Technical Analysis of Stock
January 8, 2019

Investing in the Money Market

What is the Money Market?

This is a market segment in which financial instruments with high liquidity and very short maturities are traded. Maturities are usually one year.

Some of the special characteristics of the money market are as follows:

  • The money market is a fixed income market which means it deals in financial instruments which pay a fixed rate on the investment. This is the opposite of the capital markets where there is no fixed return on investments.
  • Investing in the money markets is considered to be very safe as the returns are fixed in nature. Since investing in this market is safe it also means that the returns are lower. This is on account of the risk-return trade-off. Higher the risk, higher is the return and vice-versa. On the other hand, the capital markets which do not have a fixed return on investments are volatile in nature and riskier as compared to the money markets. However, capital markets present the opportunity to earn a high rate of return.

Money market instruments are highly liquid in nature. This is the reason why financial institutions and Governments approach the market for short-term needs.

Money market instruments are short-term in nature. The maturity of these instruments is generally less than a year. The maturity of these securities can be as less as one day also.

This money market is dominated by wholesale transactions and retail investors like you and me will not have direct access to this market. The main reason for this is the ticket size or the value of transactions. Money market transactions are high in value as opposed to capital market transactions. Individual investors will not have enough funds to cope up with this market.

TYPES OF MONEY MARKET INSTRUMENTS

CALL: Call money is one of the most liquid forms of money market instruments. Banks can have shortfalls which they can fund through borrowing call money from the money market. Other banks who have access or surplus cash can invest in other banks through call money.

Other financial institutions can also invest/borrow through call money. The rate at which call money can be borrowed or invested in the market is called as the call rate.

The main reason why banks require call money is for maintaining the statutory reserves such as cash reserves. Banks have to maintain certain liquid cash on a day-to-day basis as a mandatory requirement by Central Bank. In case there is a shortage of liquid cash which does not cover the mandatory requirement at the end of the day, banks turn to the call money market for funds.

TREASURY BILLS: Treasury bills are issued by the Central Bank of the country on behalf of its Government. Whenever Government is in need of funds, it raises money in the market through Treasury Bills. This is considered as one of the safest investment as it is backed by the government itself. The tenure of these bills is generally from 14 days to 364 days.

One of the important features of the Treasury Bills is that they are issued at a discount.

E.g. if the face value of the Treasury Bills is N100, they will be issued at N95 with a discount of N5. So when you buy the Treasury Bills, you buy it at N95 and at the time of maturity, the government will pay the full amount i.e. N 100. This discounted value of N5 is nothing but the upfront interest earned. Interest is not paid separately on Treasury Bills.

Note: Since treasury bills are considered as the safest form of investment, the interest rate at which Treasury Bills are traded in the market is considered as the risk-free rate of return in many financial models

COMMERCIAL PAPERS: Commercial Papers are generally used by various companies to fund their short-term working capital needs such as buying of inventory. These are unsecured in nature which makes that there is an underlying asset of the company attached to it. They are short-term in nature. Just like the Treasury Bills, these are also issued at a discount and therefore, interest is not paid separately. The rate of interest is determined by the forces of demand and supply of liquid funds in the market.

The rate of interest is higher compared to Treasury Bills as they are unsecured in nature.

REPO: Repo is a short repurchase agreement. Let us take an example of Bank A is in need of funds and Bank B has surplus funds. Bank A will enter into an agreement with Bank B for selling its securities (mostly Treasury Bills) and get the required funds from Bank B. However, this does not end here. There is a twist in the agreement which states that Bank A will repurchase these securities from Bank B at a fixed future date.

These are very short-term in nature. They can be for just overnight purposes or up to a period of one month depending on the agreement between the banks. These are popular amongst banks because this eliminates the credit risk involved as the securities are directly transferred to one another.

 

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