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Different Types of
Money Markets:
There are several different instruments
in the money market, offering different returns and different risks. Below are
the most common ones:
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Why
would the government need to borrow money? Doesn't it get all that
tax revenue?
It's a fact that US
government receive huge amount of tax revenue. But it spends more
money than it receives in tax revenues. So they borrow money just
like us. Let's suppose ordinary Joe spends more money this month
than his income. This situation would be called a "budget
deficit". So you borrow. The amount you borrowed (and now owe) is
called your debt. You have to pay interest on your debt. If next
month you don't have enough money to cover your spending then you
would incur another deficit, you must borrow some more, and you'll
still have to pay the interest on the loan. If you have a deficit
every month, you keep borrowing and your debt grows. Soon the
interest payment on your loan is bigger than any other item in
your budget.
Each year since 1969,
Congress has spent more money than its income. The Treasury
Department has to borrow money to meet Congress's appropriations.
The total borrowed is well over $6 trillion ($6,000,000,000,000)
and growing.
Even when government officials claim to have a surplus, they still
spend more than they get in. |
Treasury Bills (T-bills):
T-bills are the most popular and marketable money market security. Their popularity is mainly due to their simplicity. T-bills
are basically a way for the U.S. government to raise money from the public.
T-bills are short-term securities with a maturity date of 4, 13, or 26
weeks. You
buy T-bills for a price less than (discount) to their par (face) value, and
when they mature, the government pays you their par value. This is different
than coupon bonds,
which pay interest semi-annually. 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 $9,500 and held it until maturity, your interest would
be $500.
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 prepared either non-competitively 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. More information on auctions is available
at:
www.treasurydirect.gov/sec/secfaq.htm#secfaq4
The biggest reasons that T-Bills are so popular is because they are one of the
few money market instruments that are affordable to the individual investors.
T-bills are usually issued in denominations of $1,000, $5,000, $10,000, $25,000,
$50,000, $100,000, and $1 million. Other positives are that T-bills (and all
treasuries) are considered to be the safest investments in the world because the
U.S. government backs them. In fact, they are often considered risk-free
investments.
Also, interest is federally taxable but exempt from state and local taxes.
The only downside is that you won't get a great return because Treasuries are
exceptionally safe. Corporate bonds, CDs, and money market funds will often give
higher rates of interest. What’s more, you might not get back all of your
investment if you cash out before the maturity date.
Certificate of Deposit (CD):
CDs are time deposits offered by banks and insured by
the Federal Deposit Insurance Corporation (FDIC). You generally earn compound
interest at a fixed rate, which is determined by the current interest rate and
the CD's term, which can range from a week to several years. However, rates can
vary significantly from bank to bank, and some banks also offer or offer
adjustable rate CDs or hybrid CDs whose earnings are tied to a stock index such
as the Standard & Poor's 500-stock Index (S&P 500). You usually have to pay a
penalty if you withdraw funds before your CD matures, often equal to the
interest that has accrued up to the time you make the withdrawal.
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What is
compound interest?
When the interest you
earn on an investment is added to form the new base on which
future interest accumulates, it is said to be compound interest.
Without compounding, you earn simple interest, and your investment
doesn't grow as quickly.
For example, if you earn 10% compounded interest on $100 every
year for five years, you'll have $110 after one year, $121 after
two years, $133.10 after three years, and $161.05 after five years
— for total growth of 61.1% on your investment. With simple
interest, you would have earned $10 a year for five years, for
$150, or 50% growth. The $11.05 difference is the effect of
compounding. Compound interest earnings are reported as annual
percentage yield (APY), though the compounding can be figured
annually, monthly, or daily. |
CDs offer a slightly higher yield than T-Bills because of the slightly higher default
risk for a bank, but overall the likeliness of a large bank going broke is
pretty slim. Of course, the amount of interest you earn depends on a number of
factors such as the current interest rate environment, how much money you
invest, the length of time, and your specific bank.
A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY)
and annual percentage rate
(APR). APY is the total amount of interest you earn in one year taking into
account compound interest. APR is simply the stated interest you earn in one
year, without taking into account compounding.
The difference results from when interest is paid. The more frequently interest
is calculated, the greater the yield will be. When an investment pays interest
annually, its rate and yield are the same. But when interest is paid more
frequently, the yield gets higher. For example, say you purchase a 1-year,
$1,000 CD that pays 5% semiannually. After 6 months, you'll receive interest
payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of compounding
starts. The $25 payment starts earning interest of its own, which over the next
6 months amounts to 62.5 cents ($25 x 5% x .5 years). As a result, the rate on
the CD is 5 percent, but its yield is 5.06. It may not sound like a lot, but
compounding adds up over time.
The main advantage of CDs is their safety and knowing the return you'll receive.
You'll earn more than in a savings account, and you won't be at the mercy of the
stock market. Plus, the FDIC guarantees your investment up to
$100,000.
There are two main disadvantages to CDs. The returns are paltry and your money
is tied up for the length of the CD. You can't get your money out without paying
a harsh penalty.
Commercial Paper (CP):
To help meet their immediate needs for cash, banks and corporations
sometimes issue unsecured, short-term debt instruments known as commercial
paper, typically for
financing
accounts receivable and inventories. Commercial paper can be a good place
for investors and institutional investors in particular to park cash
temporarily. That's because commercial paper is liquid and essentially risk
free, since it is typically issued by profitable, long-established
organizations.
Furthermore, typically only companies with high credit ratings and credit
worthiness issue commercial paper. Over the past 40 years, there have only
been a handful of cases where corporations have defaulted on
their commercial paper repayment. It is usually issued at a discount,
reflecting current market interest rates. Maturities on commercial paper are
usually no longer than 9 months, with maturities of 1-2 months being the
average. It is usually issued with denominations of $100,000 or more.
Therefore, smaller investors can only invest in commercial paper indirectly
through money market funds.
Bankers' Acceptance (BA):
A BA is a short-term credit investment created by a non-financial firm and
guaranteed by a bank to make payment.
For corporations, a BA acts as a negotiable time draft for financing
imports, exports, or other transactions in goods. This is especially useful
when the creditworthiness of a foreign trade partner is unknown. Acceptances
sell at discount from the face value (see example below).
One advantage of a bankers acceptance is that they do not need to be held on
until maturity. Instead they can be sold off in the secondary
markets where investors and institutions constantly trade BAs.
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Face value
of Bankers Acceptance |
$1,000,000
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Minus 2% per
annum commission for one year |
-$20,000
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Amount
received by exporter in one year |
$980,000
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Eurodollars:
Contrary to the name, Eurodollars have very little to do with the Euro
or European countries. Eurodollars are US currency deposited in banks
outside the US, usually but not always in Europe. Certain debt securities
are issued in eurodollars and pay interest in US dollars into non-US bank
accounts. Eurodollars are a form of eurocurrency. This market evolved in Europe, hence 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. As a result, 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 CDs in the states, except that it's the liability of a
non-U.S. bank, and they are typically less liquid and so offer higher
yields. The
Eurodollar market is obviously out of reach for all but the largest
institutions. The only way for individuals to invest in this market is
indirectly through a money market fund.
Re-purchase agreement (Repos):
Repo is short for repurchase agreement. Those who deal in
government securities use repos as a form of overnight borrowing. A
dealer or other holder of government securities (usually T-bills) sells
the securities to a lender and agrees to repurchase them at an agreed
future date at an agreed price. They are usually very short-term, from
overnight to 30 days or more. This short-term maturity and government
backing means repos provide lenders with extremely low risk.
Repos are popular because they can virtually eliminate credit problems.
Unfortunately, a number of significant losses over the years from
fraudulent dealers suggest that lenders in this market have not always
checked their collateralization closely enough.
There are also variations on standard repos:
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Reverse Repo - The complete opposite of a repo, where a
dealer buys government securities from an investor and then sells
them back on a later date at a higher price.
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Term Repo - Exactly the same as a repo except the term of
the loan is greater than 30 days.
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How do I invest in Money Markets?
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