sible for their nation’s monetary policy. Go to
tral banks (for example, Norway). Review that bank’s
tion of monetary policy. How does this bank’s poli-
cies compare to those of the U.S. central bank?
The Money Markets
Preview
If you were to review Microsoft’s annual report for 2009, you would find that the
company had over $6 billion in cash and equivalents. The firm also listed
$25 billion in short-term securities. The firm chose to hold over $30 billion in
highly liquid short-term assets in order to be ready to take advantage of invest-
ment opportunities and to avoid the risks associated with other types of invest-
ments. Microsoft will have much of these funds invested in the money markets.
Recall that money market securities are short-term, low-risk, and very liquid.
Because of the high degree of safety and liquidity these securities exhibit, they
are close to being money, hence their name.
The money markets have been active since the early 1800s but have
become much more important since 1970, when interest rates rose above his-
toric levels. In fact, the rise in short-term rates, coupled with a regulated ceiling
on the rate that banks could pay for deposits, resulted in a rapid outflow of
funds from financial institutions in the late 1970s and early 1980s. This outflow
in turn caused many banks and savings and loans to fail. The industry regained
its health only after massive changes were made to bank regulations with
regard to money market interest rates.
This chapter carefully reviews the money markets and the securities that
are traded there. In addition, we discuss why the money markets are important
to our financial system.
PA R T F I V E F I N A N C I A L M A R K E T S
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C H A P T E R
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The Money Markets Defined
The term money market is actually a misnomer. Money—currency—is not traded in
the money markets. Because the securities that do trade there are short-term and
highly liquid, however, they are close to being money. Money market securities, which
are discussed in detail in this chapter, have three basic characteristics in common:
• They are usually sold in large denominations.
• They have low default risk.
• They mature in one year or less from their original issue date. Most
money market instruments mature in less than 120 days.
Money market transactions do not take place in any one particular location or
building. Instead, traders usually arrange purchases and sales between participants
over the phone and complete them electronically. Because of this characteristic,
money market securities usually have an active secondary market. This means that
after the security has been sold initially, it is relatively easy to find buyers who will
purchase it in the future. An active secondary market makes money market securi-
ties very flexible instruments to use to fill short-term financial needs. For example,
Microsoft’s annual report states, “We consider all highly liquid interest-earning invest-
ments with a maturity of 3 months or less at date of purchase to be cash equivalents.”
Another characteristic of the money markets is that they are wholesale markets.
This means that most transactions are very large, usually in excess of $1 million. The
size of these transactions prevents most individual investors from participating directly
in the money markets. Instead, dealers and brokers, operating in the trading rooms
of large banks and brokerage houses, bring customers together. These traders will buy
or sell $50 or $100 million in mere seconds—certainly not a job for the faint of heart!
As you may recall from Chapter 2, flexibility and innovation are two important
characteristics of any financial market, and the money markets are no exception.
Despite the wholesale nature of the money market, innovative securities and trad-
ing methods have been developed to give small investors access to money market
securities. We will discuss these securities and their characteristics later in the chap-
ter, and in greater detail in Chapter 20.
Why Do We Need the Money Markets?
In a totally unregulated world, the money markets should not be needed. The bank-
ing industry exists primarily to provide short-term loans and to accept short-term
deposits. Banks should have an efficiency advantage in gathering information, an
advantage that should eliminate the need for the money markets. Thanks to con-
tinuing relationships with customers, banks should be able to offer loans more cheaply
than diversified markets, which must evaluate each borrower every time a new secu-
rity is offered. Furthermore, short-term securities offered for sale in the money
markets are neither as liquid nor as safe as deposits placed in banks and thrifts. Given
the advantages that banks have, why do the money markets exist at all?
The banking industry exists primarily to mediate the asymmetric information
problem between saver-lenders and borrower-spenders, and banks can earn profits by
capturing economies of scale while providing this service. However, the banking indus-
try is subject to more regulations and governmental costs than are the money mar-
kets. In situations where the asymmetric information problem is not severe, the money
markets have a distinct cost advantage over banks in providing short-term funds.
Chapter 11 The Money Markets
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