Terms Beginning With 'm'

Money Market

  • October 21, 2020
  • Team Kalkine

What are the money markets?

The money market is a market of short-term debt instruments with maturities up to one year. The primary features of the money market are short maturities and high liquidity. It is one of the prime funding markets for Governments and corporations.

The Government issues sovereign debt as well as money market debt in the form of treasury bills. Participation in money markets is driven by a wider spectrum of investors, including individual investors, institutional investors, banks, companies. Money markets also fall under the broader capital markets and are a significant source of quick funding for an economy.

As a result, the market remains highly liquid for instruments as well as investors. Idle cash with investors usually finds its way to the money markets to earn something. Since cash-generating businesses extensively use this funding market, corporations prefer to park ready money in short term securities trading in money markets.

With a range of issuers, the coupon rates vary across maturities and security type. Government-issued short-term money market instruments set a benchmark for other instruments having similar maturities. 

If compared to other capital markets, money markets provide a higher level of security and a low level of returns. This attribute also designates money markets as a preferred choice for parking idle cash and earning little returns. 

Investment management industry, which includes ETF providers, also operate money market funds for investors. With accessibility to money markets being this high, investors with lesser resources also participate in money markets indirectly.

Money markets also facilitate overnight trades of short-term debt products. They can be bought and sold in large quantities. This makes the market very attractive for investors seeking liquidity and some returns. 

What are the functions of money markets?

Funding 

Money markets facilitate the funding market for corporation and nations, especially for short-term need ranging up to a year. It serves as a financing mechanism for local and international traders who often need short term funds to execute deals. 

It allows Governments to borrow money for short term needs. Most of the issuers prefer money markets because it is relatively easier to borrow from markets compared to banks, especially for meeting short term financial needs.

Monetary policy 

Money markets are effective for managing money flow and liquidity in overall markets. A well-established market allows implementing monetary policy initiatives of Central banks. Monetary policy decisions on short term rates are executed in money markets. 

By influencing short term rates in money markets, Central banks impact the banking industry of an economy, therefore credit flow and lending are consequently influenced by monetary policy decision on short term rates. 

Short-term money market interest rates also set the benchmark for long term interest rates in the market, thus monetary policies are also implemented in money markets. 

Growth in the economy 

A money market is an effective and efficient source of funding for industries. Businesses with credible profiles often access money markets to fund their working capital needs. Money markets are useful for short-term business funding because of the inherent cash realisation cycle. 

Short-term needs of businesses could be payment of wages, buying raw materials, etc., and money market instruments like commercial papers provide business with funding at competitive interest rates depending on credit rating. 

Money markets do not cater to long term borrowing needs of Government and corporation but are influential in setting up the trajectory for long term interest rates in the economy. 

What are the types of money market instruments?

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Treasury bills

Treasury bills are the most common instruments in the money market. They are issued by the Government of the jurisdiction and counted among the safest capital market securities. The maturity of treasury bills ranges to one, three, six, and twelve months. 

They are issued below their par value and redeemed at the full amount. The difference in the buying value and maturity value of the instrument is interest earned by investors. T-bills are traded in primary as well as secondary markets. 

Investors in T-bills include banks, broker-dealers, investment managers, insurance companies, pension funds, individual investors, companies etc. 

Commercial bills

Commercial bills or papers are issued by large corporations to finance short term cash needs of the business. Such businesses are usually high cash generators, and investors often find them credible enough to lend money for short-term. 

Similar to T-bills, they are also issued at a discount and redeemed at par, making up for returns. Commercial papers carry higher returns than the Treasury bills because the probability of default remains higher relatively. 

A commercial paper is an unsecured short-term debt instrument, and the issuers of commercial bills usually carry high credit rating, which also helps investors to price them in secondary markets. 

Repurchase agreements

A repurchase agreement is a short-term borrowing instrument for issuers, who agree to pay a higher value for the securities at the time of repurchase. The underlying securities in the agreement are sold to investors and repurchased at a higher price to compensate for the returns. 

Approved parties generally facilitate these transactions, and repurchase agreements largely involve highly liquid Government securities, including bonds, T-bills, State Government bonds, municipal corporation bonds. 

Certificate of deposits 

Certificate of deposits is generally issued by financial organisations such as banks. The amount involved in a certificate of deposits is large compared to normal bank deposits. Their maturities could be in years, but they are also issued for months such as one, three, or six months. 

CDs usually have a fixed maturity and fixed interest rate. The issuer could charge a penalty for redeeming certificate of deposit before its maturity. The interest rates on deposits could vary on invested amount, and sometimes interest rates are also negotiable. 

Banker’s acceptance 

Banker’s acceptance is issued by a corporation but guaranteed by a bank, which promises to pay the future amount. A major use of the banker’s acceptance is during international trade deals while establishing a guarantee of payment to one party. 

Investors also exchange banker’s acceptance in secondary markets and usually price trading at discounts. The maturities of banker’s acceptance usually range from one month to six months. 

Difference between actual and an expected return. For example, if a stock increased by 7% because of some update, but the average market only increased by 3% and the stock has a beta of 1, then the abnormal return was 4% (7% - 3% = 4%)

Refers to most commonly the realty sector and indicates the rate of sale of homes in a certain market during a given period of time. It is calculated as the ratio of the average number of sales in a month by the total number of available homes.

Condition in which potential loss from the risk is not enough to spend money on it to avoid the risk. Such cases emerge when the risk is either too less or very unlikely to occur.  

Darvas Box system Every great trader/investor in the history of the markets had a specific method to approach the markets, which eventually led them to create a good fortune, Darvas Box system is one such method. It is a trend following strategy developed by Nicholas Darvas in the 1950s to identify stocks for good upside potential. This is one of the few methods to trade the markets which uses the combination of both the technical analysis and fundamental analysis for a much more refined decision.  The fundamentals were used to identify the stocks, and technical analysis was used to time the entry and exits. Who was Nicholas Darvas? Nicholas Darvas was arguably one of the greatest stock traders/investors during 1950s – 1960s, but surprisingly he was a ball dancer by profession and not a professional stock trader. Even while trading and building his fortune, he was on a world tour for his performances in many countries and took up trading as a part-time job. In November 1952 he was invited to a Toronto Nightclub for which he received an unusual proposition of getting paid in shares by the club owners. At that time, all he knew was there is something called stocks which moves up and down in value, that’s it. He accepted the offer and received 6k shares of a Canadian mining company Brilund at 60 cents per share, with the condition that if the stock falls below this price within six months, then the owners would make up the difference. This was the introduction of a professional ball dancer to the stock market. Nicholas Darvas couldn’t perform at the club, so he bought those shares as a gesture. Within two months, Brilund touched $1.9, and his initial investment of $3000 turned to $11400, netting in almost three times of his investment. This triggered a curiosity into the stock markets, and he started to explore trading. Origin of the Darvas Box theory Initially, he was trading on his broker’s recommendation, tips from wealthy businessmen, he even approached some advisory services or any source that he could get his hands on for the tips, but all led him to losses. After losing a lot of money, he decided to develop his own theory, and after a lot of trial and error, his observations and continuous refinements he eventually invented his theory “The Box Theory”. So what exactly is the Box Theory? Fundamentals Analysis As stated earlier, the box theory uses a judicious bend of both the technical and fundamentals. Darvas believed that in order to spot a good stock or even a multibagger, there should be something brewing up in the respective sector as a whole or some major fundamental change in that specific company. Generally, the fundamentals that Darvas used to study were on a broader sector level, and not the company-specific fundamentals. Even for the specific company Darvas used to look from a general perspective like, is the company launching a new product which could be a blockbuster hit. He completely refrained from looking at numbers and financial statements as his initial experiment with ratios and financial statements didn’t yield any good result. To know more on the three financial statements read: Income Statement (P&L) Balance Sheet Cash Flow Statement Technical Analysis Darvas was a big believer in price action and volume of the stock. He believed if some major fundamental changes were to take place in a company, this soon shows up in the stock price and its volume of trading as more people get interested in buying or selling the stock. With his observations here realized by just observing the price action, he can participate in the rally which gets triggered by some major fundamental development without actually knowing about the change. Using the box theory, Darvas used to scan stocks based on rising volume as he needed mass participation in the rally. Also, he only picked up those stocks that were already rising. His theory is all about “buy high, sell higher” instead of the conventional belief of “buy low, sell high”. After the stock satisfies both the parameters of increasing price and volume with major underlying fundamental change, Darvas looks to enter the stock. Good read on momentum trading. How and where to enter? Major part of the box theory is based on entry and exit levels. To enter a stock, Darvas looked for a consolidation phase preceded by a rally. A consolidation phase is the price action wherein the price moves up and down in a tight range, that is, a non-directional move. He would then mark the high and low of the consolidation phase with the horizontal line, essentially making it a box-like structure, hence the name “Box Theory”. The high point is called the ceiling, and low is called the floor. Whenever the stocks break above the ceiling, Darvas would look to buy one tick above the ceiling with one tick below floor as a stop-loss point. Pyramiding Darvas discovered early on, in order to become successful in the market your winning bets should yield much more profit than the loss in the losing bets. This led him to do pyramiding in his winning trade, which is clearly defined in the box theory. Pyramiding means to increase the existing position if the stock is going in the favour, which leads to a much higher profit in the winning trades. According to the box theory, the repetition of the entry criterion is the new signal for adding onto the existing position. In other words, after a position, if the stocks stage the same setup, that is, a consolidation after a rally, then the break above the ceiling of this new box would signal to increase position with the revised stop loss of 1 tick below the new floor. In any case, whenever the stock falls below the current floor, the entire position would we sold off at once. This is the only exit condition in the box theory, and there is no method of booking profit upfront as Darvas believed in holding on to a rising stock. The only way to book profit is to let the stock to take out the revised stop loss.

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