Back To CourseBusiness Math: Help and Review
11 chapters | 107 lessons
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.
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 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.
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.
|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|
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.
|Money Market Securities||Issuer||Buyer|
|Treasury Bills||US Government||Consumers and companies|
|Repurchase Agreements||Businesses and banks||Businesses and banks|
|Negotiable Certificates of Deposit||Large money center banks||Businesses|
|Commercial Paper||Finance companies and businesses||Businesses|
|Eurodollar Deposits||Non US Banks||Businesses, governments, and banks|
Money market securities are investment securities. As such, participants expect a return on their investment. Four different return, or yield, measurements exist. They are bank discount yield, holding period yield, effective annual yield, and money market yield. Let's review each calculation. The amounts used are to simplify the examples and often represent higher than normal returns.
T-bills are sold at a discount. The price of the T-bill is sold at less than face value. It is useful to convert this discount into an annualized yield. The formula below provides this measurement. In this example, a money market security with a face value of $1,000 is purchased at a discounted price of $900. It will mature in 180 days. The return or yield on this investment is 20%.
It may be helpful to calculate the yield for the length of time for the investment - the holding period. In this case, the purchase price, the price paid at maturity, and interest distributions are required. For this calculation, a security with a face value of $10,000 is purchased at a discount for $9,500. $250 of interest is paid. The holding period yield is 7.89%.
When considering alternative investments, you may want to use this formula to compound the yield. Using the holding period yield in this calculation of 7.89% calculated in the above example, the EAY is 16.65%.
The money market yield, or CD equivalent yield is quoted on a 360 day basis. This calculation is usually used for short term investments. In this example, we use the bank discount yield of 20% calculated above for a period of 180 days. The money market yield is 22.2%.
The money market allows organizations to invest large sums of cash for short periods of time. The federal government uses the money market to fund government operations and control the money supply in the economy. Companies borrow money through commercial paper. The funds invested in the money market accounts are relatively risk-free and highly liquid. These money market securities can be sold and purchased on the secondary markets at a discount or premium after the initial security has been issued.
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Back To CourseBusiness Math: Help and Review
11 chapters | 107 lessons
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