Money Market Instruments

Money market instruments are short-term debt securities with maturities of one year or less. They are characterized by high liquidity, low risk, and are used by corporations, governments, and financial institutions to manage short-term cash needs.

Characteristics of Money Market Securities

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Types of Money Market Instruments

Commercial Paper

Commercial paper is an unsecured promissory note issued by corporations to raise short-term funds.

Key Characteristics:

• Maturity: 270 days or less (exempt from SEC registration)
• Sold at a discount to face value
• Unsecured (backed only by issuer's creditworthiness)
• Minimum denomination: Usually $100,000
• Issued by large, creditworthy corporations
• Rated by credit agencies (must be high-quality to be marketable)

Why 270 Days? Commercial paper with maturity of 270 days or less is exempt from SEC registration under the Securities Act of 1933. This makes issuance faster and cheaper.

Exam Tip: If you see "270 days" and "unsecured corporate debt," think commercial paper.

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Bankers' Acceptances (BAs)

Bankers' acceptances are time drafts used primarily to finance international trade.

Key Characteristics:

• Maturity: Typically 30 to 180 days
• Used for importing and exporting goods
• "Accepted" (guaranteed) by a bank
• Sold at a discount to face value
• Very safe because backed by bank's credit

How BAs Work:

1. Importer needs to pay for goods from overseas
2. Importer's bank issues a time draft (promise to pay at future date)
3. Bank "accepts" the draft, guaranteeing payment
4. The BA can be sold in the secondary market

Exam Tip: If you see "importing," "exporting," or "international trade," the answer is probably bankers' acceptance.

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Repurchase Agreements (Repos)

Repos are short-term collateralized loans, typically using Treasury securities as collateral.

Key Characteristics:

• Maturity: Overnight to several months (most are very short-term)
• Most liquid of all money market instruments
• Used by dealers to finance inventory
• Used by the Federal Reserve for monetary policy
• Collateralized by government securities

How Repos Work:

1. Dealer sells Treasury securities to investor
2. Dealer agrees to repurchase them at a higher price on a specified date
3. The price difference is the interest (repo rate)
4. If dealer defaults, investor keeps the collateral

Reverse Repo: Same transaction from the investor's perspective (investor buys securities with agreement to sell back).

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Negotiable Certificates of Deposit (CDs)

Negotiable CDs are large-denomination time deposits issued by banks that can be traded in the secondary market.

Key Characteristics:

• Minimum denomination: $100,000 (typically $1 million+)
• Fixed maturity and interest rate
• Can be sold before maturity in secondary market
• FDIC insurance up to $250,000 per depositor
• Interest rate higher than regular savings

Difference from Regular CDs: Regular CDs have early withdrawal penalties. Negotiable CDs can be sold in the secondary market without penalty (though you may get more or less than face value).

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Federal Funds

Federal funds are overnight loans between banks to meet reserve requirements.

Key Characteristics:

• Maturity: Usually overnight
• Unsecured loans between banks
• Interest rate = Fed Funds Rate
• Used to meet reserve requirements
• Key benchmark rate for other short-term rates

The Fed Funds Rate:

• Target set by the Federal Open Market Committee (FOMC)
• Influences all other short-term interest rates
• When Fed wants to stimulate economy: lowers target rate
• When Fed wants to slow economy: raises target rate

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Money Market Comparison

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Money Market Risk Levels

While all money market instruments are considered low-risk, there is a hierarchy:

Lowest Risk:

1. Treasury Bills — Full faith and credit of U.S. government
2. Repos — Collateralized by government securities

Low Risk: 3. Bankers' Acceptances — Bank guarantee 4. Negotiable CDs — FDIC insurance (up to limits)

Slightly Higher Risk: 5. Commercial Paper — Unsecured, depends on issuer credit 6. Fed Funds — Unsecured interbank loans

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Tax Treatment

Exam Tip: Only T-Bills among money market instruments are exempt from state and local taxes.