Chapter 16: Money markets and complex financial instruments

Chapter learning Objectives

Upon completion of this chapter you will be able to:

  • explain the role of the money markets in providing short-term liquidity to industry and the public sector
  • explain the role of the money markets in providing short-term trade finance
  • explain the role of the money markets in allowing a multinational firm to manage its exposure to FOREX and interest rate risk
  • explain the role of the banks and other financial institutions in the operation of the money markets
  • explain the role of the treasury management function in the short-term management of the firm’s financial resources
  • explain the role of the treasury management function in the longer term maximisation of shareholder value
  • explain the role of the treasury management function in the management of risk exposure
  • describe the characteristics of coupon bearing and discount instruments and their use in the money markets
  • describe the characteristics of derivatives and their use in the money markets
  • explain and evaluate the role of money market instruments (coupon bearing, discount and derivatives) for the short term financing of a multinational business

1 Introduction – the financial system

Collectively the financial system does the following:

(1) Channels funds from lenders to borrowers.

(2) Provides a mechanism for payments – e.g. direct debits, cheque clearing system.

(3) Creates liquidity and money – e.g. banks create money through increasing their lending.

(4) Provides financial services such as insurance and pensions.

(5) Offers facilities to manage investment portfolios – e.g. to hedge risk.

Details of the financial system

The financial system

‘The financial system’ is an umbrella term covering the following:

  • Financial markets – e.g. stock exchanges, money markets.
  • Financial institutions – e.g. banks, building societies, insurance companies and pension funds.
  • Financial assets and liabilities – e.g. mortgages, bonds, bills and equity shares.

Financial markets

The financial markets can be divided into different types, depending on the products being issued/bought/sold:

  • Capital markets which consist of stock-markets for shares and bond markets.
  • Money markets, which provide short-term (< 1="" year)="" debt="" financing="" and="">
  • Commodity markets, which facilitate the trading of commodities (e.g. oil, metals and agricultural produce).
  • Derivatives markets, which provide instruments for the management of financial risk, such as options and futures contracts.
  • Insurance markets, which facilitate the redistribution of various risks.
  • Foreign exchange markets, which facilitate the trading of foreign exchange.

Within each sector of the economy (households, firms andgovernmental organisations) there are times when there are cashsurpluses and times when there are deficits.

  • In the case of surpluses the party concerned will seek to invest/deposit/lend funds to earn an economic return.
  • In the case of deficits the party will seek to borrow funds to manage their liquidity position.

2 Money market instruments

A financial manager needs to understand the characteristics of the following money market instruments:

Explanation of money market instruments

Coupon bearing instruments

Coupon bearing securities have a fixed maturity and a specified rate of interest.

Certificates of deposit (CDs)

  • CDs are evidence of a deposit with an issuing bank (or building society).
  • They are fully negotiable and hence attractive to the depositor since they ensure instant liquidity if required.
  • They provide the bank with a deposit for a fixed period at a fixed rate of interest.

Sale and repurchase agreements (‘repos’)

  • In a repo transaction, X sells certain securities (treasury bills, bank bills etc) to Y and simultaneously agrees to buy them back at a later date at a higher price.
  • This could be arranged through the repo desk of a major bank, for example.
  • In effect, a repo is a secured short-term loan and the higher repurchase price reflects the interest on the loan.
  • Central banks often fix the short-term repo interest rate, which in turn affects all other short-term interest rates (e.g. base rates, LIBOR).

Illustration of repos

Reaper Co enters a repo agreement as follows:

(1) Sell £4 million (nominal) UK Treasury Bills for £3.94 million.

(2) Buy them back 45 days later for £3.96 million.

Determine the effective interest rate.


Interest rate = ((3.96 - 3.94)/(3.94)) × 365/45 = 0.0411, or 4.11%

This could be compared with the borrowing rate offered by banks, for example.

Note: In some areas, notably the USA, a 360 day count is used instead of 365.

Discount instruments

In the discount market, funds are raised by issuing bills at a discount to their eventual redemption or maturity value.

Bills have the following characteristics:

  • Issued in large denominations.
  • Highly liquid – due to short maturity and highly organised market for buying/selling.
  • Reward for the lender comes as a capital gain.
  • Effectively fixed-interest as redemption value fixed.

Treasury bills

  • Issued mainly by governments via central banks.
  • Usually one or three month maturity.

Commercial bills

  • Similar to treasury bills except issued by large corporations.

Commercial paper

  • Initial maturity usually between seven and forty-five days.
  • May be unsecured so credit ratings important.
  • High issue costs so only suitable for larger amounts.

Banker’s acceptances

  • These are discussed in more detail below under trade finance.

Illustration of commercial paper

CP Co wishes to issue £10 million of commercial paper for 90 days at an implicit interest rate of 5% pa.

(Note: this could be expressed as stating that the paper will be issued ‘at a discount of 5%’.)

Determine the issue price.


Issue price = present value of future redemption

= £10m × 1/(1 + 0.05 × 90/365) = £9,878,213


Derivatives are so called because their value derives from the value of other assets.

  • Instruments bought on the ‘over the counter’ market – OTC are purchased from the major banks and are usually ‘tailor-made’ to suit the precise requirements of the company.
  • Exchange-traded instruments are of a standard size thus ensuring that they are marketable.

There are essentially two types of derivative:

  • Instruments that fix a future price (e.g. FRAs, futures).
  • Instruments that give the owner the right but not the obligation to fix a future price (e.g. options).

Money market instruments include the following:

  • Forward rate agreements (FRAs).
  • Caps and floors (options on FRAs).
  • Interest rate futures.
  • Options on interest rate futures.
  • Interest rate swaps.
  • Swaptions.

Specific details of individual instruments are discussed in more detail elsewhere in this Text.

The role of money market instruments for short term financing

While some firms encounter a mixture of short-term cash surplusesand deficits, many can be classified as either cash generators or cashconsumers.

  • Cash generators (e.g. many retailers) will look to lay off cash on short-term markets or return surplus funds to investors (e.g. via a dividend).
  • Cash consumers (e.g. young, fast growing firms) will look to borrow short-term.

Test your understanding 1

By considering the product lifecycle, comment as towhether a major drugs company is likely to be a cash generator or a cashconsumer?

3 The role of the money markets in international business

Managing short-term liquidity


  • For many companies bank borrowing is the simplest method of short-term finance.
    • Loans are usually fixed term, may be for variable or fixed rates and are normally secured, overdrafts variable rate and unsecured.
    • Rates will depend on perceived credit risk.
  • Factoring can be useful where sales are made to low risk customers.
  • Companies with high credit ratings often take advantage of commercial paper markets, where they may be able to borrow at lower rates than those offered by banks.


  • Banks participate in ‘inter-bank markets’, either lending to other banks, or borrowing from them. Recently they have been joined by the larger building societies.
  • This is a very important source of funds to banks. For example, the London Inter-Bank Offered Rate (or LIBOR) is now used instead of base rate to determine the interest payable on some types of company borrowing.

Local authorities

Local authorities obtain their borrowing requirements from:

  • central government and money markets
  • stock exchanges, and
  • from advertising for loans from the general public.

Test your understanding 2

What do you consider to be the key factors to consider when choosing which instruments to use?


All the markets in a money market closely inter-mesh with eachother and in that way the market may be regarded as an entity. Theplayers are the same and they pass the ball between each other.

However, since the global "credit crunch" of 2008, the liquidity inthe money markets has reduced as the different players have begun toview each other with suspicion. The credit crunch is covered in moredetail in the later chapter on topical issues.

Illustration 1

  • A large company might deposit $500,000 with Bull’s Bank, which issues it with a CD.
  • Bull’s Bank then looks at the local authority market, decides that rates there are rather low, and instead lends the money for a week on the inter-bank market to another bank that is short of funds.
  • A week later local authority rates have improved and Bull’s Bank lends the $500,000 to a big city council.
  • Meanwhile, the large company has decided to bring forward an investment project and wants its $500,000 quickly to help pay for some sophisticated new electronic equipment. It sells the CD to a bank, which might either carry it to maturity or sell it to any of the banks – except Bull’s Bank.

All these transactions, with the possible exception of the CDdeals, will have taken place through a broker who sits at the end of atelephone switching the funds from one market to another as rates moveand potential borrowers and lenders acquaint the broker with informationabout their requirements.

Short-term trade finance

As well as having routine cash surpluses/deficits that needmanaging, firms often need short-term finance for individual (usuallylarge) trade deals. A supplier faces two problems in such cases:

  • Default risk from the customer.
  • The time delay between cash outflows to make the product and receipt of payment.

The most common way of managing these is by using banker’s acceptances by creating a ‘letter of credit’.

Letter of credit illustration

Step 1 Initial trade deal

  • Company A agrees to buy goods from Company B for $10 million (say), payable in 30 days’ time.

Step 2 Create letter of credit (LOC)

  • Co. A agrees payment terms with their bank (Bank A).
  • Bank A issues Co. B’s bank (Bank B) with a letter of credit, stating that it will pay the $10m in 30 days.
  • Bank B informs Company B of the receipt.

Step 3 Supply of goods

  • Co. B then ships the goods to Co. A.
  • Co. B passes shipping and other necessary documents to Bank B.

Step 4 Create banker’s acceptance

  • Bank B passes the letter of credit and supporting documentation back to Bank A.
  • If all is in order, Bank A ‘accepts’ the letter of credit, accepting responsibility for payment. This creates the ‘banker’s acceptance’, which is passed back to Bank B.

Step 5 Options for using the banker’s acceptance.

Bank B could:

  • wait until payment in 30 days
  • request immediate payment (of the discounted value) from Bank A – effectively selling it back to Bank A
  • sell the acceptance (at its discounted value) to the money markets.

Step 6 Banker’s acceptance redeemed

  • After 30 days Bank A redeems the acceptance, paying the then holder.

Short-term risk management

Money markets are particularly useful for hedging interest rate andexchange rate risks. These are discussed in detail in the hedgingchapters.

The role of banks and other financial institutions

Faced with a desire to lend or borrow, there are three choices open to the end-users of the financial system:

(1) Lenders and borrowers contact each other directly.

This is rare due to the high costs involved, the risks of default and the inherent inefficiencies of this approach.

(2) Lenders and borrowers use an organised financial market.

For example, an individual may purchase corporate bonds from arecognised bond market. If this is a new issue of bonds by a companylooking to raise funds, then the individual has effectively lent moneyto the company.

If the individual wishes to recover their funds before theredemption date on the bond, then they can sell the bond to anotherinvestor.

(3) Lenders and borrowers use intermediaries.

In this case the lender obtains an asset which cannot usuallybe traded but only returned to the intermediary. Such assets couldinclude a bank deposit account, pension fund rights, etc.

The borrower will typically have a loan provided by an intermediary.

Financial intermediaries thus have a number of important roles.

  • Risk reduction
  • Aggregation
  • Maturity transformation
  • Financial intermediation

The important roles of financial intermediaries

Risk reduction

By lending to a wide variety of individuals and businessesfinancial intermediaries reduce the risk of a single default resultingin total loss of assets.


By pooling many small deposits, financial intermediaries are ableto make much larger advances than would be possible for mostindividuals.

Maturity transformation

Most borrowers wish to borrow in the long term whilst most saversare unwilling to lock up their money for the long term. Financialintermediaries, by developing a floating pool of deposits, are able tosatisfy both the needs of lenders and borrowers.

Financial intermediation

Financial intermediaries bring together lenders and borrowers through a process known as financial intermediation.

4 The role of the treasury department

The role of the treasury function

The treasury function of a firm usually has the following roles:

Short-term management of resources

  • Short-term cash management – lending/borrowing funds as required.
  • Currency management.

Long-term maximisation of shareholder wealth

  • Raising long-term finance, including equity strategy, management of debt capacity and debt and equity structure.
  • Investment decisions, including investment appraisal, the review of acquisitions and divestments and defence from takeover.
  • Dividend policy.

Risk management

  • Assessing risk exposure.
  • Interest rate risk management.
  • Hedging of foreign exchange risk.

Risk management in general, and the hedging of foreign exchangerisk and interest rate risk in particular, were covered in detail inChapters 12, 13 and 14.

Treasury: cost centre or profit centre?

As a cost centre the aggregate treasury function costs would simplybe charged throughout the group on a fair basis. If no such fair basiscan be agreed, the costs can remain as central head office unallocatedcosts in any group segmental analysis.

However it is also possible to identify revenues arising fromtreasury departments and thus to establish the treasury as a profitcentre. Revenues could be realised as follows:

  • Each division can be charged the market value for the services provided by the treasury. The total value charged throughout the group should exceed the treasury’s costs enabling it to report a profit.
  • By deciding not to hedge all currency and interest rate risks. Experts in the treasury could decide which risks not to hedge, hoping to profit from unhedged favourable exchange rate and interest rate movements.
  • Hedging using currency and interest rate options leaves an upside potential which could be realised if the rate moves in the company’s favour.
  • Taking on additional exchange rate or other risks purely as a speculative activity, e.g. writing options on currencies or on shares held.

The trend in recent years has been for large companies to turntheir treasuries from cost centres into profit centres and to expect thetreasury to pay its way and generate regular profits each year.

However the following points should be noted:

  • A treasury engaged in speculation must be properly controlled by the company’s board of directors. Millions of dollars can be committed in one telephone call by a treasurer, so it is crucial that limits are set on traders’ risk exposures and that these limits are monitored scrupulously. The temptation has been for directors to let treasurers ‘get on with whatever they do’ as long as regular profits are being earned. Such a policy is no longer acceptable; the finance director in particular must control the treasury on a day-to-day basis.
  • For example, in 1993 the German oils and metals company Metallgesellschaft managed to lose $1 billion after becoming over-exposed to oil derivative contracts.
  • Treasury staff must be well trained and probably well paid, so that staff of the right calibre can be secured.
  • The low volume of foreign currency transactions undertaken by a small company would probably make a profit centre approach unviable. A regular flow of large foreign transactions is needed before the cost centre approach is abandoned.

The international treasury function

The corporate treasurer in an international group of companies willbe faced with problems relating specifically to the internationalspread of investments.

  • Setting transfer prices to reduce the overall tax bill.
  • Deciding currency exposure policies and procedures.
  • Transferring of cash across international borders.
  • Devising investment strategies for short-term funds from the range of international money markets and international marketable securities.
  • Netting and matching currency obligations.

The centralisation of treasury activities

The question arises in a large international group of whether treasury activities should be centralised or decentralised.

  • If centralised, then each operating company holds only the minimum cash balance required for day to day operations, remitting the surplus to the centre for overall management. This process is sometimes known as cash pooling, the pool usually being held in a major financial centre or a tax haven country.
  • If decentralised, each operating company must appoint an officer responsible for that company’s own treasury operations.

Advantages of centralisation

  • No need for treasury skills to be duplicated throughout the group. One highly trained central department can assemble a highly skilled team, offering skills that could not be available if every company had their own treasury.
  • Necessary borrowings can be arranged in bulk, at keener interest rates than for smaller amounts. Similarly bulk deposits of surplus funds will attract higher rates of interest than smaller amounts.
  • The group’s foreign currency risk can be managed much more effectively from a centralised treasury since only they can appreciate the total exposure situation. A total hedging policy is more efficiently carried out by head office rather than each company doing their own hedging.
  • One company does not borrow at high rates while another has idle cash.
  • Bank charges should be lower since a situation of carrying both balances and overdraft in the same currency should be eliminated.
  • A centralised treasury can be run as a profit centre to raise additional profits for the group.
  • Transfer prices can be established to minimise the overall group tax bill.
  • Funds can be quickly returned to companies requiring cash via direct transfers.

Advantages of decentralisation

  • Greater autonomy leads to greater motivation. Individual companies will manage their cash balances more attentively if they are responsible for them rather than simply remitting them up to head office.
  • Local operating units should have a better feel for local conditions than head office and can respond more quickly to local developments.

Test your understanding 3

Compare and contrast the roles of the treasury and finance departments with respect to a proposed investment.

5 Chapter summary

Test your understanding answers

Test your understanding 1

In the drug development stage of the product lifecycle, the firm willbe a cash consumer due to the huge sums that need to be spent onresearch and development.

If patent protection can be established, then high prices shouldensure that the company is a cash generator until the patent expires.

Test your understanding 2

  • Effective interest rate – linked to default risk.
  • Risk – especially with regard to investing surplus cash.
  • Amounts.
  • Marketability/liquidity.
  • Timescales/maturity.
  • Availability.

Test your understanding 3

Treasury is the function concerned with the provision and use offinance and thus handles the acquisition and custody of funds whereasthe Finance Department has responsibility for accounting, reporting andcontrol. The roles of the two departments in the proposed investment areas follows:


  • Treasury will quantify the cost of capital to be used in assessing the investment.
  • The finance department will estimate the project cash flows.


  • Treasury will establish corporate financial objectives, such as wanting to restrict gearing to 40%, and will identify sources and types of finance.
  • Treasury will also deal with currency management – dealing in foreign currencies and hedging currency risks – and taxation.
  • The finance department will be involved with the preparation of budgets and budgetary control, the preparation of periodic financial statements and the management and administration of activities such as payroll and internal audit.


  • The Treasury Department has main responsibility for setting corporate objectives and policy and Financial Control has the responsibility for implementing policy and ensuring the achievement of corporate objectives. This distinction is probably far too simplistic and, in reality, both departments will make contributions to both determination and achievement of objectives.
  • There is a circular relationship in that Treasurers quantify the cost of capital, which the Financial Controllers use as the criterion for the deployment of funds; Financial Controllers quantify projected cash flows which in turn trigger Treasurers’ decisions to employ capital.

Created at 5/24/2012 3:59 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:55 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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