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Home Articles Types of Instruments Traded in the Money Market

Types of Instruments Traded in the Money Market

IndianMoney.com Research Team | Updated On Friday, May 17,2019, 01:13 PM

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Types of Instruments Traded in the Money Market

 

 

The money market plays an important role in the Indian economy. It is a securities market where highly liquid and short term securities are traded. The Money market is a platform that enables the government; large corporations and companies raise funds from investors to meet short term fund requirements.

Types of Instruments Traded in the Money Market:

Treasury Bills: Treasury bills are issued by the Government of India in order to raise funds from investors and use for short-term monetary needs. Treasury bills are one of the safest modes of investment, among the money market instruments. Treasury bills are short term instruments that have maturities generally ranging from 91 days to 364 days. Investors invest in treasury bills as they are less risky and highly liquid.

Treasury bills are an ideal option for people to park their surplus funds for short term needs. The treasury bills are issued at a discount and redeemed at par. Apart from being investment instruments, treasury bills play an important role in the financial market. Treasury bills are held by commercial banks. The RBI auctions T-bills on every Wednesday and they are held by Financial Institutions. Treasury bills are given by the RBI to banks to get money under repo. They are parked as part of SLR requirements. T-Bills are issued with maturities of 91 days, 182 days and 364 days.

Certificate of Deposit: A certificate of deposit is a money market instrument; that works in a similar way to a fixed deposit. Certificates of deposits have a fixed lock-in period and the money deposited cannot be withdrawn before maturity. The certificate of deposit provides a higher rate of interest and is one of the safest modes of investment available at banks and financial organizations.

There are certain contrasts between a certificate of deposit and fixed deposits. Certificate of deposits are issued in dematerialised form and can be negotiated in the secondary market. The CDs are generally held in the DEMAT accounts.  Unlike a fixed deposit, CDs cannot be purchased at lower denominations. They are generally issued for a higher sum of money.

Commercial Paper: Commercial paper refers to an unsecured short term loan or promissory note, whose maturity is not longer than 9 months. Commercial papers were introduced in the Indian market in 1990 and are a recent addition to the money market instruments. These financial instruments can be issued only by those entities that have a high credit rating.

These entities borrow money from investors to meet working capital requirements. These money market instruments are issued by finance companies, banks and large corporates, domestic and foreign firms. The commercial papers are issued at a discounted rate reflecting the current interest rate prevailing in the market. Commercial papers are available only in higher denominations and can be freely traded in the secondary market.

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SEE ALSO: Features Of Indian Money Market

Money Market

Bankers Acceptance: Banker’s acceptance is basically a document issued by a company to pay a specific amount at a future date. Bankers acceptance works like a post-dated cheque and promises payments in the future. These instruments are widely used in foreign trade. They are highly liquid instruments and can be traded in the secondary market. They are very reliable and a safe investment as they enjoy a bank guarantee. It mainly contains details on the date of payment, the due amount and the details of the individual to whom the payment is to be made. Bankers acceptance has short maturities of around a month to 3 months.

Repurchase Agreements: Repurchase agreements are a contract between two parties, where the seller agrees to purchase the security back from the buyer at a future date at a higher price. Repurchase agreements work in a similar manner to secured loans. Here the repurchase agreement works as loans and securities serve as collateral. For example, a commercial bank sells securities to some other bank and promises to purchase it in the future within a stipulated date and time. The security is held as collateral in case of a default. This is not a real sale but a secured loan. The incremental amount paid by the seller to the buyer to repurchase the security, is the interest earned by the buyer.

Money Market

Bankers Acceptance: Banker’s acceptance is basically a document issued by a company to pay a specific amount at a future date. Bankers acceptance works like a post-dated cheque and promises payments in the future. These instruments are widely used in foreign trade. They are highly liquid instruments and can be traded in the secondary market. They are very reliable and a safe investment as they enjoy a bank guarantee. It mainly contains details on the date of payment, the due amount and the details of the individual to whom the payment is to be made. Bankers acceptance has short maturities of around a month to 3 months.

Repurchase Agreements: Repurchase agreements are a contract between two parties, where the seller agrees to purchase the security back from the buyer at a future date at a higher price. Repurchase agreements work in a similar manner to secured loans. Here the repurchase agreement works as loans and securities serve as collateral. For example, a commercial bank sells securities to some other bank and promises to purchase it in the future within a stipulated date and time. The security is held as collateral in case of a default. This is not a real sale but a secured loan. The incremental amount paid by the seller to the buyer to repurchase the security, is the interest earned by the buyer.

Money must be accepted as a unit of account and a means of exchange or payment, be durable, scarce, easily dividable and stable in value. Money that is on account of the Central Bank is the Real Money. All other forms for e.g. the account balances with Commercial Banks even cash (check out the note by the RBI governor on Indian currency note) are promises to pay money but not real money. Like individuals Banks and large institutions also transact amongst each other lending and borrowing huge amounts of money. In these transactions cash is not involved, real money kept in accounts with the Central Bank will be transacted.

SEE ALSO: Indian Money Market

E.g.: IDBI Bank needs to pay SBI Rs.10 Crores balancing figure at the end of the day. This transaction happens by requesting RBI to increase the account balance of SBI by 10 Crores and corresponding decrease in the account balance of IDBI. Now with this the balances or total money with IDBI reduces. But it might be requiring that money for transactions with its other customers. This means a party (IDBI) which wants to borrow money now. There might be another institution that might be having surplus money that it does not require in the near future, say ICICI Bank having surplus money for 15 days (the same duration that IDBI wants it for). So we have ICICI loaning IDBI Rs.10 Crores for 15 days at an agreed rate. This is a Money Market transaction.

Particularly Money Market provides short-term finance (for a period less than 1 year.) The parties involved in Money Markets are Central Bank, Commercial Banks, Financial Institutions, Mutual Funds and Primary Dealers. The extension of Money Market is Capital Market where finance is transacted for a period longer than 1 year, in form of both Debt & Equity. Money Markets exist because of the main need of Working Capital Management where balance between Liquidity and Profitability is vital.

The market provides a medium for Cash surplus and deficient organizations to manage and reach an equilibrium regarding the cost of funds (interest rates.) The borrowing and lending in money markets is high volume, Low risk and short-term. As it is short-term transaction costs are high relative to the interest that can be earned. And transaction costs are high relative to the interest that can be earned, dealings in the money market lean to be for very large amounts. Short-term is generally understood as less than one year, even though, in fact most money market activity is concentrated in terms to maturity between overnight and one-week.

Indian Money Market

The money market is an instrument that deals with the lending and borrowing of short term finances. The India Money Market has come of age in the past two decades. In order to learn the money market of India in detail, we first need to know the parameters about which the money market in India revolves.

The show of the Indian Money Market is greatly dependent on real interest rate that is the interest rate that is inflation adjusted. Though the money market is free from interest rate ceilings, structural barriers and other institutional factors can be detained accountable for creating distortions in India Money Market. Apart from the call market rates the other interest rates in the Indian Money Market usually do not change in the short run. It is due to this difference between the opposite forces that is common in the money market in India that a well distinct income path cannot be traced.

Due to the deregulation of the interest rate in the early nineties following the economic reforms laid down by the finance minister Dr. Manmohan Singh, a study concerning the behavior of interest rate was restricted. However the liquidity of the market makes it’s a good subject for experiential research.

The Indian Money Market involves a broad variety of instruments. Here, maturities range from one day to a year issued by banks and corporates of various sizes. The money market is also closely connected with the Foreign Exchange Market throughout the procedure of covered interest arbitrage in which the forward premium acts as a connection between domestic and foreign interest rates.

To examine the interest rates that characterize the Indian Money Market the following fundamentals need to be covered :

  • The term structure of interest rate.
  • The difference between domestic and international interest rates
  • The market arrangement differences between the auction markets that clear continuously and the Customer markets.
  • The credit speed between instruments connecting similar maturity but diverse risk factor.

Money Market Instruments

Money market borrowing and lending utilizes a variety of different instruments. These include :

  • Deposits and loans,
  • Repurchase agreements, and number of securitized debt instruments
  • Treasury bills
  • Bankers’ acceptances
  • Commercial paper (CP)
  • Certificates of deposit (CD)

Borrowers in money markets are all high superiority names and so the securities issued and traded have low risk, low yield, high liquidity characteristics which are attractive to risk reluctant lenders In terms of risk Profiles: Treasury Bills, Banker’s Acceptances, CD and CPs range from the lowest to highest risk in that order being governed by the credit worthiness of party backing it. As a result the returns are in inverse order for these instruments. Normal issues of Treasury bills backed by central government have the lowest default risk, creating the deepest market segment of homogeneous, highly liquid paper - with consequently the lowest yield. This is because governments’ are usually assumed to have a very low default risk.

Bankers' Acceptances are also very safe investments as they carry the responsibility to honor payment by both a corporate and a bank and in addition, because they generally represent a business deal with specific fundamental goods. Certificates of Deposit, honored by a single bank, normally trade a few basis points higher but this can only be a generalization as the market section is itself tiered, the variety of names issuing resulting in different credit and liquidity premiums.

The profitable Paper section presents the greatest degree of tiering. Major grade CP normally trades a few base points over CDs, but again some corporates are perceived as being more creditworthy than some banks. Medium grade CP offers the highest yields to attract investors.

Repurchase agreement (REPO)

A repurchase (repo) agreement can be seen as a short term swap among cash and securities. Repurchase agreements or repos are specialized but important aspects of many markets, particularly those for government securities. In essence if a security holder wants to maintain his or her long-term position but needs cash for a short period, he or she can go into a repo agreement whereby the securities are sold together with a required agreement to repurchase them at a future date regularly fairly near-term. The result is to provide the security holder with a short-term loan based on the collateral of the government securities he or she owns. In main markets with repo systems, it is a cheap, simple and effective way to raise short-term funds.

For banks and large corporates, liquidity management is about receiving a fine return on cash, which they may need at short notice. They do this by borrowing and lending among each other - using either money market securities or deposits and loans - in the interbank market.

When does a bank participate in Money Market

Banks will participate in the money market in the following cases.

Take Debt

  • When they fall short of statutory Reserve necessities may be due to a change in rates or next 2 points.
  • When they fall short of funds to meet withdrawal necessities from customers.
  • When they fall short of funds to lend at more attractive rates

Loan Debt

When they have surplus idle funds.

Major Players in money market

The major players and their main role in the money market is listed below :

Player

Role

Central Bank

Intermediary

Government

Barrowers/Issuers

Bank

Barrowers/Issuers

Discount Houses

Market markets

FI’s

Barrowers/Issuers

MF’s

Lenders/Investors

FII’s

Investors

Dealers

Intermediaries

Corporates

Issuers

Can individual investors invest in Money markets?

One of the main differences among the money market and the stock market is that the majority money market securities trade in very high denominations and so individual investors has partial entrance to them. The easiest way for individual investors to increase entrée to the money market is with a money market mutual fund or sometimes a money market bank account. These accounts and funds pool jointly the assets of thousands of investors and buy the money market securities on their behalf. Even though some money market instruments like treasury bills may be purchased directly or through other large financial institutions with straight access to these markets. In summary Money markets are markets for financing the short term fund necessities of Government, Banks, Corporate and other Financial Institutions. Like any other markets there are intermediaries like Dealers who make dealings possible and easy for these participants. The instruments in the market are to a great amount governed by Central Bank’s policies regarding supply of money therefore inflation in the economy and the rates of interest. The well-organized process of the markets is very critical for any developed economy to enable the large institutions get easy access to cheap funds, therefore enabling them maintain the important balance between profitability and liquidity.

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