IndiaFilings » Learn » Money Market Instruments

Money Market Instruments

Money Market Instrument

Money Market Instruments

Money Market, according to the Reserve Bank of India (RBI), refers to a market where short-term financial assets are set to be traded. These assets are a close substitute for money and help in the exchange of funds executed in the primary and secondary markets. Here, short-term usually refers to a duration of a year or less. Therefore, the money market can be considered as an apparatus that facilitates the borrowing and lending of short-term funds. However, Money Market Instruments are merely instruments or tools that can assist one to operate in the money market. In this article, we take a look at Money Market Instruments and the various aspects of the same.

Money Market

One should understand that Money Market is a part of a much larger financial market. It comprises of various other smaller sub-markets such as acceptance market, bill market, call money market to name a few. The two characteristic features of the instruments that are traded in the Market are:

  • Short Maturity Period
  • High Liquidity

The deals fixed and carried out in Money Market are not made in cash/ money. Instruments such as Treasury Bills, Promissory Notes, Government Papers, and so on, are used instead of liquid finances.

It should be noted that transactions in Money Market are to carried out through mediums such as formal documentation and, oral or written communication. It cannot be carried out through brokers. Institutions such as Commercial Banks, Acceptance Houses and Non-Banking Financial Companies (NBFCs) are the main components that the money market depends on.

Objectives of Money Market

The following are some of the several essential objectives that are maintained by the Money Market in the overall economy.

  • Money Markets not only helps in the storage of surplus of short-term funds but also helps in bringing down short-term deficits.
  • It helps short-term fund users to achieve their requirements at a reasonable cost.
  • It helps the central bank of the country, Reserve Bank of India (RBI), to regulate the liquidity of finances in the economy.
  • The Market helps to develop trade and industry as well as other markets such as the Capital Market.
  • It helps to facilitate the smooth functioning of commercial banks.
  • Money Market plays a vital role in designing effective monetary policies.

Money Market Instruments

Money Market Instruments has a crucial role in the functioning of the Money Market. These instruments are merely tools that can assist one to operate in the money market. They serve a dual purpose of enabling borrowers to meet their short-term requirements and quickly offers liquidity to the lenders. Some of the most common money market instruments are Treasury Bills, Repurchase Agreements, Banker’s Acceptance, Commercial Papers and Certificate of Deposits.

Characteristics of MMI

Governments, businesses and other financial organisations can finance short-term cash requirements with the help of Money Market Instruments. The most notable features of Money Market Instruments are the following.

  • Safety: The most primary advantage of money market instrument over any other short-term investment options is the fact that they are relatively safer than mutual funds or shares. Moreover, money market instruments have the capability to bring a decent rate of return for the time period of investments.
  • Liquidity: Money Market Instruments have high liquidity. The liquidity of the Market permits investors to reap the benefits of the return within a short period of time. Therefore, they may choose the appropriate instruments as per their requirement.
  • Yield: Money Market Funds are known to offer great flexibility with respect to investments as they have the option to be issued and withdrawn within short durations.

Types of MMI

The following are the types of money market instruments that every investor must be aware of before making a decision.

Treasury Bills

One of the safest money market instruments is Treasury Bills. This is a short-term borrowing instrument that has been issued by the RBI for the Central Government. They are an ideal zero-risk instrument. However, the returns may not be so attractive. It is accessible to both, the primary and the secondary Market. Treasury Bills are essentially a promise to pay a certain determined amount after a pre-determined time period. These bills are short-term securities and mature in a year or less from their date of issue. Typically, they are issued with a maturity period that lasts for 3 months, 6 months and 1 year.

Repurchase Agreements/ Repo Transaction/ Reverse Repo Transaction

Repo Transactions are short-term loan transactions where two parties agree to sell and repurchase the same security. This is generally used for overnight borrowing and lending. These transactions may only be executed by parties who are approved by the RBI and through RBI-approved securities. Under such an agreement, the seller agrees to sell specific securities under the condition that the same would be repurchased at a mutually determined price and date. Hence, the transaction is called a Repo Transaction when viewed from the perspective of the seller, and Reverse Repo when seen from the buyer’s point of view.

Commercial Papers (CPs)

Commercial Papers are considered to be cost-effective alternatives to bank loans. It can be defined as a short-term unsecured promissory note issued by financial and corporate institutions at a value lesser than the actual face value. They are generally issued with a fixed maturity that ranges between 1 to 270 days. They are used to finance accounts receivables, inventories and meets short-term liabilities. They yield a much higher return when compared to Treasury Bills. However, security is less, and the chances of default are quite negligible. Commercial Papers are not considered zero-risk instruments. Only entities with high quality in credit ratings would find buyers easily as they are not backed by any collateral.

Certificate of Deposits (CDs)

It is considered a short-term borrowing and in many ways is similar to a bank term deposit account. Certificates of Deposits are promissory notes issued in the form of a certificate by the bank. CDs entitle the bearer to receive interest by a bank. However, CDs have a maturity date along with a value and a fixed rate of interest. It can be issued in any given denomination, and are stamped and transferred through endorsement. The term of a CD ranges from 3 months to 5 years although restricts the holder to withdraw any funds on demand. However, the funds can be withdrawn on payment of a specific penalty. The returns on such MMIs are higher than Treasury Bills as it involves a higher level of risk.

Banker’s Acceptance (BA)

A Banker’s Acceptance is a short-term credit investment that is created by a non-financial firm. This is often guaranteed by banks to make payments. It is merely a bill of exchange secured by an individual and accepted by a bank. The buyer promises to pay a particular amount by a specific date to the seller. The banker of the buyer assures the same. Here, a claim on the goods is considered as collateral. The individual making the bill must have a spectacular credit rating in order to trade the BA. Generally, the term for a BA is 90 days. However, they may range to a span of 30 days to 180 days.