Money Markets

Money Markets#

import pandas as pd

import matplotlib.pyplot as plt
%matplotlib inline
plt.rcParams['figure.figsize'] = (12,6)
plt.rcParams['font.size'] = 15
plt.rcParams['legend.fontsize'] = 13

Overview of Money Markets#

Source: Bloomberg BTMM

Fed Funds Rate#

The Fed Funds rate is the rate at which private banks agree to lend each other money overnight.

  • It is a transaction between two private parties, so the rate is determined by market forces.

  • Still, the Fed has a great ability to manipulate this rate through the money supply.

  • Thus, monetary policy is typically discussed in terms of targeting the Fed Funds rate.

  • The rate gets its name because the Fed sets a reserve requirement that the banks must have in their vaults overnight.

  • Thus, the overnight lending between banks is really about having the funds mandated by the Fed.

filename = '../data/fed_data.xlsx'
info = pd.read_excel(filename,sheet_name='info').set_index('ticker (FRED)')
data = pd.read_excel(filename,sheet_name='data').set_index('date')
#refrates.columns = ['Tbill 3m','FedFunds Effective','SOFR']

ticks = ['EFFR','DFEDTARU','DFEDTARL']
leg = info.loc[ticks,'description'].to_list()

data[ticks].plot(xlim=('2008',data.index[-1]),ylim=[-.05,6])
plt.legend(leg)
plt.show()

data[ticks].plot(xlim=('2020-03-01',data.index[-1]),ylim=(-.05,6))
plt.legend(leg)
plt.show()
../_images/9dd75838e9f4493e9cfebbffcb25dedc38a3df75d3958c268705bdd2baeaa96b.png ../_images/2acee4633892ad81d55b6c364b1f594b5a9f6d0b96b207fbf4f9738a908d0267.png

Excess Reserves#

ioer = data[['IOER']].dropna().rename(columns={'IOER':'reserve rate'})
iorb = data[['IORB']].dropna().rename(columns={'IORB':'reserve rate'})
rate_reserves = pd.concat([ioer.iloc[:-1], iorb],axis=0)

fig, ax = plt.subplots(2,1,figsize=(12,12))
rate_reserves.plot(ax=ax[0], title='Interest Rate on Reserves', legend=[], xlim=('2007',None),ylabel='rate (%)',linewidth=3)
(data[['TOTRESNS']].dropna()).plot(ax=ax[1],title='Reserves',xlim=('2007',None),ylabel='billions USD',color='r',linewidth=3)

plt.tight_layout()
plt.show()
../_images/392858abf98b6046cc8db4dd98b260b8f7db17b15d54deb3ab4df77d3441fc31.png

The Discount Window#

ticks = ['EFFR','DPCREDIT']
leg = info.loc[ticks,'description'].to_list()

data[ticks].plot(linewidth=3,title='Fed Rates')
plt.legend(leg)
plt.show()
../_images/09a8fc54f2bb465f76b9a235e474656f788d19dce824c87a145c933cddb5fc1e.png

fed_bb_dashboard.png

Source#

Bloomberg FED

Secured Overnight Financing Rate (SOFR)#

The SOFR Index#

The big picture

  • Tracks the interbank overnight interest rate.

Sourcing:

  • First published April 3, 2018

  • SOFR is an index published by the NY Fed in cooperation with the U.S. Office of Financial Research.

  • Based on Treasury repo transactions.

    • Tri-party cleared and settled by the Bank of New York Mellon.

    • Bilateral cleared through FICC

SOFR vs LIBOR#

LIBOR is the London InterBank Offer Rate.

  • Based on a panel of banks’ estimates for borrowing/lending costs.

  • For various reasons, it is being phased out.

  • This phaseout was discussed for 10 years, but the market is finally making the transition.

Key SOFR Aspects#

Secured

  • Rate of collateralized borrowing/lending via repo on U.S. Treasuries.

Overnight

  • Rate is historic, based on the previous overnight lending.

  • Rate is backed by actual transactions, not surveys or estimates.

  • No set of tenors (term structure) to SOFR. It is just an overnight rate.

  • One can impute a term structure of SOFR-related rates from derivatives based on SOFR.

filename = '../data/ref_rates.xlsx'
refrates = pd.read_excel(filename,sheet_name='data').set_index('date').dropna()
refrates.columns = ['Tbill 3m','FedFunds Effective','SOFR']

refrates.plot()
plt.show()

refrates.plot(xlim=('2020-01-01',None),ylim=(0,6))
plt.show()
../_images/7acdbb4d295e75d40cb5789e2db9252605989bde4c7b308b8738e2b6536bf647.png ../_images/586c92b59c1725b8124182d0449bd99bc0f21f688d6a09a6ca8d1415161551b3.png

Blip in Oct, 2019#

SOFR spikes briefly.

This is not an error in the graph.

Stressed markets (institutional issues) caused this temporary spike.

  • Reason for concern for SOFR as new benchmark.

  • Has not had any such issue in the past few years, including Mar 2020 with COVID market jumps.

More on SOFR#

Data:#

  • Published in the Fed H.15. Release

  • Accessed easily in the Fed’s FRED data platform

  • Full methodology

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/users-guide-to-sofr2021-update.pdf

References#

CME has a useful course to learn more about SOFR.

https://www.cmegroup.com/education/courses/introduction-to-sofr.html

  • CME offers futures contracts based on SOFR

  • So the material is somewhat focused on this aspect.

Eurodollars#

A Eurodollar is a dollar deposited in a bank outside the U.S. It is widely used in interest-rate futures.

  • The Eurodollar rate is the interest earned on these dollar-denominated deposits held by banks outside the U.S, (in many countries besides Europe.)

  • The Federal Reserve reports of the Eurodollar rate tend to match the LIBOR rate.

  • The Fed publishes the Eurodollar rate on release H.15.

Repo#

A repurchase agreement (repo) is a contract where a dealer sells securities to another party with a deal to buy them back at a later date at a predetermined price.

  • Repo is a common form of short-term borrowing.

  • The difference between the selling price and the re-purchase price is the interest paid. This effective interest rate is the repo rate.

  • The difference between the value of the collateral and the sell price is the haircut on the repo.

  • The repo is, in essence, a collateralized loan.

Example:#

Suppose an asset has a market value of \\(100 and a bank sells it for \\\)80 with an agreement to repurchase it for \\(88. \)\(* The repo rate is 10\%. \)\frac{88−80}{80}$$\( \)\(* The haircut is 20\%. \)\frac{100−80}{100}$$$

Repo risk#

Repo is considered very safe as the security transacted serves as collateral against default by either party.

  • The most common repo is overnight. Longer term repos are referred to as term repo.

  • Notably, the repo security is not subject to bankruptcy procedures. Either party can “walk away” if counterparty defaults.

Why Repo?#

Repo is part of the core infrastructure of financial transactions.

What important functions does it serve?

Repo References#

Repo Haircuts and Rates Distributions#

https://www.federalreserve.gov/econres/notes/feds-notes/the-dynamics-of-the-us-overnight-triparty-repo-market-20210802.html

SIFMA Charts#

https://www.sifma.org/resources/research/reports/us-repo-market-chart-book/ https://www.sifma.org/wp-content/uploads/2022/02/SIFMA-Research-US-Repo-Markets-Chart-Book-2022.pdf

Fed’s declining use of Reverse Repo Rates#

https://www.wsj.com/economy/central-banking/treasury-markets-are-losing-their-shock-absorber-75ed6ea1#

Other Money Market Rates#

Certificates of Deposit#

A certificates of deposit (CD) is a time deposit where the bank pays back principal and interest at the end of a fixed term.

  • A CD is considered a savings account, and are thus FDIC insured.

  • Deposits can not be withdrawn on demand.

  • A large enough CD, (say \$100,000,) is typically transferable, so there is a market for these.

  • Most traded CD’s have a very short maturity, (3 months or less.)

Commercial Paper#

Commercial paper is short-term, unsecured debt issued by firms.

  • This is an important source of funding for nonfinancial firms.

  • The paper typically matures in one to two months. It must be less than 270 days in order to avoid SEC registration and regulation.

  • The paper is typically issued in \$100,000 denominations.

  • While the paper is unsecured, its short maturity makes it relatively safe.

Money Market Funds#

Money market funds provide small investors with access to money market securities.

  • Money market mutual funds aim to keep net asset value (NAV), or share value constant at $1. The interest rate paid out fluctuates with the return of the assets in the fund.

  • Money market mutual funds have become an important funding source for money market instruments.

The data

https://fred.stlouisfed.org/series/MMMFFAQ027S

Risk of money market funds#

Money market funds have been very successful in maintaining NAV at $1.

  • Furthermore, money market funds have restrictions to enhance safety.

  • Average maturity of securities had to be less than 90 days. In response to crisis, moved to 60.

  • Enhanced rules on allocations, ratings of investments, etc.

Money market funds in the crisis#

If the share value of the market fund falls below \$1, it is said to “break the buck.”

  • Given the safe assets held by the fund, this is a very unlikely event. Until 2008, it had only happened once.

  • When Lehman failed, its commercial paper was worthless. This caused a fund to break the buck and another to liquidate due to redemptions.

  • The U.S. Treasury intervened and offered insurance like FDIC.

  • At the end of 2008, the balance in money market funds was at $3,757. (Source: Flow of Funds. Board of Governors.)

Risk-Free Rate?#

Financial models often use a risk-free rate.

This is often taken as a T-bill rate, but be careful.

  • T-bills are used to fulfill a variety of regulatory requirements, and they are given preferential regulatory treatment.

  • T-bills are given favorable tax treatment. (State and municipal taxes do not apply.)

  • These facts cause extra demand for T-bills, driving the rates (artificially?) lower.

Models more sensitive to the interest rate will typically use SOFR, Eurodollar, or swap rates.

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