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Primary dealers are dealer firms that are qualified to trade securities directly with the Federal Reserve Bank of New York. ?Primary dealers agree to “meaningfully participate” in trading with the Federal Reserve at any time the Fed wishes, to make “realistic” bids, and to trade continuously in the full range of government securities. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 55 Primary Dealers ? Primary dealers have a significant incentive to attempt to corner the government securities market and to collude and place mon bids, so that all the dealers can get some share of the new securities to fill their customers’ orders and make a profit. ? In the wake of a scandal involving Salomon Brothers in 1991, auction rules were tightened and a marketsurveillance mittee was created. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 56 Primary Dealers ? Then in 1998, the . Treasury abandoned its firstprice sealedbid, or English auction approach, in which each successful bidder paid the price that it had bid. ? It adopted the uniformprice, or Dutch auction method, in which all successful bidders receive securities at the same price – the marketclearing or stopout price. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 57 Dealers in the Money Market ?The bulk of the dealers’ operating capital is obtained through borrowings from mercial banks and other institutions. ? The two most heavily used sources of dealer funds are demand loans from the largest banks and repurchase agreements with banks and other lenders. ? A demand loan may be called in at any time if the banks need cash urgently. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 58 Dealers in the Money Market ? Under a repurchase agreement (RP), the dealer sells securities to a lender but makes a mitment to buy back the securities at a later date at a fixed price plus interest. ? RPs are simply a temporary extension of credit collateralized by marketable securities. ? Term RPs are for a set length of time (overnight, a few days, 1 month, 3 months, …) while continuing contracts may be terminated by either party on short notice. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 59 Dealers in the Money Market ? Interest ine from RPs = Amount ? Current ? Number of days loaned . of loan RP rate 360 days ? Periodically, RPs are marked to market. If the price of the pledged securities has dropped, the borrower may have to pledge additional collateral. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 60 Sources of Dealer Ine ? Dealers hope to earn a profit (the positive spread between the bid and ask prices) from their marketmaking activities. ? By correctly anticipating interest rate movements, dealers may earn sizable position profits too. ? If interest rates fall (and security prices rise), dealers will experience capital gains on a long position (but losses on a short position). ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 61 Sources of Dealer Ine ? Dealers also receive carry ine, the difference between interest earned on the securities they hold and their cost of borrowing funds. ? In addition, dealers receive miscellaneous service fees for their advice and assistance to customers. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 62 Dealer Positions in Securities ? Dealer holdings of securities are both huge and subject to erratic fluctuations, due mainly to interest rate movements and expectations. ? Today, dealers make heavy use of interest rate hedging tools to further protect their portfolios from losses due to changes in interest rates. ? They are active participants in the financial futures markets and are also making increased use of forward mitments. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 63 Government Security Brokers ? Government securities dealers usually trade among themselves through brokers. ? Government security brokers do not take investment positions themselves, but try to match bids and offers placed with them by dealers and other investors. ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 64 Banks in the Money Market Principal channel for payments for loans, securities amp。 A cce p t a n ce sBa n k Pri m e L o a n sT re a s u ry Bi l l s% ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 11 Commercial Paper Advantages ?Relatively low interest rates ?Flexible interest rates choice of dealer or direct paper ?Large amounts may be borrowed conveniently ?The ability to issue paper gives considerable leverage when negotiating with banks ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 12 Commercial Paper Disadvantages ?Risk of alienating banks whose loans may be needed when an emergency develops ?May be difficult to raise funds in the paper market at times ?Commercial paper must generally remain outstanding until maturity does not permit early retirement without penalty ? 2020 by The McGrawHill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 13 Continuing Innovation in the Paper Market ? Innovations and extensions of the paper market include: ? Master note – the investing firm agrees to take some paper each day up to an agreedupon maximum amount ? Mediumterm notes – 9month to 10year notes ? Asse