Money markets definition invest small amounts of money in a low-

risk market.
 As the name suggests, money market  It also allows individual investors to
instrument is an investment mechanism invest small amounts of money in a low-
that allows banks, businesses, and the risk market
government to meet large, but short-
term capital needs at a low cost. Functions of the Money Market

 Money market has a short term maturity, The money market contributes to the economic
the debt instruments that are traded in stability and development of a country by
money market undergo the least price providing short-term liquidity to governments,
fluctuation and so are the least risky commercial banks, and other large
investment. organizations. Investors with excess money that
they do not need can invest it in the money
 Short-term credit market: where debt market and earn interest.
securities having original maturities of 1
year or less are traded. 1. Financing Trade

The money market provides financing to local

 The money market provides commercial and international traders who are in urgent need
banks with a ready market where they of short-term funds. It provides a facility to
can invest their excess reserves and discount bills of exchange, and this provides
earn interest while maintaining liquidity. immediate financing to pay for goods and
services.
Feature/Nature of Money Market
2. Guiding the monetary policy
 Liquidity: They are considered highly
liquid as they are fixed-income The central bank is responsible for guiding the
securities which carry short maturity monetary policy of a country and taking
periods of a year or less. measures to ensure a healthy financial system.
Through the money market, the central bank can
perform its policy-making function efficiently.
 Safety: Since the issuers of money
market instruments have strong credit 3. Growth of Industries
ratings, it automatically means that the
money instruments issued by them will The money market provides an easy avenue
also be safe. where businesses can obtain short-term loans to
finance their working capital needs. Through
commercial paper and finance bills, they can
easily borrow money on a short-term basis.
 Discounted price: One of the main
features of money market instruments is 4. Commercial Banks Self-Sufficiency
that they are issued at a discount on
their face value. The money market provides commercial banks
with a ready market where they can invest their
Significance excess reserves and earn interest while
maintaining liquidity.
 The money market is an organized
exchange market where participants can How it works
lend and borrow short-term, high-quality
debt securities with average maturities The money market exists to provide the loans
of one year or less. that financial institutions and governments need
 The money market enables to carry out day-to-day operations. For instance,
governments, banks, and other large banks may sometimes need to borrow in short
institutions to sell short-term securities term to fulfill their obligations to their customers
to fund their short-term cash flow needs. and they use the money market to do so.
It also allows individual investors to
Classes of Money Market Instrument Certificates of deposit (CDs) are
certificates issued by a federally
chartered bank against deposited
1. Treasury Bills funds that earn a specified return
for a definite period of time
The Treasury bills are issued by the
Central Government and known to be 6. Repurchase agreement
one of the safest money market
instruments available. Besides, they Repo’s are also known as Reverse
carry zero risk, so the returns are not Repo or as Repo. They are loans of
attractive. short duration which are agreed by buyers and
sellers for the purpose of selling and
2. Promissory notes
repurchasing.
A promissory note is one of the earliest
type of bills. It is a financial instrument
with a written promise by one party, to 7. Banker’s Acceptance
pay to another party, a definite sum of
money by demand or at a specified Is a bank draft issued by a firm, payable
future date, although it falls in due for at some future date, and
payment after 90 days within three days guaranteed for a fee by the banks
of grace. that stamps it “accepted”. The issuing
the instrument is required to deposit
the required funds into its account
3. Commercial Paper to cover the draft.

Commercial papers can be compared to Function of Money Market Instrument

an unsecured short-term promissory
note which is issued by top rated 1. Helps Government
companies with a purpose of raising
capital to meet requirements directly The money market instruments prove
from the market. helpful to the government in borrowing
short-term funds on the basis of treasury
They usually have a fixed maturity bills at low interest rates. Besides, it
period which can range anywhere from would lead to inflationary pressures in
1 day up to 270 days. the economy if the Government had to
issue paper money or borrow from the
central bank.
4. Bill of exchange/Commercial paper
2. Helps in Monetary Policy

The bills of exchange can be compared The existence of a well-developed

to the promissory note; besides it money market will help in successfully
is drawn by the creditor implementing the monetary policies of
and is accepted by the bank of the central bank. Is only through money
debater. The bill of exchange can be market the central banks can control the
discounted by the creditor with a bank banking system and therefore Influence
or a broker. Additionally, there is a commerce and the industry.
foreign bill of exchange which
becomes due for payment from 3. Helps in Financial Mobility
the date of acceptance.
The Monet market helps in financial
5. Certificate of Deposit stability by smoothening the transfer for
funds from one sector to another. And,
financial mobility is important for the
development of commerce and industry.
 interbank trading is done by banks on
4. Promotes Liquidity and Safety behalf of large customers, most
interbank trading is proprierty, means
Apart from encouraging savings and
that it takes place on behalf of the banks
investments, the money market
instruments promote liquidity and safety own account.
of financial assets.
• Bank use the Interbank market to
5. Equilibrium between Demand and manage exchange rate and interest rate
Supply of Funds risk.
• The rate of interest earned on banks’
The money market brings a balance money is based on the current federal
between the demand and supply of funds rate. This is set by Federal
loanable funds by allocating saving into reserve in the U.S and also known as
investment channels. the interbank rate or overnight rate.
• The federal rate is a tool that the federal
6. Economy in Use of Cash funds rate. This is set by the federal
reserve uses to increase or decrease
The money market instruments deal the amount of cash in the over all
with assets which are not cash but system.
equivalent to cash and thus help in • It is also known as the federal funds
economizing the use of cash. And rate, is the interest charged on short-
hence it can be considered as a term loans made between financial
convenient way to transfer funds from institutions.
one place to another. • The term “interbank rate” may also refer
to the “Forex” rate paid in banks when
Risk vs. Return they trade currencies with other banks.

Risk Foreign Exchange Rate (FOREX)

 Risk is something everyone faces when
they make an investment. • Foreign exchange has no centralized
market. Instead, a forex market exist
whenever the trade of two foreign
 Defined in financial term as the chance
currencies are taking place.
that an outcome or investment’s actual
• Forex is essential infrastructure for
gains will differ from an expected
international trade and global investing.
outcome or return.
 Includes the possibility of losing some or
Commercial Paper
all of an original investment.
• Is a short-term debt obligation of a
Return
private-sector, firm or government-
 Return is the amount of money you
sponsored and corporation.
receive to take a risk measured in
• An unsecured loan and highly liquid
interest, dividend, capital appreciation of
issued by a corporation typically
your investment and/or profits you make
financing day to day operation.
from starting a business.
• Commercial paper is very safe
 Basically, a return is your reward for investment because the financial
taking a risk. situation of a company can easily be
 Also known as financial return, in its predicted over a few months.
simplest term, is the money made or lost • Commercial paper’s maturity is greater
on an investment over some period of than 90 days but less than 9 months.
time. • It is not for general public.
Interbank Market
Nature of CP
• Is the Global network utilized by
1. Unsecured Instruments as they are not
financial institution to trade currencies backed by other asset
between themselves. While some 2. Highly liquid
 3. Helps the highly rated companies to get • For inventors, returns are higher as
cheaper funds from commercial paper compared to bank deposits
rather than borrowing from banks • It is exempt from registering in Security
and Exchange Commission
Kinds of CP

1. DRAFT- Is a written instruction by a person Disadvantage of CP

to another to pay the specified amount to a third
person. • Only large bank and large corporation
a. SIGHT DRAFT- payable as soon as can issue commercial paper, hence it is
it is preferred to the drawee for a source of fund which is available to all
payment. • Small investment cannot directly invest
b. TIME DRAFT- not payable until the in commercial paper
lapse of the a particular time period
stated on the draft.
The rate of interest
2. CHECK- special form of the draft where the
 Interest rate is a rate of return paid by a
drawee is a bank.
borrower of funds to a lender of them, or
a price paid by a borrower for a service,
3. NOTE- a promise in made by one person to the right to make use of funds for a
pay another a certain sum of money to another. specified period. Thus it is one form of
yield on financial instruments.
4. CERTIFICATE OF DEPOSIT(CD)- an
instrument wherein the bank acknowledge the Risk Premium
receipt of deposit. It is a special form of
promissory notes.
 is an addition to the interest rate
demanded by a lender to take into
account the risk that the borrower might
Kinds of CP in terms of Security default on the loan entirely or may not
repay on time (default risk).
1. Unsecured Commercial Paper
Interest Rate Structure
• These are traditional paper and allotted
without any security  Is the relationships between the various
• short-term rates of interest in an economy on
financial instruments of different lengths
2. Secured Commercial Paper (terms) or of different degrees of risk.

• Assured by other financial asset Real Interest Rate

• long-term
 is the difference between the nominal
Use of CP rate of interest and the expected rate of
inflation. It is a measure of the
1. Funding Operating expenses anticipated opportunity cost of borrowing
2. Financing of Payroll, accounts payable, in terms of goods and services forgone.
inventories, and meeting other short-
term liabilities

Advantage of CP

• No collateral is needed
• Lowest cost of funding
• High-rated instruments, hence fewer
chances of default
Interest Rate Theories: Loanable Funds different lengths of time to maturity. That
Theory is, it shows the term structure of interest
rates.
1.) Time Preference
 Used as a benchmark for other debt in
o describes the extent to which a the market, such as mortgage rates or
person is willing to give up the bank lending rates, and is used to
satisfaction obtained from predict changes in economic output and
present consumption in return growth.
for increased consumption in
the future. Types of Yield Curve

2.) Loanable Funds 1.) Normal Yield Curve

- is which short-term debt instruments
o are funds borrowed and lent in have a lower yield than long-term debt
an economy during a specified instruments of the same credit quality.
period of time, the flow of - referred to as “Positive Yield Curve”.
money from surplus to deficit
units in the economy. 2.) Steep Yield Curve
- is a variation of the normal yield curve
Interest Rate Theories: Liquidity Preference possessing the same basic properties whereby
Theory the interest rates paid on securities with shorter
maturities is lower than rates paid on debt with
1.) Liquid Asset longer maturities.

o is the one that can be turned 3.) Flat Yield Curve

- is observed when all maturities have
into money quickly, cheaply and
similar yields.
for a known monetary value.
- a flat curve sends signals of
o money balances can be held in
uncertainty in the economy.
the form of currency or checking - Humped curve results when short-term
accounts, however it does earn and long-term yields are equal and medium-term
a very low interest rate or no yields are higher than those of the short-term
interest at all. and long-term.
2.) Liquidity Preference
4.) Inverted Yield Curve
- reflects a scenario in which short-term
o is preference for holding debt instruments have higher yields than long
financial wealth in the form of term instruments.
short-term, highly liquid assets - is often seen as an indicator of an
rather than long-term illiquid impending recession.
assets, based principally on the
fear that long-term assets will
lose capital value over time.
Theories of Term Structure of Interest Rates
o the level of interest rates is
determined by the supply and
1.) Expectation Theory
demand for money balances.
The money supply is controlled
by the policy tools available to o assumes that investors are
the country’s Central Bank. indifferent between investing for
a long period on the one hand
Yield Curve and investing for a shorter
period with a view to reinvesting
 Shows the relationships between the the principal plus interest on the
interest rates payable on bonds with other hand.
 • A written document outlining a debtor’s
2.) Liquidity Premium Theory indebtedness to a creditor.

o some investors may prefer to

own shorter rather than longer
term securities because a
shorter maturity represents
greater liquidity.

3.) Market Segmentation Theory

o interest rates for different

maturities are determined
independently of one another.
The interest rate for short
maturities is determined by the
supply of and demand for short
term funds. Long term interest
rates are those that equate the
sums that investors wish to lend
long term with the amounts that
borrowers are seeking on a long
term basis.

4.) Preferred Habitat Theory

o is a variation on the market

segmentation theory.
o allows for some substitutability
between maturities.
o views that interest premiums are
needed to entice investors from
their preferred maturities to
other maturities.

Treasury Bills

2 Types of Bidders under Treasury Bills

• Competitive Bidders – are the only ones

who actually influence the discount rate.
• Non-competitive Bidders – agree to buy
at the average price which are accepted
of all competitive bidders.

Bill of exchange

• Generally do not pay interest making

them essence of Post-Dated Checks.
• Involved by three parties (Drawee,
Payee, Drawer).
• Aren’t used much today, have been
replaced with paper currency, bank
wires, debit cards/credit cards.