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Inside Money Market Funds: How They Work

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Abstract graphic depicting global financial tradeMoney market funds are comprised of a number of highly liquid assets that together form what is called the money market, a vast exchange that is used daily by governments, businesses and financial institutions, as well as retail investors. Each of these come to this vast market to buy or sell various highly secure and very liquid securities. Here is a description of what’s inside money market funds, how the components of such funds work, along with examples. 

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How the Money Market Works

The money market is an engine for the financial world. Government, businesses and institutions must have some way to easily borrow short-term money to fulfill their financing needs. If it weren’t for the large amounts of low-cost, short-term financing that the money market supplies, many businesses would never be founded and there would be little growth and expansion. The money market provides a place where businesses can raise working capital during periods of slowdown. It facilitates international trade and supports transactions between countries. Without the money market, companies would have to wait on invoices they have sent, but that have not been paid, to purchase raw materials and participate in the production process.

Companies hold marketable securities in their portfolios. Marketable securities are money market investments with a maturity of less than one year. Marketable securities are also known as cash equivalents. Cash equivalents are short-term, high-credit-quality securities that provide the company with liquidity. They are quickly and easily convertible to cash to meet the company’s financing needs.

There are three asset classes. They are cash and cash equivalents, equity securities and fixed-income securities. Investors in the cash equivalent securities provide the money that allows the money market to operate and money market funds to be maintained. Because of the low risk of money market securities, the return on them is also low.

Keep in mind that money market funds, which are comprised of money market securities, are not money market accounts, the latter of which is more like a savings account and which is insured by either the National Credit Union Administration or the Federal Deposit Insurance Corporation.

Functions of the Money Market

Retail investor checks her money market fundThere are four main functions of the money market. One is to implement Federal Reserve policies: The Federal Reserve sets the monetary policy for the U.S. The prevailing interest rates in the money market help the Federal Reserve establish the appropriate level of interest rates through commercial banks.

Another is to provide short-term financing: The money market fuels global and local trade by providing capital to business firms for short-term use.

A third function is to provide very safe investment vehicles to investors: The money market provides short-term, liquid investments that investors can buy – in the form of money market funds – to give them a secure place to park cash and cash equivalents.

Fourthly, the money market offers services to commercial banks so they can invest their excess reserves in money market investments to earn some interest. They can also borrow from the money market.

Examples of the Money Market in Action

  • Commercial paper – If a company needs short-term financing, investing in commercial paper, a money market security, is one way to get it. Commercial paper is issued by only the most creditworthy companies. It has a short maturity of no more than 270 days. Because it has moderate risk, its return is higher than some other money market investments. Commercial paper has moderate risk since it is not insured by the Federal Deposit Insurance Corporation (FDIC). That means it has some risk of the company defaulting. However, it provides a company with a lot of quick capital. It’s not as suitable for an individual investor as other money market instruments since it is only denominated in very large amounts.
  • Treasury bills – Treasury bills, a money market security, are an excellent investment vehicle to build up the cash portion of your portfolio. They have virtually no default risk because they are backed by the full faith and credit of the U.S. federal government. You buy Treasury bills at a discount. When they mature, you get back the face value of the t-bill. You can invest with as little as $100 and t-bills typically mature within four to 52 weeks.
  • Banker’s acceptances – Welcome to the world of international trade. Banker’s acceptances are money market securities that facilitate transactions between two countries. Let’s say a company wants to import products from another country. A banker’s acceptance is the bank’s guarantee that the company will pay the bill.
  • Discount window – Banks borrow from each other continuously at the federal funds rate. But, if a bank has a shortfall and cannot get a short-term loan from another bank, it goes to the Federal Reserve’s discount window. Loans from the discount window have a slightly higher interest rate than the federal funds rate to encourage banks to borrow from each other.

The Bottom Line

Female banker accesses the money market

The money market is vast and services private investors, companies, institutions and the government by providing short-term financing for many of their needs. Money market securities, which is what money market funds are comprised of, have two primary characteristics: They are reasonably safe, and they are liquid. There are many types of money market securities that serve a variety of types of investors. Money market funds, for example, give individual investors access to cash equivalents for their portfolios.

Tips for Investing

  • If you are uncertain about which money market investments you should invest in, consult with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Choose a money market investment for your short-term needs by maturity matching. Try to match the maturity of the security with your timeline when you will need the money.

Photo credit: ©iStock.com/peshkov, ©iStock.com/FG Trade, ©iStock.com/Laurence Dutton

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