Money Market Instruments - Definition, Types and List of Money Market Instruments (2024)

Money market instruments are short-term financing instruments aiming to increase the financial liquidity of businesses.

What are Money Market Instruments?

The main characteristic of money market instruments is that they can be easily converted to cash, thereby preserving an investor's cash requirements.

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.

Objectives of Money Market

The following are the primary goals of the money market-

• Providing short-term financing to borrowers such as private investors, governments, and others at a reasonable cost. Lenders will also benefit from liquidity because money market securities are short-term.
• Since most businesses lack the necessary working capital, the money market assists such businesses in obtaining the monies required to meet their working capital requirements.
• It is a major source of government funding for both domestic and foreign trade. As a result, it provides an opportunity for banks to lodge their excess funds.
• It also enables lenders to convert idle capital into productive investments. Both the lender and the borrower benefit from this arrangement.
• The RBI oversees the money market. As a result, it contributes to the regulation of the economy's liquidity level.

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 investors looking for low-risk investment opportunities for a short tenure.

Thelist 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.

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, it 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'sAcceptance

One of the most commonmoney market instrumentstraded 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 circ*mstances 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 have low risk associated with their 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.

Investing in the money market and its instruments through mutual funds preserves an investor's liquidity interests, as the time horizon of such a mutual fund is generally extremely short-term. 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 the following factors in mind:

1. The investment period for such tools is very short, ranging from three months up to a year.
2. Expense ratios are applicable in money market mutual funds and are charged at 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.
3. Mutual funds are subject to various tax gains under the Income Tax Act, 1961. Short-term capital gains are taxable at 15%.
4. 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. Varioustypes of money market instrumentsare clubbed together to pose as one of the safest investment tool available in the market. This risk factor, even though minimal, should not be written off.

Pros and Cons of Money Market Instruments

• Pros

Money market instruments are more liquid than other fixed-income securities. Investors can sell their interests at any moment because there is no lock-in period.

The rate of return on a money market instrument is slightly higher than the rate of return on a savings account.

• Cons

Without a doubt, the interest rate is larger than that of savings bank accounts. However, the interest rate does not account for the economy's rising inflation. While other investment tools, such as mutual funds, provide a better return on investment over time.

As a result, if the goal of the investment is to achieve capital appreciation while outperforming inflation, money market instruments are not a suitable alternative.