FIN521 Chap.2 Money Markets and Short Term Instruments
Money Markets and Short Term Instruments
Four adjectives, and what each one costs
The money market is the part of the debt market where maturities run to a year or less, and its instruments are described as highly marketable, highly liquid, low risk and issued in large denominations. Each of those is a constraint rather than a boast, and the return on offer is what survives them. Two cautions travel with the definition.
Currency trading is something else entirely, and money itself is not what changes hands here; what trades are near-money claims, secure and convertible at short notice.
And low risk describes normal conditions, because in a crisis liquidity evaporates from exactly these markets at the moment a holder needs it.
Why the market exists at all when banks could do the job
A banking system accepts short deposits, extends short loans and understands its borrowers far better than a faceless market ever will, so in principle it could cover the whole job.
The reason the market exists anyway is regulatory cost. Supervision is much heavier on a bank, supervision costs money, and any borrower or investor large enough to approach the market without an intermediary finds better terms there.
That is the same trade-off the course keeps returning to, stated in institutional form: the regulation that makes a deposit safer is precisely what makes it more expensive.
The bill, and the auction that prices it
Governments fund themselves at the short end by issuing bills below face value and repaying them at it. Interest is never paid separately, so the difference between the two amounts is the entire return.
Bills are auctioned weekly and the allocation rule is fixed and examinable. Noncompetitive bids, which state only an amount, are filled first. Priced bids are then worked through in descending order of price until the offered amount runs out, and whoever sits at the cut-off usually receives only a fraction of what was asked for.
Every successful bidder then pays the same price, the lowest one accepted, which is why bidding aggressively buys certainty of allocation rather than a better outcome.
The rest of the catalogue, sorted by what stands behind it
Once the bill is understood, the remaining instruments are variations on who owes and what secures the promise.
A certificate of deposit is a claim on a bank, insured to a limit, and its negotiable version can be sold before maturity. A Eurodollar is a dollar time deposit held outside the United States. Federal funds are reserve balances lent between banks overnight at the rate that anchors almost every other short rate. A repurchase agreement is a collateralised loan dressed as a sale, with the coupons staying with the seller.
And commercial paper is unsecured debt of a large company, backed by nothing but its name and a bank credit line, which is why it pays a little more.
What this chapter covers
- 01
What the short end of the debt market is for
- 02
Why regulation makes a bank deposit dearer than a market instrument
- 03
Treasury bills, discount pricing and the holding period return
- 04
Competitive against noncompetitive bidding at auction
- 05
The single clearing price and why partial fills land on the margin
- 06
Certificates of deposit, negotiability and deposit insurance
- 07
Eurodollars, federal funds and the benchmark short rate
- 08
Repurchase agreements as collateralised lending
- 09
Commercial paper and the price of being unsecured
Rank an auction book and identify who gets nothing
- 2Remove the noncompetitive amount from the issue before ranking anything.
- 3Rank the competitive bids by price and allocate down the ranking.
- 3Name the stop-out price and the bidder who is filled only in part.
Key terms
- Money Market
- The subsector of the debt market for instruments maturing within a year, characterised by marketability, liquidity, low risk and large denominations.
- Treasury Bill
- Short-term government debt sold below face value and redeemed at it, with no coupon, so the whole return is the discount.
- Stop-Out Price
- The lowest price accepted at a bill auction, which every successful bidder pays regardless of what they themselves bid.
- Noncompetitive Bid
- An auction bid stating only an amount and accepting whatever price the auction settles at. It is filled first and in full.
- Negotiable Certificate
- A certificate above the size threshold that may be resold to another investor before it matures. The word means tradable and has nothing to do with haggling.
- Eurodollar
- A United States dollar time deposit of a year or less held at a bank outside the United States, which exists because so many international contracts settle in dollars.
- Federal Funds Rate
- The rate at which banks lend reserve balances to one another overnight, and the benchmark from which most other short-term rates are set.
- Repurchase Agreement
- A security transferred today under a commitment to reacquire it on a stated date at a stated price, which in substance is short-term borrowing against a pledge.
- Commercial Paper
- Short borrowing by a large and familiar corporate name, secured on nothing but that name and a standby bank line, maturing within 270 days and usually far sooner.
- Bid-Ask Spread
- The difference between the price a dealer will pay and the price a dealer will sell at, which is the dealer's revenue and the investor's cost.
Money Markets and Short Term Instruments FAQ
Why would anyone submit a noncompetitive bid?
Because the single-price rule makes it rational. Every winner pays the lowest accepted price, so a bidder who states only an amount receives exactly the same terms as the most sophisticated participant in the room while saving the cost of forming a view about where the auction will clear.
The trade is certainty of allocation in return for no say in the price, and for a small investor with no analytical edge that is a good exchange rather than a concession.
Is a repurchase agreement a loan or a sale?
Legally it is a pair of sales and economically it is a secured loan, and the course expects you to be able to say both. Whoever supplies the money is really lending it, the security stands as the pledge, and because beneficial ownership never moves, income thrown off during the interval still accrues to the party that handed the security over.
Naming the economic substance and the legal form separately is what makes an answer here look considered rather than memorised.
Are money market instruments safe?
Low risk is not the same as risk-free, and the course is explicit about the distinction. In ordinary conditions these instruments are among the safest available and pay accordingly. In a financial crisis liquidity can disappear from these markets, and the holder who needs cash discovers that marketability was a feature of the environment rather than of the instrument.
Commercial paper adds a second exposure, because it is unsecured and backed only by the issuer's name.
Exam move
Draw the maturity ladder from memory once a week until the order is automatic: overnight federal funds, repurchase agreements of a few days, commercial paper within 270 days, bills to a year. Then work two auction allocations with different noncompetitive amounts, because the arithmetic is trivial and the ordering is where marks go.
Finish by writing one sentence for each instrument naming who owes and what secures it, which is the shape most short-answer questions on this chapter take.
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