The money market is referred to as dealing in debt instruments with less than a year to maturity bearing fixed income. In this article, we will cover the meaning of money market instruments along with its types and objectives.
Table of contents
- What is Money Market?
- Objectives of Money Market
- Importance of the Money Market
- Characteristics of Money Market Instruments
- Types of Money Market Instruments in India
- Features of Money Market
- Money Market vs Stock Market
- What are Money Market Funds?
- Factors to determine Interest Rates of Money Market Instruments
- What is Maturity?
- What is the Yield on Security?
- Frequently Asked Questions
What is Money Market?
Money Market is a financial market where short-term financial assets having liquidity of one year or less are traded on stock exchanges. The securities or trading bills are highly liquid. Also, these facilitate the participant’s short-term borrowing needs through trading bills. The participants in this financial market are usually banks, large institutional investors, and individual investors.
There are a variety of instruments that trade in the money market in both the stock exchanges, NSE and BSE. These include treasury bills, certificates of deposit, commercial paper, repurchase agreements, etc. Since these securities that trade are highly liquid in nature, the money market is considered as a safe place for investment.
The Reserve Bank controls the interest rate of various instruments in the money market. The degree of risk is smaller in the money market. This is because most of the instruments have a maturity of one year or less.
Hence, this gives minimal time for any default to occur. The money market thus is a market for financial assets that are near substitutes for money.
Objectives of Money Market
Below are the main objectives of the money market:
- Providing borrowers such as individual investors, government, etc. with short-term funds at a reasonable price. Lenders will also have the advantage of liquidity as the securities in the money market are short-term.
- It also enables lenders to turn their idle funds into an effective investment. In this way, both the lender and borrower are at a benefit.
- RBI regulates the money market. Therefore, in turn, helps to regulate the level of liquidity in the economy.
- Since most organizations are short on their working capital requirements. The money market helps such organizations to have the necessary funds to meet their working capital requirements.
- It is an important source of finance for the government sector for both national and international trade. And hence, provides an opportunity for the banks to park their surplus funds.
Importance of the Money Market
The money market is a market for short term transactions. Hence it is responsible for the liquidity in the market. Following are the reasons why the money market is essential:
- It maintains a balance between the supply of and demand for the monetary transactions done in the market within a period of 6 months to one year..
- It enables funds for businesses to grow and hence is responsible for the growth and development of the economy.
- It aids in the implementation of monetary policies.
- It helps develop trade and industry in the country. Through various money market instruments, it finances working capital requirements. It helps develop the trade in and out of the country.
- The short term interest rates influence long term interest rates. The money market mobilises the resources to the capital markets by way of interest rate control.
- It helps in the functioning of the banks. It sets the cash reserve ratio and statutory liquid ratio for the banks. It also engages their surplus funds towards short term assets to maintain money supply in the market.
- The current money market conditions are the result of previous monetary policies. Hence it acts as a guide for devising new policies regarding short term money supply.
- Instruments like T-bills, help the government raise short term funds. Otherwise, to fund projects, the government will have to print more currency or take loans leading to inflation in the economy. Hence the it is also responsible for controlling inflation.
What are Money Market Instruments?
Money market instruments are financial instruments that help companies, corporations, and government bodies to raise short-term debt for their needs. The borrowers meet their short-term needs at a low cost and the lenders benefit from interest rates and liquidity. Money market instruments include bonds, treasury bills, certificates of deposit, commercial paper, etc.
What are the Pros and Cons of Money Market Instruments?
Pros of Money Market Instruments
The following are the advantages of investing in money market instruments:
- Highly Liquid: Money market instruments offer higher liquidity than other fixed-income securities, enabling investors to liquidate their holdings at any time. These instruments have no lock-in period.
- Higher Interest Rate: Unlike traditional savings accounts, money market instruments offer slightly higher interest. Thus, these are a good alternative to holding cash in a savings account.
Cons of Money Market Instruments
Following is the disadvantage of money market instruments:
- Doesn’t offer inflation-beating returns: Although the interest rate on money market instruments is higher than savings accounts, it doesn’t necessarily counteract the effects of a growing economy and inflation. Therefore, if the investment goal is capital appreciation while surpassing inflation, money market instruments might not be the most suitable choice.
Characteristics of Money Market Instruments
- It is a financial market and has no fixed geographical location.
- It is a market for short term financial needs, for example, working capital needs.
- It’s primary players are the Reserve Bank of India (RBI), commercial banks and financial institutions like LIC, etc.,
- The main money market instruments are Treasury bills, commercial papers, certificate of deposits, and call money.
- It is highly liquid as it has instruments that have a maturity below one year.
- Most of the money market instruments provide fixed returns.
Types of Money Market Instruments in India
1. Treasury Bills
Treasury Bills are one of the most popular money market instruments. They have varying short-term maturities. The Government of India issues it at a discount for 14 days to 364 days.
These instruments are issued at a discount and repaid at par at the time of maturity. Also, a company, firm, or person can purchase TB’s. And are issued in lots of Rs. 25,000 for 14 days & 91 days and Rs. 1,00,000 for 364 days.
2. Commercial Bills
Commercial bills, also a money market instrument, works more like the bill of exchange. Businesses issue them to meet their short-term money requirements.
These instruments provide much better liquidity. As the same can be transferred from one person to another in case of immediate cash requirements.
3. Certificate of Deposit
Certificate of Deposit (CD’s) is a negotiable term deposit accepted by commercial banks. It is usually issued through a promissory note.
CD’s can be issued to individuals, corporations, trusts, etc. Also, the CD’s can be issued by scheduled commercial banks at a discount. And the duration of these varies between 3 months to 1 year. The same, when issued by a financial institution, is issued for a minimum of 1 year and a maximum of 3 years.
4. Commercial Paper
Corporates issue CP’s to meet their short-term working capital requirements. Hence serves as an alternative to borrowing from a bank. Also, the period of commercial paper ranges from 15 days to 1 year.
The Reserve Bank of India lays down the policies related to the issue of CP’s. As a result, a company requires RBI’s prior approval to issue a CP in the market. Also, CP has to be issued at a discount to face value. And the market decides the discount rate.
Denomination and the size of CP:
Minimum size – Rs. 25 lakhs
Maximum size – 100% of the issuer’s working capital
5. Call Money
It is a segment of the market where scheduled commercial banks lend or borrow on short notice (say a period of 14 days). In order to manage day-to-day cash flows.
The interest rates in the market are market-driven and hence highly sensitive to demand and supply. Also, historically, interest rates tend to fluctuate by a large % at certain times.
Features of Money Market
- Its main feature is liquidity. All the submarkets, such as call money, notice money, etc. have close interrelation with each other. This helps in the movement of funds from one sub-market to another.
- The volume of traded assets is generally very high.
- It enables the short-term financial needs of the borrowers. Also, it deals with investments that have a maturity period of 1 year or less.
- It is still evolving. There is always a possibility of adding new instrument.
Money Market vs Stock Market
|Particulars||Money Market||Stock Market|
|Maturity of the instruments||The money market instruments carry a maturity period of less than a year.||However tradable in the short term, stocks create wealth creation when invested for a number of years.|
|Financing needs||These instruments are used to fund the short-term needs of the borrower.||Used for long-term fund requirements.|
|Types of instruments||Instruments of money market include T-bills, certificate of deposits, inter-bank call money, etc.||It’s a stock of an independently listed company|
|Degree of risk||Risk is comparatively lower due to the short-term maturity period||Risk is higher.|
What are Money Market Funds?
Money Market Mutual Funds, MMMFs are highly liquid open-ended dent funds generally used for short term cash needs. The money market fund deal only in cash and cash equivalents with an average maturity of an year with fixed income.
The fund manager invests in money market instruments like treasury bills, commercial paper, certificate of deposits, bills of exchange etc.
Recommended Read: Fixed Income Instruments
Who Should Invest in Money Market Mutual Funds?
Money market mutual funds serve a suitable and secure investment choice for investors with a short term investment horizon. These mutual funds are distinguished by their low-risk association with money market instruments.
Money market MFs have a diversified portfolio, they invest across various types of money market instruments to optimize returns.
Therefore, investor who want highly liquid and safe investment for the short term can invest in money market mutual funds.
Factors to determine Interest Rates of Money Market Instruments
Currently, the interest rate is dependent on the market forces of demand for; and supply of short term money.
Fiscal deficit, for example, occurs when the government expenditure is more than government revenue. To fund this deficit, the government requires money which in turn leads to borrowing by the government and hence influencing the interest rates.
In other words, the higher the fiscal deficit more will be the money required by the government. Hence, it will lead to an increase in interest rates.
What is Maturity?
The maturity in respect of money market instruments means the time period within which the securities will mature. This is generally less than a year in case of money market instruments.
What is the Yield on Security?
In simple words, the yield is the interest rate you earn by investing in securities. The below formula can calculate it:
Yield = (Face value – Sale value)/sale value* (days or months in a year/period of discount)*100
Let’s understand the above with the help of an example:
Face value or amount of issue – Rs. 100
Period – 6 months
Discount rate – 10%
Discount – 100*(6/12)*(10/100) = Rs. 5
By using the above formula for yield we get
Y = (100-95)/100*(12/6)*100
Y = 10%
Money Markets vs. Capital Markets
Money markets primarily cater to short-term liquidity needs and offer low-risk options like Treasury Bills and Commercial Papers. Capital markets, however, operate for long-term investments, with instruments like stocks and bonds involving higher risks and potentially higher returns. While instruments of money market include highly liquid assets with shorter maturity periods, capital markets are regulated with longer-term investments.
Money market participants primarily include banks and financial institutions seeking short-term funding. The capital market involves various entities such as stockbrokers, mutual funds, retail investors, and underwriters dealing with long-term investment options like stocks and bonds. Overall, money markets aim to meet short-term liquidity needs, while capital markets channel savings for long-term growth and development.
For a detailed understanding, refer to our article on Money Market vs Capital Market.
Frequently Asked Questions
A treasury bill (T Bill) is a short term government debt obligation. The Reserve Bank of India issues it. It has a maturity of one year or less. Hence, these are short term instruments. The T-bills are issued to address the liquidity shortfall in the economy.
T-bills are zero-coupon securities. In other words, these instruments do not earn any interest. However, these are issued at a discount to the face value. The difference between the face value and the issue price is the return to the investor.
For example, the face value of a 91day T-bill is INR 100. However, the RBI issues them at a discounted price of INR 95. Upon maturity, the investor would get INR 100. Hence, the return for an investor is INR 5.
Following are the types of T-bills in India:
1. 14-day Treasury bill
2. 91-day Treasury bill
3. 182-day Treasury bill
4. 364-day Treasury bill
Money markets are unorganised markets. Financial institutions, banks, brokers and money dealers trade for a short period. T Bills, commercial paper, certificate of deposit, trade credit, bills of exchange, promissory notes, call money, etc. are some of the examples of money market instruments. These are highly liquid instruments and can be redeemed easily. Most money market trades take place over the counter (OTC).
Capital market deals in financial products such as stocks (equity shares), preference shares, debentures, bonds, etc. These instruments are traded for longer durations. The capital market instruments are used to finance long term capital requirements.
The capital market consists of two categories:
1. Primary Market: A market in which a fresh issue of securities takes place.
2. Secondary Market: A market where securities are traded on the exchange between the investors.
No, a fixed deposit (FD) is not a money market instrument. However, a certificate of deposit is a money market instrument. A certificate of deposit is similar to a fixed deposit as both pay an interest higher than a bank savings account. However, a certificate of deposit is negotiable, and a fixed deposit is not. A certificate of deposit has a higher minimum investment and longer investment horizon than a fixed deposit.
The money market is the component of a financial market that deals with short term borrowings. On the other hand, the capital market is also a component of the financial market that allows long term trading of equity and debt securities.
Money markets deal in short term lending, borrowing, buying and selling. In contrast, capital markets deal in long term lending or borrowing. Corporations or investors with sizeable investible amount deal in capital markets. Financial regulators in India are responsible for overseeing the capital market activities. Their role is to ensure that companies do not default investors.
Businesses are seeking to fulfil short term credit requirements go-to money market. In comparison, capital markets meet the long term financial needs of the business.
Capital markets offer highly volatile instruments. On the other hand, the money market offers comparatively, safer assets. Returns from capital markets are comparatively higher. The returns from capital markets correlate with the volatility (level of risk). However, this is not always the case. Returns from money market instruments are low but steady.
Maturity of money market instruments is usually up to one year. At the same time, the maturity of capital markets instruments is longer. They don’t have a specific time frame.
No investment is risk-free. All investments have different levels of risk associated with them. Money market funds are not inherently risk-free. Following are the risks associated with money market funds:
1. Default Risk (Credit Risk) : Money market instruments carry the risk of default. There is no guarantee that the borrower will repay the amount. Therefore, there is a default risk associated with these instruments.
2. Interest Rate Risk : Fluctuations in the interest rates have an impact on the yields. A higher volatile fund implies that it is exposed to higher interest rate risk. In a scenario where interest rates fall, the opportunity cost of holding this fund can be high.
3. Price Risk : Similar to share price fluctuations, there is a possibility that prices of money markets funds fluctuate too. In other words, there is a chance that the worth of the instrument might be lesser while selling.
4. Liquidity Risk : The inability to sell the instruments will result in liquidity risk. Liquidity risk comes into play when a money market fund experiences major unexplained cash outflows. The fund is forced to sell because there aren’t enough liquid assets used to manage the outflows.
5. Inflation Risk : Similar to other assets, money market funds also carry inflation risk. The returns from these investments may not be able to keep up with the inflation rate in the economy.
Even though the money market instruments do not carry many risks, it would be incorrect to say that they are entirely risk-free. The reason is simple. While getting money is easier for borrowers with an outstanding track record or credit ratings, there is always a possibility that the borrower might default in the repayment. It is always advisable to refer to the credit ratings before investing or trading.
The money market in India is regulated by both the Reserve Bank of India and the Securities u0026 Exchange Board of India (SEBI).
T-bills are one of the most popular money market instruments. This instrument issued comes with varying short-term maturities. The instrument issued by the Government of India comes at a discount for 14 days to 364 days.
The Government of India aims to provide investors with instruments of varying duration. These government securities are also introduced 14 days, 28 days, 91 days and 364 days T-bills on an auction basis
Individuals, banking companies, other corporate bodies (registered or incorporated in India), and unincorporated bodies can invest. Additionally, non-resident Indians (NRIs) and foreign institutional investors (FIIs), etc can also invest in CPs. Foreign Institutional investors can invest in CP subject to the criteria and conditions laid down by SEBI.
Investors including corporations, banking institutions, companies, and individuals can invest in money market instruments. Money market instruments are best suited for the short-term investment objectives of the investors. Hence, an investor who wishes to earn a higher interest rate on their surplus funds must consider these instruments.
The major difference between money market instruments and equity securities is that these instruments are meant to fund short-term capital needs. On the other hand, equity securities are issued to raise capital for the long term. Owning to the intent of the issuing companies the risk and return involved is different as well. Due to the short-term maturity, the risk involved is comparatively lower for money market instruments. The risk associated with equity securities is higher than with money market instruments.
Fixed income instruments are financial instruments that provide a fixed return or interest rate. The interest rate is predetermined and payable at a fixed date. For example, a fixed deposit is a fixed income instrument. It provides interest income at a predetermined rate and date. While money market instruments also provide a fixed return on investment. However, both instruments vary in terms of maturity, risk, and liquidity. Money market instruments have a maturity of less than 1 year providing greater liquidity along with lower credit default risk.
Examples of money market instruments are treasury bills, commercial papers, certificates of deposits, call money, call (overnight), commercial bills and short-notice (up to fourteen days) money, and term money. All these instruments will have a maturity period of less than 1 year.
The money market instruments are issued by government agencies or bodies, banking institutions, financial institutions, companies, and corporations. These entities are large enterprises and thereby the credit default is comparatively lower. These instruments provide a rate of return which is higher than savings account interest rates. All the types of instruments differ in their maturity, rate of return, and other factors. Hence, before investing the investor must always match their investment objectives with these factors. The best money market instrument will be the instrument which is best suited for the investment objective.
No, bonds are not money market instruments. Bonds with a maturity period of more than 1 year are capital market instruments.
No, mutual funds are not money market instruments. Mutual funds belong to the capital market in the economy. However, the money market funds belong to the money market. These funds invest in money market instruments.
The money market instruments are issued by a borrower who wants to raise capital for a short term. These borrowers include government agencies or bodies, banking institutions, financial institutions, companies, and corporations.