Money Markets
September 3, 2021
What are “Money Markets”?
Money markets deal or trade-in high-quality debt instruments that mature in one year or less and are a crucial component of the financial system. The key function of money market instruments is to help institutions maintain liquidity. The money markets – via short-term debt instruments – provide companies, governments, and commercial banks with significant amounts of capital for periods ranging from overnight, a couple of days, weeks, or several months to less than a year. Money markets are a vital funding source for financial institutions.
The common types of money market instruments are government securities, (Treasury bills), repurchase agreements, commercial paper, federal funds, certificates of deposit, short-term, Eurodollars, banker’s acceptance, mortgage-backed securities, and asset-backed securities. Further, there are money market rates, such as LIBOR or EURIBOR, that provide benchmark rates vis-à-vis pricing of fixed income securities and loan contracts.
Key Learning Points
- Money markets provide short-term liquidity to the financial system
- The most common type of money market instruments are Treasury bills, commercial paper, certificates of deposit and repurchase agreements
- There are four types of yield measures – money market: bank discount yield, holding period yield, effective annual yield and money market yield
Types of Money Market Instruments
Money market instruments generally have two core characteristics – liquidity and safety. The most common ones are:
Treasury Bills (T-Bills)
Treasury bills are the most marketable money market securities. Governments issue these bills to borrow money for a short-period – with maturities ranging from 1 month to a year. These securities are sold at a discount (i.e. less than par value). The interest received is the difference between the purchase price and the par value. Treasury bills are considered the safest and most risk averse investments. However, they provide lower returns than other money market instruments.
Commercial Paper (CP)
Commercial Paper is a common type of short-term, unsecured debt instrument that is issued by large corporations and financial institutions – generally for a time period of up to 270 days. It is typically sold at discount to its face value and pays a fixed rate of interest to the holder of the instrument. Companies issue commercial paper to raise short-term funds, in order to meet their short-term financial obligations. It is considered a very cost-effective means of financing.
Certificates of Deposit
Certificates of Deposit these short-term debt instruments are issued by commercial banks and other qualified financial institutions. They tend to be issued in large volumes by such institutions. When investors purchase certificates of deposit, they are lending to the institution who then pays them a rate of interest. The largest investors in this money market instrument are money market funds, corporations, local government agencies and banks. The maturity period of certificates of deposit should not be less than 7 days and not more than a year. Certificates of Deposit may be issued at discount on face value.
Repurchase Agreements (Repos)
Repurchase agreements these are a form of short-term borrowing (used by several financial institutions, banks and some companies) which involves the buying of securities with the simultaneous promise to sell them back at a pre-specified date (a later date – often the next day), at a higher price. The difference between sale and the repurchase price of the security is reflective of the implied interest rate.
Who Can Invest in the Money Market?
The money market is accessible to a wide range of participants, including:
- Central Banks:They use the money market to implement monetary policy and manage liquidity in the financial system.
- Non-Financial Corporations:These entities invest in the money market to manage their short-term funding needs and excess cash.
- Banks:Banks participate in the money market to manage their liquidity and meet reserve requirements.
- Governments:Governments issue short-term securities like Treasury bills to finance their short-term funding needs.
- Mutual and Pension Funds:These funds invest in money market instruments to provide liquidity and safety for their investors
Money Market – Types of Yield Measures
There are four types of yield measures in the money market that one should be aware of. These are: bank discount yield, holding period yield, effective annual yield, and the money market yield.
Bank Discount Yield (BDY): is the annualized rate of return on a discount-based instrument such as treasury bills, commercial paper, etc. It is calculated using the formula below:
Bank Discount Yield (%) = D/F * 360/t
D= Face Value – Issue Price
F= Value
t=Days to Maturity
Holding Period Yield: is the return on investment that is earned, if the instrument is held until maturity.
Holding Period Yield (%) = P1 – P0 + D1/P0
P0 = Purchase price of investment
P1 = Amount received at maturity
Effective Annual Yield: is the annualized holding period yield predicated on a 365-day year. It takes into account the impact of compounding interest.
Effective Annual Yield (%) = (1 + Holding Period Yield)^365/t -1
Money Market Yield: is the annualized holding period yield predicated on a 360-day year using simple interest.
Money Market Yield (%) = Holding Period Yield * 360/t
Money Market – Example
Given below is an example of a US Treasury bill with a face value of US$100 and 90 days to maturity. It is selling at a discount of US$4, so at a price of US$96. Based on this information, the four types of yield measures have been calculated below.
Money Markets vs. Capital Markets
The money market is a specific part of the financial market which as you know, in general facilitates the flow of capital between those who need it, to those who have a surplus which they would like to invest. We often divide this financial market into two main categories: the capital market and the money market.
Money markets deal with short-term debt instruments with maturities ranging from 1 day to 1 year, while capital markets involve long-term financial instruments such as equity and long-term debt.
Advantages and Disadvantages of Money Markets
Advantages
- Liquidity:Money markets provide short-term liquidity to the financial system, allowing for quick access to funds.
- Safety:Money market instruments, such as Treasury bills, are considered safe investments with low risk.
- Short-term Investment:Ideal for short-term investment horizons, typically ranging from overnight to less than a year.
- Benchmark Rates:Money markets offer benchmark rates like LIBOR or EURIBOR, which are used for pricing fixed income securities and loan contracts.
Disadvantages
- Lower Returns:Money market instruments generally provide lower returns compared to other investment options.
- Interest Rate Risk:Changes in interest rates can affect the returns on money market investments.
- Limited Growth:Money markets are not suitable for long-term growth as they do not offer significant capital appreciation.
Money Market Benchmarks
Money market benchmark rates are publicly accessible, regularly updated interest rates that reflect the general level of borrowing costs in a specific market. These benchmarks include:
Term Deposit Benchmarks (IBORs)
Interbank offered rates such as LIBOR and EURIBOR. Historically, these rates were survey-based, but significant reforms have been made following the LIBOR scandal. For example, LIBOR rates have ceased to exist or lost representativeness, while other IBORs like EURIBOR are still in use12.
Overnight Rate Benchmarks (RFRs)
Near risk-free rates such as SOFR (USD), SONIA (GBP), ESTR (EUR), and TONAR (JPY). These rates are based on overnight borrowing and are published by respective central banks the following business day3
Conclusion
Money markets play a vital role in maintaining financial system liquidity by dealing in high-quality debt instruments that mature within a year. These markets provide essential short-term capital to companies, governments, and banks. Common money market instruments include Treasury bills, commercial paper, certificates of deposit, and repurchase agreements. While money markets offer liquidity and safety, they also come with lower returns and interest rate risks.