Money Markets: Reduce Your Risks – Part 2
Posted by Stock Online Trader in Educational, Investment on 03-22-2007
Tags: Educational, Investment, Money Market, Trading Technique
As part of the money market post, let us have a look at few more worthy money market instruments. Just before doing that let me do a quick recap from the previous post.
The money market specializes in debt securities that mature in less than a year. Money market securities are liquid and considered very safe resulting in lower returns than other securities. Money market mutual fund is the easiest way to gain access to money markets. T-bills are short-term government securities that mature in one year or less. Certificate of deposit (CD) is a time deposit with a bank, which are safe investments with not so great returns. Commercial paper is an unsecured, short-term loan issued by a corporation with higher returns than T-bills because of the risk factor.
Bankers Acceptance (BA)
A bankers acceptance is a short-term discount instrument that usually arises in the course of international trade. Bankers Acceptance starts as an order to a bank by importer X to pay an amount to exporter Y at the future date (something like a postdated check). Once customer X and the bank completes the acceptance agreement, the bank keeps the acceptance (draft) in return for cash which is an amount less than the face value of the draft. The bank keeps that difference (like interest). The importer X will use that amount to pay to exporter Y.
A bankers acceptance is a short-term discount instrument that usually arises in the course of international trade. Bankers Acceptance starts as an order to a bank by importer X to pay an amount to exporter Y at the future date (something like a postdated check). Once customer X and the bank completes the acceptance agreement, the bank keeps the acceptance (draft) in return for cash which is an amount less than the face value of the draft. The bank keeps that difference (like interest). The importer X will use that amount to pay to exporter Y.
The bank may hold the acceptance in its portfolio or it may sell, or rediscount, it in the secondary market. Also depending on the bank’s reputation, importer X may be able to sell the bankers acceptance, that is, sell the time draft accepted by the bank. It will sell for the discounted value of the future payment. In this manner, the bankers acceptance becomes a discount instrument traded in the money market.
Advantage
- Bankers acceptances are considered very safe assets which can be traded at discounts from face value.
- They are used widely in foreign trade.
- If the bank is well known and enjoys a good reputation, the accepted draft may be readily sold in an active market.
- Does not need to be held until maturity, and can be sold off in the secondary markets.
- Maturities are generally between 1-6 months.
Disadvantage
- The only way for individuals to invest in this market is indirectly through a money market fund.
Eurodollars
Eurodollars have very little to do with the euro or European countries. Eurodollars are U.S. dollars deposited at banks outside United States. Eurodollars are not under the jurisdiction of the Federal Reserve, which means less regulation, allowing for higher margins.
Eurodollars have very little to do with the euro or European countries. Eurodollars are U.S. dollars deposited at banks outside United States. Eurodollars are not under the jurisdiction of the Federal Reserve, which means less regulation, allowing for higher margins.
A variation on the eurodollar time deposit is the eurodollar CD. A eurodollar CD is basically the same as a domestic CD, except that it’s the liability of a non-U.S. bank. Again the returns are generally higher than domestic CD due to slightly higher risk factor.
Advantage
- Margins are higher since eurodollar market is relatively free of regulation compared to their counterparts in the United States.
- Maturity period is less than 6 months.
Disadvantage
- The average eurodollar deposit is very large (say few millions). This makes it out of reach for individual investors. The only way for individuals to invest in this market is indirectly through a money market fund.
Repurchase Agreement (Repo)
Repurchase Agreement is an agreement where the holder (repo seller) of a government security sells the security to a lender (repo buyer) and can repurchase it back at an agreed future date and price. Normally for short-term (30-days) borrowing a repo seller sells securities to the repo buyer in return of cash and agrees to repurchase those securities from the repo buyer for a greater sum of cash at some later date.
Repurchase Agreement is an agreement where the holder (repo seller) of a government security sells the security to a lender (repo buyer) and can repurchase it back at an agreed future date and price. Normally for short-term (30-days) borrowing a repo seller sells securities to the repo buyer in return of cash and agrees to repurchase those securities from the repo buyer for a greater sum of cash at some later date.
There are also variations on standard repos:
- Reverse Repo – Complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price
- Term Repo – Same as a repo except the term of the loan is greater than 30 days.
Advantage
- They are usually very short-term, from overnight to 30 days or more. This short-term maturity and government backing means repos provide lenders with extremely low risk.
- Repos are popular because they can eliminate credit problems.
- Any security (be it T-Bills, Bonds, Stocks) can be used in a repo.
Disadvantage
- Bad credit check by the lender can be lead to fraud activity.
Conclusion: When the stock market looks volatile and too risky, money markets can provide an excellent alternative. Their short-term maturity make them more attractive. Obviously the returns are not very thrilling, but there are times when even the most ambitious investor puts some cash on the sidelines. I intend to write a post in future to compare the actual rates for different money markets.
Recommended Books:
- The Handbook of Fixed Income Securities
- The Bank Customer’s Guide To Safe & Smart Investing
- Why The Biggest Stock Market Crash in History is Still Coming…and How You Can Prepare Yourself and Profit From It!
- Trend Trading: Timing Market Tides
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(Source: Investopedia, Wikipedia)
Individuals can purchase BA directly.