Lesson 5

What is a Money Market Account?

• A money market account is a type of savings account that typically offers higher interest rates in exchange for higher minimum balance requirements.

Definition of Money Market

• The money market refers to the network of corporations, financial institutions, investors, and governments that manage the flow of short-term capital.

Functions of Money Market

• Businesses need cash for short periods until payments are received.

• Banks invest deposits of customers that can be withdrawn anytime.

• Governments may utilize short-term liquidity to manage payrolls amidst seasonal tax fluctuations.

Accessibility of Money Market

• Investors can deposit money with investment companies offering competitive interest rates without long-term commitments.

• Borrowers can access short-term debt from investors at competitive rates, avoiding traditional bank loans.

Mechanism of Money Market

• Money markets connect borrowers and lenders directly, reducing costs compared to bank intermediation.

• This allows borrowers to address short-term liquidity needs and irregular cash flows efficiently.

Currency and Interest Rates in Money Market

• Each currency has its identifiable money market due to varying interest rates.

• Investors and borrowers may shift funds based on relative interest rates across currencies; however, regulations can limit foreign investments.

Operations of Money Market

• The money markets do not operate in a specific location or under a single regulatory framework.

• They consist of web-like networks among borrowers and lenders, linked by technology, with central banks influencing interest rates.

Participants in Money Market

• Key players include treasurers from businesses and government agencies focused on safe and profitable cash investment.

• Banks and investment companies facilitate trading, ensuring competitiveness.

Impact of Financial Crisis (2007)

• Money markets faced significant challenges during the 2007 financial crisis as investors became risk-averse, valuing capital safety over returns.

• Many banks appeared distressed, leading to credit reluctance even for short-term lending, halting normal money market functions and leading to recession.

Money Market Statistics

• In 2012, approximately $13 trillion in money-market instruments circulated globally; a drop from $14 trillion in 2008 but up from $6 trillion in 2001.

Nature of Money Markets

• Money markets generally pertain to the buying and selling of short-term debt instruments maturing in one year or less.

• They provide credit without ownership or management control in the borrowing entities.

Economic Role of Money Markets

• Active money markets provide benchmarks for longer-term securities, impacting interest rates across financial instruments.

• They ensure liquidity, allowing continual short-term transactions that keep longer-term rates low.

Investment Perspective

• Small investors often find short-term instruments less attractive due to high assessment costs relative to low yield.

• Thus, investors usually opt for money-market funds to pool resources.

Money-Market Funds

• Retail money-market funds cater to individual investors, while institutional funds serve corporations, foundations, and government agencies.

• Money-market funds offer lower operational costs than banks due to the absence of branch maintaining costs.

Intermediation Cost Efficiency

• Money-market funds don’t need to reserve funds for potential losses, allowing them to offer higher interest than banks.

Spread Analysis

• The difference between what money-market funds pay investors and charge borrowers is significantly smaller compared to banks.

Post-2008 Trends

• After 2008, many investors reduced their money-market holdings due to declining interest rates, with many funds showing annual rates below 1%.

Stable Value Funds

• Stable value funds advertise consistent share value despite fluctuating interest rates, typically maintaining a $1 value per share.

• However, underlying securities values may fluctuate, sometimes requiring fund operators to cover losses to maintain fixed share values.

Vulnerability During Crisis

• In 2009, some money market funds faced valuation losses linked to bank failures, leading to instances of "breaking the buck."

Central Bank Involvement

• Central banks can lend directly to money markets, assisting financial institutions amid liquidity crises.

• Their loan rates are generally less attractive than market options to encourage private borrowing first.

Monitoring Interest Rates

• Differences in interest rates across instruments are critical indicators of market expectations.

• Central banks and investors closely watch these rates, including overnight rates and prime rates affecting consumer credit.