Chapter 30 Working Capital Management 801
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return over three months is 1.25/98.75 = .0127, or 1.27%. This is equivalent to an annual yield
of 5.16%. Note that the return is always higher than the discount. When you read that an
investment is selling at a discount of 5%, it is very easy to slip into the mistake of thinking that
this is its return.^16
Yields on Money-Market Investments
When we value long-term debt, it is important to take account of default risk. Almost any-
thing may happen in 30 years, and even today’s most respectable company may get into trou-
ble eventually. Therefore, corporate bonds offer higher yields than Treasury bonds.
Short-term debt is not risk-free, but generally the danger of default is less for money-
market securities issued by corporations than for corporate bonds. There are two reasons for
this. First, the range of possible outcomes is smaller for short-term investments. Even though
the distant future may be clouded, you can usually be confident that a particular company
will survive for at least the next month. Second, for the most part only well-established com-
panies can borrow in the money market. If you are going to lend money for just a few days,
you can’t afford to spend too much time in evaluating the loan. Thus, you will consider only
blue-chip borrowers.
Despite the high quality of money-market investments, there are often significant differ-
ences in yield between corporate and U.S. government securities. Why is this? One answer
is the risk of default. Another is that the investments have different degrees of liquidity or
“moneyness.” Investors like Treasury bills because they are easily turned into cash on short
notice. Securities that cannot be converted so quickly and cheaply into cash need to offer
relatively high yields. During times of market turmoil investors may place a particularly high
value on having ready access to cash. On these occasions the yield on illiquid securities can
increase dramatically.
The International Money Market
In Chapter 24 we pointed out that there are two main markets for dollar bonds. There is the
domestic market in the United States and there is the eurobond market centered in London.
Similarly, in addition to the domestic money market, there is also an international market for
short-term dollar investments, which is known as the eurodollar market. Eurodollars have
nothing to do with the euro, the currency of the European Monetary Union (EMU). They are
simply dollars deposited in a bank in Europe.
Just as there is both a domestic U.S. money market and a eurodollar market, so there is
both a domestic Japanese money market and a market in London for euroyen. So, if a U.S.
corporation wishes to make a short-term investment in yen, it can deposit the yen with a bank
in Tokyo or it can make a euroyen deposit in London. Similarly, there is both a domestic
money market in the euro area as well as a money market for euros in London.^17 And so on.
Major international banks in London lend dollars to one another at the London interbank
offered rate (LIBOR). Similarly, they lend yen to each other at the yen LIBOR interest rate,
and they lend euros at the euro interbank offered rate, or Euribor. These interest rates are used
as a benchmark for pricing many types of short-term loans in the United States and in other
countries. For example, a corporation in the United States may issue a floating-rate note with
interest payments tied to dollar LIBOR.
If we lived in a world without regulation and taxes, the interest rate on a eurodollar loan
would have to be the same as the rate on an equivalent domestic dollar loan. However, the
international debt markets thrive because governments attempt to regulate domestic bank
(^16) To confuse things even more, dealers in the money market often quote rates as if there were only 360 days in a year. So a discount
of 5% on a bill maturing in 91 days translates into a price of 100 − 5 × (91/360) = 98.74%.
(^17) Occasionally (but only occasionally) referred to as “euroeuros.”