Options and Futures Markets

6.           Options and Futures Markets

The first formal options market was the Chicago Board Options Exchange (CBOE). Soon after, several exchanges introduced options contracts to their “product lines.” Now options are traded on such exchanges as the CBOE, the Chicago Board of Trade (CBOT), the Pacific Stock Exchange, the Philadelphia Stock Exchange, and the American Stock Exchange.

7.           Money Markets

Money market securities are not traded in a physical location; rather these securities are traded over-the-counter through banks and dealers that are networked together by telephone and computer lines. These intermediaries bring together buyers and sellers from around the world. In the United States, most trading is centered on large banks (called money center banks) located in the major financial centers of the country. Many banks and dealers specialize in specific instruments, such as commercial paper or bankers’ acceptances.

The United States has a central monetary authority known as the Federal Reserve System. The Federal Reserve System (often referred to as the “Fed”) acts as the U.S. central bank, much like the Bank of England and the Bank of France are central banks in their respective countries.

The role of a central bank is to carry out monetary policy that serves the best interests of the country’s economic well-being. Monetary policy is the set of tools that a central bank can use to control the availability of loanable funds. These tools can be used to achieve goals for the nation’s economy. Along with the U.S. Treasury, the Fed determines policies that affect employment and prices.

The Federal Reserve System is comprised of 12 district banks, with the Federal Reserve Board of Governors overseeing the activities of the district banks. The members of the Board are appointed by the President of the United States and confirmed by the U.S. Senate, and each serves a term of 14 years, with terms staggered through time. The president also appoints the chairman of the board from among the members on the board. The chairman serves in this capacity for a term of four years. [6, p.64]

The Federal Reserve District Banks are not-for-profit institutions. Their responsibilities include (1) handling the vast majority of checkclearing in the United States, (2) issuing money, and (3) acting as the bankers’ bank, accepting deposits from other financial institutions. [6, p.65] Financial managers and investors are interested in the supply and demand for money because it is the interaction of supply and demand that ultimately affects the interest rates paid to borrow funds and the amount of interest earned on investing funds. The demand for money is determined by the availability of investment opportunities. The supply of money is determined, in large part, by the actions of a nation’s central bank.

The decisions of the Fed affect the money supply of the United States. The money supply consists of cash and cash-like items. In fact, there are different definitions of the money supply, depending on the cash-like items you include. For example, the most basic definition of money supply, M1, consists of [6, p.66]:

· cash (currency and bills) in circulation,

· demand deposits (non-interest earning deposits at banking institutions

· that can be withdrawn on demand),

· other deposits that can be readily withdrawn using checks, and

· travelers’ checks.

A broader definition of money supply is M2, which consists of everything in M1, plus [6, p.66]:

· savings deposits,

· small denomination time deposits,

· money market mutual funds, and

· money market deposit accounts.

A still broader definition of money supply is M3, which consists of everything in M2, plus [6, p.67]:

· large denomination time deposits,

· term repurchase agreements issued by commercial banks and thrift institutions, term Eurodollars held by U.S. residents, and

· institution-owned balances in money market funds.

Thus, the money market is a market in which the cash requirements of market participants who are long cash are met along with the requirements of those that are short cash. The money market is traditionally defined as the market for financial assets that have original maturities of one year or less. In essence, it is the market for short-term debt instruments. Financial assets traded in this market include such instruments as U.S. Treasury bills, commercial paper, some medium-term notes, bankers acceptances, federal agency discount paper, most certificates of deposit, repurchase agreements, floating-rate agreements, and federal funds.

There are three types of money market funds: (1) general money market funds; (2) U.S. government short-term funds; and (3) short-term municipal funds. A money market exists in virtually every country in the world, and all such markets exhibit the characteristics we described in this chapter to some extent. In the UK money market, unit trusts typically invest in deposits, with a relatively small share of funds placed in money market paper such as government bills or certificates of deposit. Economies such as Japan and Germany are based more on banking relationships, with banks providing a large proportion of corporate finance.

Money market securities are short-term indebtedness. These are treasury bills (T-bills), commercial paper, certificates of deposit (CDs), Eurodollar certificates of deposit, bankers’ acceptances.

U.S. financial sector divided on: equity markets, stock exchanges, OTC market, stock market indicators, bond markets, options and futures markets, money markets. The United States has a central monetary authority known as the Federal Reserve System.

Monetary policy is the set of tools that a central bank can use to control the availability of loanable funds. These tools can be used to achieve goals for the nation’s economy. Along with the U.S. Treasury, the Fed determines policies that affect employment and prices.

Chapter 3

Money Management. Cash Management for Finance Managers

Any firm can deal in government securities, but when the Federal Reserve engages in trades of Treasuries in order to implement monetary policy, the New York Fed’s Open Market Desk will deal directly only with dealers that it designates as primary or recognized dealers. The primary dealer system was established in 1960 and is designed to ensure that firms requesting status as primary dealers have adequate capital relative to positions assumed in Treasury securities and that their trading volume in Treasury securities is at a reasonable level. The Federal Reserve requires primary dealers to participate in both open market operations and Treasury auctions. In addition, primary dealers provide market information and analysis which may be useful to the Open Market Desk in the implementation of monetary policy. Primary dealers include diversified and specialized firms, money center banks, and foreign-owned financial entities. [5, p.44]

Primary dealers trade with the investing public and with other dealer firms. When they trade with each other, it is through intermediaries known as interdealer brokers. Dealers leave firm bids and offers with interdealer brokers who display the highest bid and the lowest offer in a computer network tied to each trading desk and displayed on a monitor.

The dealer responding to a bid or offer by “hitting” or “taking” pays a commission to the interdealer broker. [5, p.45] The size and prices of these transactions are visible to all dealers at once. The fees charged are negotiable and vary depending on transaction volume.

Six interdealer brokers handle the bulk of daily trading volume. They include Cantor, Fitzgerald Securities, Inc.; Garban Ltd.; Liberty Brokerage Inc.; RMJ Securities Corp.; Hilliard Farber & Co. Inc.; and Tullett & Tokyo Securities Inc. These six firms serve the primary government dealers and approximately a dozen other large government dealers aspiring to be primary dealers. [5, p.46]

Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished. With the exception of Cantor, Fitzgerald Securities Inc., interdealer brokers do not trade for their own account, and they keep the names of the dealers involved in trades confidential. The quotes provided on the government dealer screens represent prices in the “inside” or “interdealer” market.

We have already learned U.S. Treasury bills are very important instruments in the money market, there is some evidence which suggests that bill yields no longer serve as benchmark instruments from which other money market instruments are priced. LIBOR is the interest rate which major international banks offer each other on Eurodollar certificates of deposit (CD) with given maturities. The maturities range from overnight to five years. So, references to “3-month LIBOR” indicate the interest rate that major international banks are offering to pay to other such banks on a CD that matures in three months. Eurodollar CDs pay simple interest at maturity on an ACT/360 basis. [5, p.35] LIBOR serves as a pricing reference for a number of widely traded financial products and derivatives (e.g., floaters, swaps, structured notes, etc.).

Because of LIBOR’s importance in the global money markets, it is instructive to examine the relationship between Treasury bill yields and LIBOR. We expect LIBOR rates to be higher than the yields on bills of the same maturity because investors in Eurodollars CDs are exposed to default risk.

U.S. Treasury securities and the U.S. dollar are considered “safe havens” in times of crisis, regardless of their underlying causes. During times of turmoil, the resulting “flight to quality” widens the spread between LIBOR rates and T-bill rates.

U.S. money market is managed by U.S. government agencies. [5, p.54] U.S. government agency securities can be classified by the type of issuer—those issued by federal agencies and those issued by government sponsored enterprises. Moreover, U.S. government agencies that provide credit for the housing market issue two types of securities: debentures and mortgage-backed/asset-backed securities.

Federal agencies are fully owned by the U.S. government and have been authorized to issue securities directly in the marketplace. Government sponsored enterprises (GSEs) are privately owned, publicly chartered entities. [5, p.56] They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance. The entities in these privileged sectors include farmers, homeowners, and students. GSEs issue securities directly in the marketplace.

The Federal National Mortgage Association (“Fannie Mae”) is a GSE chartered by the Congress of the United States in 1938 to develop a secondary market for residential mortgages. [5, p.70] Fannie Mae buys home loans from banks and other mortgage lenders in the primary market and either holds the mortgages until they mature or issues securities backed by pools of these mortgages. Fannie Mae’s housing mission is overseen by the U.S. Department of Housing and Urban Development (HUD), and its safety and soundness is overseen by the Office of Federal Housing Enterprise Oversight (OFHEO). Although it is controversial, Fannie Mae maintains a direct line of credit with the U.S. Treasury.

If a corporation needs short-term funds, it may attempt to acquire funds via bank borrowing. One close substitute to bank borrowing for larger corporations with strong credit ratings is commercial paper. Commercial paper is a short-term promissory note issued in the open market as an obligation of the issuing entity. [2, p.40] Commercial paper is sold at a discount and pays face value at maturity. The discount represents interest to the investor in the period to maturity. Although some issues are in registered form, commercial paper is typically issued in bearer form.

Although commercial paper, as noted, is the largest sector of the money market, there is relatively little trading in the secondary market. The reason being is that most investors in commercial paper follow a “buy and hold” strategy. This is to be expected because investors purchase commercial paper that matches their specific maturity requirements. Any secondary market trading is usually concentrated among institutional investors in a few large, highly rated issues. If investors wish to sell their commercial paper, they can usually sell it back to the original seller either dealer or issuer.

The largest players in the global money markets are financial institutions — namely depository institutions (i.e., commercial banks, thrifts, and credit unions), insurance companies, and investment banks. [3, p.89] These institutions are simultaneously among the biggest buyers and issuers of money markets instruments. Moreover, there are certain short-term debt instruments peculiar to financial institutions such as certificates of deposits, federal funds, bankers acceptances, and funding agreements.

Depository institutions are required to hold reserves to meet their reserve requirements. The level of the reserves that a depository institution must maintain is based on its average daily deposits over the previous 14 days. To meet these requirements, depository institutions hold reserves at their district Federal Reserve Bank. These reserves are called federal funds. [5, p.100]

Because no interest is earned on federal funds, a depository institution that maintains federal funds in excess of the amount required incurs an opportunity cost of the interest forgone on the excess reserves. Correspondingly, there are also depository institutions whose federal funds are short of the amount required. The federal funds market is where depository institutions buy and sell federal funds to address this imbalance. Typically, smaller depository institutions (e.g., smaller commercial banks, some thrifts, and credit unions) almost always have excess reserves while money center banks usually find themselves short of reserves and must make up the deficit. The supply of federal funds is controlled by the Federal Reserve through its daily open market operations.

Most transactions involving federal funds last for only one night; that is, a depository institution with insufficient reserves that borrows excess reserves from another financial institution will typically do so for the period of one full day. Because these reserves are loaned for only a short time, federal funds are often referred to as “overnight money.” [5, p.101]

The interest rate at which federal funds are bought (borrowed) by depository institutions that need these funds and sold (lent) by depository institutions that have excess federal funds is called the federal funds rate. The federal funds is a benchmark short-term interest. Indeed, other short-term interest rates (e.g., Treasury bills) often move in tandem with movements in the federal funds rate. The rate most often cited for the federal funds market is known as the effective federal funds rate. [5, p.101]

But, coming back to corporations, it is necessary to note, that managers base decisions about investing in short-term projects on judgments about future cash flows, the uncertainty of those cash flows, and the opportunity costs of the funds to be invested.

Cash flows out of a firm as it pays for the goods and services it purchases from others. Cash flows into the firm as customers pay for the goods and services they purchase. When we refer to cash, we mean the amount of cash and cash-like assets—currency, coin, and bank balances. [6, p.642] When we refer to cash management, we mean management of cash inflows and outflows, as well as the stock of cash on hand.

The primary players in the global money markets are banking and financial institutions which include investment banks, commercial banks, thrifts and other deposit and loan institutions. Banking activity and the return it generates reflects the bank’s asset allocation policies. Asset allocation decisions are largely influenced by the capital considerations that such an allocation implies and the capital costs incurred. The cost of capital must, in turn, take into account the regulatory capital implications of the positions taken by a trading desk. [5, p.307] Therefore, money market participants must understand regulatory capital issues regardless of the products they trade or they will not fully understand the cost of their own capital or the return on its use.

The rules defining what constitutes capital and how much of it to allocate are laid out in the Bank for International Settlements (BIS) guidelines, known as the Basel rules. [5, p.310] Although the BIS is not a regulatory body per se and its pronouncements carry no legislative weight, to maintain investors and public confidence national authorities endeavor to demonstrate that they follow the Basel rules at a minimum.

So, any firm can deal in government securities; the primary dealer system was established in 1960. Primary dealers include diversified and specialized firms, money center banks, and foreign-owned financial entities. The dealer responding to a bid or offer by “hitting” or “taking” pays a commission to the interdealer broker. Only six interdealer brokers handle the bulk of daily trading volume.

Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished. They use LIBOR. LIBOR is the interest rate which major international banks offer each other on Eurodollar certificates of deposit (CD) with given maturities.

U.S. money market is managed by U.S. government agencies. Federal agencies are fully owned by the U.S. government and have been authorized to issue securities directly in the marketplace.

 The largest players in the global money markets are financial institutions — namely depository institutions (i.e., commercial banks, thrifts, and credit unions), insurance companies, and investment banks. Most transactions involving federal funds last for only one night.

The primary players in the global money markets are banking and financial institutions. The rules defining what constitutes capital and how much of it to allocate are laid out in the Bank for International Settlements (BIS) guidelines.

Conclusion

So, we have considered the global money markets. It is possible to draw the following conclusions. The simple statement, that money is a commodity whose economic function is to facilitate the interchange of goods and services. But money carries out also other functions. These are function of money as a general medium of payment, and the functions of money as a transmitter of value through time and space. There are 3 categories of money: commodity money, fiat money, credit money. And the last - money is not a free good.

The money market is a market in which the cash requirements of market participants who are long cash are met along with the requirements of those that are short cash. The money market is traditionally defined as the market for financial assets that have original maturities of one year or less. In essence, it is the market for short-term debt instruments. Financial assets traded in this market include such instruments as U.S. Treasury bills, commercial paper, some medium-term notes, bankers acceptances, federal agency discount paper, most certificates of deposit, repurchase agreements, floating-rate agreements, and federal funds.

There are three types of money market funds: (1) general money market funds; (2) U.S. government short-term funds; and (3) short-term municipal funds. A money market exists in virtually every country in the world, and all such markets exhibit the characteristics we described in this chapter to some extent.

Money market securities are short-term indebtedness. These are treasury bills (T-bills), commercial paper, certificates of deposit (CDs), Eurodollar certificates of deposit, bankers’ acceptances.

U.S. financial sector divided on: equity markets, stock exchanges, OTC market, stock market indicators, bond markets, options and futures markets, money markets. The United States has a central monetary authority known as the Federal Reserve System.

Monetary policy is the set of tools that a central bank can use to control the availability of loanable funds. These tools can be used to achieve goals for the nation’s economy. Along with the U.S. Treasury, the Fed determines policies that affect employment and prices.

Any firm can deal in government securities; the primary dealer system was established in 1960. Primary dealers include diversified and specialized firms, money center banks, and foreign-owned financial entities. The dealer responding to a bid or offer by “hitting” or “taking” pays a commission to the interdealer broker. Only six interdealer brokers handle the bulk of daily trading volume.

U.S. money market is managed by U.S. government agencies. Federal agencies are fully owned by the U.S. government and have been authorized to issue securities directly in the marketplace.

 The largest players in the global money markets are financial institutions — namely depository institutions (i.e., commercial banks, thrifts, and credit unions), insurance companies, and investment banks.

Bibliography

1.   Ludwig von Mises. The Theory of Money and Credit. Indianapolis: Liberty Fund, 1982.

2.   Ralph Vince. The Mathematics of Money Management. New Jersey: John Wiley & Sons, Inc., 1992.

3.   Dr. Randall G. Holcombe. Public Finance. New York: Academic Press, 2000.

4.   J. Orlin Grabbe. Chaos & Fractals in Financial Markets. 2001. [http://www.aci.net/kalliste/chaos_index.htm]

5.   Frank J. Fabozzi, Steven V. Mann, Moorad Choudhry. The Global Money Markets. New Jersey: John Wiley & Sons, Inc., 2002.

6.   Frank J. Fabozzi. Financial Management and Analysis. New Jersey: John Wiley & Sons, Inc., 2003.

[1] A Eurocurrency is a currency that is traded outside of its national border, and can be any currency rather than just a European one.