What is a money market?

Money Market is a financial market that deals in securities or assets which are short-term in nature. The money market is responsible for keeping up the liquidity of the businesses and the organizations. These securities are usually held for a period of 12 months or less and are issued by institutions that require cash or funds for their short-term cash flow requirements. The Money market is regulated by the Federal Government. This market consists of various money market instruments whose features most resemble cash and are a substitute for cash. This is considered as a substitute for cash because it could be converted into cash on very short notice. It is considered a safe market for investors.

Features of money market instruments

There are certain characteristics and unique features of money market instruments that make them different from other markets. Some of them are as follows:

• The liquidity of the money market is high

Liquidity refers to a feature of an asset that could be converted into cash very easily. The money market instruments also have this feature that provides the organization with liquidity. Due to high liquidity, the funds are available on short notice to the investor

• Investment is more secure

This feature of the money market instrument also provides a fixed income to the investor. Hence, the volatility or the variance of this market reduces and makes it a safer investment.

• Investments are at discount pricing

The funds in the money market are usually issued at a discount on their par value. These funds are bought at a price lower than the face value and are redeemed at par.

• Aids in monetary policy

The monetary policy of the country decides the money supply in the country. The money market helps in deciding the interest rate, bank rate, and other short-term rates that define the monetary policy.

All entities must maintain a sufficient cash flow readily available for use. This helps them to meet their short-term operating costs and debt obligations. The working capital is pertinent to the day-to-day cash requirements of the company. The instruments in the money market are considered the best sources of raising funds for the working capital. It keeps the business activities working smoothly.

Money Market Instruments

Many instruments are used by the different forms of organizations to raise their finances or funds for different purposes. These instruments are also referred to as money market securities. 

Treasury bills or T-bills

These are the instruments that are issued by the government for the different maturity dates. These are considered safe instrument because it has a guarantee of the government attached to them. Different maturity periods of the T-bills are one month, three months, six months, and a year. The T-bills are issued at a discount rate and redeemed at the face value on maturity. There are no interest rates under this security. The difference between the face value and the discounted rate results in profits that are earned by the investor. The risk in the treasury bills is negligible.

Certificates of deposits

Certificates of deposits are the instruments that are issued by commercial banks in a country. The maturity period of the certificate of deposits lies between three months to five years. These are usually purchased by brokerage firms. The interest rates are fixed in the certificate of deposits. If this instrument is withdrawn before the date of maturity, the fixed interest that is to be paid gets reduced.

Commercial papers

This instrument is issued by large corporations. Whenever these companies require short-term finances, they issue commercial papers. Commercial papers are issued having a particular denomination such as $100,000 and above. The maturity period of this instrument lies between one month to nine-month. These are issued just like the treasury bills are issued. i.e., at discounts. The difference between this issue price after discount and the face value is the interest or the profit made by the investor.

Repurchase agreements

These are the short-term borrowings made by the dealers in the money market. These agreements involve government security such as treasury bills. The dealers promise to repurchase these securities at a higher rate. This also helps in maintaining the flow or the supply of money in the market. The maturity period of the repurchase agreements lies between a fortnight to a month or more.

Some other money market instruments include promissory notes, bills of exchange, mutual funds, and others. Mutual funds are the portfolio of securities that are invested for the short-term period. The interest rates in the market are often regulated by these money market instruments as well.

Money market funds and mutual funds

The money market fund is a type of mutual fund. Mutual funds are the portfolio of securities. The money market is said to be like that of mutual funds because mutual funds are invested in highly liquid assets. Similarly, the money market funds are highly liquid instruments with a high credit rating. There is a term money market mutual funds that usually deal in the highly liquid assets, especially cash and cash equivalents to satisfy its requirement of finances. The individuals or the companies looking for a less risky investment may need to invest in these mutual funds. The interest rates in these funds are usually less flexible. Mutual funds or money market funds are different from money market accounts. Money market accounts are also known as a savings account.

Money market vs capital market

The money market and the capital market form part of the global financial system. Both markets have buyers and sellers in the market. These markets consist of some securities that are used to raise funds for the functioning of business activities. The point of difference between the money market and capital market is the risk factor. The risk factor is lower in the case of the money market whereas higher in the case of the capital market. The funds from the money market are raised for the short-term purpose while for the long-term purpose from the capital market. The objective of investing in the money market is to maintain the existing wealth. However, the capital market is used to generate wealth. The liquidity that is maintained in the money market is higher than that of the capital market. The volatility or the variance of the funds is low in the case of the money market and high in the capital market. The money market usually deals in instruments like promissory notes, bills of exchange, commercial bills, treasury bills, call money, mutual funds, etc., while the instruments dealt in the capital market include equity, debentures, bonds, preference shares, etc. The capital market consists of Eurodollars which is the biggest dollar-denominated capital market accounts.

Context and Applications

The aspiring students can pursue further specialization in this field into the following streams:

• Bachelor of Business Administration
• Masters of Business Administration
• Bachelors of Science in Finance
• Masters of  Science Finance
• Chartered Financial Analyst (CFA)

Practice Problems

Question 1: Money market funds are the funds that are for a short-term period. What is the purpose of issuing securities under this market?

1. 1. To maintain liquidity.
   2. Increase profitability.
   3. Improve financial position.
   4. All of the above

Answer: (d)

Explanation: All of the above are directly or indirectly the purposes of issuing liquid instruments.

Question 2: Which of the following instrument has a maturity of one month, three months, six months, or a year?

1. 1. Repurchase agreements
   2. Treasury bills
   3. Commercial papers
   4. Certificate of deposits

Answer: (b)

Explanation: The treasury bill is issued by the government for a maturity period of one month, three months, six months, or a year.

Question 3: Under which market does the call money as an instrument fall?

1. 1. Capital market
   2. Money market
   3. Both markets
   4. None of these

Answer: (b)

Explanation: The call money is the instrument that is used for the short-term and the short-term finances are raised from the money market.

Question 4: There are certain statements given regarding the capital market. Which of the following is incorrect?

1. 1. High risk
   2. Long maturity period
   3. Irregular and high income
   4. Fixed and regular income

Answer: (d)

Explanation: A capital market is a market in which there is a presence of high risk due to higher volatility. The maturity period in the capital market instruments is usually more than a year and the incomes and the returns earned out of it are irregular and high.

Question 5: Which of the following is not a feature of commercial papers?

1. 1. Issued by the government
   2. Carries a fixed rate as an interest
   3. An instrument with a maturity period of more than a year.
   4. All of the above

Answer: (d)

Explanation: Commercial papers are issued by large companies. These are issued at a discount. These have a maturity of less than a year. Hence, all the statements given in the question related to the commercial paper are incorrect.

Common Mistakes

It is often observed that the students ignore the topic. It is one of the important topics that is considered by the organization for raising its funds for the short-term purpose. The money market is often confused with the capital market as well. The terms of issue of commercial papers and certificate of deposits, eligibility requirements are necessary for understanding the commercial nature of these money market instruments.

Related Concepts

While studying this topic, it is recommended to read the following topics to get a better knowledge:

• Financial System
• Capital Structure
• Capital markets
• Sources of Financing