A Money Market Is A Financial Market For Shor1

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A money market is a financial market for short-term borrowing and lending, typically up

to thirteen months. This contrasts with the capital market for longer-term funds. In the
money markets, banks lend to and borrow from each other, short-term financial
instruments such as certificates of deposit (CDs) or enter into agreements such as
repurchase agreements (repos). It provides short to medium term liquidity in the global
financial system. Money market derivatives include forward rate agreements (FRAs) and
short-term interest rate futures.

Trading takes place between banks in the "money centers" (London, New York and
Tokyo primarily, also Charlotte, Chicago, Frankfurt, Hong Kong, Mumbai, Paris,
Sydney, San Francisco, Singapore, and Toronto).

[edit] Common money market instruments


• Bankers' acceptance - A draft or bill of exchange accepted by a bank to guarantee
payment of the bill.
• Certificate of deposit - A time deposit with a specific maturity date shown on a
certificate; large-denomination certificates of deposits can be sold before
maturity.
• Commercial paper - An unsecured promissory note with a fixed maturity of one to
270 days; usually it is sold at a discount from face value.
• Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch
located outside the United States.
• Federal Agency Short-Term Securities - (in the US). Short-term securities issued
by government sponsored enterprises such as the Farm Credit System, the Federal
Home Loan Banks and the Federal National Mortgage Association.
• Federal funds - (in the US). Interest-bearing deposits held by banks and other
depository institutions at the Federal Reserve; these are immediately available
funds that institutions borrow or lend, usually on an overnight basis. They are lent
for the federal funds rate.
• Municipal notes - (in the US). Short-term notes issued by municipalities in
anticipation of tax receipts or other revenues.
• Repurchase agreements - Short-term loans—normally for less than two weeks and
frequently for one day—arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.
• Treasury bills - Short-term debt obligations of a national government that are
issued to mature in 3 to 12 months. For the U.S., see Treasury bills.(In USA)it is
issued for 91 and 92days every week.
• Money market mutual funds - Pooled short maturity, high quality investments
which buy money market securities on behalf of retail or institutional investors.

The money market is better known as a place for large institutions and government to manage
their short-term cash needs. However, individual investors have access to the market through a
variety of different securities. In this tutorial, we'll cover various types of money market securities and how
they can work in your portfolio.

The money market is a subsection of the fixed income market. We generally think of the term fixed income
as being synonymous to bonds. In reality, a bond is just one type of fixed income security. The difference
between the money market and the bond market is that the money market specializes in very short-term
debt securities (debt that matures in less than one year). Money market investments are also called cash
investments because of their short maturities.

Money market securities are essentially IOUs issued by governments, financial institutions and large
corporations. These instruments are very liquid and considered extraordinarily safe. Because they are
extremely conservative, money market securities offer significantly lower returns than most other securities.

One of the main differences between the money market and the stock market is that most money market
securities trade in very high denominations. This limits access for the individual investor. Furthermore, the
money market is a dealer market, which means that firms buy and sell securities in their own accounts, at
their own risk. Compare this to the stock market where a broker receives commission to acts as an agent,
while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of
a central trading floor or exchange. Deals are transacted over the phone or through electronic systems.

The easiest way for us to gain access to the money market is with a money market mutual funds, or
sometimes through a money market bank account. These accounts and funds pool together the assets of
thousands of investors in order to buy the money market securities on their behalf. However, some money
market instruments, like Treasury bills, may be purchased directly. Failing that, they can be acquired through
other large financial institutions with direct access to these markets.

There are several different instruments in the money market, offering different returns and different risks. In
the following sections, we'll take a look at the major money market instruments.

Money Market: Treasury Bills (T-Bills)


Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their
simplicity. Essentially, T-bills are a way for the U.S. government to raise money from the public. In this
tutorial, we are referring to T-bills issued by the U.S. government, but many other governments issue T-bills
in a similar fashion.

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. Effectively, your
interest is the difference between the purchase price of the security and what you get at maturity. For
example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your
investment. This differs from coupon bonds, which pay interest semi-annually.

Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If
you want to buy a T-bill, you submit a bid that is
prepared either non-competitively or competitively.
In non-competitive bidding, you'll receive the full
amount of the security you want at the return
determined at the auction. With competitive
bidding, you have to specify the return that you
would like to receive. If the return you specify is too high, you might not receive any securities, or just a
portion of what you bid for. (More information on auctions is available at the TreasuryDirect website.)

The biggest reasons that T-Bills are so popular is that they are one of the few money market instruments
that are affordable to the individual investors. T-bills are usually issued in denominations of $1,000, $5,000,
$10,000, $25,000, $50,000, $100,000 and $1 million. Other positives are that T-bills (and all Treasuries) are
considered to be the safest investments in the world because the U.S. government backs them. In fact, they
are considered risk-free. Furthermore, they are exempt from state and local taxes. (For more on this, see
Why do commercial bills have higher yields than T-bills?)

The only downside to T-bills is that you won't get a great return because Treasuries are exceptionally safe.
Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest.
What's more, you might not get back all of your investment if you cash out before the maturity date.

Money Market: Commercial Paper


For many corporations, borrowing short-term money from banks is often a laborious and annoying task. The
desire to avoid banks as much as possible has led to the widespread popularity of commercial paper. (See
Why do companies issue bonds instead of borrowing from the bank?)

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.

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. Over the past 40 years, there have only been a handful of
cases where corporations have defaulted on their commercial paper repayment.

Commercial paper is usually issued in denominations of $100,000 or more. Therefore, smaller investors can
only invest in commercial paper indirectly through money market funds.

Money Market: 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 (from three months to five
years), 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 like those in a checking account.

CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank but, overall,
the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn
depends on a number of other factors such as the current interest rate environment, how much money you
invest, the length of time and the particular bank you choose. While nearly every bank offers CDs, the rates
are rarely competitive, so it's important to shop around.

A fundamental concept to understand when buying a CD is the difference between annual percentage
yield (APY) and annual percentage rate (APR). APY is the total amount of interest you earn in one year,
taking compound interest into account. APR is simply the stated interest you earn in one year, without
taking compounding into account. (To learn more, read APR vs. APY: How The Distinction Affects You.)

The difference results from when interest is paid. The more frequently interest is calculated, the greater the
yield will be. When an investment pays interest annually, its rate and yield are the same. But when interest is
paid more frequently, the yield gets higher. For example, say you purchase a one-year, $1,000 CD that pays
5% semi-annually. After six months, you'll receive an interest payment of $25 ($1,000 x 5 % x .5 years).
Here's where the magic of compounding starts. The $25 payment starts earning interest of its own, which
over the next six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result, the rate on the CD is 5%,
but its yield is 5.06. It may not sound like a lot, but compounding adds up over time.

The main advantage of CDs is their relative safety and the ability to know your return ahead of time. You'll
generally earn more than in a savings account, and you won't be at the mercy of the stock market. Plus, in
the U.S. the Federal Deposit Insurance Corporation guarantees your investment up to $100,000.

Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry compared
to many other investments. Furthermore, your money is tied up for the length of the CD and you won't be
able to get it out without paying a harsh penalty.
Money Market: 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. This is especially useful when the creditworthiness of a foreign trade partner is unknown.

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 Year -$20,000
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.

Money Market: Eurodollars


Contrary to the name, eurodollars have very little to do with the euro or European countries. Eurodollars are
U.S. dollar-denominated deposits at banks outside of the United States. This market evolved in Europe
(specifically London), hence the name, but eurodollars can be held anywhere outside the United States.

The eurodollar market is relatively free of regulation; therefore, banks can operate on narrower margins than
their counterparts in the United States. As a result, the eurodollar market has expanded largely as a way of
circumventing regulatory costs.

The average eurodollar deposit is very large (in the millions) and has a maturity of less than six months. A
variation on the eurodollar time deposit is the eurodollar certificate of deposit. A eurodollar CD is basically
the same as a domestic CD, except that it's the liability of a non-U.S. bank. Because eurodollar CDs are
typically less liquid, they tend to offer higher yields.

The eurodollar market is obviously out of reach for all but the largest institutions. The only way for individuals
to invest in this market is indirectly through a money market fund.

Money Market: Repos


Repo is short for repurchase agreement. 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.
Repos are popular because they can virtually eliminate credit problems. Unfortunately, a number of
significant losses over the years from fraudulent dealers suggest that lenders in this market have not always
checked their collateralization closely enough.

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.
Money Market: Conclusion
We hope this tutorial has given you an idea of the securities in the money market. It's not exactly a sexy
topic, but definitely worth knowing about, as there are times when even the most ambitious investor puts
cash on the sidelines.

• The money market specializes in debt securities that mature in less than one year.
• Money market securities are very liquid, and are considered very safe. As a result, they offer a
lower return than other securities.
• The easiest way for individuals to gain access to the money market is through a money market
mutual fund.
• T-bills are short-term government securities that mature in one year or less from their issue date.
• T-bills are considered to be one of the safest investments - they don't provide a great return.
• A certificate of deposit (CD) is a time deposit with a bank.
• Annual percentage yield (APY) takes into account compound interest, annual percentage rate
(APR) does not.
• CDs are safe, but the returns aren't great, and your money is tied up for the length of the CD.
• Commercial paper is an unsecured, short-term loan issued by a corporation. Returns are higher
than T-bills because of the higher default risk.
• Banker's acceptances (BA)are negotiable time draft for financing transactions in goods.
• BAs are used frequently in international trade and are generally only available to individuals
through money market funds.
• Eurodollars are U.S. dollar-denominated deposit at banks outside of the United States.
• The average eurodollar deposit is very large. The only way for individuals to invest in this market is
indirectly through a money market fund.
• Repurchase agreements (repos) are a form of overnight borrowing backed by government
securities.

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