The money market is the arena in which financial institutions make available to a broad range of borrowers and investors the opportunity to buy and sell various forms of short-term securities. The money market is not a physical place, but an informal network of banks and traders linked by telephones, fax machines, and computers. Money markets exist both in the United States and abroad.
The short-term debts and securities sold on the money markets—which are known as money market instruments—have maturities ranging from one day to one year and are extremely liquid. Some examples of common money market instruments include treasury bills, federal agency notes, certificates of deposit (CDs), eurodollar deposits, commercial paper, bankers' acceptances, and repurchase agreements. The suppliers of funds for money market instruments are institutions and individuals with a preference for the highest liquidity and the lowest risk.
The money market is important for businesses because it allows companies with a temporary cash surplus to invest in short-term securities, and it also allows companies with a temporary cash shortfall to sell securities or borrow funds on a short-term basis. In essence, it acts as a repository for short-term funds. Large corporations generally handle their own short-term financial transactions, participating in the money market through dealers. Small businesses, on the other hand, often choose to invest in money-market funds, which are professionally managed mutual funds consisting only of short-term securities.
Although securities purchased on the money market carry less risk than long-term debt, they are still not entirely risk free. After all, banks do sometimes fail, and the fortunes of companies can change rather rapidly. But, as Richard A. Brealey and Stewart C. Myers explained in their book Principles of Corporate Finance, "the range of possible outcomes is less for short-term investments. Even though the distant future may be clouded, you can usually be confident that a particular company will survive for at least the next month. Second, only well-established companies can borrow in the money market. If you are going to lend money for only one day, you can't afford to spend too much time in evaluating the loan. Thus you will consider only blue-chip borrowers."
TYPES OF MONEY MARKET INSTRUMENTS
TREASURY BILLS Treasury bills (T-bills) are short-term notes issued by the U.S. government. They come in three different lengths to maturity:90, 180, and 360 days. The two shorter types are auctioned on a weekly basis, while the annual types are auctioned monthly. T-bills can be purchased directly through the auctions or indirectly through the secondary market. Purchasers of T-bills at auction can enter a competitive bid (although this method entails a risk that the bills may not be made available at the bid price) or a noncompetitive bid. T-bills for noncompetitive bids are supplied at the average price of all successful competitive bids.
FEDERAL AGENCY NOTES Some agencies of the federal government issue both short-term and long-term obligations, including the loan agencies Fannie Mae and Sallie Mae. These obligations are not generally backed by the government, so they offer a slightly higher yield than T-bills, but the risk of default is still very small. Agency securities are actively traded, but are not quite as marketable as T-bills. Corporations are major purchasers of this type of money market instrument.
SHORT-TERM TAX EXEMPTS These instruments are short-term notes issued by state and municipal governments. Although they carry somewhat more risk than T-bills and tend to be less negotiable, they feature the added benefit that the interest is not subject to federal income tax. For this reason, corporations find that the lower yield is worthwhile on this type of short-term investment.
CERTIFICATES OF DEPOSIT Certificates of deposit (CDs) are certificates issued by a federally chartered bank against deposited funds that earn a specified return for a definite period of time. They are one of several types of interest-bearing "time deposits" offered by banks. An individual or company lends the bank a certain amount of money for a fixed period of time, and in exchange the bank agrees to repay the money with specified interest at the end of the time period. The certificate constitutes the bank's agreement to repay the loan. The maturity rates on CDs range from 30 days to six months or longer, and the amount of the face value can vary greatly as well. There is usually a penalty for early withdrawal of funds, but some types of CDs can be sold to another investor if the original purchaser needs access to the money before the maturity date.
Large denomination (jumbo) CDs of $100,000 or more are generally negotiable and pay higher interest than smaller denominations. However, such certificates are insured by the FDIC only up to $100,000. There are also eurodollar CDs, which are negotiable certificates issued against U.S. dollar obligations in a foreign branch of a domestic bank. Brokerage firms have a nationwide pool of bank CDs and receive a fee for selling them. Since brokers deal in large sums, brokered CDs generally pay higher interest rates and offer greater liquidity than CDs purchased directly from a bank.
COMMERCIAL PAPER Commercial paper refers to unsecured short-term promissory notes issued by financial and nonfinancial corporations. Commercial paper has maturities of up to 270 days (the maximum allowed without SEC registration requirement). Dollar volume for commercial paper exceeds the amount of any money market instrument other than T-bills. It is typically issued by large, credit-worthy corporations with unused lines of bank credit and therefore carries low default risk.
Standard and Poor's and Moody's provide ratings regarding the quality of commercial paper. The highest ratings are A1 and P1, respectively. A2 and P2 paper is considered high quality, but usually indicates that the issuing corporation is smaller or more debt burdened than A1 and P1 companies. Issuers earning the lowest ratings find few willing investors.
Unlike some other types of money-market instruments, in which banks act as intermediaries between buyers and sellers, commercial paper is issued directly by well-established companies, as well as by financial institutions. "By cutting out the intermediary, major companies are able to borrow at rates that may be 1 to 1 ½ percent below the prime rate charged by banks," according to Brealey and Myers. Banks may act as agents in the transaction, but they assume no principal position and are in no way obligated with respect to repayment of the commercial paper. Companies may also sell commercial paper through dealers who charge a fee and arrange for the transfer of the funds from the lender to the borrower.
BANKERS' ACCEPTANCES "A banker's acceptance begins life as a written demand for the bank to pay a given sum at a future date," Brealey and Myers noted. "The bank then agrees to this demand by writing 'accepted' on it. Once accepted, the draft becomes the bank's IOU and is a negotiable security. This security can then be bought or sold at a discount slightly greater than the discount on Treasury bills of the same maturity." Bankers' acceptances are generally used to finance foreign trade, although they also arise when companies purchase goods on credit or need to finance inventory. The maturity of acceptances ranges from one to six months.
REPURCHASE AGREEMENTS Repurchase agreements—also known as repos or buybacks—are Treasury securities that are purchased from a dealer with the agreement that they will be sold back at a future date for a higher price. These agreements are the most liquid of all money market investments, ranging from 24 hours to several months. In fact, they are very similar to bank deposit accounts, and many corporations arrange for their banks to transfer excess cash to such funds automatically.