Updated July 10, 2023
What is Money Market?
The term “money market” refers to the financial market where short-term and open-ended asset trading occurs. At the wholesale level, this is associated with large-volume trading between institutions and traders.
On the other hand, it involves investments in money market mutual funds by individual investors at the retail level. Commercial banks, non-banking finance corporations, and acceptance houses primarily make up the money market.
Features of Money Market
Some of the main features are as follows:
- Liquidity: These financial instruments are liquid as they are fixed-income securities traded in large volumes in the market and can be easily converted to cash.
- Safety: The issuers of these financial instruments tend to have healthy credit ratings, which indicates that the securities issued will be safe.
- Discounted Price: Given that these are debt instruments, they are issued at a discount and are redeemed at par; the difference is the profit or return on the investments.
How Does it Work?
The money market is an important part of the financial system of any nation. It encompasses overnight swaps of large amounts of money between commercial banks and the government. In addition, the wholesale transactions between financial institutions and large companies form a major part of the money market transactions.
Institutions like banks lend to each other and large companies; companies raise funds by issuing commercial papers purchased by other companies or institutions, and high net worth investors purchase bank certificates of deposit as a safe short-term investment option. Some of these wholesale transactions are pooled into financial instruments that make their way to retail investors through money market mutual funds.
Example of Money Market
While the money market helps the borrowers find short-term funding sources, it also offers easy liquid investment options to interested lenders and investors. Some of the most common examples include treasury bills, certificates of deposit, repurchase agreements, commercial papers, banker’s acceptances, money market mutual funds, etc.
Types of Money Market
The following are some of the major types:
1. Treasury Bills
These are considered the safest financial investments as the government fully guarantees their issuance. The Treasury regularly issues them to refinish the maturing Treasury bills and finance the federal government’s fiscal deficits. They are issued at a discount on their par value with a maturity period of one year or less. These instruments are purchased by broker-dealers, banks, individual investors, insurance companies, pension funds, and other large institutions.
2. Certificates of Deposit
These are directly issued by commercial banks and can be purchased through brokerage firms. These are issued in any denomination and the maturity periods fall from three months to five years. Most of these are offered at fixed interest rates and attract penalties if withdrawn before maturity.
3. Commercial Papers
Large corporations issued unsecured loans to fund their short-term capital needs, such as receivables and inventory. These are issued at a discount and redeemed at par value. Institutions with high credit ratings are only allowed to issue commercial papers, which makes them a safe investment option. These are issued with maturity periods ranging between one month and nine months. Individual investors can indirectly invest in these financial instruments through money market funds.
4. Banker’s Acceptances
These are short-term debts that are issued by firms but guaranteed by banks. These negotiable instruments provide the bearer the right to the money indicated on their face. These are used in international trading as they extend benefits to both the drawers and the bearers. Their maturity period falls from one month to six months from the date of issuance.
5. Repurchase Agreements
These short-term borrowing instruments involve selling securities with the agreement to repurchase them at a higher price later. They are often used by dealers in government securities who issue the Treasury bills to the lenders and promise to repurchase them at a pre-decided price later. These agreements usually mature in 15 days to a month or more.
Advantages of Money Market
Some of the major advantages are as follows:
- It is a haven when the stock market seems extremely volatile and investors seek a safer option. The reason is that these funds usually invest in low-risk vehicles.
- It mostly deals in fairly high-demand securities, which means they are more liquid and can be easily converted to cash without any significant loss in value.
Disadvantages of Money Market
Some of the major disadvantages are as follows:
- The investors may not earn high returns in the money market, which can adversely impact their ability to build wealth.
- Although money market instruments are considered relatively safe, there is still some risk as they are usually not insured by the government.
Key Takeaways
Some of the key takeaways of the article are:
- It involves the trading of large volumes of short-term and open-ended debt products.
- It is primarily made up of wholesale traders, like banks, large companies, and the government. However, retail investors may participate by purchasing money market mutual funds or similar products.
- It provides short-term funds for large borrowers and, at the same time, offers safe investment options for interested investors.
Conclusion
So, it offers virtually risk-free investment options but with low-interest rates. On the other hand, it is a great source of short-term funding for large institutions, corporates, and the government. Overall, it is a win-win situation for borrowers, lenders, and investors.
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