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Financial Markets and Institutions

Chapter No. 02: MONEY MARKET: A BRIEF.

Introduction:
The concept of money markets is an essential aspect of the financial system. Money markets
refer to the segment of the financial market where short-term borrowing and lending of
funds take place. These markets facilitate the trading of highly liquid and low-risk financial
instruments with maturities typically less than one year. Because of the high degree of safety
and liquidity these securities exhibit, they are close to being money, hence their name.

What is a Money Market?

The term money market is actually a misnomer. Money—currency—is not traded in the
money markets. Because the securities that do trade there are short-term and highly liquid,
however, they are close to being money. Money market securities have three basic
characteristics in common:
 They are usually sold in large denominations.
 They have low default risk.
 They mature in one year or less from their original issue date. Mostly less than 120
days.
Money market transactions do not take place in any one particular location or building.
Instead, traders usually arrange purchases and sales between participants over the phone
and complete them electronically. Because of this characteristic, money market securities
usually have an active secondary market. This means that after the security has been sold
initially, it is relatively easy to find buyers who will purchase it in the future. An active
secondary market makes money market securities 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 investments with a maturity of 3 months or less at date of
purchase to be cash equivalents.”
Money markets are wholesale markets. Transactions are very large, usually in excess of $1
million. Instead of individual investors, dealers and brokers bring customers together.
These traders will buy or sell $50 or $100 million in mere seconds — certainly not a job for
the faint of heart!

Purpose of the Money Markets:

 Money market is an ideal place for a firm or financial institution to “warehouse” surplus
funds until they are needed.

 It also provides a low-cost source of funds to firms, the government, and intermediaries
that need a short-term infusion of funds.

 Most investors use the money market as an interim investment that provides a higher
return than holding cash or money in banks.

 Idle cash represents an opportunity cost in terms of lost interest income. The money
markets provide a means to invest idle funds and to reduce this opportunity cost.

 Investment advisers often hold some funds in the money market so that they will be able
to act quickly to take advantage of investment opportunities they identify.
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 Most investment funds and financial intermediaries also hold money market securities to
meet investment or deposit outflows.

 The sellers of money market securities find that the money market provides a low cost
source of temporary funds.

Who Participates in the Money Markets?

Money Market Instruments:

A variety of money market instruments 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.

1. Treasury Bills:
The U.S. Treasury Department issues a variety of debt securities to finance the national
debt. The most widely held and most liquid security is the Treasury bill. Treasury bills are
sold with 4-, 13-, 26-, and 52-week maturities. The Federal Reserve is the Treasury’s agent
for the distribution of all government securities.
The government does not actually pay interest on Treasury bills. Instead, they are issued at
a discount from par (their value at maturity). The investor’s yield comes from the increase in
the value of the security between the time it was purchased and the time it matures.

The discount rate is computed as:

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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. The fed funds
market began in the 1920s when banks with excess reserves loaned them to banks that
needed them. The interest rate for borrowing these funds was close to the rate that the
Federal Reserve charged on discount loans.
The Federal Reserve has set minimum reserve requirements that all banks must maintain.
To meet these reserve requirements, banks must keep a certain percentage of their total
deposits with the Federal Reserve. The main purpose for fed funds is to provide banks with
an immediate infusion of reserves. Banks can borrow directly from the Federal Reserve, but
the Fed actively discourages banks from regularly borrowing from it.

3. Repurchase Agreements:
Repurchase agreements (repos) work much the same as fed funds except that nonbanks can
participate. A firm can sell Treasury securities in a repurchase agreement whereby the firm
agrees to buy back the securities at a specified future date. Most repos have a very short
term, the most common being for 3 to 14 days. There is a market, however, for one- to
three-month repos.

4. Negotiable Certificates 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. 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.
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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.

5. Commercial Paper:
Commercial paper or bills 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. The interest rate the
corporation is charged reflects the firm’s level of risk.
Commercial paper always has an original maturity of less than 270 days. This is to avoid the
need to register the security issue with the Securities and Exchange Commission. Most
commercial paper actually matures in 20 to 45 days. Like T-bills, most commercial paper is
issued on a discounted basis.
About 60% of commercial paper is sold directly by the issuer to the buyer. The balance is
sold by dealers in the commercial paper market. A strong secondary market for commercial
paper does not exist. A dealer will redeem commercial paper if a purchaser has a dire need
for cash, though this is generally not necessary.

6. Banker’s Acceptances:
A banker’s acceptance is an order to pay a specified amount of money to the bearer on a
given date. Banker’s acceptances have been in use since the twelfth century.
They are used to finance goods that have not yet been transferred from the seller to the
buyer. For example, suppose that Builtwell Construction Company wants to buy a
bulldozer from Komatsu in Japan. Komatsu does not want to ship the bulldozer without
being paid because Komatsu has never heard of Builtwell and realizes that it would be
difficult to collect if payment were not forthcoming. Similarly, Builtwell is reluctant to send
money to Japan before receiving the equipment. A bank can intervene in this standoff by
issuing a banker’s acceptance whereby the bank in essence substitutes its creditworthiness
for that of the purchaser.
Because banker’s acceptances are payable to the bearer, they can be bought and sold until
they mature. They are sold on a discounted basis like commercial paper and T-bills. Dealers
in this market match up firms that want to discount a banker’s acceptance (sell it for
immediate payment) with companies wishing to invest in banker’s acceptances. Interest
rates on banker’s acceptances are low because the risk of default is very low.

7. Eurodollars:
Many contracts around the world call for payment in U.S. dollars due to the dollar’s
stability. For this reason, many foreign companies and governments choose to hold dollars.
Prior to World War II, most of these deposits were held in New York money center banks.
However, as a result of the Cold War that followed, there was fear that deposits held on
U.S. soil could be expropriated. Some large London banks responded to this opportunity by
offering to hold dollar-denominated deposits in British banks. These deposits were dubbed
Eurodollars.
The Eurodollar market has continued to grow rapidly. The primary reason is that depositors
often receive a higher rate of return on a dollar deposit in the Eurodollar market than in
their domestic market. This is because multinational banks are not subject to the same
regulations restricting U.S. banks and because they are willing and able to accept narrower
spreads between the interest paid on deposits and the interest earned on loans.
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Comparing Money Market Securities:

All money market instruments have a very low risk and a short term. They all have deep
markets and so are priced competitively. In addition, because these instruments have so
many of the same risk and term characteristics, they are close substitutes. Consequently, if
one rate should temporarily depart from the others, market supply-and-demand forces
would soon cause a correction. It is also noteworthy how rapidly these rates responded to
the global recession that followed the 2007–2008 financial crisis. Money market rates were
still at historic lows years later.
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