Chapter 3

Money Markets

 Money markets are used to facilitate the transfer of short-term funds from individuals,
corporations, or governments with excess funds to those with deficient funds. Even
investors who focus on long-term securities tend to hold some money market securities.
Money markets enable financial market participants to maintain liquidity.

 MONEY MARKET SECURITIES

Money market securities are debt securities with a maturity of one year or less. They
are issued in the primary market through a telecommunications network by the Treasury,
corporations, and financial intermediaries that wish to obtain short-term financing. The
means by which money markets facilitate the flow of funds are illustrated in Figure 1.

Figure 1 How Money Markets Facilitate the Flow of Funds

The Treasury issues money market securities (Treasury bills) and uses the
proceeds to finance the budget deficit. Corporations issue money market securities and
use the proceeds to support their existing operations or to expand their operations.
Financial institutions issue money market securities and bundle the proceeds to make
loans to households or corporations. Thus, the funds are channeled to support
household purchases, such as cars and homes, and to support corporate investment in
buildings and machinery. The Treasury and some corporations commonly pay off their
debt from maturing money market securities with the proceeds from issuing new money
market securities. In this way, they are able to finance expenditures for long periods of
time even though money market securities have short-term maturities. Overall, money
markets allow households, corporations, and the government to increase their
expenditures; thus the markets finance economic growth.
Money market securities are commonly purchased by households, corporations
(including financial institutions), and government agencies that have funds available for
a short-term period. Because money market securities have a short-term maturity and
can typically be sold in the secondary market, they provide liquidity to investors. Most

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 firms and financial institutions maintain some holdings of money market securities for
this reason.

A variety of money market securities are available to meet the diverse needs of market
participants. One security will be perfect for one investor; a different security may be best
for another.
The more popular money market securities (instruments) are:
■ Treasury bills (T-bills)
■ Commercial paper
■ Negotiable certificates of deposit
■ Repurchase agreements
■ Banker’s acceptances

 Treasury Bills
When the government needs to borrow funds, the Treasury frequently issues short-term
securities known as Treasury bills. The Treasury issues T-bills with 28-day, 91-day, and
182-day maturities. It periodically issues T-bills with terms shorter than four weeks, which
are called cash management bills. It also issues T-bills with a one-year maturity on a
monthly basis. Treasury bills were formerly issued in paper form but are now maintained
electronically.

Investors in Treasury Bills. Depository institutions commonly invest in T-bills so that

they can retain a portion of their funds in assets that can easily be liquidated if they
suddenly need to accommodate deposit withdrawals. Other financial institutions also
invest in T-bills in the event that they need cash because cash outflows exceed cash
inflows. Individuals with substantial savings invest in T-bills for liquidity purposes. Many
individuals invest in T-bills indirectly by investing in money market funds, which in turn
purchase large amounts of T-bills. Corporations invest in T-bills so that they have easy
access to funding if they suddenly incur unanticipated expenses.

Credit Risk. Treasury bills are attractive to investors because they are backed by the
government and are therefore virtually free of credit (default) risk. This is a very desirable
feature, because investors do not have to use their time to assess the risk of the issuer,
as they do with other issuers of debt securities.

Liquidity. Another attractive feature of T-bills is their liquidity, which is due to their short
maturity and strong secondary market. At any given time, many institutional investors
are participating in the secondary market by purchasing or selling existing T-bills. Thus,
investors can easily obtain cash by selling their T-bills in the secondary market.
Government securities dealers serve as intermediaries in the secondary market by
buying existing T-bills from investors who want to sell them, or selling them to investors
who want to buy them. These dealers profit by purchasing the bills at a slightly lower
price than the price at which they sell them.

Pricing Treasury Bills. The par value (amount received by investors at maturity) of T-
bills is $1,000 and multiples of $1,000. Since T-bills do not pay interest, they are sold at
a discount from par value, and the gain to the investor holding a T-bill until maturity is
the difference between par value and the price paid. The price that an investor will pay
for a T-bill with a particular maturity depends on the investor’s required rate of return on
that T-bill. That price is determined as the present value of the future cash flows to be
received. The value of a T-bill is the present value of the par value. Thus, investors are

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 willing to pay a price for a one-year T-bill that ensures that the amount they receive a
year later will generate their desired return.

Example
If investors require a 4 percent annualized return on a one-year T-bill with a
$10,000 par value, the price that they are willing to pay is

P = $10,000/1.04
P = $9,615.38

If the investors require a higher return, they will discount the $10,000 at that higher
rate of return, which will result in a lower price that they are willing to pay today.
You can verify this by estimating the price based on a required return of 5 percent
and then on a required return of 6 percent.

To price a T-bill with a maturity shorter than one year, the annualized return can be
reduced by the fraction of the year in which funds will be invested.

Example
If investors require a 4 percent annualized return on a six-month T-bill, this reflects
a 2 percent unannualized return over six months. The price that they will be
willing to pay for a T-bill with a par value of $10,000 is therefore

P = $10,000/1.02
P = $9,803.92

 Commercial Paper
Commercial paper is a short-term debt instrument issued only by well-known,
creditworthy firms that is typically unsecured. It is normally issued to provide liquidity or
to finance a firm’s investment in inventory and accounts receivable.
The issuance of commercial paper is an alternative to short-term bank loans.
Some large firms prefer to issue commercial paper rather than borrow from a bank
because it is usually a cheaper source of funds. Nevertheless, even the large
creditworthy firms that are able to issue commercial paper normally obtain some short-
term loans from commercial banks in order to maintain a business relationship with them.
Financial institutions such as finance companies and bank holding companies are major
issuers of commercial paper.

Denomination. The minimum denomination of commercial paper is usually $100,000,

and typical denominations are in multiples of $1 million. Maturities are normally between
20 and 45 days but can be as short as 1 day or as long as 270 days. The 270-day
maximum is due to a Securities and Exchange Commission ruling that paper with a
maturity exceeding 270 days must be registered.
Because of the high minimum denomination, individual investors rarely purchase
commercial paper directly, although they may invest in it indirectly by investing in money
market funds that have pooled the funds of many individuals. Money market funds are
major investors in commercial paper. Although the secondary market for commercial
paper is very limited, it is sometimes possible to sell the paper back to the dealer who
initially helped to place it. However, in most cases, investors hold commercial paper until
maturity

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 Credit Risk. Because commercial paper is issued by corporations that are susceptible
to business failure, commercial paper is subject to credit risk. The risk of default is
affected by the issuer’s financial condition and cash flow. Investors can attempt to
assess the probability that commercial paper will default by monitoring the issuer’s
financial condition. The focus is on the issuer’s ability to repay its debt over the short
term because the payments must be completed within a short-term period.
Although issuers of commercial paper are subject to possible default, historically
the percentage of issues that have defaulted is very low, as most issuers of commercial
paper are very strong financially. In addition, the short time period of the credit reduces
the chance that an issuer will suffer financial problems before repaying the funds
borrowed. However, during the credit crisis in 2008, Lehman Brothers (a large securities
firm) failed. This made investors more cautious before purchasing securities.

Credit Risk Ratings. Commercial paper is commonly rated by rating agencies such as
Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Investor Service.
The possible ratings assigned to commercial paper are shown in Figure 2. The rating
serves as an indicator of the potential risk of default. Some investors rely heavily on the
rating to assess credit risk, rather than assess the risk of the issuer themselves. A money
market fund can invest only in commercial paper that has a top-tier or second-tier rating,
and second-tier paper cannot represent more than 5 percent of the fund’s assets. Thus,
corporations can more easily place commercial paper that is assigned a top-tier rating.
Some commercial paper (called junk commercial paper) is rated low or not rated at all.

Figure 2 Possible Ratings Assigned to Commercial Paper

 Negotiable Certificates of Deposit

A negotiable certificates of deposit is a bank-issued security that documents a deposit
and specifies the interest rate and the maturity date. Because a maturity date is
specified, a CD is a term security as opposed to a demand deposit: Term securities
have a specified maturity date; demand deposits can be withdrawn at any time. A
negotiable CD is also called a bearer instrument. This means that whoever holds the
instrument at maturity receives the principal and interest. The CD can be bought and
sold until maturity.
The minimum denomination is $100,000, although a $1 million denomination is
more common. Nonfinancial corporations often purchase NCDs. Although NCD
denominations are typically too large for individual investors, they are sometimes
purchased by money market funds that have pooled individual investors’ funds. Thus,
money market funds allow individuals to be indirect investors in NCDs, creating a more
active NCD market.
Maturities on NCDs normally range from two weeks to one year. A secondary
market for NCDs exists, providing investors with some liquidity. However, institutions
prefer not to have their newly issued NCDs compete with their previously issued NCDs

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 being resold in the secondary market. An oversupply of NCDs for sale could force
institutions to sell their newly issued NCDs at a lower price.

 Repurchase Agreements
With a repurchase agreement (or repo), one party sells securities to another with an
agreement to repurchase the securities at a specified date and price. In essence, the
repo transaction represents a loan backed by the securities. If the borrower defaults on
the loan, the lender has claim to the securities. Most repo transactions use government
securities, although some involve other securities such as commercial paper or NCDs.
A reverse repo refers to the purchase of securities by one party from another with an
agreement to sell them. Thus, a repo and a reverse repo refer to the same transaction
but from different perspectives. These two terms are sometimes used interchangeably,
so a transaction described as a repo may actually be a reverse repo.
Financial institutions such as banks, savings and loan associations, and money
market funds often participate in repurchase agreements. Many nonfinancial institutions
are also active participants. The most common maturities are from 1 to 15 days and for
one, three, and six months. A secondary market for repos does not exist. Some firms in
need of funds will set the maturity on a repo to be the minimum time period for which
they need temporary financing. If they still need funds when the repo is about to mature,
they will borrow additional funds through new repos and use these funds to fulfill their
obligation on maturing repos.

 Banker’s Acceptances
A banker’s acceptance indicates that a bank accepts responsibility for a future
payment. Banker’s acceptances are commonly used for international trade transactions.
An exporter that is sending goods to an importer whose credit rating is not known will
often prefer that a bank act as a guarantor. The bank therefore facilitates the transaction
by stamping ACCEPTED on a draft, which obligates payment at a specified point in time.
In turn, the importer will pay the bank what is owed to the exporter along with a fee to
the bank for guaranteeing the payment.
Exporters can hold a banker’s acceptance until the date at which payment is to
be made, but they frequently sell the acceptance before then at a discount to obtain cash
immediately. The investor who purchases the acceptance then receives the payment
guaranteed by the bank in the future. The investor’s return on a banker’s acceptance,
like that on commercial paper, is derived from the difference between the discounted
price paid for the acceptance and the amount to be received in the future. Maturities on
banker’s acceptances typically range from 30 to 270 days. Because there is a possibility
that a bank will default on payment, investors are exposed to a slight degree of credit
risk. Thus, they deserve a return above the T-bill yield in compensation. Because
acceptances are often discounted and sold by the exporting firm prior to maturity, an
active secondary market exists. Dealers match up companies that wish to sell
acceptances with other companies that wish to purchase them. A dealer’s bid price is
less than its ask price, and this creates the spread (or the dealer’s reward for doing
business). The spread is normally between one-eighth and seven-eighths of 1 percent.

Steps Involved in Banker’s Acceptances. The sequence of steps involved in a

banker’s acceptance is illustrated in Figure 3. To understand these steps, consider the
example of a U.S. importer of Japanese goods. First, the importer places a purchase
order for the goods (Step 1). If the Japanese exporter is unfamiliar with the U.S. importer,
it may demand payment before delivery of goods, which the U.S. importer may be
unwilling to make. A compromise can be reached by creating a banker’s acceptance.
The importer asks its bank to issue a letter of credit (L/C) on its behalf (Step 2). The L/C

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represents a commitment by that bank to back the payment owed to the Japanese
exporter. Then the L/C is presented to the exporter’s bank (Step 3), which informs the
exporter that the L/C has been received (Step 4). The exporter then sends the goods to
the importer (Step 5) and sends the shipping documents to its bank (Step 6), which
passes them along to the importer’s bank (Step 7). At this point, the banker’s acceptance
(B/A) is created, which obligates the importer’s bank to make payment to the holder of
the banker’s acceptance at a specified future date. The banker’s acceptance may be
sold to a money market investor at a discount. Potential purchasers of acceptances are
short-term investors. When the acceptance matures, the importer pays its bank, which
in turn pays the money market investor who presents the acceptance.

Figure 3 Sequence of Steps in the Creation of a Banker’s Acceptance

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 The types of money market securities are summarized in Figure 4. When money market
securities are issued to obtain funds, the type of securities issued depends on whether
the issuer is the Treasury, a depository institution, or a corporation. When investors
decide which type of money market securities to invest in, their choice depends on the
desired return and liquidity characteristics.

Figure 4 Summary of Commonly Issued Money Market Securities

 INSTITUTIONAL USE OF MONEY MARKETS

The institutional use of money market securities is summarized in Figure 5. Financial
institutions purchase money market securities in order to earn a return while maintaining
adequate liquidity. They issue money market securities when experiencing a temporary
shortage of cash. Because money markets serve businesses, the average transaction
is very large and is typically executed through a telecommunications network.
Money market securities can be used to enhance liquidity in two ways. First,
newly issued securities generate cash. The institutions that issue new securities have
created a short-term liability in order to boost their cash balance. Second, institutions
that previously purchased money market securities will generate cash upon liquidation
of the securities. In this case, one type of asset (the security) is replaced by another
(cash).

Figure 5 Institutional Use of Money Markets

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 Most financial institutions maintain sufficient liquidity by holding either securities
that have very active secondary markets or securities with short-term maturities. T-bills
are the most popular money market instrument because of their marketability, safety,
and short-term maturity. Although T-bills are purchased through an auction, other money
market instruments are commonly purchased through dealers or specialized brokers.
For example, commercial paper is purchased through commercial paper dealers or
directly from the issuer, NCDs are usually purchased through brokers specializing in
NCDs, federal funds are purchased (borrowed) through federal funds brokers, and
repurchase agreements are purchased through repo dealers.

Madura, J. (2013). Financial markets and institutions (11th ed.) Cengage Learning Stamford

Mishkin, F. and Eakins, S. (2012) Financial Markets and Institutions (7th ed.) Pearson
Education, Inc. Boston

Levinson, M. (2005). The Economist: Guide to the Financial Markets (4th ed.) Profile Books
Ltd London