Chapter 13: Money Markets

Question 1

3 Main players in the money market

Answer 1

• Clearing banks
  Lend and borrow via short-term deposits (often overnight) to control their liquidity levels
• The central bank
  Acts as a lender of last resort, standing by to provide liquidity to the clearing banks. The central bank also sets short-term interest rates via repo rates and the sale and purchase of bills.
• Other financial and non-financial institutions
  Also lend and borrow short term funds.

Question 2

Why would financial institutions, such as insurers and pension funds hold money market instruments?

Answer 2

Money market instruments are liquid, meaning that they could be bought / sold easily and have stable capital values. This makes them a good match for known short-term outgoings, for uncertain outgoings, and for taking advantage of opportunities.
Institutions may also hold cash when they think that the value of other securities such as bonds and equities might fall. This could be because they expect - ahead of the market - that interest rates may rise or that there will be a recession.

Stable capital values make money market instruments attractive to risk-averse investors or during times of general economic uncertainty.

Question 3

Why wouldn’t financial institutions, such as insurers and pension funds hold a LARGE PROPORTION of funds in money market instruments?

Answer 3

• Such instruments would be expected to give a LOWER RETURN than more risky assets.
• They may be a POOR MATCH to longer-term liabilities.
• REINVESTMENT RISK: Whilst the proceeds can be continually reinvested, this introduces the risk that the terms for reinvestment are unknown in advance.