Money Market is a market for securities with short term maturities up to 1 year. Banks, Non-Banking Financial Companies and acceptance houses make up the money market. It facilitates the transactions for short-term funds, and maintains appropriate liquidity in the market.
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What are Money Market Instruments?
Financial instruments with short term maturity up to 1 year, used as tools for raising capital by the issuer are known as money market instruments.
These are debt securities that offer a fixed interest rate and are generally unsecured. There is no collateral backing up the security, and the risk of non-repayment is theoretically high. However, money market instruments have a high credit rating ensuring that issuers don’t default, which makes them a go-to avenue for investors looking for options to park their money for the short term and earn fixed returns on the same.
Features of Money Market Instruments
1. High Liquidity
One of the key features of these financial assets is high liquidity offered by them. They generate fixed-income for the investor and short term maturity make them highly liquid. Owing to this characteristic money market instruments are considered as close substitutes of money.
2. Secure Investment
These financial instruments are one of the most secure investment avenues available in the market. Since issuers of money market instruments have a high credit rating and the returns are fixed beforehand, the risk of losing your invested capital is minuscule.
3. Fixed returns
Since money market instruments are offered at a discount to the face value, the amount that the investor gets on maturity is decided in advance. This effectively helps individuals in choosing the instrument which would suit their needs and investment horizon.
Also Know About: Money Market Fund
What is the Purpose of a Money Market?
1. Maintains Liquidity in the Market
One of the most crucial functions of the money market is to maintain liquidity in the economy. Some of the money market instruments are an important part of the monetary policy framework. RBI uses these short-term securities to get liquidity in the market within the required range.
2. Provides Funds at a Short Notice
Money Market offers an excellent opportunity to individuals, small and big corporations, banks of borrowing money at very short notice. These institutions can borrow money by selling money market instruments and finance their short-term needs.
It is better for institutions to borrow funds from the market instead of borrowing from banks, as the process is hassle-free and the interest rate of these assets is also lower than that of commercial loans. Sometimes, commercial banks also use these money market instruments to maintain the minimum cash reserve ratio as per the RBI guidelines.
3. Utilisation of Surplus Funds
Money Market makes it easier for investors to dispose off their surplus funds, retaining their liquid nature, and earn significant profits on the same. It facilitates investors’ savings into investment channels. These investors include banks, non-financial corporations as well as state and local government.
4. Aids in Financial Mobility
Money Market helps in financial mobility by allowing easy transfer of funds from one sector to another. This ensures transparency in the system. High financial mobility is important for the overall growth of the economy, by promoting industrial and commercial development.
5. Helps in monetary policy
A developed money market helps RBI in efficiently implementing monetary policies. Transactions in the money market affect short term interest rate, and short-term interest rates gives an overview of the current monetary and banking state of the country. This further helps RBI in formulating the future monetary policy, deciding long term interest rates, and a suitable banking policy.
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Types of Money Market Instruments:
1. Treasury Bills (T-Bills)
Treasury bills or T- Bills are issued by the Reserve Bank of India on behalf of the Central Government for raising money. They have short term maturities with highest upto one year. Currently, T- Bills are issued with 3 different maturity periods, which are, 91 days T-Bills, 182 days T- Bills, 1 year T – Bills.
T-Bills are issued at a discount to the face value. At maturity, the investor gets the face value amount. This difference between the initial value and face value is the return earned by the investor. They are the safest short term fixed income investments as they are backed by the Government of India.
2. Commercial Papers
Large companies and businesses issue promissory notes to raise capital to meet short term business needs, known as Commercial Papers (CPs). These firms have a high credit rating, owing to which commercial papers are unsecured, with company’s credibility acting as security for the financial instrument.
Corporates, primary dealers (PDs) and All-India Financial Institutions (FIs) can issue CPs.
CPs have a fixed maturity period ranging from 7 days to 270 days. However, investors can trade this instrument in the secondary market. They offer relatively higher returns compared to that from treasury bills.
3. Certificates of Deposits (CD)
CDs are financial assets that are issued by banks and financial institutions. They offer fixed interest rate on the invested amount. The primary difference between a CD and a Fixed Deposit is that of the value of principal amount that can be invested. The former is issued for large sums of money ( 1 lakh or in multiples of 1 lakh thereafter).
Because of the restriction on minimum investment amount, CDs are more popular amongst organizations than individuals who are looking to park their surplus for short term, and earn interest on the same.
The maturity period of Certificates of Deposits ranges from 7 days to 1 year, if issued by banks. Other financial institutions can issue a CD with maturity ranging from 1 year to 3 years.
4. Repurchase Agreements
Also known as repos or buybacks, Repurchase Agreements are a formal agreement between two parties, where one party sells a security to another, with the promise of buying it back at a later date from the buyer. It is also called a Sell-Buy transaction.
The seller buys the security at a predetermined time and amount which also includes the interest rate at which the buyer agreed to buy the security. The interest rate charged by the buyer for agreeing to buy the security is called Repo rate. Repos come-in handy when the seller needs funds for short-term, s/he can just sell the securities and get the funds to dispose. The buyer gets an opportunity to earn decent returns on the invested money.
5. Banker’s Acceptance
A financial instrument produced by an individual or a corporation, in the name of the bank is known as Banker’s Acceptance. It requires the issuer to pay the instrument holder a specified amount on a predetermined date, which ranges from 30 to 180 days, starting from the date of issue of the instrument. It is a secure financial instrument as the payment is guaranteed by a commercial bank.
Banker’s Acceptance is issued at a discounted price, and the actual price is paid to the holder at maturity. The difference between the two is the profit made by the investor.
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Frequently Asked Questions
Q. Who should invest in Money Market Instruments?
A. Investors looking to park their money for short-term, and earn fixed income on the same can consider investing in money market instruments mentioned above.
Q. What is the importance of the money market in the economy?
A. The money market is important for the economy as it paves the way for business houses and corporations to park their temporary cash surplus, or raise short term debt through issuance of corporate bonds.
Q. What is credit quality?
A. Credit quality of an instrument indicates the ability of the issuer to pay back the principal investment plus the yield back to the holders of the security. There are various credit rating agencies in India which assess the creditworthiness of the issuers, such as CRISIL, ICRA, etc.
Q. Who regulates the money market in India?
A. Currently, the Reserve Bank of India and the Securities and Exchange Board of India (SEBI) regulate the money market in the country.
Q. How are money market instruments different from equity securities?
A. Those who hold money market instruments are essentially creditors, they’re not the owners of the entity issuing the security, whereas, equity represents partial ownership of the entity. For instance, holders of corporate bonds are creditors of that corporate firm, whereas those who hold equity of that firm are partial owners of that firm.
Q. Are money market instruments entirely risk-free?
A. No, because the possibility of banks failing and big corporations declaring bankruptcy still persists, even though it is quite low.
Q. How to mitigate risk from investment in money market instruments?
A. The classic way to mitigate market risk on investment in money market instruments is to hold them till maturity, and not make a panic sale in the secondary market. One can also consider rebalancing their portfolio, by selling securities when they become short-term and replacing them with long-term securities to mitigate portfolio risk. However, the transaction costs involved in this should also be taken into consideration.
Q. How are Government Securities (G-secs) such T-Bills issued?
A. G-Secs are issued by the Reserve Bank of India through auctions, on its electronic platform called E-Kuber.
Q. Who can make the bid at G-secs auctions?
A. Commercial banks, scheduled Urban Cooperative Banks, Primary Dealers, insurance companies and provident funds, investors who maintain funds account (current account) and securities accounts with RBI, are members of the electronic platform E-Kuber, and can make the bid in the auction. Non-members can make the bid by opening a dematerialized account with scheduled commercial banks or Primary Dealers.
Q. When does the RBI conduct auctions for T-Bills?
A. The RBI generally conducts auctions every Wednesday, to issue T-bills with 91 days, 180 days and 364 days maturity. The central bank issues a quarterly calendar of issuance of T-bills.
Q. Who is eligible to invest in Commercial Papers (CPs)?
A. Individuals, corporate bodies (either registered or incorporated in India), banking companies, unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Institutions (FIIs) can invest in CPs. SEBI sets up the limits on investment by FIIs from time-to-time.
Q. For what amount, can a Commercial Paper (CP) be issued?
A. A CP is issued in denominations of Rs. 5 lakh or its multiples, thereof.