The Money Market

What is it?

The money market is the system for short-term borrowing and lending, with loan periods, or maturities, lasting up to one year. It's distinct from the capital market, which handles longer-term financing through stocks and bonds. Think of the money market as the plumbing of the financial system, allowing major institutions to manage their daily cash needs.

To keep the system stable, only high-quality entities like governments and large, stable corporations are allowed to borrow, which minimises default risk (the risk that a borrower won't be able to pay back their loan).

Key Characteristics

Most money market instruments share a few common traits:

• They are issued in high denominations.

• They have very low default risk.

• They offer relatively low interest rates.

• They have short maturities (less than one year).

Types of Money Market Instruments

The market uses several different products, or instruments, for these short-term loans.

• Treasury Bills (T-bills): These are short-term loans made to the government. They are discount instruments, meaning you buy them for less than their face value and receive the full face value at maturity. The difference is your return.

• Federal Funds: This is a US-only market where financial institutions lend money to each other, usually for just one day (overnight). This helps banks manage their daily reserve requirements.

• Commercial Paper: This is an unsecured short-term note issued by large companies. "Unsecured" means the loan is not backed by any collateral; it's backed only by the company's reputation and creditworthiness.

• Negotiable Certificates of Deposit (CDs): A CD is a savings certificate with a fixed maturity date and interest rate. "Negotiable" means it can be sold to someone else in the secondary market before it matures.

• Banker's Acceptances: These are essentially post-dated checks that have been guaranteed by a bank. They are often used in international trade to ensure payment.

• Repurchase Agreements (Repos): A repo is a formal agreement to sell securities and then buy them back later at a slightly higher price. It's functionally a short-term loan secured by collateral (the securities). Central banks, like the Bank of England, use repos to supply funding and control interest rates.

Liquidity & Yields in Money Markets

Liquidity refers to how quickly an asset can be sold for cash without losing its value. This is a crucial concept in money markets.

• Secondary Market: This is where investors can sell securities they've already bought before the maturity date.

• Liquidity Premium: If an asset is hard to sell quickly (it has low liquidity), it must offer a higher yield to attract investors. This extra return is called a liquidity premium, and it compensates the lender for the risk of not being able to get their money back on short notice.

• Instrument Liquidity:

  • T-bills are very liquid and are actively traded.

  • Commercial Paper, CDs, and Banker's Acceptances are much less liquid. Buyers often just hold them until they mature.

  • Repos are so short-term that no secondary market has developed for them.

Eurodollar Markets

The Eurodollar market has nothing to do with the Euro currency. It refers to U.S. dollar-denominated deposits and instruments held and traded outside the United States.

• Origin: This market emerged in the 1960s as an act of regulatory arbitrage. This is when companies use loopholes or differences between regulatory systems to their advantage. U.S. regulations limited how much multinationals could borrow in the U.S., so they simply started borrowing dollars abroad.

• LIBOR: The London Interbank Offered Rate (LIBOR) is the rate paid on these Eurodollar deposits. The key takeaway is that the currency of the debt matters, not the location where it's issued.

Annuities & Perpetuities 

These are financial tools used to value a series of fixed payments over time. An annuity provides equal payments for a set number of years, while a perpetuity provides payments that continue forever.

How to Value Them

We value them using their Present Value (PV), which tells you what a stream of future cash is worth in today's money. This is done using a discount rate (r).

• Annuity Valuation:

  • The PV formula is: PV=rc​(1−(1+r)n1​).

  • An interesting way to think about an annuity is as the difference between two perpetuities: the value of a perpetuity starting now minus the value of a perpetuity that is delayed until the annuity ends. The formula is: PV=rc​−rc​×(1+r)n1​.

• Perpetuity Valuation:

  • The formula is much simpler: PV=rc​.

Internal Rate of Return (IRR) 

The Internal Rate of Return (IRR) is the specific discount rate that makes the Net Present Value (NPV) of an investment's cash flows equal to zero. In simple terms, it's the project's expected annual rate of return. For bonds, this is called the yield to maturity.

How It's Used

IRR is a rule used to choose between investment projects, a higher IRR is preferable. To find it, you must solve the NPV equation for the rate (r) where NPV equals zero. This generally cannot be done by hand and requires financial software.

• Potential Problems:

  • For projects with complex cash flows (e.g., costs at the beginning and end), you might find more than one IRR, or no IRR at all.

  • The IRR rule can sometimes give misleading advice when comparing mutually exclusive projects.

  • These issues are rarely a problem for simple financial assets, which usually have a single outflow followed by positive inflows.

Leasing

A lease is a contract where an owner (lessor) lets someone else (lessee) use an asset in return for regular payments.

Types of Leases

• Operating Leases: These are short-term, cancellable leases motivated by operational efficiency. The lessor handles maintenance and faces the risk of the asset being unused. Think of renting a car for a weekend.

• Financial Leases (or Capital Leases): These are long-term contracts that are economically similar to borrowing money to buy the asset. They are often motivated by tax considerations, especially in cross-border deals where the lessor and lessee are in different tax situations.

Strategic & Accounting Motives

Leasing can be used to get around internal spending controls or as a form of off-balance-sheet financing. Since a financial lease is a firm commitment to make payments, it is economically identical to a loan.

• Capitalisation: To prevent companies from hiding their true debt levels, U.S. accounting standards require financial leases to be capitalis, meaning the asset and the liability must be included on the balance sheet.

• Creative Accounting: Some companies structure long-term leases to just barely qualify as operating leases so they can keep them off the books. Investors are likely to see this as an attempt to understate the company's true financial leverage (its level of debt).