Traditionally, the term 'money market' comprises the market in short term interest-based instruments and the foreign exchange market. The following are some of the common products encountered.
Bills are securities promising repayment of a specified amount, the face value, at a specified date, the redemption date. The price paid for the bill implies a rate of return to the holder. This rate of return is expressed not as a rate of interest on the amount paid for the bill, but as a rate of discount from its face value. Major issuers of bills are the government which issues Treasury bills (deemed to be risk free), and companies which issue commercial bills. Any bill which can be sold to the Bank of England in one of its repurchase operations is said to be an 'eligible bill'. When such bills include commercial bills they must be of top credit quality. Eligible bills are very liquid and virtually risk free since the Bank guarantees to buy whatever amount of such bills as are offered it by the discount houses.
When an amount of funds is lent to a borrower for a pre-agreed period of time, a deposit is said to have been made by the lender. The length of the deposit is the pre-agreed period of time for which the loan is made and a rate of interest will be charged by the lender, repayable with the amount initially borrowed, on the maturity of the deposit.
An FRA (Forward rate agreement) is an agreement made between two counterparties based on the interest rate of a deposit of a given period that begins at a specified future date. An FRA for a period of three months that begins in six months time is described as a 6's 9's FRA, whilst a 2's 4's FRA relates to a period of two months that begins in two months time. There is no physical transfer of cash between the two counterparties, the settlement of the FRA being dependent upon the prevailing market interest rate for a deposit of the quoted length on the specified future date, termed the 'settlement date'. The payer of the FRA rate is the 'taker' and the receiver of the FRA rate is the 'giver'. Should the actual deposit rate at the settlement date be above that agreed on the FRA, the giver will pay the difference between the FRA rate and the actual settlement rate, multiplied by the nominal amount and discounted at the settlement rate. Should the settlement rate be below the FRA rate, then the settlement amount will be paid by the taker to the giver. An FRA is therefore an example of a 'contract for differences', since it is the difference between two rates that is the subject of the FRA trade rather than any actual transfer of funds. For example, a 3's 6's FRA is traded at 10% in $20 million (A gives to B). Say that the FRA relates to a deposit period of 90 days (this being the number of days between the 3 and 6 month date). The money market basis in $'s is Actual/360. On the settlement date (three months from the trade date), the actual rate for a three month deposit quoted in the market is 11%. The settlement amount is calculated as follows:
Difference between FRA rate and settlement rate = 1%
Settlement amount before discounting = 20,000,000 × 0.01 × 90/360 or $50,000
Settlement amount after discounting = 50,000 / (1 + .11 × 90/360) or $48661.80
Short term interest rate futures
An interest rate future is a future contract on any interest bearing instrument. Thus a future contract on a bond is termed a bond future contract, and a future contract on a three month money market deposit is termed a 'three month interest rate future contract' (or sometimes a 'short term interest rate future contract').
Since futures contracts always operate in price terms, short term interest rate future contract prices are quoted as (100 - interest rate %) in order to conform to the standard future market convention. An FRA rate of 10% therefore equates to a future price of 90.00. Since the future is quoted on a given contract value (£500,000 in £), traders will need to trade the appropriate number of contracts in order to achieve their desired nominal exposure. Thus to lock in a borrowing rate on £5,000,000 in a three month deposit beginning in June, a trader will need to trade 10 June futures contracts. Since the trader is locking in a borrowing rate he will structure his trade such that it benefits from any increase in rates. An increase in rates will be reflected in the future contract by a price fall. The trader will therefore sell the future contract. Any gain in the future contract trade enacted will then offset the increased interest cost of borrowing incurred under the new higher rate of interest. The future contract trade is therefore said to be a 'hedge' of the underlying borrowing requirement. If the trader's futures contract hedge is a perfect one, then the profit or loss resulting from the future trade will exactly offset the increase or decrease in the actual borrowing rate incurred.
Since the future contract is quoted in percent of nominal, 100% of nominal should represent 100% of contract value. Since contract value in £ is £500,000, 1% of contract value should be worth £5,000 and 0.01% of contract value £50. However, when one examines the value of 0.01% in £ (the so called tick value, being the smallest move that the future price can make up or down), one will see that it is in fact worth only £12.50. This is because the future contract represents a three month period of interest. A trader who buys one contract at 90.00 and sells it at 90.20, will therefore profit by an amount of:
20 ticks × £12.50 per tick = £250.00.
A swap is an agreement between two counterparties to exchange different kinds of interest payment at agreed dates for an agreed length of time. This length of time is called the term of the swap. Swaps fall broadly into two categories. Firstly, swaps in which interest payments in the same currency are swapped, commonly called 'interest rate swaps', and secondly swaps in which interest payments in different currencies are swapped, commonly termed 'currency swaps'. Each category can be further divided into two further swap types, namely those swaps where the interest payments swapped are both floating rates of interest (called 'basis swaps'), and those swaps in which one of the rates swapped is a fixed rate (called 'fixed for floating' swaps). In 'zero-coupon' or 'bullet' swaps, payments of the fixed rate in a fixed for floating swap are paid in one future valued lump sum at the end of the swap term. Currency swaps in which payments of the interest obligations on the two currencies are both paid in terms of the same currency are called 'diff' swaps. Asset swaps involve the packaging of a swap with an asset such as a bond, to enhance or change the basis of that asset's yield. A fixed for floating interest rate swap is priced according to the expected market repo rate for the government bond during each period of the swap's life. A currency basis swap is priced according to the related currency swap and fixed for floating interest rate swap.
Foreign exchange or 'forex' markets allow counterparties to exchange different currencies at market exchange rates. An exchange rate can be seen as the price of one currency in terms of another. There are thus two ways of quoting a forex rate, for example $/£ or £/$. If $/£ = 1.50 this signifies that the number of dollars one receives for one pound is $1.50. If £/$ = 0.66667, this signifies that the number of pounds one receives in exchange for one dollar is £0.66667. The latter amount is simply the inverse of the former and denotes the same exchange rate but in each case the base currency is alternated. The base currency is the one which appears on the right hand side of the notation, thus for the quote £/$, the base currency is $. Each market has its own convention for which currency to use as the base. In sterling against dollars, exchange rates are quoted as the number of dollars per pound. For other currencies against the dollar, it is the dollar that is the base currency.
A cross rate is an exchange rate that is derived for a currency from two other exchange rates in which that currency is quoted. For example, if DM/$ = 2.00 and DM/£ = 3.00, one can derive the $/£ cross rate as 1.50. This is simply DM/£ divided by DM/$. A forward foreign exchange rate is the forward price for a given exchange rate determined with reference to the spot exchange rate and the money market rates of interest available in the two currencies. Thus if £ one year deposit rates are 10%, $ one year interest rates are 5% and the spot forex rate is $/£ = 1.50, then the fair forward foreign exchange rate must be $/£1.4318. £1 borrowed at 10% for one year requires repayment of £1.10. The borrower of the £1 can exchange it into $1.50 at the beginning of the period and invest this amount for one year at 5% to produce $1.575. In order for there to be no arbitrage between the money market and the forward foreign exchange market, the forward foreign exchange rate must therefore offer a rate which exchanges $1.575 for £1.10 in one year's time (1.575/ 1.10 = 1.4318). Should the forward exchange rate be lower than this, say $/£ = 1.00, then the holder of $1.575 could exchange this amount for £1.575 at the forward date, repay the loan and interest amount of £1.10, leaving a profit on the arbitrage of £0.475.
Securities borrowing and lending
A security borrowing agreement is an agreement between two counterparties, one of whom accepts cash from the other, that other receiving a security as collateral for the duration of the loan period. Traders may use securities borrowing facilities because :
a) it allows the lender of the security to access liquidity
b) the security acts as collateral for the lender of cash and may result in lower interest charges thereby
c) the borrowing of a security allows the borrower to 'short' that security in the market
d) security borrowing or lending allows users to build up leveraged short or long positions in the market
e) market-makers in securities borrowing and lending may profit from the operation of a bid/offer spread