Money Market

MONEY MARKET
Meaning of Money Market:
Money market refers to the market where money and
highly liquid marketable securities are bought and sold
having a maturity period of one or less than one year. It
is not a place like the stock market but an activity
conducted by telephone. The highly liquid marketable
securities are also called as ‘ money market instruments’
like treasury bills, government securities, commercial
paper, certificates of deposit, call money, repurchase
agreements etc.
 Participants

 Commercial banks
 Finance, industrial, and service companies
 Governments
 Money market mutual funds
 All other financial institutions (investing)
1. Constituents/Elements of Money Market:
Like other markets, money market also has
three constituents: (a) It has buyers and
sellers in the form of borrowers and lenders,
(b) It has a commodity; it deals with short-
maturity credit instruments, like commercial
bills, treasury bills, etc. (c) It has a price in the
form of rate of interest which is an item of
cost to the borrower and return to the lender.
2. Heterogeneous Market:
The money market is not a single
homogeneous market but consists
of several sub-markets, each market
dealing with a specific short-term
credit instrument.
3. Dealers of Money Market:
The borrowers in the money market are
traders, manufactures, speculators, and even
government institutions. The lenders in the
money market are commercial banks, central
banks, non-bank financial intermediaries, etc.
4. Short-term Loans:
Money market deals with short-term loans. In
a money market, the borrowers can obtain
funds for periods varying from a day, a week,
a month, or three to six months.
5. near-Money Assets:
Money market does not deal in money, but in
short-term financial instruments or near-
money assets. These assets are relatively
liquid and readily marketable. The assets
against which the funds can be borrowed in
the money market include short-term
government securities, bills of exchange,
bankers' acceptances, etc.
6. Physical Contact Not Necessary:
Money market does not refer to a specific
place where borrowers and lenders meet
each other. In fact, it is not necessary that the
borrowers and lenders should have personal
contact with each other at a particular place.
 It’s a OTC maket
7. Different from Capital Market:
Money market is different from capital market
on the basis of maturity period. Money
market deals with the short-term lending and
borrowing of funds, while capital market
deals with medium and long-term lending
and borrowing of funds.
8. Change with Place and Time:
 Though the functions of money markets in
different countries are broadly the same, the
instruments, institutions and practices of these
markets vary considerably from country to
country. Money markets also change with time.
 For example, in London money market, bill of
exchange used to be of great importance. But,
now because of change in business practices and
the growth of public debt, government treasury
bills have become more important.
 Types of Investment Risk

 Market risk – The risk that the market value of an asset will
decline, resulting in a capital loss when sold. Also called interest
rate risk.

 Reinvestment risk – The risk that an investor will be forced to

place earnings from a security into a lower-yielding investment
because interest rates have fallen.

 Default risk – The probability that a borrower fails to meet one

or more promised principal or interest payments on a security.
 Types of Investment Risk

 Inflation risk – The risk that increases in the general price

level will reduce the purchasing power of earnings from the
investment.

 Currency risk – The risk that adverse movements in the price

of a currency will reduce the net rate of return from a foreign
investment. Also called exchange rate risk.

 Political risk – The probability that changes in government

laws or regulations will reduce the expected return from an
investment.
Characteristics of Money Market Instrumen
 Liquidity - Since they are fixed-income
securities with short-term maturities of a year or
less, money market instruments are extremely
liquid.

 Safety - They also provide a relatively high degree

of safety because their issuers have the
highest credit ratings.

 Discount Pricing- A third characteristic they have

in common is that they are issued at a discount to
their face value.
Treasury Bills (T-Bills)

 Treasury Bills (T-bills) are the most

marketable money market security.
 T-bills are short-term securities that mature
in one year or less from their issue date.
 They are issued with three- month, six-
month and one-year maturities.
 T-bills are purchased for a price that is less
than their par (face) value; when they mature,
the government pays the holder the full par
value.
Example of T-Bills

you bought a 90-day T-bill at $9,800 (face

value is $10000) and held it until maturity, you
would earn $200 on your investment. This
differs from coupon bonds, which pay interest
semi-annually.
 Money Market Securities

 Estimating the yield

 T-bills are sold at a discount from par value
 The yield is influenced by the difference between

the selling price and the purchase price

 If a newly-issued T-bill is purchased and held until

maturity, the yield is based on the difference

between par value and the purchase price

 The annualized yield SP  PP

YT  PP 
is: 365
`Where, SP = Selling Pricen
PP = Purchase Price
n = holding period
Commercial Paper
 Commercial paper is
an unsecured, short-term loan issued
by a corporation, typically for
financing accounts receivable and
inventories.
 It is usually issued at
a discount, reflecting current market
interest rates.
 Maturities on commercial paper are
usually no longer than nine months,
with maturities of between one and
two months being the average.
Commercial Paper

 For the most part, commercial paper is a very

safe investment because the financial
situation of a company can easily be
predicted over a few months.
 Furthermore, typically only companies with
high credit ratings and credit worthiness
issue commercial paper.
 Commercial paper is usually issued
in denominations of $100,000 or
more.
 Money Market Securities
Commercial
paper:
 Estimating the yield
 The yield on commercial paper is slightly higher than on a T-bill
 The nominal return is the difference between the price paid and the par valu
commercial paper with a 120 an investor purchase. What is the annualized $289
for a price of $300,000 par value of commercial paper yield:

300,000- 289,000 360

Ycp  
289,000 120
 11.42%
Banker's Acceptance

 A bankers' acceptance (BA) is a short-term

credit investment created by a non-
financial firm and guaranteed by a bank to
make payment.
 Acceptances are traded at discounts from
face value in the secondary market.
 For corporations, a BA acts as a
negotiable time draft for financing imports,
exports or other transactions in goods.
Example of BA

Acceptances sell at a discount from the face value:

Face Value of Banker\'s Acceptance- $1,000,000

Minus 2% Per Annum Commission for One $20,000

Year-

Amount Received by Exporter in One Year- $980,000

 One advantage of a banker's acceptance is that it

does not need to be held until maturity, and can
be sold off in the secondary markets where
investors and institutions constantly trade BAs.
Sequence of Steps in the Creation
of A
Banker’s Acceptance
1 Purchase Order

Importer Exporter
5 Shipment of Goods

4 L/C Notification
2 L/C Application
6 Shipping Documents

3 L/C

American Bank Shipping Documents Bangladeshi Bank

(Importer’s Bank) (Exporter’s Bank)
7 & Time Draft Accepted
Repurchase agreement or Repo
 Those who deal in government securities use
repos as a form of overnight borrowing.
 A dealer or other holder of government securities
(usually T-bills) sells the securities to a lender and
agrees to repurchase them at an agreed future
date at an agreed price.
 They are usually very short-term, from overnight
to 30 days or more.
 This short-term maturity and government backing
means repos provide lenders with extremely low
risk.
Repurchase agreement or Repo
There are also variations on standard repos:
 Reverse Repo - The reverse repo is the

complete opposite of a repo. In this case,

a dealer buys government securities from
an investor and then sells them back at a
later date for a higher price
 Term Repo - exactly the same as a repo

except the term of the loan is greater than

30 days.
 Certificate Of Deposit (CD)

 A certificate of deposit (CD) is a time deposit

with a bank.
 CDs are generally issued by commercial
banks but they can be bought through
brokerages.
 They bear a specific maturity date, a
specified interest rate, and can be issued in
any denomination, much like bonds.
 Like all time deposits, the funds may not
be withdrawn on demand
 CDs offer a slightly higher yield than T-
Bills because of the slightly higher default
risk.