18-08-2012, 05:00 PM
Money Market Tutorial
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Introduction
Whenever a bear market comes along, investors realize (yet again!) that the stock
market is a risky place for their savings, a fact we tend to forget while enjoying the
returns of a bull market! This, unfortunately, is part of the risk/return tradeoff. That
is, to get higher returns, you have to take on a higher level of risk. But for many
investors, a volatile market is too much to stomach - an alternative is the money
market.
The money market is better known as a place for large institutions and government
to manage their short-term cash needs. However, individual investors have access to
the market through a variety of different securities. It is these money market
instruments that we will learn about in this tutorial.
What is the Money Market?
The money market is a subsection of the fixed income market. Many people think of
the term "fixed income" as synonymous with bonds, but technically, a bond is just
one type of fixed income security. The difference between the money market and the
bond market is that the money market specializes in very short term debt securities
(debt that matures in less than one year). Money market investments are also called
cash investments because of their short maturities.
Money market securities are essentially IOUs issued by governments, financial
institutions, and large corporations.
Treasury Bills
Treasury Bills (T-bills) are the most marketable money market security. Their
popularity is ma inly due to their simplicity. T-bills are basically a way for the U.S.
government uses to raise money from the public. In this tutorial we are referring to
T-bills issued by the U.S. government, but many other governments issue T-bills in a
similar fashion.
T-bills are short-term securities that mature in one year or less from their issue date.
T-bills are issued with 3 month, 6 month, and 1 year maturities. You buy T-bills for a
price less than their par (face) value, and when they mature, the government pays
you their par value. This is different than coupon bonds, which pay interest semiannually.
Effectively, your interest is the difference between the purchase price of
the security and what you get at maturity. If a bought a 90 day T-bill at $9,800 and
held it until maturity, your interest would be $200.
Treasury bills (as well as notes and bonds) are issued through a competitive bidding
process at auctions. If you want to buy a T-bill, you submit a bid that is done either
noncompetitively or competitively. Noncompetitive bidding means you'll receive the
full amount of the security you want at the return determined at the auction.
Competitive bidding means you have to specify the return that you would like to
receive. If the return you specify is too high, you might not receive any securities, or
just a portion of what you bid for.
Eurodollars
Contrary to the name, Eurodollars have very little to do with the Euro or European
countries. Eurodollars are U.S. dollar-denominated deposit at banks outside of the
United States. This market evolved in Europe (specifically London), and thus the
name, but Eurodollars can be held anywhere outside the United States.
The Eurodollar market is relatively free of regulation, and so banks can operate on
narrower margins than their counterparts in the United States. Thus, the Eurodollar
market has expanded largely as a way of circumventing regulatory costs.
The average eurodollar deposit is very large (in the millions) and has a maturity of
less than 6 months. A variation on the Eurodollar time deposit is the Eurodollar
certificate of deposit. A Eurodollar CD is basically the same as a domestic CD, except
that it's the liability of a non-U.S.