Money Market: Meaning, Features, Types & Function | Finschool By 5paisa (2024)

The money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. It enables governments, banks, and other large institutions to sell short-term securities to fund their short-term cash flow needs. Money markets also allow individual investors to invest small amounts of money in a low-risk setting. Some of the instruments traded in the money market include Treasury bills, certificates of deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-backed securities and asset-backed securities.

Large corporations with short-term cash flow needs can borrow from the market directly through their dealer, while small companies with excess cash can borrow through money market mutual funds.

Money Market

The money market is a crucial financial market segment where short-term borrowing and lending of funds occur. It facilitates the smooth functioning of the economy by providing a platform for participants to meet their immediate cash needs and manage liquidity. The participants in the money market include governments, corporations, financial institutions, and individual investors. Transactions in the money market typically involve highly liquid and low-risk instruments with maturities of one year or less.

How does the money market work?

The money market operates through the interaction of various participants, including governments, corporations, financial institutions, and individual investors. These participants engage in short-term borrowing and lending to meet their immediate cash needs and manage liquidity. Here’s a breakdown of how the money market works:

• Borrowers: Entities needing short-term funds, such as governments or corporations, approach the money market to meet their immediate financial obligations. They issue money market instruments to raise funds quickly. These instruments act as a form of borrowing from investors.
• Money Market Instruments: Borrowers issue various instruments with varying maturities, interest rates, and credit ratings. These instruments include Treasury bills, commercial paper, certificates of deposit, and repurchase agreements. These instruments are highly liquid and considered low risk.
• Investors: Investors with surplus funds seeking short-term investment opportunities turn to the money market. They purchase money market instruments issued by borrowers. In return, investors receive interest payments or discounts on the tools, which serve as their returns on investment.
• Trading and Secondary Market: Money market instruments can be traded on the secondary market, allowing investors to buy and sell them before maturity. This secondary market enhances liquidity, as investors can access their funds before the instrument matures.
• Money Market Funds: Money market funds pool investments from institutional and individual investors and invest in a diversified portfolio of money market instruments. These funds allow investors to indirectly participate in the money market while benefiting from professional management.
• Regulatory Oversight: The money market operates within a regulated environment. Regulatory bodies monitor and enforce rules and regulations to ensure transparency, stability, and fair practices. This oversight helps maintain the integrity and reliability of the money market.

Who uses the money market?

Various participants utilize the money market, including governments, corporations, financial institutions, and individual investors. Let us look at each of these groups and their involvement in the money market:

• Governments: Governments often play a significant role in the money market. They issue money market instruments, such as Treasury bills, to finance their short-term funding requirements. These instruments are considered highly secure, backed by the government’s creditworthiness.
• Corporations: Large and tiny corporations utilize the money market to meet short-term funding needs. They issue commercial paper, which represents unsecured promissory notes, to raise funds for operational expenses, inventory management, or capital investments.
• Financial Institutions: Banks and other financial institutions actively participate in the money market. They use money market instruments to manage their liquidity and meet regulatory requirements. Financial institutions also invest in money market instruments as a source of income to ensure the stability of their cash positions.
• Individual Investors: Individual investors, including retail investors, also engage with the money market. They can invest in money market instruments such as Treasury bills, certificates of deposit, or money market funds offered by banks or investment firms. These investments provide individuals with a safe and short-term avenue to park their surplus funds or earn modest returns.
• Money Market Funds: These are investments that pool funds from individual and institutional investors. Professional investment managers oversee managing these funds, and they distribute the pooled funds among various money market instruments. Money market funds provide investors with a convenient way to access the money market and benefit from diversification.
• Central Banks: They play a crucial role in the money market by conducting monetary policy operations. They use tools such as open market operations to buy or sell money market instruments to manage the money supply, influence interest rates, and stabilize financial markets.

Features of Money Market Instruments

1. High Liquidity- One of the key features of these financial assets is high liquidity offered by them. They generate fixed-income for the investor and short term maturity makes them highly liquid. Owing to this characteristic money market instruments are considered as close substitutes of money.

2. Secure Investment- These financial instruments are one of the most secure investment avenues available in the market. Since issuers of money market instruments have a high credit rating and the returns are fixed beforehand, the risk of losing your invested capital is minuscule.

3. Fixed returns- Since money market instruments are offered at a discount to the face value, the amount that the investor gets on maturity is decided in advance. This effectively helps individuals in choosing the instrument which would suit their needs and investment horizon.

Types of Instruments Traded in the Money Market

1. Treasury bills- are short term borrowing instruments issued by the Government of India. These are the oldest money market instruments that are still in use. The Treasury bill does not pay any interest, but are available at a discount of face value at the time of issue. Treasury Bills can be classified in two ways i.e. based on maturity and bases on type. These are the safest instruments as they are backed by a government guarantee. The rate of return, also known as risk-free rate, is low for treasury bills like T-364, T-182 and so on, as compared to all other instruments.

2. Commercial papers- commercial papers is an unsecured money market instruments issued in the form of promissory note. It was introduced In India in 1990 with the objectives of enabling corporate borrowers diversify their sources of short-term borrowing and to provide an additional investment instrument to investors. Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet short-term debt obligations and is backed only by an issuing bank or company’s promise to pay the face value on the maturity date specified on the note.

3. Certificate of Deposit- A certificate of deposit (CD) is issued directly by a commercial bank, but it can be purchased through brokerage firms. It comes with a maturity date ranging from three months to five years and can be issued in any denomination. Most CDs offer a fixed maturity date and interest rate, and they attract a penalty for withdrawing prior to the time of maturity. Just like a bank’s checking account, a certificate of deposit is insured by the Federal Deposit Insurance Corporation (FDIC).

4. Banker’s acceptance- a banker’s acceptance is a document that promises future payment that is guaranteed by the commercial bank. It is considered to be a very safe investment option and is widely used in foreign trade, bankers acceptance are time drafts which are accepted and guaranteed by the banks and drawn on a deposit at the bank. The maturity period of banker’s acceptance can range from 30 to 180 days.

5. Repurchase Agreements- Also known as repos or buybacks, Repurchase Agreements are a formal agreement between two parties, where one party sells a security to another, with the promise of buying it back at a later date from the buyer. It is also called a Sell-Buy transaction. The seller buys the security at a predetermined time and amount which also includes the interest rate at which the buyer agreed to buy the security.

Function of money market

1. Provides funds– the money market provides short term funds for borrowing at a lower rate of interest. The private and the public institutions can borrow money from the money market to finance capital requirements and fund business growth through the system of finance bills and commercial paper. The govt. can also borrow funds the money market by issuing treasury bills. However, money market issues money market instruments like commercial papers, treasury bills and so on and helps in development of trade, industry and commerce within and outside India.

2. Central Bank Policies- The central bank is responsible for guiding the monetary policy of a country and taking measures to ensure a healthy financial system. Through the money market, the central bank can perform its policy-making function efficiently.

For example, the short-term interest rates in the money market represent the prevailing conditions in the banking industry and can guide the central bank in developing an appropriate interest rate policy. Also, the integrated money markets help the central bank to influence the sub-markets and implement its monetary policy objectives.

3. Helps government- the money market instruments helps the government raise money for financing government projects for public welfare and infrastructure development. The govt. can borrow short term funds by issuing treasury bills at low interest rates. On the other hand, if the government were ton issue paper money or borrow short term funds by issuing treasury bills at low interest rates. On the other hand, if the govt. were to issue paper money or borrow from the central bank, it would lead to inflation in the economy.

4. Helps in Financial Mobility- the money market helps in financial mobility by enabling easy transfer of funds from one sector to the other. Financial mobility is essential for the development of industry and commerce in the economy.

5. Promote Liquidity and Safety- this is one of the most important functions of money market, as it provides safety and liquidity of funds. It also encourages saving and investments. These investments instruments have shorter maturity which means they can readily be converted to cash. The money market instruments are issues by entities with good credit score which a=makes them safe investment option.

6. Economy in use of cash- as the money market deals in near-money assets and not proper money; it helps in economizing the use of cash. It provides a convenient and safe way of transferring funds from one place to another, there by immensely helps commerce and industry in India.

Money Markets vs. Capital Markets: Understanding the Differences

In finance, two key market segments play distinct roles in facilitating the flow of funds and supporting economic activities: the money market and the capital market. While both markets serve essential functions, they differ regarding the types of securities traded, their investment horizons, and the nature of participants. Let’s delve into the dissimilarities between money markets and capital markets:

Key Differences:

• Securities: Money markets primarily deal with short-term debt instruments, while capital markets involve long-term securities, including stocks and bonds.
• Maturity: Money market securities have short maturities of one year or less, whereas capital market securities have longer maturities exceeding one year.
• Risk and Return: Money market instruments are generally lower risk and offer modest returns, while capital market securities carry varying levels of risk and potential for higher returns.
• Investment Horizon: Money market investments have a short-term focus, typically from overnight to one year, whereas capital market investments have a longer-term horizon, spanning several years or more.
• Participants: Money markets attract many participants, including governments, financial institutions, corporations, individual investors, and mutual funds. Capital markets involve a mix.

Advantages and Disadvantages of Money Markets

Advantages:

• Liquidity:Money market instruments are highly liquid, meaning they can be easily bought or sold with minimal impact on market value. This allows investors to access their funds quickly, providing flexibility and ease of cash management.
• Safety:Money market instruments are generally considered low risk. They frequently come from respectable institutions like governments and reputable businesses, which lowers the risk of default. This makes money market investments a relatively safe option for preserving capital.
• Stable Returns:Money market instruments offer stable and predictable returns. They typically provide interest payments or discounts at maturity, allowing investors to earn a modest return on their investments. This makes money market investments suitable for those seeking stability and capital preservation.
• Diversification:Money market instruments provide an opportunity for portfolio diversification. Investing in various money market instruments with varying maturities and issuers can spread their risk and reduce exposure to any single entity or maturity date.
• Short-Term Financing:For borrowers, money markets offer a convenient and efficient source of short-term financing. Governments, corporations, and financial institutions can issue money market instruments to raise funds quickly and meet their immediate cash flow needs. This enables them to bridge temporary funding gaps and manage liquidity effectively.

Disadvantages:

• Lower Returns:While money market investments offer stability, they generally provide lower returns than other investment options, such as stocks or long-term bonds. The conservative nature of money market instruments translates to a lower potential for significant capital appreciation or high yields.
• Inflation Risk:Money market investments may be susceptible to inflation risk. If the interest rates on money market instruments fail to keep pace with inflation, the real value of the investment can erode over time. This can impact the purchasing power of the investor’s funds.
• Limited Growth Potential:Money market investments may not provide significant opportunities for capital growth. These instruments primarily focus on capital preservation and short-term liquidity management, making them less suitable for investors seeking substantial growth or long-term wealth accumulation.
• Regulatory Changes:Money market investments can be subject to regulatory changes, which may impact their performance and liquidity. Changes in regulations governing money market funds or the issuers of money market instruments can introduce uncertainties and affect the attractiveness of these investments.
• Market Conditions:Current market conditions, such as interest rate fluctuations and market volatility, can have an impact on money market investments. Changes in interest rates can affect the yields on money market instruments, potentially impacting returns for investors.
• Limited Investment Options:Money markets provide a narrower range of investment options than broader financial markets. Investors looking for more diverse investment opportunities or higher potential returns may need to explore other financial market segments.

Pros and Cons of Money Market Accounts:

Pros:

• Higher interest rates compared to traditional savings accounts.
• High liquidity with easy access to funds through check-writing privileges and transfers.
• FDIC insurance protection on accounts offered by banks.
• Stability and security due to low-risk investments.

Cons:

• Higher minimum balance requirements.
• Limited transactions or withdrawals per month.
• Lower returns compared to long-term investments.
• Susceptibility to inflation risk.

Considering these factors and evaluating your financial goals and needs is important before opening a money market account.

Factors to Consider Before Investing in Money Market Funds in India:

Investing in money market funds in India requires careful consideration of various factors. Some important factors to consider before investing in money market funds are:

• Investment Objective: Clarify your investment objective, whether capital preservation, regular income, or a combination of both. Money market funds focus on providing stability and liquidity, making them suitable for short-term investment goals.
• Risk Tolerance: Evaluate your risk tolerance. While money market funds are generally considered low risk, a small risk is still associated with investing in debt securities. Understand the potential risks and ensure they align with your risk tolerance level.
• Fund Performance and Track Record: Research the performance and track record of the money market fund you intend to invest in. Review historical returns, expense ratios, and the fund manager’s expertise. Consider funds with consistent performance and a good track record.
• Expense Ratio and Fees: Compare the expense ratios and fees associated with different money market funds. Lower expense ratios can help maximize your returns, while excessive fees can affect your overall gains. Pay attention to management fees, transaction fees, and other applicable charges.
• Regulatory Framework: Understand the regulatory framework governing money market funds in India. Be aware of the rules and restrictions imposed by regulatory authorities to ensure compliance and protect your investments.
• Tax Implications: Consider the tax implications of investing in money market funds. Understand the tax treatment of interest income and any potential capital gains taxes. Consult with a tax professional to understand the tax implications specific to your situation.
• Fund Provider and Reputation: Evaluate the reputation and credibility of the fund provider. Look for established fund houses with a strong track record of managing money market funds. Research their financial stability.

Taxation of Money Market Investments

Taxation of money market investments involves taxing interest income generated from these investments. Interest income is considered taxable and is typically categorized as ordinary income. The tax rate applied to this income depends on the investor’s overall taxable income and the prevailing tax laws. Financial institutions provide a Form 1099-INT to report the total interest income earned. Some money market funds may be designated as tax-exempt, providing tax advantages. Capital gains taxes generally do not apply to money market investments due to their stable net asset value. State and local taxes may also apply. Consultation with a tax professional is recommended to understand specific tax obligations.

List of AMC in India

Conclusion

The money market is a fascinating and integral part of the financial landscape. Understanding its key features, instruments, and investment strategies is essential for anyone looking to maximize their returns while minimizing risk. By diversifying your investments, conducting thorough risk assessments, and staying informed about market conditions, you can navigate the money market with confidence.