These solutions for the discount rate % and the investment rate % match those reported
Chapter 11 The Money Markets
263
Risk
Treasury bills have virtually zero default risk because even if the government
ran out of money, it could simply print more to redeem them when they mature.
The risk of unexpected changes in inflation is also low because of the short term
to maturity. The market for Treasury bills is extremely deep and liquid. A deep
market is one with many different buyers and sellers. A
liquid market is one in
which securities can be bought and sold quickly and with low transaction costs.
Investors in markets that are deep and liquid have little risk that they will not be
able to sell their securities when they want to.
On a historical note, the budget debates in early 1996 almost caused the gov-
ernment to default on its debt, despite the long-held belief that such a thing could
not happen. Congress attempted to force President Clinton to sign a budget bill by
refusing to approve a temporary spending package. If the stalemate had lasted much
longer, we would have witnessed the first-ever U.S. government security default.
We can only speculate what the long-term effect on interest rates might have been
if the market decided to add a default risk premium to all government securities.
Treasury Bill Auctions
Each week the Treasury announces how many and what kind
of Treasury bills it will offer for sale. The Treasury accepts the bids offering the
highest price. The Treasury accepts competitive bids in ascending order of yield until
the accepted bids reach the offering amount. Each accepted bid is then awarded at
the highest yield paid to any accepted bid.
As an alternative to the competitive bidding procedure just outlined, the
Treasury also permits noncompetitive bidding. When competitive bids are offered,
investors state both the amount of securities desired and the price they are willing
to pay. By contrast, noncompetitive bids include only the amount of securities the
investor wants. The Treasury accepts all noncompetitive bids. The price is set as
the highest yield paid to any accepted competitive bid. Thus, noncompetitive bidders
pay the same price paid by competitive bidders. The significant difference between
the two methods is that competitive bidders may or may not end up buying securi-
ties whereas the noncompetitive bidders are guaranteed to do so.
In 1976, the Treasury switched the entire marketable portion of the federal debt
over to book entry securities, replacing engraved pieces of paper. In a book entry
system, ownership of Treasury securities is documented only in the Fed’s computer:
Essentially, a ledger entry replaces the actual security. This procedure reduces the
cost of issuing Treasury securities as well as the cost of transferring them as they
are bought and sold in the secondary market.
The Treasury auction of securities is supposed to be highly competitive and
fair. To ensure proper levels of competition, no one dealer is allowed to purchase more
than 35% of any one issue. About 40 primary dealers regularly participate in the auc-
tion. Salomon Smith Barney was caught violating the limits on the percentage of
one issue a dealer may purchase, with serious consequences. (See the Mini-Case box
“Treasury Bill Auctions Go Haywire.”)
Treasury Bill Interest Rates
Treasury bills are very close to being risk-free. As
expected for a risk-free security, the interest rate earned on Treasury bill securities
is among the lowest in the economy. Investors in Treasury bills have found that in some
years, their earnings did not even compensate them for changes in purchasing power
Access
www.treasurydirect
.gov
. Visit this site to study
how Treasury securities are
auctioned.
G O O N L I N E
264
Part 5 Financial Markets
due to inflation. Figure 11.2 shows the interest rate on Treasury bills and the infla-
tion rate over the period 1973–2006. As discussed in Chapter 3, the real rate of
interest has occasionally been less than zero. For example, in 1973–1977, 1990–1991,
and 2002–2004, the inflation rate matched or exceeded the earnings on T-bills. Clearly,
the T-bill is not an investment to be used for anything but temporary storage of excess
funds, because it barely keeps up with inflation.
Federal Funds
Federal funds are short-term funds transferred (loaned or borrowed) between finan-
cial institutions, usually for a period of one day. The term federal funds (or fed
funds) is misleading. Fed funds really have nothing to do with the federal govern-
ment. The term comes from the fact that these funds are held at the Federal Reserve
bank. The fed funds market began in the 1920s when banks with excess reserves
loaned them to banks that needed them. The interest rate for borrowing these funds
was close to the rate that the Federal Reserve charged on discount loans.
Purpose of Fed Funds
The Federal Reserve has set minimum reserve requirements
that all banks must maintain. To meet these reserve requirements, banks must keep
a certain percentage of their total deposits with the Federal Reserve. The main pur-
pose for fed funds is to provide banks with an immediate infusion of reserves should
they be short. Banks can borrow directly from the Federal Reserve, but the Fed
actively discourages banks from regularly borrowing from it. So even though the inter-
est rate on fed funds is low, it beats the alternative. One indication of the popular-
ity of fed funds is that on a typical day a quarter of a trillion dollars in fed funds will
change hands.
M I N I - C A S E
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