Federal funds, also known as fed funds are reserves that banks hold in their Federal Reserve Bank account. These fed funds need to be maintained as per the Regulation D reserve requirement. Banks having excess fed funds above the requirement can lend to other financial institutions having account at a Federal Reserve Bank. The common terminology is fed funds purchased and fed funds sold.

<strong>Characteristics</strong>
<ul>
	<li>Fed funds purchases are not government-insured and are not subject to Regulation D reserve requirements or insurance assessments.</li>
	<li>Only depositary institutions that are required to hold reserves with Federal Reserve Banks can borrow fed funds. These include commercial banks, savings banks, savings and loan associations, and credit unions.</li>
	<li>These transactions do not require any formal written contract.</li>
	<li>These transactions are conducted on an overnight-only basis. Term fed funds generally mature between two days to one year.</li>
	<li>The contracts can be continuing contracts that are automatically renewed unless specifically terminated by either party. The interest payments on continuing contract are computed based on each day’s average fed funds rate.</li>
	<li>Fed funds transactions are usually unsecured. However, collateralization may be required for the seller if the credit quality of the purchaser is not strong.</li>
	<li>Funds may be transferred between depositary institutions using two methods:
<ul>
	<li>The selling institution authorizes its district Federal Reserve Bank to debit its reserve account and credit the reserve account of the buying institution. Fedwire, the Federal Reserve’s electronic funds and securities transfer network, is used to complete the transfer with immediate settlement. On the maturity date, the funds are reversed in the same way.</li>
	<li>A respondent bank tells its correspondent that it intends to sell funds. In response, the correspondent bank purchases funds from the respondent by reclassifying the respondent’s demand deposits as federal funds purchased. The respondent does not have access to its deposited money as long as it is classified as federal funds on the books of the correspondents. Upon maturity of the loan, the respondent’s demand deposit account is credited for the total value of the loan plus interest.</li>
</ul>
</li>
</ul>
<strong>Uses</strong>

The fed funds are lent by banks to other banks which need more funds to meet Regulation D reserve requirements or as an additional funding source. Reserve accounts do not earn interest, therefore, banks prefer to sell fed funds instead of maintaining excess funds in their reserve accounts. Community banks hold overnight fed funds sold as a source of primary liquidity.

Federal Funds

Fed fund yields are quoted on an add-on basis on an actual/360-day basis. The fed funds rate is a key rate for the money market. Bid/offer spreads may vary among institutions, although the differences are usually slight.

The Wall Street Journal publishes the fed effective rate on overnight fed funds, which is the weighted average of all fed funds transactions done in the broker’s market.

The general credit quality of banks is rated by Thompson Bankwatch. These ratings are used by banks when determining credit risk for Fed funds sold.

Term fed funds rates are quoted over-the-counter or in the broker’s market.

Money market brokers also publish indicative quotes on the Telerate screen.
<h3><strong>Risks</strong></h3>
The three key risks are interest rate risk, credit risk, and liquidity risk.

<strong>Interest-Rate Risk</strong>

Since non-term fed funds have very short maturity, there is minimal interest rate risk. However, for term fed funds, the interest rate risk increases with the increase in term.

<strong>Credit Risk</strong>

Sellers of fed funds are exposed to credit risk. Therefore collateral may be required to compensate for their risks. Lending banks are required to assess the credit quality of borrowers and also set limits for each potential counterparty.

<strong>Liquidity Risk</strong>

The fed fund overnight market is highly liquid. There is is no secondary market for term fed funds rates, and their liquidity is directly related to their maturity.

Federal Funds: Pricing and Risks

STRIPS is the acronym for "Separate Trading of Registered Interest and Principal Securities". These are zero-coupon securities (zeros) of the U.S. Treasury created by physically separating the principal and interest cash flows. The process of stripping is known as coupon stripping.

All new Treasury bonds and notes with maturities of 10 years and longer are eligible to be stripped and are direct obligations of the U.S. government. Under the STRIPS program, the holder of any eligible security can request that the U.S. Treasury create separate book-entry instruments for all of the principal and interest cash flows. The principal and interest portions of these instruments are assigned separate identification (CUSIP) numbers and may be owned and traded separately.

STRIPS and other zero-coupon instruments can be tailored to meet a wide range of portfolio
objectives because of their known cash-flow value at specific future dates. Specifically, they
appeal to investors who want to lock in a terminal value without incurring the risk associated
with reinvesting intervening cash flows.

They also appeal to investors with definite opinions on interest rates, as prices of STRIPS
are highly sensitive to changes in interest rates. Due to this high sensitivity to interest-rate
changes, disproportionately large long-maturity holdings of Treasury derivatives such as STRIPS, CATS, or TIGRs in relation to the total investment portfolio or total capital of a depository institution would be considered an imprudent investment practice.

The STRIPS program provides that all stripped securities be maintained in a book-entry format.
For maintenance and transfer purposes, each marketable Treasury security has a unique identification (CUSIP) number. Under STRIPS, each principal and interest component is assigned a separate CUSIP number. All STRIPS are traded over the counter (OTC), with the primary government securities dealers being the largest and most important market participants. A small group of interdealer brokers disseminates quotes and broker trades on a blind basis between market participants. Arbitrageurs continually monitor the prices of STRIPS and underlying coupon-bearing bonds, looking for profitable opportunities to strip or reconstitute. Price transparency is relatively high for STRIPS since several information vendors disseminate prices to the investment public.

<em>Reference: Federal Reserve Board</em>

US Treasury STRIPS

The prices of STRIPS are quoted on a discount basis, as a percentage of par. Eligible securities can be stripped at any time. For a book-entry security to be separated into its component parts, the par value must be an amount which, based on the stated interest rate, will produce a semiannual interest payment of $1,000 or a multiple of $1,000. Quotes for STRIPS are quoted in yields to maturity.

<strong>Hedging</strong>

Zeros are typically hedged in the futures or options markets, or by taking a contra position in another Treasury security. The effectiveness of any hedge depends on yield-curve and basis risk. Also, if a position in zeros is hedged with an OTC option, the relative illiquidity of the derivative Treasury security and the option may diminish the effectiveness of the hedge.

<strong>Risks</strong>

The two key risks are interest rate risk and liquidity risk. There is no credit risk because STRIPS are considered to be free from default.

<strong>Interest-Rate Risk</strong>

Increases in the level of interest rates increase the advantages of stripping. This is because the constant-yield method applied to premium bonds results in a lower price than linear amortization does. Zeros have higher sensitivity to changes in interest rates than bonds with the same maturity. Because they are zero-coupon bonds, their duration equals their maturity. The higher the <a title="What is Macaulay Duration?" href="https://financetrain.com/what-is-macaulay-duration/">duration</a>, the higher the potential volatility.

<strong>Liquidity Risk</strong>

The STRIPS market is significantly less liquid than the U.S. Treasury bond market. Investors encounter wider bid/ask spreads and are subject to higher commissions. In addition, liquidity may fluctuate significantly in times of market instability. However, since a dealer can strip or reconstitute bonds in a fairly flexible manner, if zero-coupon prices diverge too far from their equilibrium levels, a new supply can be created or reduced through the stripping and reconstitution process.

<em>Reference: Federal Reserve Board</em>

US Treasury STRIPS: Pricing and Risks

Treasury inflation-indexed securities (TIIs) are issued by the US Treasury Department and represent direct obligations of the U.S. government. The key feature of these securities is that they provide investors protection against the rise in inflation.

Since they are backed by the full faith and credit of the government, there is minimal credit risk. The Treasury securities are primarily sold through banks as primary dealers. Banks can also sell the securities in the secondary markets and invest their own money in them.

<strong>Characteristics</strong>

The primary purpose of TIIs is to provide long-term investors protection/hedge of their principal against the rise in inflation.

For each new TII issue, the initial par amount is indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U).

The index ratio is determined by dividing the current CPI-U level by the CPI-U level that applied at the time the security was issued or last re-indexed.

If there is deflation, the principal value can be reduced below par at any time. However, if the inflation-adjusted principal amount is below par even at maturity, the security will be redeemed at par.

Interest is paid every sixed months based on a fixed rate determined at the initial auction. The interest is calculated based on the inflation-adjusted principal amount.

TIIs are also eligible for <a title="US Treasury STRIPS" href="https://financetrain.com/us-treasury-strips/">Treasury STRIPS program</a>, and can be stripped to interest and principal components.

TIIs do not provide any tax benefit and investors must pay tax on the accretion to the principal amount of the security, even though the increase in principal is not received in cash. The tax payment reduces the effective yield on the security.

Let’s take an example to understand how TIIs work. Let’s say you purchase a $1,000 note at the beginning of the year, in which the interest rate set initially is 4%. Assume that inflation for the first year is 5%. At the end of year 1, the $1,000 principal would be $1,050, after adjusting for inflation. The investor will receive 4% interest payment on the increased principal balance of $1,050. The above example assumed that the interest payments will be made annually, however, it will actually be semi-annual in reality.

<strong>Uses of Treasury Inflation-Indexed Securities</strong>
<ul>
	<li>Primary use is to hedge against erosion in value due to inflation.</li>
	<li>Banks also use TIIs for investment, hedging, and speculative purposes.</li>
	<li>They also appeal to investors who are not subject to tax.</li>
</ul>
An investor in TIIs is expecting the real interest rates to fall. Real interest rate is the nominal rate of interest minus the inflation rate.

If nominal rates fall, but inflation does not, there is a decrease in real interest rates. TIIs will appreciate because their fixed coupon will now represent a more attractive rate relative to the market.

If inflation rises, but nominal rates rises more, there is an increase in real interest rates. The TII will decrease in value because it will only partially adjust to the new rate climate.

Treasury Inflation-Indexed Securities

U.S. Treasury bills, notes, and bonds, together known as “Treasuries”, are issued by the Treasury Department and represent direct obligations of the U.S. government. Treasuries are backed by the full faith and credit of the U.S. government, and have very little credit risk.

They issued in various maturities of up to 10 years.

<h2>Characteristics</h2>

<strong>Treasury Bills</strong>
<ul>
	<li>Negotiable, noninterest-bearing securities with original maturities of three months, six months, and one year.</li>
	<li>Offered in minimum denominations of $10,000, with multiples of $5,000 thereafter, and are offered only in book entry form.</li>
	<li>Issued at a discount from face value and are redeemed at par value.</li>
	<li>The difference between the discounted purchase price and the face value is the interest income for the purchaser.</li>
	<li>The yield is a function of interest income and maturity of the T-bill.</li>
</ul>
<strong>Treasury Notes and Bonds</strong>
<ul>
	<li>Issued in maturities of 2, 3, 5, and 10 years on a regular schedule.</li>
	<li>Treasury notes are not callable.</li>
	<li>Pay interest semiannually, when coupon rates are set at the time of issuance based on market interest rates and demand for the issue.</li>
	<li>Issued monthly or quarterly, depending on the maturity of the issue.</li>
	<li>Settle regular-way, which is one day after the trade date (T+1).</li>
	<li>Interest is calculated using actual/365-day-count convention.</li>
</ul>
Treasuries are used for all investment, hedging, and speculative purposes.

<h2>Issuing Practices</h2>

T-bills are issued at regular intervals on a yield auction basis. The three-month and six-month T-bills are auctioned every Monday. The one-year T-bills are auctioned in the third week of every month. The amount of T-bills to be auctioned is released on the preceding Tuesday, with settlement occurring on the Thursday following the auction. The auction of T-bills is done on a competitive-bid basis (the lowest yield bids are chosen because they will cost the Treasury less money). Noncompetitive bids may also be placed on purchases of up to $1 million.

The price paid by these bids (if allocated a portion of the issue) is an average of the price resulting from the competitive bids. Two-year and 5-year notes are issued once a month. The notes are generally announced near the middle of each month and auctioned one week later. They are usually issued on the last day of each month. Auctions for 3-year and 10-year notes are usually announced on the first Wednesday of February, May, August, and November. The notes are generally auctioned during the second week of those months and issued on the 15th day of the month.

<strong>Primary Market</strong>

Treasury notes and bonds are issued through yield auctions of new issues for cash. Bids are separated into competitive bids and noncompetitive bids. Competitive bids are made by primary government dealers, while noncompetitive bids are made by individual investors and small institutions. Competitive bidders bid yields to three decimal places for specific quantities of the new issue. Two types of auctions are currently used to sell securities:

<strong>Multiple-price auction.</strong> Competitive bids are ranked by the yield bid, from lowest to highest. The lowest price (highest yield) needed to place the allotted securities auction is determined. Treasuries are then allocated to noncompetitive bidders at the average yield for the accepted competitive bids. After all Treasuries are allocated to noncompetitive bidders, the remaining securities are allocated to competitive bidders, with the bidder bidding the highest price (lowest yield) being awarded first. This procedure continues until the entire allocation of securities remaining to be sold is filled. Regional dealers who are not primary government dealers often get their allotment of Treasury notes and bonds through primary dealers, who may submit bids for the accounts of their customers as well as for their own accounts. This type of auction is used for 3-year and 10-year notes.

<strong>Single-price auction.</strong> In this type of auction, each successful competitive bidder and each noncompetitive bidder is awarded securities at the price equivalent to the highest accepted rate or yield. This type of auction is used for 2-year and 5-year notes. During the one- to two-week period between the time a new Treasury note or bond issue is auctioned and the time the securities sold are actually issued, securities that have been auctioned but not yet issued trade actively on a when-issued basis. They also trade when-issued during the announcement to the auction period.

<strong>Secondary Market</strong>

Secondary trading in Treasuries occurs in the over-the-counter (OTC) market. In the secondary market, the most recently auctioned Treasury issue is considered ‘‘current,’’ or ‘‘on-the-run.’’ Issues auctioned before current issues are typically referred to as ‘‘off-the-run’’ securities. In general, current issues are much more actively traded and have much more liquidity than off-the-run securities. This often results in off-the-run securities trading at a higher yield than similar-maturity current issues.

<em>Reference: Federal Reserve Board</em>

US Treasury Bills, Notes and Bonds

In 1989, the Brady plan, named after then-U.S. Treasury Secretary Nicholas Brady, was announced to restructure much of the debt of developing countries that was not being fully serviced due to economic constraints. The plan provided debt relief to troubled countries and, in theory, opened access to further international financing. It also provided the legal framework to securitize and restructure the existing bank debt of developing countries into bearer bonds. Linking collateral to some bonds gave banks the incentive to cooperate with the debt reduction plan.

Brady bonds are restructured bank loans. They comprise the most liquid market for below investment- grade debt and are one of the largest debt markets of any kind. Banks are active participants in the Brady bond market. Once strictly an interbank market, the Brady market has evolved into one with active participation from a broad investor base.
<h3>Features</h3>
Brady bonds have long-term maturities, and many have many features such as callable bonds or step-up. Some Brady bonds also have additional income sources based on economic factors or the price of oil. Below are some characteristics of different types of Brady bonds.
<ul>
	<li>Par bonds have fixed coupons or coupon schedules and bullet maturities of 25 to 30 years.</li>
	<li>Discount bonds have floating-rate coupons typically linked to LIBOR. These bonds have principal and rolling interest-rate guarantees.</li>
	<li>Front-loaded interest-reduction bonds provide a temporary interest-rate reduction. These bonds have a low fixed-interest rate for a few years and then step up to market rates until maturity.</li>
	<li>Debt conversion bonds (DCBs) and new money bonds are exchanged for bonds at par and yield a market rate. Typically, DCBs and new money bonds pay LIBOR + 7⁄8. These bonds are amortized and have an average life of between 10 and 15 years.</li>
</ul>
<h3>Emerging Markets Bonds</h3>
The terms of local debt market instruments also vary widely, and issues are denominated in either local or foreign currency such as U.S. dollars.
<ul>
	<li>Letes are Argentine Treasury bills. They are offered on a discount basis and have maturities of 3, 6, and 12 months. Letes are sold through auctions every month.</li>
	<li>The primary internal debt instruments issued in Brazil are called BBC bonds. These bonds are issued by the central bank.</li>
	<li>In Mexico there are different debt instruments such as Ajustabonos, Bondes, Cetes, Tesobonos, and UDIbonos.
<ul>
	<li>Ajustabonos are peso-denominated Treasury bonds. They are indexed to inflation and pay a real return over the Mexican consumer price index (CPI).</li>
	<li>Bondes are floating-rate, peso-denominated government development bonds. They have maturities of 364 and 728 days.</li>
	<li>Cetes are government securities and are the equivalent of Mexican T-bills. They are denominated in pesos and are sold at a discount. Cetes have maturities of 28, 91, 182, 364, and 728 days.</li>
	<li>Tesobonos are dollar-indexed government securities with a face value of U.S.$1,000. At the investors’ option, they are payable in dollars, and they are issued at a discount. Maturities include 28, 91, 182, and 364 days.</li>
	<li>UDIbonos are inflation-adjusted bonds denominated in accounting units or UDIs (a daily inflation index), which change in value every day. These instruments replaced the ajustabonos.</li>
</ul>
</li>
</ul>
<h3>Issuing Practices</h3>
A Brady deal exchanges dollar-denominated loans for an agreed-upon financial instrument. These instruments include various debt instruments, debt equity swaps, and asset swaps. At the close of a collateralized Brady deal (not all

Brady bonds are collateralized), collateral is primarily posted in the form of U.S. Treasury zero-coupon bonds and U.S. Treasury bills. The market value of this collateral depends on the yield of 30-year U.S. Treasury strips and tends to increase as the bond ages.
<h3>Pricing</h3>
The price of a Brady bond is quoted on its spread over U.S. Treasuries. The bonds are usually priced using the standard bond pricing models, with emphasis on the credit risk of the issuers (sovereign risk) in determining whether a sufficient risk premium is being paid. Most of the volatility of Brady bonds comes from movement in the spread over U.S. Treasuries.
<h3>Risks</h3>
<strong>Sovereign Risk</strong>

One of the most significant risks related to trading of LDC debt is sovereign risk. This includes political, regulatory, economic stability, tax, legal, convertibility, and other forms of risks associated with the country of issuance.

<strong>Liquidity Risk</strong>

In emerging markets, liquidity risk can be significant. During the Mexican peso crisis, bids on various instruments were nonexistent.

<strong>Interest-Rate Risk</strong>

Debt issues of various countries are subject to price fluctuations because of changes in sovereign-risk premium in addition to changes in market interest rates and changes in the shape of the yield curve. Spreads between U.S. rates and sovereign rates capture this sovereign-risk premium.

<em>Reference: Federal Reserve Board</em>

Brady Bonds

Eurodollar certificate of deposit, or just Eurodollar CD, is a negotiable dollar-denominated time deposit issued by a U.S. bank located outside the US or by a foreign bank located abroad. It’s the same thing as a domestic CD expect that it’s the liability of a non-US bank. Eurodollars also include dollars deposited in international banking facilities in the US.

<strong>Characteristics</strong>
<ul>
	<li>Eurodollar CDs are not insured by FDIC, and are also free from US regulations and reserve requirements. They also don’t attract any fees imposed by FDIC.</li>
	<li>Eurodollar CDs are generally issued in denominations above $1 million, however the stipulated minimum is $100,000.</li>
	<li>They are denominated in US dollars (not in the foreign currency).</li>
	<li>They have a maturity of minumum 7 days, but are mostly issued for 3 to 6 months.</li>
	<li>Issuing banks are not allowed to purchase their owm CDs.</li>
	<li>Eurodollar CDs sold at face value either directly to investors or depositors or through dealers/brokers.</li>
	<li>Settlement is on a two-day basis.</li>
</ul>
<strong>Uses</strong>
<ul>
	<li>Issuers have the benefit of lower cost of funds due to no regulatory costs and reserve requirements.</li>
	<li>Buyers receive slightly higher yields while maintaining reasonable liquidity.</li>
	<li>Issuers can use the funds received for various purposes such as invest, improve reserves, maintain liquidity, or even lend to others outside the US.</li>
</ul>
<strong>Marketplace</strong>

London is the center of the he Eurodollar CD, however, activity also happens in offshore branches. The market is mostly accessible to large institutions. The small investors may access these through money market funds.

<strong>Pricing</strong>

Eurodollar CDs are priced based on LIBOR.  Since they are issued in a foreign country, they are considered slightly riskier compared to the docestic CDs, and therefore offer a higher yield.

Eurodollar CDs are quoted on an actual/360-day basis. The bid/offer quotes are in 16ths (for example, 12 7/16). A bid/offer rates of 10 7/16 and 10 3/16 would roughly translate to a bid interest rate of 10.4375% and an offer rate of 10.1875% percent, respectively, giving the dealer a spread of 25 basis points.

<strong>Risks</strong>

The key risks include credit risk, sovereign risk, and liquidity risk.

The Eurodollar CDs are not rates, however most issuers issuers are rated by either Thompson Bankwatch (for domestic banks) or IBCA, Ltd. (for foreign banks).

Eurodollar Certificates of Deposit (CD)

Key Financial Instruments

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Key Financial Instruments

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