The Money Market

The money market is the market for short term debt – that is, debt that matures in less than or equal to one year. The main instruments found in this market are commercial paper (CPs), negotiable certificates of deposit (NCDs), Treasury Bills (T-Bills), repurchase agreements (Repos), bankers acceptances (BAs), Euro-dollar loans, and central bank loans at the discount window. These securities are called money market instruments.

The money market functions are 1. Financing Trade: Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade. 2. Financing Industry: Money market contributes to the growth of industries in two ways: (a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc. (b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market. 3. Profitable Investment: Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity.

4. Self-Sufficiency of Commercial Bank: Developed money market helps the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market. 5. Help to Central Bank: Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank. Money market helps the central bank in two ways: (a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy, (b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy.

Treasury Bill $10, day maturity

The Discount Yield Method The following formula is used to determine the discount yield for T-bills that have three- or six-month maturities: Discount yield = [(FV - PP)/FV] * [360/M] FV = face value PP = purchase price M = maturity of bill. For a three-month T-bill (13 weeks) use 91, and for a six-month T-bill (26 weeks) use = the number of days used by banks to determine short-term interest rates (the investment yield method is based on a calendar year: 365 days, or 366 in leap years). Example What is the discount yield for a 182-day T-bill, auctioned at an average price of $9, per $10,000 face value? Discount yield = [(FV - PP)/FV] * [360/M] FV = $10,000 PP = $9, M = 182 Discount yield = [(10,000) - (9,659.30)] / (10,000) * [360/182] Discount yield = [340.7 / 10,000] * [ ] Discount yield = = 6.74%

The Investment Yield Method When comparing the return on investment in T-bills to other short-term investment options, the investment yield method can be used. This yield is alternatively called the bond equivalent yield, the coupon equivalent rate, the effective yield and the interest yield. The following formula is used to calculate the investment yield for T-bills that have three- or six-month maturities: Investment yield = [(FV - PP)/PP] * [365 or 366/M] Example What is the investment yield of a 182-day T-bill, auctioned at an average price of $9, per $10,000 face value? Investment yield = [(FV - PP)/PP] * [365/M] FV = $10,000 PP = $9, M = 182 Investment yield = [(10, ,659.30) / (9,659.30)] * [365/182] Investment yield = [340.70] / 9,659.30] * [ ] Investment yield = = 7.07%

Market expectations (pure expectations) hypothesis This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. Using this, future rates, along with the assumption that arbitrage opportunities will be minimal in future markets, and that future rates are unbiased estimates of forthcoming spot rates, is enough information to construct a complete expected yield curve. For example, if investors have an expectation of what 1-year interest rates will be next year, the 2-year interest rate can be calculated as the compounding of this year's interest rate by next year's interest rate. More generally, rates on a long-term instrument are equal to the geometric mean of the yield on a series of short-term instruments. This theory perfectly explains the observation that yields usually move together. However, it fails to explain the persistence in the shape of the yield curve. Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds (because forward rates are not perfect predictors of future rates). 1) Interest rate risk 2) Reinvestment rate risk

Liquidity premium theory The Liquidity Premium Theory is an offshoot of the Pure Expectations Theory. The Liquidity Premium Theory asserts that long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty. Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward. Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term. The market expectations hypothesis is combined with the liquidity premium theory: Where is the risk premium associated with an year bond.

Market segmentation theory This theory is also called the segmented market hypothesis. In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined largely independently. Prospective investors decide in advance whether they need short-term or long- term instruments. If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments. Therefore, the market for short-term instruments will receive a higher demand. Higher demand for the instrument implies higher prices and lower yield. This explains the stylized fact that short-term yields are usually lower than long-term yields. This theory explains the predominance of the normal yield curve shape. However, because the supply and demand of the two markets are independent, this theory fails to explain the observed fact that yields tend to move together (i.e., upward and downward shifts in the curve).

Preferred habitat theory The preferred habitat theory is another guide of the liquidity premium theory, and states that in addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity, or habitat. Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market, and therefore longer-term rates tend to be higher than short-term rates, for the most part, but short-term rates can be higher than long-term rates occasionally. This theory is consistent with both the persistence of the normal yield curve shape and the tendency of the yield curve to shift up and down while retaining its shape.

These theories do not look like they are very important or practical, but actually monetary policy, if it is to be effective, requires a clear understanding of how short term rates of interest relate to long term rates of interest. That is just the term structure.

See You in Class