Financial Institutions 20% project.

Financial Institutions and Markets: Group Project – (GROUP SIZE 2/3)
Marks: 20
Submission Date: 29/07/2024
Answer the following questions:
1. Explain the terms credit crisis, credit risk premium and liquidity risk in the commercial
paper market.
2. Explain how the credit crisis affected the credit risk premium in the commercial paper
market. Undertake empirical analysis and investigation.
3. Applying Term Structure Theories to Commercial Paper. Apply the term structure of
interest rate theories that were discussed in Chapter 3 to explain the shape of the existing
commercial paper yield curve and
4. When does the Fed use a loose-money policy and when does it use a tight-money policy?
What is a criticism of a loose-money policy? What is the risk of using a monetary policy
that is too tight?
5. Describe the economic tradeoff faced by the Fed in achieving its economic goals.
6. During the credit crisis, the Fed used a stimulative monetary policy. Why do you think the
total amount of loans to households and businesses did not increase as much as the Fed had
hoped? Are the lending institutions to blame for the relatively small increase in the total
amount of loans extended to households and businesses?
Note: Using of examples and graphs is important. Provide references to the intext citations.
Minimum of 5 Pages
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The information in this chapter was last updated in 1993. Since the money market evolves very rapidly, recent
developments may have superseded some of the content of this chapter.
Federal Reserve Bank of Richmond
Richmond, Virginia
1998
Chapter 9
COMMERCIAL PAPER
Thomas K. Hahn
Commercial paper is a short-term unsecured promissory note issued by corporations and foreign
governments. For many large, creditworthy issuers, commercial paper is a low-cost alternative to bank
loans. Issuers are able to efficiently raise large amounts of funds quickly and without expensive Securities
and Exchange Commission (SEC) registration by selling paper, either directly or through independent
dealers, to a large and varied pool of institutional buyers. Investors in commercial paper earn competitive,
market-determined yields in notes whose maturity and amounts can be tailored to their specific needs.
Because of the advantages of commercial paper for both investors and issuers, commercial paper has
become one of America’s most important debt markets. Commercial paper outstanding grew at an annual
rate of 14 percent from 1970 to 1991. Figure 1 shows commercial paper outstanding, which totaled $528
billion at the end of 1991.
This chapter describes some of the important features of the commercial paper market. The first section
reviews the characteristics of commercial paper. The second section describes the major participants in the
market, including the issuers, investors, and dealers. The third section discusses the risks faced by investors
in the commercial paper market along with the mechanisms that are used to control these risks. The fourth
section discusses some recent innovations, including asset-backed commercial paper, the use of swaps in
commercial paper financing strategies, and the international commercial paper markets.
CHARACTERISTICS OF COMMERCIAL PAPER
The Securities Act of 1933 requires that securities offered to the public be registered with the Securities and
Exchange Commission. Registration requires extensive public disclosure, including issuing a prospectus on
the offering, and is a time-consuming and expensive process.1 Most commercial paper is issued
1 Registration for short-term securities is especially expensive because the registration fee is a percent of the face amount at
each offering. Thirty-day registered notes, rolled over monthly for one year, would cost 12 times as much as a one-time issuance
of an equal amount of one-year notes.
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FIGURE 1
Commercial Paper Outstanding
Source: Board of Governors of the Federal Reserve System.
under Section 3(a)(3) of the 1933 Act which exempts from registration requirements short-term securities as
long as they have certain characteristics. 2 The exemption requirements have been a factor shaping the
characteristics of the commercial paper market.
One requirement for exemption is that the maturity of commercial paper must be less than 270 days. In
practice, most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the
average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less
constant amount of their assets using commercial paper. Continuous rollover of notes does not violate the
nine-month maturity limit as long as the rollover is not automatic but is at the discretion of the issuer and the
dealer. Many issuers will adjust the maturity of commercial paper to suit the requirements of an investor.
2 Some commercial paper is issued under one of the two other exemptions to the Securities Act. Commercial paper which is
guaranteed by a bank through a letter of credit is exempt under Section 3(a)(2) regardless of whether or not the issue is also
exempt under Section 3(a)(3). Commercial paper sold through private placements is exempt under Section 4(2). See Felix (1987)
for more information on the legal aspects of commercial paper issuance.
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A second requirement for exemption is that notes must be of a type not ordinarily purchased by the
general public. In practice, the denomination of commercial paper is large: minimum denominations are
usually $100,000, although face amounts as low as $10,000 are available from some issuers. Because most
investors are institutions, typical face amounts are in multiples of $1 million. Issuers will usually sell an
investor the specific amount of commercial paper needed.
A third requirement for exemption is that proceeds from commercial paper issues be used to finance
“current transactions,” which include the funding of operating expenses and the funding of current assets
such as receivables and inventories. Proceeds cannot be used to finance fixed assets, such as plant and
equipment, on a permanent basis. The SEC has generally interpreted the current transaction requirement
broadly, approving a variety of short-term uses for commercial paper proceeds. Proceeds are not traced
directly from issue to use, so firms are required to show only that they have a sufficient “current transaction”
capacity to justify the size of the commercial paper program (for example, a particular level of receivables or
inventory). 3 Firms are allowed to finance construction as long as the commercial paper financing is
temporary and to be paid off shortly after completion of construction with long-term funding through a bond
issue, bank loan, or internally generated cash flow.4
Like Treasury bills, commercial paper is typically a discount security: the investor purchases notes at
less than face value and receives the face value at maturity. The difference between the purchase price and
the face value, called the discount, is the interest received on the investment. Occasionally, investors
request that paper be issued as an interest-bearing note. The investor pays the face value and, at maturity,
receives the face value and accrued interest. All commercial paper interest rates are quoted on a discount
basis.5
Until the 1980s, most commercial paper was issued in physical form in which the obligation of the issuer
to pay the face amount at maturity is recorded by printed certificates that are issued to the investor in
exchange for funds. The certificates are held, usually by a safekeeping agent hired by the investor, until
3 Some SEC interpretations of the current transaction requirement have been established in “no-action” letters. “No-action”
letters, issued by the staff of the SEC at the request of issuers, confirm that the staff will not request any legal action concerning
an unregistered issue. See Felix (1987, p. 39).
4Past SEC interpretations of Section 3(a)(3) exemptions have also required that commercial paper be of “prime quality” and be
discountable at a Federal Reserve Bank (Release No. 33-4412). The discounting requirement was dropped in 1980. An
increased amount of commercial paper in the later 1980s was issued without prime ratings.
5 The Federal Reserve publishes in its H.15 statistical release daily interest rates for dealer-offered and directly placed
commercial paper of one-month, three-month and six-month maturities. All rates are based on paper with relatively low default
risk. Commercial paper rates of various maturities for select finance issuers and a dealer composite rate are also published daily
in The Wall Street Journal.
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presented for payment at maturity. The exchanges of funds for commercial paper first at issuance and then
at redemption, called “settling” of the transaction, occur in one day. On the day the commercial paper is
issued and sold, the investor receives and pays for the notes and the issuer receives the proceeds. On the
day of maturity, the investor presents the notes and receives payment. Commercial banks, in their role as
issuing, paying, and clearing agents, facilitate the settling of commercial paper by carrying out the
exchanges between issuer, investor, and dealer required to transfer commercial paper for funds.
An increasing amount of commercial paper is being issued in book-entry form in which the physical
commercial paper certificates are replaced by entries in computerized accounts. Book-entry systems will
eventually completely replace the physical printing and delivery of notes. The Depository Trust Company
(DTC), a clearing cooperative operated by member banks, began plans in September 1990 to convert most
commercial paper transactions to book-entry form. 6 By May 1992, more than 40 percent of commercial
paper was issued through the DTC in book-entry form.
The advantages of a paperless system are significant. The fees and costs associated with the bookentry system will, in the long run, be significantly less than under the physical delivery system. The expense
of delivering and verifying certificates and the risks of messengers failing to deliver certificates on time will
be eliminated. The problem of daylight overdrafts, which arise from nonsynchronous issuing and redeeming
of commercial paper, will be reduced since all transactions between an issuing agent and a paying agent will
be settled with a single end-of-day wire transaction.
MARKET PARTICIPANTS
Issuers and Uses of Commercial Paper
Commercial paper is issued by a wide variety of domestic and
foreign firms, including financial companies, banks, and industrial firms. Table 1 shows examples of the
largest commercial paper issuers. Figure 2 shows outstanding commercial paper by type of issuer. The
biggest issuers in the financial firm category in Figure 2 are finance companies. Finance companies provide
consumers with home loans, retail automobile loans, and unsecured personal loans. They provide
businesses with a variety of short- and medium-term loans including secured loans to finance purchases of
equipment for resale. Some finance companies are wholly owned subsidiaries of industrial firms that provide
financing for purchases of the parent firm’s products. For example, a major activity of General Motors
Acceptance Corporation (GMAC)
6 See The Depository Trust Company (1990).
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TABLE 1
Commercial Paper Outstanding by Major Issuer
Billions of Dollars
Category
Major Issuer
Average
Amount
Outstanding
Finance
General Electric Capital
(subsidiary of GE)
$36.9
Direct, Multiple
General Motors Acceptance
(subsidiary of GM)
$23.6
Direct
Investment Banking
Merrill Lynch
$ 7.5
Dealer is subsidiary
Commercial Banking
J.P. Morgan
$ 4.4
Multiple
Industrial
PepsiCo
$ 3.4
Multiple
Foreign
Hanson Finance
$ 3.5
Multiple
Asset-Backed
Corporate Asset Funding
$ 5.3
Goldman Sachs
Auto Finance
Dealer
Note: Quarterly Average Commercial Paper is for the first quarter of 1992, except GE, GMAC, and PepsiCo, which are for the
fourth quarter of 1991.
Source: Moody’s Global Short-Term Record, June 1992.
FIGURE 2: Commercial Paper Oustanding by Issuer Type
End of 1991 Total $528.1 Billion
Billions of Dollars
Source: Board of Governors of the Federal Reserve System.
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is the financing of purchases and leases of General Motor’s vehicles by dealers and consumers. The three
largest issuers—GMAC, General Electric Capital, and Ford Motor Credit—accounted for more than 20
percent of the total nonbank financial paper outstanding at the end of 1991.
The financial issuer category also includes insurance firms and securities firms. Insurance companies
issue commercial paper to finance premium receivables and operating expenses. Securities firms issue
commercial paper as a low-cost alternative to other short-term borrowings such as repurchase agreements
and bank loans, and they use commercial paper proceeds to finance a variety of security broker and
investment banking activities.
Commercial bank holding companies issue commercial paper to finance operating expenses and
various nonbank activities. Bank holding companies have recently decreased their commercial paper issues
following declines in the perceived creditworthiness of many major domestic bank issuers.
More than 500 nonfinancial firms also issue commercial paper. Nonfinancial issuers include public
utilities, industrial and service companies. Industrial and service companies use commercial paper to finance
working capital (accounts receivable and inventory) on a permanent or seasonal basis, to fund operating
expenses, and to finance, on a temporary basis, construction projects. Public utilities also use commercial
paper to fund nuclear fuels and construction. Figure 3 shows that commercial paper as a percent of
commercial paper and bank loans for nonfinancial firms rose from just 2 percent in 1966 to over 15 percent
at the end of 1991.
The domestic commercial paper issuers discussed above include U.S. subsidiaries of foreign
companies. Foreign corporations and governments also issue commercial paper in the U.S. without use of a
domestic subsidiary and these foreign issues have gained increased acceptance by U.S. investors. Foreign
financial firms, including banks and bank holding companies, issue almost 70 percent of foreign commercial
paper (Federal Reserve Bank of New York 1992). Industrial firms and governments issue the remainder.
Japan, the United Kingdom, and France are among the countries with a significant number of issuers.
Investors
Money market mutual funds (MMFs) and commercial bank trust departments are the major
investors in commercial paper. MMFs hold about one-third of the outstanding commercial paper, while bank
trust departments hold between 15 and 25 percent.7 Other important investors, holding between 5 and 15
percent, are nonfinancial corporations, life insurance companies, and private and government pension
funds. Other mutual funds, securities dealers,
7Precise data on holdings of commercial paper by investor type, except by MMFs, are not available. Some estimates are
provided in Board of Governors of the Federal Reserve System (1992, p. 52), Stigum (1990, p. 1027), and Felix (1987, p. 13).
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FIGURE 3
Commercial Paper as a Percent of Commercial Paper and
Bank Loans, Nonfinancial Firms
Source: Board of Governors of the Federal Reserve System.
and banks also hold small amounts of commercial paper. Individuals hold little commercial paper directly
because of the large minimum denominations, but they are large indirect investors in commercial paper
through MMFs and trusts.
There have been major shifts in ownership of commercial paper during the post-World War II period.
Prior to World War II, the most important investors in commercial paper were banks, which used commercial
paper as a reserve asset and to diversify their securities portfolios. In the fifties and sixties, industrial firms
began to hold commercial paper as an alternative to bank deposits, which had regulated interest rates that
at times were significantly below the market-determined rates on commercial paper. Historically high and
variable interest rates during the 1970s led households and businesses to hold more of their funds in shortterm assets and to transfer funds from bank deposits with regulated interest rates to assets like MMF shares
with market-determined rates. At the same time, many large businesses found that they could borrow in the
commercial paper market at less expense than they could borrow from banks. MMFs demanded the
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TABLE 2
Money Market Mutual Funds and Commercial Paper
Commercial
MMF
MMF
Paper
Holdings CP as Percent Percent of
Year- Assets Outstanding
of CP
of MMF
CP Held
End ($ billions) ($ billions) ($ billions)
Assets
by MMFs
1975
3.7
47.7
0.4
11
1
1980
74.5
121.6
25.0
33
21
1985
207.5
293.9
87.6
42
30
1990
414.8
557.8
199.1
48
36
1991
449.7
528.1
187.6
42
36
Note: MMFs exclude tax-exempt funds.
Source: Board of Governors of the Federal Reserve System.
short-term, large-denomination, relatively safe, and high-yield characteristics offered by commercial paper
and hence absorbed a major portion of new commercial paper issues. Table 2 shows that both the
commercial paper market and MMFs have experienced very rapid growth since 1975. By the end of 1991,
MMFs held 36 percent of the commercial paper outstanding and commercial paper composed 42 percent of
their total assets.
Placement and Role of the Dealer
Most firms place their paper through dealers who, acting as principals,
purchase commercial paper from issuers and resell it to the public. Most dealers are subsidiaries of
investment banks or commercial bank holding companies. A select group of very large, active issuers, called
direct issuers, employ their own sales forces to distribute their paper. There are approximately 125 direct
issuers, most of which are finance companies or bank holding companies. These issuers sell significant
amounts of commercial paper on a continuous basis.
When an issuer places its commercial paper through a dealer, the issuer decides how much paper it will
issue at each maturity. The dealer is the issuer’s contact with investors and provides the issuer with relevant
information on market conditions and investor demand. Dealers generally immediately resell commercial
paper purchased from issuers and do not hold significant amounts of commercial paper in inventory. Dealers
will temporarily hold commercial paper in inventory as a service to issuers, such as to meet an immediate
need for a significant amount of funds at a particular maturity.
The difference between what the dealer pays the issuer for commercial paper and what he sells it for,
the “dealer spread,” is around 10 basis points on an annual basis. A large commercial paper program with
$500 million in paper outstanding for one year would cost the issuer $500,000 in dealer fees.
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Because independent dealers are relatively inexpensive, only large and well-recognized issuers
distribute their own commercial paper. Direct issuers are typically committed to borrowing $1 billion or more
in the commercial paper market on a continuous basis (Felix 1987, p. 20). Partly as a result of the decline in
dealer spreads over the last ten years, the percentage of total commercial paper issued directly fell from
almost 55 percent in 1980 to just 35 percent at the end of 1991. An additional factor in the growth of dealerplaced commercial paper has been the entry into the market of smaller issuers who do not have borrowing
needs large enough to justify a direct sales force.
Competition among dealers significantly increased in the late 1980s after the entrance into the market of
bank dealers, which are subsidiaries of bank holding companies. Prior to the mid-1980s, commercial banks
mainly acted as agents who placed commercial paper without underwriting and who carried out the physical
transactions required in commercial paper programs, including the issuing and safekeeping of notes and the
paying of investors at maturity. Bank dealers entered the market after legal restrictions on underwriting by
bank holding companies were relaxed, and the increased competition led to declines in profit margins and
the exit from the market of some major investment bank dealers. Salomon Brothers closed its dealership
and Paine Webber sold its dealership to CitiCorp. Goldman Sachs, another important dealer, responded to
increased competition by rescinding its longstanding requirement that it be the sole dealer for an issuer’s
commercial paper. Issuers have increased their use of multiple dealers for large commercial paper
programs, frequently including a bank dealer in their team of dealers.
The largest commercial paper dealers are still the investment banks, including Merrill Lynch, Goldman
Sachs, and Shearson Lehman. Commercial bank holding companies with large commercial paper dealer
subsidiaries include Bankers Trust, CitiCorp, BankAmerica, and J.P. Morgan. Some foreign investment and
commercial bank holding companies have also become significant dealers.
The secondary market in commercial paper is small. Partly the lack of a secondary market reflects the
heterogeneous characteristics of commercial paper, which makes it difficult to assemble blocks of paper
large enough to facilitate secondary trading. Partly it reflects the short maturity of the paper: investors know
how long they want to invest cash and, barring some unforseen cash need, hold commercial paper to
maturity. Dealers will sometimes purchase paper from issuers or investors, hold the paper in inventory and
subsequently trade it. Bids for commercial paper of the largest issuers are available through brokers.
Some direct issuers offer master note agreements which allow investors, usually bank trust
departments, to lend funds on demand on a daily basis at a rate tied to the commercial paper rate. Each day
the issuer tells the investor the rate on the master note and the investor tells the issuer how much it will
deposit that day. At the end of 1991, approximately 10 percent of GMAC’s short-term notes
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outstanding were master notes sold to bank trust departments (GMAC 1992, p. 13).
RISK IN THE COMMERCIAL PAPER MARKET
Ratings
Since 1970, when the Penn Central Transportation Co. defaulted with $82 million of commercial
paper outstanding, almost all commercial paper has carried ratings from one or more rating agency.
Currently, the four major rating agencies are Moody’s, Standard & Poor’s, Duff & Phelps, and Fitch. An
issuer’s commercial paper rating is an independent “assessment of the likelihood of timely payment of
[short-term] debt” (Standard & Poor’s 1991, p. iii). Table 3 lists the four rating agencies, the rating scales
they publish, and the approximate number of commercial paper ratings issued at the end of 1990. The
ratings are relative, allowing the investor to compare the risks across issues. For example, Standard &
Poor’s gives an A-1 rating to issues that it believes have a “strong” degree of safety for timely repayment of
debt, an A-2 rating to issues that it believes have a degree of safety that is “satisfactory,” and an A-3 rating
to issues that it believes have a degree of safety that is “adequate.” Below these
TABLE 3
Rating Agencies and Commercial Paper Ratings
Major
Approx. Publication
Speculative
# of CP Listing
Higher Lower Below
Defaulted Ratings CP Ratings
A/Prime A/Prime Prime
Moody’s
P-1
P-2, P-3 NP
NP
2,000
Moody’s Global
Short-Term
Market Record
Standard &
Poor’s
A-1+, A-1 A-2, A-3 B, C
D
2,000
S&P
Commercial
Paper Ratings
Guide
Duff & Phelps
Duff 1+,
Duff 1,
Duff 1-
Duff 5
175
Short-Term
Ratings and
Research Guide
Fitch
F-1+, F-1 F-2, F-3 F-5
D
125
Fitch Ratings
Duff 2,
Duff 3
Duff 4
Range of
AAA, AA, A, BBB BB, B,
Likely S&P Long- A
CCC,
Term Bond
CC, C
Rating
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three categories are the speculative grades in which the capacity for repayment is small relative to the
higher-rated issues. Finally, a D rating indicates the issuer has defaulted on its commercial paper. Almost all
issuers carry one of the two highest Prime or A ratings.
Issuers hire the rating agencies to rate their short-term debt and pay the agencies an annual fee ranging
from $10,000 to $29,000 per year. For an additional fee the agencies will also rate other liabilities of the
issuer, including their long-term bonds. The ratings are provided to the public, generally by subscription,
either through publications, computer databases, or over the phone. Major announcements by the rating
agencies are also reported on news wire services. Table 3 lists each agency’s major publication in which
commercial paper ratings appear.
Rating agencies rely on a wide variety of information in assessing the default risk of an issuer. The
analysis is largely based on the firm’s historical and projected operating results and its financial structure.
Relevant characteristics include size (both absolute and compared to competitors), profitability (including the
level and variation of profits), and leverage. Table 4 shows the means of selected historical characteristics of
a sample of publicly traded nonfinancial issuers by commercial paper rating category. The table shows that
higher-rated issuers are on average more profitable than lower-rated issuers and, with some exceptions,
larger. Additionally, higher-rated issuers rely less heavily on debt financing than lower-rated issuers and
have stronger interest-coverage and
TABLE 4
Characteristics of Industrial Commercial Paper Issuers by Rating,
Three-Year Averages
Standard &
Poor’s
Commercial
Paper Rating
Number of
Companies
Assets
(millions)
Interest
Coverage
Debt
Coverage
Leverage
Profitability
A-1+
91
$4,547
8x
.7x
27%
18%
A-1
102
$2,924
5x
.5x
35%
16%
A-2
97
$1,866
4x
.4x
36%
14%
A-3
9
$5,252
2x
.2x
52%
10%
Notes: Sample consists of nonfinancial commercial paper issuers required to file with the SEC.
Interest coverage is defined as the ratio of income available for interest to interest expense. Income available for interest is
defined as pre-tax income less special income plus interest expense.
Debt coverage is defined as the ratio of cash flow to short- and long-term debt. Cash flow is income plus preferred dividends
plus deferred taxes.
Leverage is defined as the ratio of total debt to invested capital. Invested capital is the sum of short- and long-term debt,
minority interest, preferred and common equity, and deferred taxes.
Profitability is defined as the ratio of income available for interest to invested capital.
Source: Standard & Poor’s Compustat Services.
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debt-coverage ratios.8 In addition to evaluating the firm’s operating results and financial structure, rating
agencies also evaluate more subjective criteria like quality of management and industry characteristics. The
same factors influence the issuer’s short-term and long-term debt rating so there is generally a close
correspondence between the commercial paper rating and the bond rating.
Ratings are crucially important in the commercial paper market. Ratings are useful as an independent
evaluation of credit risk that summarizes available public information and reduces the duplication of analysis
in a market with many investors (Wakeman 1981). Ratings are also used to guide investments in
commercial paper. Some investors, either by regulation or choice, restrict their holdings to high-quality paper
and the measure of quality used for these investment decisions is the rating. For example, regulations of
MMFs limit their holdings of commercial paper rated less than A1-P1. Other market participants, including
dealers and clearing agencies, also generally require issuers to maintain a certain quality. Again, credit
quality is measured by the rating.
Backup Liquidity
Commercial paper issuers maintain access to funds that can be used to pay off all or
some of their maturing commercial paper and other short-term debt. These funds are either in the form of
their own cash reserves or bank lines of credit. Rating agencies require evidence of short-term liquidity and
will not issue a commercial paper rating without it. The highest-rated issuers can maintain liquidity backup of
as little as 50 percent of commercial paper outstanding, but firms with less than a high A1-P1 rating
generally have to maintain 100 percent backup.
Most commercial paper issuers maintain backup liquidity through bank lines of credit available in a
variety of forms. Standard credit lines allow borrowing under a 90-day note. Swing lines provide funds on a
day-to-day basis, allowing issuers to cover a shortfall in proceeds from paper issuance on a particular day.
Increasingly, backup lines of credit are being structured as more secure multi-year revolver agreements in
which a bank or syndicate of banks commit to loan funds to a firm on demand at a floating base rate that is
tied to the prime rate, LIBOR rate, or certificate of deposit rate. The spread over the base rate is negotiated
at the time the agreement is made and can either be fixed or dependent on the bond rating of the borrower
at the time the loan is drawn down. The length of the revolver commitment varies, but the trend in revolvers
has been towards shorter terms, typically around three years. As compensation for the revolver
commitment, the firm pays various fees to the bank. The facility fee is a percentage of the credit line and is
paid whether or not the line is activated. The commitment fee is a percentage of the unused credit line. This
type of fee has
8 Because ratings depend on historical operating results, researchers have had some success in predicting ratings based on
accounting data. See, for example, Peavy and Edgar (1983).
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become less common in recent years. A usage fee is sometimes charged if the credit line is heavily used.
Backup lines of credit are intended to provide funds to retire maturing commercial paper when an event
prevents an issuer from rolling over the paper. Such an event may be specific to an issuer: an industrial
accident, sudden liability exposure, or other adverse business conditions that investors perceive as
significantly weakening the credit strength of the issuer. Or the event may be a general development
affecting the commercial paper market. For instance, a major issuer might default, as Penn Central did in
1970, and make it prohibitively expensive for some issuers to roll over new paper, or a natural disaster such
as a hurricane may interrupt the normal function of the market.
Backup lines of credit will generally not be useful for a firm whose operating and financial condition has
deteriorated to the point where it is about to default on its short-term liabilities. Credit agreements frequently
contain “material adverse change” clauses which allow banks to cancel credit lines if the financial condition
of a firm significantly changes. Indeed, the recent history of commercial paper defaults has shown that as an
issuer’s financial condition deteriorates and its commercial paper cannot be rolled over, backup lines of
credit are usually canceled before they can be used to pay off maturing commercial paper.
General factors affecting the commercial paper market may also result in the disruption of backup lines
of credit. Standard & Poor’s has emphasized this point in an evaluation of the benefits to investors of backup
credit lines: “A general disruption of commercial paper markets would be a highly volatile scenario, under
which most bank lines would represent unreliable claims on whatever cash would be made available through
the banking system to support the market” (Samson and Bachmann 1990, p. 23). Part of the risk assumed
by commercial paper investors is the possibility of this highly volatile scenario.
Credit Enhancements
While backup lines of credit are needed to obtain a commercial paper rating, they
will not raise the rating above the underlying creditworthiness of the issuer. Issuers can significantly increase
the rating of their paper, however, by using one of a variety of credit enhancements which lower default risk
by arranging for an alternative party to retire the commercial paper if the issuer cannot. These credit
enhancements differ from backup lines of credit in that they provide a guarantee of support which cannot be
withdrawn. Some smaller and riskier firms, which normally would find the commercial paper market
unreceptive, access the commercial paper market using these enhancements.
Some large firms with strong credit ratings raise the ratings of smaller and less creditworthy subsidiaries
by supporting their commercial paper with outright guarantees or with less secure “keepwell” agreements
which describe the commitment the parent makes to assist the subsidiary to maintain a certain
creditworthiness (Moody’s, July 1992). Since parent companies may have incentives
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to prevent default by their subsidiaries, the affiliation of a subsidiary with a strong parent can raise the credit
rating of the subsidiary issuer.
Firms also raise their credit ratings by purchasing indemnity bonds from insurance companies or
standby letters of credit sold by commercial banks. Both of these enhancements provide assurance that the
supporting entity will retire maturing commercial paper if the issuer cannot. With a letter of credit, for
example, the issuer pays a fee to the bank, attaches the letter of credit to the commercial paper and
effectively rents the bank’s rating. The attention of the rating agency and investors shift from the issuer to the
supporting bank. The issue will generally receive the same rating as the bank’s own commercial paper and
offer an interest rate close to the bank’s paper. Since relatively few U.S. banks have A1-P1 ratings, highly
rated foreign banks are the primary sellers of commercial paper letters of credit. At the end of the first
quarter of 1992, approximately 6 percent of commercial paper was fully backed by a credit enhancement,
primarily bank letters of credit, issued by a third party unaffiliated with the issuer (Federal Reserve Bank of
New York 1992).
Slovin et al. (1988) show that the announcement of a commercial paper program with a credit
enhancement9 has been associated with a significant increase in the value of the issuer’s equity, but the
announcement of a commercial paper program with no credit enhancement has no impact on firm value.
This evidence suggests that by issuing a letter of credit and certifying the creditworthiness of the issuer, the
commercial bank provides new information to the capital markets. These results provide support for the
hypothesis that banks generate information relevant for assessing credit risk that the securities markets do
not have. Banks supply this information to the capital market through commercial paper programs supported
by letters of credit.
Default History and Yields
Commercial paper pays a market-determined interest rate that is closely
related to other market interest rates like the rate on large certificates of deposit. Because commercial paper
has default risk, its yield is higher than the yield on Treasury bills. From 1967 through 1991, the spread of
the one-month commercial paper rate over the one-month Treasury bill rate averaged 117 basis points.
Default risk also creates a differential between the rates on different quality grades of commercial paper.
Figure 4 shows the spread between the yield on commercial paper rated A1-P1 and the yield on paper rated
A2-P2. This spread averaged 52 basis points from 1974 through 1991. Default risk as measured by the
quality spread shows some variation over time, rising during recessions and falling during expansions.
9 The credit enhancements examined were standby letters of credit and, for programs outside the United States, note issuance
facilities.
Page 119
FIGURE 4
Spread Between the Rates on Prime- and
Medium-Grade Commercial Paper
Source: Board of Governors of the Federal Reserve System.
Historically, the commercial paper market has been remarkably free of default. As shown in Table 5, in
the 20-year period from 1969 through 1988 there were only two major defaults. The low default rates in the
commercial paper market largely reflect the tastes of commercial paper investors. As shown in Table 4,
investors typically prefer commercial paper issued by large firms with long track records, conservative
financing strategies, and stable profitability. Most investors will not buy paper from small, unknown, highly
leveraged issuers unless the paper has credit enhancements attached. Moreover, rating services will not
assign a prime rating to these issues and most dealers will not distribute the paper.
Even a major issuer can find the commercial paper market unreceptive if its financial condition is
perceived by the market to have weakened. Fons and Kimball (1992) estimate that issuers who defaulted on
long-term debt withdrew from the commercial paper market an average of almost three years prior to
default. As ratings declined, these issuers significantly decreased their commercial paper borrowings. Fons
and Kimball (1992) take this “orderly exit” mechanism as evidence that investors in the commercial paper
market are “unreceptive to lower-quality paper.” Crabbe and Post (January 1992) document the orderly exit
Page 120
TABLE 5
Major Defaults in the U.S. Commercial Paper Market
Original Rating
of Longest
Outstanding
Defaulting CP
Moody’s S&P
Issuer
Date of
Default
Amount
Outstanding
at Default
($ millions)
Penn Central
6/21/70
82.0
NR
NR
Manville Corp.
8/26/82
15.2
P-2
A-2
Integrated Resources
6/15/89
213.0
NR
A-2
Colorado Ute Electric
8/17/89
19.0
P-1
A-1
Equitable Lomas Leasing
9/12/89
53.0
P-3
A-3
Mortgage & Realty Trust
3/15/90
166.9
NR
A-2
Washington Bancorp
5/11/90
36.7
NR
NR
Stotler Group
7/25/90
0.8
NR
NR
Columbia Gas
6/12/91
268.0
P-2
A-2
Source: Fons and Kimball (1992), Wall Street Journal, Dow Jones News Wire, Business Week, Standard & Poor’s.
mechanism using a sample of bank holding company issuers during 1986 to 1990. For issuers which
experienced Moody’s commercial paper rating downgrades, commercial paper outstanding declined on
average by 12.2 percent in the ten weeks prior to the rating change and 15.7 percent in the first four weeks
after the change.
The number of commercial paper defaults rose to seven in 1989 to 1991, but even in this period the
default rate was low. Fons and Kimball (1992) estimate the dollar amount of defaults over this period as a
percentage of the total volume issued.10 They find that the default rate for the United States was only 0.0040
percent in 1989-91, which means that “an investor purchasing U.S.-issued commercial paper. . . throughout
the 1989-1991 period experienced, on average, interruption in promised payments of roughly [40/100] of a
penny for every $100 invested” (p. 13).
The rise in defaults in the 1989 to 1990 period may have partially reflected an increased tolerance for
riskier paper in the later part of the 1980s. Unrated commercial paper grew significantly in the late 1980s to
$5 billion in January 1990. Over the same period, the spread between the yields on A1-P1 paper and A2-P2
paper was unusually low (averaging less than 30 basis points). These developments were reversed in the
early 1990s following the rise in commercial paper defaults, the deterioration in economic conditions, and
the bankruptcy
10 Fons and Kimball (1992) estimate the total volume of commercial paper issuance as average outstanding commercial paper
times (365/average maturity). Average maturity is estimated at 30 days.
Page 121
of Drexel Burnham, a major dealer and promoter of unrated commercial paper. By early 1991, unrated paper
outstanding had fallen to below $1 billion and the A1-A2 spread had risen to almost 50 basis points, its
highest level since 1982.
The commercial paper defaults in 1989 and 1990 had a significant impact on the demand for lowerrated paper by money market mutual funds. Several MMFs were major holders of defaulted paper of
Integrated Resources and Mortgage & Realty Trust.11 Following these defaults, some MMFs began to
voluntarily restrict their commercial paper holdings to A1-P1 issues. Then in June 1991, SEC regulations
became effective that limited MMFs to investing no more than 1 percent of their assets in any single A2-P2
issuer and no more than 5 percent of assets in A2-P2 paper. Previously, there had been no restriction on
MMF total holding of A2-P2 paper, and MMFs had held approximately 10 percent of their assets in A2-P2
paper at the end of 1990. Crabbe and Post (May 1992) find that by the end of 1991, MMFs had reduced
their holdings of A2-P2 commercial paper to almost zero. Along with the 1989 and 1990 defaults, they point
to the June 1991 regulations as an important factor influencing MMF investment choices.
INNOVATIONS
Asset-Backed Commercial Paper
A relatively new innovation in the commercial paper market is the
backing of commercial paper with assets. The risk of most commercial paper depends on the entire firm’s
operating and financial risk. With asset-backed paper, the paper’s risk is instead tied directly to the
creditworthiness of specific financial assets, usually some form of receivable. Asset-backed paper is one
way smaller, riskier firms can access the commercial paper market. The advantages of asset-backed
securities have led large, lower-risk commercial paper issuers to also participate in asset-backed
commercial paper programs. Asset-backed programs have grown rapidly since the first program in 1983.
Standard & Poor’s has rated more than 60 asset-backed issues (Kavanagh et al. 1992, p. 109) with an
estimated $40 billion outstanding.
Asset-backed commercial paper is issued by a company, called a special purpose entity, which
purchases receivables from one firm or a group of firms and finances the purchase with funds raised in the
commercial paper market. The sole business activity of the special company is the purchase and finance of
the receivables so the risk of the company and the commercial paper it issues is isolated from the risk of the
firm or firms which originated the receivables.
11 Value Line’s MMF, for example, held 3.5 percent of its portfolio in $22.6 million of Integrated’s paper. Value Line protected the
fund’s investors, absorbing the loss at an after-tax cost of $7.5 million.
Page 122
The trade receivables and credit card receivables that are typically used in asset-backed programs have
a predictable cash flow and default rate so the risk of the assets can be estimated. Asset-backed paper
programs are structured so that the amount of receivables exceeds the outstanding paper. In addition to this
over-collaterization, credit enhancements are used, including guarantees by the firm selling the receivables,
bank letters of credit, or surety bonds. As with all commercial paper issues, rating agencies require backup
liquidity.
The combining of similar receivables from a group of companies into a pool large enough to justify a
commercial paper program allows small firms to participate in asset-backed programs and serves to
diversify some of the receivables’ default risk. Typically, the financing firm which pools the receivables is
managed by a commercial bank which purchases assets from its corporate clients.
Swaps
A factor in the growth of the commercial paper market during the 1980s has been the rapid growth
in the market for interest rate swaps. Interest rate swaps are one of a variety of relatively new instruments
that have significantly increased the financing options of commercial paper issuers. Swaps provide issuers
with flexibility to rapidly restructure their liabilities, to raise funds at reduced costs, and to hedge risks arising
from short-term financing programs.
Interest rate swaps are agreements between two parties to exchange interest rate payments over some
specified time period on a certain amount of unexchanged principle. To appreciate the role of swaps it is
necessary to understand that there are two interest rate risks associated with commercial paper borrowing.
First, the firm faces market interest rate risk: the risk that the rate it pays on commercial paper will rise
because the level of market interest rates increases. A change in the risk-free rate, such as the Treasury bill
rate, will cause a corresponding change in all commercial paper and borrowing rates. Second, the firm faces
idiosyncratic interest rate risk: the risk that commercial paper investors will demand a higher rate because
they perceive the firm’s credit risk to have increased. With idiosyncratic risk, the rate on its commercial paper
can rise without an increase in the risk-free rate or in other commercial paper rates.
A commercial paper issuer can eliminate market interest rate risk by entering into a swap and agreeing
to exchange a fixed interest rate payment for a variable interest rate. For example, in the swap the firm may
pay a fixed interest rate that is some spread over the multi-year Treasury bond rate and receive the floating
six-month LIBOR rate. If the commercial paper rate rises because of a general rise in the market interest
rate, the firm’s increased interest payment on its commercial paper is offset by the increased payment it
receives from the swap. This swap allows the firm to transform its short-term, variable-rate commercial
paper financing into a fixed-rate liability that hedges market interest rate risks in the same manner as longterm fixed-rate, noncallable debt. Note that the firm still bears the risk of idiosyncratic changes in its
commercial paper rate. If its own commercial paper rate rises while other rates, including the LIBOR rate, do
not
Page 123
rise, the cost of borrowing in the commercial paper market will rise without a corresponding increase in the
payment from the swap.
Alternatively, the firm can fix the cost of its idiosyncratic risk by borrowing in the long-term market at a
fixed rate and entering into a swap in which it pays a floating rate and receives a fixed rate. The swap
effectively converts the long-term fixed-rate liability into a floating-rate liability that is similar to commercial
paper. The firm now faces the risk of a general change in the level on interest rates, just like a financing
strategy of issuing commercial paper, but has fixed the cost of its idiosyncratic risk by borrowing long-term in
the bond market at a fixed-rate.
One important and unresolved issue is what the advantage of swaps are relative to alternative financing
strategies. For example, why would a firm issue short-term debt and swap the flexible rate into a long-term
rate instead of issuing long-term debt? Researchers have advanced a variety of hypotheses to explain the
rapid growth of the interest rate swap market, but no real consensus has been reached. Many explanations
view swaps as a way for firms to exploit differences in the premium for credit risk at different maturities and
in different markets. For example, one firm may find it can issue commercial paper at a rate close to the
average for similarly rated issuers but pays a significantly higher spread in the long-term fixed-rate market. If
the firm prefers fixed-rate financing, a commercial paper program combined with a swap may provide
cheaper financing than issuing fixed-rate debt. But it is uncertain what causes these borrowing
differentials.12
The two interest rate swaps discussed above are the most basic examples of a wide variety of available
swaps. The examples are constructed to highlight some important aspects of interest rate swaps, but it is
not known how many of these swaps are currently being used in conjunction with commercial paper
programs.13 Some commercial paper programs involve international debt issues in conjunction with both
interest rate and currency swaps.
Foreign Commercial Paper Markets
While the U.S. market is by far the largest, a variety of foreign
commercial paper markets began operating in the 1980s and early 1990s. Table 6 lists the international
markets and shows estimates of paper outstanding at the end of 1990. Even though the U.S. commercial
paper market continued to grow in the later 1980s, its share of the worldwide commercial paper market fell
from almost 90 percent in 1986 to less than 65 percent in 1990. The Japanese market, which began in 1987,
is the largest commercial paper market outside the United States. In Europe, the French, Spanish, and
12 Some suggested reasons include market inefficiencies and differences in agency costs and bankruptcy costs across various
forms of debt. Wall and Pringle (1988) provide a review of the uses and motivations for interest rate swaps.
13 Einzig and Lange (1990) discuss some examples of interest rate swaps used in practice.
Page 124
TABLE 6
International Commercial Paper Markets
Amounts Outstanding, End of 1990
Billions of U.S. Dollars
United States
557.8
Japan
117.3
France
31.0
Canada
26.8
Sweden
22.3
Spain
20.0 *
Australia
10.9
United Kingdom
9.1
Finland
8.3
Norway
2.6
Netherlands
2.0
Euro-CP
70.4
Total
878.5
* Estimate
Source: Bank for International Settlements.
Swedish commercial paper markets are well established and the German market has shown rapid growth
since it began in 1991. 14
Some U.S. firms simultaneously maintain a commercial paper program in the United States and issue
dollar-denominated commercial paper abroad in the Euro commercial paper market. The Euro commercial
paper market developed from note issuance and revolving underwriting facilities of the late 1970s in which
firms issued tradable notes with the characteristics of commercial paper in conjunction with a loan
agreement in which a bank or bank syndicate agreed to purchase the notes if the issuer was unable to place
them with investors. In the early 1980s, higher-quality issuers began issuing notes without the backup
facilities. The Euro commercial paper market grew rapidly from 1985 to 1990. By the middle of 1992,
outstanding Euro commercial paper totaled $87 billion. U.S. financial and industrial firms are important
issuers, either directly or through their foreign subsidiaries. Approximately 75 percent of Euro commercial
paper is denominated in U.S. dollars while the remainder is denominated in European currency units, Italian
liras, and Japanese yen. Issuers commonly issue Euro commercial paper in dollars and use swaps or
foreign exchange transactions to convert their borrowings to another currency. The foreign markets,
including the Euro commercial paper market, provide issuers flexibility in raising
14 Bank for International Settlements (1991) reviews the international commercial paper markets. Also see Euromoney (1992) for
a review of the European money markets.
Page 125
short-term funds, allowing them to diversify their investor base, to establish presence in the international
credit markets, and to obtain the lowest cost of funds.
While the Euro commercial paper market has similarities to the U.S. market, there are some important
differences. The maturity of Euro commercial paper has been longer than in the United States, typically
between 60 to 180 days, and, partly reflecting the longer maturities, there is an active secondary market.
There is some evidence that the credit quality of the typical issuer in the Euro commercial paper market is
not as high as in the U.S. market. Both Standard & Poor’s and Moody’s rate Euro commercial paper
programs, but ratings have not been as crucial in the Euro market as they have been in the U.S. market.
U.S. firms with less than A1-P1 ratings have found that the Euro market has been more receptive than the
domestic market to commercial paper issues with no credit enhancements attached. Higher default rates
abroad reflect the less stringent credit standards. Fons and Kimball (1992) estimate that the amount of
defaults as a percent of the total volume of commercial paper issued in the non-U.S. markets (including the
Euro commercial paper market) in 1989 to 1991 was 0.0242 percent, which was significantly greater than
the 0.0040 percent in the U.S. market. In 1989, the four Euro commercial paper defaults affected almost 1
percent of the market.
The Growing Importance of Commercial Paper
The rapid growth of commercial paper shown in Figure
1 reflects the advantages of financing and investing using the capital markets rather than the banking
system. To a significant extent, the advantage of commercial paper issuance is cost: high-quality issuers
have generally found borrowing in the commercial paper to be cheaper than bank loans. The cost of
commercial paper programs, including the cost of distribution, agent fees, rating fees, and fees for backup
credit lines, are small, amounting to perhaps 15 basis points in a large program. A highly rated bank borrows
at a cost of funds comparable to other commercial paper issuers, and it must add a spread when lending to
cover the expenses and capital cost of its operations and to cover any reserve requirements. Riskier firms
are willing to pay this spread because the bank adds value by generating information about the
creditworthiness of the borrower which enables it to lend at less cost than the commercial paper market. A
large creditworthy issuer will generally find it cheaper to bypass the bank and raise funds directly in the
credit market.
The growth of the commercial paper market can be viewed as part of a wider trend towards corporate
financing using securities rather than bank loans. Other aspects of this trend, commonly referred to as asset
securitization, include the rapid growth of the bond and junk bond markets and the market for asset-backed
securities. The pace of asset securitization increased sharply in the 1980s. New security technology,
including the development of risk management tools like
Page 126
swaps and interest rate caps, became widespread. At the same time, established markets expanded to
include new issuers. Smaller, riskier firms increased their issuance of long-term bonds and entered the
commercial paper market with asset-backed paper and letter of credit programs. Commercial paper is likely
to remain a significant source of financing for domestic and foreign firms and a relatively safe short-term
security for investors.
REFERENCES
Bank for International Settlements. International Banking and Financial Market Developments. Basle, Switzerland,
August 1991.
Board of Governors of the Federal Reserve System. Flow of Funds Accounts, Financial Assets and Liabilities, First
Quarter 1992. Washington: Board of Governors, 1992.
Crabbe, Leland, and Mitchell A. Post. “The Effect of SEC Amendments to Rule 2A-7 on the Commercial Paper
Market.” Washington: Board of Governors of the Federal Reserve System, May 1992.
________. “The Effect of a Rating Change on Commercial Paper Outstandings.” Washington: Board of Governors of
the Federal Reserve System, January 1992.
The Depository Trust Company. Final Plan for a Commercial Paper Program. Memorandum, April 1990.
Einzig, Robert, and Bruce Lange. “Swaps at TransAmerica: Analysis and Applications,” Journal of Applied Corporate
Finance, vol. 2 (Winter 1990), pp. 48-58.
“1992 Guide to European Domestic Money Markets,” published with Euromoney, September 1992.
Federal Reserve Bank of New York. Press Release No. 1932, Market Reports Division, May 13, 1992.
Felix, Richard, ed. Commercial Paper. London: Euromoney Publications, 1987.
Fons, Jerome S., and Andrew E. Kimball. “Defaults and Orderly Exits of Commercial Paper Issuers,” Moody’s Special
Report, Moody’s Investor Service, February 1992.
General Motors Acceptance Corporation. 1991 Annual Report. Detroit, Mich.: 1992.
Kakutani, Masaru, M. Douglas Watson, Jr., and Donald E. Noe. “Analytical Framework Involving the Rating of Debt
Instruments Supported by ‘Keepwell’ Agreements,” Moody’s Special Comment, Moody’s Investors Service,
July 1992.
Kavanagh, Barbara, Thomas R. Boemio, and Gerald A. Edwards, Jr. “Asset-Backed Commercial Paper Programs,”
Federal Reserve Bulletin, vol. 78 (February 1992), pp. 107-16.
Peavy, John W., and S. Michael Edgar. “A Multiple Discriminant Analysis of BHC Commercial Paper Ratings,”
Journal of Banking and Finance, vol. 7 (1983), pp. 161-73.
Samson, Solomon B., and Mark Bachmann. “Paper Backup Policies Revisited,” Standard & Poor’s Creditweek,
September 10, 1990, pp. 23-24.
Page 127
Slovin, Myron B., Marie E. Sushka, and Carl D. Hudson. “Corporate Commercial Paper, Note Issuance Facilities, and
Shareholder Wealth,” Journal of International Money and Finance, vol. 7 (1988), pp. 289-302.
Standard & Poor’s Corporation. Commercial Paper Ratings Guide. April 1991.
Stigum, Marcia. The Money Market. Homewood, Ill.: Dow Jones-Irwin, 1990.
Wakeman, L. Macdonald. “The Real Function of Bond Rating Agencies,” Chase Financial Quarterly, vol. 1 (Fall
1981), pp. 19-25.
Wall, Larry D., and John J. Pringle. “Interest Rate Swaps: A Review of the Issues,” Federal Reserve Bank of Atlanta
Economic Review, November/December 1988, pp. 22-40.
Monetary Theory and Policy
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
 Monetary theory
 Tradeoff faced by the Fed
 Economic indicators monitored by the Fed
 Lags in monetary policy
 Assessing the impact of monetary policy
 Integrating monetary and fiscal policies
 Global effects of monetary policy
2
 Pure Keynesian Theory
◦ One of the most popular theories influencing the
Fed
◦ Developed by John Maynard Keynes
◦ Suggests how the Fed can affect the interaction
between the demand for money and the supply of
money to influence:
 Interest rates
 The aggregate level of spending
 Economic growth
3
 Pure Keynesian Theory (cont’d)
◦ Can be explained by using the loanable funds
framework
 Demand for and supply of loanable funds determine
the equilibrium interest rate
 The business investment schedule illustrates the
inverse relationship between interest rates on loanable
funds and the level of business investment
4
 Pure Keynesian Theory (cont’d)
◦ Correcting a weak economy
 The Fed would use open market operations to increase
the money supply
 A higher level of the money supply would reduce interest
rates
 Lower interest rates encourage more borrowing and
spending
 Keynesian philosophy advocates an active role for the
government in correcting economic problems
5
Correcting a Weak Economy
S1
S2
i1
i1
i2
i2
D1
Demand and Supply of Loanable Funds
B1
B2
Business Investment Schedule
6
 Pure Keynesian Theory (cont’d)
◦ Correcting high inflation
 The Fed would sell Treasury securities (decrease the
money supply)
 A lower level of the money supply reduces the level of
spending
 Less spending slows economic growth and reduces
inflationary pressure (demand-pull inflation)
7
Correcting High Inflation
S2
S1
i2
i2
i1
i1
D1
Demand and Supply of Loanable Funds
B2
B1
Business Investment Schedule
8
 Pure Keynesian Theory (cont’d)
◦ Effects of a credit crunch on a stimulative policy
 The economic impact of monetary policy depends on the
willingness of banks to lend funds
 If banks are unwilling to extend credit despite a
stimulative policy, the result is a credit crunch
 A credit crunch can occur during a restrictive policy since
some borrowers will not borrow because of the high
interest rates
9
 Quantity Theory and the Monetarist
approach
 The quantity theory suggests a particular relationship
between the money supply and the degree of
economic activity in the equation of exchange:
MV = PGQ
 Velocity is the average number of times each dollar
changes hands per year
 The right side of the equation is the total value of goods
and services produced
 If velocity is constant, a change in the money supply will
produce a predictable change in the total value of goods
and services
10
 Quantity Theory and the Monetarist
approach (cont’d)
◦ An early form of the theory assumed a
constant Q
 Assumes a direct relationship between the money
supply and prices
◦ Under the modern quantity theory of money,
the constant quantity assumptions has been
relaxed
 A direct relationship exists between the money supply
and the value of goods and services
11
 Quantity Theory and the Monetarist
approach (cont’d)
◦ Velocity represents the ratio of money stock to
nominal output
◦ Velocity is affected by any factor that
influences this ratio:
 Income patterns
 Factors that change the ratio of households’ money
holdings to income
 Credit cards
 Inflationary expectations
12
 Comparison of the Monetarist and
Keynesian Theories
◦ The Monetarist approach advocates stable, low
growth in the money supply
 Allows economic problems to resolve themselves
◦ Keynesian approach would call for a loose
monetary policy to cure a recession
13
 Comparison of the Monetarist and
Keynesian Theories (cont’d)
◦ Monetarists are concerned about maintaining
low inflation and are willing to tolerate a
natural rate of unemployment
◦ Keynesians focus on maintaining low
unemployment and are willing to tolerate any
inflation that results from stimulative
monetary policies
14

Theory of Rational Expectations
◦ Holds that the public accounts for all existing
information when forming its expectations
◦ Suggests that households and business will use
historical effects of monetary policy to forecast the
impact of an existing policy and act accordingly
 Households spend more with a loose monetary policy to
avoid inflation
 Businesses will increase their investment with a loose
monetary policy to avoid higher costs
 Labor market participants will negotiate higher wages with a
loose monetary policy
◦ Supports the Monetarist view that changes in monetary
policy do not have a sustained impact on the economy
15
 Which theory is correct?
◦ The FOMC recognizes the virtues and
limitations of each theory
 The FOMC adjusts monetary growth targets to control
economic growth, inflation, and unemployment
 Recognizing the Monetarist view, the FOMC is
concerned about the inflation resulting from a loose
monetary policy
16
 Ideally, the Fed would like:
◦ Low inflation
◦ Steady GDP growth
◦ Low unemployment
 There is a negative relationship between
unemployment and inflation
◦ Phillips curve
◦ A tight money policy can curb inflation but
increase unemployment and vice versa
17
 Impact of other forces on the tradeoff
◦ Cost factors such as energy costs and insurance
costs can influence the tradeoff
◦ When both inflation and unemployment are high,
Fed members may disagree as to the type of
monetary policy that should be implemented
18

Impact of other forces on the tradeoff (cont’d)
◦ How the Fed’s focus shifted during the Persian Gulf War
 There were numerous indications of a possible recession in the
summer of 1990
 The abrupt increase in oil prices placed upward pressure on U.S.
inflation
◦ How the Fed’s emphasis shifted during 2001–2004
 The focus shifted from high inflation to the weak economy over
time
 From January to December 2001, the FOMC reduced the
targeted federal funds rate ten times
 In 2002 and 2003, the Fed reduced the federal funds target rate
twice
19
 Indicators of economic growth
◦ Gross domestic product (GDP)
 Measures the total value of goods and services
produced
 Measured each month
 The most direct indicator of economic growth
◦ Level of production
 A high level indicates strong economic growth and can
result in increased demand for labor
20
 Indicators of economic growth (cont’d)
◦ National income
 The total income earned by firms and individual
employees
 A strong demand for goods and services results in a large
amount of income
◦ Unemployment rate
 Does not necessarily indicate the degree of economic
growth
 Can decrease in weak economic growth periods if new
jobs are created
21
 Indicators of economic growth (cont’d)
◦ Industrial production index
◦ Retail sales index
◦ Home sales index
◦ Composite index
◦ Consumer confidence surveys
22
 Indicators of inflation
◦ Producer and consumer price indexes
 The PPI measures prices at the wholesale level
 The CPI measures prices on the retail level
 Both indexes are used to forecast inflation
 Agricultural and housing price indexes also exist
◦ Other indicators
 Wages, oil prices, transportation costs, the price of
gold, indicators of economic growth
23
 How the Fed uses indicators
◦ The Fed uses indicators to anticipate how economic
conditions will change and then determines what
monetary policy would be appropriate
 Weak economic conditions suggest an expansionary
monetary policy
 High productivity and employment suggest a
restrictive monetary policy
24
 Index of Leading Economic Indicators
◦ The Conference Board publishes indexes of
leading, coincident, and lagging economic
indicators
 Leading economic indicators are used to predict future
economic activity
 Three consecutive monthly changes in the same direction
suggest a turning point in the economy
 Coincident economic indicators reach their peaks and
troughs at the same time as business cycles
 Lagging economic indicators tend to rise or fall a few
months after business-cycle expansions and contractions
25
 The recognition lag is the lag between the
time a problem arises and the time it is
recognized
 The implementation lag is the lag between
the time a serious problem is recognized
and the time the Fed implements a policy to
resolve it
 The impact lag is the lag between the a
policy is implemented and the time the
policy has its full impact on the economy
26
 Lags hinder the Fed’s control of the economy
◦ By the time a policy is implemented, economic
conditions may have reversed
◦ Without monetary policy lags, implemented policies
would have a higher rate of success
27
 Financial market participants will not all react
to monetary policy in the same manner
◦ Different securities are affected differently
 Participants trading the same securities may
still be affected differently
◦ Expectations about the policy’s impact on economic
variables may differ
28

Forecasting money supply movements
◦ Periodicals sometimes specify the weekly ranges of M1 and
M2 based on the Fed’s disclosure of target ranges
◦ When the actual money supply falls outside the target
range, a change in the Fed’s range has not yet been
publicly announced
◦ Improved communication from the Fed
 Uncertainty about FOMC meeting results prior to 1999 caused
volatile price movements
 Since 1999, the Fed has been more willing to disclose its
conclusions (federal funds rate target changes and possible
future tightening or loosening of the money supply)
29
 Forecasting the impact of monetary policy
◦ Even if market participants correctly anticipate
changes in the money supply, they may not be
able to predict future economic conditions
 The historic relationship between the money supply and
economic variables has not been stable
 Impact of monetary policy across financial markets
 Monetary policy affects the securities traded in all financial
markets due to its effect on interest rates and economic
growth
30
 The Fed’s monetary policy is commonly
influenced by the administration’s fiscal
policies
 The Fed and the administration often use
complementary policies to resolve economic
problems
 Fiscal policy typically influences the demand
for loanable funds, while monetary policy
normally has a larger impact on the supply
of loanable funds
31
 History
◦ Presidential administrations have been more
concerned with maintaining strong economic
growth and low unemployment
 The Fed shared the same concerns in the early 1970s
 By 1980, there was high inflation and unemployment
 The administration cut taxes to stimulate the economy
 The Fed used a tight monetary policy to reduce inflation
 The Fed ultimately loosened the money supply in 1983
32
 Monetizing the debt
◦ Should the Fed help finance the federal budget
deficit that has been created from fiscal policy?
 Loosening the money supply in response to a higher
budget deficit is called monetizing the debt
 If the Fed does not monetize the debt, a weak economy
may be more likely
 If the Fed monetizes the debt, higher money supply
growth is required
33
 Market assessment of integrated policies
◦ Market participants must consider both fiscal and
monetary policies when assessing future
economic conditions
 The supply of loanable funds can be affected by the Fed’s
adjustment of the money supply or changes in tax
policies
 The demand for loanable funds is affected by changes in
the money supply or government expenditures and
possibly tax revisions
 Once the supply and demand for loanable funds has been
forecasted, interest rate movements can be forecast
34
 Impact of the dollar
◦ A weak dollar stimulates exports and discourages
imports, which stimulates the economy
◦ The Fed is less likely to use a stimulative
monetary policy when the dollar is weak
 Impact of global economic conditions
◦ When global economic conditions are strong,
foreign countries purchase more U.S. products,
which stimulates the U.S. economy
35
 Transmission of interest rates
◦ Upward pressure on U.S. interest rates may be
offset by foreign inflows of funds
◦ A high U.S. budget deficit may lead to higher
interest rates in other countries
 Global crowding out
 Fed policy during the Asian Crisis
◦ The Fed may have lowered interest rates more
than it would have without the crisis
 Offset the lower demand for U.S. exports and helped to
sustain U.S. demand for foreign exports
36
Money Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
 Money market securities
 Institutional use of money markets
 Valuation of money market securities
 Risk of money market securities
 Interaction among money market yields
 Globalization of money markets
2
 Money market securities:
◦ Have maturities within one year
◦ Are issued by corporations and governments to
obtain short-term funds
◦ Are commonly purchased by corporations and
government agencies that have funds available for a
short-term period
◦ Provide liquidity to investors
3
 Treasury bills:
◦ Are issued by the U.S. Treasury
◦ Are sold weekly through an auction
◦ Have a par value of $1,000
◦ Are attractive to investors because they are
backed by the federal government and are free of
default risk
◦ Are liquid
◦ Can be sold in the secondary market through
government security dealers
4
 Treasury bills (cont’d)
◦ Investors in Treasury bills
 Depository institutions because T-bills can be easily
liquidated
 Other financial institutions in case cash outflows exceed
cash inflows
 Individuals with substantial savings for liquidity purposes
 Corporations to have easy access to funding for
unanticipated expenses
5
 Treasury bills (cont’d)
◦ Pricing Treasury bills
 The price is dependent on the investor’s required rate
of return:
Pm = Par /(1 + k )n
 Treasury bills do not pay interest
 To price a T-bill with a maturity less than one year,
the annualized return can be reduced by the fraction
of the year in which funds would be invested
6
A one-year Treasury bill has a par value of
$10,000. Investors require a return of 8
percent on the T-bill. What is the price
investors would be willing to pay for this
T-bill?
Pm = Par /(1 + k )n
= $10,000 /(1.08 )
= $9,259
7
 Treasury bills (cont’d)
◦ Treasury bill auction
 Investors submit bids on T-bill applications for the
maturity of their choice
 Applications can be obtained from a Federal Reserve
district or branch bank
 Financial institutions can submit their bids using the
Treasury Automated Auction Processing System (TAAPSLink)
 Institutions must set up an account with the Treasury
 Payments to the Treasury are withdrawn electronically from
the account
 Payments received from the Treasury are deposited into the
account
8
 Treasury bills (cont’d)
◦ Treasury bill auction (cont’d)
 Weekly auctions include 13-week and 26-week T-bills
 4-week T-bills are offered when the Treasury anticipates
a short-term cash deficiency
 Cash management bills are also occasionally offered
 Investors can submit competitive or noncompetitive bids
 The bids of noncompetitive bidders are accepted
 The highest competitive bids are accepted
 Any bids below the cutoff are not accepted
 Since 1998, the lowest competitive bid is the price
applied to all competitive and noncompetitive bids
9
 Treasury bills (cont’d)
◦ Estimating the yield
 T-bills are sold at a discount from par value
 The yield is influenced by the difference between the
selling price and the purchase price
 If a newly-issued T-bill is purchased and held until
maturity, the yield is based on the difference between par
value and the purchase price
10
 Treasury bills (cont’d)
◦ Estimating the yield (cont’d)
 The annualized yield is:
YT =
SP − PP 365

PP
n
◦ Estimating the T-bill discount
 The discount represents the percent discount of the
purchase price from par value for newly-issued Tbills:
Par − PP 360
T – bill discount =

Par
n
11
An investor purchases a 91-day T-bill for
$9,782. If the T-bill is held to maturity,
what is the yield the investor would earn?
SP − PP 365

PP
n
10,000 − 9,782 365
=

9,782
91
= 8.94%
YT =
12
Using the information from the previous
example, what is the T-bill discount?
Par − PP 360

Par
n
10,000 − 9,782 360
=

10,000
91
= 8.62%
T – bill discount =
13

Commercial paper:
◦ Is a short-term debt instrument issued by well-known,
creditworthy firms
◦ Is typically unsecured
◦ Is issued to provide liquidity to finance a firm’s investment
in inventory and accounts receivable
◦ Is an alternative to short-term bank loans
◦ Has a minimum denomination of $100,000
◦ Has a typical maturity between 20 and 270 days
◦ Is issued by financial institutions such as finance
companies and bank holding companies
◦ Has no active secondary market
◦ Is typically not purchased directly by individual investors
14
 Commercial paper (cont’d)
◦ Ratings
 The risk of default depends on the issuer’s financial
condition and cash flow
 Commercial paper rating serves as an indicator of the
potential risk of default
 Corporations can more easily place commercial paper that
is assigned a top-tier rating
 Junk commercial paper is rated low or not rated at all
15
 Commercial paper (cont’d)
◦ Volume of commercial paper:
 Has increased substantially over time
 Is commonly reduced during recessionary periods
◦ Placement
 Some firms place commercial paper directly with
investors
 Most firms rely on commercial paper dealers to sell it
 Some firms (such as finance companies) create in-house
departments to place commercial paper
16
 Commercial paper (cont’d)
◦ Backing commercial paper
 Issuers typically maintain a backup line of credit
 Allows the company the right to borrow a specified maximum
amount of funds over a specified period of time
 Involves a fee in the form of a direct percentage or in the
form of required compensating balances
◦ Estimating the yield
 The yield on commercial paper is slightly higher than on a
T-bill
 The nominal return is the difference between the price
paid and the par value
17
An investor purchases 120-day commercial
paper with a par value of $300,000 for a
price of $289,000. What is the annualized
commercial paper yield?
300,000 – 289,000 360
Ycp =

289,000
120
= 11.42%
18
 Commercial paper (cont’d)
◦ The commercial paper yield curve:
 Illustrates the yield offered on commercial paper at
various maturities
 Is typically established for a maturity range from 0 to 90
days
 Is important because it may influence the maturity that is
used by firms that issue CP
 Is similar to the short-term range of the Treasury yield
curve
 Is affected by short-term interest rate expectations
 Is similar to the yield curve on other money market
instruments
19
 Negotiable certificates of deposit (NCDs):
◦ Are issued by large commercial banks and other
depository institutions as a short-term source of
funds
◦ Have a minimum denomination of $100,000
◦ Are often purchased by nonfinancial corporations
◦ Are sometimes purchased by money market
funds
◦ Have a typical maturity between two weeks and
one year
◦ Have a secondary market
20
 Negotiable certificates of deposit (NCDs)
(cont’d)
◦ Placement
 Directly
 Through a correspondent institution
 Through securities dealers
◦ Premium
 NCDs offer a premium above the T-bill yield to
compensate for less liquidity and safety
 Premiums are generally higher during recessionary
periods
21
 Negotiable certificates of deposit (NCDs)
(cont’d)
◦ Yield
 NCDs provide a return in the form of interest and the
difference between the price at which the NCD was
redeemed or sold and the purchase price
 If investors purchase a NCD and hold it until maturity,
their annualized yield is the interest rate
22

Repurchase agreements
◦ One party sells securities to another with an agreement to
repurchase them at a specified date and price
 Essentially a loan backed by securities
◦ A reverse repo refers to the purchase of securities by one
party from another with an agreement to sell them
◦ Bank, S&Ls, and money market funds often participate in
repos
◦ Transactions amounts are usually for $10 million or more
◦ Common maturities are from 1 day to 15 days and for one,
three, and six months
◦ There is no secondary market for repos
23
 Repurchase agreements (cont’d)
◦ Placement
 Repo transactions are negotiated through a
telecommunications network with dealers and repo
brokers
 When a borrowing firm can find a counterparty to a repo
transaction, it avoids the transaction fee
 Some companies use in-house departments
◦ Estimating the yield
 The repo yield is determined by the difference between
the initial selling price and the repurchase price,
annualized with a 360-day year
24
An investor initially purchased securities at a
price of $9,913,314, with an agreement to
sell them back at a price of $10,000,000 at
the end of a 90-day period. What is the
repo rate?
SP − PP 360

PP
n
10,000,000 − 9,913,314 360
=

9,913,314
90
= 3.50%
Repo rate =
25
 Federal funds
◦ The federal funds market allows depository
institutions to lend or borrow short-term funds
from each other at the federal funds rate
 The rate is influenced by the supply and demand for
funds in the federal funds market
 The Fed adjusts the amount of funds in depository
institutions to influence the rate
 All firms monitor the fed funds rate because the Fed
manipulates it to affect economic conditions
 The fed funds rate is typically slightly higher than the Tbill rate
26
 Federal funds (cont’d)
◦ Two depository institutions communicate directly
through a communications network or through a
federal funds broker
◦ The lending institution instructs its Fed district
bank to debit its reserve account and to credit the
borrowing institution’s reserve account by the
amount of the loan
◦ Commercial banks are the most active
participants in the federal funds market
◦ Most loan transactions are or $5 million or more
and usually have one- to seven-day maturities
27

Banker’s acceptances:
◦ Indicate that a bank accepts responsibility for a future
payments
◦ Are commonly used for international trade transactions
 An unknown importer’s bank may serve as the guarantor
 Exporters frequently sell an acceptance before the payment date
◦ Have a return equal to the difference between the
discounted price paid and the amount to be received in the
future
◦ Have an active secondary market facilitated by dealers
28
 Banker’s acceptances (cont’d)
◦ Steps involved in banker’s acceptances
 First, the U.S. importer places a purchase order for goods
 The importer asks its bank to issue a letter of credit (L/C)
on its behalf
 Represents a commitment by that bank to back the payment
owed to the foreign exporter
 The L/C is presented to the exporter’s bank
 The exporter sends the goods to the importer and the
shipping documents to its bank
 The shipping documents are passed along to the
importer’s bank
29
Purchase Order
1
Importer
Shipment of Goods
5
2
Exporter
4
L/C Notification
6
Shipping Documents & Time Draft
L/C Application
3
American Bank
(Importer’s Bank)
L/C
Shipping Documents
7 & Time Draft Accepted
Japanese Bank
(Exporter’s Bank)
30
Financial institutions purchase money market
securities to earn a return and maintain adequate
liquidity
 Institutions issue money market securities when
experiencing a temporary shortage of cash
 Money market securities enhance liquidity:

◦ Newly-issued securities generate cash
◦ Institutions that previously purchased securities will
generate cash upon liquidation
◦ Most institutions hold either securities that have very active
secondary markets or securities with short-term maturities
31
 Financial institutions with uncertain cash
in- and outflows maintain additional money
market securities
 Institutions that purchase securities act as a
creditor to the initial issuer
 Some institutions issue their own money
market instruments to obtain cash
 Many money market transaction involve two
financial institutions
32
 For money market securities making no
interest payments, the value reflects the
present value of a future lump-sum payment
◦ The discount rate is the required rate of return by
investors
33
 Explaining money market price
movements
◦ The price of a noninterest-paying money
market security is:
n
Pm = Par /(1 + k )
◦ A change in the price can be modeled as:
Pm = f ( k ) and k = f ( Rf , RP )
34
 Explaining money market price
movements (cont’d)
◦ Impact of September 11
 The weak economy combined with this event caused
investors to transfer funds into money market
securities
 The additional demand placed upward pressure on
their price and downward pressure on their yields
 The Fed added liquidity to the banking system and
reduced the federal funds rate
35

Indicators of future money market security
prices
◦ Economic growth is monitored since it signals changes
in short-term interest rates and the required return from
investing in money market securities
 Employment
 GDP
 Retail sales
 Industrial production
 Consumer confidence
 Indicators of inflation
36

Because of the short maturity, money market
securities are generally not subject to interest
rate risk, but they are subject to default risk
◦ Investors commonly invest in securities that offer a
slightly higher yield than T-bills and are very unlikely to
default
◦ Although investors can assess economic and firmspecific conditions to determine credit risk, information
about the issuer’s financial condition is limited

Measuring risk
◦ Money market participants can use sensitivity analysis
to determine how the value of money market securities
may change in response to a change in interest rates
37
 Money market instruments are
substitutes for each other
◦ Market forces will correct disparities in yield
and the yields among securities tend to be
similar
 In periods of heightened uncertainty,
investors tend to shift from risky money
market securities to Treasuries
◦ Flight to quality
◦ Creates a greater differential between yields
38
Interest rate differentials occur because
geographic markets are somewhat segmented
 Interest rates have become more highly
correlated:

◦ Conversion to the euro
◦ The flow of funds between countries has increased
because of:
 Tax differences
 Speculation on exchange rate movements
 A reduction in government barriers
◦ Eurodollar deposits, Euronotes, and Euro-commercial
paper are widely traded in international money markets
39

Eurodollar deposits and Euronotes
◦ Eurodollar certificates of deposit are U.S. dollar deposits
in non-U.S. banks
 Have increased because of increasing international trade
and historical U.S. interest rate ceilings
◦ In the Eurodollar market, banks channel deposited
funds to other firms that need to borrow them in the
form of Eurodollar loans
 Typical transactions are $1 million or more
 Eurodollar CDs are not subject to reserve requirements
 Interest rates are attractive for both depositors and
borrowers
 Rates offered on Eurodollar deposits are slightly higher than
NCD rates
40

Eurodollar deposits and Euronotes (cont’d)
◦ Investors in fixed-rate Eurodollar CDs are adversely
affected by rising market rates
◦ Issuers of fixed-rate Eurodollar CDs are adversely
affected by declining rates
 Eurodollar-floating-rate CDs (FRCDs) periodically adjust to
LIBOR
◦ The Eurocurrency market is made up of Eurobanks that
accept large deposits and provide large loans in foreign
currencies
◦ Loans in the Eurocredit market have longer maturities
than loans in the Eurocurrency market
◦ Short-term Euronotes are issued in bearer form with
maturities of one, three, and six months
41
 Euro-commercial paper (Euro-CP):
◦ Is issued without the backing of a banking
syndicate
◦ Has maturities tailored to satisfy investors
◦ Has a secondary market run by CP dealers
◦ Has a rate 50 to 100 basis points above LIBOR
◦ Is sold by dealers at a transaction cost
between 5 and 10 basis points of the face
value
42
 Performance of foreign money market
securities
◦ Measured by the effective yield (adjusted for
the exchange rate
Ye = (1 + Yf )  (1 + %S ) − 1
◦ Depends on:
 The yield earned on the money market security in the
foreign currency
 The exchange rate effect
43
A U.S. investor buys euros for $1.15 and
invests in a one-year European security
with a yield of 8 percent. After one year,
the investor converts the proceeds from
the investment back to dollars at the spot
rate of $1.16 per euro. What is the
effective yield earned by the investor?
Ye = (1 + Yf )  (1 + %S ) − 1
= 1.08  1.0087 − 1
= 8.94%
44