List and explain the operation of any three money market instruments.
Examples of money market instruments include government bonds, certificates of deposit, commercial paper, repurchase agreements, and overnight funds. Debt instruments traded in the money market have short terms to maturity and do pass through the least price fluctuations and are less risky investments.
- Government bonds – government bonds in the money market are issued for less than 12 months, some for 6, 3, and 1 month. These bonds are sold at a discount and they do not pay interest. They pay a set amount of money at the date of maturity. Government bonds are the most liquid securities in the money market, there is the safest instrument in the money market because there is no possibility of default on payments from the government. This is based on the assumption that the government will always be able to make its interest payments through tax revenue. The main holders of government bonds are the banks, with small amounts held by households, corporations, and other financial institutions.
- Certificate of deposit – this is the debt instrument sold by banks to a depositor. The certificate of deposit pays the depositor who is the holder of the certificate a certain amount of annual interest and original purchase price on the date of maturity. Certificate of deposit can be negotiable or non-negotiable. Negotiable certificate of deposit can be resold, while non-negotiable instruments cannot be sold to someone else and cannot be redeemed from the bank before maturity without a penalty. A negotiable certificate of deposit has short-term while a non-negotiable certificate of deposit has long-term maturity.
- Commercial paper – these are unsecured short-term debt instruments issued in local currency or foreign currency by banks and well-established corporations with a good reputation. Since they are unsecured, only the largest, creditworthy corporations with a good reputation can issue commercial paper. Compared to other securities, the interest rate on commercial paper is low, but it is higher as compared to government bonds and this interest rate is determined by the level of risk of a particular corporation.
- Repurchase agreements – these are short-term loans with a maturity of fewer than two weeks, which have government bonds as collateral security, which the lender receives if the borrower does not pay back the borrowed amount. A company with surplus funds will lend the bank those funds, buy purchase treasury bills from a bank, which are going to be purchased back by the bank at a slightly higher price in the future.
- Overnight funds – these are loans available among banks. A bank will use overnight loans to settle its daily requirements with the central bank. The interest rate for overnight loans is the overnight interest rate.
