Understanding the Money Market

 
 
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by S. Wade Hansen

What is the Money Market?

The money market plays a key role in the global financial markets. In fact, the money market is so important, the U.S. Treasury had to pledge $50 billion to support failing money market funds when the Reserve Primary Fund—the first money market fund ever created—"broke the buck" by announcing its shares were worth less than $1 each during the financial crisis that began in 2008. This was virtually unheard of in the financial world as "breaking the buck" had only happened once before. But all of this begs the question, what exactly is the money market? Economy Chokes as Banks Hoard Cash
 
Unlike the name suggests, the money market is not a market where investors go and trade money back and forth. In fact, there isn't even a centralized exchange, or "market," where money-market investors go. The money market is actually a collection of financial markets in which investors trade financial instruments that are considered to be "just as good" as money. These instruments include the following:

- United States Treasury bills (T-bills)

- Federal agency securities (from agencies like the Federal National Mortgage Association—Fannie Mae)

- Commercial paper

- Repurchase agreements (Repos)

- Negotiable certificates of deposit (CDs)

- Federal funds

- Short-term municipal securities

 Investors consider these financial instruments to be just as good as money because they meet the following three requirements:

1. They are generally extremely liquid—you can easily buy and sell them

2. They are considered to be quite safe because they are issued by strong, credit-worthy institutions (Like the U.S. Government)

3. They carry very little price risk because of their short-term expirations

For instance, one of the most popular financial instruments traded in the money market is the T-bill. T-bills are short-term debt obligations issued by the U.S. Treasury to cover current deficits in the federal budget and refinance maturing long-term government debt. T-bills meet the three "good as money" requirement because they are extremely liquid because there is a huge secondary market for them, and there are billions of dollars worth of T-bills in the market at any given time, they are considered to be virtually risk free because they are backed by the full faith and credit of the U.S. government and they carry very little price risk becaue the Treasury issues T-bills with expiration dates as close as 13 weeks and 26 weeks but never longer that 52 weeks.

Check out the second part of this article, with its accompanying video, in Understanding the Money Market - Part 2.

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