face value upon maturity. Investor
earns the spread in exchange for allowing the government to borrow your money
 Face Value – the face value of the T-Bill is the nominal value or the
peso value of the T-Bill
 Maturity Date – the date when the face value of the T-Bill must be paid
back.
 Settlement Date – the date when the trade on the T-Bill becomes final.
The day when the buyer must pay for the securities being acquired.
 Bid Price – the price at which the buyer is willing to purchase the
security.
 Ask Price – the price is the price being sought by the seller for security.
 Ask Yield – the return the investors would receive if they paid the ask
price and held the T-Bill to maturity.
o As a rule, “BUY AT ASK, SELL AT BID”

How do you earn from T-Bills?

Example: A P 1,000,000 91-day T-Bill was sold for P 900.00 on Jan 1, 2021. On April 2,
2021, it is redeemed at P 1,000,000.
o The investor earns the spread of P 1,000,000 for allowing the government to
borrow his/her money.

Treasury Bills Example:

Suppose you bought a T-bill maturing Sep 15, 2016 for P 9,991.362. The T-Bill
matures 122 days after the settlement date on May 17, 2016 and has face value of P
10,000.00

Calculating The Ask or Discount Yield

 Calculating The Bond Equivalent Yield

Calculating The Effective Annual Rate

B. Federal Funds
o These are short- term unsecured loans between financial institutions usually for a
period of one day by trading their excess reserves at their local federal reserve to
other banks that need to borrow funds because they a short of reserves.
o Transaction between banks.
o The overnight interest rate in the interbank lending market is the federal fund
rate. It is the interest rate for borrowing federal funds
o Federal funds are considered single-payment loans. Since the borrowing bank
will pay the lending bank the face value of the loan and the interest at the
prevailing federal fund rate.

Federal Funds Yields

o Federal funds are considered single-payment loans. Since the borrowing bank
will pay the lending bank the face value of the loan and the interest at the
prevailing federal fund rate.

Example: The overnight federal funds rate for Aug 2021 was 0.09%. To convert this to
bond equivalent yield, we use the single payment yield formula:

Because fed funds are loaned only for a day, we can calculate the EAR as well:

C. Repurchase Agreements
o These are agreements involving the sale of securities to one party by another
with a promise to repurchase the same securities at a specific price on a specific
date in the future.
 Similar with pacto de retro sale
 Collateralized federal fund loan
 o Often arranged between two parties directly or with the help of brokers or
dealers.
o Buyer acquires the title to the securities for the term of the agreements
o Upon maturity of the repurchase (repo), the transactions are reversed and the
repo seller or the borrower transfers additional cash corresponding to the
payment of interest.
o This is basically a collateralized federal fund loan, The collateral being the
securities.
o These have very short-term maturity, usually from 1-14 days.
o The loans are slightly smaller than the market securities pledged as collateral to
account for the underlying risk of the collateral security

Repurchase Agreement Yields

o Repurchase agreements are backed by treasury securities, the risk on these
agreements are low and the interest rates are lower than the uncollateralized fed
funds. The repurchase agreement yields are computed at an annualized
percentage between the initial selling price of the securities and the agreed
repurchase price using. A 360-day year.

Where:
Pf = Repurchase price of securities (selling price + interest paid on the
repurchase agreement)
P0 = Selling price of the securities
n = number of days until the repurchase matures

Repurchase Agreements Yields: An Example

Suppose a bank enters a reverse repurchase agreement in which it agrees to buy
fed funds from one of its corresponding banks at a price of 10 million, with a promise to
sell these funds back at 10,000,291.67, including interest, after 5 days. The yield is
calculated below:

D. Commercial Papers
o A short-term unsecured, promise to pay (promissory note) issued by a
corporation to raise short-term cash often to finance working capital
requirements.

In section 1 of the Negotiable Instruments Law, for an instrument to be

negotiable:
1. Must be in writing and signed by the maker (promissory note) or drawer
(check)
2. Must contain an unconditional promise or order to pay a sum certain in
money
 3. Must be payable on demand or at a fixed determinable future time
4. It must be payable to order or bearer
5. Where an instrument is addressed to a drawee, he must be named or
indicated with reasonable certainty

If only the first 4 requisites are met, then it is a promissory note. If there is a
drawee included, then it is a bill of exchange.

o These are single payment securities often sold at a discount with interest
payments made at the maturity date.
o Companies with a strong credit rating can borrow money at a lower interest rate
by issuing a commercial paper than by directly borrowing money from the bank
via a loan.

Commercial Paper Yields: An Example

Suppose Mr. Rodriguez purchases a 95-day commercial paper with a par value
of 1 million for the price if P 990,023.

The Discount Yield on the commercial paper would be: 3.78%

The Bond Equivalent Yield is: 3.87%

The Effective Annual Return is: 3.93%

E. Negotiable Certificates Of Deposit

o This is a bank-issued time deposit that specifies interest rate and maturity date
and is negotiable in the secondary market.
o Well-known banks can offer CDs at slightly lower rates than their lesser known
counterparts. Newly established banks offer higher interest rates compared to
well-known banks to encourage investors to invest.
o It is a Bearer Instrument – meaning, whoever holds the CD at the date of
maturity is entitled to receive the principal and interest.
 Unlike an order instrument where the name of the entitled receiver is
specified (endorsed) in the instrument.
 Once a bearer instrument, always a bearer instrument.
 An order instrument can be a bearer instrument if it is endorsed in blank.
 It is more practical to buy a CD, closer to its maturity date.
o These are purchased by money market mutual funds – a pool of funds of
individual investors used to indirectly purchase negotiable CDs.
 If you were to invest in a mutual fund company, your money will go to
their mutual fund, in exchange of their shares of stock. The funds they
collected will be invested either in stocks, bonds, or a CD (short-term).
  Mutual fund companies balance their funds placement. They will not put
all of their money in stocks. They will allocate it to different investment
opportunities.
o In the Philippines we have Long term Negotiable Certificates of Deposit which
have a longer tenor than the CD in the US.
Yields Negotiable Certificate Of Deposit
A bank has issued a 6-month 1 million CD with a 0.72% quoted annual interest
rate. The bond equivalent yield will be:

At maturity (IN 6 MONTHS), the investor will receive:

The Effective Annual Return on the CD is:

F. Banker’s Acceptance
o A time draft payable to seller of goods and services, with the payment
guaranteed by a bank.
o This money market instrument from international trades and letters of credit
used to finance trade in goods that have yet to be shipped from a foreign
exporter to a domestic buyer where the foreign sellers prefer banks to act as
guarantor for payments before sending the goods to local importers.
 Example: Letter of Credit or Guarantee
 You bought a condo unit in SMDC, and your balance of 80% is
to be bank financed.
 The developer will not turnover the unit to you without a letter
of guarantee from the bank, stating that you have entered into a
bank loan or financing that is guaranteed to be credited in
SMDC’s account.
o If there is an immediate need for cash, the foreign exporters can sell the
acceptance before the maturity date at a discount. The ultimate bearer will
receive the face value of the acceptance at maturity date.

Practice Problems:
What is the discount yield, bond equivalent yield and effective annual return on a P 1
million treasury bill that currently sells at 99.375% of its face value and is 65 days from
maturity?

To compute for the discount yield, we employ the formula below:

 To compute for the bond equivalent yield, we employ the formula below:

To compute for the effective annual return, we employ the formula below:

You would like to purchase a T-Bill that is 125 days from maturity for P 9,875. The T-
Bill has a face value of P 10,000.00. Calculate the T-Bill’s quoted discount yield and its bond
equivalent yield.

The Quoted Discount Yield is:

The Bond Equivalent Yield is:

You can buy a commercial paper for a major PH corporation for P 498,000.00. The
commercial paper has a face value of P 500,000.00 and is 45 days from maturity. Calculate the
discount yield and the bond equivalent yield on the commercial paper.

The Quoted Discount Yield is:

 The Bond Equivalent Yield is:

Paul Justin would like to purchase a treasury bill that is 100 days from maturity for
P9,750. The treasury bill has a face value of P 10,000. How much is the discount yield?

id =( 10,000−9,750
10,000 ) x 360 =
250
x
360
100 10,000 100
=0.025 x 3.6=0.09∨9 %

Harold is purchasing a commercial paper from RB Corporation for P 494,700.00. The

commercial paper has a face value of P 500,000.00 and is 63 days from maturity. Calculate the
bond equivalent yield on the commercial paper.

i be = [ (500,000−494,700 ) 365
494,700
x
63 ]
=0.06207∨6.21 %

Marco has invested all his 1,000,000 savings in treasury bills. He wants you to calculate
for the bond equivalent yield and effective annual return on the treasury bills he bought at 99.4%
of its face value, 35 days maturity.

[
i be =
(1,000,000−994,000 ) 365
994,000
x
35 ]
=0.06294∨6.29 %

( )
365 /35
0.06294
EAR= 1+ −1
365/35

( )
10.42857
0.06294
¿ 1+ −1=0.06476∨6.48 %
10.42857

AJ has invested in a 3-month 1,000,000 certificate of deposit with an annual interest rate
of 1.5%. How much will he be receiving at maturity in total from this investment?

At maturity=1,000,000 1+ ( 1.52 %
4 )
=1,003 , 800

Mayee owns a 50-day maturity money market security that has a bond equivalent yield
of 3.60%. The EAR of this security is?
 ( )
365/ 50
0.0360
EAR= 1+ −1=3.66 %
365 /5 0

Luis just bought a P10,000 treasury bill a 120- day treasury bill that has a discount yield
of 4% today. At what price did he buy it for to the nearest peso?

[ (
EAR= 1− 0.04 x
120
360 )]
−1=9866.67