INSTRUMENTS IN THE MONEY & CAPITAL MARKETS Treasury and Agency Securities Size of the market Treasury Bills, Notes, and Bonds

Agency securities

Auction process Competitive and non-competitive bids

Secondary market High level of activity Unique dealer structure Inter-dealer market

Stripping Treasuries history and institutional details uses of stripped Treasuries

Repurchase agreements

Treasury and Agency Securities

Overall size of the Treasury and agency markets

Types of liabilities of the federal government Treasury Bill - liability of US Treasury with original maturity of < 1 year; sold as a pure discount insturment

Treasury Note - liability of US Treasury with original maturity between 2 and 10 years; sold as a coupon-bearing instrument

Treasury Bond - liability of US Treasury with original maturity greater than 10 years

Distinguishing feature is that these instruments are backed by the full faith and credit of the US govt credit risk? interest rate risk? liquidity of secondary markets?

Agency securities come in 2 types securities issued by federally sponsored agencies - privately owned and publicly chartered entities created by Congress to reduce the costs of borrowed funds for particular sectors of the economy includes Federal Farm Credit Bank System, Federal Home Loan Mortgage Corporation, Federal National Mortgage Association, Student Loan Marketing Association securities issued by Federal Financing Bank to finance federally related instituitions (arms of the gov’t that seek financing for their activities separately from the Treasury) federally related institutions include Export-Import Bank, Comodity Credit Corporation, the Federal Housing Administration, the General Services Administration, the Maritime Administration, the Small Business Administration, the Tennessee Valley Authority, and the Washington Metropolitan Area Transit Authority most are backed by full faith and credit of the US govt

THE AUCTION PROCESS The schedule Treasury Bills - 3 and 6 month Bills are auctioned weekly on Mondays; 1 year Bills are auctioned once a month on Monday of the 3rd week

Cash Management Bills - auctioned when the Treasury is temporarily short of cash; maturities tailored according to anticipated issue dates for Notes/Bonds or tax collection dates

Treasury Notes and Bonds - per schedule

Bidding for Treasuries Competitive bids show face value desired and the bank discount yield bid for T-Bills (shows yield-to-maturity bid for Notes and Bonds). Any bid in excess of $5,000,000 face value

Non-competitive bids show only the face value to be purchased. Noncompetitive bids are filled at the average of the competitive bids that are accepted. cannot exceed $5,000,000

Procedure for filling bids 1. Subtract amount of non-competitive bids and Fed purchases from total to be auctioned.

2. Remainder is distributed to competitve bidders in order of ascending rates until the auction amount is sold out.

3. Non-competitive bids are filled at the average of the competitive bids.

STOP YIELD/PRICE - highest yield/lowest price of a competitive bid that is accepted. Up to this point, bidders bet the full amount that they bid for. Above this point, they get nothing. “ties” at the stop yield are filled on a pro rata basis

TAIL of auction = average of accepted yields - stop yield measures depth of bidding

the 35% rule and the Saloman Brothers scandal

THE SECONDARY MARKET - composed primarily of a network of dealers most active and liquid market in the world distinguished by 3 characteristics #1: Volume Traded Avg daily vol. in 1992 maturity group amount T-Bills $33.2 billion Coups w/ mat < 3.5 yrs 50.1 3.5 to 7.5 yrs 44.3 7.5 to 15 yrs 18.9 > 15 years 18.5 on the run vs off the run issues

#2: Network of Dealers Primary dealers (38) vs secondary dealers (several hundred) who are the primary dealers responsibilities and privileges of primary dealers extent of price information available to trading public competition between dealers for volume

#3: the “interdealer” market 5 screen brokers provide a computer network to the primary dealers

At each moment the computer lists the available quotes for each outstanding Treasury issue

All listings are anonymous

Traders working for each dealer key in desired trades. brokers handle settlement of all trades

Screen

STRIPPING TREASURIES Traditionally, all Treasury issues with maturities > 1 year have been coupon bearing instruments

In 1982, Merrill Lynch and Saloman Bros started trading created synthetic zero coupon Treasuries Treasury Income Growth Receipts (TIGRs) Certificates of Accrual on Treasury Securities (CATS)

Procedure 1. Securities firm buys Treasury issue 2. Securities firm deposits Treasury with a bank acting as a trustee 3. Securities firm sell claims against each coupon and the principalof the Treasury issue The claims against the securities firm are effecively collateralized by Treasuries held by trustee.

Historical development Prior to 1982, govt opposed stripping 1982-1985: govt tolerated stripping 1985: Treasury introduced its own program called “Separate Trading of Registerd Interest and Principal of Securities” (or STRIPS) STRIPS yields quoted in WSJ

STRIPS differed from TIGRs and CATS because resulting security was a liability of US govt

Why would investors pay more for the strips (e.g., 60 coupons and 1 principal payment traded as 61 separate instruments) than the bond traded as a single security (60 coupons and principal payment traded as a single unit)? Market inefficiencies create arbitrage profits Imperfections or impediments restrict choices available to investors. When a valuable new opportunity becomes available, investors pay for it.

What valuable new opportunity do strips provide?

REPURCHASE AGREEMENT - an agreement to sell (buy) a secrity today and to repurhase (resell) it from (to) the same party a predetermined price at specified date in the future.

Repo and reverse Repo Repo rate Most transactions have maturities of one business day term repos - maturity > 1 week

Repo trades are collateralized loans where collateral is an actively traded security. Most common seller is a govt securities dealer

Why is Repo rate > rate on underlying security? Where does credit risk enter?

Why are Repos common with short term Treausuries but uncommon in corporate and municipal debt markets?