Keywords: Money Market, Financial Instruments, Commercial Paper, Money Market Accounts (MMA), Money Market Funds, Treasury Bills (T-Bills), Banker’s Acceptance (BA), Repurchase Agreement (Repo), Certificate of Deposits (CDs)
1. What is the Money Market?
The money market is defined as an exchange market where short-term loans and debt securities (with maturities of less than one year) are traded. Financial instruments with short-term maturity, high liquidity and low risk are also traded in the money market.
- Debt securities: A debt security is a financial asset with defined terms that can be traded between a borrower and a lender. Examples include bonds and Certificates of Deposits (CDs).
Functions and importance
The money market allows savers to lend their money through financial instruments to those who have an urgent need for short-term funds. By doing so, lenders can earn interest with their excess money, and the borrower can pay their near-term obligations.
Who are the borrowers and lenders in the money market?
Most money market trades are made between banks, governments and corporations at a wholesale level. As a result, the borrowers and lenders of the money market usually include banks, corporations, governments, and mutual funds.
However, Treasury Bills, mutual funds and money market accounts also provide individual investors with opportunities to trade in the money market.
What are the financial instruments in the money market?
There are 7 main financial instruments commonly used in the money market:
- Commercial Paper
- Money Market Accounts (MMA)
- Money Market Funds
- Treasury Bills (T-Bills)
- Banker’s Acceptance (BA)
- Repurchase Agreement (Repo)
- Certificate of Deposits (CDs)
2. Commercial Paper
Definition of Commercial Paper:
Commercial paper is a debt security issued by corporations to raise funds. It typically has a fixed maturity of less than 270 days and is issued in denominations of $100,000 with increments of $1,000. The buyer of a commercial paper will be paid both interest and principal at maturity.
A corporation issues commercial paper to meet its short term obligations, such as payroll or funding for a new project. As a result, maturities of a commercial paper are usually set between a few weeks to a few months.
Risks and Interest Rates:
The commercial paper is a convenient way for a corporation to obtain funds because it does not need to be registered under the Securities and Exchange Commission (SEC) for trading. However, at the same time, a commercial paper is not insured by the government and is instead solely backed by the issuer, making it unsecure.
Commercial papers are rated in the same manner as corporate bonds, with the highest rating of AAA equating to a stable low-risk investment. Generally, the lower a commercial paper is rated, the more interest an issuer will have to pay (on the risk).
3. Money Market Accounts (MMAs)
Definition of MMAs:
A Money Market Account (MMA) is a deposit account offered by banks or credit unions that provides interest rates contingent on current interest rates in the money market.
Features of MMAs:
- MMAs generally offer higher interest rates than savings accounts do.
- MMAs charge a service fee if the balance of the account falls below certain amount.
- MMAs are better for short-term goals (such as saving for vacation) than long-term goals (such as saving for retirement).
- MMAs are insured by the Federal Deposit Insurance Corporation (FDIC).
4. Money Market Funds
Definition of Money Market Funds:
A money market fund is a mutual fund that invests in money market securities, such as commercial papers and T-Bills. The management goal of market money funds is to maintain a highly stable asset value using liquid investments.
Features of Money Market Funds:
- High liquidity with low risk.
- Investors of money market funds receive dividends as a return.
- Though money market funds are not insured, they are still considered low risk.
- Money market funds are suitable for short-term investments, as investors can temporarily place their money into these before making other investments.
- Money market funds are regulated by the SEC.
5. Treasury Bills
Definition of Treasury Bills
Treasury Bills (T-Bills) are U.S. government bonds that mature in one year or less. Instead of receiving periodic interests, investors profit from T-Bills by buying them at a discount value and later redeem them at the par value when they reach maturity.
Features of T-Bills
- Treasury Bills are considered low risk because they are backed by the U.S. government.
- T-bills are generally issued in denominations of $1,000, but can sometimes be sold in denominations of few million dollars.
- Common T-Bills have a maturity of 4 weeks, 8 weeks, 13 weeks, 26 weeks, and 52 weeks. The longer the maturity, the higher the interest rate.
6. Banker’s Acceptance (BA)
Banker’s Acceptance (BA) is a method of payment where a company issues a piece of paper representing a promised future payment by a bank. The main advantage of BAs is that parties without established relationships can reduce credit risks between them, since BAs are guaranteed by banks.
7. Repurchase Agreement (Repo)
A Repurchase Agreement (Repo) is a form of short-term borrowing where a dealer agrees to sell government securities to investors and repurchase them back at a higher price in the future. Repos are often used to obtain short-term money for overnight to 48 hours.
8. Certificate of Deposits (CDs)
A Certificate of Deposit (CD) is a financial product where investors leave a deposit in a bank (or credit union) untouched for a fixed period of time. In return, the bank (or credit union) gives the investor an interest rate premium.
Certificate of Deposits (CDs) with maturity of a year or less are considered money market securities.
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