Mastering the Money Market: Your Guide to Short-Term Investments

WHAT IS MONEY MARKET?

The money market is a segment of the financial market where short-term debt securities are bought and sold. It provides liquidity to financial institutions and governments to meet short-term funding needs.

Here are some key components of the money market:

1. Call Money:

These are the short-term funds borrowed or lent in the interbank market for a duration of one day. Banks use call money to manage their short-term liquidity needs.

Example: Suppose Bank A urgently needs funds to meet its reserve requirements. It can borrow call money from Bank B overnight by pledging eligible securities as collateral. The next day, Bank A repays the borrowed amount along with interest.

2. Repo (Repurchase Agreement):

A transaction where one party (usually a dealer or financial institution) sells securities to another party (typically a central bank or another financial institution) with an agreement to repurchase them at a later date, usually the next day, at a slightly higher price. It serves as a short-term borrowing mechanism.

Example: Bank X sells government securities to the Central Bank under a repo agreement, agreeing to repurchase them at a slightly higher price the next day. This transaction provides Bank X with short-term liquidity, and the Central Bank earns a return on its funds.

Types of repo

i.) Open Repo: A repo agreement with no fixed term, allowing either party to terminate the agreement at any time.

Example: A financial institution enters into an open repo agreement with a money market mutual fund, allowing the institution to borrow funds against collateralized securities with no fixed maturity date. The institution can terminate the agreement at any time by returning the borrowed funds and receiving back the collateral.

ii.) Term Repo: A repo agreement with a specified term longer than one day, typically ranging from a few days to several months.

Example: Corporation Y enters into a term repo agreement with Bank Z to borrow funds for three months, pledging corporate bonds as collateral. Bank Z agrees to lend the funds at an agreed-upon interest rate, and Corporation Y repurchases the bonds at the end of the term.

 3. Reverse Repo:

The opposite of a repo transaction, where one party purchases securities from another party with an agreement to sell them back at a later date. It serves as a short-term lending mechanism.

Example: The Central Bank conducts a reverse repo transaction with commercial banks, temporarily absorbing excess liquidity from the banking system by purchasing government securities with an agreement to sell them back at a later date.

4. Certificate of Deposit (CD):

A time deposit issued by banks with a specified maturity date and fixed interest rate. CDs typically have higher interest rates than regular savings accounts but impose penalties for early withdrawal.

Example: Investor C purchases a $10,000 CD from Bank D with a maturity of six months and an annual interest rate of 2.5%. Bank D issues the CD, and Investor C cannot withdraw the funds before the maturity date without incurring penalties.

5. Commercial Papers: 

Short-term unsecured promissory notes issued by corporations to raise funds for short-term financing needs, such as payroll or inventory management.

Example: Corporation E issues $1 million worth of commercial papers with a maturity of 90 days to raise funds for short-term operational expenses. Investors purchase the commercial papers, and Corporation E repays the principal amount along with interest at maturity.

6. Treasury Bills (T-Bills):

Short-term debt securities issued by governments (such as the U.S. Treasury) with maturities ranging from a few days to one year. T-Bills are sold at a discount to face value and do not pay interest; instead, investors earn a return by purchasing them at a discount and receiving the full face value at maturity.

Example: The U.S. Treasury auctions $1 billion worth of 3-month T-Bills with a discount rate of 1.5%. Investors bid on the T-Bills, and the Treasury issues them to the highest bidders. At maturity, investors receive the full-face value of the T-Bills.

These instruments play crucial roles in facilitating liquidity management, short-term financing, and investment opportunities within the financial system.