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Money
Markets
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Money Markets include short-term, highly liquid, relatively
low-risk debt instruments sold by governments, financial
institutions, and corporations to investors with temporary excess
funds to invest. This market is dominated by financial
institutions, particularly banks, and governments. The size of the
transactions in the money market typically is large ($100,000 or
more). The maturities of money market instruments range from one
day to one year and are often less than 90 days.
Some of these instruments are negotiable and actively traded,
and some are not. Investors may invest directly in some of these
securities, but more often they do so indirectly through money
market mutual funds, which are investment companies organized to
own and manage a portfolio of securities and which in turn are
owned by investors. Thus, many individual investors own shares in
money market funds that, in turn, own one or more of these money
market certificates.
Another reason of knowledge of these securities is important is
the use of the Treasury bill (T-bill) as a benchmark asset. Although
in some pure sense there is no such thing as a risk-free financial
asset, on a practical basis the Treasury bill is risk free.
There is no practical risk of default by the U.S. government.
The Treasury bill rate, denoted RF, is used throughout the
text as proxy for the nominal (today. s dollars) risk-free rate
of return available to investors (e.g., the RF shown and discussed
in Figure 1-1).
In summary, money market instruments are characterized as
short-term, highly marketable investments, with an extremely low
probability of default. Because the minimum investment is
generally large, money market securities are typically owned by
individual investors indirectly in the form of investment
companies known as money market mutual funds, or, as they are
usually called, money market funds.
Money market rates tend to move together, and most rates are
very close to each other for the same maturity. Treasury bill
rates are less than the rates available on other money market
securities, approximately one-third of a percentage point, because
of their risk-free nature.
Important Money Market Securities
- Treasury bills. The premier money market instrument,
a fully guaranteed, very liquid IOU from the U.S. Treasury. They
are sold on an auction basis every week at a discount from face
value in denominations of $10,000 to $1 million; therefore, the
discount determines the yield. The greater the discount at time
of purchase, the higher the return earned by investors. Typical
maturities are 13 and 26 weeks. New bills can be purchased by
investors on a competitive or noncompetitive bid basis.
Outstanding (i.e., already issued) bills can be purchased and
sold in the secondary market, an extremely efficient market
where government securities dealers stand ready to buy and sell
these securities.
- Negotiable certificates of deposit (CDs). Issued in
exchange for a deposit of funds by most American banks, the CD
is a marketable deposit liability of the issuer, who usually
stands ready to sell new CDs on demand. The deposit is
maintained in the bank until maturity, at which time the holder
receives the deposit plus interest. However, these CDs are
negotiable, meaning that they can be sold in the open market
before maturity. Dealers make a market in these unmatured CDs.
Maturities typically range from 14 days (the minimum maturity
permitted) to one year. The minimum deposit is $100,000.
- Commercial paper. A short-term, unsecured promissory
note issued by large, well-known, and financially strong
corporations (including finance companies). Denominations start
at $100,000, with a maturity of 270 days or less. Commercial
paper is usually sold at a discount either directly by the
issuer or indirectly through a dealer, with rates comparable to
CDs. Although a secondary market exists for commercial paper, it
is weak and most of it is held to maturity. Commercial paper is
rates by a rating service as to quality (relative probability of
default by the issuer).
- Eurodollars. Dollar-denominated deposits held in
foreign banks or in offices of U.S. banks allocated abroad.
Although this market originally developed in Europe,
dollar-denominated deposits can now be made in many countries,
such as those of Asia. Eurodollar deposits consist of both time
deposits and CDs, with the latter constituting the largest
component of the Eurodollar market. Maturities are mostly short
term, often less than six months. The Eurodollar market is
primarily a wholesale market, with large deposits and large
loans. Major international banks transact among themselves with
other participants including multinational corporations and
governments. Although relatively safe, Eurodollar yields exceed
those of other money market assets because of the lesser
regulation for Eurodollar banks.
- Repurchase agreements (RPs). An agreement between a
borrower and a lender (typically institutions) to sell and
repurchase U.S. government securities. The borrower initiates an
RP by contracting to sell securities to a lender and agreeing to
repurchase these securities at a prespecified price on a stated
date. The effective interest rate is given by the difference
between the purchase price and the sale price. The maturity of
RPs is generally very short, from three to 14 days, and
sometimes overnight. The minimum denomination is typically
$100,000.
- Banker. s acceptance. A time draft drawn on a bank by a customer,
whereby the bank agrees to pay a particular amount at a
specified future date. Banker. s acceptance are negotiable instruments because
the holder can sell them for less than face value
(i.e., discount them) in the money market. They are normally
used in international trade. Banker. s acceptances are traded on
a discount basis, with a minimum denomination of $100,000. Maturities typically
range from 30 to 180 days, with 90 days being
the most common.
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