Fixed Income Markets
A money market is a part of the fixed income market, which is in turn a part of the financial markets. A financial market is a place where persons, both real and corporate, can buy, sell and trade financial fungibles. A financial marketplace may have an actual physical presence, like a stock brokerage on Wall Street, or be a website where fungibles can be traded.
In a fixed income market, fixed income securities are traded. These are securities that offer pre-defined periodic returns and the return of the principle upon maturity. Examples of these are U.S. Savings Bonds and municipal bonds. One feature of these securities is that they often do not pay interest along the way. Instead, they are bought at a price below their face value, also called par value. When securities are bought a price below their face value, they are said to be purchased at a discount. The discount is the difference between the purchase price and the par value. At their maturity they can be turned in for their face value.
Fungibles are any items that can be bought and sold which have the property of mutual substitution. This means that any one of the items is interchangeable with any another. If you lend someone a five dollar bill, they probably won’t give you the same one back. It doesn’t matter, because any two five dollar bill are identically valuable.
As was stated earlier, a money market is a part of the fixed income market. Money markets focus on short-term debt securities, ones that come due in less than one year. These securities are very liquid, which means they can be bought and sold very quickly, and with little effect on their value. Because of the entities that are backing them, they are usually considered to be very safe. This safety brings a downside, however. They usually bring much lower returns than other securities.
Money Market Accounts and Mutual Funds
These are ways that individual consumers can get into money markets. Most money market securities are bought and sold in very large numbers and very large dollar amounts. Also there is no controlling entity like a stock exchange. That is why money market accounts and mutual funds came to be. They are a way for large numbers of small investors to get together and buy these securities. Money market accounts are often created by commercial banks, and will operate similarly to a checking account. Money market mutual funds are bought through brokerages.
Money Market Securities
There are several types of securities that are part of the money market. Here are descriptions of some of them.
Treasury bills (T-bills) are securities that are issued by the U.S. government. Treasury bills have several advantages for the individual investor. They are relatively affordable, as denominations start at $1000. They are safe. As a matter of fact, because they are backed by the government they are considered to be free of risk. Of course this means that they won’t carry a great return.
T-bills are available with three, six and 12 month maturities.
There are a couple of ways to buy T-bills . They can be purchased directly from the Treasury department, or they can be bought though a commercial bank or a broker. No matter where you buy them, the process will be the same. They are sold in an auction, and you must submit a bid. There are two types of bids, competitive and non-competitive. In general, non-competitive bids are used by individuals and small investors, and competitive bids are used by institutions such as corporations or money market accounts.
In a competitive bid, the buyer specifies a total dollar amount they want to spend and a discount rate they would like to receive. The investor who bids the highest, that is the least below face value, will receive T-bills equal to the dollar amount that they bid. If the there are more securities left available in the auction, they will go to the next lower bidder, until none are left.
Non-competitive bidders are guaranteed to get the denomination they want in the dollar amount they want. The rate they get is the average of the competitive bids.
Certificates of Deposit
Certificates of deposit (CDs) are examples of securities called time deposits. This means money is deposited with the understanding that it cannot be withdrawn except by written request. There will also be a penalty charged for withdrawal before the maturity date.
There are two important numbers to be aware of when shopping for CDs. The first is Annual Percentage Rate (APR). This is the baseline interest that will be given on a yearly basis. Suppose your CD has an APR of one percent, and interest is paid annually. If your CD was purchased for $1000, then after one year one percent of 1000, or $10, would be added to your CD. Usually, though, interest will be added more often than annually. This is where Annual Percentage Yield (APY) comes in. The APY takes into account how often interest is added. If interest is paid quarterly for example, then after three months interest would be paid equal to the APR times the amount of the CD times 0.25. Since the next interest payment will be based on the original amount plus the first interest payment, slightly more interest will be paid at each increment. Thus the APY will be higher than the APR, and will more accurately reflect the amount of interest you will get.
CDs typically offer a higher return than T-bills, but it still will not be very high. This low return is offset by the safety of CDs and their defined return.
Commercial paper is a short-term security issued by a corporation. They are usually issued for less than nine months, and often for only one or two months. They are issued at a discount, and are considered to be very safe. This is because the credit rating of the issuing company is known, and the financial situation of the company can be predicted fairly accurately for the time span of the loan.
These securities are issued by companies and backed by banks. They are issued at a discount, usually with maturities of less than six months. Because they do not have to kept until they mature, they are often traded on the money market or used as forms of payment in financial dealings.
Repurchase agreements, or repos, are a way for dealers in securities to quickly, but temporarily, get cash. In a repo, a dealer sells securities, usually T-bills, with an agreement to buy them back later at a higher price. The agreement may be to buy back the securities anywhere from the next day to one month or more.
The main things to know about money market securities is that they are short-term, are usually very liquid and very safe, but give poor returns. They are usually traded in very large dollar amounts by corporations and financial institutions. Individual participation in money markets is limited to T-bills, CDs and accounts at commercial banks and brokerages. That is the basics of money markets.