The money markets consist of a network of corporations, financial institutions, investors and governments, which need to borrow or invest short- term capital (up to 12 months). For example, a business or government that needs cash for a few weeks only can use the money market. So can a bank that wants to invest money that depositors could withdraw at any time. Through the money markets, borrowers can find short- term liquidity by turning assets into cash. They can also deal with irregular cash flows- in-comings and out-goings of money- more cheaply than borrowing from a commercial bank.
Similarly, investors can make short- term deposits with investment companies at competitive interest rates: higher ones than they would get from a bank. Borrowers and lenders in the money markets use banks and investments such as stocks, bonds, short- term loans and debts, rather than lending money. In brief, the money market is a short term debt market that deals with different money market instruments.
III. Common money market instruments There are several different instruments in the money market, offering different returns and different risks.
In the following sections, we’ll take a look at the common money market instruments. 1. Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the government to raise money from the public. In this tutorial, we are referring to T-bills issued by governments. T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities- the length of time before a bond become repayable.
T- Bills in a country’s own currency are generally the safest possible investment. They are usually sold at a discount from their face value- the value written on them- rather than paying interest; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. 2. For many corporations, borrowing short-term money from banks is often a laborious and annoying task.
The desire to avoid banks as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured (which means it is not guaranteed by the company’s assets) short-term loan issued by major companies and typically for financing accounts receivable and inventories. It is usually sold at a discount, with a yield slightly higher than Treasury bills. Maturities on commercial paper are usually no longer than nine months, with maturities of between one and two months being the average.
For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper. Over the past 40 years, there have only been a handful of cases where corporations have defaulted on their commercial paper repayment. 3. Certificates of deposit (CDs) are short- or medium- term, interest- paying debt instruments- written promises to repay a debt. They are issued by banks to large depositors who can then trade them in the short- term money markets.
They are known as time deposits, because the holder agrees to lend the money- by buying the certificate- for a specified amount of time. CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn depends on a number of other factors such as the current interest rate environment, how much money you invest, the length of time and the particular bank you choose.
While nearly every bank offers CDs, the rates are rarely competitive, so it’s important to shop around. A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest you earn in one year, taking compound interest into account. APR is simply the stated interest you earn in one year, without taking compounding into account. The difference results from when interest is paid. The more frequently interest is calculated, the greater the yield will be.
When an investment pays interest annually, its rate and yield are the same. But when interest is paid more frequently, the yield gets higher. For example, say you purchase a one-year, $1,000 CD that pays 5% semi-annually. After six months, you’ll receive an interest payment of $25 ($1,000 x 5 % x . 5 years). Here’s where the magic of compounding starts. The $25 payment starts earning interest of its own, which over the next six months amounts to $ 0. 625 ($25 x 5% x . 5 years). As a result, the rate on the CD is 5%, but its yield is 5. 06. It may not sound like a lot, but compounding adds up over time.
The main advantage of CDs is their relative safety and the ability to know your return ahead of time. You’ll generally earn more than in a savings account, and you won’t be at the mercy of the stock market. Plus, in the U. S. the Federal Deposit Insurance Corporation guarantees your investment up to $100,000. Despite the benefits, there are two main disadvantages to CDs. First of all, the returns are paltry compared to many other investments. Furthermore, your money is tied up for the length of the CD and you won’t be able to get it out without paying a harsh penalty.
IV. CONCLUSION We hope this tutorial has given you an idea of the securities in the money market. It’s not exactly a sexy topic, but definitely worth knowing about, as there are times when even the most ambitious investor puts cash on the sidelines. ? The money market specializes in debt securities that mature in less than one year. ? Money market securities are very liquid, and are considered very safe. As a result, they offer a lower return than other securities. ? T-bills are short-term government securities that mature in one year or less from their issue date. T-bills are considered to be one of the safest investments – they don’t provide a great return. The purchase price is less than the the face value. ? A certificate of deposit (CD) is a time deposit with a bank. The return on the certificate of deposit is higher than the Treasury Bills because it assumes a higher level of risk. ? CDs are safe, but the returns aren’t great, and your money is tied up for the length of the CD. ? Commercial paper is an unsecured, short-term loan issued by a corporation. Returns are higher than T-bills because of the higher default risk.
Cite this Money Market Essay
Money Market Essay. (2016, Nov 14). Retrieved from https://graduateway.com/money-market/