In my previous post about Zero Coupons Bonds, we talked about the basics of bonds and bond evaluation. But it’s hard to talk about the essentials of finance and investment without talking about money market instruments. Consider this post as a short and quick guided tour of financial instruments. I expect all my readers to be experts on money market instruments and the basic terminology that goes with it by the end of this post. Capisce?
What the hell are money market instruments?
Very short-term fixed income securities. Money market instruments are actually a very important part of the global financial markets and these assets serve a bunch of super important functions:
- Allows us young and naïve investors to dump money in some very liquid assets and provides the underlying market (kind of)
- Allows us super entrepreneurs to borrow short-term money (kind of)
- Actually lets the Federal Reserve Bank to execute their planned monetary policy (true)
Let’s start with the simplest ones, T-Bills.
Yup. Or rather Treasury Bills. T-bills are probably the simplest form of fixed income securities. The Treasury (be it Indian. US, Canadian, etc.) borrows from the general public by issuing treasury securities. These are basically risk-free or default-free assets considering that these are issued by governments as opposed to companies or organizations. Barring a Mars Attack or World War Z-esqe scenario, it’s probably a good bet that the government is not gonna run away with your money. Hence, the default risk free status.
Wait, so isn’t that a bond?
Yup. Treasury Bill is basically a zero coupon bond but with very short maturities, usually less than a year. Fun fact, the first Treasury Bills in India were issued back in 1917. Source? Wow, how dare you! Just google it.
Treasury bills are very liquid and are issued as 91-days, 182-days, and 364-days T-bills in India. Basically at 3 months, 6 months, and 12 months maturities. Risk-free status comes at a trade-off though. T-bills typically carry very low interest rates so I doubt you can pull a Wolf of Wall Street by dumping money in T-bills.
Good. Next up is Commercial Paper.
Commercial Paper is a short-term unsecured debt instrument that is very popular with large corporations. This money market instrument is frequently used by companies to fund their day to day operations.
Imagine you are running a company, say you’re making headphones. You’re probably not getting paid till you buy raw materials, convert them into useful products, pack them up, and finally sell them to materialistic people like me. You still need to pay wages to your employees, buy shipping boxes, pay for electricity, you get the idea.
You do that by tapping into the commercial paper market. Commercial paper, thus, allows companies to borrow from public markets to fulfill their short-term financial needs. Remember, short-term implies short maturities on these assets.
Coolio, what’s next?
You are probably aware of CD or Certificate of Deposit. A CD is also a short-term deposit with a bank where the bank pays the depositor an interest for the time duration of their investment.
Yeah. I knew that. No Lies!
Then there are things like Repos and Reverse-Repos. These are repurchase agreements where the seller pinky-promises to buy back an underlying security at a given price and a given date. The security could be, for example, T-bills. These serve as a collateral against the loan essentially. Repo markets are frequently used by traders to borrow and lend $$$ on short-term basis.
Awesome! Tell me more.
Eh, that’s pretty much it. I mean there is obviously more to it but that’s all I can realistically cover in this basics edition. But you are now an expert at money market instruments, Congratulations!
(I am not liable for any damages that may occur, unless you make some $$$ from this post. Then please send some to my paypal :)
Stay tuned for another lesson in my Everything Finance series. Check out the links below to catch up!
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Views presented in the article are those of the author and not of ED.