Money Markets Explained: Treasury Bills, Commercial Paper, and More

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

This is Chapter 6 of Madura’s textbook, and it covers money markets. These are the markets where short-term debt gets traded. We are talking about securities that mature in one year or less. They might not be exciting, but they keep the financial system running.

What Money Markets Do

Money markets exist so that people, companies, and governments can park their cash for short periods or borrow funds quickly. Think of them as the financial system’s plumbing. The water (money) needs to flow from those who have extra to those who need it right now.

The U.S. Treasury issues Treasury bills to fund the budget deficit. Corporations issue commercial paper to cover day-to-day operations. Financial institutions issue their own short-term securities and then use the money to make loans to households and businesses. Everyone who buys a car, pays a mortgage, or swipes a credit card is, in some way, connected to money markets.

The Main Money Market Securities

Madura walks through six types of money market securities. Here is the quick rundown.

Treasury Bills (T-Bills)

T-bills are short-term debt issued by the U.S. government. They come in 4-week, 13-week, 26-week, and 1-year maturities. They do not pay interest in the traditional sense. Instead, you buy them at a discount and get the full face value when they mature. The difference is your return.

For example, you buy a 6-month T-bill with a $10,000 face value for $9,800. When it matures, you get $10,000. That $200 difference is your profit.

T-bills are considered virtually risk-free because the federal government backs them. They are also very liquid because there is a huge secondary market. Banks, corporations, individuals, and money market funds all hold T-bills. The weekly T-bill auction is how the government sells them, and investors can bid competitively or noncompetitively through the Treasury Direct website.

Commercial Paper

Commercial paper is unsecured short-term debt issued by well-known, creditworthy corporations. It is an alternative to borrowing from a bank, and it is usually cheaper. Maturities range from 1 to 270 days. The minimum denomination is usually $100,000, so regular people do not buy it directly. But if you own a money market fund, you probably own commercial paper indirectly.

Commercial paper carries some credit risk. Rating agencies like Moody’s, S&P, and Fitch rate it. Money market funds can only invest in top-tier or second-tier rated paper.

The credit crisis of 2008 hit the commercial paper market hard. When Lehman Brothers went bankrupt, it defaulted on hundreds of millions in commercial paper. Investors panicked and stopped buying. In two months, the commercial paper market shrank by about $370 billion. The Fed actually stepped in and started buying commercial paper to keep the market alive.

Negotiable Certificates of Deposit (NCDs)

NCDs are large deposits (minimum $100,000, usually $1 million) issued by commercial banks. They pay interest and have maturities from two weeks to one year. They have a secondary market, but it is not as active as the T-bill market. NCDs yield a bit more than T-bills to compensate for the extra risk and lower liquidity.

Repurchase Agreements (Repos)

A repo is basically a short-term loan backed by securities. One party sells securities to another and agrees to buy them back at a higher price on a set date. The difference in prices is the interest. Repo transactions are usually $10 million or more, with maturities from 1 to 15 days.

The repo market is massive, around $4.5 trillion. During the 2008 crisis, Bear Stearns relied heavily on repos and used mortgage securities as collateral. When investors stopped trusting that collateral, Bear Stearns could not get funding and nearly collapsed. The lesson: repo funding requires collateral that investors actually trust.

Federal Funds

The federal funds market is where banks lend to each other overnight. The federal funds rate is one of the most important rates in the economy because the Fed uses it as a tool for monetary policy. When you hear “the Fed changed rates,” they are usually talking about this rate. It normally sits slightly above the T-bill rate.

Banker’s Acceptances

These are used mainly for international trade. When a U.S. company imports goods from, say, Japan, and the Japanese exporter does not know the importer’s credit, a bank can step in and guarantee the payment. The bank stamps “ACCEPTED” on a draft, creating a banker’s acceptance. The exporter can then sell this acceptance at a discount to get cash immediately. Maturities range from 30 to 270 days.

How Money Market Securities Are Valued

The price of any money market security is the present value of its future cash flows. Since these securities do not pay periodic interest, the cash flow is just the lump sum you get at maturity. The price formula is simple:

Price = Par Value / (1 + required return)^n

When interest rates go up, required returns go up, and money market prices go down. But because these securities mature so quickly, they are much less sensitive to interest rate changes than bonds. That is the whole point of holding them: they are safe and liquid.

Going Global

Money markets are not just an American thing. As international trade grew, money markets developed worldwide. Interest rates vary among countries based on local supply and demand for short-term funds.

Madura introduces Eurodollars, which are U.S. dollar deposits held in banks outside the United States. Eurodollar CDs, Euronotes, and Euro-commercial paper are all variations. The rates in the Eurodollar market are tied to LIBOR, the London Interbank Offer Rate.

Speaking of LIBOR, Madura mentions the 2012 scandal where banks were caught falsely reporting their interbank lending rates to manipulate LIBOR. Even a tiny manipulation of 0.1 percent could generate millions in profits from derivative positions. It was a reminder that even the most fundamental market benchmarks can be corrupted.

Who Uses Money Markets

Every major financial institution participates. Commercial banks issue NCDs, borrow and lend federal funds, and do repos. Finance companies issue commercial paper. Money market mutual funds buy everything. Insurance companies and pension funds keep money market holdings for liquidity. The entire financial system depends on these markets working smoothly.

My Take

This chapter is a good reminder that the flashy stuff in finance (stocks, IPOs, crypto) gets all the attention, but the boring stuff keeps the lights on. Money markets are the short-term lending infrastructure that every corporation and financial institution depends on. Nobody talks about commercial paper at dinner parties, but when it stops working (as it did in 2008), the entire economy feels it.

The Lehman Brothers and Bear Stearns examples really drive home how interconnected everything is. One firm’s failure in one market can freeze up completely different markets overnight. That is systemic risk in action.

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