Lesson 10: The Money Market

Lesson 10: The Money Market

Stack of money
This is money. I am talking about the money market. You’re welcome.

The term money market is actually a great example of a misnomer. One might think that “money” in the form of currencies (Euros, U. S. dollars, Chinese Yen, etc.) are traded in this market.  This is incorrect. Instead the money market consists of highly liquid, short term debt investments.  The money market is the alternative to the capital markets which consist of longer term bonds and stocks.  An easy way to remember the difference is that if the asset is short term (it matures in one year), you are in the money market.  If the asset is long term (stocks, bonds, etc.) you are in the capital markets.

Financial Market Breakdown Chart
Here is a nifty breakdown to help remember.

Key Points

  • The money market is where short term debt instruments are traded.
  • Some of the key players in the money market include the U.S. Treasury, Federal Reserve, large companies, and individuals.
  • One of the main purposes of the money market is to house surplus funds and meet short term needs of funds.
  • Some of the securities traded in the money market include T-bills, commercial paper, federal funds, negotiable CDs, Eurodollars, and repurchase agreements.
  • The money market (mainly in the trading of T-bills) is where short term interest rates are determined.

What is the Money Market?

Say a company wants to build a new building or make a long term investment in a new product. A bond would be a perfect way for the company to raise a large amount of funds and pay it back over many years.  What if a company needs a smaller amount of cash for a quick payment (say to fill a small gap in the weekly payroll)? As the process for issuing bonds is very costly in terms of both dollar amount and time, it would be ineffective to issue bonds to address this small need of funds.  Thus in this case and others the money market instruments arose to fulfill the need of short term funds.

There are three common characteristics of money market instruments:

  1. Money market instruments mature in less than one year. Unlike bonds or stocks, money market instruments mature in less than one year than issue date whereas bonds mature in 5-10 years and stocks theoretically never mature.
  2. Money market instruments are highly liquid. The instruments in the money markets have high liquidity due to the large amount of participants and the large amount of funds that flow through the market.
  3. Money market instruments have low risk relative to the average risk of stocks and bonds. With their short maturities and high liquidity money market instruments in general possess very low risk when compared to their capital market counterparts.

Key Participants in the Money Market

The major participants in the money market include the U.S. Treasury, the U.S. Federal Reserve, large public companies, institutional investors, and individual investors.

  • U.S. Treasury: Remember those Treasury bonds that we mentioned in the bond market lesson? Well the U.S.
    Treasury Building
    This whimsical, fun looking building is the U.S. Treasury.

    Treasury also issues T-bills. We will discuss T-bill specifics later, but for now just now that the U.S. Treasury is the largest borrower of money market instruments which it uses to fund the federal debt.

  • Federal Reserve: The U.S. Federal Reserve (Fed) is the most influential player in the U.S. money market. It buys and sells vast amounts of T-bills to influence the money supply and short term interest rates in America.
  • Large Public Companies: Large companies participate in the money markets through buying and selling of securities.  One instrument associated with large companies in the money market is commercial paper which will be discussed later.
  • Institutional Investors: Due to their low risk many institutions (insurance companies, pension funds, etc.) will hold large amounts of money market instruments to generate investment returns while maintaining minimum risk.
  • Individual Investors: Primarily through the use of mutual funds (which we discuss in the next lesson) individual investors are able to participate in the buying and selling of the large dollar denomination securities in the money market.

Purpose of the Market

The primary purpose of the money markets is to provide a market that matches large amounts of excess funds from financial institutions to other firms and governments in need of short term funds.  Imagine a firm, let’s say Apple, has over $1 billion in excess cash.  What should Apple do with these funds? Furthermore let’s assume that the market for stocks and bonds has been volatile and therefore unusually risky lately.  One option is to buy money market instruments to generate higher return than the return that cash offers. (It is important to note that the return on cash is zero. Another way of thinking of this is cash in your wallet generates no return for you).  The money market allows Apple to invest in short term liquid securities that do not put Apple at significant risk and provides short term funds to other firms that need it.

Another way to think about the money market is imagine you as an individual have excess cash. One option you have is to go to a bank and put the money in a savings deposit.  The return on this account will be quite low. Now imagine there is a market where you can invest and get a slightly higher return with a corresponding slightly higher risk profile. You will provide the funds to institutions and businesses who have a short term need for funds and will compensate you with a higher rate for doing so.  This is the purpose of the money market.

Types of Money Market Instruments

  • T-bills: Treasury bills are issued by the U.S. Treasury Department and are used to finance the federal debt. The U.S. Treasury bill is arguably the most liquid and widely traded security in the world. As a result the interest rate offered on T-bills is used as a proxy for the short term risk-free rate.  T-bills do not pay interest and are instead sold at a discount and later matures at par value.  (Similar to the zero-coupon bonds discussed last chapter)
  • Federal Funds: Federal funds are short-term funds transferred between large financial institutions (usually larger commercial banks). Because banks must have minimum reserves relative to the amount of deposits they have, some banks need quick, overnight funds to avoid legal repercussions. As an investor you may hear the “federal funds rate” mentioned. This is the interest rate charged on these overnight bank loans.
  • Commercial Paper: Commercial paper are money market securities that are issued by corporations and mature in less than 270 days.  Commercial paper is offered directly from issuer to buyer and is used to fund the issuing companies’ activities.
  • Negotiable CDs: Negotiable certificates of deposit (CDs) are large, bank issued securities that range in value from $100,000- $10 million. Most individual investors will have little interaction with negotiable CDs, but it is worth noting that a negotiable CD is not the same instrument as the certificate of deposit that an individual can get at a consumer bank.
  • Repurchase agreements: Repurchase agreements (repos) occur when a firm sells Treasury securities and agrees to buy back the securities at a later date. In essence a repo is a short-term loan.  One firm sells the securities for quick funds and promises to rebuy the securities at a later date.  Repos are used by the Federal Reserve in conducting monetary policy.

The Risk Free Interest Rate

As mentioned above the T-bill is one of the most important securities within the financial markets.  The interest rate on the 3 month Treasury bill is commonly used as the “interest-free rate”. The interest free rate represents the return an investor should expect to earn on an investment with no risk. The T-bill is used for this theoretical rate because of its unparalleled liquidity and the ability of the U.S. Federal government to create more money to pay off the T-bill obligations as they come due.

 

Definitions

  1. Money market: The market for short term debt obligations used to facilitate short term borrowing and lending of excess funds.
  2. Interest free rate: The theoretical return an investor should earn on a security with zero risk. The interest rate on the 3-month Treasury bill is commonly used as a proxy for this theoretical rate.

Further Reading

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