The Money Markets Handbook
Moorad Choudhry
In the book The Money Markets Handbook, the author Moorad Choudhry has explained the functioning of money market and various instruments that are transacted in a money market. The author has tried to provide technical knowledge about different aspects of money market. He has divided the various instruments dealt in a money market into chapters to cover all the aspects related to a particular instrument. All concepts are well explained with hypothetical and real life illustrations supplemented with all the formulae needed for the calculation of prices and interest rates, etc.
The first chapter of the book deals with the introduction to the money market. In this chapter the author has explained the meaning and significance of money market in the financial system of an economy. A market instrument that has maturity of one year or less is defined as a money market product. Money market instruments include various cash instruments and a wide range of exchange-traded and over-the-counter off-balance sheet derivative instruments. In this chapter he has reviewed cash instruments traded in money market.
The cash instruments traded in the money market include Time Deposits, Treasury Bills, Certificates of Deposits (CDs), Commercial Paper (CP), bankers Acceptances and Bills of exchange. The author has explained how all these instruments are traded in the money market by different institutions for different purposes. He further explains how these instruments differ from each other in terms of their functioning in the market. He explained how calculation of interest in money market differs from the calculation of accrued interest in the corresponding bond market. He has classified these cash instruments into two classes; those quoted on a yield basis and those quoted on discount basis. The two cash instruments, which are yield based, are Money market deposit/ Time deposit and Certificate of Deposits while others are discount based. The author has explained how these two instruments are traded in the market and how the interest rates for these instruments are calculated in different markets like in London markets and for Euros. Money market deposits are fixed interest term deposits of up to one year. It carries a fixed interest rate related to the London Interbank Offer Rate (LIBOR). The only difference between Money market deposits and Certificates of Deposit is that the former is not negotiable while the later is negotiable.
Then the author has explained other cash instruments that are discount based along with the methods for calculating price of a T-bill, discount rates, amount of repayment, etc. These instruments are issued on a discount to the face value, and are redeemed on maturity at face value. Treasury bills, bills of exchange, banker’s acceptances and commercial papers are examples of money market securities that are quoted on a discount basis. Treasury bills being issued by government carry minimum risk, so the interest rate charged on these is also minimum. Banker acceptances are instrument created to facilitate commercial trade transactions. The instrument is called a banker’s acceptance because a bank accepts the ultimate responsibility to repay the loan to its holder. While Commercial paper is a short-term money market funding instrument issued by corporates to fund their short-term capital and working capital needs. The author then explained the asset-backed commercial paper (ABCP) and increasing contribution of ABCP in total trade of Commercial Papers. He then described Extendable Note, which is a recent development in the ABCP market.
In the 2nd chapter the author overviews foreign exchange market and calculation of exchange rates for both spot and forward exchanges. He describes how USD is used as a common denominator for calculating exchange rates of different currencies. He then explained the calculation of exchange rate of different types of forward transactions like forward outright, forward swaps, forward cross-rates, forward-forwards, long-dated forward contracts and non-deliverable forward.
The next chapter deals with Floating-rate notes or FRNs. FRNs are bonds that do not pay a fixed coupon but instead pay coupon that changes in line with another specified reference interest rate. The chapter mentions the features of FRNs and measurement of yield on the same. FRNs can have cap or floor on their interest yield. In the end of the chapter various kinds of FRNs are explained such as collared FRNs, Step-up recovery FRNs, Corridor FRNs and finally Inverse/reverse FRNs.
After explaining the FRNs the author starts with Repurchase Agreements or Repo as a money market instrument. A repo is a transaction where one party sells securities to the other and commits to repurchase identical securities on a specified date and at a specified price. In return he gets cash at a specified rate, which is called repo rate. The author mentioned two main types of repo, the classic repo and sell/buy back. He then explained about margins such as initial margin, haircut and variation margin used for lending money under repo transaction. He has explained other types of repos also, like reverse repo, basket repo, synthetic repo, tri-party repo, hold-in-custody repo, cross-currency repo, etc. He further explained how the prices and margins of collateral are calculated under different repo transactions. He talks about the legal aspects of repo followed by Gilt repo legal agreement.
5th chapter deals with money market derivatives where two main contracts used in money markets trading, the short-term interest rate future and the forward rate agreement (FRA), are reviewed. An FRA is an agreement to borrow or lend a notional cash sum for a period of time lasting up to twelve months at an agreed rate of interest. FRA is an over-the-counter derivative instrument. The chapter includes the standard terms used in the market for dealings. The author has described how the FRAs are priced using standard forward rate principles. In the later part of the chapter short-term interest rate futures or future contracts are explained. A future contract is a transaction that fixes the price today for a commodity that will be delivered at some point in future. The author then explained how the concept of buying and selling interest rate futures differs from FRAs. The mechanism of pricing and trading of interest rate futures is also explained with required formulas. The concept of Hedging using interest-rate future was also explained in this chapter. In the end interest rate swaps and overnight-index swaps and the relation between interest rate swaps and FRAs followed by the concept of Zero-coupon swap pricing.
The next chapter covers the functioning of the money market yield curve. The yield curve is an important indicator and knowledge source of the state of a debt capital market. As money market instruments trade on a simple yield basis, so the money market curve is simple to construct. The “Libor curve” for money market is the main measure of money market return. After these the main uses of yield curve are summarized. Various commonly used yield curves such as yield to maturity yield curve, the par yield curve, the zero-coupon (or spot) yield curve are discussed with hypothetical examples. The forward yield curve is also described and the relationship between spot and forward interest rate is explained. Further the calculation of spot rates from forward rates is described.
The subsequent chapter discusses a major part of banking activity, which is asset and liability management (ALM). The spread between the borrowing and lending rates is in principle the bank’s profit. The obvious risk from such a strategy is that the level of short-term rates rises during the term of the loan, so that when the loan is refinanced the bank makes a lower profit or a net loss. Managing this risk exposure is the key function of ALM desk. In this chapter the author reviewed the concept of balance sheet management, the role of the ALM desk, liquidity risk and maturity gap risk. The basic gap report is also discussed. The concluding part of the chapter includes an introduction to Securitization and the increasing use of securitization. Securitization is a process undertaken by banks to both realize additional value from assets held on the balance sheet as well as to remove them from the balance sheet entirely, thus freeing up lending lines. Further the process and benefits of securitization was described.
The last chapter discusses bank regulatory capital. The author has included this topic in the book to explain how asset allocation decision is influenced by capital consideration. In this chapter he reviews the main elements of Basel rules. The rules defining what constitutes capital and how much of it to allocate are laid out in the Bank of International Settlements (BIS) guidelines, known as Basel rules. These rules are in the process of being updated and modernized as Basel II. The chapter also introduces the Basel II proposals, and how risk exposure determines the extent of capital allocation. These rules provide some guidelines regarding capital adequacy requirements, ratio of capital to assets, asset risk allocation, etc, to protect the financial system of banks. To overcome the shortcomings of Basel I, Basel II was designed. The new Basel II rules have three pillars, and are designed to more closely relate to the risk levels of particular credit exposure.
At the end the author has included an Appendix which is nothing but a formula summary and a glossary highlighting all the terms widely used in money market. So the book consists of all the crucial aspects related to money market operations. |
