Petar Petrov ECON 1465 Fall 2010 Brown University What is a Treasury US Government debt obligations backed by its full faith and credit Bills lt 1y Notes 15y Bonds gt5y TIPS ID: 141724
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The U.S. Treasury: Types of Markets and Auctions
Petar
Petrov
ECON 1465, Fall 2010
Brown UniversitySlide2
What is a Treasury
U.S. Government debt obligations backed by its full faith and credit
Bills (< 1y), Notes (1-5y), Bonds (>5y), TIPS
Very low risk associated
Used for funding government projects
Used for controlling money supply
Over $2 trillion in securities are issued every yearSlide3
Types by issue date
While issued: when the issue is announced but the auction is not yet carried out
On-the-run: the current newest issue of a particular type of securities
Off-the-run: when a newer issue of the same type of securities is auctioned, the old ones become off-the-runSlide4
Markets for Treasuries
Primary market – Auctions
Frequency: 4-, 13-, 26-week bills – weekly, 52-week, 2-, 3-, 5- and 7-year notes – monthly, 10- and 30-year bonds – biannually
Competitive bidders (18 primary dealers) post a pair of bid-quantity, representing the quantity they want to buy at that price, multiple bids possible
Noncompetitive bidders post a quantity they want to buy, all of them win at a price which is the quantity weighted average of the competitive bidsSlide5
Markets for Treasuries
Secondary Markets: over the counter and electronically organized systems by
interdealers
Federal Bank of NY – biggest trader
Primary dealers act as market makers, providing bid-ask quotes, holding inventory
Biggest market in the world, relatively liquidSlide6
Markets for Treasuries
When-issued Market: a forward market between the primary dealers and their institutional investors
Quantity in the futures: ranging from a small one to several times the size of the issue
Starts at the announcement of the auction and ends and settles at the date of the issue
Close to the Chicago Board of Trade Treasuries futures marketSlide7
Types of Auctions: Discriminatory price
Competitive bidders place bid-quantity sealed bids
Each winning competitive bidder pays the bid he submitted
Noncompetitive bidders pay a quantity-weighted average of the winning competitive bidsSlide8
Types of Auctions: Uniform price
Competitive bidders place bid-quantity sealed bids
Each winning competitive bidder pays the highest loosing bid
Noncompetitive bidders pay a quantity-weighted average of the winning competitive bidsSlide9
Common properties of auctions
The common value assumption: no matter how much they pay in the auction, the buyers face the same value in the secondary market
Asymmetry of information: each buyer has a unbiased private value of the uniform unknown value they are going to face on the secondary market. The average of all those values is believed to be close to the actual valueSlide10
Problems with the markets: The purpose of Treasuries and incentives
The main purpose of the Treasuries is to raise funds for the U.S. Government in order to fund its projects and programs, thus revenue maximization is the main problem
The seller must set the right incentives and lower the risk for the buyers as much as possible in order for them not to underbidSlide11
Problems with the markets: The cost of gathering information
Proprietary forecasting models or purchasing information from an outside source are costly
Forward and futures markets have implied volatility because of speculators that do not cover their bets
These costs are offset by underbidding
The seller should release as much information as possible about the auctions and securities issued
The government should facilitate the forward and futures market, lower the risk involved in participating in them in order to make the signals more stable, significant and reliableSlide12
Problems with the markets: The cost of reselling
Discriminatory auctions favor fewer buyers, which face bigger losses if they cannot sell their inventories
Tending to those transactions has a cost
The cost must be offset by underbidding
It is proposed that the seller might save up to 75 basis points if he switches to uniform price auctionsSlide13
Problems with the markets: Sending signals to the secondary market
Competitive sellers want to clear part of their inventories and thus if they have a firm belief of a drop of interest rates and thus a hike in prices, they would like to signal that
Assuming investors learn from auction results, a good way of signaling is through the bids made
A higher bid, however, costs the bidders more in a discriminatory auction, so they tend to shed their bids more
In contrast, the desire to signal information results in a more aggressive bidding strategies in the uniform price auctions, resulting in higher revenuesSlide14
Problems with the markets: Winner’s Curse
The Winner’s Curse is the situation in which the winning bidders pay more than the shared average price of the item
Bidders’ fear of the Winner’s Curse makes them lower their bids
Winner’s Curse is directly proportional to uncertaintySlide15
Problems with the markets: Winner’s Curse
Seller– disclose honest and complete information about the auction and expectation of the secondary-market price
Uniform price auctions decrease the fear of the Winner’s Curse since all the bidders pay the bid of the first looser, which makes them bid closer to their real expectations of the secondary-market price an leads to a overall more aggressive bidding strategiesSlide16
Problems with the markets: Noncompetitive bidding and
squizes
Noncompetitive behavior/lack of participants disturbs the efficient allocation of the securities among investors in the secondary market
Uniform price auctions discourage this kind of auction, because costs of participation are lower, allowing more bidders, and the incentives of a dealer to break out of a ring are higher, since he only pays the uniform price, while still winning by overbiddingSlide17
Empirical Data: Difference in under pricing between the auctions
Time of day
Discriminatory
Uniform
Difference
P-value
12:50 – 1:00
0.59
0.32
0.27
0.024
12:30 – 1:00
0.61
0.40
0.22
0.072
1:00 – 1:30
0.86
0.32
0.53
0.000
Under pricing is measured in basis points and is defined as the auction yield minus the average when-issued yield close to the 1:00 auction time.
The auction yield is the average winning yield for discriminatory auctions and the market-clearing yield for uniform-price auctions
Yield is reversely proportional to prices!Slide18
Conclusion
Uniform price auctions show better results and effectively deal with more problems
Maximum amount of information should be disclosed to the public
For future research: move away from static auctions and look into ascending or descending auctions as they give stronger signals to the secondary market and better information to the participating bidders, diminishing the Winner’s Curse, while have ambiguous effects on some of the problemsSlide19
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