Money market and types of money market instruments

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Money market and types of money market instruments

  1. 1. Money Market and Types of Money MarketInstrumentsRead more at: http://www.goodreturns.in/classroom/2011/07/money-market-and-types-of-money-market-instruments-28.html Money Market is the part of financial market where instruments with highliquidity and very short-term maturities are traded. The money market is used byparticipants as a means for borrowing and lending in the short term, from several daysto just under a year. Its the place where large financial institutions, dealers andgovernment participate and meet out their short-term cash needs.They usually borrow and lend money with the help of instruments or securities to generateliquidity. Due to highly liquid nature of securities and their short-term maturities, moneymarket is treated as safe place.Role of Reserve Bank of India: The Reserve Bank of India (RBI) plays a key role ofregulator and controller of money market. The intervention of RBI is varied – curbing crisissituations by reducing key policy rates or curbing inflationary situations by rising key policyrates such as Repo, Reverse Repo, CRR etc.Money Market Instruments: Money Market Instruments provide the tools by which onecan operate in the money market. Money market instrument meets short term requirementsof the borrowers and provides liquidity to the lenders. The most common money marketinstruments are Treasury Bills, Certificate of Deposits, Commercial Papers, RepurchaseAgreements and Bankers Acceptance. a) Treasury Bills (T-Bills): Treasury Bills are one of the safest money market instruments as they are issued by Central Government. They are zero-risk instruments, and hence returns are not that attractive. T-Bills are circulated by both primary as well as the secondary markets. They come with the maturities of 3-month, 6-month and 1-year. The Central Government issues T-Bills at a price less than their face value and the difference between the buy price and the maturity value is the interest earned by the buyer of the instrument. The buy value of the T-Bill is determined by the bidding process through auctions. At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. b) Certificate of Deposits (CDs): Certificate of Deposit is like a promissory note issued by a bank in form of a certificate entitling the bearer to receive interest. It is similar to bank term deposit account. The certificate bears the maturity date, fixed rate of interest and the value. These certificates are available in the tenure of 3 months to 5 years. The returns on certificate of deposits are higher than T-Bills because they carry higher level of risk. 1
  2. 2. c) Commercial Papers (CPs): Commercial Paper is the short term unsecured promissory note issued by corporate and financial institutions at a discounted value on face value. They come with fixed maturity period ranging from 1 day to 270 days. These are issued for the purpose of financing of accounts receivables, inventories and meeting short term liabilities. The return on commercial papers is is higher as compared to T-Bills so as the risk as they are less secure in comparison to these bills. It is easy to find buyers for the firms with high credit ratings. These securities are actively traded in secondary market. d) Repurchase Agreements (Repo): Repurchase Agreements which are also called as Repo or Reverse Repo are short term loans that buyers and sellers agree upon for selling and repurchasing. Repo or Reverse Repo transactions can be done only between the parties approved by RBI and allowed only between RBI-approved securities such as state and central government securities, T-Bills, PSU bonds and corporate bonds. They are usually used for overnight borrowing. Repurchase agreements are sold by sellers with a promise of purchasing them back at a given price and on a given date in future. On the flip side, the buyer will also purchase the securities and other instruments with a promise of selling them back to the seller. e) Bankers Acceptance: Bankers Acceptance is like a short term investment plan created by non-financial firm, backed by a guarantee from the bank. Its like a bill of exchange stating a buyers promise to pay to the seller a certain specified amount at a certain date. And, the bank guarantees that the buyer will pay the seller at a future date. Firm with strong credit rating can draw such bill. These securities come with the maturities between 30 and 180 days and the most common term for these instruments is 90 days. Companies use these negotiable time drafts to finance imports, exports and other trade.Call money marketThe call money market deals in short term finance repayable on demand, with a maturityperiod varying from one day to 14 days. Commercial banks, both Indian and foreign, co-operative banks, Discount and Finance House of India Ltd.(DFHI), Securities tradingcorporation of India (STCI) participate as both lenders and borrowers and Life InsuranceCorporation of India (LIC), Unit Trust of India(UTI), National Bank for Agriculture andRural Development (NABARD)can participate only as lenders. The interest rate paid on callmoney loans, known as the call rate, is highly volatile. It is the most sensitive section of themoney market and the changes in the demand for and supply of call loans are promptlyreflected in call rates. There are now two call rates in India: the Interbank call rate and thelending rate of DFHI. The ceilings on the call rate and inter-bank term money rate weredropped, with effect from May 1, 1989. The Indian call money market has been transformedinto a pure inter-bank market during 2006–07. The major call money markets arein Mumbai, Kolkata, Delhi, Chennai, Ahmedabad. 2
  3. 3. Concept of Repo Rate and Reverse Repo RateRepo (Repurchase) Rate: Repo rate also known as Repurchase rate is the rate at whichbanks borrow funds from the RBI to meet short-term requirements. RBI charges someinterest rate on the cash borrowed by banks. This interest rate is called repo rate. If the RBIwants to make it more expensive for the banks to borrow money, it increases the repo rate;similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.Reverse Repo Rate: Reverse Repo rate is the rate at which Reserve Bank of India (RBI)borrows money from banks. This is the exact opposite of repo rate. RBI uses this tool whenit feels there is too much money floating in the banking system. If the reverse repo rate isincreased, it means the RBI will borrow money from the bank by offering lucrative rate ofinterest. Banks feel comfortable lending money to RBI since their money would be in safehands and with a good interest. It is also a tool which can be used by the RBI to drain excessmoney out of the banking system.Money Market & Capital Market:  Money Market is a place for short term lending and borrowing, typically within a year.  It deals in short term debt financing and investments. On the other hand, Capital Market refers to stock market, which refers to trading in shares and bonds of companies on recognized stock exchanges.  Individual players cannot invest in money market as the value of investments is large, on the other hand, in capital market, anybody can make investments through a broker.  Stock Market is associated with high risk and high return as against money market which is more secure.  Further, in case of money market, deals are transacted on phone or through electronic systems as against capital market where trading is through recognized stock exchanges.Benefits and functions of Money Market: • Money markets exist to facilitate efficient transfer of short-term funds between holders and borrowers of cash assets. • For the lender/investor, it provides a good return on their funds. • For the borrower, it enables rapid and relatively inexpensive acquisition of cash to cover short-term liabilities. • One of the primary functions of money market is to provide focal point for RBI’s intervention for influencing liquidity and general levels of interest rates in the economy. RBI being the main constituent in the money market aims at ensuring that liquidity and short term interest rates are consistent with the monetary policy objectives. 3
  4. 4. Functions of the money marketThe money market functions are • transfer of large sums of money • transfer from parties with surplus funds to parties with a deficit • allow governments to raise funds • help to implement monetary policy • determine short-term interest ratesParticipants  Participants in the call money market are  scheduled commercial banks,  non-scheduled commercial banks,  foreign banks,  state, district and urban,  cooperative banks,  Discount and Finance House of India (DFHI) and  Securities Trading Corporation of India (STCI).  The DFHI and STCI borrow as well as lend, like banks and primary dealers, in the call market. At one time, only a few large banks, particularly foreign banks, operated in the call money market.Short essay on Indian Money MarketIn India the money market plays a vital role in the progress of economy. But, it is not welldeveloped when compared to American and London money markets. In this market short-termfunds are borrowed and lent among participants permitted by RBI.Money Market ensures that institutions which have surplus funds earn certain returns on thesurplus. Otherwise these funds will be idle with the institutions. Similarly, the money marketensures funds for the needy at reasonable interest. This way liquidity position is assured bymoney market operations.Let us now discuss the various money market instruments in India. In India the Money Marketis regulated by RBI. Hence, the instruments traded and the players in the market require to beapproved by RBI. The instruments currently traded are as follows:(i) Call Money:Call money is a method of borrowing and lending for one day. This is also called overnightmoney. The rate of interest used to be decided by RBI earlier. After 1989, the interest rate wasderegulated and now the liquidity position (availability of funds) determines the rate ofinterest. 4
  5. 5. The lender issues a cheque or pay order or its account maintained with RBI in favour ofborrower. Accordingly, RBI transfers funds by debit to lenders account to the borrowersaccount.On repayment, the process is reversed through RBI. In times of tight money, situation orliquidity crunch, the call money interest rate goes up even beyond 50 per cent per annum.Only permitted organizations like scheduled commercial banks, large co-operative banks,DHFI, Primary dealers, NABARD are permitted to borrow funds through call money market.However, funds can be provided or lent even by other entities like LIC, GIC, large corporate,big mutual funds, etc.(ii) Notice Money / Short-term Money:Under Notice/Short-term Money Market, funds are borrowed and lent for a maximum periodof 14 days. Repayment requires a formal notice or demand from the lender. Interest rate isdecided by the market forces. The market is similar to call money market explained above.(iii) Treasury Bills:It is the most important money market instrument for the central government. Treasury Billsare short-term promissory notes issued by RBI on behalf of Central Government for raisingfunds to meet shortfalls in revenue collections, i.e., to meet revenue expenditure.These are issued at discount to face value. RBI auctions these Treasury Bills at regularperiodical intervals, i.e., weekly and fortnightly. These days five types of Treasury Billsdepending upon their maturity are auctioned by RBI.These are 14-day Treasury Bills; 28-day Treasury Bills, 91-day, 182 day and 364 day TreasuryBills. Any person can invest in Treasury Bills. These are very high liquid and safe instruments.Treasury Bills are approved securities for investment by banks under SLR requirement.(iv) Commercial Bills:Banks are discounting Commercial Bills drawn by business entities/organisations. Banks canget such discounted bills rediscounted in Money Market. It is not necessary for banks torediscount each and every discounted bill.Banks can certify the large number of bills intended to be rediscounted through a singledocument known as "Derivative Usance Promissory Note" (DUPN). In other words, DUPN isa money market instrument backed by genuine commercial bills.Banks can get the value of DUPN discounted and obtain funds. This way banks can borrowfunds without transferring the bills. It is necessary that the original bills in the portfolio ofbanks should not be drawn for period exceeding 120 days. The maturity of DUPN, however,should not exceed 90 days.(v) Commercial Paper:Commercial Paper (C.P.) is a short-term money market instrument issued by eligiblecorporates for raising funds to meet working capital needs. It was introduced in 1989. The C.P.is in nature of negotiable usance promissory notes issued at a discount to face value.The C.P. should have fixed maturity period of not less than 30 days and not more than oneyear. Corporates having fund-based working capital facility of Rs. 4 crore or more from banksare only eligible to issue C.Ps. Aggregate value of C.Ps. which can be issued by a corporate islimited to the maximum working capital facility fixed by the banks.Investors in C.Ps. should have a minimum investment of Rs. 10 lakh and multiples of Rs. 5lakh thereafter. The RBI decides about the eligibility criteria for corporates to raise fundsthrough C.Ps. on the basis of working capital fund limit (Rs. 4 crore or more); minimumcurrent ratio (1.33); and minimum credit rating (P2 of CRISIL or A2 of ICRA, etc.).Primary Dealers are also recently permitted to issue C.Ps. Funds raised through C.Ps. shouldnormally be cheaper as compared to bank funds. Hence, corporates raise funds through issueof C.Ps. only when the money market interest rates are fairly low.(vi) Certificate of Deposits: 5
  6. 6. It is another form of short-term time deposit. The receipt issued for such a deposit is calledCertificate of Deposit. Banks can raise short-term funds, say for 3 or 6 months at rate ofinterest different from its normal Time Deposit rate through issue of C.Ds. Interest is paidfrom the date of purchase till maturity.Banks issue C.Ds. to manage liquidity and to raise funds at marginally varying rate of interestas compared to short-term deposit rates. As per RBI regulations C.Ds. can be issued for aminimum maturity of 3 months and a maximum period of 1 year.Minimum investment should be of Rs.10 lakh and further investments should be in multiple ofRs. 5 lakh. These are issued at discount to face value. In India this instrument was firstintroduced in 1989. Individuals, Corporates, Trusts and any persons can invest in Certificate ofDeposits.(vii) Inter-Bank Participation Certificates:Inter-Bank Participation Certificates or simply Participation Certificates (PC) are short-termpapers issued by scheduled commercial banks to raise funds from other banks against big loanportfolios.When banks are short of liquidity to carry on their immediate operations and need short-termfunds, they may approach other banks to share/participate in their lending portfolios. In otherwords, part of the specified loans and advances of the borrowing bank will be passed on to thelender-bank against cash.This will have the effect of reducing the exposure of borrower-bank on its particular loanportfolio and increase in the portfolio of lender-bank when the participation is withoutrecourse basis.Borrower-banks can have access to the facility only, up to certain percentage (currently 40%)of their standard or performing assets, i.e., Loans and Advances which are being servicedwithout default. PCs. can be issued only for a maximum period of 180 days and not less than a90-day period.(viii) Inter-Corporate Deposits:Inter-Corporate Deposits or ICD is another money market instrument for corporate to parktheir temporary surplus funds with other corporate. What a participation certificate for banksis an inter-corporate deposits between corporate.Under ICD, corporate lend temporary funds generally to their own group companies;otherwise the credit risk will be higher. Any corporate can issue the instrument without therebeing any prescription about minimum size of such lending and borrowings. This market is notwell-regulated for want of adequate information.(ix) Repo Instruments:Repo or Repurchase Transactions have been explained in Chapter 14. RBI conducts Repotransactions to influence short-term interest level in money market. By Repo operation the RBItransmit interest rate signals to the market. When it announces a fixed rate Repo for certainnumber of days/period it conveys its intention to the market about the desirable level of ashort-term interest rate.Due to greater level of integration among money market, foreign exchange market andTreasury Bill Market, the Repo transactions ensure stability of short-term rates in all the threemarkets. At the same time Repo transactions of RBI provide an opportunity to banks to parttheir surplus funds with a minimum rate of return.You may understand that when RBI conducts repos, the short-term interest rate in the moneymarket may not go below the RBI repo rate as, if rate of interest is lower in other markets,holders of funds may go for Repos with RBI. The RBI also provides liquidity support, i.e.,infusion of funds into the market by conducting reverse Repo transactions with PrimaryDealers against Government Securities. 6

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