SkarpChapter 10 of 27
Short-Term Debt and Money Market Instruments
Survey the ultra-short-term instruments—Treasury bills, commercial paper, and more—that institutions use to manage cash and liquidity.
Big Picture: What Are Money Market Instruments?
What Is the Money Market?
The money market is where high-quality, short-term debt (maturity of one year or less) is issued and traded. It is used mainly for cash and liquidity management.
Key Characteristics
Money market instruments have very short maturities, high credit quality, low price volatility, and therefore relatively low yields compared with longer-term bonds.
Exam-Relevant Skills
You must recognize common instruments, know who issues and buys them, and explain their uses for short-term funding and investing.
Capital vs Money Market
Think of the capital market as long-term funding (bonds, stock) and the money market as where institutions handle short-term funding and park cash.
General Features: How Money Market Instruments Work
Maturities and Sizes
Money market instruments have original maturities of one year or less and are usually issued in large denominations, often $100,000 or more.
Discount Instruments
Many are sold at a discount to par with no coupons. The investor pays less than face value and receives full par at maturity; the difference is interest.
Liquidity and Safety
They are generally highly liquid and relatively safe, though credit risk varies by issuer. Treasuries are safer than corporate commercial paper.
Purpose vs Long-Term Bonds
Money markets emphasize capital preservation and liquidity, while long-term bonds focus on higher yields and long-term financing.
Treasury Bills (T-Bills): The Benchmark Money Market Instrument
What Are T-Bills?
Treasury bills are short-term U.S. government securities with maturities of one year or less, sold at a discount and paying no coupons.
Risk and Liquidity
They are backed by the full faith and credit of the U.S. government, considered free of default risk, and are among the most liquid securities.
Discount Example
A 26-week $100,000 T-bill sold for $97,500 returns $100,000 at maturity. The $2,500 difference is the investor’s interest income.
Who Uses T-Bills?
Banks, money market funds, corporations, and dealers use T-bills to park cash and as collateral; individuals may access them directly or via funds.
Commercial Paper: Corporations Borrowing Short-Term
What Is Commercial Paper?
Commercial paper is an unsecured, short-term promissory note issued by corporations and financial firms to cover short-term funding needs.
Maturities and Form
CP usually matures in 1 to 270 days and is commonly sold at a discount from par, similar to T-bills, but without government backing.
Issuer and Investor Uses
Issuers use CP for working capital and bridge financing; investors are mainly institutions and money market funds seeking modest yield.
Key Risks for SIE
Unlike T-bills, CP is unsecured and exposed to credit and liquidity risk. Remember: corporate, unsecured, short-term, usually discount.
Certificates of Deposit and Bankers’ Acceptances
Certificates of Deposit (CDs)
A CD is a time deposit at a bank. Negotiable (jumbo) CDs are large-denomination, tradable deposits and are true money market instruments.
Retail vs Negotiable CDs
Retail CDs sold to individuals are small and non-negotiable, so they are not money market securities. Negotiable CDs can be bought and sold.
What Is a Banker’s Acceptance?
A banker’s acceptance is a time draft that has been guaranteed by a bank, turning it into a marketable short-term instrument.
Use in International Trade
BAs often finance imports and exports. They are typically sold at a discount and mature in 30–180 days, with the bank’s guarantee reducing risk.
Repurchase Agreements (Repos) and Federal Funds
What Is a Repo?
A repurchase agreement is a short-term, collateralized loan: one party sells securities and agrees to buy them back later at a higher price.
Repo Example
A dealer sells $10 million of T-bills and repurchases them the next day for $10,001,000. The $1,000 difference is the interest on the overnight loan.
Federal Funds
Federal funds are overnight loans between banks of balances held at the Federal Reserve, with the federal funds rate as the interest rate.
Key Distinctions
Repos are collateralized and often involve securities; fed funds are unsecured, overnight interbank loans of reserves.
Worked Examples: Comparing Money Market Instruments
Scenario: Corporate Cash
A corporation with $50 million for 60 days might choose T-bills, high-grade commercial paper, or negotiable CDs, balancing safety, yield, and liquidity.
Scenario: Dealer Funding
A dealer finances Treasury inventory overnight through a repo, borrowing cash today and agreeing to repurchase the securities tomorrow.
Scenario: Trade Finance
In international trade, a bank issues a banker’s acceptance guaranteeing payment in 90 days; the exporter can sell it at a discount for cash now.
Risk Ranking Exercise
Credit risk from lowest to highest: T-bill, negotiable CD from a strong bank, then commercial paper from a lower-rated industrial firm.
Risks and Limitations of Money Market Investments
Credit and Liquidity Risk
T-bills have minimal default risk, but commercial paper and negotiable CDs can face credit and liquidity problems, especially in stressed markets.
Reinvestment Risk
Short maturities mean frequent reinvestment. If rates fall, investors may repeatedly reinvest at lower yields, reducing long-term returns.
Inflation Risk
Low nominal yields may not keep up with inflation, eroding purchasing power and sometimes producing negative real returns.
Suitability Considerations
Money market instruments fit short-term, safety-focused goals, but are generally too conservative for long-term growth objectives.
Thought Exercise: Matching Instruments to Needs
Use this self-check activity to connect instruments with real-world needs. Jot down your answers before checking mentally.
1. Short-term safety vs yield
You manage cash for a nonprofit and must keep $5 million absolutely safe for 3 months. Which instruments are most suitable, and which would you avoid? Explain your reasoning in one or two sentences.
- Hint: Think about credit quality and government backing.
2. Yield-seeking within the money market
A corporate treasurer is willing to take slightly more risk for a higher yield on a 90-day investment. List two money market instruments that might offer higher yields than T-bills and why.
3. Liquidity priorities
Rank these instruments from most liquid to least liquid in typical conditions: T-bills, negotiable CDs, commercial paper, banker’s acceptances.
- Then ask: in a financial crisis, how might this ranking change, if at all?
4. Reinvestment risk reflection
Suppose you roll over a series of 30-day T-bills for a year. Rates start at 4% annualized and drop to 2% by the end of the year. How does this pattern illustrate reinvestment risk compared with buying a 1-year bond at 4% and holding it?
5. Suitability question (SIE-style)
Consider these investor profiles:
- Investor A: Needs to preserve principal and access funds in 6 months for a house down payment.
- Investor B: 25 years old, saving for retirement in 40 years.
For each, state whether a money market fund is a primary, secondary, or poor choice and briefly justify.
Pause and actually think through each prompt. The reasoning you practice here is very similar to what SIE suitability questions test.
Quiz 1: Core Concepts of Money Market Instruments
Test your understanding of the basics before moving on.
Which of the following BEST describes a typical money market instrument compared with a long-term bond?
- Shorter maturity, lower credit quality, and higher price volatility
- Shorter maturity, higher credit quality, and lower price volatility
- Longer maturity, higher credit quality, and higher price volatility
- Longer maturity, lower credit quality, and lower price volatility
Show Answer
Answer: B) Shorter maturity, higher credit quality, and lower price volatility
Money market instruments are defined by their short maturities (one year or less), typically high credit quality (especially T-bills and top-tier issuers), and relatively low price volatility compared with long-term bonds. Therefore, the correct choice is 'Shorter maturity, higher credit quality, and lower price volatility.'
Quiz 2: Instrument Identification
Identify the instrument described in this scenario.
A large bank issues a $1,000,000 time deposit that pays interest, can be sold to other investors before maturity, and matures in 90 days. This is best described as:
- A retail certificate of deposit
- A Treasury bill
- A negotiable (jumbo) certificate of deposit
- Commercial paper
Show Answer
Answer: C) A negotiable (jumbo) certificate of deposit
The key clues are: large denomination ($1,000,000), time deposit at a bank, pays interest, and is tradable before maturity. That matches a negotiable (jumbo) certificate of deposit, which is a money market instrument. Retail CDs are small and non-negotiable; T-bills are issued by the U.S. Treasury and sold at a discount; commercial paper is an unsecured corporate note, not a bank deposit.
Key Money Market Terms Review
Flip through these flashcards to reinforce core definitions and exam-ready distinctions.
- Money market
- The segment of the financial market where high-quality, short-term debt instruments (original maturities of one year or less) are issued and traded, primarily for cash and liquidity management.
- Treasury bill (T-bill)
- A short-term U.S. government security with a maturity of one year or less, sold at a discount and paying no periodic interest, backed by the full faith and credit of the U.S. government.
- Commercial paper
- An unsecured, short-term promissory note issued by a corporation or financial institution, typically with a maturity from 1 to 270 days, often sold at a discount and used to finance working capital.
- Negotiable (jumbo) certificate of deposit
- A large-denomination, interest-bearing time deposit at a bank that can be traded in the secondary market and typically has a short-term maturity, making it a money market instrument.
- Retail certificate of deposit
- A smaller-denomination time deposit sold to individual investors, generally non-negotiable and not considered a tradable money market security.
- Banker’s acceptance
- A time draft that has been guaranteed (accepted) by a bank, commonly used to finance international trade and typically sold at a discount with a short-term maturity.
- Repurchase agreement (repo)
- A short-term, collateralized loan in which one party sells securities and simultaneously agrees to repurchase them at a specified later date and higher price; the difference reflects interest.
- Federal funds
- Overnight loans of reserve balances between depository institutions held at the Federal Reserve, with the federal funds rate as the interest rate on these loans.
- Reinvestment risk
- The risk that cash flows from an investment, such as maturing principal, will have to be reinvested at lower interest rates than the original investment.
- Inflation (purchasing power) risk
- The risk that the return on an investment will not keep pace with inflation, reducing the investor’s real purchasing power over time.
Key Terms
- money market
- The segment of the financial market where high-quality, short-term debt instruments (original maturities of one year or less) are issued and traded, primarily for cash and liquidity management.
- federal funds
- Overnight loans of reserve balances between depository institutions held at the Federal Reserve, with the federal funds rate as the interest rate on these loans.
- inflation risk
- The risk that the return on an investment will not keep pace with inflation, reducing the investor’s real purchasing power over time.
- commercial paper
- An unsecured, short-term promissory note issued by a corporation or financial institution, typically with a maturity from 1 to 270 days, often sold at a discount and used to finance working capital.
- reinvestment risk
- The risk that cash flows from an investment, such as maturing principal, will have to be reinvested at lower interest rates than the original investment.
- banker’s acceptance
- A time draft that has been guaranteed (accepted) by a bank, commonly used to finance international trade and typically sold at a discount with a short-term maturity.
- Treasury bill (T-bill)
- A short-term U.S. government security with a maturity of one year or less, sold at a discount and paying no periodic interest, backed by the full faith and credit of the U.S. government.
- repurchase agreement (repo)
- A short-term, collateralized loan in which one party sells securities and simultaneously agrees to repurchase them at a specified later date and higher price; the difference reflects interest.
- negotiable certificate of deposit
- A large-denomination, interest-bearing time deposit at a bank that can be traded in the secondary market and typically has a short-term maturity, making it a money market instrument.