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CHAPTER 4

4.1 Introduction

T

he largest security market in the world is the U.S. Treasury market. The securities traded in this market have probably the lowest default risk of any security in the world, given the political stability, economic size, and military strength of the U.S. Thus, for all practical purposes, the default risk associated with these securities is assumed to be zero.

Being the largest security market means that the Treasury market is the most liquid securities market. Billions of dollars of Treasury instruments are traded every day. It is attractive to money managers worldwide because a $100 million dollar position can be liquidated in a typical business day and have virtually no impact upon prices in the market. The size of this market is a direct consequence of the size of the U.S. national debt, which now exceeds $4 trillion.

Treasury securities are debt obligations of the U.S. government. When it sells Treasury securities to financial institutions, the public, and other countries, the U.S. government agrees to make future interest or face value payments in exchange for receiving cash now.

The major Treasury securities are:

1. Treasury bills,

2. Treasury notes, and

3. Treasury bonds.

These securities differ in terms of their cash flows and time to maturity. For some Treasury note and bond issues, trading is permitted in the separate components of the cash flows (i.e., the coupon payments and the face value, separately). The Treasury makes this possible by recording separate ownership rights for the coupon payments and the face value. This practice creates a large set of pure discount securities known as "strips".

Treasury bills have an initial life equal to 3, 6, and 12 months. Treasury notes have an initial life from 2 to 10 years. Treasury bonds have a life longer than 10 years and, since the beginning of 1973, as long as 30 years.

Treasury securities are originally auctioned directly by the U.S. government to investors in the primary markets. They are subsequently traded among investors in the secondary markets. The ability to retrade these securities in the secondary markets increases the set of maturity dates available to investors.

For example, the original issue of 15 year Treasury bonds commenced and ended in 1980, but this does not mean that no 15 year bonds exist. To the contrary, as time passes, the time to maturity for 30 year bonds decreases, so, in the secondary markets for a 30 year Treasury bond that was issued 15 years earlier, we see the exact equivalent of a 15 year Treasury bond.

Since there are a very large number of maturities available at any one point in time, you can get a very detailed picture of the U.S. yield curve at any point in time.

Originally, Treasury securities were issued in the form of engraved certificates. Coupon notes and bonds had detachable semiannual coupons for the payment of coupon interest (hence the expression, "clipping coupons"). Later, the Treasury favored only registered issues and coupon payments were automatically sent to owners. By 1985-1986, the Treasury had moved completely to an electronic book system for registering ownership rights to Treasury bills, notes, and bonds.

Under the current system, members of the Federal Reserve can hold securities directly in a computerized system. From the purchaser's perspective, this means that buyers receive only a receipt (not an engraved certificate with physical coupons) when they purchase Treasury securities. In October 1987, the Treasury completed its Treasury Direct program, requiring that all personal Treasury security information be recorded in a single master account available for access at any branch of the Federal Reserve Bank.

Movement toward a book entry system had the positive effect of accelerating the development of the Treasury strip market from the earlier dealer-specific markets.

In the Treasury security secondary market, there are generally two prices: a bid price and an ask price. The bid is the price at which someone is willing to buy the security. If you accept the bid, you agree to sell at that price. Similarly, an ask is the price at which someone is willing to sell the security; this is the price you would pay if you bought the security. Typically, the ask is higher than the bid. The difference between these prices is called the bid-ask spread. Every time you buy at the ask and sell to the bid, you lose the bid-ask spread.