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The major purpose of financial markets is to transfer funds from lenders to borrowers. Participants in the financial market commonly distinguish between the "capital market" and the "money market," with the latter term generally referring to borrowing and lending for periods of a year or less. The United States money market is very efficient in that it enables large sums of money to be transferred quickly and at a low cost from one economic unit (business, government, bank, etc.) to another for relatively short periods of time.
The need for a money market arises because receipts of economic units do not coincide with their expenditures. These units can hold money balances to insure that planned expenditures can be maintained independently of cash receipts (that is, transactions balances in the form of currency, demand deposits, or NOW accounts). There are however, a cost in the form of foregone interest involved, by holding these balances. To enable the economic units to minimize this cost, they usually seek to hold the minimum money balances required for day-to-day transactions. They supplement these balances with holdings of money market instruments. The advantages of money market instruments are: that it can be converted to cash quickly and at a relatively low cost, and it have low price risk due to their short maturities. Economic units can also meet their short-term cash demands by maintaining access to the money market and raising funds there when required.
There is a high degree of safety of principal. They are most commonly issued in units of $1 million or more.
range from one day to one year; the most common are three months or less.
The money market encompasses a group of short-term credit market instruments, futures market instruments, and the Federal Reserve's discount window. The major participants in the money market are commercial banks, governments, corporations, government-sponsored enterprises, money market mutual funds, futures market exchanges, brokers and dealers, and the Federal Reserve.
Banks play three important roles in the money market. First, they borrow in the money market to fund their loan portfolios and to acquire funds to satisfy noninterest-bearing reserve requirements at Federal Reserve Banks. Banks are the major participants in the market for federal funds. Federal funds are very short-term--mainly overnight--loans of immediately available money; that is, funds that can be transferred between banks within a single business day. The funds market efficiently distributes reserves throughout the banking system. The borrowing and lending of these reserves takes place at a competitively determined interest rate known as the federal funds rate.
Banks and other depository institutions can also borrow on a short-term basis at the Federal Reserve discount window and pay a rate of interest set by the Federal Reserve called the discount rate. The decision to borrow at the discount window depends on the relation of the discount rate to the federal funds rate, as well as on the administrative arrangements surrounding the use of the window.
Banks also borrow funds in the money market for longer periods by issuing large negotiable certificates of deposit (CDs) and by acquiring funds in the Eurodollar market. A large denomination CD is a certificate issued by a bank as evidence that a certain amount of money has been deposited for a period of time. The time period usually ranging from one to six months. At maturity the CD will be redeemed with interest. Eurodollars are dollar-denominated deposit liabilities of banks located outside the United States (or of International Banking Facilities in the United States). They can be either large CDs or nonnegotiable time deposits. U.S. banks raise funds in the Eurodollar market through their overseas branches and subsidiaries.
A final way banks raise funds in the money market is through repurchase agreements (RPs). An RP is a sale of securities with a simultaneous agreement by the seller to repurchase them at a later date. (For the lender-, (the buyer of the securities in such a transaction)- the agreement is often called a reverse RP.) This agreement (when properly executed) is in effect a short-term collateralized loan. Most RPs involve U.S. government securities or securities issued by government-sponsored enterprises. Banks are active participants on the borrowing side of the RP market.
A second important role of banks in the money market is as dealers in the market for over-the-counter interest rate derivatives, which has grown rapidly in recent years. Over-the-counter interest rate derivatives set terms for the exchange of cash payments based on subsequent changes in market interest rates. For example, in an interest rate swap, the parties to the agreement exchange cash payments to one another based on movements in specified market interest rates. Banks frequently act as middleman in swap transactions by serving as a counterparty to both sides of the transaction.
A third role of banks in the money market is to provide, in exchange for fees, commitments that help insure that investors in money market securities will be paid on a timely basis. The types of commitments provided are:
The U.S. Treasury and state and local governments raise large sums in the money market. The Treasury raises funds in the money market by selling short-term obligations of the U.S. government called Treasury bills. These bills have the largest volume outstanding and the most active secondary market of any money market instrument. Bills typically have the lowest interest rate at a given maturity, because they are generally considered to be free of default risk, while other money market instruments have some default risk. State and local governments raise funds in the money market through the sale of both fixed- and variable-rate securities. A key feature of these securities is that their interest income is generally exempt from federal income taxes, which makes them particularly attractive to investors in high income tax brackets.
Nonfinancial and nonbank financial businesses raise funds in the money market primarily by issuing commercial paper, which is a short-term unsecured promissory note. An increasing number of firms have in recent years gained access to this market, and commercial paper has grown at a rapid pace. Business enterprises--generally those involved in international trade--also raise funds in the money market through bankers acceptances. A bankers acceptance is a time draft drawn on and accepted by a bank (after which the draft becomes an unconditional liability of the bank). In a typical bankers acceptance a bank accepts a time draft from an importer and then discounts it (the importer are then given slightly less than the face value of the draft). The importer then uses the proceeds to pay the exporter. The bank may hold the acceptance itself or rediscount (sell) it in the secondary market.
Government-sponsored enterprises are a group of privately owned financial intermediaries with certain unique ties to the federal government. These agencies borrow funds in the financial markets and channel these funds primarily to the farming and housing sectors of the economy. A substantial part of their funds are raised in the money market.
Short-term investment pools are a highly specialized group of money market intermediaries that includes money market mutual funds, local government investment pools, and short-term investment funds of bank trust departments.
These intermediaries purchase large pools of money market instruments and sell shares in these instruments to investors. They thereby enable individuals and other small investors to earn the yields available on money market instruments. These pools, which were virtually nonexistent before the mid-1970s, have grown to be one of the largest financial intermediaries in the United States.
Money market futures contracts and futures options are traded on organized exchanges which set and enforce trading rules.
A money market futures contract is a standardized agreement to buy or sell a money market security at a particular price on a specified future date. There are actively traded contracts for 13-week Treasury bills, three-month Eurodollar time deposits, and one-month Eurodollar time deposits. There is also a futures contract based on a 30-day average of the daily federal funds rate.
A money market futures option gives the holder the right, but not the obligation, to buy or sell a money market futures contract at a set price on or before a specified date. These options are currently traded on three-month Treasury bill futures, three-month Eurodollar futures, and one-month Eurodollar futures.
smooth functioning of the money market depends critically on brokers and
dealers. They play a key role in marketing new issues of money market
instruments and in providing secondary markets where outstanding issues
can be sold prior to maturity.
Brokers match buyers and sellers of money market instruments on a commission basis. They play a major role in linking borrowers and lenders in the federal funds market. Brokers are also active as intermediaries in trades between dealers in various of other markets.
The Federal Reserve is a key participant in the money market. They control the supply of reserves available to banks and other depository institutions primarily through the purchase and sale of Treasury bills, either outright in the bill market or on a temporary basis in the market for repurchase agreements. The Federal Reserve is able to influence the federal funds rate by controlling the supply of reserves. Movements in this rate, in turn, can have pervasive effects on other money market rates. The Federal Reserve's purchases and sales of Treasury bills--called "open market operations"--are carried out by the Open Market Trading Desk at the Federal Reserve Bank of New York. The Trading Desk frequently engages in billions of dollars of open market operations in a single day.
Reserves and money market rates can also be influenced by the Federal Reserve through its administration of the discount window and the discount rate. Under certain Federal Reserve operating procedures, changes in the discount rate have a strong direct effect on the funds rate and other money market rates. The discount window and the discount rate are of widespread interest in the financial markets, because of their roles in the implementation of monetary policy.
The following table summarizes the instruments of the money market:
The Money Market
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