A money market is a market for instruments and a means of lending (or investing) and borrowing funds for relatively short periods, typically regards as from one day to one year. Such means and instruments include short term bank loans. Treasury bills, bank certificates of deposit, commercial paper, banker’s acceptances and repurchase agreements and other short term asset backed claims.
As a key elements of the financial system of a country, the money market plays a crucial economic role that if reconciling the cash needs of so called deficit units (such as farmers needing to borrow in anticipation of their later harvest revenues), with the investment needs of surplus units (such as insurance companies wanting to invest cash productively prior to making long term investment choices). Holding or borrowing liquid claims is more productive than holding cash balances. A smoothly functioning money market can perform these functions very efficiently if borrowing lending spreads (or bid offers spreads for traded instruments) are small (operational efficiency), and if funds are lent to those who can make the most productive use of them (allocation efficiency). Both borrowers and lenders prefer to meet their short term needs without bearing the liquidity risk or interest rate risk that characterizes longer term instruments, and money market instruments allow this. In addition money market investors tend not to want to spend much time analyzing credit risk, so money market instruments are generally characterized by a high degree of safety of principal. Thus the money market sets a market interest rate that balances cash management needs, and sets different rates for different uses that balance their risks and potential for productive use. Unlike stock or futures markets, the money markets of the major industrial countries have no central location; they operate as a telephone market that is accessible from all parts of the world.
The international money market can be regarded as the market for short term financing and investment instruments that are issued or traded internationally. The core of this market is the Euro-currency market, where bank deposits are issued and traded outside of the country that issued the currency. Other instruments such as Euro commercial paper and floating rate notes, serve some what different purposes and attract a different investment clientele. However, each is to a degree a substitute for each of the other instruments, and the yield and price of each are sensitive to many of the same influences, so we may feel justified in lumping them together in something called a market. The fact that many of the other instruments of the international money market are priced off LIBOR, the interest rate of Eurodollar deposits, suggest that market participants themselves regard the different instruments as having a common frame of reference.
Today many domestic cash and derivative instruments, such as US. Treasury bills and Euro-currency futures contracts are traded globally and so are effectively parts of the international money market. Euro-market instruments simply represent part of a spectrum of financial claims available in the money market of a particular currency, claims that are distinguished by risk, cost and liquidity just like domestic money market instruments. However domestic money markets are called upon to play public as well as private roles. The latter include the following three functions.
- The money market, along with the bond market, is used to finance the government deficit.
- The transmission of monetary policy (including exchange rate policy) is typically done through the money market, either through banks or through freely traded money market instruments.
- The government uses the institutions of the money market to influence credit allocation toward favored uses in the economy.
International Money Market Instruments
Euro-currency Time Deposits and Certificates of Deposit
The overwhelming majority of bank deposits in the Euro-currency market take the forms of non negotiable time deposits. Those who want greater liquidity invest in shorter maturities. A very high proportion of Eurodollar time deposits, especially in the inter-bank market, mature in one week or less.
Alternatively, the invest can buy a negotiable Euro certificate of deposit (Euro CD), which is simply a time deposit that is transferable and thus has the elements of a security. Some banks are a little reluctant to issue CDs, because they would prefer not to have their paper traded in a secondary market, especially at times when the bank might be seeking additional short term funding. The secondary paper might compete with the primary paper being offered. Other will issue CDs readily if investors prefer them, perhaps paying ¼ percent or ore below their equivalent time deposit rate to reflect the additional liquidity and the somewhat greater documentary inconvenience of CDs.
Other banks (particularly if they wish to have their names better known in the market) might deliberately undertake a funding program using Euro CDs. In this circumstance, the CDs are to be distributed like securities, so as to increase awareness of the issuers name and raise a larger volume of funds for longer maturities than might be possible in the conventional euro-deposit market.
Bankers Acceptances and Letters of Credit
Banker’s acceptances are money market instruments arising, typically, from international trade transactions that are financed by banks. The banker’s acceptance (BA) itself represents an obligation be a specific bank to pay a certain amount on a certain date in the future. To simplify a bit, it is a claim of the bank that differs little from other short term claims such as CDs. Indeed BAs, when they are traded in a secondary market, trade at a return that seldom deviates much from comparable CDs issued by the same bank.
Letters of credit (L/C) are documents issued by banks in which the bank promises to pay a certain amount on a certain date, if and only if documents are presented to the bank as specified in the terms of the credit. A letter of credit is generally regarded as a very strong legal commitment on the part of a bank to pay if the conditions of trade documents are fulfilled.
In a typical export transaction, the exporter will want to be paid once the goods arrive (and are what they are supposed to be) in the foreign port. So the exporter asks for acceptance is the importers bank of a time draft (essentially an invoice that requests payment on a future date). Upon acceptance by the importers bank, the innocuous little time draft becomes a valuable document, a banker acceptance. Acceptance means that the bank obliges itself to pay the face amount upon the due date. The means by which an exporter gets paid is be selling this BA to its own bank, which can hold it as an investment or sell it in the secondary market, when it becomes a money market instrument. Bankers acceptances are sold at a discount from face value, like Treasury bills and Commercial paper, and yields are quoted as discount yields. Why should the bank pay the exporter? The reason is that it has promised the exporter hat it will do so upon presentation of documents conveying title to the goods. That promise is what we gave described as the letter of credit.
Euro-notes and Euro-commercial Paper
These instruments are short term unsecured promissory notes issued by corporations and banks. Euro-notes, the more general term, encompasses note issuance facilities, those that are underwritten, as well as those that are not underwritten. The term Euro-commercial paper is generally taken to mean notes that are issued without being backed by an underwriting facilities that is, without out the support of a medium term commitment by a group of banks to provide funds in the event that the borrower is unable to roll over its Euro-notes on acceptable terms. The Euro-notes market takes the form of non underwritten Euro-commercial paper (ECP), so the actual paper that an investor will find available for investment is likely to be ECP.
Like US commercial paper, Euro-notes and ECP are traded by conversion on a discount basis, and interest is calculated as “actual/360,” meaning that the price is set as 100 minus the discount interest rate multiplied by the actual number of days to maturity, over 360.