The Money Market
I. Introduction
In the field of finance, the money market refers to a market for short term debt.
Any transaction, which involves the exchange of debt claims, having maturities less
than or equal to one year, are part of the money market. Sometimes these transactions
are for overnight credit only, and often they take the form of a short term loan or
accommodation.
Most small investors cannot transact in the money market because the face values
(or the denominations) of the instruments are too high, usually $10,000 and often
above $100,000. This means that most transactions are among banks, corporations,
pension funds, insurance companies, and the government. In addition to primary
markets in these debt claims, some instruments trade on secondary markets, usually
OTC.
The list of money market instruments is quite long and includes such things as
Treasury Bills (T-Bills), negotiable certificates of deposit (NCD's), bankers
acceptances (BA's), repurchase agreements (repos), commercial paper (CP's), Federal
funds and central bank loans, and Eurodollar loans. Each of these instruments are
created for a specific purpose. For example, the US Federal government issues TBills to fund its spending rather than use taxes. Bankers acceptances result from
international trade, while commercial paper is often used to finance short term
expenses of business.
Once this debt has been issued, it can often be traded in secondary markets. This
is especially true of NCD's and T-Bills. However, CP's are generally not traded in the
US on a secondary market. The 90 day T-bill is a closely watched financial
instrument. Like all money market debt, its maturity is less than one year and its
interest rate is quoted on a discount basis. This means that the T-Bill always sells for
less than its face value. The discount rate on the T-Bill is calculated by expressing the
discount as a percentage of the face value, multiplying by 360, and then dividing by
the term of the bill. For example, a $1,000,000 90 day T-Bill having 30 days left till
maturity which is selling for $995,000 has a discount rate of 6.0%. Note however that
this does not mean that the annual rate of interest is 6.0%. The annual rate of interest
for this T-Bill is slightly higher at 6.2%. Discount rates are always less than their
annualized rates. Care must be taken when reading rates to avoid confusing discount
rates with annualized interest rates.
II. Examples and Uses of Money Market Instruments
Money market instruments arise in a number of ways. T-Bills are issued by the
Treasury Department of the US Federal Government, and are sold at auctions every
week. T-Bills can also be bought by wealthy individual investors at any Federal
Reserve Bank, but the lowest denomination is $10,000. Once T-Bills are sold they
can be traded in the secondary market over the counter. There is no established
exchange for T-Bills. T-Bills are an important investment tool for portfolio managers
who want to reduce their risks. We often say that the T-Bill rate is a riskless rate of
interest. The government will not default on this debt since it always has the power to
tax.
Negotiable certificates of deposit (NCD's) are issued by banks to attract funds to
lend and to meet reserve obligations. The term negotiable means that the holder of the
NCD can transfer ownership over the debt at any time. Often large businesses will
buy NCD's when they have a sudden increase in cash flow. Small investors rarely
have sufficient funds to purchase NCD's.
Commercial paper (CP) is basically a short term, unsecured promissory note. It
is often issued to finance short term current expenditures and to raise funds for
alternative investments. Only large and financially sound corporations can issue high
quality commercial paper. The maturity on most commercial paper is less than 270
days, since any maturity exceeding this must be registered with the Securities and
Exchange Commission (SEC), and such registration can be costly. Often large
corporations will issue commercial paper directly to investors, while smaller
corporations may use underwriters to sell them.
Federal Funds, or what we simply call Fed Funds, are very short term loans made
between banks. Each bank has an account with the central bank (called the Fed), and
banks which have surplus reserves can loan them to other banks which have deficit
reserves. The interest rate charged on such loans is called the Federal Funds rate.
Often Fed Funds are loaned for only 24 hours. An alternative to borrowing Fed Funds
is to borrow from the Fed itself. The interest rate charged by the Fed to banks for
these types of loans is called the Federal Reserve discount rate. Naturally, the Fed
Funds rate and the Federal Reserve discount rate are closely related and are carefully
watched by investors.
Bankers acceptances typically arise from international trade. When an exporter
sells goods internationally, he will receive his money in the form of a bank draft
which is accepted now for payment at a later date by the importer's bank. This draft is
really a short term debt claim owned by the exporter. If he wishes, he can discount
this bankers acceptance with his own bank. Once the draft has been accepted, it
becomes a negotiable instrument and part of the money market.
Repurchase agreements (or repos) often occur when a company has excess cash
and wants to invest it for a short period of time. The company can purchase a
financial instrument (e.g. a T-Bill) from a bank with the condition that the bank will
repurchase the same security 24 hours later at a slightly higher price. The bank gets
the use of the funds for 24 hours, and the company gets interest on its money. Repos
are an important alternative to Fed Funds and direct loans from the Fed.
Eurodollars consist of all US dollar deposits held in banks outside the US. These
banks are not necessarily located in Europe; they can be in Asia or Latin America, as
well. Such banks make short term US dollar loans, often to banks located in the US.
It is important to note that Eurodollar deposits are really claims to US dollars in the
US. The US dollars never leave the US banking system; instead when Eurodollars are
created the ownership of US dollars merely changes from US to foreign entities.
III. The Importance of the Money Market
The money market is where short term interest rates (or more precisely, discount
rates) are determined. When more money market instruments are issued, the supply of
short term debt increases and their prices fall. This causes short term interest rates to
rise. The supply of short term debt increases whenever there is a stronger demand for
liquidity. An increase in the supply of short term debt is often associated with an
increase in the demand for money the most liquid of all assets. This is why we call
this market the
money market”.
As one might expect, demand for short term debt is largely governed by the
amount of liquidity in the economy. That is, it is determined mainly by the supply of
money. If the government supplies more money to the economy, the short run effect
should be to raise the prices on money market instruments, and therefore to lower
their yields. Short term interest rates would therefore tend to fall when the supply of
money increases.
The importance of short term interest rates is that they are related to long term
interest rates through the term structure. The term structure of interest rates is a curve
showing the yields to maturity for short, middle, and long term debt. In general, the
term structure curve slopes upward since long term interest rates are greater than short
term interest rates. Unfortunately, there is no generally accepted theory explaining the
relationship between short term and long term rates. Higher short term rates may at
times cause long term rates to rise if credit is sufficiently restricted. At other times, it
may lower long term rates, if expected inflation falls. Ideally, reductions in short term
rates would lead to lower long term rates, and this would stimulate business and
consumer spending.
Another important aspect of the money market is that short term rates can have a
substantial effect on the movement of exchange rates. A change in short term interest
rates tends to attract funds from abroad. When these foreign funds are sold for US
dollars, the exchange rate falls and the US dollar appreciates. When the dollar
appreciates, US firms find it difficult to export, and therefore this source of demand
for US goods is weakened.
Short term interest rates generally rise when the economy is expanding and fall
during recessions. The reason for this is simple. As demand increases, firms find it
useful to borrow short term to finance greater inventory. Also, an expansion in the
economy causes new business starts to increase and leads to a rise in the demand for
liquidity to finance these startups. Consumer spending also rises during expansions
and creates an increased demand for funds in the banking sector, leading to greater
Fed Funds transactions and more repos. Recessions have exactly the opposite effect
on short term interest rates.
Discussion Questions:
#1. What are the basic money market instruments?
#2. Why is it difficult for small investors to invest in the money market?
#3. A $1,000,000 180 day T-Bill with a 50 day term is currently selling for $994,000.
What is its discount rate? What is its annualized interest rate?
#4. Explain what you know about each of the money market instruments.
#5. Assume short term interest rates are rising. Explain some reasons why they are
rising.
#6. How can changes in short term interest rates affect investment and consumer
spending?
#7. What is the term structure of interest rates?
#8. What are Eurodollars and how are they used?
#9. How can short term interest rates affect exports and imports?
#10. Does Taiwan have a money market? If so, describe it.