Financial Markets Dr S.M.Tariq Zafar M.Com, PGDMM, PhD (Social Sector Investment)

Financial Market Chapter - III Money Markets

What is Money  Medium of exchange  Allows specialization in production  Solves the divisibility problem, i.e. where medium of exchange does not represent equal value for the parties to the transaction  Facilitates saving  Store of wealth

Importance Of Money Markets The money market is created by the financial relationship between suppliers and demanders of short–term funds with maturities of one year or less. Money markets exist because investors often have temporarily idle funds that they wish to place in some type of liquid asset interest – earning instrument. At the same time, other entities (organizations) find themselves in need of seasonal (temporary) financing.

Money Markets Wholesale markets in which short-term securities are issued and traded  Securities highly liquid  Term to maturity of one year or less  Highly standardised form  Deep secondary market No specific infrastructure or trading place Enable participants to manage liquidity

Money Market (cont.) Money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes, eurodollars, federal funds and repurchase agreements (repos). Money market investments are also called cash investments because of their short maturities.

Money Market (cont.) The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities. However, there are risks in the money market that any investor needs to be aware of, including the risk of default on securities such as commercial paper.

 Money Market Securities  Cash deposits (11 a.m. and 24-hour call)  Commercial bills  Treasury notes  Government bonds  Promissory notes  Intercompany loans  Interbank loans

Money Market Participants:  Reserve Bank:-  Financial system liquidity  Implementation of monetary policy Banks Finance companies Funds managers Building societies Credit unions Companies

 Money Market Sub-Markets  Intercompany market  Interbank market  Bills market  Commercial paper market  Negotiable certificates of deposit (CDs) market

Fundamental Characteristics of Money Market Money markets provides the designed to meet the short-run cash requirements of corporations, institutions, and governments by providing a mechanism for granting loans as short as overnight and as long as one year to maturity. At the same time, the money market provides an investment outlet for those spending units that hold surplus cash for short period of time and wish to earn at least some return on temporarily idle funds.

Reasons for a Money Market The money market serves to bridge the gap between receipts and expenditures of funds. As money is one of the most perishable of all commodities, the holding of idle surplus cash is expensive. This is because cash balance earns little or no income for their owners. As cash runs low relative to current expenditure, such units must once again enter the money markets as borrowers of funds, issuing short–term notes attractive to money market investors. A surplus cash position – bring such firms in to the money markets as net lenders of funds. Cash deficits force them in to the borrowing side.

Investors Goals in Money Market  Investors in the money market seek mainly safety and liquidity plus the opportunity to earn some interest income.  The funds invested in the money market represent only temporary cash surpluses and are usually needed in the near future to meet obligations, For this reason, money market investors are especially sensitive to risk.  Money market investors strongly avert (or avoid) risks. That is, when a given financially strong money market borrower defaults on its short-term securities, the money market investors refuse to buy newly issued commercial papers of even top–grade companies.

Types of Risks in Money Market A. Market Risk It is the risk that the market price (value) of an asset will decline, resulting in a capital loss when sold. (It is sometimes referred to as interest rate risk.). B. Reinvestment Risk It is the risk that an investor will be forced to place earnings from a loan or security in to a low-yielding investment because interest rates have subsequently fallen. C. Default Risk It is the probability that a borrower will fail to meet one or more promised principal or interest payments on a loan or security.

Types (Cont). D. Inflation Risk It is the risk that increases in the general price level will reduce the purchasing power of investor earnings from a loan or security. E. Currency Risk The risk that adverse movements in the price of one national currency vis-à-vis another will reduce the net rate of return from a foreign investment. (It is sometimes called exchange-rate risk.) F. Political Risk It is the probability that changes in government laws or regulations will reduce the investor’s expected return from an investment.

Treasury Bills Treasury Bills represents the large volume of daily purchases in the money markets. The interest rates on T-Bills are the base for all other money market interest rates. The government IOUs, which includes T-Bills, notes, and long-term bonds, carry great weight in the financial system due to their zero default risk, ready marketability, and high liquidity. Deep recessions which reduced government tax revenue and Repaid expansion of certain federal programs such as federal defense. Repaid growth of the U.S. and the global economies have also created a greater need for liquid assets such as bills to aid commercial banks.

How the Treasury Bills are Sold Bills are sold using the auction technique and hence, it is the market place, not government treasuries that sets bill prices and yields. In this regard, interested investors fill out a form tendering an offer to the treasury for a specific bill issue at a specific price. Types of Tenders A. Competitive Tenders: Competitive tenders are submitted by large investors, including commercial banks and government securities dealers, who buy several million dollars’ worth at one time. Institutions submitting competitive tenders bid aggressively for bills, offering a price high enough to win an allotment of bills but not too high, because the higher the bid price, the lower will be the rate of return to the investors.

B. Non-Competitive Tenders: Non-competitive tenders (normally less than 1 million each) are submitted by small investors who agree to accept the average price set in the weekly or monthly bill auction (i.e. the Dollar- Weighted Average Auction Price Commercial Papers Commercial paper is one of the oldest of all money market instruments. By definition, commercial paper consists of short term, unsecured promissory notes issued by well known companies that are financially strong and carry high credit ratings. The funds are used for current transactions – i.e., to purchase inventories, pay taxes, meet payrolls, and cover other short-term obligations. However, a growing number of paper issues today are used provide “bridge financing” for long term projects such as building of ships, office buildings, etc.

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