UNIT 3 – THE MONEY MARKET

MONEY MARKET OVERVIEW

• Refers to the network of corporations, financial institutions, investors, and governments

dealing with short-term capital flow.
• Used for businesses needing cash for a few months, banks investing money that depositors
can withdraw at any moment, and governments meeting payroll amid seasonal fluctuations
in tax receipts.
• Expanded significantly due to the general outflow of money from the banking industry, a
process known as disintermediation.
• Until the 1980s, financial markets were centered on commercial banks, with savers and
investors keeping most of their assets on deposit with banks.
• Financial deregulation and electronic money movement led to banks losing market share in
deposit gathering and lending.
• Money markets bring borrowers and investors together without the costly intermediation
of banks, enabling them to meet short-run liquidity needs and deal with irregular cash
flows.
• Money markets are webs of borrowers and lenders, linked by telephone and computers,
with central banks at the center and treasurers of businesses and government agencies at
the center.
• The constant soundings among these diverse players for the best available rate keep the market
competitive.

MONEY MARKETS VS BOND MARKETS

Definition and Function of Money Markets

• Money markets refer to the buying and selling of debt instruments maturing in one year or less.
• They are related to bond markets, where corporations and governments borrow and lend based
on long-term contracts.

Key Differences Between Money Markets and Bond Markets

• Bond issuers raise money to finance investments that will generate profits or public benefits for
many years.
• Money-market issuers focus more on cash management or financing their financial assets.

Role of Money Markets in Long-Term Securities

• Well-functioning money markets facilitate the development of a market for longer-term
securities.
• Active money markets allow borrowers and investors to engage in short-term transactions,
holding down longer-term rates.
• Countries with less active money markets tend to have less active bond markets.

MONEY-MARKET FUNDS AND INTEREST RATES

• Money-market funds are entities that pool money-market securities, allowing investors to
diversify risk.
• Retail funds cater to individuals, while institutional funds serve corporations, foundations,
government agencies, and other large investors.
• These funds are required by law to invest only in cash equivalents, securities with similar safety
and liquidity as cash.
• They reduce investors' search costs and risks, and perform intermediation at lower cost than
banks.
• They are not required to set aside a portion of investors’ funds to cover possible losses,
allowing them to pay higher interest rates.
• The spread between the rate money-market funds pay investors and the rate they lend out is
usually a few tenths of a percentage point.
• Most money-market securities pay interest at a fixed rate, determined by market conditions at
the time they are issued.
• The value of money-market securities changes inversely to changes in short-term interest rates.

TYPES OF MONEY MARKET INSTRUMENTS

• Commercial paper: A short-term debt obligation of a private-sector firm or government-

owned corporation. It typically has a maturity of 90 days but less than nine months.
• Bankers’ acceptances: A promissory note issued by a non-financial firm to a bank in return
for a loan. The bank resells the note in the money market at a discount and guarantees payment.
• Government Agency Notes: National government agencies and government-owned or
controlled corporations are heavy borrowers in the money market.
• Local Government Notes: Issued by provincial or local government, and by agencies of these
governments. The ability of these governments to issue money-market securities varies greatly
from country to country.

Interbank Loans
• Loans extended from one bank to another with which it has no affiliation. They are used by
borrowing banks to lend to its own clients.
• Overnight loans are short-term unsecured loans from one bank to another. They may be used to
help the borrowing bank finance loans to clients or to balance assets and liabilities.

Time Deposits
• Interest-bearing bank deposits that cannot be withdrawn without penalty before the specified
date.
• Large-time deposits are often used by corporations, governments, and money-market funds to
invest cash for brief periods.

International Agency Paper

• Issued by the World Bank, Asian Development Bank, and other organizations owned by
member governments. They often borrow in many different currencies, depending upon interest
and exchange rates.

Repos
• Repurchase agreements, known as repos, play a critical role in the money market. They ensure
a constant supply of buyers for new money-market instruments.

MONEY MARKET TRADING AND RATINGS

Trading Process
• Money market instruments are traded over computer systems.
• Dealers, either banks or non-banks, sign contracts with a central clearing house.
• The clearing house settles the trade by debiting the bank account of the buyer and crediting the
account of the seller.
• The clearing house reduces counterparty risk by holding the instrument on behalf of the new
owner.
• Disputes between parties must be resolved by the parties themselves or in the legal system.
• Clearing houses strive for real-time settlement to prevent the collapse of important banks or
securities dealers.

Ratings and the Money Market

• Rating agencies offer opinions about the creditworthiness of borrowers in financial markets.
• Issuers of treasury bills, agency notes, local government notes, and international agency paper
usually obtain ratings before bringing their issues to market.
• Participants in interbank lending and buyers of bankers’ acceptances look for a rating not of the
particular deal, but of the financial institutions involved.
• Three firms, Moody’s Investor Services, Standard & Poor’s (S&P), and Fitch, rate money-
market issuers worldwide.