The money market is referred to as dealing in debt instruments with less than a year to maturity bearing fixed income. In this article, we will Learn the meaning of money market instruments and their types and objectives.
What Is the Money Market?
A Money Market is a financial market where short-term financial assets having liquidity of one year or less are traded on stock exchanges. The securities or trading bills are highly liquid. Also, these facilitate the participant’s short-term borrowing needs through trading bills. The participants in this financial market are usually banks, large institutional investors, and individual investors.
The Reserve Bank controls the interest rate of various instruments in the money market. The degree of risk is smaller in the money market. This is because most instruments have a maturity of one year or less.
In all of these cases, the money market is characterized by a high degree of safety and relatively low rates of return.
Understanding the Money Market
The money market is one of the pillars of the global financial system. It involves overnight swaps of money between banks and the U.S. government. The majority of money market transactions are wholesale transactions that take place between financial institutions and companies.
Institutions that participate in the money market include banks that lend to one another and to large companies in the eurocurrency and time deposit markets; companies that raise money by selling commercial paper into the market, which other companies or funds can buy; and investors who purchase bank CDs as a safe place to park money in the short term. Some of those wholesale transactions eventually make their way into the hands of consumers as components of money market mutual funds and other investments.
Types of Money Market Instruments
A Money Market is an exchange where the trade of cash and cash-equivalent instruments takes place. The instruments traded in the money markets have maturities that can vary from overnight to one year. Here are some key money market instruments in India:
1) Treasury Bills or T-Bills–
The Government of India issues treasury bills to raise funds for up to 365 days. Since the government issues these, they are considered very safe. However, lower risks also translate into lower returns which is the case with treasury bills. The returns on T-bills are lower than other money market instruments.
2) Certificate of Deposit or CD–
Most certificates of deposit are not strictly money market funds because they are sold with terms of up to 10 years. However, CDs with terms as short as three to six months are available.
As with money market accounts, bigger deposits and longer terms yield better interest rates. Rates in August 2021 for 12-month CDs ranged from about 0.50% to 0.70%, depending on the deposit size. Unlike a money market account, the rates offered with a CD remain constant for the deposit period. A penalty is usually associated with an early withdrawal of funds deposited in a CD.
3) Commercial Paper-
Companies and financial institutions with a high credit rating can issue a commercial paper or a short-term, unsecured promissory note. It allows such entities to diversify their short-term borrowing sources. CPs are usually issued at a discounted rate, while the redemption is done at face value. The investor earns the difference.
4) Money Market Funds-
The wholesale money market is limited to companies and financial institutions that lend and borrow from $5 million to over $1 billion per transaction. Mutual funds offer baskets of these products to individual investors. Such funds’ NAV is intended to stay at $1. During the 2008 financial crisis, one fund fell below that level. That triggered market panic and a mass exodus from the funds, ultimately leading to additional restrictions on their access to riskier investments.
5) Money Market Accounts-
Money market accounts are a type of savings account. They pay interest, but some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. Banks typically calculate interest on a money market account daily and make a monthly credit to the account.
Money market accounts generally offer slightly higher interest rates than standard savings accounts. But the difference in rates between savings and money market accounts has narrowed considerably since the 2008 financial crisis. Average interest rates for money market accounts vary based on the amount deposited.
6) Repos-
The repurchase agreement (repo), is part of the overnight lending money market. Treasury bills or other government securities are sold to another party with an agreement to repurchase them at a set price on a set date.
Functions of Indian money markets
The instruments of this market are liquid when we compare them with other financial instruments. We can convert these instruments into cash easily. Thus, they can address the need for the lenders’ short-term surplus funds and the borrowers’ short-term fund requirements.
The major functions of such market instruments are to cater to the short-term financial needs of the economy. Some other functions are as follows:
- It helps in the effective implementation of the RBI’s monetary policy.
- This market helps to maintain demand and supply equilibrium about short-term funds.
- It also meets the need for short-term fund requirements of the government.
- It helps maintain liquidity in the economy.
One important consideration about money market investment is that retail investors have very limited scope for directly participating in it. Recently NSE being offering some instruments of the money market for retail investors. However, due to the large ticket size of trade and low liquidity, it is out of reach of retail investors. But nothing to worry much about on this front. As retail investors in India, you can passively invest in any such instruments through money market mutual funds.
Advantages and Disadvantages of Money Markets
There are several pros and cons of money market investments. Most money market securities are considered extremely low-risk due to the protection of FDIC insurance, backing by a government or bank, or the high creditworthiness of the borrowers. They are also very liquid, which can readily be exchanged for cash at short notice.
The tradeoff of having low risk is that these investments also have low returns. Not only do money markets underperform other asset classes, they often don’t even keep pace with inflation. In addition, any fees associated with an account can easily eat into those slim returns.
Moreover, these advantages do not extend to all money market securities. Some are not FDIC insured, and there is a chance that even the most trustworthy borrowers may default. Some money market accounts have minimum balance requirements or restrictions on withdrawals.
Pros and Cons of Money Market Accounts
Pros
- Extremely low risk.
- FDIC may insure it.
- Highly liquid.
- Higher returns than most bank accounts.
Cons
- Low returns that may not keep pace with inflation.
- Not all money market securities are insured.
- It may have high minimum investments or withdrawal restrictions.
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