The money market is an investment area where investors can buy short-term debt securities. Money market investments are the short-term debts of governments, banks, financial institutions and corporations that mature in anywhere from one day to one year. The vast majority of investors in these securities are institutions; few are individuals.
Larger securities broker-dealer firms and large commercial banks usually handle money market securities.
This tutorial will cover seven areas of the money market:
WHAT MAKES A MONEY MARKET INVESTMENT?
Money market securities are highly marketable and are quickly convertible into cash (making them very liquid). They also have the shortest maturities of any debt securities. Money markets are used to invest great amounts of cash safely for short periods.
To be classified as a money market instrument, a debt must meet the following criteria:
- Un-collateralized short-term (one year or less) debt of an issuer with a high credit standing.
- Very marketable, readily transferable, and very acceptable to institutional investors.
- Non-interest bearing "discount paper" quoted by using annualized discount yield, which is the way money market securities are quoted (negotiable CD's are an exception).
We will begin to cover types of money market investments now, beginning with a variation on the certificate of deposit.
NEGOTIABLE CERTIFICATES OF DEPOSIT
Negotiable certificates of deposit are issued in denominations over $100,000. They are sold on the open market. The depositor of a negotiable CD is allowed to negotiate the interest rate with the bank.
The secondary market is where investors can sell their CDs to other investors before maturity if they need cash. However, the CDs must be $1 million or more in value to be traded.
Negotiable CDs have maturities ranging from 14 days to more than one year. Their rates are closely tied to the going rate of Treasury bills. They are the only interest-bearing money market instruments. They are liquid and considered relatively safe. The NASDAQ will quote negotiable CDs, but they must have a minimum maturity of 14 days to be quoted.
Credit unions issue negotiable certificates of deposit called credit union shares.
Read below to learn about Treasury Bills.
TREASURY BILLS
The Treasury department sells T-bills at weekly auctions every Monday at New York City's Federal Reserve Bank. The Federal Reserve Board acts as the fiscal agent and conducts the auction, called a yield auction. The bills are sold at discounts. The investors in attendance bid on how much the bills are worth to them that day. The winning bidders pay on the following Thursday. The Federal Reserve System, participating banks and the Treasury Department record their ownership of the T-bills in book-entry form.
Bids over $1 million are called competitive bids; those less than $1 million are non-competitive bids. T-Bills are sold at competitive bids first. The remaining T-Bills are then sold non-competitively for the average price of the winning competitive bids.
Both institutional and private investors may bid on Treasury bills. Institutional investors include banks, governments, mutual funds, etc. Broker-dealers also buy T-bills for resale in the secondary market. Before bidding, however, any prospective investor must demonstrate to the Fed that it is in good financial shape.
COMMERCIAL PAPER
Commercial paper is an unsecured short-term IOU issued by corporations with good credit. Proceeds are usually used to buy inventories. Both corporations and individuals buy commercial paper. Banks and brokerage houses buy it to resell to individuals in smaller lots. Most of the companies that buy this investment do so because they have temporary reserves of money that would otherwise sit idle.
Most large, established companies sell commercial paper. Banks sell bank paper, and finance companies sell finance paper. Commercial paper is considered relatively safe.
Maturities of commercial paper range from a few days up to 270 days. Amounts sold range from $25,000 to the millions. These notes are sold at discount.
BANKER'S ACCEPTANCES
Banks use banker's acceptances to finance importing and exporting with firms in foreign countries. They work in the following way: an importer's bank backs the importer by paying the foreign party on the importer's behalf. The importer is then obliged to repay the bank within a period of three to six months. If the bank so desires, it may sell the contract before it is repaid as a way to replenish its cash. This feature makes it highly liquid. The bank is liable for payment if the importer defaults.
Banker's acceptances are usually issued in denominations over $100,000 and are sold at discounts. Their maturities range from 30 to 180 days and their yields are a little less than those of CDs.
Read below to learn about repurchase agreements.
REPURCHASE AGREEMENTS
A repurchase agreement (repo) is a contract between a buyer and a seller of debt securities stating that the seller will repurchase the securities after a certain length of time or after certain conditions have been met. The contract requires that the seller repurchase the securities later for a price higher than what it was originally sold for. This difference between what the buyer paid, and what the seller paid for repurchase, is called the repo rate.
Term repos are repurchase agreements for periods of 30 to 90 days. They cannot be sold on the open market because they are tailored to the original buyers' and sellers' needs. Overnight repos last only one day. This puts them at the shortest end of the maturity spectrum.
The advantage of a repurchase agreement is that the seller can get needed cash for short-term use without really losing control of their investment portfolio. Because the repurchase agreement specifies the repo rate, the seller may earn a higher return on the repurchased portfolio than with the repo rate.
Click here to learn how investors who want to participate in the money market but lack the large amounts of money needed have an option of their own.
MONEY MARKET MUTUAL FUNDS
Money market mutual funds (MMMF) bring the market for T-bills, commercial paper and other such investments to the small investor. For an initial investment as low as $500 (depending on the fund), you can get in on the market for high-yielding, short-term investments without having to hand over thousands per investment. The funds pool money from large numbers of investors and use it to buy these securities.
You can buy tax-exempt money funds, which invest in tax-exempt municipal securities. You can also buy government securities money funds, which buy short-term U.S. Treasury securities.
The returns in an MMMF rise and fall as money market rates themselves raise and fall. Because they can be volatile, your mutual fund's yields may vary greatly. Money market mutual funds are considered very safe, because the securities they buy are liquid short-term debts.
SOME FINAL WORDS
Current information on the rates of return on money instruments can be found in the financial section of most large newspapers and in other financial media.
Like all investments, money market instruments have risks. Study all investements carefully before making a decision on which investment best meets your individual needs, goals, and characteristics.
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