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Understanding the money market

BY BATANAI MATSIKA

Piggy’s first experience in a Bank Treasury Dealing room was the same as that of a casino floor. The atmosphere was charged, everyone was focused on their machines (PCs) and over-head screens were displaying different economic indicators and investment rates. It was busy and dealers spent most of the time on the phone, quoting some rates and funding the bank’s position. The dealers are normally referred to as financial traders or money market dealers.

The money market is where the buying, selling, lending and borrowing of short-term funds occurs. Banks are the major players and the money market includes a wide range of securities, including Treasury Bills (TBs), commercial paper, bankers’ acceptances and negotiable certificates of deposit, among others.

The money market is basically a subsector of the fixed-income market. It consists of very short-term debt securities that usually are highly marketable. Many of these securities trade in large denominations, and so are out of the reach of individual investors.

Money market funds, however, are easily accessible to small investors. These mutual funds pool the resources of many investors and purchase a wide variety of money market securities on their behalf. This article investigates some of the instruments traded on the money market.

Treasury Bills

There are securities representing financial obligations of the government. The government raises money by selling TBs to the public. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the holder receives from the government a payment equal to the face value of the bill.

TBs have maturities of less than one year. They have the unique feature of being issued at a discount from their stated value at maturity. In other words, a sum of money is paid today for a greater fixed dollar amount in the future at maturity.

For example, TBs may sell for US$98 000 when issued and have a maturity value of US$100 000 in six months. Thus, the dollar return to the investor is US$2 000.

During this six-month period, the investor earns interest, although the interest is not paid in cash, but is merely accrued.

Another unique feature of TBs is that they are virtually risk-free. Ignoring inflation and default of a government (which is rare in most countries), the TB will pay the stated yield with certainty. Also, because it is a short-term asset, changes in interest rates do not affect the price significantly. Therefore, it is common to refer to the yield on TBs as the risk-free interest rate.

Certificates of deposit

A certificate of deposit or CD is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD. Short-term CDs are highly marketable, although the market significantly thins out for maturities of three months or more.

Commercial paper

Large, well-known companies often issue their own short-term unsecured debt notes rather than borrow directly from banks. These notes are called commercial paper.

Very often, commercial paper is backed by a bank line of credit, which gives the borrower access to cash that can be used (if needed) to pay off the paper at maturity. Commercial paper is a safe asset, because a firm’s condition presumably can be monitored and predicted over a term as short as one month. Many firms issue commercial paper intending to roll it over at maturity, that is, issue new paper to obtain the funds necessary to retire the old paper.

Bankers’ acceptances

A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within six months. At this stage, it is similar to a post-dated cheque.

When the bank endorses the order for payment as “accepted”, it assumes responsibility for ultimate payment to the holder of the acceptance. At this point, the acceptance may be traded in secondary markets like any other claim on the bank.

Bankers’ acceptances are considered very safe assets because traders can substitute the bank’s credit standing for their own. They are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from the face value of the payment order, just as TBs sell at a discount from par value.

Lean more about money market instruments by downloading a copy of the Investor 101 Handbook from www.piggybankadvisor.com

Matsika is the head of research at Morgan & Co and founder of piggybankadvisor.com. — batanai@morganzim.com/ batanai@piggybankadvisor.com or +263 783 584 745.

 

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