Components

Money Market

The money market is a sub sector of the fixed-income market, differing from the bond market in that it's made up of debt securities that are very short-term (less than one year) and very liquid. Most of the money market securities trade in large denominations that out price small investors; however, money market mutual funds and money market bank accounts are easily available to small investors. Money market securities are considered very safe--and accordingly they offer relatively small but secure returns.

Treasury Bills (T-bills)

U.S. Treasury Bills (or T-bills) are sold to the public by the government to raise money. They are the most marketable securities in the money market which denotes very low transaction costs. T-bills are issued with maturities of 28, 91, 182, or 365 days (1, 3, 6, or 12 months) and are sold in denominations from $1,000 to $5 million, which makes them easy for the small investor to buy. T-bills are sold at a discount from their face value. A $10,000 T-bill selling at a 3% interest rate, for example, would be selling for $9,708.74. The buyer pays $9,708.74 for the T-bill and then cashes it in for $10,000 when it is due. The income earned from T-bills is exempt from all state and local taxes. Since T-bills are backed by the U.S. government, they are considered completely safe and they are often quoted to show the risk-free interest rate.

Certificates of Deposit (CDs)

A certificate of deposit (CD) is a time deposit with a bank, which means that it cannot be withdrawn on demand (like a checking account). A depositor deposits a certain amount for a fixed term and a stated annual percentage rate. At the end of the fixed term (which can be anywhere from a month to several years) the bank returns the deposit with accumulated interest. Since banks have a slightly higher risk of default than the US government, CD's give a slightly higher return than a T-bill; however, the FDIC does insure CD's up to $100,000.

Commercial Paper

Instead of borrowing from banks, large companies will often issue their own short-term, unsecured debt notes called commercial paper. It is usually issued in multiples of $100,000 with maturities of less than two months. Maturities can go as high as 270 days, after which companies would have to register with the SEC, which they would rather avoid. Commercial paper is mainly used to finance inventories and accounts receivable. Since a company's well-being can usually be predicted over a short period of time, commercial paper is fairly secure; however, there have been cases of firms defaulting on commercial paper. Commercial paper is often rolled over at its maturity--new paper is issued to pay off the maturing paper.

Bankers' Acceptances

A banker's acceptance is similar to a post-dated check. A bank customer, usually a business, will make an order to a bank to pay a large amount of money at a future date, usually within 6 months. When the bank accepts payment it takes on responsibility for the debt, and then the acceptance can be traded openly on the secondary market. Bankers' acceptances are often used in foreign trade when the credit security of one of the traders is unknown. In a banker's acceptance, the bank's credit is substituted for the customer's credit, which makes bankers' acceptances very secure. Acceptances sell at a discount of their face value, similar to T-bills.

Eurodollars

Eurodollars are dollar-denominated time deposits in banks outside the U.S. (including branches of U.S. banks outside the U.S.). These are not limited to Europe, as the name implies, but can be anywhere outside the U.S. Because the banks are outside of the U.S., the Federal Reserve board has no jurisdiction over them; hence they can operate under tighter margins without as many regulations. This can allow the banks to make more money off the deposits and also makes Eurodollars more risky, but this translates to higher interest. Eurodollar deposits are usually in the millions and last less than 6 months; thus the average investor is out priced, but Eurodollars can be invested in through money market funds. A variant of a Eurodollar time deposit is a Eurodollar CD, which is just like a U.S. CD only that it's held outside the U.S.

Repos

A repo, or repurchase agreement, is an overnight loan usually made by government security dealers. The dealer will make an agreement with an investor to sell him securities overnight and then buy them back at a slightly higher price the next day. The investor will make overnight interest equal to the difference for which he buys and sells back the securities. Basically, a repo is a one day loan with securities used as collateral. A term repo is a simply a repo with a longer term, like 30 or so days. A reverse repo is when the investor holds the securities and sells them and buys them back from the security dealer.

Federal Funds

All banks which are members of the Federal Reserve System (which I believe is every legal U.S. bank) are required to keep a certain amount of money in their reserve account, which is their deposit with "the Fed." The money in their account is called "federal funds" and the amount of money they are required keep is equal to the reserve ratio, which is set by the Fed, multiplied by the amount of deposits in their bank. For instance, if I deposit $100 in my bank and the reserve ratio is 10%, then my bank must put another $10 in their Federal Reserve account. At the end of the day, some banks come up short while others have more than enough federal funds. In order to meet the legal requirements, banks make overnight loans to each other at the "federal funds rate," which is also set by the Fed. Although this was set up primarily as a means of securing banks and ensuring they had enough funds, many large banks now use federal funds as one of their resources for funding.

Brokers' Calls

When people buy stocks on margin, they are borrowing part of their money from their broker. Their broker, in turn, will often borrow the money from the bank agreeing to pay the bank immediately if the money is called for. The rate on these loans is usually about 1% higher than the rate on short-term T-bills and is also known as the call loan rate.

The LIBOR Market

The LIBOR rate is basically the rate at which London banks borrow from each other. LIBOR stands for the London Interbank Offered Rate. It is the rate that participating banks offer each other for inter-bank deposits. There are many variables such as time and type currency that are factored into rate calculations; the British Bankers Association quotes the LIBOR rate each day for various maturities based on current averages. It has become the foremost short term interest rate quoted in the European money market.

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