Tuesday, November 24, 2009

What is a money market?

The money market is one of the markets that companies and government used to raise funds. What is special about the money market is that securities with a maturity of less that one year are traded in it.

In general all of the money market are debt instruments issued government, banks and companies. These instrument are very liquid and quite safe. As a result because of this safety they have a relatively low return. You would understand that generally instruments that are quite risky have higher yield and vice versa.

The following are the different money market instruments that you can invest in:

  1. Treasury bills
  2. Banker’s acceptance 
  3. Negotiable certificate of deposits
  4. repos and reverse repos
  5. Commercial papers
  6. Eurodollars

However compared to the stock market whereby individual investors can buy individual stocks, money market instruments are issued in high denominations and as a result it is quite difficult for individual investors to but them. The only way for investors to invest in them is through mutual funds and exchange traded funds. However if you have a lot of money you can buy treasury bills from the reserve bank offices.

These money market instruments are like instruments in the bond market in that they are not traded in a stock exchange like shares but are traded over the counter.

There are various reasons for an investor, a bank or an institution to buy securities in the money market and they are as follows:

  1. The securities in the money market are very secure and as a result investors that have some money for a short period that they cannot lose prefer to invest in the money market and get a small return until they need the money. They can when needed sell the securities easily to get their money back since money market securities are highly liquid.
  2. Some banks are obliged by law to hold a certain amount of money market securities to use as collateral in repo transaction with the central bank. These banks must also have assets that they can easily convert to cash in case money is needed to satisfy liabilities. Since these money market securities are highly liquid they are easily sold in the secondary market.
  3. Some type of financial market institutions like short term insurer need by law to hold a certain amount of highly liquid money market instrument so that they can   meet their liabilities.
  4. Some investors are risk averse and as a result they have a low risk tolerance. These investors prefer to forgo the high return associated with stocks and prefer to hold safe money market securities that however have low return.
  5. Investors and financial institutions that have excess cash, for example after selling stocks and bonds that are falling in value or are about to default and are waiting to invest in other securities, can invest in money market securities and have a small return instead of holding cash with no return.

There are also many other reasons for investing in the money market and as time go by I would increase and refine the list above. So if any of the reasons is appropriate to you then go ahead.

However keep in mind that in the long run investing in the money market is not advised as the return is low. However there is a type of investing strategies called the permanent portfolio that relies on investing in the money market. I would write on it in another post.

Bookmark and Share

No comments:

Post a Comment