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Chapter 2

ACTSC371 Chapter 2: Chapter 2

Actuarial Science
Course Code
Ken Seng Tan

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Chapter 2 Textbook Reading + Review:
The money market includes short-term, marketable, liquid, low-risk debt securities. Money market
instruments are sometimes called cash equivalents because of their safety and liquidity.
Capital markets, in contrast, include longer-term and riskier securities. Securities in the capital
market are much more diverse than those found within the money market.
2.1 Money Market:
-The money market is a sub-sector of the fixed-income market.
-It consists of very-short-term debt securities that usually are highly marketable.
-Many of these securities trade in large denominations and so are out of reach of individual
-Money market funds, however, are easily accessible to small investors.
Treasury Bills (T-Bills)
What is T-Bills:
Treasury bills (T-bills) are the most marketable of all Canadian money market instruments. They
represent the simplest form of borrowing: the government raises money by selling bills to the
public. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the
holder receives from the government a payment equal to its face value. The difference between
the purchase price and ultimate maturity value constitutes the investors earnings.
-T-bills with initial maturities of 3, 6, and 12 months are issued biweekly.
-Sales are conducted by auction, at which chartered banks and authorized dealers can submit
only competitive bids.
A competitive bid is an order for a given quantity of bills at a specific offered price. The order is filled only if the bid is high
enough relative to other bids to be accepted. By contrast, a noncompetitive bid is an unconditional offer to purchase at
the average price of the successful competitive bids; such bids can be submitted only for bonds. The government rank-
orders bids by offering price and accepts bids in order of descending price until the entire issue is absorbed.
-T-bills are purchased primarily by chartered banks, by investment dealers, by the Bank of
Canada (as part of its monetary policy), and by individuals who obtain them on the secondary
market from a government securities dealer.
-T-bills are highly liquid; that is, they are easily converted to cash and sold at low transaction cost
with not much price risk.
-T-bills are now offered in denominations of $1,000, $5,000, $25,000, $100,000, and $1 million.
Certificates of Deposit and Bearer Deposit Notes:
-A certificate of deposit (CD) is a time deposit with a chartered bank.
-Time deposits may not be withdrawn on demand.
-The bank pays interest and principal to the depositor only at the end of the fixed term of
the deposit.
-A similar time deposit for smaller amounts is known as a guaranteed investment
certificate (GIC).

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-Although both CDs and GICs are nontransferable in Canada, some bank time deposits
issued in denominations greater than $100,000 are negotiable; that is, they can be sold
to another investor if the owner needs to cash in the deposit before its maturity date. In
Canada these marketable
-CDs are known as bearer deposit notes (BDNs).
-By contrast, a CD in the United States is a marketable instrument, similar to BDNs. Some trust
companies also have issued transferable GICs as well as GICs with variable rates or with
payoffs linked to equity indices. CDs and GICs are treated as bank deposits by the Canada
Deposit Insurance Corporation (CDIC), so they are insured for up to $100,000 in the event of a
bank insolvency.
Commercial Paper:
Investopedia: An unsecured, short-term debt instrument issued by a corporation, typically for the
financing of accounts receivable, inventories and meeting short-term liabilities.
Large, well-known companies often issue their own short-term unsecured debt notes rather
than borrow directly from banks. These notes are called commercial paper.
-Very often, commercial paper is backed by a bank line of credit, which gives the borrower
access to cash that can be used (if needed) to pay off the paper at maturity.
-Commercial paper maturities range up to one year; longer maturities would require
registration under the Ontario Securities Act and so are almost never issued. Most often,
commercial paper is issued with maturities of less than one or two months and minimum
denominations of $50,000.
-Considered as safe assets; because a firm’s condition presumably can be monitored and
predicted over a term as short as one month.
While non-financial firms issue most commercial paper, in recent years there was a sharp increase in asset-backed
commercial paper issued by financial firms such as banks. This was short-term commercial paper typically used to
raise funds for the institution to invest in other assets, most notoriously, subprime mortgages.
Bankers’ Acceptances
A bankers’ acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at
a future date, typically within six months. At this stage, it is similar to a postdated cheque. In return
for a stamping fee, the bank endorses the order for payment as “accepted”; it thereby assumes
responsibility for ultimate payment to the holder of the acceptance, making the instrument second
only to T-bills in terms of default security. At this point, the acceptance may be traded in secondary
markets like any other claim on the bank. Bankers’ acceptances are considered very safe assets,
because traders can substitute the bank’s credit standing for their own.
They are used widely in foreign trade where the creditworthiness of one trader is unknown to the
trading partner. Acceptances sell at a discount from the face value of the payment order, just as
T-bills sell at a discount from par value, with a similar calculation for yield.
Eurodollars are US dollar–denominated deposits at foreign banks or foreign branches of American

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-By locating outside the United States, these banks escape regulation by the Federal Reserve
-Accounts need not be in European banks
-Most Eurodollar deposits are for large sums, and most are time deposits of less than six months’
-A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit, which
resembles a U.S. domestic bank CD, except that it is the liability of a non-U.S. branch of a bank
(typically a London branch). The advantage of Eurodollar CDs over Eurodollar time deposits is
that the holder can sell the asset to realize its cash value before maturity.
-Eurodollar CDs : less liquid and riskier than U.S. domestic CDs; higher yields.
-Firms also issue Eurodollar bonds, which are dollar-denominated bonds in Europe, although
bonds are not a money market investment because of their long maturities.
-All of the above instruments—time deposits, CDs, and bonds—also exist denominated in all
major currencies; these are labelled Eurocurrency instruments when located outside the country
of currency.
-When issued in Canadian dollar denominations then they are referred to as Euro-Canadian
dollars; these constitute a minor portion of the Eurocurrency market, which is dominated by
Eurodollar trading.
Repos and Reverses
Dealers in government securities use repurchase agreements (also called repos or RPs) as a form
of short-term, usually overnight, borrowing. The dealer sells government securities to an
institutional investor on an overnight basis, with an agreement to buy back those securities the next
day at a slightly higher price. The increase in the price is the overnight interest. The dealer thus
takes out a one-day loan from the investor, and the securities serve as collateral.
A term repo is essentially an identical transaction, except that the term of the implicit loan can be
30 days or more. Repos are considered very safe in terms of credit risk, because the loans are
backed by the government securities.
Reverse repo:
A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding government
securities and buys them, agreeing to sell them back at a specified higher price on a future date.
Federal Funds:
Just as most of us maintain deposits at banks, many banks operating in the United States
maintain deposits of their own at a Federal Reserve bank. Each member bank of the Federal
Reserve System, or “the Fed,” is required to maintain a minimum balance in a reserve account
with the Fed.
-In the federal funds market, banks with excess funds lend to those with a shortage. These loans,
which are usually overnight transactions, are arranged at a rate of interest called the federal
funds rate .
Brokers’ Call Loans
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