The money market is basically one of the component of the financial markets. The key feature of the money market is that at its fundamental level it involves trading of financial instruments which are
1) Debt based
2) Short term in nature (maturing in a year or less) and
3) Traded OTC (Over the counter) i.e. not on an exchange.
A typical money market transaction involves an entity (either a large corporation, a bank or the government) borrowing money and in exchange giving an IOU to the lender. The IOU among other things specifies when the amount which was borrowed needs to be repaid (usually ranging from overnight repayment to a year) and at what interest.
The IOU might or might not be backed by a collateral.The debt is considered secured if it is backed by a collateral and if not backed by a collateral then its unsecured.
The IOU might be issued by a bank (Certificate of deposit), a corporation (Commercial Paper, Bankers acceptance), or the government (T-Bills).
Purpose of the Money Market
The main purpose of the money market is to help large corporations, banks and the government to either
1) Raise money to meet their short term obligations.
2) Park surplus money for the short term.
3) Transfer large sums of money.
* The money markets are also used by the central banks to set short term interest rates.
Markets other than the Money markets
Some of the other components of the financial markets you might be familiar with include the stock market, bond market, commodities market, foreign exchange (forex) market among others. These components of the financial market are quite familiar to an individual investor because they can easily be accessed via a broker and an average investor can trade/invest securities on them and try to make a profit. In contrast money markets, for the most part, are out of reach from the average investor.
Okay, so money markets are debt based. So how are they different from the bond market then?
Money market vs Bond market
Both money markets and bond markets do indeed broadly come under the fixed income market but there are a few key differences between the money market and bond market.
1) Money market deals with financial instruments that are very short term in nature (maturing usually in less than a year) unlike the bond market which deals with fixed income securities that are of longer term (maturing in more than a year).
2) Money market usually deals with securities that are of very high denomination, often in multiples of $1,000,000 and are therefore out of reach for an individual investor unlike the bond market. (However, its possible for an individual investor to invest in money market instruments with the help of money market mutual funds which we will be dealing with in the next article)
3) Trading in the money markets is done exclusively OTC (over the counter). While a large proportion of trading in the bond market is done OTC, a relatively small proportion of bonds are also listed and traded on the exchange (stock exchange).
4) Almost all the money market instruments are considered extraordinarily safe and are highly liquid due to their short term nature and high credit quality. In contrast, not all the securities on the bond market are of investment grade.
Money market instruments
Some of the common money market instruments include
1) Treasury bills
2) Commercial paper
3) Certificate of deposit
4) Repurchase agreements (involving secured/collateralized borrowing/lending)
5) Federal funds (involving unsecured interbank borrowing/lending)
6) Bankers Acceptance
7) Short term asset backed securities
8) Negotiable instruments (Promissory note & Bill of exchange)Now lets look at each of the above mentioned money market instrument and try to understand what they are about.
1) T-Bills (Treasury bills)
T-Bills are short term IOU’s issued by the government of a country. In case of most countries the treasury bills are issued by the government through the central bank of that country.
Purpose – T-Bills help the government of a country to raise money from the public.
Basically they are short term (maturing in less than a year) highly liquid securities (very easy to sell/buy them) and are considered extremely safe as they are backed by the government.
In case of the US, the US issues T-Bills which mature in 3, 6 or 12 months. They are issued at a discount to the face value and the government pays the full par value when the T-Bill matures. They are among the few money market instruments accessible to the individual investor as their denomination starts from $1,000 and proceeds to $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million.
2) Commercial paper
Commercial paper are short term IOU’s issued by corporations. They are unsecured (i.e. not backed by a collateral).
Purpose – Commercial paper help large corporations to borrow money in order to meet short term obligations.
Since commercial paper are unsecured, only large corporations (blue-chip companies) with good credit ratings would be able to raise money with reasonable interest rates.
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