Types of Money Market Instruments

A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos). The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities, but there are risks in the market that any investor needs to be aware of including the risk of default on securities such as commercial paper. The money market is different from the capital market. The differences can be read in the article Financial Markets: Capital vs. Money Market and Getting to Know the Money Market. In the financial marketplace, a distinction is made between the capital markets and the money markets. The capital market is a source of intermediate-term to long-term financing in the form of equity or debt securities with maturities of more than one year. The money market provides very short-term funds to corporations, municipalities and the United States government. Money market securities are debt issues with maturities of one year or less. For more information, review our Money Market tutorial.

The money market is the arena in which financial institutions make available to a broad range of borrowers and investors the opportunity to buy and sell various forms of short-term securities. There is no physical "money market." Instead it is an informal network of banks and traders linked by telephones, fax machines, and computers. Money markets exist both in the United States and abroad. The short-term debts and securities sold on the money markets—which are known as money market instruments—have maturities ranging from one day to one year and are extremely liquid. Treasury bills, federal agency notes, certificates of deposit (CDs), Eurodollar deposits, commercial paper, bankers' acceptances, and repurchase agreements are examples of instruments. The suppliers of funds for money market instruments are institutions and individuals with a preference for the highest liquidity and the lowest risk. The money market is important for businesses because it allows companies with a temporary cash surplus to invest in short-term securities; conversely, companies with a temporary cash shortfall can sell securities or borrow funds on a short-term basis. In essence the market acts as a repository for short-term funds. Large corporations generally handle their own short-term financial transactions; they participate in the market through dealers. Small businesses, on the other hand, often choose to invest in money-market funds, which are professionally managed mutual funds consisting only of short-term securities. Although securities purchased on the money market carry less risk than long-term debt, they are still not entirely risk free. After all, banks do sometimes fail, and the fortunes of companies can change rather rapidly. The low risk is associated with lender selectivity. The lender who offers funds with almost instant maturities ("tomorrow") cannot spend too much time qualifying borrowers and thus selects only blue-chip borrowers. Repayment therefore is assured (unless you caught Enron just before it suddenly nose-dived). Borrowers with fewer credentials, of course, have difficulty getting money from this market unless it is through well-established funds.

Types of Money Market Instruments

Treasury Bills

Treasury bills are short-term securities issued by the U.S. Treasury. The Treasury sells bills at regularly scheduled auctions to refinance maEagleTraders.comg issues.  It also helps to finance current federal deficits. They further sell bills on an irregular basis to smooth out the uneven flow of revenues from corporate and individual tax receipts. Treasury bills (T-bills) are short-term notes issued by the U.S. government. They come in three different lengths to maturity: 90, 180, and 360 days. The two shorter types are auctioned on a weekly basis, while the annual types are auctioned monthly. T-bills can be purchased directly through the auctions or indirectly through the secondary market. Purchasers of T-bills at auction can enter a competitive bid (although this method entails a risk that the bills may not be made available at the bid price) or a noncompetitive bid. T-bills for noncompetitive bids are supplied at the average price of all successful competitive bids.

Federal Agency Notes

Some agencies of the federal government issue both short-term and long-term obligations, including the loan agencies Fannie Mae and Sallie Mae. These obligations are not generally backed by the government, so they offer a slightly higher yield than T-bills, but the risk of default is still very small. Agency securities are actively traded, but are not quite as marketable as T-bills. Corporations are major purchasers of this type of money market instrument.

Short-Term Tax Exempts

These instruments are short-term notes issued by state and municipal governments. Although they carry somewhat more risk than T-bills and tend to be less negotiable, they feature the added benefit that the interest is not subject to federal income tax. For this reason, corporations find that the lower yield is worthwhile on this type of short-term investment.

Certificates of Deposit

A certificate of deposit is a document evidencing a time deposit placed with a depository institution. The following information appears on the certificate:

• The amount of the deposit;
• The date on which it matures;
• The interest rate; and
• The method under which the interest is calculated.
• Large negotiable CDs are generally issued in denominations of $1 million or more.

Certificates of deposit (CDs) are certificates issued by a federally chartered bank against deposited funds that earn a specified return for a definite period of time. They are one of several types of interest-bearing "time deposits" offered by banks. An individual or company lends the bank a certain amount of money for a fixed period of time, and in exchange the bank agrees to repay the money with specified interest at the end of the time period. The certificate constitutes the bank's agreement to repay the loan. The maturity rates on CDs range from 30 days to six months or longer, and the amount of the face value can vary greatly as well. There is usually a penalty for early withdrawal of funds, but some types of CDs can be sold to another investor if the original purchaser needs access to the money before the maturity date. Large denomination (jumbo) CDs of $100,000 or more are generally negotiable and pay higher interest rates than smaller denominations. However, such certificates are only insured by the FDIC up to $100,000. There are also Eurodollar CDs; they are negotiable certificates issued against U.S. dollar obligations in a foreign branch of a domestic bank. Brokerage firms have a nationwide pool of bank CDs and receive a fee for selling them. Since brokers deal in large sums, brokered CDs generally pay higher interest rates and offer greater liquidity than CDs purchased directly from a bank.

Commercial Paper

Commercial paper is a short-term unsecured promissory note issued by corporations and foreign governments.  It is a low-cost alternative to bank loans, for many large, credit worthy issuers.   Issuers are able to efficiently raise large amounts of funds quickly and without expensive Securities and Exchange Commission (SEC) registration.  They sell paper, either directly or through independent dealers, to a large and varied pool of institutional buyers. Investors in commercial paper earn competitive, market-determined yields in notes whose maturity and amounts can be tailored to their specific needs.

Commercial paper refers to unsecured short-term promissory notes issued by financial and non financial corporations. Commercial paper has maturities of up to 270 days (the maximum allowed without SEC registration requirement). Dollar volume for commercial paper exceeds the amount of any money market instrument other than T-bills. It is typically issued by large, credit-worthy corporations with unused lines of bank credit and therefore carries low default risk. Standard and Poor's and Moody's provide ratings of commercial paper. The highest ratings are A1 and P1, respectively. A2 and P2 paper is considered high quality, but usually indicates that the issuing corporation is smaller or more debt burdened than A1 and P1 companies. Issuers earning the lowest ratings find few willing investors. Unlike some other types of money-market instruments, in which banks act as intermediaries between buyers and sellers, commercial paper is issued directly by well-established companies, as well as by financial institutions. Banks may act as agents in the transaction, but they assume no principal position and are in no way obligated with respect to repayment of the commercial paper. Companies may also sell commercial paper through dealers who charge a fee and arrange for the transfer of the funds from the lender to the borrower.

Bankers' Acceptances

A banker’s acceptance, or BA, is a time draft drawn on and accepted by a bank. Before acceptance, the draft is merely an order by the drawer to the bank to pay a specified sum of money on a specified date to a named person or to the bearer of the draft, it is not an obligation of the bank.  Upon acceptance, which occurs when an authorized bank employee stamps the draft "accepted" and signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is well known and enjoys a good reputation, the accepted draft may be readily sold in an active market. A banker's acceptance is an instruments produced by a non financial corporation but in the name of a bank. It is document indicating that such-and-such bank shall pay the face amount of the instrument at some future time. The bank accepts this instrument, in effect acting as a guarantor. To be sure the bank does so because it considers the writer to be credit-worthy. Bankers' acceptances are generally used to finance foreign trade, although they also arise when companies purchase goods on credit or need to finance inventory. The maturity of acceptances ranges from one to six months.

Repurchase Agreements

The terms repurchase agreement (repo or RP) and reverse repurchase agreement refer to a type of transaction in which a money market participant acquires immediately available funds by selling securities and simultaneously agreeing to repurchase the same or similar securities after a specified time at a given price, which typically includes interest at an agreed-upon rate.  A transaction viewed from the perspective of the supplier of securities (the party acquiring funds) is called a repo, and it's a reverse repo or matched sale-purchase agreement when described from the point of view of the supplier of funds. Repurchase agreements—also known as repos or buybacks—are Treasury securities that are purchased from a dealer with the agreement that they will be sold back at a future date for a higher price. These agreements are the most liquid of all money market investments, ranging from 24 hours to several months. In fact, they are very similar to bank deposit accounts, and many corporations arrange for their banks to transfer excess cash to such funds automatically.