The money market is the sector of the financial market that includes financial instruments that have a maturity or redemption date that is one year or less at the time of issuance. Typically, money market instruments are debt instruments and include Treasury bills, commercial paper, negotiable certificates of deposit, repurchase agreements, and bankers acceptances. There is one form of equity, preferred stock, that can be viewed under certain conditions as a money market instrument.
Treasury bills (popularly referred to as T-bills) are short-term securities issued by the U.S. government; they have original maturities of either four weeks, three months, or six months. T-bills carry no stated interest rate. Instead, they are sold on a discounted basis. This means that the holder of a T-bill realizes a return by buying these securities for less than their maturity value and then receiving the maturity value at maturity.
Commercial paper is a promissory note—a written promise topay— issued by a large, creditworthy corporation or a municipality. This financial instrument has an original maturity that typically ranges from one day to 270 days. Most commercial paper is backed by bank lines of credit, which means that a bank is standing by ready to pay the obligation if the issuer is unable to. Commercial paper may be either interest bearing or sold on a discounted basis.
Certificates of deposit (CDs) are written promises by a bank to pay a depositor. Nowadays, they have original maturities from six months to three years. Negotiable certificates of deposit are certificates of deposits issued by large commercial banks that can be bought and sold among investors. Negotiable certificates of deposits typically have original maturities between one month and one year and are sold in denominations of $100,000 or more. Negotiable certificates of deposits are sold to investors at their face value and carry a fixed interest rate. On the maturity date, the investor is repaid the principal plus interest.
A Eurodollar certificates of deposit is a negotiable CD for a U.S. dollar deposit at a bank located outside the United States or in U.S. International Banking Facilities. The interest rate on Eurodollar certificates of deposits is the London Interbank Offered Rate (LIBOR), which is the rate at which major international banks are willing to offer term Eurodollar deposits to each other.
Another form of short-term borrowing is the repurchase agreement. To understand a repurchase agreement, we will briefly describe why the instrument is created. There are participants in the financial system that use leverage in implementing trading strategies in the bond market. That is, the strategy will involve buying bonds with borrowed funds. Rather than borrowing from a bank, a market participant can use the bonds it has acquired as collateral for a loan. Specifically, the lender will loan a certain amount of funds to an entity in need of funds using the bonds as collateral. This common lending agreement is referred to as a repurchase agreement or repo because it specifies that the (1) the borrower sell the bonds to the lender in exchange for proceeds; and (2) a some specified future date, the borrower repurchases the bonds from the lender at a specified price. The specified price, called the repurchase price, is higher than the price at which the bonds are sold because it embodies the interest cost that the lender is charging the borrower. The interest rate in a repo is called the repo rate. Thus, a repo is nothing more than a collateralized loan. It is classified as a money market instrument because the term of a repo is typically less than one year.
Bankers’ acceptances are short-term loans, usually to importers and exporters, made by banks to finance specific transactions. An acceptance is created when a draft (a promise to pay) is written by a bank’s customer and the bank “accepts” it, promising to pay. The bank’s acceptance of the draft is a promise to pay the face amount of the draft to whomever presents it for payment. The bank’s customer then uses the draft to finance a transaction, giving this draft to her supplier in exchange for goods. Since acceptances arise from specific transactions, they are available in a wide variety of principal amounts. Typically, bankers’ acceptances have maturities of less than 180 days. Bankers’ acceptances are sold at a discount from their face value, and the face value is paid at maturity. Since acceptances are backed by both the issuing bank and the purchaser of goods, the likelihood of default is very small.
We mentioned that preferred stock under certain circumstances can be a money market instrument. Some preferred stock can be redeemed weekly by contract or via an option granted by the issuer that allows the preferred stockholder the right to force the issuer to redeem the preferred stock. In fact, there are mutual funds (a financial entity that we describe in the next chapter) that invest only in money market instruments. These mutual funds are referred to as money market funds and have restrictions as to what they can invest under U.S. securities law. Preferred stock would qualify if certain conditions are satisfied.