What are “Money Markets”?
Money markets deal or trade-in high-quality debt instruments that mature in one year or less and are a crucial component of the financial system. The key function of money market instruments is to help institutions maintain liquidity. The money markets – via short-term debt instruments – provide companies, governments, and commercial banks with significant amounts of capital for periods ranging from overnight, a couple of days, weeks, or several months to less than a year. Money markets are a vital funding source for financial institutions.
The common types of money market instruments are government securities, (Treasury bills), repurchase agreements, commercial paper, federal funds, certificates of deposit, short-term, Eurodollars, banker’s acceptance, mortgage-backed securities, and asset-backed securities. Further, there are money market rates, such as LIBOR or EURIBOR, that provide benchmark rates vis-à-vis pricing of fixed income securities and loan contracts.
Key Learning Points
- Money markets provide short-term liquidity to the financial system
- The most common type of money market instruments are Treasury bills, commercial paper, certificates of deposit, and repurchase agreements
- There are four types of yield measures – money market: bank discount yield, holding period yield, effective annual yield, and money market yield
Money Market Instruments
Money market instruments generally have two core characteristics – liquidity and safety. The most common ones are:
Treasury Bills: these are the most marketable money market securities. Governments issue these bills to borrow money for a short period – with maturities ranging from 1 month to a year. These securities are sold at a discount (i.e. less than par value). The interest received is the difference between the purchase price and the par value. Treasury bills are considered the safest and most risk-averse investments. However, they provide lower returns than other money market instruments.
Commercial Paper: is a common type of short-term, unsecured debt instrument that is issued by large corporations and financial institutions – generally for a time period of up to 270 days. It is typically sold at discount to its face value and pays a fixed rate of interest to the holder of the instrument. Companies issue commercial paper to raise short-term funds, in order to meet their short-term financial obligations. It is considered a very cost-effective means of financing.
Certificates of Deposit: these short-term debt instruments are issued by commercial banks and other qualified financial institutions. They tend to be issued in large volumes by such institutions. When investors purchase certificates of deposit, they are lending to the institution who then pays them a rate of interest. The largest investors in this money market instrument are money market funds, corporations, local government agencies, and banks. The maturity period of certificates of deposit should not be less than 7 days and not more than a year. Certificates of Deposit may be issued at discount on face value.
Repurchase agreements: these are a form of short-term borrowing (used by several financial institutions, banks, and some companies) which involves the buying of securities with the simultaneous promise to sell them back at a pre-specified date (a later date – often the next day), at a higher price. The difference between a sale and the repurchase price of the security is reflective of the implied interest rate.
Money Market – Types of Yield Measures
There are four types of yield measures in the money market that one should be aware of. These are: bank discount yield, holding period yield, effective annual yield, and the money market yield.
Bank Discount Yield (BDY): is the annualized rate of return on a discount-based instrument such as treasury bills, commercial paper, etc. It is calculated using the formula below:
Bank Discount Yield (%) = D/F * 360/t
D= Face Value – Issue Price
t=Days to Maturity
Holding Period Yield: is the return on investment that is earned, if the instrument is held until maturity.
Holding Period Yield (%) = P1 – P0 + D1/P0
P0 = Purchase price of investment
P1 = Amount received at maturity
Effective Annual Yield: is the annualized holding period yield predicated on a 365-day year. It takes into account the impact of compounding interest.
Effective Annual Yield (%) = (1 + Holding Period Yield)^365/t -1
Money Market Yield: is the annualized holding period yield predicated on a 360-day year using simple interest.
Money Market Yield (%) = Holding Period Yield * 360/t
Money Market – Example
Given below is an example of a US Treasury bill with a face value of US$100 and 90 days to maturity. It is selling at a discount of US$4, so at a price of US$96. Based on this information, the four types of yield measures have been calculated below.