Money Market Instruments and Short-Term Funding
The short end of the curve
Money market instruments mature in one year or less and include treasury bills, commercial paper, bankers' acceptances, certificates of deposit, and repurchase agreements. Candidates must understand discount quoting conventions versus add-on yield conventions, and why a bill quoted on a discount basis produces a different yield than the discount rate suggests.
Concepts to master
Understand the mechanics of a repurchase agreement: a sale of securities with an agreement to repurchase at a set price and date. Know the difference between a repo and a reverse repo from each party's perspective, and the role of haircuts and margin in managing counterparty risk. Understand the overnight versus term funding markets, and the role of central bank facilities. Know the credit and liquidity risks specific to money market instruments, including rollover risk for issuers relying on commercial paper.
Traps
A recurring trap is treating the discount rate on a treasury bill as the investor's return. The discount is calculated on face value, but the return is earned on the price paid, so the yield is higher than the quoted discount rate. Another trap is confusing the direction of a repo: the party selling securities and agreeing to buy them back is borrowing cash. Watch for questions on haircuts where a higher haircut reduces the cash advanced, not the collateral value.
Worked example
A 90-day bill with a face value of 1,000 is quoted at a 4% discount rate. The discount is 4% × 90/360 × 1,000 = 10, so the price is 990. The investor's return is 10/990 annualised over 90 days, which is greater than 4%. Recognising that the true yield exceeds the discount rate is often enough to eliminate wrong answers.
Rule of thumb
Discount rate applies to face value; yield applies to price paid. Whenever the two are confused, the yield is understated.