Money Market Instruments

Now that you understand insured deposits, let's move to money market instruments: short-term debt securities that trade in the open market. Unlike bank deposits, most of these are not insured by the Federal Deposit Insurance Corporation (FDIC).

Commercial Paper

• Commercial paper is a short-term, unsecured promissory note issued by corporations to fund short-term liabilities (payroll, inventory, accounts payable)
• Maturities typically range from 1 to 270 days
  • The 270-day limit exists to avoid Securities and Exchange Commission (SEC) registration under Securities Act Section 3(a)(3)
• Sold at a discount to face value; no coupon payments (the return is the difference between purchase price and face value)
• Available primarily to institutional investors; minimum denominations often $100,000+
• Credit quality depends on the issuer; rated by agencies (Moody's P-1, S&P A-1 are the highest short-term ratings)
• Not FDIC insured - this is a corporate obligation, not a bank deposit

Exam Tip: Gotchas

Commercial paper maturities stay at or below 270 days specifically to avoid SEC registration. If a question asks why commercial paper has short maturities, the answer is the registration exemption, not investor preference.

Treasury Bills (T-Bills)

• Treasury bills are short-term U.S. government obligations
• Available maturities: 4, 8, 13, 26, or 52 weeks
• Sold at a discount; the difference between purchase price and face value is the return
• Considered virtually risk-free (backed by the full faith and credit of the U.S. government)
• Highly liquid - active secondary market
• Used as the benchmark for the risk-free rate in financial calculations (Capital Asset Pricing Model, Sharpe ratio)

T-Bill Tax Treatment

• Federal income tax: Yes - the discount earned is subject to federal income tax
• State and local tax: No - T-bills are exempt from state and local taxes
• This tax advantage makes T-bills attractive to investors in high-tax states

Exam Tip: Gotchas

All U.S. Treasury securities (bills, notes, bonds) share the same tax treatment: federally taxable, state and local tax exempt. The exam tests this frequently.

Other Money Market Instruments

Banker's Acceptances

• Short-term drafts (typically 1 to 6 months) guaranteed by a bank
• Primarily used in international trade to facilitate imports and exports
• Sold at a discount, like T-bills and commercial paper
• The bank guarantee makes them relatively safe

Repurchase Agreements (Repos)

• Short-term borrowing where securities are sold with an agreement to repurchase at a higher price on a specified date
• Essentially a collateralized short-term loan - the securities serve as collateral
• Used by institutions (broker-dealers, banks) and the Federal Reserve for monetary policy (open market operations)
• Maturities are very short, often overnight

Think of it this way: A repo is like pawning your watch overnight. You hand over the watch (securities), get cash, then buy it back the next day for slightly more. The "slightly more" is the interest on the loan.

Federal Funds

• Overnight loans between banks of their excess reserves held at the Federal Reserve
• The federal funds rate is the interest rate on these loans and serves as a key monetary policy benchmark
• The Fed targets the federal funds rate through open market operations but does not directly set it - it is a market-determined rate

Exam Tip: Gotchas

The federal funds rate is NOT set by the Fed. The Federal Open Market Committee (FOMC) sets a target range, but the actual rate is determined by supply and demand in the interbank market. The exam tests this distinction.

Money Market Funds

• Money market funds are mutual funds that invest in money market instruments (T-bills, commercial paper, repos, etc.)
• Seek to maintain a stable $1.00 net asset value (NAV) per share, but this is not guaranteed
• Regulated under SEC Rule 2a-7 (Investment Company Act of 1940)
• NOT FDIC insured - they are securities, not bank deposits
• Can "break the buck" if the NAV falls below $1.00 (rare but it has happened)

Money Market Fund vs. Money Market Deposit Account

Think of it this way: If the name includes "fund," it is a security and is NOT FDIC insured. If the name includes "account," it is a bank deposit and IS FDIC insured. The word "fund" vs. "account" is your signal.

This is one of the most heavily tested distinctions on the exam:

Exam Tip: Gotchas

Money market funds are NOT FDIC insured and can lose value. Money market deposit accounts at banks ARE FDIC insured. The word "fund" vs. "account" changes everything. If the exam says "money market" - read carefully to see which one they mean.

Summary: Cash and Cash Equivalents at a Glance