8 Types of Money Markets and How Do They Work?

The money market is the place where the purchase and sale of large volumes of short-term debt products take place. The main transactions of the money market are wholesale transactions between financial institutions and companies.

It plays an important role in the global financial system by enabling economic units to manage their liquidity position. Money market funds facilitate security with the aim of never losing money and keeping net asset value.

There are various types of money market instruments like treasury bills, money market funds, money market accounts, commercial paper, certificate of deposit, banker’s acceptance, Eurodollars, repos etc.

1) Treasury Bills

Treasury bills are short-term instruments and they have different lengths of maturity. Treasury bills are purchased through auctions or secondary markets and are held until the maturity date.

The treasury bill will pay a higher interest rate to the investor when the maturity date is long. Treasury bills have a risk that existing bondholders may lose out on higher rates in the future. Factors like monetary policy, macroeconomic conditions, etc. may influence treasury bill prices.

2) Certificates of Deposit

Certificates of deposit are safe short-term interest-bearing deposits offered by banks. The certificate constitutes the bank’s agreement to repay the loan to an individual or company at a certain period of time. The maturity period is usually three to six months.

It has become an attractive option for those who want to earn more without taking the risk of market volatility.

There is a penalty for the early withdrawal of a certificate of deposits but if required some types of certificates of deposits are sold to another investor before the maturity date.

See also  What is the Weighted Average Cost of Capital (WACC)? Definition, Formula, and Example

3) Commercial Paper

Commercial papers are short-term promissory notes issued by financial and non-financial institutions.

Commercial papers have maturity periods up to 270 days and they are used for meeting short-term liabilities. Companies also sell commercial paper through dealers who charge a fee for the arrangement of funds from the lender to the borrower.

The commercial paper does not need to be registered with the Securities and Exchange Commission (SEC) if it matures before nine months. Commercial paper plays an important role during the financial crisis.

4) Banker’s Acceptances

Banker’s acceptance is a short-term instrument guaranteed by a non-financial institution but in the name of a bank.

It is a document that indicates that the bank will pay the face value of the instrument at a future date. The maturity of the acceptance can be one to six months.

5) Money Market Account

Money market accounts are interest-bearing savings account sometimes referred to as money market deposit accounts.

Banks perform calculations on money market account on daily basis. Money market accounts pay higher interest than other savings accounts. It also provides insurance protection and debit card facilities.

6) Repurchase Agreement

Repurchase agreement or Repo agreement is an instrument used by large financial institutions to finance ownership of different types of debt securities.

The maturity of this type of instrument is 24 hours to several months. In this agreement both parties agree to the future repurchase of an asset.

Dealers usually buy repo contracts for raising short-term finance and these agreements are the most liquid of all money market instruments.

See also  Is It Worth Investing in Breeze Airways Stock? Here What You Should Know

Mortgage-backed securities, corporate bonds, government bonds, and agency securities can be used in a repurchase agreement. The risk with repo transactions is that some default risk is inherent, and the securities will depreciate before the maturity date.

7) Eurodollars

Eurodollars are dollar-denominated deposits that are held in foreign banks. The eurodollar market is free of regulations.

The Eurodollar market is one of the world’s primary international capital markets consisting of sophisticated financial instruments that require a steady supply of depositors.

If the supply of deposits drops, Eurodollar banks may have problems with their liquidity. Most of the transactions in the Eurodollar market take place overnight and they mature on the next business day.

8) Swaps

A swap is a contract between two parties to exchange the cash flows or liabilities from two different financial instruments.

Swap is an instrument that allows the bank to act as a middleman for companies that want to protect themselves from interest rate changes.

Swaps help in exchanging the value of bonds and most swaps have adjustable interest rate payments.

With the help of swaps, instrument investors offset the risk of changes in future interest rate changes. If there is a potential default in a bond swaps can be used.

Interest rate swap is a most common type of swap. Retail investors do not get engaged in swaps and swaps are over-the-counter contact between business organizations or financial institutions.