The money market is a financial market that allows you to buy and sell a wide range of debt securities with short maturities. Some instruments routinely traded in the market include certificates of deposit, commercial paper, Treasury Bills (T-bills), and repurchase agreements.
How does the money market work
Now that you know the definition of the money market, let us look at how it works with a couple of examples.
The primary objective of the money market is to give investors access to low-risk, short-term debt securities with maturities ranging from one day to one year. Similar to the equity market, the money market can also be classified into two types: primary and secondary.
Primary market
In the primary market, issuing entities interact directly with investors. This forms the central core of the primary money market’s functionality. Issuing entities, which are usually governments and corporate institutions, use money market instruments to raise funds to meet their short-term financial needs. Investors, who are often a mix of retail and institutional participants, provide funds to the issuing entities by purchasing the newly issued money market instruments.
For example, assume a company, ABC Limited, is involved in manufacturing electronic goods. The company decides to issue commercial paper (CP) to raise funds to meet its short-term financial needs. Each commercial paper, issued at Rs. 4,90,000, shall be redeemed at its face value of Rs. 5,00,000 after six months from the date of issue.
As an investor looking to park some idle funds, you decide to purchase two units of the company’s CP at Rs. 9,80,000. At the end of six months, the company shall redeem your investment by repaying Rs. 10,00,000, giving you a total return of Rs. 20,000.
Secondary market
In the secondary market, investors purchase and sell existing money market securities among themselves without the involvement of the issuing entity. It allows existing investors to liquidate their money market instruments before the end of the investment tenure.
For instance, assume you wish to invest in an existing money market security, such as the 182-day Treasury Bill issued by the Reserve Bank of India (RBI). Through the secondary market, you can purchase the instrument from another investor who already holds the security. However, remember that you must first open a trading and Demat account with a stockbroker to access the secondary money market.
Once you purchase the T-bill from another investor, it will be credited directly to your Demat account. At this point, you can either proceed to hold the T-bill until maturity or sell it to another investor through the secondary market.
Who uses the money market
A wide range of market participants routinely use the money market. Knowing the various entities often using the market can help you understand its dynamics better. Here is an overview of some of the most common participants in this segment.
- Governments
The money market is a good avenue for governments to quickly raise capital to meet their short-term financial obligations. In India, the Reserve Bank of India (RBI) regularly issues short-term instruments like T-bills with different maturities to raise funds on behalf of the government. Since money market instruments issued by governments and central banks have sovereign guarantees, they carry little to no risk of default. - Companies
Companies that need funds to meet their working capital requirements or other short-term debt obligations also use the money market. They issue commercial papers (CPs), which are essentially unsecured financial instruments that are offered at a discount and redeemed at face value. - Financial institutions
Financial institutions like banks have stringent liquidity requirements that they need to meet at all times. In case of any shortfalls in their reserves, the institutions may turn to the money market to raise funds to cover such gaps. For this purpose, financial institutions often issue certificates of deposit (CDs), which are fixed-income securities with tenures ranging from seven days to one year. - Retail investors
Of late, retail investors have also started to participate in the money market frequently to invest in various short-term debt securities. The secondary money market, in particular, has been very useful since it helps retail investors gain exposure to the debt market easily. - Asset management companies
Asset management companies (AMCs) are entities that manage mutual funds and other investment vehicles. These entities pool money from multiple investors and invest in various money market securities.
Features of money market instruments
Money market instruments have certain key features that set them apart from other investment options. Here are four such defining characteristics.
- Short maturity periods
Money market instruments have very short maturities, ranging from one day to one year. This makes them ideal for investors seeking short-term investment opportunities with moderate return generation potential. - Security
Money market instruments issued by governments are highly secure and have little to no risk of default. Additionally, instruments with high credit ratings issued by large financial institutions and fundamentally strong companies also tend to have a low risk of default. - High liquidity
Since the demand for money market instruments is very high, you can quickly liquidate them by selling them on the secondary market. - Fixed returns
Most money market instruments are issued at a discount and redeemed at face value. Since the returns are fixed and known beforehand, you can make better financial decisions by choosing securities that align with your financial requirements.
Conclusion
The money market is a major financial market that enables the free exchange of short-term debt instruments. As an investor, it is not enough to just know the meaning of the money market. If you wish to make informed investment decisions, you must also understand the dynamics and factors that influence this market segment before you begin trading.
