MONEY MARKETS

DEFINITION
 Refers to a section of the financial market where
financial instruments with high liquidity and short-
term maturities are traded.
 Consist of negotiable instruments such as treasury
bills, commercial papers, and certificate of deposits.
 exist to transfer funds from individuals,
corporations, and government units with short-
term excess funds (suppliers of funds) to economic
agents who have short-term needs for funds (users
of funds).
Moneymarkets
economic
(short-term issued
agents
investments)

tra
de

Active
secondary
markets
Opportunity Cost
 The forgone interest cost from the holding of
cash balances when they are received.
 The forgone interest cost from the holding of
cash balances when they are received
 Consequently, holders of cash invest “excess”
cash funds in financial securities that can be
quickly and relatively costlessly converted
back to cash when needed with little risk of
loss of value over the short investment
horizon.
Default Risk

 The risk of late or nonpayment of principal or

interest.
 Since cash lent in the money markets must be
available for a quick return to the lender,
money market instruments can generally be
issued only by high-quality borrowers with
little risk of default.
Yields in Money Market Securities

Bond Equivalent Yield

 The bond equivalent yield, is the quoted
nominal, or stated, yield on a security. The bond
equivalent yield is the product of the periodic
rate and the number of periods in a year.
Effective Annual Return
 The bond equivalent yield does not consider the
effects of compounding of interest during a less
than one year investment horizon.
 The bond equivalent yield on money market
securities with a maturity of less than one year
can be converted to an effective annual interest
return ( EAR ) using the following equation:
 Discount Yields
 Instead of directly received interest payments
over the investment horizon, the return on
these securities results from the purchase of
the security at a discount from its face value
(P0) and the receipt of face value (P f) at
maturity.
 Further, yields on these securities use
a 360-day year rather than a 365-day
year. Interest rates on discount
securities, or discount yields, are
quoted on a discount basis using the
following equation:
 An appropriate comparison of interest
rates on discount securities versus non-
discount securities, adjusting for both the
base price and days in the year differences,
requires converting a discount yield into a
bond equivalent yield in the following
manner:
Single-Payment Yields

 Some money market securities pay interest only

once during their lives: at maturity. Thus, the
single-payment security holder receives a
terminal payment consisting of interest plus the
face value of the security. Such securities are
special cases of the pure discount securities that
only pay the face value on maturity.
 Further, quoted nominal interest rates on
single-payment securities (or single-payment
yield) normally assume a 360-day year. In
order to compare interest rates on these
securities with others, that pay interest based
on a 365-day year, the nominal interest rate
must be converted to a bond equivalent yield
in the following manner:
 Further, allowing for interest rate
compounding, the EAR for single-
payment securities must utilize the
bond equivalent yield as follows: