Money Market Instruments

None of these instruments sits at a bank the way a deposit does, so each one's safety comes from a different source: the issuer's credit, a bank guarantee, government backing, or posted collateral, depending on the instrument. That distinction from the deposits in the previous lesson drives many of the exam questions on this material.

What Is 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 because the Securities Act of 1933 exempts short-term paper of 270 days or less from registration
• 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.

What Are Treasury Bills (T-Bills)?

• Treasury bills are short-term U.S. government obligations
• Available maturities: 4, 8, 13, 17, 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)

How Are T-Bills Taxed?

• 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.

What Other Money Market Instruments Should You Know?

What Are 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

What Are 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 back the loan
• 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.

What Are 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 anchors 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.

What Are 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 the money-market-fund quality and maturity rule (Investment Company Act of 1940), which restricts holdings to high-quality, short-maturity instruments
• 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)

How Do Money Market Funds Differ From Money Market Deposit Accounts?

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.

How Do All These Instruments Compare?

What Should You Check on Exam Day?

• None of the instruments taught in this lesson are FDIC insured; commercial paper, T-bills, banker's acceptances, repos, and money market funds are all securities or obligations, not bank deposits
• Commercial paper matures in 1 to 270 days to stay exempt from Securities Act registration; that exemption, not investor preference, sets the ceiling
• T-bills mature in 4, 8, 13, 17, 26, or 52 weeks, are taxed federally but exempt from state and local tax, and anchor the risk-free rate
• The federal funds rate is market-determined within a Fed-set target range, not a rate the Fed sets directly
• A money market fund targets a $1.00 NAV and can break the buck; a money market deposit account is FDIC insured and cannot lose principal within the coverage limit