Money Market Instruments and Their Applications

The hidden river of money that keeps your world afloat

Money market instruments are securities that offer huge sums of low-cost capital to businesses, banks, and the government for a short period of time. The period can be a few hours, days, weeks, or even months, but it is never more than a year. The financial markets meet longer-term cash needs. Because payments for goods and services can take months to arrive, businesses require short-term liquidity. Companies would have to wait until payments for things already sold if they didn't use money market instruments. This would cause the purchasing of raw materials to be delayed and the fabrication of the finished product. Money market instruments worth $4.59 trillion were issued worldwide in early 2022.

Business ivestment of extra cash

Managers can use money market products to receive cash rapidly when they need it. As a result, money market products must be highly secure. Money market instruments are also used by businesses to invest surplus funds. It will earn a little interest until its fixed operational costs are met. Rent, utilities, and labor are examples of fixed costs. The stock market, for example, is far too dangerous. When the company needs to pay bills, prices may drop, and they may receive less than they require for these charges. Money markets must be simple to access and withdraw funds from. They can't charge a lot of money for transactions. Otherwise, the company would just store additional cash in a safe. Interest rates are influenced by the quantity of the money supply, which influences economic growth. Many of these money market instruments are included in the US money supply. Currency, check deposits, money market funds, certificates of deposit, and savings accounts are all examples of money market instruments.

Types of money market instruments

Money market instruments come in 15 different varieties. Some are geared toward banks and large financial institutions, while others are geared toward businesses. Each caters to the unique requirements of various clientele. To meet their financial demands, certain businesses may use a variety of different money market accounts.

Commercial Paper

Large corporations with excellent credit can quickly issue short-term unsecured promissory notes to raise funds. Commercial paper is a derivative that is based on asset-backed commercial paper.

Federal Funds

The only businesses that use federal funds are banks. Each night, banks employ them to meet the Federal Reserve's requirements. It accounts for nearly 10% of all bank liabilities - over $58.8 million. Due to the worldwide health crisis, the Federal Reserve cut the reserve requirement to zero on March 26, 2020. If a bank does not have sufficient cash to meet the demand, it will borrow from other banks. The federal funds rate is the interest rate at which banks lend each other government funds. The current fed funds rate determines all other short-term interest rates.

Discount Window

If a bank cannot borrow federal funds from another bank, it can turn to the Federal Reserve's discount window for assistance. The Fed sets a discount rate that is slightly higher than the fed funds rate. It prefers that banks borrow from one another. Although most banks avoid using the discount window, it is available in the event of an emergency.

Certificates of Deposit

To raise short-term cash, banks offer certificates of deposit. They can last anywhere from one to six months. The longer the cash is maintained in a CD, the higher the interest rate.

Eurodollars

Banks also issue CDs in other countries. These are kept in euros rather than dollars.

Repurchase Agreements

When a bank offers securities, it also promises to repurchase them at a better price later. This is known as a "repo." This usually signifies a little more interest the next day. A reverse repo is executed by the buyer of the securities, who is the lender. Even though it is a sale, the transaction is recorded as a short-term collateralized loan.

Bankers Acceptances

This is analogous to a bank loan in terms of overseas trade. The bank guarantees that one of its customers will pay for products received 30 to 60 days after they are received. An importer, for example, wants to place an order for products, but the exporter refuses to offer him credit. He goes to his bank, which ensures that the payment will be made. The bank has agreed to bear the cost of the payment.

Swaps

A swap is a contract between two parties in which all future interest rate payments on a loan are exchanged. It's a derivative of some sort. The underlying value of the two streams of interest payments is used to calculate the swap's value. Swaps allow banks to act as middlemen for businesses seeking to protect themselves from interest rate fluctuations. Swaps are a way of exchanging bond values without dealing with the legalities of buying and selling actual bonds. Most swaps are based on bonds with variable-rate interest payments that fluctuate over time. Swaps allow investors to hedge against interest rate changes in the future.

Backup Line of Credit

A backup line of credit is a short-term loan that safeguards a company's investors. If the issuer defaults, a bank will guarantee to pay 50 percent to 100 percent of the money market instrument.

Credit Enhancement

The bank issues a letter of credit if the issuer does not redeem the money market instrument.

Treasury Bills

The federal government uses Treasury bills to raise funds. They are only for a year or less.

Municipal Notes

To raise funds, cities, and states issue short-term municipal bonds. Interest payments on this are tax-free in the United States. Money market instruments are used in some investments.

Shares in money market instruments

Money market funds are a type of mutual fund that invests in various money market products. Investors buy shares in these funds from the fund companies.

Futures Contracts

Futures contracts bind traders to purchase or sell a money market security at a pre-determined price on a pre-determined date in the future. The most common instruments employed are Treasury bills, interest swaps, eurodollars, and a 30-day average of the fed funds rate.

Futures Options

Traders can also purchase the option to buy or sell a money market futures contract at an agreed-upon price on or before a specific date, but not the contract itself. For example, Treasury options are available on 5-year, 10-year, and "ultra" 10-year Treasury notes.

Role of Money Market Instruments in the Financial Crisis

Most people were surprised to learn that money market instruments were at the heart of the 2008 financial crisis, given how safe they are in general. The $62.6 billion Reserve Primary Fund "broke the buck" on September 16, 2008. As a result, the fund's managers could not keep the share price at $1. That value served as a benchmark for money market funds. After Lehman Brothers went bankrupt, investors panicked. They were withdrawing money far too quickly. They were concerned that the fund would go insolvent due to its Lehman Brothers investments. The Fed had to develop several new and inventive programs to keep the money market working. Because the Fed's programs were formed fast, their names were technical descriptions of what they did. For example, the Federal Reserve Bank of New York provided "senior secured funding to a series of special-purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors" through the Money Market Investor Funding Facility (MMIFF). This may have made sense to bankers, but it made little sense to the rest of the population. These tools were practical, yet they perplexed the general public. Because of the complication, there was skepticism regarding the Fed's objectives and actions. These measures were no longer needed after the financial crisis ended, and they were phased out.

What it means to you

Many money market instruments have high liquidity, which you can take advantage of. Money market mutual funds, Treasury bills, Treasury bill mutual funds, and municipal note mutual funds are among the options available through your broker. If you plan to hold treasury bills until maturity, you can purchase them directly from the US Treasury. CDs can be purchased at a bank. Futures contracts can be purchased from a brokerage. Futures options can be traded through a financial services firm or a broker.

Protection during rising interest rates

Look for savings products with variable interest rates that will climb in lockstep with the inflation rate. Some of these securities will keep you safe if interest rates rise. Money market mutual funds, short-term CDs, and Treasury bills are examples. Your bank can also provide you with savings and money market accounts. These aren't based on financial instruments like the stock market. Instead, they're bank-issued interest-bearing accounts. Unlike money market mutual funds, these accounts are insured by the Federal Deposit Insurance Corporation. If interest rates rise, it may have a negative impact on some investments. Longer-term assets, for example, will be more vulnerable to rising interest rates and will most likely lose value as rates climb. CDs and short-term bond funds are examples of this. Both pay the same low-interest rate over time. As interest rates rise, the value of these assets decreases. Avoid any long-term bond funds for the same reason. They should only be used to diversify your portfolio and lower risk.

Frequently Asked Questions (FAQs)

Which money market instruments don't trade on the secondary market?

The secondary markets for most money market instruments are busy and liquid. Municipal securities and commercial paper, for example, have less active secondary markets.

What is a money market account?

Money market items have two basic possibilities for those interested. They can purchase shares in a money market fund or open a money market account. Both products invest in money market instruments, but money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC) and function similar to savings accounts.

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