Comprehensive Analysis of Money Market, Eurocurrency, and Fed Funds

This report provides a detailed analysis of the money market, Eurocurrency market, and related financial instruments. It explores the functions of the money market in transferring funds, distinguishing between the capital and money markets, and outlining the key participants including commercial ba...Read More

THE MONEY MARKET
Functions of the Money Market
The purpose of the money market is to transfer funds from lenders to borrowers. A common
distinction made by money market participants is between the “Capital Market and the “Money
Market”, with the latter term generally referring to borrowing and lending for periods of a year
or less.
The money market encompasses a group of short term credit market instruments, futures market
instruments and the Federal Reserve discount window. The major participants in the money
market are commercial banks, government, brokers and dealers and the Federal Reserve.
THE EUROCURRENCY MARKET
What is the Eurocurrency Market?
Definition:
A Eurocurrency is a currency which is available for deposit or loan in a country which is not the
domestic currency. As such, it can be virtually any currency which is not subject to stringent
control in its domestic location and is not limited to only European currencies. Then why “Euro”
in the name? This was because the market for the depositing and lending of such funds first
started in Europe in the 50’s and early 60’s.
The definition given above embraces all currencies for “Euro” purposes but such is the
omnipotence of the US$ that the market itself s often referred to as the Eurodollar market. The
major currencies and to a certain extent in varying degrees other currencies such as Saudi Riyals
and S$ are also found suitable. In fact, ignoring Exchange Controls, any convertible currency if it
is backed by a swap market can exist in Euro form.
The Eurocurrency market is essentially a deposit market and there is no buying or selling of
currencies. The period of time for the deposits most commonly range from call to 6 months
although some business is concluded on periods up to 10 yea
Profile of the Eurocurrency Market
Historically, the Eurocurrency market started with the Eurodollar market. After World War 2, the
communist countries in Europe found themselves with foreign exchange reserves denominated
largely in US$. The natural way to hold these reserves would have been to keep them in bank
deposits and other securities in the United States. However, due to the cold war which existed
after the war, the danger that the United States might expropriate or otherwise control these !)

reserves became unacceptable to these communist countries. As an alternative, these countries
began placing their deposits in banks outside the United States, often in London. The deposit
were still denominated largely in US$, however the immediate legal iabilities fell outside the
United States. The sharp rise of crude oil prices in the early 1970’s led to vast accumulation of
dollar reserves (later known as petro-dollars) which further accentuated the growth of this
market.
Market Features:
1) Must be unregulated – there must be complete freedom in the flow of funds to and from the
market, that is, no central bank, government bodies or international bodies in any of the
participating countries to control the flow of the market ( although in recent times because of the
terrorist scourge some form of controls were implemented to stem the flow of funds to these
groups).
2) No reserve requirement against Eurodeposits
3) The Eurodeposit is an external currency deposit in the country it is located, hence the term
“Offshore Banking” to refer to such funding activities.
4) Wholesale market – it is predominantly an interbank market. Amounts normally range from
US$1 million upwards- although sizes of 0.5 million or less may be dealt.
5) Primarily short-term – Overnight to 1 year most readily quoted. There is a very thin market for 1
to
5 years and hardly anything beyond 5 years.
6) Eurocurrency interest rates are typically higher than the domestic interest rates because there is
no reserve requirement.
All transactions are done on an unsecured basis without collateral or securities.
EURO-DOLLAR MARKET
Factors contributing to the Growth of the Eurodollar Market
While the cold war may have kicked off the Euromarket, there were other factors that stimulated
its development. Historically, the GBP played a key role in world trade. A great deal of trade not
only within the British Commonwealth nations and the rest of the world or between non-
commonwealth countries was denominated in GBP and financed in London through borrowing of
GBP. After World War 2, this began to change as the UK ran began to run big balance of payment
deficits and as a result led to the devaluation of the GBP.The chronic weakness of the GBP made
it a less attractive currency to earn and to hold which inturn stimulated the trend for more and more
international trade to be denominated in US$.

During the early 1950’s when the Russian and East European banks began depositing US$ outside
The United States, the London branches of U.S banks were not taking Eurodollar deposits. They
began to do. So very reluctantly several years later when some of their good US customers said to
them “Cant’t you Take our deposits in London?. The foreign banks do and they give u better rates
than you can in New York Because of Regulation Q- the imposition of maximum interest rates on
certain categories of deposits offered By domicile American banks. For several years this worked
out satisfactorily because the head offices of the US banks involved could use the dollars deposited
with their London branches in the U.S; this was so because the structure of loan and other interest
rates in the U.S was such that US banks could well afford to pay higher rates than those permitted
under Regulation Q.
A third factor that stimulated the growth of the Euromarket was the operation of Regulation Q
during the tight money years of 1968 and 1969. At that time, US money market rates rose above
the rates that banks were permitted to pay under RegulationQ on domestic large denominated
CD’s. In order to finance loans US banks were force to borrow money in the Euromarket. The
operation of Regulation Q also encouraged foreign holders of dollars who would have deposited
them in New York to put them in London.
The persistent balance of payments deficits in the U.S have often been given substantial credit for
the development of the Euromarket. By spending more abroad than it earned, the U.S. in effect put
dollars into the hands of foreigners and thus created a natural supply of dollars in the Euromarket.
What has made the Euromarket attractive to depositors and given it much of its vitality is the
freedom from restrictions under which this market operates, in particular the absence of the
implicit tax that exists on US domestic bankingactivities because of the reserve requirements
imposed by the Fed.
Petro-Dollars
Major Eurocurrency Centres
A) Europe – London, Paris, Zurich and Frankfurt
B) Asia – Singapore, Hong Kong, Tokyo and Australia.
C) Middle East – Bahrain
D) Western Hemisphere – Nassau and Grand Cayman
Fed Funds and Clearing House Funds:
Federal Funds or Fed Funds as they are commonly called are funds held in a bank’s reserve
account at its local Federal Reserve Bank. There are 12 Federal Reserve Banks each for one of the
12 Federal Resrve districts which the U.S is divided into. Thus all banks that are members of the
Federal Reserve System are required to keep minimum reserves at their respective Federal Reserve
Bank. A commercial bank’s reserve account is much like a consumers checking account; the bank
makes deposit into it and can transfer funds out of it.The main difference is that while a consumer
can run the balance in his checking account down to zero, each member bank is required to

maintain some minimum average balance in its reserve account and that minimum balance
depends on the size of the previous weeks. Hence any increase in bank deposits entail the supply
of Fed Funds, while loans made and securities purchased reduce that supply. Thus the basic
amount of money any bank can lent out and otherwise invest equals the amount of funds it has
received from depositors minus the reserves it is required to maintain.
For some banks, this supply of available funds roughly equals the amount they choose to invest in
securities plus that demanded from them by borrowers. But this may not be the case for most
banks. In reality, because the nations largest corporations tend to concentrate their borrowing in
big money centre banks in New York and other major financial centres, the loans and investments
these banks have to fund exceed the deposits they receive. In contrast, many smaller banks receive
more money from local depositors that they lend locally or choose to invest. Many of these smaller
regional banks have excess funds at the Federal and therefore are able to lend to big money centre
banks.
The borrowing is done in the Fed Funds Market. Most of the Fed Funds loans are for overnight
transaction.Some of these transactions are made directly between banks while others are done
through money brokers in the big money centres. Lending of Feds is usually referred to as sale
while borrowing of Feds is usually referred to as purchase. Longer period transactions are referred
to as term Fed Funds.
-3-
The importance of the Fed Funds Market
The rate of interest paid on overnight loans of Fed Funds (Fed Funds rate) is the key interest rate in
the money market and all other short-term rates are influenced by it. Without doubt this market has
grown to become one of the most important market in the U.S. and is watched very closely by the
rest of the financial markets globally.
The importance of this single day rate stems from the fact that it gives a clue to the rest of the
world’s financial community to the monetary inclinations of the Federal Reserve. This rate is
highly sensitive to the Federal Reserve actions through its control and provision of reserves of
member banks in the U.S. The level of Fed Funds rate influences the yields and as such the overall
return on investment and likewise the cost of money.
Repurchase Agreement or Repos
Apart from the Fed Funds market which is mainly an overnight market, banks or securities dealers
needing funds or having excess funds for a slightly longer period can turn to the repo market. A
repo agreement is the sale of securities under an agreement to repurchase it back at a later date
(normally a few days). Effectively, this is borrowing using the securities as a collateral. It is free of
reserve requirements.
Discount Rate ( lender of last resort)

The oldest instrument of central banking is what is called the “Bank Rate “ in the UK and the
discount rate of the Federal Reserve Banks in the U.S. The discount rate charged to would-be
borrowers (commercial banks) dictates all other key interest rates such as prime rates. However,
care should be taken to generalize the above statement as the traditional view of the importance of
the discount rate has changed in recent years. Open market operations are now seen as the most
powerful and flexible monetary tool of the Fed.
Nostro and Vostro Accounts
For money market and foreign exchange operations which involves sizeable foreign currency
funds flow, banks maintain an intricate network of accounts and counteraccounts among different
banks all over the world. A local bank in Singapore or a German Bank in Frankfurt have to
maintain a US dollar a/c with a bank in New York for purposes of making a US$ payment or
receiving US$ receipts. Likewise a US bank need to have a EURO account with an ECB bank or a
Singapore dollar account with a local bank for payment and receiving EURO’s ans S$
respectively.
Such accounts are referred to as due from (nostro) and due to (vostro)accounts. A nostro is a
foreign currency account of a bank maintained with its foreign correspondents abroad. In the above
example the local bank in Singapore and and German bank in Frankfurt each have their respective
US$ nostro accounts with their respective US banks in New York. The respective US banks in
return regard the Singapore and German bank’s account with them as vostro as they are account
due.
Take an example if Deutsche Bank Singapore maintains its US$ account with Citibank New York
and Malaysian Ringgit account with Bank Bumiputra Kuala Lumpur. If a dealer in Deutsche Bank
asked “What’s our balance in our nostros in New York and Kuala Lumpur”? – he is in fact asking
what Deutsche have in balances in US$ and Malaysian Ringgit in their respective account in
Citibank New York and Bank Bumiputra Kuala Lumpur..
Money Market Instruments
There are basically two types of instruments issued and traded in the money market,
namely:
 Instruments which pay interest on the amount invested, where the interest is
normally paid to the holder of the instrument (the lender), together with the
redemption amount at redemption date. Interim interest payments may be made
in certain cases. These instruments are called interest instruments. Instruments in
this category include:

Negotiable Certificate of Deposit (NCDs)
Interest rate instruments issued by the private sector, with terms to maturity of less than
three years.
 Instruments that do not pay interest on the amount invested but are issued at a
discount on the nominal value (the redemption amount). These instruments are
called discount instruments. Instruments in this category include:
Bankers' Acceptances (BAs)
Treasury Bills (TBs)
Commercial Paper (CPs)
Negotiable certificates of deposit (NCDs)
A negotiable certificate of deposit is a certificate issued by a bank for a deposit made at
the bank. This deposit attracts a fixed rate of interest, which is normally payable to the
holder of the instrument together with the nominal amount invested, at redemption date.
NCDs are normally issued in multiples of $1000 but more likely $100,000. The NCD
will contain the following information:
 name of the issuing bank
 date of issue
 date of redemption (maturity date)
 amount of the deposit
 maturity value
 annual interest rate paid on the deposit.
NCDs are bearer documents, which means that the name of the owner (holder or
depositor) does not appear on the document. The bearer or holder of the document will
receive the maturity value (the amount deposited plus interest) at maturity date.
Characteristics
 Large denominations time deposit, less than six months maturity
 Negotiable - may be sold and traded before maturity
 Issued at face value with coupon rate
 Purchased mainly by corporate businesses
Calculations:
The maturity value (MV) of an NCD will be the nominal amount deposited

(N) plus the interest for the period. If for instance a deposit of $1 million is
made on 1 March for 90 days, and interest paid on the amount is 15%
(referred to as a 15% 90-day NCD), the maturity value is calculated as
follows:
Nominal amount $1 000 000
Interest for period (15% x $1 000 000 x 90/360) $ 37 500
MV $1 037 500
The general formula would be:
MV = N x (1 + (1 x c/100 x d/360)
where
MV = maturity value
N = nominal amount of the certificate (amount deposited)
c = interest paid on the amount deposited, as indicated on the certificate
(referred to as the coupon rate). This is expressed as a fixed amount
and not as a percentage, e.g. 15 and not 15%
d = period of the instrument in days referred to as the tenor
In this case
N = $1 000 000
c = 15
d = 90
MV = R1 037 500
If the holder sells this instrument to another party before the redemption date, the
proceeds can be calculated. Remember that financial instruments are traded between
parties on a yield to maturity (expressed as an interest rate) basis, because interest is the
price that is paid for money borrowed. The proceeds of the sale are calculated as follows:
Proceeds = MV / [1 + (d/360 x i/100)]
where
MV = maturity value
d = remaining tenor in days
i = yield at which the instrument was traded expressed as a fixed
amount
If, in the above example, the NCD is sold on 31 March at a yield of 14%, the proceeds to
the seller (the amount the buyer will pay) is:

Proceeds = $1 037 500 / [1 + (60/360 x 14/100)]
= $1 013 846 where
MV = $1 037 500
d = 60
i = 14
The buyer will be the new holder, and he may present the NCD to the bank on
redemption date to receive the maturity value of $1 037 500 or sell it in the secondary
market prior to maturity.
Bankers' acceptances
A bankers' acceptance was invented to suit the needs of a party requiring temporary
finance to facilitate the trading of specific goods. The party needing finance would
approach investors for this temporary finance. The investors or lenders would then lend a
certain amount to the borrower in exchange for a document stating that the debt would be
paid back on a certain date in the short-term future. For this arrangement to be attractive
to the lender, the amount paid back by the borrower (called the nominal amount) would
have to be more than the amount advanced by die lender. The difference between the
amount advanced and the amount paid back (the nominal amount) is known as the
discount on the nominal amount. The two parties would normally be brought together by
a bank.
The redemption of the loan would have to be guaranteed by a bank, called the acceptance
by the bank making the arrangement. Thus the name "bankers' acceptance".
The holder of the document may, at the redemption date approach the bank who will pay
the nominal amount to the holder. The bank will then claim the nominal amount from the
borrowers.
A bank acceptance can, in formal terms, be described as an unconditional order in writing
 addressed and signed by a drawer (the lender)
 to a bank which signs the document and becomes the acceptor
 promising to pay a certain amount of money at a fixed date in the future
 to the bearer or holder (the borrower) of the document (the acceptance).
Characteristics
 Time draft - order to pay in future

 Direct liability of bank
 Mostly trade related
 Secondary market - dealer market
 Discounted in market to reflect yield
 Standard maturities of 30,60,90 and 180 days
Calculations
Since there is theoretically no interest payable on a bankers' acceptance, the investor
would want to pay less than the nominal amount for the acceptance in order to receive a
certain yield on his investment when, at redemption, he receives the nominal amount
from the borrower. The rate quoted on a bank acceptance is the rate of discount on the
nominal amount of the acceptance that is used to calculate the amount advanced by the
lender. The rate is given as an annual rate.
In the following example a BA (bank acceptance) is issued at 12%. The nominal amount
of the BA is $1 million and it is issued for 90 days.
The discount on this BA would be worked out as follows:
Discount = N x d/360 x di/100
where
N = nominal value
d = tenor in days
di = discount rate as a fixed amount
In this case
Discount = $1 000 000 x 90/360 x 12/100
= $30 000
The proceeds which the borrower (drawer) would get at issue date, which is equal to the
amount that the investor or lender would pay would be:
Proceeds = nominal amount - discount
In this case
Proceeds = $1 000 000 - $30 000
= $ 970 000
If the investor needs his money before the redemption date, this BA maybe sold in the
market to another investor who would then become the new lender. This can be done

because the BA is a bearer document. Once again the transaction would take place at a
certain discount rate against which the proceeds would be calculated.
If, in the case above, the original investor now sells the BA at a discount rate of 11%
when there are still 60 days left to redemption, the proceeds (also called the consideration
that the buyer would pay) will be calculated as follows:
Proceeds or consideration = N - (N x d/360 x di/100)
where
N = nominal amount of BA
d = remaining tenor in days
di = discount rate at which transaction was concluded
In this case
Proceeds or consideration
= $1 000 000 - ($1 000 000 x 60/360 x 11/100)
= $981 667
Treasury bills
The government issues treasury bills. They are discount instruments issued for the short
term, similar to BAs. The issue and redemption of these instruments are handled by die
by the Fed on behalf of the government. Treasury bills are issued in bearer form, and the
bearer or holder of the instrument may present it for payment of the nominal amount at
redemption date. The Fed would normally pay this amount into the holder's current bank
account on the redemption date.
Weekly treasury bills are issued and allocated on a tender basis. These bills have a tenor
of 91 days and are allocated to interested parties who submitted tenders on these bills on
a Friday for settlement during the following week. The amount of bills on offer for that
week is announced in multiples of $1 million the previous Thursday.
From time to time the Fed will issue treasury bills other than weekly treasury bills on a
special tender basis to parties who regularly participate at weekly tenders.
Characteristics
 Sold on discount basis
 Maturities up to one year - 91, 182 and 364
 Denominations are in multiples of US$1000
 Bills auction weekly by US Treasury

Calculations
Before a party will tender for a bill, he has to decide on the discount rate that he would
like to earn on his investment. This rate will probably be market related and not far from
the ruling BA rate.
If, for instance, a party decides on a discount rate of 12% on his investment, the tender
price that he would submit on 91-day treasury bills would be:
Price = 100 - (di x d/360)
where
di = discount rate the party wants to earn expressed as a fixed amount
d = tenor in days
In the above example the tender price submitted will be:
Price = 100 - (12 x 91/360)
= 96,967
In the calculation of the discount, proceeds and consideration if sold prior to redemption
date, the same formula as that used for the BA can be used.
Commercial paper
Commercial paper refers to short-term unsecured promissory notes normally issued by
corporate companies with a high credit rating. These instruments are also issued on a
discount basis such as BAs. Because they are unsecured, the risk involved will be higher
than that of BAs, and therefore the issuing institution must be financially strong and
sound. Because of the risk attached to these instruments they would normally be issued
and traded at a higher discount than the prevailing BA rate.
There is an inactive secondary market for commercial paper, but dealers will make a
market in paper they issue. Direct issuers will generally honor requests to repay
commercial paper early. Some do so at principal plus accrued interest, although this
might invite abuse. Others credit interest based on the rate the investor would have
received if he had purchased the paper with a term equal to his actual holding period.
Characteristics
 Short term - one to 270 days

 Usually unsecured
 Large denominations - US$100,000 and up
 Issued by high quality borrowers
 A wholesale money market instrument with few personal investors
 Sold at a discount from par
 Directly or dealer sold
 Backed by bank lines of credit
 Credit ratings important for issuance
Example—Formula for Finding the Annualized Effective Compounded Rate of
Interest for a Discounted Note
If you bought a 4-week T-bill for $996.50 and receive $1,000 4 weeks later, what is the
effective annual compounded interest rate earned?
Solution: To find the effective rate for 4 weeks, you divide the face value of $1,000
divided by the amount that you paid, then subtract 1 for the interest rate over 4 weeks :
$1,000/$996.50 - 1 = 1.0035 -1 = .0035 (rounded) = 0.35%
This is the interest rate for the 4 weeks, but what is the interest rate per year, if
compounded so that you can compare it to other investments?
Since there are 13 4-week periods in a year, $1 compounded 13 times would equal:
(1.0035)13 - 1 = 1.046 - 1 = 4.6%

You can use this formula for calculating the yields of any money market instrument sold
at a discount.
Exhibit 1. Money Market Instruments
Investment
Instrument
Obligation
Issuer
Denominatio
n
Maturitie
s Market Yield
Basis
Comments/
Restriction
s
United
States
Treasury
Bills
U.S.
Government
obligations
$10,000 to $1
million
3, 6, 9 &
12 months
Execellen
t
secondary
market
Discounted
on 385-day
basis. Also
offered as
tax
anticipatio
n bills
through
special
actions
Popular
investment;
can be
purchased
in
secondary
market for
varying
maturities
U. S.
Agency
Securities
Various
Federal
Agencies
$1,000 to
$25,000
30 days;
270 days;
one year
Good
secondary
market
Discounted
on a 360-
day basis
Not legal
obligtation
of or
guaranteed
by the
Federal
Government
Negotiable
CDs
Commercial
Banks
$500,000 to
$1 million
Unlimited;
30-day
minimum
Active
secondary
market
Interest
maturity on
360-day
basis
Backed by
credit of
issuing bank
Non-
Negotiable
CDs
Commercial
Banks/
Savings &
Loan
Association
s
$1,000
minimum
(usually
$100.000)
30-day
minimum
Limited
secondary
market
Interest
maturity on
365-day
basis
Lower
interest
rates for
amounts
under
$100,000;
90-day
interest
penalty for
early
withdrawal
Repurchase Commercial $100,000 Overnight No Established Open: can

Agreements Banks minimum
minimum;
1 to 21
days
common
secondary
market
as part of
purchase
Yield
generally
close to
prevailing
federal
rates
be
liquidated at
any time.
Fixed:
maturity set
for specific
period
Banker's
Acceptance
s
Commercial
Banks
$25,000 to $1
million
Up to six
months
Good
secondary
market
Discounted
on a 360-
day basis
Backed by
credit of
issuing bank
with
specific
collateral
Commercial
Paper
Promissory
Notes of
Finance
Companies
$100,000 to
$5 million
5 to 270
days
No
secondary
market
Either
discounted
or interest-
bearing on
a 360-day
basis
Dealers will
often
negotiate
"buy-back"
agreements
at a lowerf
rate prior to
maturity
What is carry?
Carry is the common term used to describe the difference between the yield of a debt or
credit market instrument and the cost of funding. If the carry is positive then the net cash
flow from borrowing money to invest in the instrument is positive. If the carry is
negative, it is due to a net loss after calculating the cost of raising the funds to invest. In
order to understand why investors need to concern themselves with the cost of carry, it is
also useful to understand the yield curve. In a positive sloped yield curve environment,
shorter maturity paper yields less than longer maturity paper. In a negative yield curve
environment shorter maturity paper yields more than longer maturity paper. Since World
War II, the general shape or slope of the U.S. Treasury yield curve (the highest credit
quality) has been positive. This has abetted the concept of borrowing short and lending
long.
In other words, investors borrow money in the short-term market and invest it in the
longer-term market, anticipating that the spread difference in yields sufficient to offset
market risk. The farther out on the maturity or down on the credit spectrum investors go,
the more risk they were encountering. The point being that the spread, or carry, is itself

an inducement to accept the risk. On the other hand, if the yield curve is negative, that is
short-term rates higher than longer-term rates, investors know that they will receive less
income (yield) for accepting more market risk than the cost of the funds themselves.
Simply put, the economics of such an investment are not at all compelling.