Apr 3, 2020 in Economics
Money Market Instruments

Money market is a special sector of the market on which the funds are moving from owners of savings to borrowers; and amount of money as a particular commodity is constantly changing under the influence of supply and demand due to various economic factors. The money market consists of many streams in which funds are moved from savers to borrowers and investors. Money market instruments which represent debt instruments are less than or equal to a one year time limit. These instruments are an integral part of modern commodity-money relations and are one of the key levers of solving economic and social problems that any economy always tries to resolve constantly. To confirm this thesis, the paper has been divided into several sections, where the following features would be explored: Eurodollar deposits, negotiable certificates of deposit (CDs), banker’s acceptances, US Treasury bills, commercial paper, municipal notes, federal funds, and repurchase agreements.

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The Structure of Money Market Instruments

According to economic approach, money market instruments are divided into several categories depending on their method of generating income: coupon instruments and discount instruments (Choudhry, Didier, Gino, Pereira and Pienaar 3). At the beginning, coupon was a part of financial instrument that could be separated and presented to the issuer for payment of interest. There are different types of coupons and discount instruments on money market (Choudhry, Didier, Gino, Pereira and Pienaar 25). In addition to these listed categories, there are also derivatives and deposits, Eurodollars, and federal funds, etc (Dodd 46). In general, money market instruments structure is shown in the following list (Choudhry, Didier, Gino, Pereira and Pienaar 36).

  • A. Discount instruments:
    1. Treasury bill (T-bill).
    2. Banker's acceptance.
    3. Commercial paper (commercial paper - CP).
  • B. Coupon instruments (interests):
    1. Money market deposits - non-negotiable instruments.
    2. Certificate of deposit - CD - negotiable instruments.
    3. Repurchase agreements (repos) - negotiable instruments.
    4. Bonds including municipal notes - negotiable instruments.
  • C. Derivatives and other types of instruments.

Treasury Bills

Treasury Bill, T-Bill, is short-term government bonds aimed at meeting a temporary need for funds received after the first branch arising from the issue. A short-term debt in Anglo-American was known as Treasury bills; however, Britain was the first country issuing short-term bonds (Choudhry, Didier, Gino, Pereira and Pienaar 29). Generally, Treasury Bill is a short-term US government debt obligation with a maturity to one year. People who buy treasury bills actually give credit to the government through its validity. When the bills reach their maturity, the government pays the nominal amount of treasury bills to the borrowers of the funds (Choudhry, Didier, Gino, Pereira and Pienaar 29). Treasury bills are issued by central banks, lenders of last jurisdiction, and therefore, form the basis for determining the interest rates on other instruments. Nominal treasury bill ranges from $ 1,000 to $ 5,000,000, and in most cases it has one month (4 weeks), three months (13 weeks) or six months maturity period (26 weeks). Placement (sale) of treasury bills goes through the auction at a price below the nominal value (discounted) (“Capital, Commodity” 55). When the maturity date is over, treasury bill holder receives a nominal amount of instrument, which is also called the maturity price or future value. Thus, a market value of treasury bill defines  a certain percentage or discount rate.

Our Process

At the same time, market value of treasury bills is a present value of the price paid at maturity. In other words, the price of treasury bill is a redemption price discounted at the prevailing market lending rate (“Capital, Commodity” 55). The estimated price of treasury bills is determined by the following formula (Choudhry, Didier, Gino, Pereira and Pienaar 29).

Money Market Instruments-1

S - is a price of treasury bill;

P - is a maturity price (future value);

R - is a discount rate as a decimal;

N - is a number of days to maturity;

B - is an annual basis (360 or 365 days).

The discount rate may be determined from the formula as follows (“Capital, Commodity” 60).

Money Market Instruments-2

Yield instruments, which hold up to maturity, are compared in terms of money market yield (MMY). MMY for the tool is determined in the following order: calculating profit at maturity, which is equal to (P -S), the resulting value is represented as a percentage of the investment: (P -S) / S, the result is expressed as percent year on year. Thus, the yield rate can be defined as (“Capital, Commodity” 71).

Money Market Instruments-3

Profitability ratio in bond equivalent (bond equivalent yield - BEY) is particularly useful in comparing treasury bills, treasury bonds and notes, which is an approaching maturity. BEY allows taking into account a compound interest at the coupon payments and a coupon period of 365 days (Shapiro 5). Although a significant portion of T-bills is bought by commercial and central banks, a general issue of such securities poses a threat to the stability of the national currency, because they themselves are money substitutes, and can easily be transformed into cash or deposits. For banks it is a highly liquid asset, not bringing a high income, but it supports liquidity on certain level.

Banker's Acceptance

These instruments are used for international trade financing during several hundred of years. A bill in the UK is essentially equivalent to banker’s acceptance in the United States (“Capital, Commodity” 25). Commercial bill of exchange, or trade bill, or banker’s acceptance is a debt instrument that requires to pay a certain amount of money to the holder or by the due date (time draft, that is, a bill payment with a fixed term) or on demand (demand promissory note) (“Capital, Commodity” 40). It is an easy short-term debt instrument such as IOU, produced for commercial operation. Bankers' acceptances or bank draft  is a bill of exchange issued by commercial bank or adopted by them. Upon acceptance this tool becomes negotiable. Both Bank of England and US Federal Reserve buy and sell bank acceptances that meet reserve requirements. These banks are known as "acceptable" or first-class, and their bankers' acceptances  as "acceptable" bill (“Capital, Commodity” 34).

Acceptance of bank is widely used in foreign trade operations, such as settlement of documentary letters of credit (Choudhry, Didier, Gino, Pereira, and Pienaar 25). Accepted by the bank a note may be taken into account in another bank and then recounted by the central bank. Accepted bills of reliable banks are accepted in the banks at a lower discount rate, charged for the purchase of promissory notes (Choudhry, Didier, Gino, Pereira, and Pienaar 25).

Commercial Paper

Commercial paper refers the issuers to meet the period of 2-270 days (Choudhry, Didier, Gino, Pereira, and Pienaar 31). It is issued by the drawer, unconditionally agreed to you or asks others to pay a certain amount that is a negotiable security; the holder, in his turn, has a certain authority certificate (Choudhry, Didier, Gino, Pereira, and Pienaar 31). Commercial paper is an unsecured short-term debt instrument issued by corporations. Terms of payment by commercial paper rarely exceed 270 days (Choudhry, Didier, Gino, Pereira, and Pienaar 33). Promissory note is usually issued at a discount reflecting prevailing market interest rates. Commercial paper is not usually supported by any collateral, thus, only firms with high credit ratings can easily find the buyers without offering a significant discount on debt issuance (Choudhry, Didier, Gino, Pereira, and Pienaar 36).

The main advantage of commercial paper is that it is not necessary to register it in the U.S. Securities and Exchange Commission (the SEC) if the period of its treatment is at least nine months (270 days), making it a very cheap means of financing (Choudhry, Didier, Gino, Pereira, and Pienaar 34). Thus, this type of financing can only be used for working capital (for example, to fund reserves) and may not be used for fixed assets financing (for example, creation of new manufacturing facility) without SEC approval. Basically, companies can finance their receivables, inventory and use this tool to cover short-term liabilities (Choudhry, Didier, Gino, Pereira, and Pienaar 31).

Money Market Deposits

On interbank market there are deposits of mainly two types. Term deposit is a deposit with a fixed interest rate and maturity (Choudhry, Didier, Gino, Pereira, and Pienaar 27). Demand deposit, in its turn, is a deposit with a variable rate and which can be redeemed on demand after a certain number of days without notice to the bank. Money market dealers are quoting bilateral rates as a percentage of annualized rates. As for deposit transactions London market rates, however, are very important, as banks often use LIBOR and LIBID. LIBOR (London Interbank Offered Rate) is an offered rate of London interbank deposits upon which bank offers certain amount of money or charges for a loan (Choudhry, Didier, Gino, Pereira, and Pienaar 26). LIBID (London Interbank Bid Rate) is a buyer rate of London interbank deposits, that is, the rate at which bank buys debt instruments or takes money that pays for a loan. These instruments are useful for buyers due to certain standardized conditions (Choudhry, Didier, Gino, Pereira, and Pienaar 27).

Certificates of Deposit

A certificate of deposit can be determined as follows. It is a paid security, indicating the presence of a bank or other financial institution deposits with a fixed interest rate and maturity (Choudhry, Didier, Gino, Pereira, and Pienaar 27). In other words, a document confirming the existence of the debt, such as IOU (I owe you- I owe you) with a fixed coupon. Most certificates of deposit issued by banks are bearer appealing instruments (Choudhry, Didier, Gino, Pereira, and Pienaar 27).

The difference between the deposit certificate and deposit is as follows: deposit does not have an appealing circulation, and it is an instrument with a fixed term. On the other hand, certificate of deposit (CD) is an appealing instrument with a fixed term, that is, can be bought and sold (Choudhry, Didier, Gino, Pereira, and Pienaar 28). One of the main benefits of certificates of deposit for a depositor is a freedom in circulation. In addition, CDs are interesting to investors, who want to have good liquid collateral. Moreover, income from certificates is usually lower than earnings from conventional deposits (a few percentage points) and to fill up such an account is impossible (Shapiro 5). Disadvantages also include a high rate of taxation, and secondly, this type of contribution is not covered by the Deposit Guarantee Fund. Third, in case client loses the certificate or somebody has stolen, it is likely that someone else could take advantage of it.

Municipal Notes

In large developed industrialized countries the municipal bond market holds a huge sums of money in the form of loans, on the one hand; and the obligation to repay the loans and interest by a certain date, on the other hand. In the United States, municipal bonds amount to one trillion US dollars, which is a considerable sum; especially, because it has a tendency to increase. Municipal notes are securities that are not issued by the state, but by local government (local authorities) or by subordinate administrative units. Of course, this type of securities has a high safety (back guarantee), as the US government itself guarantees the return of the loan in full, but in turn, these securities have sufficiently low returns (Singhi 3).

The guarantor of the municipalities is the United States Government, and the guarantor of municipal bonds is their issuers (tax authorities, for example) (“Capital, Commodity” 40). There are notes also in the United States that provide an income from a variety of projects, issuance of which goes separately from the agency authorities. They are created in the cities and states, of course, in accordance with the legislation of the municipalities of data (“Capital, Commodity” 40).

Characteristic features of municipal notes, which are secured by revenues from the project, are fixed maturities. Namely, the projects are stadiums, hospitals, dormitories for students – building projects with high necessary level of investment.

Municipal notes are produced to meet the needs of states and cities in cash. Yield is provided by a fixed coupon rate and the payment of loan in its entirety occurs at a certain time in the future (which is marked). Purchase and sale transactions are made on the primary exchange market, and the owners are usually banks and other financial and credit institutions, as well as, common people (investors) (Singhi 3). At the same time, the share of banks in transactions (possession) with municipal notes is much lower than it was in the eighties of the twentieth century, since then it was a sharp decline in economic situation (stability) of the United States of America. There are some companies which seek to recover their income by investing some money in bonds (municipal) in order to enjoy the benefits of taxation (Dodd 46).

Our Benefits

Repurchase Agreements (Repos)

Repo transactions are used by central banks as a tool of monetary policy and by traders  as a means of financial investment. Their essence is defined as follows. Repo or repurchase agreement is an agreement between the two parties in which one of them is obliged to sell the other a financial instrument at a certain date and at an agreed price, and then buy it back at a later date at an agreed price (Choudhry, Didier, Gino, Pereira, and Pienaar 25). That is, reverse repurchase agreement is an agreement to purchase an instrument with an obligation to sell it at a future date at an agreed price (Choudhry, Didier, Gino, Pereira, and Pienaar 25). The largest volume of repo operations refers to daily transactions with treasury bills in the United States (Choudhry, Didier, Gino, Pereira, and Pienaar 25). The Federal Reserve uses repo transactions and conducts purchases of financial instruments at a time to feed the banking system cash resources, and the reverse repo are performed for the temporary withdrawal of funds and part of the banking system.

Federal Funds

Depository institutions are required to hold in reserve the means to ensure their needs in reserve. The level of reserves that must be maintained by depository institution depends on the average annual volume of its deposits in the last 14 days (Choudhry, Didier, Gino, Pereira, and Pienaar 32). To meet these requirements depository institutions hold their reserves in a particular bank. These reserves are called federal funds. They do not generate interest though. Federal institution keeps its federal funds in bigger amount  than required bearing the opportunity cost associated with the rejection of interest, which could lead to excess funds (Choudhry, Didier, Gino, Pereira, and Pienaar 32). Accordingly, there are depository institutions that do not have an adequate supply of reserves in federal funds.

Federal funds market is a place where the depositary institutions buy and sell federal funds to eliminate this imbalance. As a rule, small depository institutions (such as small commercial banks, provident funds and credit institutions) almost always have excess reserves, while the banks operating in the domestic market lack the reserves and always have to maintain the balance (Choudhry, Didier, Gino, Pereira, and Pienaar 32). Stocks federal funds are controlled by the Federal Reserve through annual open market operations.

Most of the operations with federal funds last only 1 night, that is, the depositary institution with a lack of reserves occupying excessive funds from another financial institution usually does so for the period until the next working day. Since reserves are only available for a short time, federal funds are often called the overnight loans. The daily effective federal funds rate is a weighted average number of bets from transactions with federal funds concluded by the largest brokers in New York.

Eurodollars

Eurodollars is the US dollar deposits in European banks (Choudhry, Didier, Gino, Pereira, and Pienaar 46). Eurodollar market development was promoted by: the US national regulation in 1958 for the foreign exchange market, when the US maintained interest rates at artificially low levels (Choudhry, Didier, Gino, Pereira, and Pienaar 46). At the same time, European banks have raised their interest rates, which contributed to the outflow of capital from the US to Europe; recovery of Western European economies, growth of European exports to the United States, and military appropriations. The United States within NATO filled the dollar markets outside the United States. Eurodollar market development also contributed to the growth of the US current account deficit, and for its covering additional emission of dollars was needed. It happened  because of the difference in interest rates that appeared in European markets and confrontation of the USSR and the USA.Starting from 1980s medium eurocredits and euronotes have been largely proliferated on the market. It is short-term liabilities with a floating interest rate based on LIBOR. Although euronotes are short-term securities, they are used to provide medium-term loans. Banks undertake to redeem the notes from borrowers for a number of years as the expiry of the previous release, and then resell them. Among the negative aspects of EU market activity should be noted a possibility reduction of foreign exchange authorities to monitor foreign exchange markets and capital markets as well as to conduct an independent monetary policy because of the strong interdependence of monetary policy in industrialized countries.

Conclusion

European markets make an efficient use of financial resources on a global scale to solve the problems associated with an imbalance of external payments, stimulate the development of the productive forces, and promote the internationalization of foreign economic activities of the countries. The importance of the money market instrument is to serve working capital movement of firms, short-term resources, banks, institutions, government and individuals. Money markets instruments allow those who can use them to receive direct money that is available for a shorter period to, but also have a very good quality to transform short-term deposits that can be given as a credit for a longer period. Thus, money market instruments are an integral part of modern commodity-money relations and it is one of the key levers of solving economic and social problems, which any economy tries to solve constantly.

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