Handbook Financing of Short-Term - Essay Example

SHORT TERM FINANCING INSTRUMENT ANALYSIS Table of Contents Introduction 3 Treasury Bills 3 3 Certificate of Deposit 4 Commercial Paper 5 Reverse Repo 6 Banker’s Acceptance 7 Euro Dollars 7 Federal Fund 8 Call Money and Notice Money 8 References 9 Bibliography 11 Introduction The short term financing instruments have maturity period of less than one year. These can be used within 1 day to 365 days. These instruments are liquid in nature, with different denomination, maturity period and risk level. Treasury Bills Treasury Bills are commonly referred as T- Bills. The time period is about 14 days - 364 days. This is the safest of the short – term financial instruments. So, it can be considered as zero risk instruments. That is why return of these instruments is not high. T- Bills are usually issued at a lesser price than its face value. But on maturity it pays full face value. The amount of difference is the interest earned by its investor. Bidding process has been followed to issue T-Bills. Bidding can be done either competitively or non - competitively. Difference lies in required return. For the first one, required return is specified. If the return specified is higher then it will not be issued to the bidder. But for non - competitive bidding it is not specified, whatever is determined in auction is received on maturity. T - Bill auctions are held on the Negotiated Dealing System (NDS). It is an electronic platform to deal with Government Securities. Banks Primary Dealers, State Governments, Provident Funds, Financial institutions, NBFCs, NRIs and OCBs, FIIs (as per prescribed norms) and Insurance Companies can invest in T- Bills. So, the special features of T- Bills are risk free, affordable and marketable (Chadda, n.d.). Certificate of Deposit CDs are a sort of Usance Promissory Notes. Its minimum maturity period is of 15 days where as maximum is that of 1 year. CDs are like bank term deposit accounts. These are freely negotiable instruments and often termed as Negotiable Certificate of Deposits. The minimum amount of CD is $ 1000, 000. It can be in the multiples of the $ 1000, 000. The interest rate of CD can be fixed or variable. It is also traded in secondary market but the amount should be more than $ 500000. The return of CD is always higher than the return of T- Bills. In this case, interest is based on Annual Percentage Rate (APR) or Annual Percentage Yield (APY). APY is based on calculation of compounded interest where as APR is built upon simple interest rate method. So, if interest mode is semi-annually or quarterly then it will be beneficial to follow APY or APR. Advantages of CD are as follows. As the rate of return is known earlier, so it is considered to be safe One can earn more as in compared to savings account It also has few disadvantages also, those are In comparison of other investment options, the return is low Money is attached along with long maturity period in case of CD and also stepping out before maturity is a matter of huge penalty (Eagle Traders, n.d.). Commercial Paper Commercial Papers are promissory notes with fixed maturity, issued by highly rated companies. This kind of short term finance can be considered as the alternative of short term bank finance used for working capital requirement. CP is mainly used when the interest rate of bank is higher than the interest rate of Commercial Papers. The maturity ranges from 15 days to nine month. As compared to Treasury bills, CP has lower denomination. The risk attached with it is not zero but negligible. As we know that it is a kind of Promissory Note, so it trades in secondary market and is freely convertible in De-Mat form. Through CP, the issuer is able to accumulate a huge amount avoiding Security Exchange Commission (SEC) registration. It is a sort of discount security. The investor can buy the notes at lesser amount than its face value and at maturity the investor gets the face value. The difference can be termed as discount. The interest rate of all commercial paper is quoted on discount basis (Hazard, 1841). Commercial Paper is mainly issued by domestic and foreign firms along with banks and other financial institutions such as security firms, insurance firms, etc. More than 500 non-financial firms also engaged with issuing CP. It includes public utilities as well as service companies. They use CP on temporary or permanent basis mainly for meeting operating expenses or to fund certain construction projects. More than 75% of Commercial Papers have been sold by financial companies and they directly sell it to the public. But the other corporations which borrow lesser amount; sell CP to the paper dealer. Paper dealer send those CP to other investor at a markup (Eagle Traders, n.d.). Repo Repo or Repurchase Agreement is a safe short term instrument mainly used by the government security holder. It is a very popular mechanism to sell the security to the borrower for very short period. Its term limit might range from 24 hours to 30 days. It is mainly used for overnight borrowing. It is a private agreement between two parties, where one party sells to another party with promise to buy back the securities on a predetermined date and rate. And there is no involvement of secondary market because of the very short period of 1 or more days. The negotiated and mutually agreed interest rate of a repo transaction is called Repo Rate (Fabozzi, 2002). The uses of Repo are to be as follows: Proper utilization of surplus cash by banks Investor can get money market return with a very low risk Bank can use it to adjust their CRR and SLR position Borrower can accumulate funds in a easy way and at better rate (Economy Watch, n.d.). Reverse Repo Reverse Repo enables one party to purchase securities with an agreement to sell them at later date. The underlying securities are mainly government securities. The underlying concept of Repo or Reverse Repo is same. Whether the agreement will consider as Repo or Reverse Repo is depended upon the party who has taken the initiation. If it is from seller side then it is termed as Repo and if from buyer side then it will be Reverse Repo (PNB Gilts Ltd, n.d.). Banker’s Acceptance It is a kind of credit investment which is guaranteed by a bank in exchange of collateral from a non - financial firm. Though the term range is from 30 days to 180 days, 90 days is the most popular duration. In simple words, it is nothing but a bill of exchange that is drawn by a person and accepted by the bank. It is used mostly in the field of export and import. Here, the holder gets an opportunity to sell it to secondary market at any time. Often Banker’s Acceptance is used by those firms that are too small or too risky to issue CP (Paton, 2009). Euro Dollars Euro dollars are nothing but US dollars deposited in foreign banks. It is not regulated by US Government. The interest rate paid on these deposits is a bit higher than the 3 - month Treasury Bills and equal to the London Interbank Offer Rate. It is a liquid instrument. Eurodollars is mainly used by large institutions. Small investors only can get hold of it through money market (Spaulding, 2008). Federal Fund All the banks under Federal Reserve System have to maintain a minimum balance with Federal Reserve Bank (FRB). Federal Funds is the amount that the banks have to deposit at FRB to maintain the balance. Few banks in major cities like New York City and San Francisco, often failed to maintain the reserve and in such case, they need to borrow from other banks which has surplus (Harvey, 1995). These loans are usually overnight loans. Those banks which are always failed to deposit may borrow for a longer period. It may be from 1 week to 6 months. This Fed Funds are known as ‘Term Fed Funds” (Gurwitz, 2000). Call Money and Notice Money Call Money and Notice Money represent borrowings made for a period of 1 day to fortnight. For Call Money, there is a predetermined maturity period but for Notice Money there is no such maturity period, the lender just sends a notice to the borrower two to three days before of repayment. References Chadda, A. (No Date). Money Market and its Instruments. CAalley. Retrieved Online on May 21, 2010 from http://www.caalley.com/art/Money_Market_and_Money_Market_Instruments.pdf Eagle Traders. (No Date). Domestic CDs. Large Negotiable Certificates of Deposit. Retrieved Online on May 21, 2010 from http://www.eagletraders.com/neg_financial_instruments/large_cd_o.htm Eagle Traders. (No Date). Commercial Papers. Large Negotiable Certificates of Deposit. Retrieved Online on May 21, 2010 from http://www.eagletraders.com/neg_financial_instruments/commercial_paper_o.htm Economy Watch (No Date). Repos. Money Market Instrument. Retrieved Online on May 21, 2010 from http://www.economywatch.com/market/money-market/money-market-instruments.html Fabozzi, F. J. (2002). The Handbook of Financial Instruments. John Wiley and Sons. Gurwitz, A. S. (2000). Managing a Family-Fixed Income Portfolio. John Wiley and Sons. Harvey. C. R. (1995). Federal Fund. Financial Instruments, Markets and Information. Retrieved Online on May 21, 2010 from http://www.duke.edu/~charvey/Classes/ba350/instrum/instrum.htm Hazard, S. (1841). United States Commercial and Statistical Register: Containing Documents, Facts and other Useful Information, Illustrative of the History and Resources of the American Union and of each State. Printed by W. F. Geddes. Paton, T. B. (2009). Digest of Legal Opinions of Thomas B. Paton, General Counsel of the American Bankers Association. PNB Gilts Ltd (No Date). Repo/Reverse Repo. Money Market Instruments. Retrieved Online on May 21, 2010 from http://www.pnbgilts.com/icds.asp Bibliography Foulke, R. A. (1980). The Commercial Paper Market. Ayer Publishing. Mishkin, F. S. (2007). The Economics of Money, Banking, and Financial Markets. Pearson Addison Wesley, 2007. Read More