Money Market
Introduction
The financial system of a country is broadly divided into two segments: the money market and the capital market. While the capital market deals with long-term funds, the Money Market deals with short-term funds.
The money market is a market for short-term funds. It is a market where funds are borrowed and lent for short periods, typically up to one year. It provides a mechanism for adjusting the liquidity needs of various financial institutions and corporations.
Money Market
Meaning
The Money Market is not a physical place but rather a concept representing the network of financial institutions, dealers, and brokers who deal in short-term monetary assets. It is a market for short-term debt instruments that are highly liquid and have original maturities of one year or less.
It plays a crucial role in providing working capital to businesses and enabling the central bank (Reserve Bank of India - RBI) to influence the economy's liquidity position and monetary policy.
Key characteristics of a Money Market:
1. Market for Short-term Funds: Deals with funds for a period of up to one year.
2. Highly Liquid Instruments: The instruments traded are close substitutes for money and can be quickly converted into cash with minimum loss.
3. No Fixed Geographical Location: Transactions are conducted over phone, internet, or through intermediaries.
4. Large Volume of Transactions: Deals with high-value transactions, primarily involving financial institutions, banks, government, and large corporations.
5. Participants: Includes RBI, commercial banks, non-banking financial companies (NBFCs), large corporations, insurance companies, mutual funds, etc.
6. Low Risk: Instruments are generally safe due to short maturity periods and involvement of creditworthy institutions.
Money Market Instruments
Various instruments are traded in the money market in India. Some of the important ones are:
Treasury Bills (T-Bills)
Treasury Bills are short-term borrowing instruments issued by the Government of India. They are used to meet the short-term financial needs of the government. T-Bills are issued at a discount to their face value and are repaid at par on maturity.
They are issued in maturities of 91 days, 182 days, and 364 days. They are considered one of the safest money market instruments as they are issued by the government.
Example: A 91-day T-Bill with a face value of ₹1,00,000 might be issued for ₹96,000. The return to the investor is the difference between the face value and the issue price (₹4,000 in this case), which is realised at maturity.
Advantages: Highly safe, high liquidity, availability of different maturities.
Disadvantages: Low return compared to other instruments due to low risk.
Commercial Paper (CP)
As discussed in the previous chapter, Commercial Paper (CP) is a short-term, unsecured promissory note issued by large, creditworthy companies to raise funds directly from investors for a short period, usually from 7 days to 1 year. It is an alternative to bank borrowing.
It is issued at a discount to face value.
Advantages: Flexible maturity, lower cost for creditworthy firms, highly liquid (secondary market). For investors, it offers a higher return than T-Bills.
Disadvantages: Unsecured (riskier than T-Bills), only for large, reputable firms, market size is limited.
Call Money, Notice Money, and Term Money
These refer to the money lent and borrowed between banks for very short periods. This market is primarily used by banks to maintain their Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements with the RBI.
a) Call Money: Lending and borrowing of funds for a period of 1 day.
b) Notice Money: Lending and borrowing of funds for a period of more than 1 day but up to 14 days.
c) Term Money: Lending and borrowing of funds for a period of more than 14 days but up to 1 year.
The interest rate in the call money market (Call Rate) is a sensitive indicator of the liquidity position in the banking system.
Advantages: Helps banks manage liquidity, provides a short-term investment avenue for surplus funds.
Disadvantages: Interest rates can be highly volatile.
Certificate of Deposit (CD)
A Certificate of Deposit (CD) is a short-term instrument issued by commercial banks and development financial institutions. It is a time deposit that is freely transferable in the market.
CDs can be issued to individuals, corporations, trusts, etc., for a period ranging from 7 days to 1 year for banks, and up to 3 years for financial institutions. They are generally issued in denominations of ₹1 Lakh and multiples thereof.
Advantages: Provides liquidity to depositors compared to fixed deposits, offers slightly higher returns than fixed deposits.
Disadvantages: Requires a minimum deposit amount, subject to market risk if sold before maturity.
Commercial Bill
A Commercial Bill (or Bill of Exchange) is a short-term, negotiable instrument arising out of a trade transaction. When a seller sells goods on credit, they can draw a bill of exchange on the buyer. The buyer accepts the bill, promising to pay the amount on a specified future date.
The seller can hold the bill until maturity or discount it with a bank to get immediate funds. The money market for commercial bills is known as the Bill Market.
Example: Company A sells goods worth ₹5 Lakhs to Company B on 90-day credit and draws a bill on B. B accepts the bill. A can discount this bill with a bank, receiving funds immediately (minus discount). The bank will collect ₹5 Lakhs from B on the due date.
Advantages: Provides liquidity to the seller, facilitates credit sales.
Disadvantages: Risk of non-payment by the buyer (unless discounted with recourse), involves transaction costs (discounting charges).
| Instrument | Issued By | Maturity | Nature | Risk Level |
|---|---|---|---|---|
| Treasury Bills | Govt. of India | 91, 182, 364 days | Discounted, Unsecured | Very Low (Sovereign) |
| Commercial Paper | Large Creditworthy Firms | 7 days to 1 year | Discounted, Unsecured Promissory Note | Low to Moderate (Depends on firm) |
| Certificate of Deposit | Banks, FIs | Banks: 7 days - 1 yr; FIs: up to 3 yrs | Discounted/Interest-bearing, Transferable | Low (Depends on issuing institution) |
| Call/Notice/Term Money | Banks (borrowing/lending) | Call: 1 day; Notice: 2-14 days; Term: >14 days-1 yr | Inter-bank lending | Low (Inter-bank risk) |
| Commercial Bill | Seller (Buyer accepts) | Short-term (often up to 90 days) | Bill of Exchange | Moderate (Depends on buyer's creditworthiness) |