Money Markets Overview Flashcards
(17 cards)
What are Money Markets
It refers to markets for financial assets that have a very short maturity and are highly liquid, making them close substitutes for money
Key Characteristics of Securities Traded in Money Market
Short Term Maturity: They generally mature in one year or less from their issue date, with most maturing in less than 120 days.
Large Denominations: Transactions typically involve large denominations, often $1,000,000 or more. This makes them primarily wholesale markets, though individuals can participate indirectly via money market mutual funds.
Low Default Risk: The securities usually carry a low default risk because they are issued by entities unlikely to default in the short term, such as governments and established financial institutions.
Who are the Participants in Money Markets
Governments: For instance, the U.S. Treasury, which issues short-term securities like Treasury Bills (T-bills).
Central Banks: Such as the Federal Reserve, which engages in money market transactions to influence the money supply and interest rates.
Commercial Banks: They borrow and lend among themselves (e.g., through federal funds) and deal with corporations.
Businesses (Corporations): They use money markets to manage short-term cash flow mismatches.
Investment Companies, Finance Companies, Insurance Companies, and Pension Funds: These institutions participate for various reasons, including managing client funds, extending credit, handling unexpected payouts, and rebalancing portfolios.
Individuals: While they cannot participate directly due to the large transaction sizes, they can invest indirectly through money market mutual funds.
Why do we Need Money Markets
Historically, companies with surplus funds deposit them in banks. Funds needing short term borrowing would go to banks.
Banks have an info advantage that helped reduce transaction costs
Money markets emerged, providing a solution to cash timing for corps and govs since it’s hard for them to sync their inflows and outflows
For Investors (Surplus) - Money markets offer warehouse surplus funds for short periods. Allowing excess cash invested efficiently instead of keeping unproductive cash balances
For Borrowers (Temporary Deficits) - Money Markets provide a low cost source of temporary funds. Crucial for covering unexpected expenditures or short term costs when immediate cash is insufficient
What does Cost Advantages Mean
Cost advantages refer to the ability of money markets to offer cheaper and more efficient financial services (especially short-term borrowing and lending) compared to traditional banks. These advantages mainly arise because money markets are not subject to the same costly regulations that banks face.
Why are Banks More Expensive
Reserve Requirements:
Banks must hold a portion of all deposits as reserves (set by central banks).
This limits how much they can lend, making lending more expensive.
Interest Rate Caps (historically):
In the past, banks were not allowed to offer high interest rates to depositors due to government-imposed ceilings (e.g., Glass-Steagall Act).
When interest rates rose in the 1970s, money market instruments like Treasury bills paid better returns, so investors pulled money from banks — this was called disintermediation.
What are the Money Markets Cost Advantages
No Reserve Requirements
Money market participants (e.g., corporations, governments) are not forced to hold reserves, so they can use funds more fully and efficiently.
Market-Driven Interest Rates
Unlike regulated banks, money markets can offer whatever interest rates the market will bear, attracting both borrowers and lenders.
Lower Transaction Costs for High-Quality Borrowers
Borrowers like governments or large corporations are trusted and well-known, so lenders don’t need to spend as much money checking creditworthiness (less asymmetric information).
What are Money Markets Instruments
They are specific debt securities that enable the money market to function
Helps address problem of cash timing for corps and govs
7 Examples of Money Market Instruments
Treasury Bills
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposits
Commercial Paper
Banker’s Acceptance
Eurodollars
What are Treasury Bills (T-Bills)
They are short term debt obligations issued by national govs (US Treasury)
Maturity ranges from 28 days to 12 months, highly liquid
They are discounted securities, investors pay less for them than their face value maturity, the return comes from the increase in price as the bill approaches maturity
What is the Auction Processes of T-Bills
They are sold through weekly auctions
Investors place competitive bids, specifying max price they’re willing to pay
Or non-competitive bids where they agree to pay the market paying price
Example:
If Treasury auctions 2.5 billion of 91 day T-Bills and receives various competitive bids and 750m, the market clearing price would be determined by checking highest competitive bid price at which entire supply can be sold
So if price is 99p allows 2.5 billion to be sold, then everyone regardless of initial bid, as long as its above 99p, has to pay the price
What are Federal Funds
These are short term funds (loaning/borrowing) transferred between financial institutions for a period of just one day
Banks use the funds to meet short term liquidity needs so reserve requirements are met
Interest rate on the funds tracks Fed target rate but central bank isn’t involved in the transaction
Unlike most money market instruments, there is no secondary market for federal funds, as they are direct bilateral arrangements
What are Repurchase Agreements
Similar to federal funds, but non-bank entities can also participate
In a repo, a firm sells Treasury Securities to a buying party and simultaneously agrees to buy the back (3-14 days later) for a certain price
Repos are short term collateral loans. Fed uses repos to conduct monetary policy either putting money in the system (buying) or selling securities in the repo market (withdrawing)
They are reversible transactions, allowing central banks to adjust money supply efficiently
What are Negotiable Certificates of Deposit
A bank issued security that docs a deposit and specifies the interest rate and maturity date
They come in large amounts from 10k to 10m
They are term securities with specified maturity dates. They are bearer instruments, meaning whoever holds the certificate at maturity receives interest
They can be bought and sold in secondary markets before maturity, offering liquidity to the holder
What is Commercial Paper
They are unsecured promissory notes issued by corporations, maturing in no more than 270 days
Corps issue commercial paper as short term borrowing mechs, an alternative to more expensive bank loans
While low risk, the liquidity of their secondary market can vary based on the issuing company
What are Banker’s Acceptances
They are orders to pay a specified amount to the bearer on a given date, contingent on certain conditions being met (usually delivery of promised goods)
They are used in international trade to facilitate transactions between buyers and sellers of different countries
Usually for when creditworthiness of foreign customer is hard to tell
Bank underwrites creditworthiness
There is an active secondary market for banker’s acceptances until maturity
Eurodollars
They are dollar denominated deposits held in foreign banks
The Eurodollar market grew due to foreign banks can often offer depositors a higher rate of return on dollar deposits than domestic US banks
The origins are from 1950s when the Soviet Union transferred dollar reserves to European Banks to avoid potential seizure by the US gov
Highlighting political concerns can drive financial innovation and market development
