Money Market Instruments

The money market is where short-term funds are borrowed and lent. Unlike the capital market (stocks and long-term bonds), money market instruments mature in one year or less. They are highly liquid, low-risk, and used as cash equivalents in portfolios.

Key Characteristics

• Maturity: One year or less (most under 6 months)
• Liquidity: Very high; easily converted to cash
• Safety: Low risk compared to other securities
• Interest: Usually issued at a discount (no periodic coupon payments)
• Purpose: Short-term financing and cash management

Buyer-seller relationship: The buyer of a money market instrument is the lender of money. The seller (issuer) is the borrower.

Commercial Paper

Commercial paper is short-term unsecured promissory notes issued by large, creditworthy corporations to finance short-term liabilities (payroll, inventory, accounts receivable). It pays no periodic interest - sold at a discount to face value, and the investor receives face value at maturity.

Why do corporations use this? Rather than draw on an expensive bank line of credit, creditworthy corporations issue commercial paper as a quick, low-cost way to bridge short-term cash needs.

• Unsecured - backed only by the issuing corporation's promise to pay (no collateral)
• Issued only by corporations with high credit ratings (investment grade)
• Rated by agencies (e.g., A-1/P-1 is the highest short-term rating from S&P/Moody's)
• NOT FDIC-insured - it is a security, not a bank deposit
• Typically held to maturity (limited secondary market)
• If maturity exceeds 270 days, the issuer must register with the SEC

Exam Tip: Gotchas

• Commercial paper is exempt from SEC registration ONLY if maturity is 270 days or less. This is the single most tested threshold for this instrument.
• Commercial paper is unsecured - there is no collateral backing it.
• Buying commercial paper = lending money. The holder is the lender, the issuer is the borrower.

Treasury Bills (T-Bills)

Treasury bills are short-term discount securities issued by the U.S. Treasury. They are backed by the full faith and credit of the U.S. government and considered risk-free. T-bills are sold at a discount to par (face value), and the investor receives par at maturity. There are no coupon payments (zero-coupon structure: the return is the discount).

Maturities and auction schedule:

Key characteristics:

Auction process:

• Competitive bids - bidder specifies the discount rate they will accept (institutional investors); may not be filled
• Non-competitive bids - bidder accepts whatever rate is determined at auction (retail investors); guaranteed to be filled
• Maximum non-competitive bid: $10 million per auction

Tax treatment:

• Discount earned is treated as interest income (not capital gains)
• Subject to federal income tax in the year of maturity or sale
• Exempt from state and local income taxes (all Treasury securities share this feature)

Exam Tip: Gotchas

• T-Bills are quoted on a bank discount yield basis (uses 360-day year and par value as denominator), which understates the true yield. The bond equivalent yield (365-day year, purchase price as denominator) gives a more accurate comparison to other investments.
• Interest is exempt from state and local taxes (like all Treasury securities).

Money Market Mutual Funds

Money market mutual funds are open-end investment companies regulated under the Investment Company Act of 1940. SEC Rule 2a-7 governs permissible investments and portfolio quality/maturity.

These funds invest in a portfolio of money market instruments (T-bills, commercial paper, repos, CDs, bankers' acceptances).

"Breaking the buck":

• Occurs when NAV falls below $1.00 per share
• Most notable example: Reserve Primary Fund (September 2008) - held Lehman Brothers commercial paper
• Extremely rare but demonstrates that money market funds are not guaranteed

Exam Tip: Gotchas

• Money market mutual funds seek to maintain a $1.00 NAV but it is NOT guaranteed. They are NOT FDIC-insured.
• The exam loves to test whether candidates confuse money market deposit accounts (FDIC-insured, at banks) with money market mutual funds (not insured, securities).

Cash Equivalents Summary