Money Market is a market for securities with short term maturities upto 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.
What are Money Market Instruments?
Financial instruments with short term maturity upto 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 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 a 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 the 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 a 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.
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.