Money Market Yield: Definition & Formula

Instructor: James Blackburn

James has an MBA from Auburn University and a MA in Humanities from Cal State-Dominguez Hills He writes on leadership, business strategy and finance.

In this lesson, we will define the money market, its purpose, and the groups that participate in the market. We will also review a few examples investors use to calculate the yield.

Opportunities for Excess Cash

We finally sold one of our start-up businesses and we need to find something to do with the $25 million in cash received from the sale. Our research department has identified several new projects to invest in, but we haven't had the time to review the different outcomes. It will take us several months before we can do the necessary diligence on each project. It seems like a waste to let the cash sit dormant, letting inflation chip away at its value, so we need a short term investment. Should we invest in the money market?

The Money Market Solution

The money market is an exchange where organizations use a broker to conduct transactions. It is a wholesale exchange where transactions take place between financial institutions and companies. Organizations with large amounts of cash will deposit funds for use by other organizations in need of short term cash. Organizations can borrow these funds as needed, but the duration of a deposit is less than one year, with an average of about 120 days.

Money market securities are unlikely to lose money, and as a result have a low default risk. This low risk allows organizations to treat money market accounts as cash equivalents. Cash equivalents are investments that can quickly be sold. The resale of these securities occur on the secondary market - an exchange made up of individual investors, very similar to the stock market.

Money Market Participants

The US Treasury, Federal Reserve, commercial banks, businesses, investment firms, and individuals can all participate in the money market. Investors in the money market expect modest returns on their investment. The table below highlights the various roles each participant performs.

Participant Role
US Treasury Sells US Treasury securities to pay for government obligations
Federal Reserve Buys and sells US Treasury securities to control the money supply
Commercial bank Sells certificates of deposit and makes short term loans
Businesses Buy and sell various short-term securities to manage their cash
Investment companies Act as a broker for trades on commercial accounts
Finance companies Lend short-term funds to individuals
Insurance companies Use securities to maintain liquidity for unexpected demands
Pension funds Maintain funds in money market instruments prior to long term investments
Individuals Buy money market funds
Money market funds Allow small investors to participate in the money market

Money Market Securities

A variety of money market securities exist. In addition to treasury bills, common securities include federal funds, repurchase agreements, negotiable certificates of deposit, commercial paper, banker acceptances, and eurodollars. Federal funds are short-term funds borrowed between banks, normally with a duration of one day. Repurchase agreements are government securities sold and repurchased at a specified time in the future - typically the next day. The duration of a repurchase agreement is usually 3 to 14 days. Negotiable certificates of deposit are issued by banks and include an interest rate and a maturity date. It's considered a term security. Organizations must wait for the maturity date before withdrawing funds.

Commercial paper are unsecured promissory notes issued by corporations. They normally mature in less than 270 days. Credit worthiness of the corporation determines the risk and the interest required. Banker's acceptances are orders to pay an amount of money to a bearer on a given date. They are very valuable in international trade as a form of guaranteed payment. Finally, eurodollars, not to be mistaken with the Euro, are US Dollars held and used for international trade. A separate eurodollar market exists for these currencies.

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