RISK BAROMETERS: MONEY MARKET

May 14, 2010 at 11:48 pm | Posted in Economics, Financial, Research | Leave a comment

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The money market

The money market 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. Trading in the money markets involves Treasury bills, commercial paper, bankers’ acceptances, certificates of deposit, federal funds, and short-lived mortgage-backed and asset-backed securities.[1] It provides liquidity funding for the global financial system.

Overview

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called “paper.” This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

Finance companies, such as GMAC, typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.

· Trading companies often purchase bankers’ acceptances to be tendered for payment to overseas suppliers.

· Retail and institutional money market funds

· Banks

· Central banks

· Cash management programs

· Arbitrage ABCP conduits, which seek to buy higher yielding paper, while themselves selling cheaper paper.

· Merchant Banks

Common money market instruments

· Certificate of deposit – Time deposits, commonly offered to consumers by banks, thrift institutions, and credit unions.

· Repurchase agreements – Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

· Commercial paper – Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.

· Eurodollar deposit – Deposits made in U.S. dollars at a bank or bank branch located outside the United States.

· Federal agency short-term securities – (in the U.S.). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.

· Federal funds – (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.

· Municipal notes – (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

· Treasury bills – Short-term debt obligations of a national government that are issued to mature in three to twelve months. For the U.S., see Treasury bills.

· Money funds – Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.

· Foreign Exchange Swaps – Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

· Short-lived mortgage-backed and asset-backed securities

References

1. Frank J. Fabozzi, Steve V. Mann, Moorad Choudhry, The Global Money Markets, Wiley Finance, Wiley & Sons (2002), ISBN 0-471-22093-0

Risk Barometers:

LIBOR-OIS spread

Overnight indexed swap (OIS)

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).[1]

In the United States, OIS rates are calculated by reference to daily Fed funds rates.

OIS rates (or, in particular, the difference or “spread” between OIS rates and LIBOR) are an important measure of risk and liquidity in the money market,[2] considered by many, including former US Federal Reserve chairman Alan Greenspan, to be a strong indicator for the relative stress in the money markets.[3] A higher spread is typically interpreted as indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks’ perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.[4]

The LIBOR-OIS spread has historically hovered around 10 basis points. However, in the midst of the financial crisis of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10-15 basis points by September 2009.[5]

External links

· LIBOR-OIS spread chart over past year

· Spread The News, The LIBOR-OIS spread reveals banks’ confidence in the market from LIBORATED.COM

References

1. CSFB Zurich note on OIS

2. Zeng, Min (September 20, 2008), “Money Flows Back to Commercial Paper”, The Wall Street Journal, http://online.wsj.com/article/SB122182900317256613.html

3. Brown, Matthew; Finch, Gavin (January 12, 2009), “Libor for Dollars Slides Most Since Dec. 17 on Cash Injections”, Bloomberg.com, http://www.bloomberg.com/apps/news?pid=20601087&sid=aOxAa22fbxKU&refer=home

4. Capo McCormick, Liz (January 24, 2008), “Interest-Rate Derivatives Signal Banks Still Reluctant to Lend”, Bloomberg.com, http://www.bloomberg.com/apps/news?pid=20601009&sid=angq2PsOg5Io&refer=bond

5. “3 MO LIBOR – OIS SPREAD”, Bloomberg.com, January 12, 2009, http://www.bloomberg.com/apps/quote?ticker=.LOIS3:IND

The Libor-OIS is the difference between LIBOR and the overnight indexed swap rate. The spread between the two rates is considered to be a measure of the health of the banking system.[1]

Risk Barometer

3-month LIBOR is generally a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR banks to borrow at a fixed rate of interest over the same period. In the United States the spread is based on the LIBOR Eurodollar rate and the Federal Reserve’s Fed Funds rate.[2]

LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is considered stable as both counterparties only swap the floating rate of interest for the fixed rate of interest. The spread between the two is therefore a measure of how likely borrowing banks will default. This reflects risk premiums in contrast to liquidity premiums.[1]

Historical levels

In the United States, the LIBOR-OIS spread generally maintains around 10bps. This changed abruptly, as the spread jumped to a rate of around 50bps in early August 2008 as the financial markets began to price in a higher risk environment. Within months, the Bank of England was forced to rescue Northern Rock from failure. The spread continued to maintain historically high levels as the crisis continued to unfold. [2]

As markets improved, the spread fell and as of October 2009, remain around 10bps once again.

References

1. a b Thorton, Daniel L. (2009) What the Libor-OIS Spread Says. Economic Synopses, Number 24, 2009. Federal Reserve Bank of St. Louis

2. a b Sengupta, Rajdeep and Yu Man Tam. (2008) The LIBOR-OIS Spread as a Summary Indicator. Economic Synopses, Number 25, 2008. Federal Reserve Bank of St. Louis

TED spread

The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (“T-bills”). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.

Initially, the TED spread was the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped T-bill futures, the TED spread is now calculated as the difference between the three-month T-bill interest rate and three-month LIBOR.

The size of the spread is usually denominated in basis points (bps). For example, if the T-bill rate is 5.10% and ED trades at 5.50%, the TED spread is 40 bps. The TED spread fluctuates over time, but historically has often remained within the range of 10 and 50 bps (0.1% and 0.5%), until 2007. A rising TED spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn.

Indicator

The TED spread is an indicator of perceived credit risk in the general economy.[1] This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases.[2]

Historical levels

The long term average of the TED has been 30 basis points with a maximum of 50 bps.

During 2007, the subprime mortgage crisis ballooned the TED spread to a region of 150-200 bps. On September 17, 2008, the TED spread exceeded 300 bps, breaking the previous record set after the Black Monday crash of 1987.[3] Some higher readings for the spread were due to inability to obtain accurate LIBOR rates in the absence of a liquid unsecured lending market.[4] On October 10, 2008, the TED spread reached another new high of 465 basis points.

References

1. Bloomberg.com Financial Glossary

2. Mission not accomplished not yet, anyway – Paul Krugman – Op-Ed Columnist – New York Times Blog

3. Financial Times. (2008). Panic grips credit markets

4. Bloomberg – Libor Jumps as Banks Seek Cash to Shore Up Finances

links:

· Current TED Spread Quote from Bloomberg

· Betting the Bank

· Understanding the TED spread from the Econbrowser blog

· What TED Said: The spread between LIBOR and T-Bills tells us much about the market from LIBORATED.COM

Risk Barometer

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