The treasury function

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1 Introduction

The role of the treasury management function within a business is to manage the firm’s financial resources in the short-term, and to manage the exposure to risk. The management of cash has been dealt with in Chapter 6 of these Course Notes, and the management of risk has been dealt with in Chapters 23 and 24.

The purpose of this chapter is to explain the role of the money markets and to explain the characteristics of the principal money market instruments.

2 What is ‘the money market’?

The money market is one part of the overall financial markets, and deals with short-term (usually up to thirteen months) borrowing and lending.

It serves to allow companies with surplus funds to be able to invest such that companies needing funds are able to borrow.

In addition it allows governments to raise money and also to implement monetary policy.

The three main functions that are of relevant to the treasury function of a business are:

The provision of short-term liquidity
The provision of short-term trade finance
Allowing the business to manage its exposure to foreign currency risk and interest rate risk

The money market is defined by its term, and questions test that definition from both ends. Its functions are the short-term ones listed above, together with giving companies that hold surplus funds somewhere to place them while companies that need funds borrow. An instrument that runs for years, or that is never repaid at all, is not a money market instrument however familiar its name.

3 The role of the banks and other financial institutions.

Commercial banks are at the centre of the money markets and act as an intermediary between lenders and borrowers.

The commercial banks lend money to each other (interbank lending), which enables them to comply with regulations regarding the amounts that the banks must have in reserves. The rate of interest that they charge each other is known as LIBOR (London interbank offer rate) and this acts as a benchmark for all short-term borrowing and lending by the banks (e.g. a bank may decide to lend money at LIBOR plus 2%).

Governments also participate in the money markets. They raise money by issuing short-term Treasury Bills.

In addition, the state (through the Central Bank) influences the supply of money and the interest rates by selling or buying back Treasury Bills to or from the banks, and by changing the reserve requirements of the banks.

Companies participate, not just by depositing with or borrowing from the banks, but also by issuing their own ‘commercial paper’ – their equivalent of Treasury Bills – which are short term borrowings.

4 Principal money market instruments

Certificates of deposit (CD’s)

These are deposits with a bank for fixed periods, usually carrying fixed interest. The rate of interest offered by the bank will depend on the amount deposited and the time period. On maturity the money is withdrawn together with the interest that has accrued. (There are not usually paper certificates any more – it is just a time deposit with the bank.)

Treasury Bills

These are short-term borrowings by governments with fixed maturity dates (a maximum of twelve months). They do not pay interest (zero-coupon), but instead are issued at a discount on par value (so the lender receives more on maturity than they originally lent).

Commercial paper

These are similar to Treasury Bills (short-term borrowing, usually zero-coupon and issued at a discount) but are issued by large corporations.

They are unsecured and therefore are only realistically issued by companies with excellent credit ratings.

Eurodollar deposits

These are time deposits (for fixed periods, carrying fixed interest) in dollars with banks that are outside the United States. (The deposits can be in any country outside the United States – the ‘euro’ in the word has no connection with Europe or the Euro currency!)

Repurchase agreements (REPO’s)

This is effectively a way of borrowing money – the borrower sells securities (e.g. Treasury Bills) to the lender (and so raises cash) together with an agreement to buy back the securities at a later date at a price higher than the original sale price. (The difference between these prices effectively being the interest (the repo rate)).

Derivatives

Derivatives are financial products whose values come from the price of a particular money market instrument. For example, you will already have read about interest rate futures in Chapter 24 of these notes. These are a derivative in that their value comes from interest rates.

The derivatives that you should be aware of for this examination are all covered in Chapter 24.

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