Money Market

&
Capital Market

1
 THE MONEY MARKET
• Money market is the term designed to include the financial
institutions which handle the purchase, sale & transfers of
short term credit instruments.
• Money-Currency-is not traded in the money markets.
• Only those securities having short term maturity period and
are close to being money securities are traded.
• The money market, therefore, is a component of the
financial markets for assets involved in short-term
borrowing and lending with original maturities of one year
or shorter time frames.
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Why Money Markets?

•Money markets have a cost advantage over banks

because of two facts.

1.Reserve requirement by central banks of a country

reduces the total amount of investible funds received
from depositors by setting a minimum reserve
requirement to commercial banks.

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2. Interest rate restrictions are used to avoid
competition among banks. This substantially
reduce the competitiveness of the banking
industry with money markets which do not
worry about such restrictions especially during
the times of high inflation

• The above two have contributed immensely for

the development of money markets.

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Characteristics of The Money Market
• The money market securities have three basic common
characteristics:
1. They are usually sold in large denominations. Money
Market Mutual funds can mitigate (alleviate) this
problem
2. They have low default risk

3. They mature in one year or less from their original

issue date. Most money market instruments mature
in less than 120 days
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4. Money market transactions do not take place in
one particular location or building rather traders
usually arrange purchase and sales between
participants over a phone and complete them
electronically.

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5. Active secondary markets makes money market
securities very flexible instruments to use to fill short
term financial needs that is the only reason why most
organizations in countries having well-developed
financial markets report them as cash on their balance
sheets.
6. Money markets are wholesale markets: most
transactions are very large as a result of this large size
most individual investors cannot invest their money
directly in the money markets. 7
• To solve this problem dealers and brokers,
operating in trading rooms of large banks and
brokerage houses, bring customers together.
• Despite the wholesale nature of the market,
innovative securities and trading methods help
investors enjoy the benefits of money market
securities.

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 The Purpose of the Money Markets

1. The well developed secondary market for money market

instruments makes the money market an ideal place for
economic units to warehouse surplus funds temporarily.
2. Similarly, the money markets provide a low cost source
of funds to firms, governments (state and local), and
intermediaries that need a short-term infusion of funds.

3. Money market funds provide a means to invest idle

funds and to reduce opportunity cost of lost interest

income because of not investing.

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Participants of the Money Market
1. Central banks
• Central Banks are frequently engaged in
injection and absorption of money supply in the
economy using a tool known as open market
operations.
• The central bank’s responsibility for money
supply makes them the single most influential
participant in the money market.
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2. Commercial Banks (CBs)

• CBs hold a large percentages of government

securities than any other institutions in many
countries including Ethiopia.
• Commercial banks in Ethiopia are the dominant
players in the country’s money market.
• In many countries regulations prohibit CBs from
investing in high risk corporate bonds and stocks
that have a higher rate of returns but entail huge
associated risks. 11
• Since money markets instruments provide almost riskless
investment opportunity with an added advantage of high
liquidity, the CBs are major issuers of money market
instruments.
3. Businesses
• Many business firms buy and sell securities in the money
market to finance their short-term capital needs as well as
to warehouse their excess funds.
• Many large corporations and firms engage in both sides
of the market as money market investments are
substantial in size. 12
4. Investment Companies: are large diversified
brokerage firms that are active in the market to
trade on behalf of their commercial accounts.
• They are very important to the liquidity of the
money market because they ensure that both
buyers and sellers can readily market their
securities.
5. Finance Companies: lend funds to individuals

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 6. Insurance Companies: property and casualty
insurance companies must maintain the liquidity
because of their unpredictable need for funds.
• Such firms, therefore, should invest some amount of
their investment funds in money market securities to
raise cash during emergency situations.
7. Pension Funds: these companies invest a portion of
their cash in money markets so that they can take
advantage of investment opportunities that they may
identify in the stock or bond markets.
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8. Individuals
• With the special help of the money market
mutual funds individual investors with
relatively small amounts of cash to invest can get
an access to invest on large denomination money
market instruments.

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Money Market Instruments

• Many number of money market instruments are available to

meet the needs of a wide range of participants in the money
market.

• The following sections discuss the following major ones:

1. Treasury bills

2. Federal Funds

3. Repurchase Agreements

4. Certificates of Deposits (CDs)

5. Commercial Papers

6. Bankers Acceptances

7. Eurodollars 16
1. Treasury Bill
• T-bills are one of the debt securities that a government issues
having a great advantage of liquidity.
• The Treasury Bill market is the only active primary market in
Ethiopia.
• Tenders/Invitations are offered periodically by the Central Bank.
• The government offers 28‐day, 91 day and 182‐day bills.

• A sample of the amounts offered and yields on T ‐Bills is shown

in the table that appear in the following slide.
• Any one can participate in the auction of Treasury Bills with the
minimum amount of birr 5000.
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18
• Most money market instruments do not pay
interest. Rather the investor pays less for the
security than it will be worth when it matures, and
the increase in price provides a return.

• In simple terms, short-term securities are issued at

discount and redeemed at par. This is because they
often mature before the issuer can mail out interest
checks.
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• The yield on an investment is found by computing the
increase in value in the security during its holding period.

• i.e. the annualized yield on the investment is found using

the following formula:

• For example, let's say you buy a 91 days T-bill priced at
$9,800. Essentially, the government writes you an IOU (I
owe you) for $10,000 that it agrees to pay back in 91 days. 
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• You will not receive regular payments as you would
with a coupon bond, for example. 
• Instead, the value to you that you will get comes from the
difference between the discounted value you originally
paid and the amount you receive back ,10,000. 
• In this case, the T-bill pays you a 2.04% interest rate of
return ($200/$9,800 = 2.04%) over a 91days period. The
annualized yield on investment can be:

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T-bills risk
• T-bills virtual have zero default risk because the
government can’t fail to pay interest and maturity
value on the maturity date.
• For this reason, t-bill rate are usually considered as
the risk free rate of return when valuing different
securities.

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• The t-bills in countries having good financial
market conditions is deep and liquid.
• Deep: presence of many buyers and sellers of a
security in a market.
• Liquid: when securities can be transferred
from on investor to another quickly and
without incurring substantial transaction costs.

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Features of TB
• Issuer: it is issued by the government for raisings
short term funds for bridging temporary gaps
between revenue and expenditure.
• Liquidity: it enjoys high degree of liquidity
• Monetary Mgt: TBs serve as an important tool of
monetary management used by the central bank of
the country to influence liquidity in to the economy.

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2. Federal Funds(interbank lending)/call money
• Are short-term funds transferred among financial
institutions usually for a period of one day.

• One of the regulation tools that central banks can use to

ensure the investor protection and liquidity in the
financial sector is setting a minimum reserve
requirement for banks that a certain portion of their
funds collected from savers in the national bank account
without earning interest.
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• To meet these reserve requirements, banks must
maintain adequate deposits in their central bank
account. At the end of daily transactions some banks
may fall short of the requirements while some ended up
with excess funds in their accounts.

• Therefore banks with shortages will borrow from banks

having excess funds for overnight. The government can
indirectly control the federal funds market by altering
the reserve requirement.
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Terms of Federal Funds
• Terms of agreements for federal funds is one day and
frequently referred to as overnight investments (call money).

• Banks analyze their reserve position on a daily basis and either

borrow or invest in these funds, depending on whether they
have excess or deficit reserves.

• A bank with excess money will call up on its correspondent

banks having reciprocal accounts and sell its excess funds to
bank(s) that offer highest rate.
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• When the dealing concludes the investor bank immediately
transfers the contracted amount to borrowers account in the
central bank using electronic communications.

• The next day, the funds are transferred back, and the
process begins again.

• The federal funds are short-term unsecured loans as deals

are completed by oral communications of participants.

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Characteristics of call money market

1. The maturity period is one day

2. “The fund" is repayable on the immediate next working day

3. The transactions are not covered by any collateral security

because call loans are repayable on demand at the option of the

borrower or lender or at a very short notice.

4. This market is the most sensitive segment of the financial

system because any change in demand & supply of short term

funds in the financial system is quickly reflected in call money

rate.
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3. Repurchase Agreements (Repos)
• Repos are much like federal funds except that non
banks can participate. In repos a firm can sell
treasury securities by agreeing to buy them back at
a specified future date.
• Most repos have a short-term maturity usually
from 3 to 14 days. However, there are also markets
for 1-3 months repos.

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• Government security dealers usually engage in repos.
The dealers may sell it to a bank with a promise that it
will buy the securities back the next day this makes
repo a short-term collateralized loan.
• Because of their collateralized nature they hold low
risk of default and ultimately have low interest rate
returns.
• Central banks also engage in repos market to conduct
the monetary policy.

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4. Negotiable Certificates of Deposits (CDs)
• Certificate of deposit is a financial document showing
that a person or organization has a specified sum on
deposit at a bank, usually for a specific period, at
special interest rate.
• A negotiable CD is a bearer instrument that whoever
holds the instrument at the date of maturity can
receive the principal and interest. The CD can be
bought and sold in the secondary market until
maturity.
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• The maturity of CDs usually ranges from 1-4
months.
• CDs charge a rate slightly higher than T-bills
because that have a slightly greater chance of
default.
• CDs are usually denominated in higher currency
values.

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Characteristics of CD
• Negotiable instrument: CDs are negotiable term
deposit certificate issued by commercial banks.
• Maturity: The maturity period of CDs ranges from 15
days to one year.

5. Commercial Papers (CPs)

• CP securities are unsecured promissory notes issued
by corporations that mature in no more than 270 days
(9 months).
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• Since CP is unsecured, only largest and most
creditworthy corporations issue them.
• Just like T-bills, CPs are issued at discount and
mature on face value.
• Thus, a commercial paper is defined as a debt
instrument that is issued by well known, high
creditworthy corporations for raising short term
financial resources from money market.

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Characteristics of CP

 They are unsecured debts of corporate.

 They are issued in the form of promissory notes

 They are redeemable at par to the holder at

maturity, i.e., they are issued at discount to face
value.

 They are issued by top rated corporate

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6. Bankers Acceptances-BOE
• Banker’s acceptance is a bank draft (a promise of payment
similar to a check) issued by a firm, payable at some
future date and guaranteed for by a fee by the bank that
stamps it as “accepted”.

• It is a short-term discount instrument that usually arises in

the course of international trade.

• It can also be defined as a short term credit investment
created by a non- financial firm and guaranteed by a bank
to make payment.
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• The firm issuing the instrument is required to
deposit the necessary funds into its account to
cover the draft.
• If the firm fails to do so, the bank’s guarantee
obligate the bank to cover the draft.
• These “accepted” drafts are often resold in a
secondary market at discount similarly as
Treasury Bill.

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7. Eurodollar
• Many contracts from various countries around the
world require payments be made in U.S. Dollars
due to dollar’s stability.
• For this reason many companies and governments
choose to hold dollars.
• Before cold war, these currency deposits were
made in New York money center banks.

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• Starting from cold war, with the fear that these deposits may be
expropriated some large London based banks responded by
offering to hold dollar denominated deposits in British banks.

• These deposits are then named as Eurodollars.

• The Eurodollar market continued to grow for the following

reasons:

1. Depositors can receive higher returns on dollar deposits in the

Eurodollar markets than in the domestic markets.

2. Borrowers can be able to receive a more favorable rate in the

Eurodollar markets than in the domestic markets. 40

• It has to be noted that the Eurodollar market is the
replacement of the federal funds that banks from
around the world buy and sell overnight funds in this
market.
• The rate paid by banks borrowing from Eurodollar
market are called London Interbank Bid rate LIBID.
• Funds are offered for sale in Eurodollar market at a
rate called London Interbank offer rate LIBOR. The
difference between the LIBID and LIBOR is the
proceed to the dealer.
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Money Issuer Buyer Usual Secondary
market Maturity Market
security
T-Bills Government Consumers and 4 weeks -1 Excellent
companies year

Federal Banks Banks 1-7 days none

Funds
Repos Business and banks Businesses and 1-15 days Good
banks

CDs Large Banks Businesses 14-120 days Good

CPs Finance Companies Businesses 1-270 days Poor
and businesses

Banker’s Banks Businesses 30-180 days Good

Acceptances

Eurodollar Foreign or non-U.S. Businesses, 1day to 1 poor

deposits Banks gov’ts and year
banks

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CAPITAL MARKETS

• Capital market is a market in which individual and

institutional investors trade long-term financial securities

(Debt and Equity) among themselves.

• Capital market instruments are defined as long term

instruments with an original maturity of greater than one

year.

• Proceeds from the sale of capital market instruments are

usually invested in assets of a permanent nature such as

industrial plants, equipment, buildings, and inventory. 43

Capital Market Participants

1. Capital market bring together BORROWERS and

SUPPLIERS of long term funds.

2. The market also allows people who hold previously

issued securities to trade those securities for cash in
the secondary capital markets.

3. Financial intermediaries purchase funds from

individuals and others, and then issue their own
securities in exchange.
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4. Individuals and households may invest
DIRECTLY in the capital markets but, more
likely, they purchase stocks and bonds through
financial institutions such as commercial banks,
insurance companies, mutual funds and pension
funds.

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1.1.The
TheBond
BondMarket
Market
•• A
A bond
bond isis aa promise
promise to
to make
make periodic
periodic coupon
coupon payments
payments
and
and to
to repay
repay principal
principal at
at maturity;
maturity; breach
breach of
of this
this promise
promise isis
an
anevent
eventof
ofdefault,
default,or
or
•• Bond
Bondisisaadebt
debtinvestment in
investment inwhich
whichan investor
an investorloans
loansmoney
money
to
to an
an entity
entity (corporate
(corporate or
or governmental)
governmental) that
that borrows
borrows the
the
funds
fundsfor
foraadefined
definedperiod
periodof
oftime
timeat
ataafixed interest
fixed interestrate.
rate.

•• Carry
Carryoriginal
originalmaturities
maturitiesgreater
greaterthan
than one
oneyear
yearso
sobonds
bondsare
are
instruments
instruments of
of the
the capital
capital markets
markets and
and issuers
issuers are
are
corporations
corporationsand
andgovernment
governmentunits
units 46
• Bonds are used as a means of financing variety of
projects and activities by companies, municipalities,
state, local and foreign governments.
• Bonds are commonly referred to as fixed-income
securities and are one of the three main financial
asset classes, along with stocks and cash equivalents
(i.e., money market securities).
• The place where bonds and other debt instruments
are sold is called the debt market.
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Basics of Bonds
• Corporate borrowers issue bonds both to raise finance
for major projects and to cover ongoing and
operational expenses.
• Bonds are also issued by public authorities, credit
institutions, companies and
supranational(Multinational) institutions in the
primary markets.
• The most common process of issuing bonds is through
underwriting. 48
• In underwriting, one or more security firms or
banks, forming a syndicate/association, buy an
entire issue of bonds from an issuer and re-sell
them to investors.

• The security firm takes the risk of being unable to

sell on the issue to end investors.

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2.2.Treasury
TreasuryNotes
Notesand
andBonds
Bonds
•• T-notes
T-notes and
and T-bonds
T-bonds issued
issued by
by the
the U.S.
U.S. treasury
treasury to
to finance
finance
the
thenational
nationaldebt
debtand
andother
otherfederal
federalgovernment
governmentexpenditures
expenditures
•• Backed
Backed by
by the
the full
full faith
faith and
and credit
credit of
of the
the U.S.
U.S. government
government
and
andare
aredefault
defaultrisk
riskfree
free
•• Pay
Payrelatively
relativelylow
lowrates
ratesof
ofinterest
interest(yields
(yieldsto
tomaturity
maturity
•• Given
Given their
their longer
longer maturity,
maturity, not
not entirely
entirely risk
risk free
free due
due to
to
interest
interestrate
ratefluctuations
fluctuations
•• Pay
Pay coupon
coupon interest
interest (semiannually),
(semiannually), notes
notes have
have maturities
maturities
from
from1-10
1-10yrs,
yrs,bonds
bonds10-30
10-30yrs
yrs

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3.
3.Municipal
MunicipalBonds
Bonds
•• Securities
Securities issued
issued by
by state
state and
and local
local governments
governments to
to fund
fund
either
either temporary
temporary imbalances
imbalances between
between operating
operating
expenditures
expenditures and
and receipts
receipts or
or to
to finance
finance long-term
long-term capital
capital
outlays
outlays for
for activities
activities such
such as
as school
school construction,
construction, public
public
utility
utilityconstruction
constructionor
ortransportation
transportationsystems
systems
•• Tax
Tax receipts
receipts or
or revenues
revenues generated
generated are
are the
the source
source of
of
repayment
repayment
•• Attractive
Attractive to
to household
household investors
investors because
because interest
interest (but
(but
not
notcapital
capitalgains)
gains)are
aretax
taxexempt
exempt
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4.
4. Corporate
Corporate Bonds
Bonds
•• All
All long-term
long-term bonds
bonds issued
issued by
by corporations
corporations
•• Minimum
Minimum denominations
denominations publicly
publicly traded
traded
corporate
corporate bonds
bonds is
is $1,000
$1,000
•• Generally
Generally pay
pay interest
interest semiannually
semiannually
•• Bond
Bond indenture/agreement:
indenture/agreement: is
is aa legal
legal contract
contract
that
that specifies
specifies the
the rights
rights and
and obligations
obligations of
of the
the
bond
bond issuer
issuer and
and the
the bond
bond holder
holder
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Cost of Bonds to the Issuer

• Cost of bond financing > short-term borrowing

• Major factors affecting the cost, i.e. interest rate

paid by the bond issuer:

– Maturity

– Issuer’s risk

– Cost of money
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• The longer the bond’s maturity, the higher the interest rate
(or cost) to the firm.
– Long-term debt pays higher interest rates than short-
term debt
– The longer the maturity of bond, the less accuracy there
is in predicting future interest rates; so the greater the
bondholder’s risk of giving up an opportunity to lend
money at a higher rate.
– The longer the term, the greater the chance that the
issuer might default.
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• The greater the default risk of the issuer, the
higher the cost of the issue (interest rate).

– Some of this risk can be reduced through the

inclusion of appropriate restrictive provisions in
the bond indenture.

– Bondholders must be compensated with higher

returns for taking greater risk.

– Bond buyers frequently rely on bond ratings to

determine the issuer’s overall risk. 55
• The cost of money in the capital market is the
basis for determining a bond’s coupon interest
rate.

– The rate on US Treasury securities of equal

maturity is used as the lowest-risk cost of
money.

– To that basic rate is added a risk premium that

reflects the above factors: maturity, and issuer’s
risk.
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Stock Markets
• Organizations/institutions in the public and
private sectors also often sell securities on the
capital markets in order to raise funds.
• Places where equity securities are traded are
called stock markets.

57
Stock Markets

Primary Markets
 A primary market sale may be a first-time issue by a
private firm going public called initial Public Offerings
(IPOs) or it can be issuance of new stock by a firm which
already placed its some shares in primary markets.
 In a primary market, stocks can be issued through either a
public sale where the stock is offered to the general
investing public or a private placement where the stock is
sold privately to the limited number of large investors.

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The End!

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