Money market instruments

Repo is essentially a secured loan. The term comes from sale and repurchase agreement however, this is not necessarily the best way to look at it. Although in a classic repo transaction legal title of an asset is transferred from the seller to the buyer during the term of the repo, in the author s opinion this detracts from the essence of the instrument a secured loan of cash. It is therefore a money market instrument. Later we formally define repo and illustrate its use for the moment we need only to think of it as a secured loan. The interest on this loan is the payment made in the repo. 

The textbook definition of a money market instrument is of a debt product issued with between one day and one year to maturity, while debt instruments of greater than one year maturity are known as capital market instmments. In practice the money market desks of most banks will trade the yield curve to up to two years maturity, so it makes sense to view a money market instmment as being of up to two years maturity. 

The classic repo is the instrument encountered in the United States, United Kingdom, and other markets. In a classic repo one party will enter into a contract to sell securities, simultaneously agreeing to purchase them back at a specified future date and price. The securities can be bonds or equities but also money market instruments such as T-bills. The buyer of the securities is handing over cash, which on the termination of the trade will be returned to them and on which they will receive interest. 

Fundamentally both classic repo and sell/buybacks are money market instruments that are a means by which one party may lend cash to another party, secured against collateral in the form of stocks and bonds. Both transactions are a contract for one party to sell securities, with a simultaneous agreement to repurchase them at a specified future. They also involve ... 

The main securities settlement mechanisms in France is SICOVAM, the central securities depositary system. This body operates a system known as Relit Grand Vitesse or RGV, an integrated real-time settlement mechanism for bonds, money market instruments and equities. It provides real-time matching, settlement and reporting cycles, and operates for 22 hours out of 24. Put simply, the settlement process works as follows ... 

Another key feature of a bond is its term to maturity the number of years over which the issuer has promised to meet the conditions of the debt obligation. The practice in the bond market is to refer to the term to maturity of a bond simply as its maturity or term. Bonds are debt capital market securities and therefore have maturities longer than one year. This differentiates them from money market securities. Bonds also have more intricate cash flow patterns than money market securities, which usually have just one cash flow at maturity. As a result, bonds are more complex to price than money market instruments, and their prices are more sensitive to changes in the general level of interest rates. 

Floating-rate bonds, often referred to as floating-rate notes (FRNs), also exist. The coupon rates of these bonds are reset periodically according to a predetermined benchmark, such as 3-month or 6-month LIBOR (London interbank offered rate). LIBOR is the official benchmark rate at which commercial banks will lend funds to other banks in the interbank market. It is an average of the offered rates posted by all the main commercial banks, and is reported by the British Bankers Association at 11.00 hours each business day. For this reason, FRNs typically trade more like money market instruments than like conventional bonds. 

Because the future values for the reference index are not known, it is not possible to calculate the redemption yield of an FRN. On the coupon-reset dates, the note will be priced precisely at par. Between these dates, it will trade very close to par, because of the way the coupon resets. If market rates rise between reset dates, the note will trade slightly below par if rates fall, it will trade slightly above par. This makes FRNs behavior very similar to that of money market instruments traded on a yield basis, although, of course, the notes have much longer maturities. FRNs can thus be viewed either as money market instruments or as alternatives to conventional bonds. Similarly, they can be analyzed using two approaches. 

A bond is a debt capital market instrument issued by a borrower, who is then required to repay to the lender/investor the amount borrowed plus interest, over a specified period of time. Bonds are also known as fixed income instruments, or fixed interest instruments in the sterling markets. Usually bonds are considered to be those debt securities with terms to maturity of over one year. Debt issued with a maturity of less than one year is considered to be money market debt. There are many different types of bonds that can be issued. The most common bond is the conventional (or plain vanilla or bullet) bond. This is a bond paying periodic interest pay-... 

One common way to distinguish between different sectors of the debt markets is by the maturity of the instruments. The money market is... 

In debt capital markets the yield on a domestic government T-bill is usually considered to represent the risk-free interest rate, since it is a shortterm instrument guaranteed by the government. This makes the T-bill rate, in theory at least, the most secure investment in the market. It is common to see the 3-month T-bill rate used in corporate finance analysis and option pricing analysis, which often refer to a risk-free money market rate. 

That is, a money market product quoted as a yield instrument, similar to a bank deposit or a certificate of deposit. The other class of money market products are discount instruments such as a Treasury bill or commercial paper. 

Quoting annualized rates allows deposits and loans of different maturities and involving different instruments to be compared. Be careful when comparing interest rates for products that have different payment frequencies. As shown in the earlier examples, the actual interest earned on a deposit paying 6 percent semiannually will be greater than on one paying 6 percent annually. The convention in the money markets is to quote the applicable interest rate taking into account payment frequency. 

This chapter considers some of the techniques used to fit the model-derived term structure to the observed one. The Vasicek, Brennan-Schwartz, Cox-Ingersoll-Ross, and other models discussed in chapter 4 made various assumptions about the nature of the stochastic process that drives interest rates in defining the term structure. The zero-coupon curves derived by those models differ from those constructed from observed market rates or the spot rates implied by market yields. In general, market yield curves have more-variable shapes than those derived by term-structure models. The interest rate models described in chapter 4 must thus be calibrated to market yield curves. This is done in two ways either the model is calibrated to market instruments, such as money market products and interest rate swaps, which are used to construct a yield curve, or it is calibrated to a curve constructed from market-instrument rates. The latter approach may be implemented through a number of non-parametric methods. 

Options price sensitivity is different from that of other financial market instruments. An option contract s value can be affected by changes in any one or any combination of the five factors considered in option pricing models (of course, strike prices are constant in plain vanilla contracts). In contrast, swaps values are sensitive to one variable only—the swap rate—and bond futures prices are functions of just the current spot price of the cheapest-to-deliver bond and the current money market repo rate. Even more important, unlike for the other instruments, the relationship between an option s value and a change in a key variable is not linear. 

---