Flash Introduction to the Money Market
Get the basics of the Money Market in under 5 minutes
Background
The Money Markets (MM) refer to the market of short term borrowing or lending. The maturities of what is traded are typically up to 12 months though there are some exceptions to this rule.
The main participants include financial institutions (where the activity is known as inter-bank lending), governments and governmental bodies as well as corporations. They all benefit from having access to a highly liquid market for short term borrowing and lending.
As with most markets, the market can be split into cash and securities. This includes T-Bills, Commercial paper, Certificates of Deposit (CDs) and secured lending.
Now let’s dive in and learn more about these products.
Treasury Bills (T-Bills) and Commercial Paper
What are T-Bills?
T-bills are fixed income (debt) securities that are issued and backed by the UK government. They have maturities of less than 12-months and are denominated up to £1000.
T-bills are issued less than par, and they mature at par. Meaning that you essentially loan the UK government some money and at the expiry date the UK government pays you back with interest.
So, why would the UK government issue such a security?
Issuing T-Bills are essentially an easy an inexpensive way for the government to raise funds for financing public projects.
Note: These types of short term government issued debt securities are called different things in different countries. UK and US T-bills, Japan Financing Bills and Germany Bubills (see more here).
Commercial Paper
Commercial Paper is the equivalent of T-Bills but when issued by corporations.
Certificate of Deposit
Certificate of deposit is an instrument that you may already be familiar with as it’s often offered by many commercial banks as well. It is essentially a fixed term for a fixed rate deposit.
The fact that this is a fixed term deposit and you cannot access your funds until the expiry, it means that there is higher risk involved, which is the reason why higher levels of interest are typically offered than the market rate of a savings account.
Repurchase Agreement (Repo)
What are the basics of a repo?
A Repurchase Agreement, or a repo as it is commonly known, is a contract where two parties agree to exchange a security for cash for a pre-agreed period of time. You can think of it as a secured loan.
A repo transaction typically has two legs:
- Leg 1: The seller of the repo, party A, sells securities (bonds) to his counterparty for cash, party B.
- Leg 2: Party A pays the cash back (with interest) and receives securities from party B.
The difference between the payment in cash from leg 1 and leg 2 is known as the Repo Rate and can be thought as the cost of funding. It’s basically the cost of getting a (secured) loan.
On the other hand, if you want to ‘buy’ a repo, rather than sell, then the transaction is known as a ‘reverse repo’.
Main types of Repo Transactions
Overnight Repo: These are very short term repos that mature within a day
Term Repo: A term repo is essentially any repo transaction whose maturity is longer than a month
Open Repo: A repo transaction that has no official maturity date. The maturity day is automatically rolled everyday until either counterparty decides to terminate the contract (something that they are legally allowed to do).
Risks Associated with Money Market Transactions
Credit Risk
The main risk associated with money market products is Counterparty Credit Risk. That is, the risk that the counterparty involved in the deal will default on its obligations.
For T-Bills, the counterparty risk is considered to be minimal; often modelled as riskless under the assumption that a well established country is highly unlikely to default.
For repos, there are essentially three types of credit risk.
- Credit Exposure: As we explained previously in ‘Flash Introduction to FX’, this is the risk that your counterparty will default before meeting its financial obligations
- Settlement Risk: This is the risk that you pay your part of your deal, but your counterparty defaults before they pay their part of the deal. This is minimised (often modelled as eliminated) through a DvP (delivery versus payment) style arrangement for most repo agreements
- Issuer Exposure: That is, as the owner of the underlying securities (the bonds that make the collateral in the repo transaction) you have exposure to the issuer of those securities. If the issuer of the securities defaults, then the securities will be worth a lot less if anything.
Market Risk
Market Risk as previously discussed is the risk that the market as a whole would change against you. Market risk cannot be reduced by diversification. The most prominent such risk for Repos is Interest Rates. Interest rates affect the value of the underlying bonds which are used as collateral, in the repo transaction.
Disclaimer
All data and information provided on this blog post is for informational purposes only. The author makes no representations as to accuracy, completeness, correctness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.
Any referenced links to internal or external website content are not owned by the blog post author and there is no affiliation. Use at your own discretion.