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What are Money Market Instruments?
Money market instruments are short-term financing instruments aiming to increase the financial liquidity of businesses. The main characteristic of these kinds of securities is that they can be converted to cash with ease, thereby preserving the cash requirements of an investor.
The money market and its instruments are usually traded over the counter, and therefore, cannot be done by standalone individual investors themselves. It has to be done through certified brokers, or a money market mutual fund.
What are the Types of Money Market Instruments?
There are multiple types of money market instruments available, each of them aiming to boost the total productive capacity and hence, the GDP of the country. It also provides secure returns to the investors looking for low-risk investment opportunities for a short tenure.
The list of money market instruments traded in the money market are:
- Certificate of Deposit
Lending substantial financial resources to an organization can be done against a certificate of deposit. The operating procedure is similar to that of a fixed deposit, except the higher negotiating capacity, as well as lower liquidity of the former.
- Commercial Paper
This type of money market instrument serves as a promissory note generated by a company to raise short term funds. It is unsecured, and thereby can only be used by large-cap companies with renowned market reputation.
The maturity period of these debt instruments lies anywhere between 7 days to one year, and thus, attracts a lower interest rate than equivalent securities sold in the capital market.
- Treasury Bills
These are only issued by the central government of a country when it requires funds to meet its short term obligations.
These securities do not generate interest but allow an investor to make capital gains as it is sold at a discounted rate while the entire face value is paid at the time of maturity.
Treasury bills are an optimal investment tool for novice investors looking for options having minimal risk associated with it. Since treasury bills are backed by the government, the default risk is negligible, thus serving as an optimal investment tool for risk-averse investors.
- Repurchase Agreements
Commonly known as Repo, is a short term borrowing tool where the issuer availing the funds guarantees to repay (repurchase) it in the future.
Repurchase agreements generally involve the trading of government securities. They are subject to market interest rates and are backed by the government.
- Banker’s Acceptance
One of the most common money market instruments traded in the financial sector, a banker’s acceptance signifies a loan extended to the stipulated bank, with a signed guarantee of repayment in the future.
Since money market instruments are traded wholesale over the counter, it cannot be purchased in standard units by an individual investor.
However, you can choose to invest in money market instruments through a money market mutual fund.
These are interest-earning open-ended funds and bear significantly low risks due to their short maturity period, and the collateral guarantee of the central government, in most cases.
Money market investments should ideally be undertaken when the stock market poses a great degree of volatility. During this time, investing in equity and debt instruments in the capital market has high risk associated with it, as the chances of underperforming are immense.
The government generally tries to enhance the money circulation in the country to minimize market fluctuations. Thus, government-backed instruments offer higher returns in these circumstances to boost the demand for the same.
Who Should Invest In Money Market Mutual Funds
Money market mutual funds are an appealing option for people who are new to the field of investment and are looking for safe options for a short period.
The characteristic gesture of such mutual funds is that they offer one of the highest returns on short term investments in the market, and have the lowest amount of risk associated with its money market instruments.
These funds generally aim to keep their portfolio as diverse as possible, through a calculated combination of different types of money market instruments so as to maximize the yield.
Money market mutual funds are ideal for people having excess funds in their bank accounts and want to earn a higher return than the interest rate given by financial institutions across the country for the safekeeping of these funds.
Investing in the money market and its instruments through mutual funds preserves the liquidity interests of an investor as well, as the time horizon of such a mutual fund generally does not exceed one financial year. Also, since these are open-ended, exiting such a fund is usually hassle-free and quick.
Things to Consider Before Investing In Money Market Mutual Funds
Money market mutual funds are subject to market fluctuations as well. Thus, before considering investing in the various types of money market instruments, you must keep these following factors in mind:
- The investment period of such tools is very short, ranging from three months up to a year.
- Expense ratios are applicable in money market mutual funds and are charged as per the discretion of the Asset Management Company in question. Ideally, a lower expense ratio indicates higher yields for the investors, as the total money deductible from the returns stays relatively less.
- Mutual funds are subject to various tax gains under the Income Tax Act, 1963. However, short term capital gains are still taxable at 15%.
- The Net Asset Value of a mutual fund is subject to fluctuation as per the market trend in the country. A rise in the aggregate interest rate leads to a fall in the NAV of a mutual fund, thereby lowering your returns and vice-versa.
5. Various types of money market instruments are clubbed together to pose as one of the safest investment tool available in the market. They are still affected by stock market fluctuations, as stated previously. This risk factor, even though minimal, should not be written off.