Money Markets: Reduce Your Risks – Part 1

Most investors are hypocrites when it comes to the stock market. In the bull market they are raving about the stock market, where as in the bear market, they cannot stop cursing it. In the bear market alot of investors get out of the stock market and park their money in the money market, that offers an alternative to high risk investments.

Introduction to Money Market
Money market is one of the significant type of fixed income market. Money market securities are issued by governments, financial institutions and large corporations. These instruments are very liquid and considered safe. They are better known as a place for large institutions and government to manage their short-term cash needs. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities.

How is Money Market different from Bond Market ?
The difference between the money market and the bond market is that the money market specializes in very short-term debt securities.

How is Money Market different from Stock Market ?
One of the main differences between the money market and the stock market is that most money market securities trade in very high amount which limits access for the individual investor. Also in case of money market, firms buy and sell securities in their own accounts, at their own risk, whereas in the stock market, a broker acts as an agent to buy and sell. Add to that, there is no central trading exchange in case of money market, but just transactions over the phone or electronic systems.

How to Get Access to Money Market ?
The easiest way to gain access to the money market is through a money market mutual fund or through a money market bank account. Some money market types, like Treasury bills, may be purchased directly. They can also be acquired through other large financial institutions with direct access to these markets.

Types of Money Market
There are different instruments in the money market, offering different returns and different risks. Let us take a look at the major money market instruments.

Treasury Bills (T-bills)
Treasury Bills are short-term securities (say 3-month, 6-month or 1-year maturity). T-bills are purchased at less than their face value. On maturity the full face value is returned. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would be returned $10,000.

To buy a T-bill, a bid has to be submitted either non-competitively or competitively. In non-competitive bidding, the full amount determined at the auction will be returned. With competitive bidding, based on the desired returns, the bid maybe a success or a failure.

Advantage

  • Their popularity is mainly due to their simplicity and affordability.
  • One of the safest investments in the world, since it is backed by U.S. government.
  • They are exempt from state and local taxes.
  • They are short-term investments instead of being locked for a longer time frame.
Disadvantage
  • The returns from this investment are not great compared to bonds, certificates of deposit and money market funds.
  • The investment cannot be liquidated before maturity date.
Certificate of Deposit (CD)
Certificate of deposit is a fixed term deposit, also known as time deposit. CDs are issued by commercial banks but can be bought through a brokerage firm. They have a maturity period ranging from 3-months to 5-years with a specified interest rate. Interest rates depend on various factors like current interest rate in the market, money invested, maturity period. A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR).

Advantage

  • CDs have a higher yield compared to T-Bills due to their slightly higher risk factor. (ie. What is the bank goes out of business)
  • Almost every bank offers CDs, which means they are easily accesible. This also means you have multiple options to get the best rates.
  • CDs are relatively safe and will earn more than in a savings account.
Disadvantage
  • CDs cannot be withdrawn instantly as desired similar to a checking account. A huge fine can be levied if the funds are withdrawn prior to maturity.
  • The returns from this investment are not very exciting compared to many other investments.
Commercial Paper
Borrowing money from banks for a short-term can be sometimes frustrating process. In response to that, commercial paper gained popularity among corporations. Commercial paper is an unsecured, discounted, short term loan issued by a corporation. Maturity period is no more than 9 months.

Advantage

  • Safe investment because the financial situation of a company can easily be predicted over a few months.
  • Only companies with high credit ratings issue commercial paper.
  • Higher returns than T-bills.

Disadvantage

  • They are not afforable to everyone, since commercial papers are issued in the range of $100,000 or more.
  • Small-time investors can only invest in commercial paper indirectly through money market funds.
Conclusion: When the stock market looks volatile and too risky, money markets can provide an excellent alternative. Their short-term maturity make them more attractive. Obviously the returns are not very thrilling, but there are times when even the most ambitious investor puts some cash on the sidelines. There are a few more instruments i did not cover in this post, which would be covered in Part-2. Hope this post opened your eye to money market securities. To be continued…

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(Source: Investopedia)