Money market refers to the market where trading is done for short term securities. Money market involves trading of debt instruments with original maturities of one year or less. Its securities are issued by high quality economic units such as governments, financial institutions and other corporate organizations of sound financial standing that require short-term funds.
A money market is a financial market in which short-term financial assets with liquidity of one year or less are traded on stock exchanges. Generally, the securities are highly liquid. Furthermore, they facilitate the participant’s short-term borrowing needs through the trading of bills. Banks, large institutional investors, and individuals usually participate in this financial market.
The money market trades a variety of instruments, including Treasury bills, certificates of deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-backed securities and asset-backed securities. Companies with short-term cash flow needs can borrow from the market directly through their dealer, while small companies with excess cash can borrow from money market mutual funds.
Objectives of Money Market
Some of the major objectives of money market are as follows:
i. It offers short-term funds at a reasonable price to borrowers such as investors, governments, etc. Moreover, short-term securities in the money market will provide lenders with liquidity.
ii. It allows lenders to turn idle funds into effective investments.
iii. It helps to regulate the level of liquidity in the economy.
iv. It provides the organizations with necessary funds to meet their working capital requirements.
v. It gives banks a place to park surplus funds.
Functions of Money Market
Some of the functions of money market are as follows:
1. Financing Trade
Money market funding is provided to traders on the local and international markets in need of short-term funding. This provides immediate financing of goods and services by discounting bills of exchange. International traders can take advantage of these markets and acceptance houses. Funds are also available on the money market for agriculture and small-scale industries.
2. Central Bank Policies
It is the central bank’s responsibility to guide a country’s monetary policy and ensure a healthy financial system. In order to perform its policy-making function efficiently, the central bank relies on the money market. Taking the short-term interest rates in the money market as an example, the central bank can develop an interest rate policy appropriate to the prevailing conditions in the banking industry. Furthermore, the integrated money markets facilitate the central bank’s ability to influence sub-markets and implement its monetary policy objectives.
3. Growth of Industries
Businesses can obtain short-term loans to finance their working capital requirements on the money market. The high volume of transactions may cause businesses to experience cash shortages related to buying raw materials, paying employees, or meeting other short-term expenses. They can borrow money on a short-term basis through commercial paper and finance bills. In spite of the fact that money markets do not offer long-term loans, they influence the capital market and can be of assistance to businesses seeking long-term financing. Accordingly, the capital market benchmarks its interest rates with the money market rate.
4. Commercial Banks Self-Sufficiency
In the money market, banks can invest excess reserves, earn interest, and maintain liquidity while investing their excess reserves. To allow customers to withdraw cash, short-term investments, such as bills of exchange, can easily be converted to cash. In addition, when faced with liquidity difficulties, they can borrow short-term from the money market as an alternative to borrowing from the central bank. This has the advantage of allowing the money market to charge lower interest rates for short-term loans than the central bank usually does.
Money Market Instruments
A money market instrument is a type of investment that allows banks, businesses, and the government to meet large, but short-term capital needs at a low cost. They allow borrowers to meet their short-term needs as well as provide lenders with easy liquidity. There are several money market instruments for trading money market. Some of the major money market instruments are as follows:
i. Treasury Bills
Treasury bills or (T-bills) refers to the short-term securities issued by the government. They represent money market debt securities issued by government that have initial maturity of one year or less. They are also considered high liquid marketable securities among all money market securities. They are sold at low transaction cost and with negotiable price risk. T-bills do not carry fixed interest rate. They are sold at discount from the par value. The discount from par value represents return to the investors. The investors who is willing to purchase treasury bills can directly purchase from the Treasury department of government or from a government securities dealer in the secondary market.
ii. Certificate of Deposit
Certificate of deposit refers to the evidence of the deposit of funds in a commercial bank or saving and loan association for a specified period of time at a specified rate of interest. They are issued by banks and thrifts to raise funds for financing their business activities. The maturity period of certificate of deposit ranges from a few days to many years. There is no limitations on the maximum maturity. But, in the USA, Federal Reserve regulations specify that maturity of any CD cannot be less than seven days. Certificate of Deposit may be negotiable or non-negotiable.
When the certificate of deposit is non-negotiable, the initial depositor must wait until the maturity date of it to get back the funds. If the depositor chooses to withdraw funds prior to the maturity date, an early withdrawal penalty is imposed. In contrast, a negotiable CD allows the initial depositor or any subsequent owner of the certificate of the deposit to sell the certificate of deposit in the open market prior to the maturity date.
iii. Commercial Paper
Commercial paper is a short-term, unsecured negotiable promissory note issued by a company to raise funds from money market. The companies which are well established and are creditworthy does bear the ability to raise funds by issuing commercial paper. The issuance of commercial paper is an alternative to bank borrowing for both financial and non-financial companies with strong credit ratings. Commercial paper is generally used to raise short-term funds for seasonal and working capital needs. It can also be used for bridge financing. Bridge Financing refers to the process of using short term source to finance fixed assets for a short period.
Generally, maturity of the commercial papers varies from a few days to a maximum of 270 days. But most of the US companies prefer commercial paper with maturity up to 90 days. In the US, it is necessary for the company to register commercial paper with Securities and Exchange Commission (SEC) if maturity period exceeds 270 days. It is most popular among corporate investors. Commercial papers are not actively traded in secondary market as the investor of commercial paper is an entity that plans to hold it until maturity.
iv. Repurchase Agreements
An repurchase agreement (repo) is a short-term form of borrowing in which a security is sold with an agreement to buy it back at a higher price at a future date. This is commonly used by dealers in government securities who sell Treasury bills to lenders and agree to repurchase them at a later date at an agreed price. It is also referred to as a Sell-Buy transaction as one party sells a security to another, with the promise of buying it back from the buyer at a later date.
Security is bought by the seller at a predetermined time and amount and includes the interest rate at which it was agreed to be purchased by the buyer. The buyers purchase a security at a certain rate which is known as repo rate. The seller uses repos when they need funds for short-term needs, as they can simply sell the securities, and get the funds they need. Investing in repos can yield decent returns for the buyer.
v. Banker’s Acceptance
A banker’s acceptance refers to a draft which is accepted by the bank and used in financing foreign and domestic trade. The buyer in order to ensure the payment to the seller requests its bank to issue a written promise on its behalf, authorizing the seller to draw a time draft on the bank in payment for the goods. Therefore, a written promise becomes a liability of both the bank and the buyer of goods which is known as banker’s acceptance. It can be sold or discounted in the money market. Generally, the yields on banker’s acceptance are slightly higher than those on Treasury bill of same maturity and below those on Certificate of Deposits and commercial paper.
Eurodollar is a dollar denominated bank deposits held at foreign banks or foreign branches of US banks. As for example, if a US company has dollar denominated bank account in a bank in Japan, it is called time Eurodollar account. The depositor receives a Eurodollar time deposit certificates from the Japanese bank. The deposit account pays interest in the form of US dollar. There are time deposits and have a fixed maturity in most of the Eurodollars.
The maturity of deposit is usually less than six months. Eurodollar CDs are considered as another variation of Eurodollar time deposits. In difference to Eurodollars time deposits, Eurodollars CDs can be sold in the secondary market to realize the cash value before the expiry of its maturity period. Eurodollar CDs are riskier but offers high return to the investors.
vii. Money Market Accounts
A money market account is a type of savings account. Many issuers pay interest on these accounts; however, some of them allow limited withdrawals and checks against the account. In the event of withdrawals exceeding those limits, the bank converts the account to a checking account. Banks calculate interest on a money market account on a daily basis, and a monthly credit is made to the account. Generally, money market accounts have slightly higher interest rates than standard savings accounts.
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