Money Market Instruments

Overview

Money market instruments are short-term debt securities with maturities of one year or less (most under 270 days). They are designed for safety and liquidity rather than return, and they serve as the "cash equivalents" of the institutional investment world. They typically trade in very large denominations and are used by corporations, banks, governments, and sophisticated investors to manage short-term cash needs.

The money market is not a physical exchange but an over-the-counter (OTC) market where institutions trade directly with each other or through dealers. Yields on money market instruments tend to track closely with the federal funds rate set by the Federal Open Market Committee (FOMC).

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Treasury Bills — The Benchmark

T-Bills (covered in depth in the U.S. Government Securities section) serve as the risk-free benchmark for the entire money market. Because they are backed by the full faith and credit of the U.S. government and mature in under one year, all other money market instruments are priced relative to T-Bills — they must offer a yield premium to compensate for additional credit, liquidity, or regulatory risk.

If a banker's acceptance yields 15 basis points above T-Bills, that spread represents the incremental risk investors perceive in non-government paper.

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Commercial Paper

Commercial paper is unsecured short-term debt issued by corporations to fund day-to-day operating needs (payroll, accounts receivable, inventory). It is essentially an IOU from a corporation.

Key characteristics:

• Maturity: Maximum 270 days — this threshold is critical because securities with maturities under 270 days are exempt from SEC registration under the Securities Act of 1933. Corporations issue commercial paper specifically to avoid the time and cost of SEC registration.
• Minimum denomination: Typically $100,000 face value — commercial paper is not a retail product
• Issued at a discount: Like T-Bills, commercial paper pays no coupon and is sold below face value; the discount represents the investor's return
• Unsecured: Backed only by the issuer's creditworthiness. Only highly rated companies (A-1/P-1 rated) can issue commercial paper, since there is no collateral
• Secondary market: Very limited; most investors hold to maturity
• Not FDIC insured: Corporate obligation, not a bank deposit

Example: A corporation issues 180-day commercial paper at a discount. A money market fund buys it at $998,500 and receives $1,000,000 at maturity — the $1,500 on $1M face is the yield for roughly 6 months.

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Banker's Acceptances (BAs)

A banker's acceptance is a time draft (a future payment order) that has been guaranteed ("accepted") by a bank. They originated in international trade finance and remain important for cross-border transactions.

How it works: A U.S. importer buying goods from a foreign exporter asks its bank to guarantee payment. The bank stamps "accepted" on the draft, making it the bank's obligation — not just the importer's. The exporter can then sell this accepted draft in the secondary market at a discount rather than waiting for payment.

Key characteristics:

• Maturity: 30 to 180 days
• Backed by: The accepting bank's full faith and credit (plus the underlying trade transaction)
• Safety: Considered very safe because the bank's guarantee converts a corporate obligation into a bank obligation
• Trading: BAs trade in an active secondary market at a discount to face value
• Use case: Primarily international trade; less common domestically since letters of credit have largely replaced them

Analogy: A BA is like getting your bank to co-sign a check. The seller of goods does not need to trust the buyer — they trust the bank's guarantee instead.

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Repurchase Agreements (Repos)

A repurchase agreement is a short-term borrowing arrangement where one party sells securities and simultaneously agrees to repurchase them at a specified higher price on a future date.

From the dealer's perspective (the borrower):

• Dealer sells Treasury securities to an investor
• Agrees to buy them back in 1 day (overnight repo) to 30 days at a slightly higher price
• The price difference = the interest rate on the loan (the repo rate)
• The securities serve as collateral for the short-term loan

From the investor's perspective:

• The investor is doing a reverse repo — buying securities and agreeing to sell them back
• Earns a small but safe return on excess cash overnight

Why repos matter: Repos are the primary mechanism by which securities dealers finance their inventory. The Federal Reserve also uses repos and reverse repos to implement monetary policy and manage bank reserves.

Key exam point: The same transaction has two names depending on perspective:

• Dealer selling and agreeing to buy back = Repo (borrowing)
• Counterparty buying and agreeing to sell back = Reverse Repo (lending)

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Negotiable Certificates of Deposit (CDs)

Negotiable CDs are large-denomination time deposits issued by commercial banks that can be bought and sold in the secondary market — unlike ordinary bank CDs which must be held to maturity (or face early withdrawal penalties).

Key characteristics:

• Minimum denomination: $100,000 (often $1 million or more in practice)
• Maturity: Typically 2 weeks to 1 year
• Interest: Pay a fixed interest rate (not issued at discount — pay face value plus interest at maturity)
• Secondary market: Active market among institutional investors, dealers, and brokers
• FDIC coverage: FDIC insures deposits up to $250,000 per depositor per bank. Negotiable CDs above $250,000 are NOT fully FDIC insured — the excess is at risk if the bank fails
• Issued by: Commercial banks (domestic) or foreign branches of U.S. banks (Eurodollar CDs)

Critical distinction: "Negotiable" means tradeable in secondary market. Regular (non-negotiable) bank CDs cannot be transferred — they must be held to maturity.

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Federal Funds

Federal funds are overnight loans between commercial banks to meet Federal Reserve reserve requirements. Banks with excess reserves lend to banks with reserve deficiencies.

The Federal Funds Rate is the interest rate at which these overnight loans occur. The FOMC (Federal Open Market Committee) sets a target range for the Fed funds rate — the primary tool of U.S. monetary policy. When the Fed raises this target, borrowing costs rise throughout the economy. When it lowers the target, borrowing becomes cheaper.

Key facts:

• Not technically a "security" — it is an unsecured overnight interbank loan
• The most sensitive short-term interest rate — reflects real-time liquidity conditions
• Loans are typically in multiples of $1 million
• Serves as the baseline for all short-term borrowing costs

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Eurodollars

Eurodollars are U.S. dollar-denominated deposits held in banks outside the United States (or in foreign branches of U.S. banks). Despite the name, they are not limited to Europe — Eurodollar deposits exist in banks in London, Singapore, Tokyo, and elsewhere.

Key characteristics:

• Denomination: U.S. dollars
• Location: Banks outside U.S. jurisdiction
• Regulation: Less regulated than U.S. bank deposits — not subject to Federal Reserve requirements or FDIC insurance
• Size: Large denominations (typically $1 million or more)
• Yield: Generally slightly higher than comparable domestic deposits due to reduced regulation and slightly higher perceived risk
• Eurodollar futures: Heavily traded futures contracts on 3-month Eurodollar deposit rates, historically used to hedge short-term interest rate exposure

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SOFR — Secured Overnight Financing Rate

SOFR is a benchmark interest rate that replaced LIBOR (London Interbank Offered Rate) as the primary reference rate for floating-rate financial instruments. LIBOR was phased out after 2023 following widespread manipulation scandals.

How SOFR is calculated: Based on actual overnight repurchase agreement transactions collateralized by U.S. Treasury securities — a broad measure of the cost of overnight secured borrowing in the Treasury repo market.

Why SOFR replaced LIBOR:

• LIBOR was based on self-reported rates from banks (subject to manipulation)
• SOFR is based on actual transactions (more reliable and verifiable)
• SOFR is transaction-based, backward-looking, and published by the Federal Reserve Bank of New York

Applications: SOFR is used as the reference rate for floating-rate mortgages, corporate loans, interest rate swaps, and other derivative instruments that previously referenced LIBOR.

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Key Terms

• Commercial paper: Unsecured corporate short-term debt; max 270 days; exempt from SEC registration
• Banker's acceptance: Bank-guaranteed time draft used in trade finance; 30-180 days
• Repo (repurchase agreement): Short-term secured borrowing using securities as collateral
• Reverse repo: The counterparty's perspective on a repo; short-term secured lending
• Negotiable CD: Tradeable large-denomination bank time deposit; minimum $100,000
• Federal funds: Overnight interbank loans to meet reserve requirements
• Fed funds rate: FOMC's primary monetary policy tool; target rate for overnight interbank lending
• Eurodollars: USD deposits held outside U.S.; unregulated, no FDIC insurance
• SOFR: Transaction-based overnight repo rate that replaced LIBOR as global benchmark
• 270-day rule: Commercial paper under 270 days avoids SEC registration under 1933 Act

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Quiz Questions:

Q1. A corporation needs short-term financing for 9 months. Why CANNOT it use commercial paper for this purpose?

A) Commercial paper is only available to banks, not corporations B) Commercial paper has a maximum maturity of 270 days, so a 9-month term would require SEC registration C) Commercial paper requires collateral that the corporation may not have D) Commercial paper must be sold to retail investors, not institutions

Answer: B — Commercial paper is exempt from SEC registration only when the maturity is 270 days or less. A 9-month term exceeds this threshold, requiring the issuer to file a registration statement — defeating the speed and cost advantage of commercial paper. A is wrong — corporations are the primary issuers. C is wrong — commercial paper is unsecured. D is completely backward.

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Q2. A securities dealer sells $50 million in Treasury bonds to a money market fund with an agreement to repurchase them the following day at a slightly higher price. From the DEALER'S perspective, this transaction is best described as:

A) A reverse repurchase agreement (reverse repo) B) A repurchase agreement (repo) C) A banker's acceptance D) A negotiable certificate of deposit

Answer: B — The dealer is selling securities now and agreeing to buy them back later — this is a repo from the dealer's perspective. It is the dealer's method of short-term borrowing using Treasury securities as collateral. A (reverse repo) is the money market fund's perspective. C and D are entirely different instruments.

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Q3. Which of the following money market instruments is MOST appropriate for a corporation seeking to invest excess cash for 60 days with maximum safety and full liquidity?

A) Eurodollar deposits B) Subordinated corporate debentures C) Negotiable CDs from a major bank D) Treasury Bills

Answer: D — T-Bills are the safest money market instrument, backed by the U.S. government, with an active secondary market providing full liquidity. Eurodollar deposits (A) are unregulated and less liquid. Subordinated debentures (B) are long-term, illiquid, and riskier corporate instruments — not money market. Negotiable CDs (C) are reasonable but carry bank credit risk and are only FDIC insured to $250,000 — not adequate for large corporate cash.

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Q4. The Federal Open Market Committee (FOMC) raises the target federal funds rate by 25 basis points. Which of the following is the MOST DIRECT effect of this action?

A) Long-term Treasury bond prices immediately rise B) Banks must pay higher rates to borrow overnight reserves from each other C) The federal deficit automatically decreases D) Commercial paper maturity limits are extended

Answer: B — The federal funds rate is the rate banks charge each other for overnight reserve loans. A FOMC rate hike directly raises this overnight rate. A is wrong because rate hikes cause bond prices to fall (not rise), and the effect on long-term bonds is indirect. C is unrelated — the federal deficit is a fiscal policy matter, not monetary. D is wrong — FOMC rate decisions have no effect on commercial paper maturity regulations.

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Q5. SOFR replaced LIBOR as the primary floating-rate benchmark. Which of the following BEST explains why SOFR is considered more reliable than LIBOR?

A) SOFR is based on self-reported bank rates from a larger panel of banks B) SOFR is set directly by the Federal Reserve each morning C) SOFR is derived from actual overnight repurchase agreement transactions, making it manipulation-resistant D) SOFR is only applicable to Eurodollar deposits, keeping it insulated from domestic rate manipulation

Answer: C — SOFR is calculated from real, observable overnight Treasury repo transactions — not from bank estimates or self-reported rates. This transaction-based methodology eliminates the manipulation incentive that plagued LIBOR (where banks could profit by reporting rates that suited their derivative positions). A is the opposite of the truth — LIBOR was survey-based; SOFR is not. B is incorrect — the Fed publishes SOFR but does not set it directly. D is wrong — SOFR applies broadly to financial instruments across markets, not just Eurodollar products.