Financial Markets and Institutions (2-downloads)

Volume of Commercial Paper

2004

2006

2008

2010

2.0

2.5

F I G U R E   1 1 . 6

Volume of Commercial Paper Outstanding

Source:

http://www.federalreserve.gov/releases/cp/histouts.txt

.

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Chapter 11 The Money Markets

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For more detail on ABCPs and their role in the subprime crisis see, “The Evolution of a Financial

Crisis: Panic in the Asset-Backed Commercial Paper Market,” by Daniel Covitz, Nellie Liang, and

Gustova Suarez, working paper from the Federal Reserve Board.

be redeemed at something less than a dollar, say 90 cents. In September 2008

the government had to set up a guarantee program to prevent the collapse of the

money market mutual fund market and to allow for an orderly liquidation of their

ABCP holdings.

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Banker’s Acceptances

A banker’s acceptance is an order to pay a specified amount of money to the bearer

on a given date. Banker’s acceptances have been in use since the 12th century. However,

they were not major money market securities until the volume of international trade

ballooned in the 1960s. They are used to finance goods that have not yet been trans-

ferred from the seller to the buyer. For example, suppose that Builtwell Construction

Company wants to buy a bulldozer from Komatsu in Japan. Komatsu does not want

to ship the bulldozer without being paid because Komatsu has never heard of Builtwell

and realizes that it would be difficult to collect if payment were not forthcoming.

Similarly, Builtwell is reluctant to send money to Japan before receiving the equipment.

A bank can intervene in this standoff by issuing a banker’s acceptance where the bank

in essence substitutes its creditworthiness for that of the purchaser.

Because banker’s acceptances are payable to the bearer, they can be bought

and sold until they mature. They are sold on a discounted basis like commercial paper

and T-bills. Dealers in this market match up firms that want to discount a banker’s

acceptance (sell it for immediate payment) with companies wishing to invest in

banker’s acceptances. Interest rates on banker’s acceptances are low because the risk

of default is very low.

Eurodollars

Many contracts around the world call for payment in U.S. dollars due to the dollar’s

stability. For this reason, many companies and governments choose to hold dollars.

Prior to World War II, most of these deposits were held in New York money center

banks. However, as a result of the Cold War that followed, there was fear that deposits

held on U.S. soil could be expropriated. Some large London banks responded to this

opportunity by offering to hold dollar-denominated deposits in British banks. These

deposits were dubbed Eurodollars (see the following Global box).

The Eurodollar market has continued to grow rapidly. The primary reason is that

depositors receive a higher rate of return on a dollar deposit in the Eurodollar mar-

ket than in the domestic market. At the same time, the borrower is able to receive

a more favorable rate in the Eurodollar market than in the domestic market. This

is because multinational banks are not subject to the same regulations restricting U.S.

banks and because they are willing and able to accept narrower spreads between

the interest paid on deposits and the interest earned on loans.

London Interbank Market

Some large London banks act as brokers in the interbank

Eurodollar market. Recall that fed funds are used by banks to make up temporary

shortfalls in their reserves. Eurodollars are an alternative to fed funds. Banks from

around the world buy and sell overnight funds in this market. The rate paid by banks

buying funds is the London interbank bid rate (LIBID). Funds are offered for

sale in this market at the London interbank offer rate (LIBOR). Because many

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