Characteristics of Money Market Instruments

by Karen Farnen

Money market instruments channel money from investors to borrowers who need money. For an investment to qualify as a money market instrument, lenders must be able to get their money back in a year or less. Choosing among short-term securities issued by banks, companies or governments, investors make their purchases through brokers, at auction or from other institutions. The different types of money market instruments share basic characteristics, but they also have important differences.

Variety

Money market instruments include short-term bank certificates of deposit (CDs), municipal bonds, Treasury bills and other government securities. More sophisticated examples include commercial paper, repurchase agreements and bankers' acceptances. Individual investors most commonly invest in money market deposit accounts and money market mutual funds. A money market deposit account is a special type of bank or savings account that allows check writing. A money market mutual fund is not a bank account even if a bank sells it. It is a mutual fund investing in money market instruments.

Liquidity

Liquidity of an investment refers to how quickly and easily investors can access their money. Money market instruments are relatively liquid by definition because the money is available in a year or less. Fixed terms range from one day to one year. Money market deposit accounts and money market mutual funds have high liquidity, as depositors may access money by check when they need it. Some money market instruments also permit resale to secondary buyers if the investor needs the principal before maturity. Treasury bills and some special CDs fall into this category.

Return

Money market instruments pay interest to the lender. Bank money market accounts, for example, add interest on each monthly statement. Other instruments, including Treasury bills, pay interest only at maturity. A few types of money market investments pay interest exempt from federal income tax. Short-term exempt bills issued by municipal and state governments fall into this category.

Safety

Money market investments are safer than most due to their liquidity. Their liquidity minimizes long-term uncertainties about companies and governments and helps protect against interest rate increases. Instruments such as Treasury bills gain additional safety from their federal government backing. Government-insured money market deposit accounts also have protection against bank failure if their balances fall within insurance guidelines. As of the date of publication, individual accounts are federally insured for up to $250,000. Money market mutual funds do not carry government insurance, so depositors can lose money if the share price dips below $1.00.

Risks and Disadvantages

The various money market instruments have some disadvantages. The most serious risk for any investment is default. If the business or government issuing the instrument fails, the investor can lose part or all of his money. Locking up money for a relatively long period, such as one year, also increases the risk of rising interest rates. Usually investors must pay a penalty to cash out a CD ahead of time. Banks also charge fees for exceeding the allowed number of checks in a money market deposit account. Money market mutual funds typically charge a management fee of 1 percent.

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