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
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 traded 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 the securities being traded 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 can be defined as a market for financial assets that are near substitutes for money.
What is the importance of money markets in the economy?
The money market plays a very significant role in the economy. It allows a variety of participants to raise funds. It offers liquidity to both the investors and the borrowers. And hence maintaining a balance between the demand and supply for money. Thus facilitating the development and growth of the economy.
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.
Types of Money Market Instruments in India
1. Treasury Bills
T-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 or 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, the interest rates have been known to fluctuate by a large % at certain times.
- It can be called as a collection of the 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
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 earned by investing securities It can be calculated by the below formula:
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
Money Market vs Stocks Market
|Particulars||Money Market Instruments||Stocks|
|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||It has instruments like 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.
What factors 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 the purpose of the money market?
- Money market maintains liquidity in the market. RBI uses money market instruments to control liquidity.
- It finances short term needs of the government and economy. Any business or organisation can borrow money at short notice for a short term.
- Helps in utilising surplus funds in the market for a short term to earn an additional return. It channelises savings to investments.
- Assists in mobilising funds from one sector to another with the utmost transparency
- Guides in devising monetary policies. 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.
What are the 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.
What is the 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 money market is also responsible for controlling inflation.
Frequently Asked Questions
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 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.
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:
Primary Market: A market in which a fresh issue of securities takes place.
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.
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:
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.
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.
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.
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.
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.