184 ch 6
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Primary Market. Explain how the Treasury uses the primary market to obtain adequate funding
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The Treasury issues Treasury bills through a weekly auction. Investors can submit competitive bids, where the Treasury will accept the highest bids first. Alternatively, investors can submit noncompetitive bids, which will automatically be accepted. The price to be paid by noncompetitive bidders is the weighted average price of accepted bids.
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T-bill Auction. How can investors using the primary T-bill market be assured that their bid will be accepted? Why do large corporations typically make competitive bids rather than noncompetitive bids for T-bills?
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-Noncompetitive bids in the Treasury auction ensure acceptance by the Treasury. -Large corporations make competitive bids because noncompetitive bidders are limited to the size of noncompetitive bids.
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Secondary Market for T-bills. Describe the activity in the secondary T-bill market. How can this degree of activity benefit investors in T-bills? Why might a financial institution sometimes consider T-bills as a potential source of funds?
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-The secondary market for Treasury bills is very active, which makes Treasury bills more attractive because it enhances their liquidity. -Financial institutions that have previously purchased Treasury bills can sell these securities in the secondary market whenever they need cash.
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Commercial Paper. Who issues commercial paper? What types of financial institutions issue commercial paper? Why do some firms create a department that can directly place commercial paper? What criteria affect the decision to create such a department?
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-Commercial paper is normally issued by well-known, creditworthy firms. -Bank holding companies and finance companies commonly issue commercial paper. -Those firms that issue commercial paper may decide to establish a department that can directly place the paper. In this way, the firms can avoid the transactions costs incurred when commercial paper dealers issue commercial paper. Such a strategy is only worthwhile if the firms continuously issue commercial paper.
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Commercial Paper Ratings. Why do ratings agencies assign ratings to commercial paper?
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Ratings are assigned to designate the degree of default risk associated with commercial paper. Companies issuing commercial paper pay rating services in order to have their paper rated.
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Commercial Paper Rates. Explain how investors' preferences for commercial paper change during a recession. How should this reaction affect the difference between commercial paper rates and T-bill rates during recessionary periods?
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Investors are less interested in commercial paper during a recession because the probability of default increases. Consequently, issuers of commercial paper must offer a higher premium above the prevailing risk-free rate in order to make the paper attractive to investors.
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Negotiable CDs. How can small investors participate in investments in negotiable certificates of deposits (NCDs)?
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Money market funds can pool invested funds by individual investors and purchase NCDs. In this way, small investors can invest in NCDs.
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Repurchase Agreements. Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Why?
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Repurchase agreements with a similar maturity as commercial paper would likely have a slightly lower yield, since they are typically backed by Treasury securities.
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Banker's Acceptances. Explain how each of the following would use banker's acceptances: (a) exporting firms, (b) importing firms, (c) commercial banks, and (d) investors.
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A banker's acceptance can (a) protect an exporter from the risk of nonpayment by the importer, (b) protect importing firms from the risk of paying for goods without ever receiving them, (c) enable banks to offer exporters and importers a service for which it charges a fee, and (d) offer investors an investment instrument (when exporters sell the acceptance in the secondary market).
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Foreign Money Market Yield. Explain how the yield on a foreign money market security would be affected if the foreign currency denominating that security declined to a greater degree.
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The foreign money market yield would be reduced if the foreign currency denominating the security depreciates to a greater degree, since the U.S. investors would have to pay a higher exchange rate for the currency than the exchange rate at which the currency is converted back to dollars.
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Motive to Issue Commercial Paper. The maximum maturity of commercial paper is 270 days. Why would a firm issue commercial paper instead of longer-term securities, even if it needs funds for a long period of time?
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The firm may be unwilling to lock in the prevailing long-term yield on bonds, perhaps because it expects that long-term interest rates (and yields offered on new bonds) will decline in the near future.
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Risk and Return of Commercial Paper. You have the choice of investing in top-rated commercial paper or commercial paper that has a lower risk rating. How do you think the risk and return performances of the two investments differ?
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The commercial paper with the lower rating should have a higher rate of return and also a higher degree of default risk.
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Commercial Paper Yield Curve. How do you think the shape of the yield curve for commercial paper and other money market instruments compares to the yield curve for Treasury securities? Explain your logic
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The shape of the commercial paper yield curve is generally upward sloping but it only applies up to a 270-day (9-month) maturity. The yields on commercial paper are normally slightly higher than yields on T-bills with the same maturity, so the yield curve on commercial paper would be very similar to the yield curve of Treasury bills up to the 9-month maturity, except that it would be slightly higher.
