Money market instruments: types, characteristics and operations

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:44

The money market is a very complex and widespread system. Understanding the essence helps familiarity with its tools. In turn, they are also very diverse, have their own characteristics. In the article, we will briefly analyze the money market instruments and their classification. Let's give each a brief description.

Definition

Money market instruments are certain investment objects that can bring current income. Feature - in the secondary market, it is easy to pay them off ahead of schedule.

There are two classifications of money market instruments in the financial world:

• On request. These are tradable securities, as well as deposits.
• By income. Two groups - income and coupon instruments.

Classification

All money market instruments fall into three broad categories:

• Trading papers.
• Deposits.
• Derivatives.

Each of the categories of these financial instruments has its ownseparation.

Deposits in the money market - its coupon instruments. The category includes the following:

• Certificates of Deposit.
• Repurchase agreements.

Trading papers are already discount instruments. Within this category, it is customary to highlight the following:

• Commercial papers.
• Treasury bills.
• Banker's acceptances (bills of exchange).

The most numerous group of financial instruments is derivatives. This includes the following:

• Agreements on future interest rate.
• Interest swap.
• Interest futures.
• Interest option. Inside it, an additional option is allocated for interest rate swaps, an option for future interest rate agreements, an option for interest rate futures.

But it is worth noting that if swaptions and interest rate swaps are circulating on the financial markets for more than one year, then they can already be attributed to debt obligations.

Reversible tools

Let's move on to the characteristics of money market instruments. The circulating group here can both be sold and bought in the secondary markets. In addition, it has the following distinguishing features:

• Fixed principal value (or face value).
• A specific maturity date at which the holder is guaranteed to receive the principal or face value.
• Fixed interest that can be paid both at maturity andthroughout the entire period. The very same interest rate will be fixed at the time of issue of the security.

Income from traded instruments is easy to calculate in advance, as the terms of the contract remain unchanged.

From here, circulating monetary instruments in the securities market can be bestowed with the following characteristics:

• Any instrument here has a known income. Regardless of the frequency of payments, future cash receipts are discounted.
• The higher the interest rate, the lower the market value, the current price of such an instrument.

Discount tools

What is the difference between transactions with money market instruments of this type? On them you will not receive a clear interest payment. Instead, these instruments are produced and sold at a discount. In other words, below its own face value. This discount in the financial market is considered a kind of alternative to paying interest. In fact, this is the difference between the price of the instrument when it was purchased and when it matures, already at face value.

Three types of discounts will circulate on money markets:

• Bill of exchange.
• Commercial paper.
• Treasury bill.

Their quotation is determined on the basis of a discount against the face value (the final price of the instrument at the time of its redemption). This tradition dates back to the time when the first bills of exchange appeared. The largest discount marketinstruments for today are US.

Derivatives

The second name for derivatives is derivatives. This is the name of futures contracts for the sale, purchase or exchange of derivatives on a set date and at a pre-agreed price.

In the money markets today, a variety of instruments related to interest rates are common. What applies to them? Interest rate swaps and options, futures, future interest rate agreements. We will look at some of them in detail below.

Interest-bearing instruments

Now the next category. Interest (or coupon) - one of the main instruments of the money market. According to them, the creditor (holder) receives certain interest payments during the entire life of the instruments.

What is in this category? There are three types of tools:

• Non-applicable. These are money market deposits.
• Converters. Certificates of deposit are implied.
• A separate type of tradable instruments stands out as repurchase agreements.

And now let's take a closer look at each of the main instruments and participants in the money market.

Deposits

Deposits, in turn, are divided into two categories:

• Urgent. Having a fixed interest rate and duration.
• On demand. Accordingly, the deposit is repaid only on demand. Here the interest rate may change.

For depositoryinstruments, the rates of the English (London) market are more important:

• LIBOR - this is how the offer rate is called on the depository interbank market in London. According to it, the bank can both offer money and charge them for a loan.
• LIBID - on the depositary interbank market of the capital of Great Britain, this is the name of the buyer's rate. According to it, the bank "buys" money or gives it as a loan.

Certificates

The money market instruments also include certificates of deposit. This is the name of tradable securities, indicating the presence in a bank (or other financial institution) of a deposit with a clear retention period and a fixed interest rate. It can also be a paper confirming the debt of the borrower, with a fixed coupon.

Most of the certificates of deposit issued by banks are transferable securities to bearer. In other words, they will belong to the one in whose hands they are.

How does a regular deposit differ from similar certificates? There are two signs:

• Deposit is a non-tradable document with a fixed term.
• Certificate of Deposit is already a circulating document with a fixed term. In other words, it can be both sold and bought.

REPO transactions

REPO transactions are so-called repurchase agreements. This is the name of a loan secured by government securities. It is mandatory to stipulate the sale of securities and their termsrepurchase already at a higher price. The difference in cost will be the payment for the loan received.

Treasury bills

Let's now consider the circulation of bills as an instrument of the money market.

A Treasury bill is a negotiable short-term bill of exchange issued by the government to finance certain government programs.

For example, the Federal Reserve Program, acting on behalf of the Government of the United States, typically sells 13 and 36 week Treasury bills every Monday (delivery on Thursday). At the same time, treasury bills valid for 52 weeks are delivered to the auction once a month.

A similar system is successfully operating in the UK. There bills are delivered to the auction for a period of 91 and 182 days. According to statistics, their main holders are accounting houses. Intermediaries between the commercial banks of the state and the Bank of England.

Bills of exchange

The second common name is bank acceptance. There is also the name "trade bill". The instruments are widely used for additional financing of international trade.

Commercial bill of exchange - an order to pay a specified amount of money to its holder in a strictly defined period or on demand. Hence, there are two types of commercial acceptances - a time draft with a fixed period of payment and a demand instrument. One of the simplest short-term debt documents thatissued for commercial transactions.

What then will be a banker's acceptance, a banker's draft? This is a bill of exchange, which is both issued by a commercial bank and accepted by it. Becomes negotiable after acceptance.

Commercial Paper

Commercial paper is called unsecured simple short-term bills with a certain period and for a certain amount. These are bearer financial transferable assets.

Usually issued for up to 270 days by various major organizations. This is a kind of counterbalance to bills of exchange and loans from banks.

It is worth noting that commercial paper does not have its own collateral. That is, when making a responsible decision to purchase such an instrument, an investor can only focus on the reputation of the issuer. This is also the reason why commercial paper is issued only by large companies with high ratings.

Future Interest Rate Agreements

They are themselves sought after derivatives in the OTC derivatives markets. This is the name of the contract concluded between the two parties, which fixes the rate on the value of the future loan or deposit. For the latter, the following must be mandatory:

• Currency and amount.
• Maturity.
• Time for loan or deposit.

Accordingly, the parties first agree on the interest rate of the future transaction. Then compensate for the existing difference betweenthe real and agreed rate at the beginning of the agreed period. The principal amount of the agreement will not be provided as there is no actual lending or borrowing.

The interest rate agreement is defined by just two digits. For example:

• 1 x 4. Starts in a month. Has a deadline of 3 months (4 - 1=3).
• 3 x 6. Starts in three months. Has a deadline of 3 months (6 - 3=3).

Interest futures

Interest futures are based on instruments whose value depends on interest rates. For example, 3-month deposits.

Interest rate futures - forward transactions with standard terms and contract sizes. The underlying asset for short-term types is Eurocurrency deposits. Calculated either at the price of the last transaction, or at the settlement price.

As for long-term interest rate futures, they are calculated at the cost of government bonds, coupon securities with terms set by the exchange.

Interest swap

An interest rate swap is an over-the-counter transaction in which two parties exchange interest on loan obligations of equal size but different interest rates.

Usually, interest rate swaps are long-term instruments, whose purpose is somewhat similar to the purpose of an agreement on a future interest rate. But at the same time, their (swap) validity period is 2-10 years for major world currencies. So the interest rate swapwill be equivalent to several future interest rate agreements at once.

Swap is an agreement between two parties to make a series of payments to each other in certain periods up to the expiration of their contract. The amount of these percentage payments to each of the parties can be calculated based on various formulas (based on the principal notional amount of such an agreement).

As you have already seen, the tools for regulating the money market today are quite diverse. They are combined by various classifications by types, categories, groups. At the same time, each of the instruments can have both its own distinguishing features, and some moments that make it look like another.