Financial Markets and Institutions (2-downloads)

Federal Funds

Treasury Bills

F I G U R E   1 1 . 3

Federal Funds and Treasury Bill Interest Rates, January 1990–January 2010

Source:

http://www.federalreserve.gov/releases/H15/data.htm/.

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Chapter 11 The Money Markets

267

To accomplish this adjustment, the Fed will buy or sell Treasury securities in the repo

market. The maturities of Federal Reserve repos never exceed 15 days.

Interest Rate on Repos

Because repos are collateralized with Treasury securities,

they are usually low-risk investments and therefore have low interest rates. Though

rare, losses have occurred in these markets. For example, in 1985, ESM Government

Securities and Bevill, Bresler & Schulman declared bankruptcy. These firms had used

the same securities as collateral for more than one loan. The resulting losses to munic-

ipalities that had purchased the repos exceeded $500 million. Such losses also caused

the failure of the state-insured thrift insurance system in Ohio.

Negotiable Certificates of Deposit

A negotiable certificate of deposit is a bank-issued security that documents a deposit

and specifies the interest rate and the maturity date. Because a maturity date is spec-

ified, a CD is a term security as opposed to a demand deposit: Term securities

have a specified maturity date; demand deposits can be withdrawn at any time. A

negotiable CD is also called a bearer instrument. This means that whoever holds

the instrument at maturity receives the principal and interest. The CD can be bought

and sold until maturity.

Terms of Negotiable Certificates of Deposit

The denominations of negotiable cer-

tificates of deposit range from $100,000 to $10 million. Few negotiable CDs are denom-

inated less than $1 million. The reason that these instruments are so large is that

dealers have established the round lot size to be $1 million. A round lot is the mini-

mum quantity that can be traded without incurring higher than normal brokerage fees.

Negotiable CDs typically have a maturity of one to four months. Some have six-

month maturities, but there is little demand for ones with longer maturities.

History of the CD

Citibank issued the first large certificates of deposit in 1961.

The bank offered the CD to counter the long-term trend of declining demand deposits

at large banks. Corporate treasurers were minimizing their cash balances and invest-

ing their excess funds in safe, income-generating money market instruments such

as T-bills. The attraction of the CD was that it paid a market interest rate. There

was a problem, however. The rate of interest that banks could pay on CDs was

restricted by Regulation Q. As long as interest rates on most securities were low,

this regulation did not affect demand. But when interest rates rose above the level

permitted by Regulation Q, the market for these certificates of deposit evaporated.

In response, banks began offering the certificates overseas, where they were exempt

from Regulation Q limits. In 1970, Congress amended Regulation Q to exempt cer-

tificates of deposit over $100,000. By 1972, the CD represented approximately 40%

of all bank deposits. The certificate of deposit is now the second most popular money

market instrument, behind only the T-bill.

Interest Rate on CDs

Figure 11.4 plots the interest rate on negotiable CDs along

with that on T-bills. The rates paid on negotiable CDs are negotiated between the

bank and the customer. They are similar to the rate paid on other money market

instruments because the level of risk is relatively low. Large money center banks

can offer rates a little lower than other banks because many investors in the mar-

ket believe that the government would never allow one of the nation’s largest banks

to fail. This belief makes these banks’ obligations less risky.

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Access

www.federalreserve

.gov/releases/CP/

. Find

detailed information on

commercial paper,

including criteria used for

calculating commercial

paper interest rates and

historical discount rates.

268

Part 5 Financial Markets

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Interest

Rate (%)