Chapter 13: Money Market
Features of MMI
Highly marketable, short-term, liquid and stable capital values.
Types of money market instruments
INSTRUMENT ISSUER TYPICAL TERM TRADABLE
Treasury Bill Central government 91 to 182 days Yes
Local Authority bill Local government 91 to 182 days Yes
Bill of Exchange Companies Up to 1 year Yes
Commercial Paper Large listed companies Up to 1 year Yes
Certificate of deposit Banks 28 days to 6 months Yes
Call Deposit Banks N/A No
Term Deposit Banks 1 week to 1 year No
Call deposits, where the depositor has “instant access” to withdraw funds
Notice deposits, where the depositor has to give a period of notice before withdrawal
Term deposits, where the depositor has no access to the capital sum earlier than the
maturity of the deposit. (Notice deposits are a subset of term deposits)
Certificates of deposit, which are tradable notes that state how much has been deposited
for a specific time at a specific rate of interest.
Interest rates on bank deposits may be:
Fixed for the term of the deposit
Fixed for initial period
Variable from day to day
The main players in the money markets
1. The clearing banks, who use money market instruments to lend excess liquid funds and to
borrow when they need short-term funds (use interbank rate)
2. Central banks, who act as lenders of last resort, stand ready to provide liquidity to the
banking system when required, and who buy and sell bills to establish the level of short-
term interest rates.
Sale and purchase of Treasury bills. A repo is sale and repurchase agreement. By
agreeing to sell a bill and subsequently repurchasing it, the central bank drives up interest
rates (temporarily)
3. Other financial institutions and non-financial companies, who lend and borrow short-term
funds.
Reasons for holding money market instruments
FEATURE BASED REASONS:
1. Liquidity
Known short term liabilities (e.g. day to day expenses, maturity outgo, surrender,
annuity payments)
Uncertain outgo: If liabilities are uncertain, then investors would like to meet any
immediate liabilities that may arise
E.g. General Insurance companies hold much more cash than long term investors,
because of large claim amounts in case of catastrophe.
E.g. Institutional investors requiring cash hold short term money market instruments for
high liquidity and low credit risk.
2. Attractive returns: Money market instruments might provide good investment opportunities
3. Use as a Waiting period investment: If a company receives large funds, the fund manager
may not be able to invest it in a long term investment instrument immediately. Therefore
until funds are invested in an investment vehicle for a long term, money market instruments
can be used for short term investments
4. Preservation of nominal value of capital and risk aversion: Good instrument for protection of
capital and individuals who are risk averse.
ECONOMIC REASONS
1. Rising interest rates:
Decreases bond prices and equity values
Borrowing becomes expensive
2. Start of economic recession: Cash investments might be more attractive than bonds and
equities at the start of a recession.
3. Cash investment helps to get Steady inflow of cash + protects capital
4. Depreciation of domestic currency (weakening of currency):
Short term interest rates may be increased by Government to defend the domestic
currency. This would make cash investments attractive because value of other assets
might be expected to fall in value.
Cash investment abroad: Investment in a stronger currency would prove attractive,
even if interest rates abroad were lower.
5. General Uneconomic uncertainty: Cash investments less risky in this case.
6. In times of high inflation, it would provide high nominal returns.
7. May have tax advantages
Investment and risk characteristics of money market instruments
Features: SYSTEM T
1. Security:
Security depends on issuer e.g. cash investment in government is more secure
than in a company
Security is good, as investment is short term.
2. Yield (real vs. nominal):
Income from cash investments approximately equals prevailing short term
interest rates set by monetary authorities.
In general real return is positive (higher than inflation rate by 2 – 3 percent)
Yield (expected return relative to other assets):
Running yield is roughly equivalent to that on government bonds
Expected returns from cash investments are lower than almost every other
type of investment, but actual return may not be lower (if other investments
perform poorly)
3. Spread (Volatility of capital values):
Nominal values are fixed and as they are short term, volatility is less.
4. Term:
Short term (less than one year, one week, even one day)
5. Expenses:
Expenses for dealing in and managing these instruments are minimal
6. Currency risk:
These investments are available in many currencies
There could risk in expected returns due to possible fluctuations in Exchange
rates.
7. Marketability:
With exception of call and term deposits, most money market instruments are
highly marketable. However they are unquoted, they are traded through an
interbank money market rather than through a stock exchange.
8. Tax:
Total return is treated as income for tax purposes.
