CHAPTER 19

MONEY MARKET
1. Money Market
Money market can be defined as a market for short-term money and financial assets that are near
substitutes for money with minimum transaction cost.
Features
• The term short-term means generally a period up to one year and near substitutes to money is
used to denote any financial asset which can be quickly converted into money.
• Low transaction cost
• It provides an avenue for equilibrating the short-term surplus funds of lenders and the
requirements of borrowers.
• It, thus, provides a reasonable access to the users of short term money to meet their
requirements at realistic prices.
• The money market can also be defined as a centre in which financial institutions congregate
for the purpose of dealing impersonally in monetary assets.
Limitations
• High volatility
• Players restricted
• Not many instruments
• Lack of transparency
• Seasonal shortage of funds

Pre-Conditions for Efficient Money Market

a. Institutional development, relative political stability and a reasonably well-developed banking
and financial system.
b. The market should be able to provide an investment outlet for any temporarily surplus funds
that may be available. Thus, there must be supply of temporarily idle cash that is seeking short-
term investment in an earning asset. There must also exist a demand for temporarily available
cash either by banks or financial institutions for the purpose of adjusting their liquidity position
and finance the carrying of the relevant assets in their balance sheets.
c. Efficient payment systems for clearing and settlement of transactions are essential for ensuring
a risk free and transparent payment and settlement system.
d. Strong Central Bank to ensure credibility in the system and to supervise the players in the
market.
e. Government/Central Bank intervention to moderate liquidity profile.
f. The market should have varied instruments with distinctive maturity and risk profiles to meet
the varied appetite of the players in the market. Multiple instruments add strength and depth to
the market; and
g. Market should be integrated with the rest of the markets in the financial system to ensure perfect
equilibrium. The funds should move from one segment of the market to another for exploiting
the advantages of arbitrage opportunities.

2. Difference between Money market and Capital Market

Capital market deals with long- and medium-term instruments of financing while money market
deals with short term instruments. Some of the points of distinction between capital market and
money market are as follows:
Money Market Capital Market

There is no classification between primary There is a classification between primary

market and secondary market. market and secondary market.

It deals for funds of short-term requirement It deals with funds of long-term requirement
(less than a year). (more than 1 year).

Money market instruments include interbank Capital Market instruments are shares and debt
call money, notice money up to 14 days, short- instruments.
term deposits up to three months, commercial
papers, 91 days treasury bills, etc.

Money market participants are banks, financial Capital Market participants include retail
institution, NRB and Government. investors, institutional investors like Mutual
Funds, Financial Institutions, corporate and
banks.

Risk involved in money market is less due to Risk is higher.

smaller term of maturity. In short term the risk
of default is less.

Transactions take place over some informal Transactions are at a formal place viz. the
platforms. Hence there is no formal place for stock exchange.
transactions.

The basic role of money market is liquidity The basic role of capital market includes
adjustment. putting capital to work, preferably to long
term, secure and productive employment.
 Regulated by central bank Regulated by securities board

3. Commercial Paper
✓ It is the short-term debt instrument issued by corporate bodies and financial institutions. It
does not provide any interest (no coupon payments) to the investors. But, it is issued at a
discounted price so that investors can gain the difference amount between the maturity value
and issue price.
✓ The interest rate earned by investor can be computed as:

% Interest rate (p.a.) = MV - IP x 365x 100

IP n

Where,
MV= Maturity Value
IP= Issue Proceeds
n= No of days to maturity

Benefits to the issuer

(i) Low interest expenses: The interest cost associated with the issuance of CP is normally
expected to be less than the cost of bank financing, as among other things, it is related to the
inter-corporate money market rate, which in normal times is within the cost of bank finance.
(ii) Access to short term funding: CP issuance provides a company with increased access to short
term funding sources. By bringing the short term borrower into direct contact with investors,
the CP market will, to some extent, disintermediate the established role of banks and pass on
the benefit to both issuers and investors.
(iii)Flexibility and liquidity: CP affords the issuer increased flexibility and liquidity in matching
the exact amount and maturity of its debt to its current working capital requirement.
(iv) Investor recognition: The issuance of CP provides the issuer with favorable exposure to major
institutional investors as well as wider distribution of its debt.
(v) Ease and low cost of establishment: A CP can be established with ease at a low cost, once
the basic criteria have been satisfied.
Note: Euro Commercial Papers (ECPs) are short-term money market instruments issued is foreign
countries in different currency denominations.
4. Treasury bills
Treasury bills are short-term debt instruments of the government, maturing in a period of less than
one year. Treasury bills are issued by NRB on behalf of government for period less than a year.
They are highly liquid instruments and issued to tide over short-term liquidity shortfalls.
Treasury bills are usually sold through an auction process. Banks and primary dealers are the major
bidders in the competitive auction process. Treasury bills are issued at a discount and redeemed at
par.

5. Repo and a Reverse Repo

The term Repurchase Agreement (Repo) and Reverse Repurchase Agreement (Reverse Repo)
refer to a type of transaction in which money market participant raises funds by selling securities
and simultaneously agreeing to repurchase the same after a specified time generally at a specified
price, which typically includes interest at an agreed upon rate. Such a transaction is called a Repo
when viewed from the perspective of the seller of securities (the party acquiring funds) and
Reverse Repo when described from the point of view of the supplier of funds.
A Repurchase Agreement (or repo) is an agreement of sale of a security with a commitment to
repurchase or buy the security back at a specified price and on a specified date. Under Repo,
commercial banks sell the government bonds and other securities held by them to NRB with
agreement to repurchase them on a specified date at a specified price. This is used by central bank
to inject additional funds in banking system when there is a liquidity crunch.
Reverse repo is a term used to describe the opposite side of a repo transaction. Reverse Repo is a
purchase of security with a commitment to sell at a pre-determined price and date. Under reverse
repo, commercial banks purchase the securities from NRB with agreement to sell it back at a
specified price on a specified date. This is used by central bank to suck funds from banking system
where there is excess liquidity.

6. Call Money
Call money or inter-bank call money is the medium through which the scheduled commercial
banks lend, borrow or call at short notice to manage the day-to-day surpluses and deficits in the
cash flow. The money that is lent for one day in this market is known as ‘call money’ or ‘overnight
money’ and if it exceeds one day (but less than 15 days), it is referred as ‘notice money’.
 Miscellaneous Practical Problems

Question 1
RBI sold a 91-day T-bill of face value of Rs. 100 at an yield of 6%. What was the issue price?
Ans: 98.53

Question 2
Z Co. Ltd. issued commercial paper worth Rs. 10 crores as per following details:
Date of issue : 16th January, 2009
Date of maturity: 17th April, 2009
No. of days : 91
Interest rate: 12.04% p.a
What was the net amount received by the company on issue of CP? (Charges of intermediary may
be ignored)
Ans: 9.7087 Crore

Question 3
M Ltd. has to make a payment on 30th January, 2010 of Rs. 80 lakhs. It has surplus cash today,
i.e. 31st October, 2009; and has decided to invest sufficient cash in a bank's Certificate of Deposit
scheme offering an yield of 8% p.a. on simple interest basis. What is the amount to be invested
now?
Ans: Rs. 78,43,558.65

Question 4
From the following particulars, calculate the effective rate of interest p.a. as well as the total cost
of funds to Bhaskar Ltd., which is planning a CP issue:
Issue Price of CP Rs. 97,550
Face Value Rs. 1,00,000
Maturity Period 3 Months
Issue Expenses:
Brokerage 0.15% for 3 months
Rating Charges 0.50% p.a.
Stamp Duty 0.175% for 3 months
Ans: 12.235% OR 11.846%

Question 5
LMN & Co. plans to issue Commercial Paper (CP) of Rs. 100,000 at a price of Rs. 98,000.
• Maturity Period: 4 Months
• Expenses for issue of CP
(i) Brokerage 0.10%
 (ii) Rating Charges 0.60%
(iii) Stamp Duty 0.15%
Find the effective interest rate per annum and the cost of Fund.
Ans: 6.12%; 6.97% (Assumption: Brokerage, etc pertain to a year)

Question 6
Wonderland Limited has excess cash of Rs. 20 lakhs, which it wants to invest in short term
marketable securities. Expenses relating to investment will be Rs. 50,000. The securities invested
will have an annual yield of 9%.
The company seeks your advice
(i) as to the period of investment so as to earn a pre-tax income of 5%.
(ii) the minimum period for the company to breakeven its investment expenditure overtime value
of money.
Ans: (i) 10 months (ii) 3.33 months

Question 7
AXY Ltd. is able to issue commercial paper of Rs. 50,00,000 every 4 months at a rate of 12.5%
p.a. The cost of placement of commercial paper issue is Rs. 2,500 per issue. AXY Ltd. is required
to maintain line of credit Rs. 1,50,000 in bank balance. The applicable income tax rate for AXY
Ltd. is 30%. What is the cost of funds (after taxes) to AXY Ltd. for commercial paper issue? The
maturity of commercial paper is four months.
Ans: 9.15%

Question 8
A money market instrument with face value of Rs. 100 and discount yield of 6% will mature in 45
days. You are required to calculate:
(i) Current price of the instrument.
(ii) Bond equivalent yield
(iii) Effective annual return.
Ans: (i) Rs.99.26 (ii) 6.05% (iii) 6.16 %

Question 9
A bond is held for a period of 45 days. The current discount yield is 6 per cent per annum. It is
expected that current yield will increase by 200 basis points and current market price will come
down by Rs. 2.50.
Calculate:
(i) Face value of the Bond and
(ii) Bond Equivalent Yield
Ans: (i) Rs. 1000 (ii) 6.06%; 8.12%
Question 10
Bank A enter into a Repo for 14 days with Bank B in 10% Government of India Bonds 2018 @
5.65% for 8 crore. Assuming that clean price be Rs. 99.42 and initial Margin be 2% and days of
accrued interest be 262 days. You are required to determine
(i) Dirty Price
(ii) Repayment at maturity. (Consider 360 days in a year).
Ans: (i) Rs.106.70 (ii) 8.3837 Cr.