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272
Part 5 Financial Markets
G L O B A L
Ironic Birth of the Eurodollar Market
One of capitalism’s great ironies is that the
Eurodollar market, one of the most important finan-
cial markets used by capitalists, was fathered by the
Soviet Union. In the early 1950s, during the height of
the Cold War, the Soviets had accumulated a sub-
stantial amount of dollar balances held by banks in
the United States. Because the Russians feared that
the U.S. government might freeze these assets in the
United States, they wanted to move the deposits to
Europe, where they would be safe from expropria-
tion. (This fear was not unjustified—consider the
U.S. freeze on Iranian assets in 1979 and Iraqi
assets in 1990.) However, they also wanted to keep
the deposits in dollars so that they could be used in
their international transactions. The solution was to
transfer the deposits to European banks but to keep
the deposits denominated in dollars. When the
Soviets did this, the Eurodollar was born.
banks participate in this market, it is extremely competitive. The spread between the
bid and the offer rate seldom exceeds 0.125%. Eurodollar deposits are time deposits,
which means that they cannot be withdrawn for a specified period of time. Although
the most common time period is overnight, different maturities are available. Each
maturity has a different rate.
The overnight LIBOR and the fed funds rate tend to be very close to each other.
This is because they are near-perfect substitutes. Suppose that the fed funds rate
exceeded the overnight LIBOR. Banks that need to borrow funds will borrow
overnight Eurodollars, thus tending to raise rates, and banks with funds to lend will
lend fed funds, thus tending to lower rates. The demand-and-supply pressure will
cause a rapid adjustment that will drive the two rates together.
At one time, most short-term loans with adjustable interest rates were tied to the
Treasury bill rate. However, the market for Eurodollars is so broad and deep that it
has recently become the standard rate against which others are compared. For exam-
ple, the U.S. commercial paper market now quotes rates as a spread over LIBOR,
rather than over the T-bill rate.
The Eurodollar market is not limited to London banks anymore. The primary bro-
kers in this market maintain offices in all of the major financial centers worldwide.
Eurodollar Certificates of Deposit
Because Eurodollars are time deposits with
fixed maturities, they are to a certain extent illiquid. As usual, the financial mar-
kets created new types of securities to combat this problem. These new securities
were transferable negotiable certificates of deposit (negotiable CDs). Because most
Eurodollar deposits have a relatively short term to begin with, the market for
Eurodollar negotiable CDs is relatively limited, comprising less than 10% of the
amount of regular Eurodollar deposits. The market for the negotiable CDs is still thin.
Other Eurocurrencies
The Eurodollar market is by far the largest short-term secu-
rity market in the world. This is due to the international popularity of the U.S. dol-
lar for trade. However, the market is not limited to dollars. It is possible to have an
account denominated in Japanese yen held in a London or New York bank. Such an
Chapter 11 The Money Markets
273
Interest
Rate (%)
0
1
2
3
4
5
6
7
8
9
Treasury bills
Fed funds
Certificates
of deposit
Commercial
paper
Jan.
2004
Jan.
2005
Jan.
2006
Jan.
2007
Jan.
2000
Jan.
2001
Jan.
2002
Jan.
2003
Jan.
1996
Jan.
1997
Jan.
1998
Jan.
1999
Jan.
1992
Jan.
1993
Jan.
1994
Jan.
1995
Jan.
1990
Jan.
1991
Jan.
2008
Jan.
2009
Jan.
2010
F I G U R E 1 1 . 7
Interest Rates on Money Market Securities, 1990–2010
Source:
http://www.federalreserve.gov/releases
.
account would be termed a Euroyen account. Similarly, you may also have Euromark
or Europeso accounts denominated in marks and pesos, respectively, and held in var-
ious banks around the world. Keep in mind that if market participants have a need
for a particular security and are willing to pay for it, the financial markets stand ready
and willing to create it.
Comparing Money Market Securities
Although money market securities share many characteristics, such as liquidity,
safety, and short maturities, they all differ in some aspects.
Interest Rates
Figure 11.7 compares the interest rates on many of the money market instruments
we have discussed. The most notable feature of this graph is that all of the money
market instruments appear to move very closely together over time. This is because
all have very low risk and a short term. They all have deep markets and so are priced
competitively. In addition, because these instruments have so many of the same
risk and term characteristics, they are close substitutes. Consequently, if one rate
should temporarily depart from the others, market supply-and-demand forces would
soon cause a correction.
274
Part 5 Financial Markets
Liquidity
As we discussed in Chapter 4, the liquidity of a security refers to how quickly, eas-
ily, and cheaply it can be converted into cash. Typically, the depth of the secondary
market where the security can be resold determines its liquidity. For example, the
secondary market for Treasury bills is extensive and well developed. As a result,
Treasury bills can be converted into cash quickly and with little cost. By contrast,
there is no well-developed secondary market for commercial paper. Most holders
of commercial paper hold the securities until maturity. In the event that a commer-
cial paper investor needed to sell the securities to raise cash, it is likely that bro-
kers would charge relatively high fees.
In some ways, the depth of the secondary market is not as critical for money mar-
ket securities as it is for long-term securities such as stocks and bonds. This is because
money market securities are short-term to start with. Nevertheless, many investors
desire liquidity intervention: They seek an intermediary to provide liquidity where
it did not previously exist. This is one function of money market mutual funds (dis-
cussed in Chapter 20).
Table 11.4 summarizes the types of money market securities and the depth of
the secondary market.
How Money Market Securities Are Valued
Suppose that you work for Merrill Lynch and that it is your job to submit the bid
for Treasury bills this week. How would you know what price to submit? Your
first step would be to determine the yield that you require. Let us assume that,
based on your understanding of interest rates learned in Chapters 3 and 4, you
decide you need a 2% return. To simplify our calculations, let us also assume we
are bidding on securities with a one-year maturity. We know that our Treasury
bill will pay $1,000 when it matures, so to compute how much we will pay today
we find the present value of $1,000. The process of computing a present value was
discussed in Example 1 in Chapter 3. The formula is
PV
⫽
FV
11 ⫹ i2
n
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