8463683689_baa33ca431What is the Money Market? An Introduction – Part 2 of 2

Certificate of deposit

Most of the confusion surrounding certificate of deposit comes from the fact that its called by various names in other countries. For example, in

  • India it goes by the name of – Fixed deposit
  • UK – Bond
  • Australia, New Zealand – Term deposit
  • USA – Certificate of deposit/ Time deposit.

Certificate of deposit is basically a “certificate” issued by banks. The certificate among other things mentions the interest which the bank pays on the deposit and the time period after which the deposit can be withdrawn (premature withdrawal usually warrants a penalty).

A typical transaction involves an individual going to the bank to deposit his money for a fixed period of time (say 3 years) at a fixed interest rate (say 1.450% APY – Annual Percentage Yield) and the bank in return gives him a certificate of deposit with all the details.

Should the individual withdraw the money prior to completion of the three years then there would be a penalty on the withdrawal.

Term deposits are quite the opposite of savings account/checking account. In the case of the latter the individual can withdraw the money at any time without any penalty. That is the reason why savings/checking account pay a lower interest than certificates of deposit/term deposit.

Repurchase Agreements (RP)

Repurchase agreements involve two parties.
The repurchase transaction occurs as follows

Lets say,
Party A is the one lending the money (Say, the US Fed)
Party B is the one borrowing the money (Say, a large bank)
RP Security refers to the Repurchase Agreement.
1) Party A (the Fed) buys the RP security from Party B (the bank) and gives money in return (basically acting as a lender).
2) Party B (the bank) sells the RP security to Party A (the fed) and gets money in return (basically acting as a borrower).
1) Party A (the Fed) sells back the RP security to Party B (the bank) and gets money + interest in return (the lender gets back his money + interest).
2) Party B (the bank) buys back the RP security from Party A (the Fed) and gives the money he borrowed + interest in return (the borrower gives back the money + interest).
The interest that is paid by the borrower (Party B/the bank in the above example) to the lender (Party A/the Fed) is called the Repo rate. All repo transactions are secured (unlike federal funds as we see later) in that a collateral needs to be given by the borrower (Party B) to the lender (Party A).
Federal Funds

All banks have to maintain a certain amount of reserves with the central bank (in the form of cash or deposits). Sometimes some banks have an excess while other banks have a deficit of these reserves. The banks with excess reserves lend (usually on an overnight basis) to the banks with deficit reserves at an interest (called the fed funds rate).

Its important to realize that these transactions don’t increase the money supply in the system. Its just a way for banks to fulfill their reserve requirements (or sometimes clear financial transactions) by borrowing and lending among themselves.

Another important point is that federal funds are unsecured. The borrowing bank doesn’t need to give a collateral to borrow from the lending bank. Hence, the federal funds rate is usually higher than the repo rate.

Bankers Acceptance

A bankers acceptance is pretty similar to a post-dated check. In other words, its a future payment accepted and guaranteed by a bank. The bankers acceptance note among other things contains details of

1) Whom to be paid
2) At what future date to be paid &
3) How much to be paid.

Since bankers acceptance are generally used in international trade transactions, lets see how a typical transaction looks like

Lets say that a firm DBZ Ltd located in the US wants to buy 10 laptops from Kyoto Electronics Ltd located in Japan.

1) DBZ Ltd first takes the laptop purchase contract and visits its bank, the USX Bank and applies for a letter of credit (a letter of credit here basically means that USX Bank guarantees the payment to Kyoto Electronics Ltd provided the delivery of the 10 laptops is done as per the contract).

2) However since Kyoto Electronics Ltd is not quite familiar with the USX Bank, it asks one of its bank, JPX Bank to check and confirm the letter of credit.

3) As per the agreement Kyoto Electronics ships the 10 laptops and delivers them to DBZ Ltd. After that is done, Kyoto Electronics Ltd provides the shipping documents along with the draft (which was negotiated earlier in the letter of credit) to JPX bank which forwards it to USX bank.

4) USX bank checks if everything is done as per the terms and conditions and finally stamps the draft as “accepted” – Hence the term Bankers acceptance.

5) DBZ Ltd is required to pay USX bank (presumably within 90 days or as stated in the initial letter of credit). USX bank uses those funds to pay Kyoto Electronics Ltd within (say) 90 days. The accepted draft (or bankers acceptance as its called now) is now given to Kyoto Electronics (via JPX Bank).

6) Kyoto Electronics Ltd may either hold the bankers acceptance till maturity (90 days) and get the money or it can sell it to another investor (at a discount to the face value).

Short term asset backed securities

As their name indicate, they are short term securities with (regular) income payments. These securities are collateralized (secured) by a pool of assets. The process of pooling the assets into financial instruments called asset-backed securities is called securitization.

In case of a default (non payment), the underlying assets may be liquidated to partially (or fully) recover the losses.

* A form of asset backed securities called Sub-prime MBS (Sub-prime mortgage backed securities) were responsible for the housing bubble and subsequent bust of 2007 in the US.

Negotiable Instrument

A negotiable instrument is basically a signed document which guarantees the payment of a specific amount of money either on demand or at a set future date.

The payment may be either to the bearer of the instrument or to a specific person/firm.

Does this ring a bell?

Yup, bankers acceptance & certificate of deposit (which we discussed earlier) are also a type of negotiable instrument.

Now that we know a bit about some of the money market instruments, lets have a look at money market mutual funds in the next article.

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I go by my online nick Sengukoi. I have various interests of which finance, economics and the markets are some of the ones at the top of the list. Connect with Sengukoi on Google+

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