The money market enables governments, banks, and large institutions to borrow short-term through securities like treasury bills and commercial paper. It also allows excess cash from corporations, governments, banks, and individuals to be invested in low-risk money market securities. Some key participants in the money market are the U.S. Treasury, which issues treasury bills to fund the national debt; commercial banks, which buy treasury securities, sell certificates of deposit, and offer money market accounts; and large corporations, which use the money market to manage short-term cash needs and surplus funds. The money market helps maintain liquidity and allows both borrowing and investment of funds over the short-term.
The money market enables governments, banks, and large institutions to borrow short-term through securities like treasury bills and commercial paper. It also allows excess cash from corporations, governments, banks, and individuals to be invested in low-risk money market securities. Some key participants in the money market are the U.S. Treasury, which issues treasury bills to fund the national debt; commercial banks, which buy treasury securities, sell certificates of deposit, and offer money market accounts; and large corporations, which use the money market to manage short-term cash needs and surplus funds. The money market helps maintain liquidity and allows both borrowing and investment of funds over the short-term.
The money market enables governments, banks, and large institutions to borrow short-term through securities like treasury bills and commercial paper. It also allows excess cash from corporations, governments, banks, and individuals to be invested in low-risk money market securities. Some key participants in the money market are the U.S. Treasury, which issues treasury bills to fund the national debt; commercial banks, which buy treasury securities, sell certificates of deposit, and offer money market accounts; and large corporations, which use the money market to manage short-term cash needs and surplus funds. The money market helps maintain liquidity and allows both borrowing and investment of funds over the short-term.
Money market is an organized emarket where paticipants can lead and borrow short-term, hight- quality debt securities with average of one year or less. Enables governments, banks, and other large institutions to sell short-term securities to fund their short-term cash flow needs Allows individual investors and large institution to invest excess cash in a low risk market. How does money market work ? Large corporation : Those with short-term cash flow needs can borrow from the market directly through their dealer, those with excess cash can invest. Small companies: those with excess cash can invest through money market mutual funds ( MM mutual fund is a professionally managed fund that buyd money market securities on behalf of investors. Individual investors: invest though their money market bank account or money market mutual fund.
II. CHARACTERISTICS OF MONEY MARKET
They have an active secondary market : money market transaction do not
take place in any one particular location or building. Instead, trader arrnge purchases and sales between participants over the phone and complete them electronically. This also means after the security has been sold initially, it is relatively easy to find buyer who will purchase it in the future. They mature in one year or less from their original issue date ( most money market instruments mature in less than 120 days) : An active secandary market makes money market secuirities very flexible instruments to use to fill short-term financial needs. For example, Microsoft's annual report states, “We consider all highly liquid interest-earning invest ments with a maturity of 3 months or less at date of purchase to be cash equivalents” They are usually sold in large denominations: Another characteristic of the money markets is that they are wholesale markete This means that most transactions are very large, usually in excess of $1 million. The size of these transactions prevents most individual investors from participating directly in the money markets. Instead, dealers and brokers, operating in the trading rooms of large banks and brokerage houses, bring customers together. These traders will buy or sell $50 or $100 million in mere seconds-certainly They have low default risk: Money market securities are considered to be very safe because they are issued by companies that must have very high credit ratings.
III. PURPOSE OF MONEY MARKET
1. Maintains Liquidity in the Market One of the most crucial functions of a money market is to maintain liquidity in the economy. Some of the money market instruments are an important part of the monetary policy framework. RBI ( uses these short-term securities to get the liquidity in the market within the required range. 2. Provides Funds at a Short Notice Money Market offers an excellent opportunity to individuals, small and big corporations, banks of borrowing money at a very short notice. These institutions can borrow money by selling money market instruments and finance their short-term needs. 3. Utilisation of Surplus Funds Money Market makes it easier for investors to dispose off their surplus funds, retaining their liquid nature, and earn significant profits on the same. It facilitates investors’ savings into investment channels. These investors include banks, non- financial corporations as well as state and local government. 4. Aids in Financial Mobility Money Market helps in financial mobility by allowing easy transfer of funds from one sector to another. This ensures transparency in the system. High financial mobility is important for the overall growth of the economy, by promoting industrial and commercial development. 5. Helps in monetary policy A developed money market helps RBI in efficiently implementing monetary policies. Transactions in the money market affect short term interest rate, and short-term interest rates gives an overview of the current monetary and banking state of the country. This further helps RBI in formulating the future monetary policy, deciding long term interest rates, and a suitable banking policy.
IV. PARTICIPANTS OF MONEY MARKET
An obvious way to discuss the players in the money market would be to list those who borrow and those who lend. The problem with this approach is that most money market participants operate on both sides of the market . Nevertheless, we can identify the primary money market players—the U.S Treasury, the Federal Reserve System, commercial banks, businesses, investments and securities firms, and individuals—and discuss their roles 1. The U.S.Treasury The U.S. Treasury is a government department in charge of managing all federal finances Characteristics: - It is always a demander of money market funds and never a supplier - It is the largest of all money market borrowers worldwide. - It issues Treasury bills (often called T-bills) and other securities that are popular with other money market participants. Role: Sells U.S. Treasury securities to fund the national debt Short-term issues enable the government to raise funds until tax revenues are received. This is considered one of the safest investments as it is backed by the government itself. 2. The Federal Reserve System (Fed) The Federal Reserve System (Fed) is the central bank of the United States. Characteristics: - The Federal Reserve is the Treasury’s agent for the distribution of all government securities. - It is the most influential participant in the U.S. money market. Role: Buys and sells U.S. Treasury securities as its primary method of controlling the money supply The Fed holds vast quantities of Treasury securities that it sells if it believes the money supply should be reduced. Similarly, the Fed will purchase Treasury securities if it believes the money supply should be expanded. 3. Commercial banks: A commercial bank is a financial institution which performs the functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit. Role: Buy U.S. Treasury securities; sell certificates of deposit and make short-term loans; offer individual investors accounts that invest in money market securities Characteristics: - Commercial banks hold a percentage of U.S. government securities second only to pension funds. This is partly because of regulations that limit the investment opportunities available to banks. Specifically, banks are prohibited from owning risky securities, such as stocks or corporate bonds. There are no restrictions against holding Treasury securities because of their low risk and high liquidity. - Banks are also the major issuer of negotiable certificates of deposit (CDs), banker’s acceptances, federal funds, and repurchase agreements to help manage their own liquidity. - Money center banks – among largest banks in the country, deal in the secondary money market for their customers 4. Businesses Role: Buy and sell various short-term securities as a regular part of their cash management Characteristics: Many businesses buy and sell securities in the money markets. Such activity is usually limited to major corporations because of the large dollar amounts involved. As discussed earlier, the money markets are used extensively by businesses both to warehouse surplus funds and to raise short-term funds. 5. Investments and securities firms 5.1. Investment companies( brokerage firms) Investment companies( brokerage firms) are firms that conducts transactions on behalf of a client Role: Trade on behalf of commercial accounts Characteristics: - Large diversified brokerage firms are active in the money markets - The primary function of these dealers is to “make a market” for money market securities by maintaining an inventory from which to buy or sell. These firms are very important to the liquidity of the money market because they ensure that sellers can readily market their securities 5.2. Finance companies (commercial leasing companies) A finance company is an organization that makes loans to individuals and businesses. Unlike a bank, a finance company does not receive cash deposits from clients, nor does it provide some other services common to banks, such as checking accounts. make a profit from the interest rates (the fees charged for the use of borrowed money) they charge on their loans, which are normally higher than the interest rates that banks charge their clients. Role: Lend funds to individuals Characteristics: Finance companies raise funds in the money markets primarily by selling commercial paper. They then lend the funds to consumers for the purchase of durable goods such as cars, boats, or home improvements 5.3. Insurance Companies An insurance company is a financial institution which underwrites the risk of loss of, or damage to, personal and business assets (general insurance) and life and limb (life and accident insurance) Role: Maintain liquidity needed to meet unexpected demands Characteristics: - Property and casualty insurance companies must maintain liquidity because of their unpredictable need for funds. - Ex: When four hurricanes hit Florida in 2004, for example, insurance companies paid out billions of dollars in benefits to policyholders. To meet this demand for funds, the insurance companies sold some of their money market securities to raise cash 5.4. Pension funds Pension funds are private financial institutions that manage employee savings and retirement Role: Maintain funds in money market instruments in readiness for investment in stocks and bonds Characteristics: - Pension funds invest a portion of their cash in the money markets so that they can take advantage of investment opportunities that they may identify in the stock or bond markets. - Like insurance companies, pension funds must have sufficient liquidity to meet their obligations. However, because their obligations are reasonably predictable, large money market security holdings are unnecessary. 6. Individuals Role: Buy money market mutual funds - A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities. - The advantage of mutual funds is that they give investors with relatively small amounts of cash access to large-denomination securities. When inflation rose in the late 1970s, the interest rates that banks were offering on deposits became unattractive to individual investors. At this same time, brokerage houses began promoting money market mutual funds, which paid much higher rates. Banks could not stop large amounts of cash from moving out to mutual funds because regulations capped the rate they could pay on deposits. To combat this flight of money from banks, the authorities revised the regulations. Banks quickly raised rates in an attempt to recapture individual investors’ dollars. This halted the rapid movement of funds, but money market mutual funds remain a popular individual investment option. The advantage of mutual funds is that they give investors with relatively small amounts of cash access to large-denomination securities.
V. MONEY MARKET INSTRUMENT
1. Treasury bills The Treasury bills are issued by the Central Government and known to be one of the safest money market instruments available. Besides, they carry zero risk, ( Risk Treasury bills have virtually zero default risk because even if the government ran out of money, it could simply print more to redeem them when they mature. The risk of unexpected changes in inflation is also low because of the short term to maturity. The market for Treasury bills is extremely deep and liquid. A deep market is one with many different buyers and sellers. A liquid market is one in which securities can be bought and sold quickly and with low transaction costs. The returns are not attractive. Also, they come with different maturity periods like 1 year, 6 months or 3 months and are also circulated by primary and secondary markets. The central government issues them at a lesser price than their face-value. For example, a Treasury bill with a par value of $10,000 may be sold for $9,500. The US Government, promises to pay the investor the full face value of the T-bill at its specified maturity date. Upon maturity, the government will pay the investor $10,000, resulting in a profit of $500. The amount of profit earned from the payment is considered the interest earned on the T-bill. the interest rate earned on Treasury bill securities is very low. Investors in Treasury bills have found that in some years, their earnings did not even compensate them for changes in purchasing power due to inflation. The real rate of interest has occasionally been less than zero. For example, in 1973–1977, 1990–1991, and 2002–2004, the inflation rate matched or exceeded the earnings on T-bills. Clearly, the T-bill is not an investment to be used for anything but temporary storage of excess funds, because it barely keeps up with inflation. 2. Federal funds Federal funds are short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. The term federal funds (or fed funds) is misleading. Fed funds really have nothing to do with the federal government. The term comes from the fact that these funds are held at the Federal Reserve bank. Fed funds help commercial banks meet their daily reserve requirements, which is the amount of money that banks are required to maintain at their regional Federal Reserve Banks will borrow or lend their excess funds to each other on an overnight basis, as some banks find themselves with too much reserves and others with too little. For example: Suppose that a bank finds that it has $50 million in excess reserves. It will call its correspondent banks (banks that have reciprocal accounts) to see if they need reserves that day. The bank will sell its excess funds to the bank that offers the highest rate. Once an agreement has been reached, the bank with excess funds will communicate to the Federal Reserve bank instructions to take funds out of the seller’s account at the Fed and deposit the funds in the borrower’s account. The next day, the funds are transferred back, and the process begins again. If a bank has too little in reserve to meet its requirement, it can borrow money over night from either the fed reserve bank or from other bank with monet at the fed reserve Most fed funds borrowings are unsecured. Typically, the entire agreement is established by direct communication between buyer and seller The federal funds rate is a target set by the central bank, but the actual market rate for federal fund reserves is determined by this overnight inter-bank lending market. The discount rate is what the fed charges for overnight loan, the fed fund rate is what banks charge each other for overnight loan. The federal funds rate is the interest banks charge each other to borrow fed funds. The current fed funds rate dictates all other short-term interest rates. 3. Repurchase agreement Repurchase Agreements (Repo) are a formal agreement between two parties, where one party sells a security to another, with the promise of buying it back at a later date from the buyer. The repurchase price is higher than the selling price. The spread between original price and the repurchase price is equivalent to interest. For example, let us take an example of Bank A is in need of funds and Bank B has surplus funds. Bank A will enter into an agreement with Bank B for selling its securities (mostly Treasury Bills) and get the required funds from Bank B. However, this does not end here. There is a twist in the agreement which states that Bank A will repurchase these securities from Bank B at a fixed future date. Because repos are collateralized with Treasury securities, they are usually low-risk investments and therefore have low interest rates. These are very short-term in nature. They can be for just overnight purposes or up to a period of one month depending on the agreement between the banks. These are popular amongst banks because this eliminates the credit risk involved as the securities are directly transferred to one another. 4. Negotiable Certificate of deposit A negotiable certificate of deposit is a bank-issued security that documents a deposit and specifies the interest rate and the maturity date. with a minimum face value of $100,000 Negotiable CD typically have a maturity of one to four months. Some have six- month maturities, but there is little demand for ones with longer maturities. Negotiable CD have a fixed maturity date and cannot be liquidated or withdrawn prior to that date. There is a penalty associated with any early withdrawal of funds deposited in a negotiable CDs. The rates paid on negotiable CD are negotiated between the bank and the customer. They are similar to the rate paid on other money market instruments because the level of risk is relatively low. Large money center banks. Along with U.S. Treasury bills, they are considered a low-risk, low-interest security.therefore the interest rate is low unlike regular CD, negotiable CD pay periodic interest, usually twice a year 5. Commercial paper Commercial paper securities are unsecured promissory notes, issued by corporations, that mature in no more than 270 days. Because these securities are unsecured, only the largest and most creditworthy corporations issue commercial paper, and it is therefore considered a safe investment. The interest rate the corporation is charged reflects the firm’s level of risk. For example, when a retail firm is looking for short-term funding to finance some new inventory for an upcoming holiday season. The firm needs $10 million and it offers investors $10.1 million in face value of commercial paper in exchange for $10 million in cash, according to prevailing interest rates. In effect, there would be a $0.1 million interest payment upon maturity of the commercial paper in exchange for the $10 million in cash, equating to an interest rate of 1%. This interest rate can be adjusted for time, contingent on the number of days the commercial paper is outstanding. They offer higher returns as compared to treasury bills. They are automatically not as secure in comparison. Also, Commercial papers are traded actively in secondary market. 6. Banker’s acceptance A Banker’s Acceptance is a document that promises future payment which is guaranteed by a commercial bank. Bankers' acceptances are generally used to finance foreign trade. For example, an importer wants to order goods, but the exporter won't give him credit. He goes to his bank which guarantees the payment. The bank is accepting the responsibility for the payment. Banker’s acceptance features maturity periods that range between 30 days up to 180 days. The holder of the acceptance may decide to sell it on a secondary market, and investors can profit from the short-term investment. Most Banker’s acceptance are issued by reputable banks, they are considered a very safe short-term investment 7. Eurodollars Eurodollars are dollar-denominated deposits held in foreign banks (typically in Europe), and are thus, not subject to Federal Reserve regulations. Money market funds, foreign banks, and large corporations invest in them because they pay a slightly higher interest rate than U.S. government debt. Most transactions in the eurodollar market are overnight, which means they mature on the next business day. THE FOREIGN EXCHANGE MARKET I. The foreign exchange market 1. Definition The term “ Foreign exchange” implies two things: Foreign exchange and exchange rate 1.1. Foreign currency Foreign exchange generally refers to foreign currency. Most countries of the world have their own currencies: The United States has its dollar; the European Monetary Union, its euro; Brazil, its real; and China, its yuan. - There are 164 national currencies in the world although the number of independent countries is 197, plus dozens of dependent territories. The reason is that some countries do not have their own currencies and use foreign currencies as their primary currency - The Euro is used as the main currency in 35 countries and territories around the globe - The US dollar is used in 10 countries outside and in the US. However, trade between countries involves the mutual exchange of different currencies (or, more usually, bank deposits denominated in different currencies). When an American firm buys foreign goods, services, or financial assets, for example, U.S. dollars (typically, bank deposits denominated in U.S. dollars) must be exchanged for foreign currency (bank deposits denominated in the foreign currency) 1.2. Exchange rate The other part of foreign exchange is exchange rate which is the price of one currency in terms of other currency. Foreign exchange market (Forex – FX) is the international market for free trade of currencies. Traders place orders to buy one currency with another currency According to Hartly Withers, “ Foreign exchange is the art and science of international monetary exchange” 2. Facts - The forex market is the world’s largest financial market. According to the Bank of International Settlements (BIS), in April 2016 trading on forex markets averaged $5.1 trillion per day. It was 27 times larger than the equities (stock) market, and 4 times larger than the entire global GDP. - The main currency used for forex trading is the US dollar, accounting for 40% of the total participating currencies. 3. Characteristics - The Forex Market has no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST on Friday because currencies are in high demand. - Most trades by phone, telex, or SWIFT (Society for Worldwide Interbank Financial Telecommunications - It has a high liquidity 4. Function Foreign exchange market performs the three following functions: - Transfer Function: The basic function of the Forex market is to facilitate the conversion of one currency into another; to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills. In performing the transfer function, the Forex market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings. - Credit Function: It provides credit for foreign trade. Bills of exchange, with a maturity period of three months, are generally used for international payments. Credit is required for this period in order to enable the importer to take possession of goods, sell them and obtain money to pay off the bill. - Hedging Function: A third function of the foreign exchange market is to hedge foreign exchange risks, Hedging means the avoidance of a foreign exchange risk. In a free exchange market when the exchange rate, i.e., the price of one currency in terms of another currency, changes, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money. For those risks, the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. Foreign bills of exchange, telegraphic transfer, bank draft, letter of credit,.. are the important foreign exchange instruments used in the Forex market to carry out its functions. 5. Types of foreign exchange market 5.1. Based on business nature - The interbank market, in which banks and financial institutions trade currencies to manage their own forex risks as well as those of their clients - The retail (over-the-counter) market, in which individuals and businesses trade through online platforms and brokers. Of these two, the interbank market is by far the larger. In April 2016, 93 percent of transactions were between financial institutions, the majority of them are banks. 5.2. Based on professional nature - Spot market (immediate transaction + recorded by 2nd business day): The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contract is signed between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market - Forward market ( transactions take place at a specified future date): A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward Market - Swap market: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations denominated in a different currency without suffering a foreign exchange risk. - Future market: The future transactions are also the forward transactions and deal with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the following grounds: The forward contracts can be customized on the client’s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized. The future contracts can only be traded on the organized exchanges, while the forward contracts can be traded anywhere depending on the client’s convenience. No margin is required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position. - Option market: The foreign exchange option gives an investor the right, but not the obligation to exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called a Call Option, while the option to sell the currency is called a Put Option. 5.3. Based on transaction locations On the basis of transaction locations, the foreign exchange market is divided into Exchange Market and OTC market. The differences between OTC and Exchange are discussed below in detail 5.4. Based on the legal nature The foreign exchange market is divided into Legal market and Illegal market - Legal market is an Organized market, with regulations on the operation of the market, standards of members, and transaction processes. Payments are strictly safe. In the official market, transactions can be done during trading hours (usually from 9:00 to 15:00 daily) and can also be done over the counter (OTC) but via a computerized system. Direct network connection, fax, telex,… between buyer and seller - OTC transaction method is continuous when electronic data is connected. - Illegal market (black market, underground market - Unorganized Market) is a place to buy and sell directly and in cash. A type of market that is not legally recognized. This market quickly solves the demand for cash in foreign currency but has a very high risk. 5.5. Based on market size The foreign exchange market is divided into the international foreign exchange market and domestic foreign exchange market - The international foreign exchange market is the foreign exchange market whose scope of activities is on the international scale. Members of this market include domestic members and eligible overseas members. - Domestic foreign exchange market: is a market only participants are banks, companies, ... in the same country. The operation of this market does not affect foreign currency flows into or out of that country. Countries that do not have a stable financial market generally only organize their domestic exchange market, to avoid the impact of external factors. 5.6. Based on the transaction method The foreign exchange market is divided into: - Direct transaction market: In this market, members participate in direct transactions with each other, not through any intermediaries. - Market transactions through brokers: Transactions on the market are done through brokers. The market participants place orders for the broker, the broker relies on it to find orders that match the client's orders. Through brokerage activities, the broker will collect commissions from the buying bank and from the selling bank. 6. Participants The participants in forex market and their activities are summerised in the chart below. II. The foreign exchange rate 1. Definition Foreign exchange rate, or FX Rate, is the value of a nation’s currency in comparison to that of another nation Ex: If the USD/AUD exchange rate is 1.30, it means that it costs a person 1.30 Australian dollars to buy 1 U.S. dollar. The first currency listed (USD) always stands for one unit of that currency; the exchange rate shows how much of the second currency (AUD) is needed to purchase that one unit of the first (USD). 2. The importance of the foreign exchange rate EX1: Suppose that Minh , a Vietnamese, decides to buy ZX 2K boost shoes to complete her shoes collection. If the price of the shoes in US is $150 and the exchange rate is 23,177 VND to the dollar, the shoes will cost Minh ( 23.177*150= 3.476.550 VND). Now suppose that Minh delays her purchase by two months, at which time the dollar has appreciated to 23,500 VND per dollar. If the domestic price of the shoes remains $150, its VND cost will have risen from 3.476.550 VND to 3.525.000 VND. When American currency rises in value relative to Vietnam, American’s goods abroad in Vietnam becomes more expensive. EX2: At an exchange rate of $1.18 per euro, a Dell computer priced at $2,000 costs Pierre the French programmer 1,695 euros; if the exchange rate increases to $1.40 per euro, the computer will cost only 1,429 euros. When French currency rises in value relative to America, foreign goods (American goods) in France become cheaper. Foreign exchange rates are important because they affect the price of domestically produced goods sold abroad and the cost of foreign goods bought domestically. Specifically, when a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.