Money markets exist to transfer funds from individuals, corporations, and government units with short-term excess funds (suppliers of funds) to economic agents who have short-term needs for funds (users of funds). Specifically, in money markets , shortterm debt instruments (those with an original maturity of one yearor less) are issued by economic agents that require short-term funds and are purchased by economic agents that have excess short-term funds
Once issued, money market instruments trade in active secondary markets. Capital markets serve a similar function for market participants with excess funds to invest for periods of time longer than one year and/or who wish to borrow for periods longer than one year. Market participants who concentrate their investments in capital market instruments also tend to invest in some money market securities so as to meet their short-term liquidity needs. The secondary markets for money market instruments are extremely important, as they serve to reallocate the (relatively) fixed amounts of liquid funds available in the market at any particular time.
Money markets played a major role in the financial crisis of 2008–2009. As mortgage and mortgage-backed securities (MBS) markets started to experience large losses, money markets froze and banks stopped lending to each other at anything but high overnight rates. The overnight London Interbank Offered Rate (a benchmark rate that reflects the rate at which banks lend to one another) more than doubled, rising from 2.57 percent on September 29, 2008, to an all-time high of 6.88 percent on September 30, 2009. Further, commercial paper markets, short-term debt used to finance companies’ day-to-day
operations, shrank by $52.1 billion (from $1.7 trillion in size) in less than a one-week period in mid-September 2008. The Notable Events from the Financial Crisis box highlights some of the actions taken by central banks around the world to stem the post-2007 crisis in the money markets. In 2010 money markets had over $6.4 trillion in financial claims outstanding, down from over $8 trillion in 2007 before the financial crisis. In this chapter, we present an overview of money markets. We define and review the various money market instruments that exist, the new issue and secondary market trading process for each, and the market participants trading these securities. We also look at international money markets and instruments, taking a particularly close look at the Euro markets.
The need for money markets arises because the immediate cash needs of individuals, corporations, and governments do not necessarily coincide with their receipts of cash. For example, the federal government collects taxes quarterly; however, its operating and other expenses occur daily. Similarly, corporations’ daily patterns of receipts from sales do notnecessarily occur with the same pattern as their daily expenses (e.g., wages and other
disbursements). Because excessive holdings of cash balances involve a cost in the form of forgone interest, called opportunity cost , those economic units with excess cash usually keep such balances to the minimum needed to meet their day-to-day transaction requirements. Consequently, holders of cash invest “excess” cash funds in financial securities that can be quickly and relatively costlessly converted back to cash when needed with little risk of loss of value over the short investment horizon. Money markets are efficient in performing this service in that they enable large amounts of money to be transferred from suppliers of funds to users of funds for short periods of time both quickly and at low cost to th transacting parties. A money market instrument provides an investment opportunity that generates a higher rate of interest (return) than holding cash (which yields zero interest), but it is also very liquid and (because of its short maturity) has relatively low default risk
Notice, from the description above, that money markets and money market securities or instruments have three basic characteristics. First, money market instruments are generally sold in large denominations (often in units of $1 million to $10 million). Most money market participants want or need to borrow large amounts of cash, so that transactions costs are low relative to the interest paid. The size of these initial transactions prohibits most individual investors from investing directly in money market securities. Rather, individuals generally invest in money market securities indirectly, with the help of financial institutions such as money market mutual funds or short-term funds. Second, money market instruments have low default risk ; the risk of late or nonpayment of principal and/or interest is generally small. Since cash lent in the money markets must be available for a quick return to the lender, money market instruments can generally be issued only by high-quality borrowers with little risk of default.
Finally, money market securities must have an original maturity of one year or less. Given that adverse price movements resulting from interest rate changes are smaller for short-term securities, the short-term maturity of money market instruments helps lower the risk that interest rate changes will significantly affect the security’s market value and price.
For many of the money market securities discussed below, returns are measured and quoted in a manner that does not allow them to be evaluated using the time value of money equations. For example, some securities’ interest rates or returns are based on a 360-day year, while others are based on a 365-day year. It is therefore inappropriate to compare annual interest rates on the various money market securities as well as on short-term and long-term securities without adjusting their interest rates for differences in the securities’ characteristics
Bond Equivalent Yields
The bond equivalent yield, i bey , is the quoted nominal, or stated, yield on a security. 1 From Chapters 2 and 3 , the bond equivalent yield is the rate used to calculate the present value of an investment. For money market securities, the bond equivalent yield is the product of the periodic rate and the number of periods in a year. It is calculated as follows:
Once issued, money market instruments trade in active secondary markets. Capital markets serve a similar function for market participants with excess funds to invest for periods of time longer than one year and/or who wish to borrow for periods longer than one year. Market participants who concentrate their investments in capital market instruments also tend to invest in some money market securities so as to meet their short-term liquidity needs. The secondary markets for money market instruments are extremely important, as they serve to reallocate the (relatively) fixed amounts of liquid funds available in the market at any particular time.
Money markets played a major role in the financial crisis of 2008–2009. As mortgage and mortgage-backed securities (MBS) markets started to experience large losses, money markets froze and banks stopped lending to each other at anything but high overnight rates. The overnight London Interbank Offered Rate (a benchmark rate that reflects the rate at which banks lend to one another) more than doubled, rising from 2.57 percent on September 29, 2008, to an all-time high of 6.88 percent on September 30, 2009. Further, commercial paper markets, short-term debt used to finance companies’ day-to-day
operations, shrank by $52.1 billion (from $1.7 trillion in size) in less than a one-week period in mid-September 2008. The Notable Events from the Financial Crisis box highlights some of the actions taken by central banks around the world to stem the post-2007 crisis in the money markets. In 2010 money markets had over $6.4 trillion in financial claims outstanding, down from over $8 trillion in 2007 before the financial crisis. In this chapter, we present an overview of money markets. We define and review the various money market instruments that exist, the new issue and secondary market trading process for each, and the market participants trading these securities. We also look at international money markets and instruments, taking a particularly close look at the Euro markets.
The need for money markets arises because the immediate cash needs of individuals, corporations, and governments do not necessarily coincide with their receipts of cash. For example, the federal government collects taxes quarterly; however, its operating and other expenses occur daily. Similarly, corporations’ daily patterns of receipts from sales do notnecessarily occur with the same pattern as their daily expenses (e.g., wages and other
disbursements). Because excessive holdings of cash balances involve a cost in the form of forgone interest, called opportunity cost , those economic units with excess cash usually keep such balances to the minimum needed to meet their day-to-day transaction requirements. Consequently, holders of cash invest “excess” cash funds in financial securities that can be quickly and relatively costlessly converted back to cash when needed with little risk of loss of value over the short investment horizon. Money markets are efficient in performing this service in that they enable large amounts of money to be transferred from suppliers of funds to users of funds for short periods of time both quickly and at low cost to th transacting parties. A money market instrument provides an investment opportunity that generates a higher rate of interest (return) than holding cash (which yields zero interest), but it is also very liquid and (because of its short maturity) has relatively low default risk
Notice, from the description above, that money markets and money market securities or instruments have three basic characteristics. First, money market instruments are generally sold in large denominations (often in units of $1 million to $10 million). Most money market participants want or need to borrow large amounts of cash, so that transactions costs are low relative to the interest paid. The size of these initial transactions prohibits most individual investors from investing directly in money market securities. Rather, individuals generally invest in money market securities indirectly, with the help of financial institutions such as money market mutual funds or short-term funds. Second, money market instruments have low default risk ; the risk of late or nonpayment of principal and/or interest is generally small. Since cash lent in the money markets must be available for a quick return to the lender, money market instruments can generally be issued only by high-quality borrowers with little risk of default.
Finally, money market securities must have an original maturity of one year or less. Given that adverse price movements resulting from interest rate changes are smaller for short-term securities, the short-term maturity of money market instruments helps lower the risk that interest rate changes will significantly affect the security’s market value and price.
For many of the money market securities discussed below, returns are measured and quoted in a manner that does not allow them to be evaluated using the time value of money equations. For example, some securities’ interest rates or returns are based on a 360-day year, while others are based on a 365-day year. It is therefore inappropriate to compare annual interest rates on the various money market securities as well as on short-term and long-term securities without adjusting their interest rates for differences in the securities’ characteristics
Bond Equivalent Yields
The bond equivalent yield, i bey , is the quoted nominal, or stated, yield on a security. 1 From Chapters 2 and 3 , the bond equivalent yield is the rate used to calculate the present value of an investment. For money market securities, the bond equivalent yield is the product of the periodic rate and the number of periods in a year. It is calculated as follows:
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