 Hello and welcome to this session. This is Professor Farhad and this session we would look at asset classes specifically the fixed income class. This topic is covered on the CPA exam as well as the CFA exam. Also covered in an Essentials of Investment whether it's an undergraduate or graduate course. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance and excel tutorial. If you like my lectures please like them, share them, subscribe to the channel, share them with other people. If they benefit you it means they might benefit them. Share the wealth connect with me on Instagram. On my website farhadlectures.com I have a catalog of various accounting and finance courses that will help you substantially whether you are taking finance or accounting courses or if you are studying for your CPA exam. So from a grand perspective we have three types of asset classes. We have fixed income, we have equity and we have derivatives. So in this in this series of recording I'm going to be focusing on these three type of classes and today we're going to be working on the fixed income which can be broken down into money market and capital market and specifically for for this session I'll be focusing on the money market. The money market is short term market, short term in nature, short term means it's going to be cashed out in the near future. So what is the money market? The money market is a subsector of the fixed income market. Fixed income market means you will be getting the same amount of money from your investment so it doesn't vary it's fixed. So when you lend money you would receive interest payment. Generally speaking that interest payment is fixed. However once you say money market think of short term. It's a short term investment it's liquid. It's liquid means it can be easily converted to cash. So if you want your cash you can sell it and get your cash and another feature of the money market it's low risk. Low risk means it's not going to change that easily and the reason it's not going to change that easily part of it it's it's short term and liquid. So those two together if something is short term and liquid it means you can sell it quickly and you can sell it in the near future. The near future should not carry that much risk relative to the long term perspective so that's why it has a low risk. It means the risk of defaulting is low. In other words the risk of not getting your money. Often those market trade enlarge denomination but we're going to look at various types of them and this is a list of them. We're going to look at treasury bills which is considered the only risk-free CD certificate of deposits, commercial papers. We'll talk about Lehman Brothers, bankers acceptance. We use an international trade, euro dollars, repose and reserve. Again we'll talk about Lehman when we talk about repose and reserve, the federal fund, the borrowing between the banks. Most of these instruments are sold at a discount. What does this count mean? It means it's below the value. So when when someone sells you a treasury bill that's I'm just going to give you a quick example. They may sell it to you for 10,000 okay but the face value is 10,000. The difference between what they sell it for you for you now and the face value is a thousand and that's the interest that you earn on that bill because you purchase it for a nine. When it matures it matures at 10 and we'll look at a real example in a moment. So let's look at specifically treasury bills. What is treasury bills? Sometimes they're called T-bills. Sometimes it's called bills for short but they're highly liquid. Highly liquid means they can be easily traded. Why? Listen to me why because it's the United States government okay. Most it's the most marketable of all money market instrument. Why? Because the US government raises money by selling those papers. So when the US government when Uncle Sam from Washington wants to borrow money from the market they sell you those T-bills those treasury bond those treasury bond. So investors buy the bill at a discount from the stated maturity rate. So when the government sells it to you they say okay if this is a 10,000 dollar if this is a 10,000 dollar bond look it's printed on a 10,000 only give us 9,800 and guess what when you come back when it matures will give you 10,000 dollars. So it's sold at a discount okay the 9,800 is the discount okay. So as the bill as the bill reaches maturity the government pay the investor the full amount or the face value the face value again is 10,000 it's printed on the bill and those bills comes in different maturities whether it's four weeks, 13 weeks, 26, 26 or 52 simply puts 52 weeks as a year. So they they come in less than a year a maturity value. So individual can purchase these treasury bill right from the government or they can they can buy it from the secondary market from the government dealer and those securities unlike other money market instruments we will see later that they that they sell with the minimum of 100,000 because they target large corporation T-bill they sell in the minimum of only 100 but 10,000 is a very common denomination but simply put anyone can lend money to the government as long as they buy those T-bills and by the way those T-bills are taxable at the federal level but they're exempt from the local and state level. Let's take a look at how they trade. So let's take a look at this bill October 12 2017 this is the maturity date. Days to mature is 177 days the bid is 0.905 the ask is 0.809 it's changed from the prior day and this is the yield. So how do we read this treasury bill so so the bill obviously maturing October 2nd 2017 and we are 177 days before this day. So we have to count back 177 days which is October 18 2017. So they tell you how many days it's still to mature. Now why is this important because if you buy this bill if you buy it you're going to be earning interest for the next 177 days because from the time you buy it the interest will start. So the yield under the column asked is given as 0.895 what does that mean? It means that the dealer was willing to sell you the bill at a discount from the face value so the price of it is 0.895 times the amount it's going to take until it mature so you'll take the price they will sell it to you at this price times the time it's going to mature. So let's see yielding 0.4410. So a bill with a 10,000 face value could be purchased sold to you at 10,000 minus 0.0044 which this is what it's going to earn. So they will sell it to you today for 900, 900 and 9,956 that's what they sell it to you for. The same thing could be said if they want to buy it similarly on the basis of the base yield of 0.95, this is what they would buy it, a dealer would be willing to purchase the bill from you if they want to purchase it, they'll purchase it for kind of a dollar less or 50 cent less because if they want to buy it they're going to say okay we'll buy it from you but it's 50 cent less notice they will buy it and how do you find this price it's 10,000 times 1 minus 0.0095 times 177 divided by 360 and prices are here are inversely related we'll talk about this a little bit more when we look at bonds. So this implies a lower bid price. CDs are another form of short-term borrowing basically what is a CD is when you deposit your money at the bank and you log that amount you log it for a period of time so you cannot take it withdraw it on demand anytime you want you you cannot go into the ATM machine and take it out and here when we talk about CDs certificate of deposits those are large certificate of deposit okay we're not talking about 10,000 we're talking 100,000 and above the bank space interest and the principal to the depositor at the end of the fixed term of the CD and this is what a CD is those CDs are usually issued in a denomination larger than 100,000 and are usually negotiable what does negotiable means it means if you carry one of those CDs you can sell it to someone else if you want your money that's the nature of the money market it's short-term liquid short-term means it's going to mature soon and there's a market for you to sell it now the market for the CDs is not as liquid it means it's not doesn't have a lot of buyers and sellers as much as other ones nevertheless it is liquid it can be sold to another investor if the owner needs the cash and the certificate before it matures it's marketable however there's a thin out for maturity market significantly thin outs for maturities of three months or more so it's marketable when the when the maturity is less than three months this is when it really becomes very much very very marketable see these are treated as bank deposits by the federal deposit insurance corporation fdic it means that CD you know you could have up to 250,000 anything more than that and your losses we cannot get indeed so the CDs are considered part of your savings account basically or your checking account another form of money market is commercial papers or for short CP and Lehman was notorious for this and we're going to talk about this a little bit more those are short-term and secure that issued by large corporation so a company like Microsoft or Apple or Amazon they need money in that in the short term so what they do is they issue those commercial papers so they give you a commercial paper saying yeah i want to borrow a million dollar they you will give them 990,000 and they'll give you a piece of paper saying we're going to pay you back a million dollar two weeks from now the short term unsecured now the well-known companies often issue those unsecured paper because they have to be well known they have to have a good credit sometime commercial paper is backed by the line of credit it means if you don't pay it you could use your bank account and your bank account will pay for it they mature in up to 270 days most of them are less than 60 days most of them are really short they come in 100,000 denomination okay so 100, 200, 300 they usually trade in millions because corporation needs large amount of money small investors can invest in those through money market funds so some money market fund even if you have five thousand dollar you can buy commercial paper but you will buy a piece of it commercial paper are safe because of its short term nature well when we say safe because some of them were not safe but let's put safe in quote and the reason it's safe because every time something the short term it's safe so their sensitivity they're traded in the secondary market it means they are quite liquid they can be sold and bought anytime you want to and they are rated rated means for example when microsoft wants to issue those commercial paper microsoft is AAA rated by one of the agencies like standard and porous so the rate they give security they give confidence to buyers and sellers and the yield on the commercial paper depends on the time of the maturity and the credit rating obviously the longer the maturity the more the company will have to pay and the lower the credit rating the lower the credit ratings they the more they have to pay if you have AAA you might pay two percent if you have AA you might have to pay 2.5 if you have an A rating you might have to pay three percent to raise money because your rating goes down and the longer you want the longer you're borrowing the more you have to pay the yield yeah the yield is depending on the maturity and the credit rating historically those papers were issued by non-financial firms simply put non-banks but what happened in the years leading to the financial crisis and i talked about this in the prior session there was a sharp increase in the so-called asset-backed commercial paper so what companies started to do like Lehman Brothers what they started to do they started to borrow money using using their assets for the commercial paper but guess what their asset was no good their asset was i'm sorry to say this was crappy so it issued by non non non by financial firms such as bank the short-term commercial paper was used to raise fund from the issuing firm to invest in other assets mostly notoriously subprime mortgage so what they say is it give us the money we need to take this money and buy subprime mortgage mortgage is long-term commercial paper is short-term so what you're doing is you are borrowing money on a short-term basis to buy asset on a long-term basis so these assets were in term use escalator those long-term assets and that's why it's called asset-backed which is very risky business by 2007 those subprime mortgage began defaulting the bank found themselves unable to issue new commercial paper to refinance their position as the old paper mature and what happened to this commercial market commercial paper market when Lehman went down it infected all the other commercial paper and everybody was scared of dealing with commercial paper so everybody started to withdraw their money and i talked about this in the prior in some other prior session in this course everybody took their money and put it in treasury bill and the commercial paper collapsed and the commercial paper is needed for corporation trades money so it was a big deal another form of a short-term short-term money market is bankers acceptance and banker acceptance is used when a company is importing and exporting basically international trade buying from overseas customers basically it's an order to a bank buy a customer to pay some amount of money at a future date to simply put if you have a banker acceptance it means the bank is guaranteeing a payment for you so when you want to buy from china if you want to import something from china the chinese the chinese firm doesn't know who you are so how would they trust you the bank would say look i will i have a bankers acceptance i will guarantee this this individual or this firm okay so typically it's within six months because the bank doesn't want to take any longer chance on you like a post data check basically you give them a post data check guarantee that the bank will honor that check once the bank endorses once the bank honors the order of payment as accepted it assumes responsibility for the ultimate payment so the bank you so do so and once that happens the instrument becomes negotiable it means whoever holds that instrument they can sell it in the secondary market for something so if if the person in china doesn't want to wait to wait for you to pay them the money they can sell it in the secondary market so the banker acceptance are considered very safe because basically the bank guarantee them obviously so as they allow traders to substitute bank credit standing of the for their own so this simply put it's a guarantee by a bank that you they will make the payment okay they are used widely in foreign trade as i told you where the credit worth in it of one trader is unknown to the other partner acceptance sells at a discount just like the t-bell when when you have it it sells at a discount euro dollars this is the biggest misnomer euro dollars has nothing to do with euro it's dollar them denominated deposit it's us dollar it's not euro it's not euros it's actual us dollar deposited in foreign banks and those deposit escape the regulation by the federal reserve because in euro because they're in in some other country and the tag euro it's not really they don't have to be europe they can be in asia they can be in south africa they can be in south america they're still considered euro dollar because it started deposits in euro but it's all over the place but that tag continued so most euro dollars are large sums of money by corporation and most of the time they are cd's less than six month in maturity then we have something called euro dollar certificate of deposit which is kind of a domestic bank cd but it's in a foreign country it's it's a liability of an un u.s branch of a bank typically a london basically holds the liability for those and we have also the euro bonds or euro dollar bonds it's either firms or countries they try to borrow money on a long-term basis so euro bonds are not money market they're basically part of the bonds market but nevertheless we just want to make sure that you don't differentiate between euro dollars euro certificate and euro bonds because they all carry the term euro so euro bonds are bonds issued in us dollar but they are sold overseas another type of money market is repose and reserve again leman brothers was notorious for using this this this type of short-term money market instrument the short-term sales of securities with an agreement to repurchase the securities at a higher rate so simply put what happened is leman will have some asset usually mortgage back security and what they do let's assume they have a million of million dollars of them they want they want money right away they want 980 000 so what they do is they transfer this this mortgage back securities to a lender and the lender will give them back 980 000 leman would give them mortgage back securities worth a million okay so this is the lender the other party and what happened leman a week later leman will go back and would say okay we're going to give you back the million give us back our securities and the lender basically made 20 000 because you know the lender only gave them 980 this is what a repo is so i would sell it to you that i will buy it back at a higher price and the lender have no problem with that because because they're giving you the mortgage back securities they've given you assets they're giving you some security the problem with leman is those securities were no good and once they were discovered they were no they were no good also the repo market froze because everybody was feared that they might have toxic asset they're holding toxic asset so dealers and government securities used to repurchase agreement also called repo is a formal short-term borrowing overnight borrowing usually it can be overnight it can be you know for a few days so if you're a dealer in government securities basically buying and selling government securities you could use those securities to raise cash okay the dealer sells the security so an investor as an overnight basis when the agreement to buy back those securities the next day at a higher rate so if somebody needs a loan for a million dollar it's okay i'll give you 990 000 today give me those securities to more or buy it back from me for a million so that's the difference is my interest the increase in the price is the overnight interest the difference is the overnight interest the dealer thus takes out one day loan from the investor the securities serve as a collateral so you give them the security you give them the the bonds that you have and you get the money tomorrow the following day you give them back the money that they gave you plus a little bit of interest and they'll give you back the bonds repos are considered very safe again unless you are you are dealing with with Lehman in terms of credit risk because the loans are literally overnight or close to overnight and they are securitized so you're lending lending me the money for one or two days or a week i should exist within one week and i'm giving you some assets and but that's not what happened with Lehman it was crazy time the Lehman's the assets were no good and Lehman did not survive we also have what's called reserve reverse which is the opposite of a repo a reverse is a mirror image of a repo where the dealer find an investor now it's the other way around holding holding government securities and buy them with an agreement to resell them so now the dealer is buying the securities that are then needing of the catch it's the opposite of a repo a broker's call and if you never watch that movie margin call you should watch that movie what happened is when you have a brokerage account let's assume you have for the sake of illustration you have $30,000 in that account well guess what you have $30,000 then the broker will give you another $30,000 so now you have a power a purchasing power of $60,000 to buy securities what's happening now is you are buying on margin now this additional $30,000 the brokers buy the brokers get it from the bank okay so individual who buys stocks on margin borrow part of the funds to pay to pay stocks from their broker now the broker in terms may borrow the funds from a bank and that's why when we have liquidity in the market the federal the federal reserve gives money to the bank the bank lend it to the brokers the brokers lend it to the investors we have a lot of liquidity the stock prices goes up so when you say well the stock prices go up because of liquidity because the banks and the federal system are dumping money into our stock market so agreeing to repay the bank immediately on call of the bank requests so the brokers say look if you want the money I can get you the money anytime on call and there's that movie called margin call you should watch it if you're interested in the stock market so the rate paid on such loans are usually about a percentage above the treasury bill so usually whatever the treasury bill is then they will charge you another percentage let's talk about the federal funds this is we're dealing with the federal reserve this is the funds and the account of commercial bank at the federal reserve so every bank when they accept the deposit let's assume they accept the 100 000 dollar deposit they they have to put some money let's assume 10 000 dollar of this deposit in the federal reserve that's why they have to put that money so it's bank maintain a deposit of their own at the Fed for example here 10 000 of the 100 000 each member of the federal reserve system is required to maintain a minimum balance and that minimum balance depends on the total of deposit of the bank's customer so it depends also on the on the federal reserve that you are dealing with at any time some bank might have more funds than required by the Fed so if you have more money you might have to increase your fund if you have less money and you have more money and at the federal reserve then you have access funds so what do you do with that access fund well banks with access fund can lend those to those to a bank with the shortage let's assume let's go back and you have a million dollar worth of deposits and you already have at the federal reserve 100 000 today a lot of people would drew money and you have 800 000 of deposits well guess what your deposit should your you should only deposit not 180 000 at the bank so you have access of 20 000 now a bank will have the another bank might have the opposite a bank might have a million and 100 000 but suddenly they have more deposits but they don't have enough money to put it away at the federal reserve therefore they will borrow that extra 20 000 from you overnight so this way they are covered at the federal reserve now the interest rate that they that these banks charge each other is called the Fed fund rate okay it's simply the rate of interest on the very short-term loans among financial institution and those loans are literally overnight until the next day that bank wired money to the federal reserve and they'll pay you back your loan well most investors cannot participate in this market the Fed fund rate command great interest as a key barometer of the monetary policy usually this Fed fund rate drives every other interest rate in the private market something similar to the Fed fund rate is the LIBOR and the LIBOR stand for the London offering interbank rate this is the lending rate among banks in the London market here we're talking about European mainly the British it's the premier short-term interest rate quoted in the European money market and serve as a reference rate for a wide range of transaction at reflect the rate at which bank lend among each other you remember we talked about the Fed fund rate the US bank lend amongst each other now LIBOR is the European bank lending among each other also when banks make loans out what they do they would say we're gonna charge you LIBOR whatever LIBOR is plus 2% there is a big a big scandal about this it's beyond the scope of the scores or I don't you know I'm not gonna discuss it in this recording so LIBOR is kind of gonna be phased out shortly okay so hundreds of trillions of dollars mortgage loans and derivatives contract are based on LIBOR so LIBOR is very important we have also EUROBOR which is the European interbank offer rate and we have TAIBOR the TOKYO interbank offer rate are quoted in terms arranging for from overnight to several months of interest rates so those are also kind of benchmarks they're all based on surveys basically and this is what happened with LIBOR the surveys were were were monkey but of rates reported say no it's reported by participating bank rather than actual transaction so that what the banks were reported and the actual rate they were not the same and this is the problem with LIBOR the British regulators have reports facing out LIBOR by 2021 and replace it with something called SONIA the sterling overnight interbank average rate very interesting names um yield on on money market instruments so it's very important to understand that concept yields on money market instrument because money market uh money market securities are low risk so they're not risk-free why because the only thing that's risk-free is the US Treasury Bill in theory the US government can always pay back their money so we have to be aware of this the securities of the money market promise yields greater than those the fault-free T bill at least in part because of the relative greater risk so the money market all money market yields greater than the Treasury Bill it should because the Treasury Bill is the safest thing you can have when you give your money to the US government this is what we started with you remember the T bill or the bills those are the safest so so investors who require more liquidity also accept lower yields on securities such as as T bills so they can be quickly and more cheaply sold for cash so if you want liquidity you'll have to accept lower yield accepting lower yield means you have T bill is your best yield and history shows that that's the case for example cd's consistently consistently certificate of deposit had offered a higher yield than T bills so look okay consistently this is the spread between the two it means the difference between the the cd the cd certificate of deposit and the Treasury Bill rate notice in terms of in times of crisis it spikes it spikes and that makes sense okay so because if you want safety you go with the you go with the Treasury Bill otherwise you know everything else is less safer okay also what we have what's called the TED spread just give me one second here the TED spread is the difference is the difference that erases the that TED spread that's another thing that they look at is the difference between LIBOR and LIBOR and US Treasury that's another rate that's that's monitored very closely and let's look at the TED spread also the TED spread is the kind of show the same thing when there is riskiness in the market that spread increase and that's why in the financial market they follow the TED spread when the difference between LIBOR and the Treasury rate goes up when when the difference between them spread a lot then it's a risky time that's that's that's an indication of risk and the next session would look at the bonds market as always I would like to remind you to connect with me link like on LinkedIn like my lectures share them if they benefit you it means they might benefit other people and don't forget to visit my website for HadLectures.com and of course stay safe if we are still living through this coronavirus good luck and study hard