Understanding the field of finance: Part I

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Finance is a hard concept to crack, even though we have had it as a subject while schooling (of course the basic level.) Due to various jargons and complicated terms, it seems hard to comprehend for people having a non-finance background. I have tried to simplify various types of markets and their segments to give you basic understanding over them. This is the first article of this series covering money market concept; the entire series would range over the money market to capital market, derivate market to OTC market and more!

 What is a financial market?

Financial market is a platform for buyers and sellers to trade various financial assets such as shares, securities, bonds, derivatives, commodity and more. Financial markets play a very crucial role in the economic activities of every nation. Financial markets are well regulated and thus act as an authentic place for transparent prices of assets to trade. The number of participants in a financial market varies from its size and functioning, but retail investors, financial institutions, investment banks, broking firms, etc. are common ones.

Money market:

Money market is the market place that satisfies the short-term requirements of borrowers by providing great liquidity on instruments such as Treasury Bills (T-bills), Commercial papers, Certificate of Deposits (CDs), etc. Money market is considered as safest and easy to liquidate marketplace. Instruments traded on money market are short-term in nature having the maturity of one night to a year. These instruments are being provided to people by Government, renowned institutions and corporations.

Money market proves really beneficial for the companies that have excess cash and wants to invest it for short term, as well as for companies that have requirements to borrow capital for short term.

For retail investors, the best way to participate in the money market is through money market mutual funds and other instruments.

There are various segments of the Money market, which are as follow.

  • Treasury bills (T-bills): Treasury Bills or T-bills are being traded by the Government of a nation to investors at a discounted rate and with a specific maturity date.

For example, Investor A wants to invest in T-bills, so he buys a 91-days T-bill at a discounted rate of Rs. 97 that has the face value of Rs. 100. He gets a discount of Rs. 3. Thus, when he would sell this T-bill after the maturity period, he is entitled to have Rs, 100, whereas he has paid only Rs.97.

In India, Government of India issues T-bills and The Reserve Bank of India holds auctions for these bills at regular intervals, whereas in the United States; T-bills can be purchased in two ways. The first option is through auction organized by U.S Treasury, and the second option is through brokers or intermediaries in the secondary market.

T-bills have a maturity of specific days such as 14 days, 91 days, 365 days, etc. and thus are really beneficial for short-term investment target. Investors are often paid interest named as the yield on this security.

  • Commercial papers: Commercial paper (CP) is a tool for companies and corporations to opt for in order to meet their short term cash requirements. Commercial Papers are usually issued for a period of 7 days to maximum a year. There is no security obligations required in order to issue a commercial paper. It’s generally issued by large banks and companies at a discounted rate.

To issues a commercial paper, a company has to have a good credit record. In India, a company can opt for a CP if it has the net tangible net worth of more than Rs. 4 crores. In addition to that, it can be issued in the denominations of Rs. 5 lakh only; whereas, for the U.S market, the denomination is kept at $100,000 or more.

Commercial papers issued by the Federal Reserve had played a very vital role in providing liquidity to the U.S market at the time of the Great Financial Crisis of 2008.

  • Certificate of Deposits: Certificate of deposits known as CDs are issued by commercial banks to investors. CDs are also a promissory note and can be issued for 7 days to three years in India and 3 months to 5 years in the United States.

Certificate of deposits also come with attractive discount rate and lucrative interest payments. An investor can choose the period of interest payment on quarterly, half-yearly or annual basis. The interest is paid on a compounding basis.

One crucial thing about CD is that it also attracts a penalty for withdrawing the deposit before maturity. There are various types of CDs, some of which are followed.

  • Banker’s acceptance: Banker’s acceptance (BA) is considered to be a very safe money market tool as it’s backed by a bank. Generally, BA is highly issued while doing a foreign trade and has the maturity period of around 30 to 180 days. BA helps in establishing a secured credit relationship between two foreign parties. It works as a short term debt tool for companies that want to trade aboard. These BAs are also traded in the secondary market at a discounted rate.

For example, company A of Australia wants to import steel from company B of China, but there is no credit relationship between them, and company A is short for making payment at present. In such a situation, company A would go to its bank with all the details about its import order from company B, and on that basis the bank would issue a Bank’s acceptance draft to company B. Bank’s Acceptance certifies that on a certain date in future, company A would pay off the certain amount of debt obligation to the company B. Banks generally charge certain percentage as the fees.

  • Eurodollars: Eurodollar term was coined famous after the World War II. Eurodollar market refers to the deposits kept in banks in the U.S dollar outside the United States, including the branches of the banks having U.S origin. The market was initiated in Europe and thus the term Eurodollar still exists, whereas the Eurodollar market is accessed by other nations as well. Rules and regulations of Federal Reserve are not implied on Eurodollar and that makes it attractive in terms of interest payments. Eurodollar futures are traded on the Chicago Mercantile Exchange (CME.)

Along with that, Eurodollar futures contracts are also quite in demand in order to seize the interest rate at the present time when the payment is due in the future. For example, in future; company A of Japan has to pay a certain amount to company B of France in terms of the U.S dollar. Company A would secure the interest payment in advance to avoid facing uncertain or excess interest rate payment in future and lessen the risk associated with it.

Devanshee Dave

 

 

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