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Money Market Instruments

Mr. C.S. Sudheer | Updated On Friday, March 29,2019, 04:31 PM

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Money Market Instruments

 

 

What are Money Market Instruments?

Money market instruments are debt securities that have short maturity periods. The money market instruments provide investors with a safe investment option for the short term. Money market instruments are liquid assets like treasury bills, repurchase agreements, commercial papers, or certificate of deposits. Money market funds are considered a good option for short term investments.

Features of Money Market:

Some of the important features of money market instruments are as follows:

  • Liquidity: the money market instruments are one of the most liquid investments as they have short maturity period of less than a year.
  • Safety: the money market allows companies or entities to issue these instruments only when they have strong credit ratings. So the money market instruments can be considered a safe investment option.
  • Discounted price: this is one of the main features of money market instruments. Some money market instruments are issued at a discount price to face value. So, the issuers raise funds by issuing these instruments at a lower price.

Functions of Money Market Instruments:

A money market instrument has an important role to play in the economic development of the country. The main functions of money market are:

Provides Funds:

The money market issues short term financial instruments for borrowing at a lower rate of interest. The private entities, the public sector companies as well as the government can raise money from the money market by issuing money market instruments to fund business growth through the system of finance bills and commercial papers. The government can also borrow funds from the money market by issuing treasury bills. However these institutions must have strong credit ratings to issue such instruments. Money market helps in the development of trade, industry and commerce within and outside India. The money market plays an important role in financing domestic as well as international trade.

SEE ALSO:  What are Money Market Instruments?

Use of Surplus Funds:

By issuing money market instruments, the banks and other lending institutions can lend surplus funds for a short period of time and earn good profit. This fulfils the main objectives of the commercial banks i.e. to maximize their income from deposits as well as maintain liquidity that would help them carry out daily transactions and meet cash requirements of the customers as well as offer loans to the people in need of credit.

No Need to Borrow from Banks:

A developed money market helps the commercial banks become self-sufficient. The existence of an established money market increases the option of borrowing money at lower interest rates. However, if there is shortage of cash in the commercial banks and central banks, they can call in some of their loans from the money market. Most of the commercial banks prefer to recall their loans rather than recalling from the central banks at higher rate of interest.

Helps government:

The money market instruments help the government raise money for financing government projects for public welfare and infrastructure development. The government issues short term instruments like treasury bills at a discounted price. After maturity the government returns the money at face value which is a source of profit for the investors.

Helps in Monetary Policy:

A properly functioning money market helps the central bank successfully implement monetary policies. The money market helps the central banks in the following ways:

  1. Short-run interest rates serve as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy.
  2. Sensitive and integrated money markets help the central bank secure quick and widespread influence on the sub-markets, thus facilitating effective policy implementation.

Helps in Financial Mobility:

The money market helps in financial mobility by enabling fast transfer of funds across sectors. It helps investors use their surplus funds and entities from different sectors raise funds through investors.

Promotes Liquidity and Safety:

This is one of the most important functions of money market; it provides short term funds that have high liquidity. These investments have shorter terms of maturity which is why they can be converted to cash easily. The money market instruments are issued by entities with an excellent credit rating which makes them a safe investment option.

Equilibrium Between Demand and Supply of Funds:

The money market creates a balance between the demand and supply of funds. The money market helps in allocating savings into investment channels. Money markets helps in mobilizing savings and make better use of them. It helps savers channelize funds, thus leading to productive use of money.

Economy in Use of Cash:

As the money market deals in near-money assets and not proper money, it helps in economizing the use of cash. It provides a convenient and safe way of transferring funds from one place to another, thereby immensely helping commerce and industry.

Important objectives of Money Market Instruments:

Given below are the important objectives of money market instruments:

  • Money market helps the RBI in regulating the liquidity in the economy.
  • Money market assists issuers in raising money by issuing money market instruments. It also helps the investors fulfill investment purposes and helps them gain returns within a short time.
  • It helps in the development of capital markets.
  • It provides short term funds and helps in the growth of investments.
  • It also helps the commercial banks become self sufficient.
  • The money market funds help investors earn money by investing in short term investment options. This way it provides liquidity to its investors as well as helps lower short term deficits.
  • Money market helps in successfully implementing monetary policies that serve as an indicator of the efficient functioning of commercial banks.
  • Enables transfer of funds from one sector to the other.

Advantages of Money Market Instruments

The money market instruments have several advantages. Some of them are as follows:

  • Safety: The primary benefit of money market instruments over other short–term investment options is they are relatively safer than shares or mutual funds. In addition, money market investments have a decent rate of return for the duration of investments which is an added advantage.
  • Liquidity: Money market funds are liquid investments. The liquidity of the market allows investors to get the benefits of returns in a short time period and therefore they can choose the money market instruments according to their requirements.
  • Yield: Money market funds offer greater flexibility in terms of investments as they can be issued and withdrawn in short durations. An investor who keeps a track of the money market and invests in funds has the knowledge on how to get good returns from investments.

Things to consider before investing in money market instruments:

  • Asset composition: Money market assets comprise of a mixed portfolio. The right mix of money market instruments helps create a strong investment strategy and obtain maximum profit from the investments.
  • Maturity profile of the portfolio: the maturity profile shows the maturity duration of all the holdings in the portfolio. Make sure to analyze the maturity profile as it is useful in evaluating the risk involved based on the diversification of the capital into various money market instruments.
  • Credit quality: the fund that you decide to invest should be of high quality, which is judged by the credit ratings. The credit quality of the money market instruments implies how trustworthy the security is.
  • Scheme track record: It is important to study the trends of money market fund portfolios to choose the appropriate mix of securities for higher returns. Check the track record of the fund over time to analyze how consistently it has been performing.

Money Market Instruments provide the tools by which one can operate in the money market. Money Market Instruments are used by corporations, governments and individual investors. Common types Of Money Market Instruments are:

Treasury Bills: 

The Treasury bills are short-term money market instrument that mature in a year or less than that. The purchase price is less than the face value. At maturity the government pays the Treasury Bill holder the full face value. The Treasury Bills are marketable, affordable and risk free. The security attached to the treasury bills comes at the cost of very low returns.

Certificate of Deposit:

The certificates of deposit are basically time deposits that are issued by the commercial banks with maturity periods ranging from 3 months to five years. The return on the certificate of deposit is higher than the Treasury Bills because it assumes a higher level of risk.

Advantages of Certificate of Deposit as a money market instrument are

1. Since one can know the returns from before, the certificates of deposits are considered much safe.

2. One can earn more as compared to depositing money in savings account.

3. The Federal Insurance Corporation guarantees the investments in the certificate of deposit.

Disadvantages of Certificate of deposit as a money market instrument:

1. As compared to other investments the returns is less.

2. The money is tied along with the long maturity period of the Certificate of Deposit. Huge penalties are paid if one gets out of it before maturity.

Commercial Paper: 

Commercial Paper is short-term loan that is issued by a corporation use for financing accounts receivable and inventories. Commercial Papers have higher denominations as compared to the Treasury Bills and the Certificate of Deposit. The maturity period of Commercial Papers are a maximum of 9 months. They are very safe since the financial situation of the corporation can be anticipated over a few months.

Banker's Acceptance: 

It is a short-term credit investment. It is guaranteed by a bank to make payments. The Banker's Acceptance is traded in the Secondary market. The banker's acceptance is mostly used to finance exports, imports and other transactions in goods. The banker's acceptance need not be held till the maturity date but the holder has the option to sell it off in the secondary market whenever he finds it suitable.

Euro Dollars: 

The Eurodollars are basically dollar- denominated deposits that are held in banks outside the United States. Since the Eurodollar market is free from any stringent regulations, the banks can operate at narrower margins as compared to the banks in U.S. The Eurodollars are traded at very high denominations and mature before six months. The Eurodollar market is within the reach of large institutions only and individual investors can access it only through money market funds.

Repos: 

The Repo or the repurchase agreement is used by the government security holder when he sells the security to a lender and promises to repurchase from him overnight. Hence the Repos have terms raging from 1 night to 30 days. They are very safe due government backing.

Repurchase agreements:

Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

Federal Agency Short-Term Securities:

(in the US). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.

Federal funds:

(in the US). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.

Municipal notes:

(in the US). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

Money market mutual funds:

Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.

 

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Article Author

Mr. C.S. Sudheer

Mr. C S Sudheer is the founder and CEO of IndianMoney.com – India’s largest Financial Education Company. He started his career with ICICI Prudential Life Insurance and later on worked with Howden India. After his brief stint in Howden India, he moved on and incorporated Suvision Holdings Pvt Ltd which is the sole promoter of IndianMoney.com. He aims to build a nation that is financially literate with investment savvy citizens.

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