MODULE 2: MONEY MARKET into the hands of consumers as components of
money market mutual funds and other
What Is the Money Market?
The money market refers to trading in very
short-term debt investments. At the wholesale
level, it involves large-volume trades between
institutions and traders. At the retail level, it
includes money market mutual funds bought by
individual investors and money market accounts
opened by bank customers. Because of these
attributes, they are often seen as cash
equivalents that can be interchangeable for
money at short notice. The money market is a
component of the economy that provides
short-term funds.
The money market deals in short-term
loans, generally for a period of a year or less. As
short term securities became a commodity, the
money market became a component of the
financial market for assets involved in short-term
borrowing, lending, buying and selling with
original maturities of one year or less. Trading in
money markets is done over the counter and is
wholesale.
The money market is crucial for the
smooth functioning of a modern financial
economy. It allows savers to lend money to those
in need of short-term loans and allocates capital
towards its most productive use. These loans,
often made overnight or for a matter of days or
weeks, are needed by governments, corporations,
and banks in order to meet their near-term
obligations or regulatory requirements. At the
same time, it allows those with excess cash on
hand to earn interest.
Understanding the Money Market
The money market is one of the pillars of
the global financial system. It involves overnight
swaps of vast amounts of money between banks
and the government. The majority of money
market transactions are wholesale transactions
that take place between financial institutions and
companies.
Institutions that participate in the money
market include banks that lend to one another and
to large companies in the eurocurrency and time
deposit markets; companies that raise money by
selling commercial paper into the market, which
can be bought by other companies or funds; and
investors who purchase bank CDs as a safe place
to park money in the short term. Some of those
wholesale transactions eventually make their way
investments.
Money Markets vs. Capital Markets
The money market is defined as dealing in
debt of less than one year. It is primarily used by
governments and corporations to keep their cash
flow steady, and for investors to make a modest
profit. The capital market is dedicated to the sale
and purchase of long-term debt and equity
instruments.
The term "capital markets" refers to the
entirety of the stock and bond markets. While
anyone can buy and sell a stock in a fraction of a
second these days, companies that issue stock
do so for the purpose of raising money for their
long-term operations. While a stock's value may
fluctuate, unlike many money market products, it
has no expiration date (unless, of course, the
company itself ceases to operate).
Participants in the Money Market
The money market consists of financial
institutions and dealers in money or credit who
wish to either borrow or lend. Participants borrow
and lend for short periods, typically up to twelve
months. Money market trades in short-term
financial instruments commonly called "paper".
This contrasts with the capital market for
longer-term funding, which is supplied by bonds
and equity.
The core of the money market consists of
interbank lending—banks borrowing and lending
to each other using commercial paper, repurchase
agreements and similar instruments. These
instruments are often benchmarked to (i.e., priced
by reference to) the London Interbank Offered
Rate (LIBOR) for the appropriate term and
currency.
● Trading companies often purchase
bankers' acceptances to tender for
payment to overseas suppliers.
● Retail and institutional money market
funds
● Banks
● Central banks
● Cash management programs
● Merchant banks
Functions of the Money Market
Financing trade
The money market plays a crucial role in
financing domestic and international trade.
Commercial finance is made available to the
traders through bills of exchange, which are
discounted by the bill market. The acceptance
houses and discount markets help in financing
foreign trade.
Financing industry
The money market contributes to the
growth of industries in two ways:
● They help industries secure short-term
loans to meet their working capital
requirements through the system of
finance bills, commercial papers, etc.
● Industries generally need long-term loans,
which are provided in the capital market.
However, the capital market depends upon
the nature of and the conditions in the
money market. The short-term interest
rates of the money market influence the
long term interest rates of the capital
market. Thus, money market indirectly
helps the industries through its link with
and influence on long-term capital market.
Profitable investments
The money market enables commercial
banks to use their excess reserves in profitable
investments. The main objective of commercial
banks is to earn income from its reserves as well
as maintain liquidity to meet the uncertain cash
demand of its depositors. In the money market,
the excess reserves of commercial banks are
invested in near money assets (e.g., short-term
bills of exchange), which are easily converted into
cash. Thus, commercial banks earn profits without
sacrificing liquidity.
Self-sufficiency of commercial banks
Developed money markets help
commercial banks to become self-sufficient. In an
emergency, when commercial banks have
scarcity of funds, they need not approach the
central bank and borrow at a higher interest rate.
They can instead meet their requirements by
recalling their old short-run loans[clarify] from the
money market.
Help to central bank
Though the central bank can function and
influence the banking system in the absence of a
money market, the existence of a developed
money market smooths the functioning and
increases the efficiency of the central bank.
Money markets help central banks in two ways:
● Short-run interest rates serve as an
indicator of the monetary and banking
conditions in the country and, in this way,
guide the central bank to adopt an
appropriate banking policy,
● Sensitive and integrated money markets
help the central bank secure quick and
widespread influence on the sub-markets,
thus facilitating effective policy
implementation
Types of Money Market Instruments
Money Market Funds
Money market funds are mutual funds that
are offered by brokerages, investment companies,
and financial services firms. They pool money
from multiple investors and invest in high-quality,
short-term securities. While they are technically
investments, they do act more like on-demand
cash accounts since the money is easily
accessible.
These mutual funds may have a minimum
initial investment requirement, as well as balance
requirements and transaction fees. There are also
associated fees that bank accounts do not incur,
including an expense ratio, which is a percentage
fee charged on the fund for management
expenses.
Money Market Accounts
Money market accounts are a type of
savings account. They pay interest, but some
issuers offer account holders limited rights to
occasionally withdraw money or write checks
against the account. (Withdrawals are limited by
federal regulations. If they are exceeded, the bank
promptly converts it to a checking account.)
Banks typically calculate interest on a money
market account on a daily basis and make a
monthly credit to the account.
In general, money market accounts offer
slightly higher interest rates than standard savings
accounts. But the difference in rates between
savings and money market accounts has
narrowed considerably since the 2008 financial
crisis. Average interest rates for money market
accounts vary based on the amount deposited.
Certificates of Deposit (CDs)
These are time deposit, commonly offered to
consumers by banks, thrift institutions, and credit
unions. Most certificates of deposit (CDs) are not
strictly money market funds because they are sold
with terms of up to 10 years. However, CDs with
terms as short as three months to six months are
available.
Commercial Paper
The commercial paper market is for buying and
selling unsecured loans for corporations in need
of a short-term cash infusion. Only highly
creditworthy companies participate, so the risks
are low.
Banker's Acceptances
The banker's acceptance is a short-term loan that
is guaranteed by a bank. Used extensively in
foreign trade, a banker's acceptance is like a
post-dated check and serves as a guarantee that
an importer can pay for the goods. There is a
secondary market for buying and selling banker's
acceptances at a discount.
Repos
The repo, or repurchase agreement (repo), is part
of the overnight lending money market. Treasury
bills or other government securities are sold to
another party with an agreement to repurchase
them at a set price on a set date.
Advantages and Disadvantages of Money
Markets
There are several pros and cons of money
market investments. Most money market
securities are considered extremely low-risk, due
to the protection of FDIC insurance, backing by a
government or bank, or the high creditworthiness
of the borrowers. They are also very liquid,
meaning that they can readily be exchanged for
cash at short notice.
The tradeoff of having low risk is that
these investments also have low returns. Not only
do money markets underperform other asset
classes, they often don't even keep pace with
inflation. In addition, any fees associated with an
account can easily eat into those slim returns.
Moreover, these advantages do not extend
to all money market securities. Some of them are
not FDIC insured, and there is a (small) chance
that even the most trustworthy borrowers may
default. Some money market accounts have
minimum balance requirements or restrictions on
withdrawals.
Pros and Cons of Money Market Accounts
Pros
● Extremely low risk.
● May be insured by FDIC.
● Highly liquid.
● Higher returns than most bank accounts.
Cons
● Low returns that may not keep pace with
inflation.
● Not all money market securities are
insured.
● May have high minimum investments or
withdrawal restrictions.
KEY TAKEAWAYS
● Money market accounts and money
market funds are considered among the
safest ways to invest one's money. They
also have much lower returns than other
investments, often even less than inflation
● The money market involves the purchase
and sale of large volumes of very short
term debt products, such as overnight
reserves or commercial paper.
● An individual may invest in the money
market by purchasing a money market
mutual fund, buying a Treasury bill, or
opening a money market account at a
bank.
● Money market investments are
characterized by safety and liquidity, with
money market fund shares targeted at $1.
● Money market accounts offer higher
interest rates than a normal savings
account, but there are higher account
minimums and limits on withdrawals