Money Market Instruments

Corporations, financial institutions, and government organizations are continually borrowing and lending money. These institutions often have excess money or a need to borrow for very short terms. Often, they borrow money by issuing bonds, but they often will raise money through money market instruments (aka cash equivalents), which consists of short-term, very low risk securities.

The money market is the market for buying and selling short-term loans and securities. The buyer of the money market instrument is the lender of money and the seller is the borrower of money. Capital markets are the other part of the financial markets, which consists of longer term or riskier securities, such as stocks, bonds, currencies, and derivatives. The main function of the money markets is to provide liquidity, so that those who have it can earn interest on it and those who need it can get it by paying the interest. Most of the major players in the money markets have many daily expenditures and receipts of cash, but they are rarely equalized for any one institution — some will have a surplus, others, a deficit. Thus, the money market allows the institutions that are short of cash to quickly acquire it from those who have an excess of cash for that period. The money markets consist of a network of dealers and brokers who transact trades over the telephone or electronically. Most of the trading in the United States (US) is done in New York City, which has a high concentration of major banks. Most transactions are settled immediately, where money is electronically transferred from the Federal Reserve account of the buyer to the Federal Reserve account of the seller. The money market instruments themselves are never traded; instead, the securities are held at certain banks and recorded as book entries, which lists the owners of the securities. When the securities are sold, the names of the previous owners are changed to those of the buyers.

Money market instruments can be negotiable or nonnegotiable. Negotiable money market instruments, such as commercial paper or negotiable certificates of deposit, can be traded in secondary market places; nonnegotiable money market instruments cannot be traded, so there is no secondary marketplace and must be held until maturity, such as interbank loans, repos, and federal funds. Nonnegotiable money market instruments generally have a very short maturity — often, such as with repos, with terms of a single day, so there is little need for a secondary market.

While money market instruments are diverse, they have several features in common. All have terms of less than 1 year, with most less than 6 months. Many money market instruments have terms of 270 days or less, because any instruments with longer maturities would have to be registered with the SEC under the Securities Act of 1933. Money market instruments have very low credit default risk and interest-rate risk. Credit default risk is low because only the most creditworthy institutions can participate in the money markets. Interest-rate risk is very low because of their short maturities. They also have high liquidity because of their short maturities or because they have highly liquid secondary markets. Transaction costs are also very low. For instance, $1 million worth of Treasury securities can be traded for less than $1.

A few money market instruments — certificates of deposit, federal funds, and repurchase agreements — are add-on instruments that are sold at par value: interest is added on to the principal when the loan is repaid. But most money market instruments, because of their short terms, are usually issued at a discount — interest is paid when the holder of the money market instrument is paid par at maturity. Because money market instruments are discounted, their yield is quoted either using the bond equivalent yield, using the actual/actual day-count convention, which is the bond yield that is equivalent to the discount, or the money market yield, which uses the actual/360 day-count convention. Either yield allows an investor to easily compare yields among different instruments and securities.

Bond Equivalent Yield (BEY)

Sometimes the yields listed for short-term discount instruments have simply been annualized without compounding the interest. This simplifies the math and can be calculated using a calculator that doesn't have a root or exponential function. This uncompounded annual interest rate is simply called the annual interest rate to distinguish it from the effective annual yield, but, most often, it is called the bond equivalent yield (BEY) (aka investment rate yield, equivalent coupon yield). The BEY uses the actual/actual day-count convention, where each day in the term and the year is counted. The BEY is used for some money market instruments. The simplified formula appears below:

BEY = Interest Rate per Term × Number of Terms per Year

Below is the formula relating BEY to the face value, price paid for the instrument, and days left to maturity:

Formula for Calculating the Annualized Bond Equivalent Yield (BEY)
Interest Rate Per Term Number of Terms per Year
BEY = Face Value − Price Paid
Price Paid
× Actual Number of Days in Year
Days Till Maturity

Note that this yield is not compounded, but is the simple interest rate annualized. However, if you only have the simple interest rate of a discount instrument, then this rate can be converted directly to any compounded rate of interest by using the formula for the present and future value of a dollar. (See Calculating the Interest Rate of a Discounted Financial Instrument for more info.)

Example: Calculating the Bond Equivalent Yield of a T-Bill

If you buy a 4-week T-bill with a face value of $1,000 for $996.50, what is the bond equivalent yield, assuming it is not a leap year?

($1,000-$996.50)/$996.50 × 365/28 = 4.58% (rounded)

Example: Formula for Finding the Annualized Effective Compounded Rate of Interest for a Discounted Note

To find the compounded rate of interest for a discounted money market instrument:

  1. Divide the par value by the discounted price.
  2. Raise the result by the number of terms in 1 year, then subtract 1.

So if you bought a 4-week T-bill for $996.50 and receive $1,000 4 weeks later, what is the effective annual compounded interest rate earned?


Since there are 13 4-week periods in a year, this T-bill rate compounded 13 times would equal:

(See how the future value of a dollar is calculated to understand the reasoning better.)

You can use this formula for calculating the yields of any money market instrument sold at a discount.

Money Market Yields

Although some money market instruments use the bond equivalent yield formula, most money market instruments use the actual/360 day-count convention, meaning that each year — called a banker's year — consists of 360 days. Thus, the formula above can be modified to calculate the money market yield (MMY):

Formula for Calculating the Annualized Money Market Yield (MMY)
Interest Rate Per Term Number of Terms per Year
Money Market Yield = Earned Interest
Price Paid
× 360
Days Till Maturity

It is also easy convert between them:

BEY = MMY × 365 / 360

MMY = BEY × 360 / 365

Example: a 90-day money market instrument has an annual money market yield of 2%. The bond equivalent yield equals:

BEY = 2% × 365/360 = 0.02 × 1.014 = 0.02028 = 2.028%

If the money market instrument has a bond equivalent yield of 2%, then the money market yield equals:

MMY = 2% × 360 / 365 = 0.02 × 0.986 = 0.0197 = 1.97%

U.S. Treasury Bills (aka T-bills)

Treasury bills are issued by the federal government and have terms of 28, 91, or 182 days, and are virtually free of credit risk. They are the most actively traded money market securities with very low bid/ask spreads due to their liquidity, and they are also exempt from state or municipal taxes. Retail investors can buy T-bills directly from the Treasury at

Federal Funds

The Federal Reserve requires each bank of the Federal Reserve System to maintain a minimum of deposits at the Federal Reserve bank to ensure that the bank can meet customer obligations. Federal funds (aka Fed funds) is the money that banks deposit at the Federal Reserve to comply with this requirement. However, some banks, especially in the large financial centers of major cities like New York, Chicago, and San Francisco, have greater loan requirements than most other banks, and often do not have enough to maintain their reserve requirements. So these banks borrow from other banks that have an excess amount of money over the requirement. Banks will lend their excess reserves to other banks, or borrow $1 million and up, if they are short, paying the federal funds rate of interest, usually for 1 day, since most of these loans are overnight loans. Some banks that are always short on money may borrow for longer terms — from 1 week to 6 months or, in rare cases, longer — from banks that usually have excess reserves. These longer term Fed funds are called term Fed funds. The federal funds rate is extremely volatile, and is regulated by the Federal Reserve as a means to control the supply and demand of money.

Repurchase Agreements (aka Repos, Sale-Repurchase Agreements)

Repurchase agreements (aka repos) are contracts that are sold, often for 1 day or a few days, with a minimum denomination of $1,000,000, with the stipulation that they will be repurchased for a price that is higher by the amount of the interest, called the repo rate.

Government security dealers typically use repos to finance the purchase of government debt, especially Treasuries. For instance, if a government bond dealer wanted to buy $1 billion worth of Treasuries, he may submit a winning bid for that amount, but pay only $300,000,000 and finance the rest by promising the U.S. Treasury that he will pay for the rest later, after he has customer orders for the rest of the purchase, usually by the next day (an overnight repo). The Treasury will charge daily interest on all issues bid, but not yet paid for. If the bond dealer can sell the Treasuries for more money than he paid, then the dealer makes a profit; if he sells the Treasuries for less, then the dealer will suffer a loss.

In a reverse repo, the dealer buys the securities with the stipulation that the dealer can sell them back for a higher price — the additional interest. The dealer is, in effect, lending the seller money and keeping the securities as collateral.

Term repos have longer maturities of a week to a few months. The market for term repos is larger than the market for overnight repos.

Sometimes a dealer will have an open repo contract with a lender to provide funds on a continuing basis, and that allows the dealer the right of substitution — to substitute securities of equal or greater value for the loans. Either party may cancel the contract at any time.

Repos are considered safer than Fed funds because they are collateralized, so the repo rate ranges from 10 to 200 basis points below the Fed funds rate.

Because repurchase agreements are private agreements between 2 parties, there is no secondary market for repos, especially considering their very short terms of 1 or more days.

Bankers' Acceptance

A banker's acceptance is a commercial bank draft requiring the bank to pay the holder of the instrument a specified amount on a specified date, which is typically 90 days from the date of issue, but can range from 1 to 180 days. The banker's acceptance is issued at a discount, and paid in full when it becomes due — the difference between the value at maturity and the value when issued is the interest. If the banker's acceptance is presented for payment before the due date, then the amount paid is less by the amount of the interest that would have been earned if held to maturity.

A banker's acceptance is used for international trade as means of verifying payment. For instance, if an importer wants to import a product from a foreign country, he will often get a letter of credit from his bank and send it to the exporter. The letter of credit is a document issued by a bank that guarantees the payment of the importer's draft for a specified amount and time. Thus, the exporter can rely on the bank's credit rather than the importer's. The exporter presents the shipping documents and the letter of credit to his domestic bank, which pays for the letter of credit at a discount because the exporter's bank will not receive the money from the importer's bank until later. The domestic bank then sends a time draft to the importer's bank, which then stamps it "accepted" and, thus, converting the time draft into a banker's acceptance. This negotiable instrument is backed by the importer's promise to pay, the imported goods, and the bank's guarantee of payment.

Commercial Paper

Creditworthy corporations can borrow from banks for the prime rate of interest, but they may be able to borrow at a lower rate by selling commercial paper to institutional investors — usually banks, pension funds, and other corporations — and the public.

Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date, and are issued by corporations with excellent credit who, thus, avoid borrowing money from a bank. They are issued at a discount, with minimum denominations of $100,000. The main purchasers are other corporations, insurance companies, commercial banks, and mutual funds. Terms range from 1 to 270 days. Commercial paper is the least traded money market instrument in the secondary market.

Finance companies sell 2/3 of the total commercial paper, and sell their issues directly to the public. But corporations that borrow less frequently sell their commercial paper — called industrial paper — to paper dealers, who then sell them at a markup to other investors. A round lot for a paper dealer is $250,000.

Negotiable Certificates of Deposit

Before 1986, the Federal Reserve Board restricted the amount of interest that banks could pay for savings or other time deposits. Often, corporations would have money available for lending, but banks couldn't compete for this money because of the interest rate restriction. Negotiable CDs were a means around the restrictions.

Negotiable certificates of deposit (aka jumbo certificates of deposits, jumbo CDs) are tradable certificates issued by commercial banks as unsecured time deposits. Terms range from a minimum of 14 days to 1 year or more. Most have terms of 1 to 3 months, but some can have maturities of 3 to 5 years, or longer. They have a minimum denomination of $100,000, but usually are issued in denominations of $1,000,000 or more. Most CDs have a fixed rate of interest, although there are some that pay a variable rate of interest. CDs are actively traded in the secondary market in round lots of $5,000,000.

Broker's Loans and Call Loans

Broker's loans are loans from commercial banks to brokers so that the broker's customers can finance stock purchases. The broker uses the stocks, held in street name, for collateral for the loans.

Time notes are loans that must be paid by a specific date for a specified interest rate, with terms of 6 months or less. A demand note (aka call loan) is a loan payable on demand the next day at 1 day's interest. If the note is not demanded, then the term is extended by another day, etc., up to 90 days. The interest rate for each day varies with the prevailing interest rate.

Eurodollars, Eurocurrency

Eurodollars usually refers to U.S. dollars deposited in banks outside of the United States. Eurocurrency is a more general term that can refer to any currency that is deposited in banks whose domestic currency is different from the deposited currency, and it can involve any country, including the Far East and the Cayman Islands. Eurodollars or Eurocurrency does not necessarily involve either Europe or the Euro. Multi-national corporations deposit their domestic currency in foreign banks because they can often get better terms trading their currency with the locals than by exchanging domestic currency for foreign currency at a domestic bank. Sometimes currency is deposited in foreign banks so that they are not subject to freezing or seizure by the local government. The interest paid on these deposits is usually equal to the London Interbank Offer Rate (LIBOR), which is slightly higher than the yield for 3-month Treasuries.

This is a sample of key money rates that were published in the Wall Street Journal on April 20, 2007. Note that because many of these rates are negotiated between private parties, and the rates fluctuate throughout the day, these rates are mostly averages that do not necessarily reflect individual transactions. Note also how the yields of the various money market instruments compare with the key interest rates.
A sample listing of key money rates for the United States and international markets.
Source: Wall Street Journal, April 20, 2007.