Overview of the Basic Instruments

TOPIC 3: THE MONEY MARKET

Aim

The aim of this topic is to introduce students to the short term debt market and provide an overview of the basic instruments used in funds management in the short end of the yield curve. During this course the short term market is referred to as the "Money Market" and is overnight to 12 months in time frame. We will look at how these products are used and the pricing of these instruments in the markets.

Learning Objectives

After working through this topic you should be able to:

1. describe the nature and functions of the money market

2. explain who are the major participants in the money market

3. describe the various products traded in the money market

4. complete calculations in the pricing of money market instruments.

5. appreciate the use of data and information

6. describe the various money market products traded in the global financial system's eurocurrency markets

OBJECTIVE 1

After working through this section you should be able to describe the nature of this market and its functions from the point of view of both deficit and surplus units.

3.1 The nature of the market

The money market is the market by which participants can buy and sell, borrow and lend money. It is generally defined as short term in nature which means for instruments with maturities less than one year. Borrowings and investments greater than one year in maturity are termed part of the capital or fixed interest market.

The money market is not a physical market: i.e. there is no central place where participants gather together to trade money. Instead it is a market that is linked by a vast network of communications which will be described in a later section.

Throughout this topic, it is intended for the material to apply to the major money markets in the world. In some cases there may be differences peculiar to a market. Overall the principles are the same throughout the world.

The money markets around the world are becoming more and more integrated as a result of financial deregulation, technological change and the increasing sophistication of market participants.

3.1.1 Functions of the money market

In its most basic form the Money Market facilitates the transfer of short-term funds from those units which are in surplus (ie. have any excess supply of money) to those units which are in deficit (ie. have a shortfall of money). This can be viewed as follows:

The Money Market is the mechanism by which this transfer takes place and has developed so that this transfer has a strong degree of reliability and safety.

3.1.1.1 Other functions of the Money Market include :

 the mechanism by which a country's government can raise short term funding

 the primary method by which a country's monetary policy is implemented

 a "determinant" of the country's interest rate structure (at least in the short term maturities)

 the market for short-term international trade finance

Money is not just a medium for exchange but is also a traded commodity.

Money Market operations comprise:

1. Placing of deposits

2. Short-term borrowing

3. Sale and purchase of money market securities

3.1.2 Historical developments - why did this market evolve?

In an economy there are units which have surplus funds and those which are in deficit. Money became an accepted means of exchange rather than a barter system because it could be used and transferred by all parties in a village or a town. The Money Market evolved to allow the transfer of funds between these units in an efficient way. For example, to bring together, either directly or indirectly investors and borrowers of funds.

One of the main intermediaries of this transfer of funds are the banks which accept deposits and then loan out these funds to borrowers.

3.1.2 Prices

As can be seen from the above example the price of borrowing money is reflected in the interest rate. As money becomes tight we usually see interest rates rising. This will influence various decision makers about their company's investments. The nature and functions of interest rates were outlined in Topic 2.

3.1.4 How do Money Market participants profit?

Borrowers of funds cannot expect to make a profit from their activities in the Money Market. How they apply those funds will determine whether a profit is to be made. Lenders of funds will of course make a return from their activities in the Money Market, but this has to be weighed against the opportunity cost - the return they could have earned in some other way and which they have foregone by investing in the Money Market. Surplus economic units and deficit economics would be more likely to view the Money Market as a way to achieve their various objectives, rather than as a way of making profits.

Intermediaries, on the on the other hand, participate in the Money Market in order to make a profit. As mentioned previously the Money Market is simply the buying and selling of money and short-term securities which is also called borrowing and investing. Using the example below, to make a profit the bank will borrow funds (accept deposits, buy money) at a lower rate than it will lend funds (sell money).

For example the bank may

Activity Rate of interest Total $ interest

Loan $1 million 5.00% $50,000

Accept a deposit

of $1 million

4.50%

$(45,000)

Profit $5,000

(Note: positive cash flows mean money received while negative cash flows mean