Before we talk anything about money market instruments, we need to understand what a 'money market' is? The money market is where short-term assets with a maturity of up to one year are traded. These assets are usually traded by institutions which can process high volume trades. These financial assets are also highly liquid. So, they are comparatively safer and are used as near substitutes for money.
Wondering what are money market instruments? Read on to know everything about them.
What are money market instruments?
Money market instruments are unsecured debt contracts that offer a fixed rate of return, and therefore, are theoretically riskier. However, they carry a high credit rating, indicating that the issuers do not default.
Money market instruments are used to fulfil large yet short-term capital needs of businesses, banks, and governments.
They are preferred by borrowers (issuers) with an immediate need for capital and lenders (investors) who want to preserve their cash requirements, invest for the short term, and earn fixed returns.
Some features of money market instruments are as follows:
- Safe: Since they are issued by businesses and popular banks, these have high credit ratings and are comparatively safer than other instruments.
- Liquid: Money market instruments have high liquidity because they have a short maturity period and provide fixed returns.
- Discount on face value: They are issued at a price lower than their face value.
- Higher Yields: Money market funds have the potential to provide greater returns than traditional cash equivalents like savings accounts in addition to being safe and liquid.
- Risk Management: Money market funds have low to moderate interest rate risk because they invest in securities with a one-year maturity or less. Since capital protection is their main priority, fund managers frequently invest in products with strong credit ratings. Money market funds therefore have a low risk profile.
- Steady Returns: Due to the fact that fund values do not move much in reaction to changes in the financial markets, money market funds produce returns that are almost constant across cycles of interest rate tightening and easing. Money market funds are also less volatile than the majority of fixed-income instruments due to the low credit risk.
Different types of money market instruments
Several types of money market instruments are available to be traded for retailers like you. A few of these are given below:
Treasury bills (T-Bills)
Treasury bills or T-Bills are issued by the Indian Government to fulfill its short-term obligations. They are considered the safest among the money market instruments in India with a maturity period ranging from 14 days to 1 year.
They are sold at a discounted rate but their full-face value is paid at the time of maturity, thus leaving room for capital gains.
Commercial papers (CPs)
Commercial papers include unsecured promissory notes that are issued by reputed, large companies. Since they are not secured, they offer higher returns than T-Bills.
Certificate of deposits (CDs)
These are negotiable term deposits that are accepted by banks. Certificates of deposits (CDs) differ from fixed deposits (FDs) as the former are freely negotiable and are issued for huge amounts like INR 1 lakh and its multiples.
Commercial bills are another popular instrument of the Indian money market, and they work like bills of exchange. A bill of exchange is drawn on the buyer of certain goods by the seller of those goods.
When a bank accepts this bill of exchange, it is called a commercial bill. A seller, when in need of money, can get this bill discounted.
Call and Notice money
Sometimes, banks and other financial institutions may borrow for a very short period to manage their cash flows.
Call money is the short-term borrowing or lending of funds for a day whereas notice money refers to borrowing or lending for up to 14 days without any collateral.
Repurchase agreements (Repo)
Repurchase agreements are commonly referred to as repo or reverse repo. These are sale agreements wherein the party selling the security agrees to repurchase it from the buyer at a later date.
The purchase price also includes a rate of interest that is known as the repo rate.
Repos are effective tools to raise short-term funds for the seller and provide a decent rate of return on the investment to the buyer.
Banker’s Acceptance (BA)
Certain individuals and organisations use a financial instrument created in the name of the bank. These are called Banker’s Acceptance.
The party issuing the instrument must pay its holder a stipulated amount within a period of 30 days to 180 days. The investor’s profit is the difference between the issue price and the sale price.
Differences between the stock market and the money market
Here are some of the key differences between the stock market and the money market.
Although stocks can be traded in the short term, they can be used effectively to generate wealth only when you stay invested for the long term.
On the other hand, money market instruments have a maturity period of one year or less.
While stocks are typically used to fulfil long-term fund requirements, money market instruments are used to satisfy short-term needs.
The stock market consists of stocks of independently listed companies, whereas there are several types of money market instruments such as treasury bills, commercial bills, call money, and much more.
The stock market is usually a long-term investment; therefore, the risk factor is higher than money market instruments that are meant for the short term.
Benefits of money market instruments
Provide short-term liquidity
For both sellers and buyers, they provide the advantage of liquidity because they are short-term investments.
Since they are regulated by the Reserve Bank of India (RBI), they also maintain the level of liquidity in the economy.
Utilise idle or surplus funds better
Lenders can make good investments of their idle or surplus money. The borrower also benefits by receiving quick funds for the short term.
Meet working capital requirements
Money market instruments are useful in helping organisations meet the demand for their working capital.
Determine crucial monetary policy decisions
Since they largely make up the short-term market, they also influence the interest rate in the short run. This helps highlight the state of money and banking in the country, which eventually helps the RBI take a call on long-term interest rates and future monetary policy.
Pros and Cons of Money Market Instruments
When compared to other fixed-income securities, money market instruments are more liquid. There is no lock-in period, so investors can sell their shares at any time.
A money market instrument's return rate is marginally greater than a savings account's return rate.
The interest rate is greater than that of savings accounts. However, the rising inflation in the economy is unrelated to the interest rate. While other financial instruments, including mutual funds, offer a superior long-term return on investment.
Money market instruments are not an option if the objective of the investment is to achieve capital appreciation while outperforming inflation.
What are money market funds in India?
Such funds are short-term debt funds that invest in various money market instruments. They are suitable for short-term profits while maintaining high liquidity.
Here is a list of a few high-performing money market funds in India:
- HDFC Money Market Fund - Growth
- ICICI Prudential Money Market Fund - Growth
- Aditya Birla Sun Life Money Manager Fund - Growth
- SBI Savings Fund - Growth
- Nippon India Money Market Fund - Growth
Who should invest in money market mutual funds (MMMFs)?
Beginners to investing
Those new to the world of investing will find Money market mutual funds (MMMFs) to their liking, especially because they are short-term.
Individuals with surplus funds
Those with extra funds in their bank accounts can consider investing in MMMFs because they tend to offer higher interest rates than other financial institutions.
Individuals looking for liquidity and high short-term returns
Money market instruments offer some of the highest returns in no time while ensuring high liquidity as they have a short maturity period.
Things to know before investing in money market funds
Similar to other financial markets, money market funds are also subject to fluctuations. So, consider the following things before you invest.
- Money market funds are not ideal long-term investments.
- The market trend has an impact on the Net Asset Value (NAV) of a mutual fund. So, if the interest rate rises, then NAV may fall, thus reducing returns.
- Expense ratios apply to these funds and depend on the Asset Management Company concerned. The expense ratio and the yield are inversely proportional.
- As per the Income Tax Act, 1961, mutual funds are subject to tax gains. But capital gains in the short term are still taxable at 15%.
Frequently Asked Questions (FAQs)
Does somebody regulate the money market?
Yes, the RBI and the Securities and Exchange Board of India (SEBI) regulate the money market presently.
Is it true that money market instruments are completely risk-free?
No. However low, there is still a chance that banks or large organisations may fail or go bankrupt.
Are money market instruments the same as equity securities?
No, money market instruments are held by creditors whereas equity of any firm is held by partial owners.
What is credit quality?
The credit quality indicates the ability of the issuer of the instrument to pay the principal and the yield to holders.
Why is a money market required?
The money market is important to the economy because it enables several organisations to raise short-term funds and allows others to park their excess funds.
What is the maturity period of Treasury Bills?
The maturity period of Treasury bills in India are 14 days, 91 days, 182 days and 364 days from the date of issue. They are auctioned every week in lot size of Rs. 25,000 to Rs. 1 lakh each.
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