Money Market Instruments

A corporation that needs cash for 45 days does not issue a 30-year bond. It borrows in the money market instead. The exam gives you four short-term instruments and asks you to tell them apart. This lesson names each one, its issuer, and how it pays.

What counts as a money market instrument

The money market is the market for debt that matures in one year or less. Every instrument traded there shares three features:

• Short maturity. One year or less, and often much less.
• High credit quality. The issuers are the US Treasury, large banks, and large corporations.
• High liquidity. An owner can usually sell before maturity.

Yields are low here, because the risk is low and the wait is short. The shortest-dated money market instruments, those maturing within three months, are also called cash equivalents.

Most of these instruments sell at a discount. You pay less than face value, then collect the full face value at maturity. The difference is your return, and no interest check arrives in between.

Treasury bills

A Treasury bill (T-bill) is US government debt that matures in one year or less. It is the safest money market instrument, because the full faith and credit of the US government stands behind it.

T-bills pay no coupon. Treasury sells them at a discount at auction and pays face value at maturity. Buy a $10,000 bill for $9,850 and hold it 26 weeks, and the $150 gain is your interest.

The T-bill yield sets the floor for the money market. Every other short-term instrument pays more for its extra credit risk.

Commercial paper

Commercial paper is a short-term, unsecured promissory note, meaning no collateral backs it, that a large corporation issues to raise cash. Companies use it to cover payroll, inventory, and other day-to-day costs, not to build a factory.

Commercial paper sells at a discount and matures at face value, the same way a T-bill does. Maturities run from a few days out to 270 days.

Issuers stop at 270 days for a legal reason. Paper that matures in 270 days or less is exempt from SEC registration under the Securities Act of 1933. The paper must also fund current business operations. Go past 270 days and the exemption is gone.

If the issuer fails, the holder stands in line as a general creditor. Credit quality decides the yield, so rating agencies publish short-term ratings on commercial paper.

Bankers' acceptances

A bankers' acceptance (BA) is a time draft that a bank has accepted. Acceptance means the bank agrees to pay the stated amount on a stated future date. Importers and exporters use BAs to finance shipments of goods.

Picture a US importer buying $2 million of machinery from a German seller. The seller wants a promise from a bank, not from a company it has never dealt with. The importer's bank accepts the draft, and the bank now owes the money on the due date.

The German seller can hold the accepted draft to maturity or sell it at a discount for cash today. BAs sell at a discount and mature at face value, and maturities usually run up to 270 days.

Read "bankers' acceptance" and think international trade. The exam pairs those two almost every time.

Negotiable certificates of deposit

A certificate of deposit (CD) is a time deposit at a bank. The customer leaves money with the bank for a fixed term, and the bank pays interest. The retail CD your customer opens at a branch cannot be sold to anyone else, and an early withdrawal costs a penalty.

A negotiable CD is a CD that the owner can sell to another investor. Banks issue them in large face amounts, $100,000 or more, and they trade in the secondary market before maturity. Nobody pays an early withdrawal penalty, because nobody breaks the deposit.

Negotiable CDs pay interest. They do not sell at a discount, which makes the negotiable CD the exception among the four instruments here.

FDIC insurance covers $250,000 per depositor, per insured bank, per ownership category. A $1 million negotiable CD is insured for $250,000, and the other $750,000 depends on the bank's credit. The exam likes to call a bank CD risk free. Check the size against the limit first.

Who uses the money market, and why

Borrowers come to the money market for cash they need briefly:

• Treasury sells T-bills to cover the gap between tax collections and spending.
• Large corporations sell commercial paper to fund payroll and inventory.
• Banks sell negotiable CDs to raise funds, and they accept drafts to finance trade.

Investors come for safety and liquidity, not for yield. A company that owes a $30 million tax bill in 60 days cannot put that cash in stocks. It buys 60-day paper instead, and the money comes back before the bill falls due.

Money market mutual funds, banks, state and local governments, and pension funds buy for the same reason. Short maturities keep interest rate risk small, because a price cannot move far when the money returns in weeks.

How this gets tested

Most items describe an instrument and ask you to name it. Sort by the issuer:

• The US government: Treasury bill.
• A large corporation, unsecured: commercial paper.
• A bank standing behind an international trade: bankers' acceptance.
• A bank, a large deposit that the owner can sell: negotiable CD.

The next favorite item asks how an instrument pays. Three of the four sell at a discount and mature at face value: T-bills, commercial paper, and bankers' acceptances. The negotiable CD pays interest.

A sample of the logic: "Which money market instrument is backed by a bank and finances imports?" The answer is the bankers' acceptance, even though a negotiable CD also comes from a bank. Trade financing points to the BA every time.