Types of Instruments Traded in the Money Market

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 FINANCIAL MARKETS:

Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly.

The two key financial markets are the money market and the capital market.

Transactions in short-term debt instruments, or marketable securities, take place in the money market. Long-term securities—bonds and stocks—are traded in the capital market.

To raise money, firms can use either private placements or public offerings.

A private placement involves the sale of a new security directly to an investor or group of investors, such as an insurance company or pension fund. Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public.

THE RELATIONSHIP BETWEEN INSTITUTIONS AND MARKETS:

Financial institutions actively participate in the financial markets as both suppliers and demanders of funds. The general flow of funds through and between financial institutions and financial markets as well as the mechanics of private placement transactions.

Flow of funds for financial institutions and markets:


THE MONEY MARKET:

 The money market is created by a financial relationship between suppliers and demanders of short-term funds (funds with maturities of one year or less).

The money market refers to trading in very short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by individual investors and money market accounts opened by bank customers.

Most money market transactions are made in marketable securities— short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by the government, business, and financial institutions, respectively. Investors generally consider marketable securities to be among the least risky investments available.

Types of Instruments Traded in the Money Market:

Several financial instruments are created for short-term lending and borrowing in the money market. They include:


1. Treasury Bills

Treasury bills are considered the safest instruments since they are issued with a full guarantee by the United States government. They are issued by the U.S. Treasury regularly to refinance Treasury bills reaching maturity and to finance the federal government’s deficits. They come with a maturity of one, three, six, or twelve months.

Treasury bills are sold at a discount to their face value, and the difference between the discounted purchase price and face value represents the interest rate. They are purchased by banks, broker-dealers, individual investors, pension funds, insurance companies, and other large institutions.

2. Certificate of Deposit (CD)

A certificate of deposit (CD) is issued directly by a commercial bank, but it can be purchased through brokerage firms. It comes with a maturity date ranging from three months to five years and can be issued in any denomination.

Most CDs offer a fixed maturity date and interest rate, and they attract a penalty for withdrawing prior to the time of maturity. Just like a bank’s checking account, a certificate of deposit is insured by the Federal Deposit Insurance Corporation (FDIC).

 3. Commercial Paper

Commercial paper is an unsecured loan issued by large institutions or corporations to finance short-term cash flow needs, such as inventory and accounts payables. It is issued at a discount, with the difference between the price and face value of the commercial paper being the profit to the investor.

Only institutions with a high credit rating can issue commercial paper, and it is therefore considered a safe investment. Commercial paper is issued in denominations of $100,000 and above. Individual investors can invest in the commercial paper market indirectly through money market funds. Commercial paper comes with a maturity date between one month and nine months.

4. Banker’s Acceptance

A banker’s acceptance is a form of short-term debt that is issued by a firm but guaranteed by a bank. It is created by a drawer, providing the bearer the rights to the money indicated on its face at a specified date. It is often used in international trade because of the benefits to both the drawer and the bearer.

The holder of the acceptance may decide to sell it on a secondary market, and investors can profit from the short-term investment. The maturity date usually lies between one month and six months from the issuing date.

5. Repurchase Agreements

A repurchase agreement (repo) is a short-term form of borrowing that involves selling a security with an agreement to repurchase it at a higher price at a later date. It is commonly used by dealers in government securities who sell Treasury bills to a lender and agree to repurchase them at an agreed price at a later date.

The Federal Reserve buys repurchase agreements as a way of regulating the money supply and bank reserves. The agreements’ date of maturity ranges from overnight to 30 days or more.

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