THE MONEY MARKETS
In times of turmoil, some money will exit the stock market.
Where would investors park their cash while
waiting to reenter the stock market?
The answer is the money market.
Interestingly, the term “money
market” is misleading.
Money conventionally means currency.
However, money is not traded in the
Instead, securities that do trade there are short-term and highly liquid; and they are close
to being money, hence their name.
We have to understand why the money markets are a preferred place
to invest temporary and otherwise idle cash.
Then, we need to know the characteristics of money market
Finally, we want to learn how to calculate the prices and yields of money market securities.
These skills are important in the balancing of liquidity and credit risk.
Economics Role of the Money Market
The economic role of the money market is to facilitate the trading of liquidity.
SSUs have excess funds
that they are looking to lend (invest) and DSUs have shortages they are looking to cover by borrowing (or
Typically, when speaking about lending or investing, the discussion concerns the placing
of funds for an extended period of time in a risky investment for the purchase of earning a decent return
on the investment.
However, in the money markets, issues are a little different.
In the money markets,
SSUs lend temporary excesses and DSUs borrow to cover temporary shortages.
While SSUs’ lending is
basically to prevent the funds from being idle, their primary concern is the ability to retrieve all of their
cash when they need it.
The ability to turn a financial asset into cash quickly without a price concession
is referred to as liquidity.
Therefore, the money markets are described as the markets for trading
Often enough, SSUs are called as lenders of liquidity and DSUs are labeled as borrowers of
The market markets are financial markets for liquidity.
Liquidity is what invests ask when they make
their funds available in the money markets.
To ensure the liquidity of these investments, money markets
have been developed around three features: (1) short-term debt instruments, (2) low default risk and high
First, money market investors only make short-term loans.
Using only short-term loans ensure that their
cash is scheduled to return in a short amount of time (by definition, one year or less).
market investors pick securities with an initial maturity that matches the period of time that they expect to
have excess funds.
Second, money market investors have a temporary excess.
This means that money market investors
expect to need their current excess within next year.
Because they expect to need their current excess to
meet their own future cash flows obligations, they will only invest these funds in securities with very low
In order words, since the investors expect to have to use their current excess funds in the
near future, they are unwilling to place these funds at risk.