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Chapter 4

MONEY MARKET
Chapter Objectives
To understand

Characteristics, Functions And Benefits Of


Money Market
Development Of Money Market In India
Different Money Market Instruments
Money Market Intermediaries
Link Between Money Market And Monetary
Policy
Tools For Managing Liquidity In The Money
Market
MONEY MARKET
Money Market is a market for
overnight to short-term funds (i.e., upto 1
year) &
for short-term money and financial assets
that are close substitutes for money,
that is, financial assets that can be quickly
converted into cash (money)
with minimum transaction cost and

without loss in value.


Importance of Money
Market
1. Development of Trade and Industry
2. Development of Capital Market
3. Smooth Functioning of Commercial
Banks
4. Effective Central Bank Control
5. Formulation of Suitable Monetary
Policy
6. Non-inflationary source of Finance to
Government
Characteristics of
Money Market
A collection of markets for several
short-term debt instruments

Wholesale market

Principal feature is honour

Need-based market
Features of a Money
Market
The following are the general features of a money
market:

1. It is a market purely for short-term funds or


financial assets called near money.

2. It deals with financial assets having a maturity


period upto one year only.

3. It deals with only those assets which can be


converted into cash readily without loss and with
minimum transaction cost.
Features of a Money
Market (cont.)
4. Generally transactions take place through
phone i.e., oral communication. Relevant
document and written communications
can be exchanged subsequently. There is
no formal place like stock exchange as in
the case of a capital market.

5. Transactions have to be conducted


without the help of brokers.
Features of a Money
Market (cont.)
6. It is not a single homogeneous market. It
comprises of several sub-markets, each
specializing in a particular type of financing
e.g., Call money market, Acceptance market,
Bill market and so on.

7. The components of a money market are the


Central Bank, Commercial Banks, Non-
banking financial companies, discount houses
and acceptance houses. Commercial banks
generally play a dominant role in this market.
Other features of the Money
Market are:
1. It is a market for short-term loanable funds
for a period of not exceeding one year.

2. This market supplies funds for financing


current business operations, working capital
requirements of industries and short period
requirements of the Government.

3. The instruments that are dealt in a money


market are bills of exchange, treasury bills,
commercial papers, certificate of deposit etc.
Other features of the Money
Market: (cont.)

4. Each single money market instrument is of


large amount. A TB is of minimum for one
lakh. Each CD or CP is for a minimum of
Rs. 25 lakhs.

5. The Central bank and Commercial banks


are the major institutions in the money
market.

6. Money market instruments generally do


not have secondary markets.
Other features of the Money
Market: (cont.)

7. Transactions mostly take place over-the-


phone and there is no formal place.

8. Transactions have to be conducted


without the help of brokers.
Objectives of Money
Market
The following are the important objectives of a
money market:

i. To provide a parking place to employ short-term


surplus funds.
ii. To provide room for overcoming short-term
deficits.
iii. To enable the Central Bank to influence and
regulate liquidity in the economy through its
intervention in this market.
iv. To provide a reasonable access to user of short-
term funds to meet their requirements quickly,
adequately and at reasonable costs.
Functions of Money
Market
1. By providing various kinds of credit
instruments suitable and attractive for
different sections, a money market augments
the supply of funds.

2. Efficient working of a money market helps to


minimize the gluts and stringencies in the
money market due to the seasonal variations
in the flow of and demand for funds.

3. A money market helps to avoid wide seasonal


fluctuations in the interest rates.
Functions of Money
Market (cont.)
4. A money market, by augmenting the
supply of funds and making them readily
available to the legitimate borrowers, help
in making funds available at cheaper rates.

5. A well organized money market, through


quick transfer of funds from one place to
another, helps to avoid the regional gluts
and stringencies of funds.
Functions of Money
Market (cont.)

6. It enhances the amount of liquidity


available to the entire country.

7. A money market, by providing profitable


investment opportunities for short-term
surplus funds, helps to enhance the
profit of financial institutions and
individuals.
Objectives/ Functions of
Money Market
These broad objectives/ functions of the
money market are three-fold:

(i) It acts as an equilibrating mechanism for


evening out short-term surpluses and
deficiencies of funds

(ii)It is the focal point of RBI intervention for


influencing liquidity in the economy and
Objectives/Functions of Money
Market (cont.)

(iii) It provides reasonable access to the


users of short-term funds to meet their
requirements at realistic/reasonable
cost or to temporarily deploy their
excess funds for earning returns.
Functions of Money
Market
To provide

A balancing mechanism

The focal point for central bank

An intervention

Reasonable access to short-term funds


Benefits of an Efficient Money
Market

Provides a stable source of funds to banks

Encourage development of non-bank


entities

Facilitates government market borrowing

Makes effective monetary policy actions

Helps in pricing different floating-interest


products
Role of the Reserve Bank in the
Money Market

Ensure liquidity

Ensure an adequate flow of credit to


the productive sectors of the economy

Bring about order in the foreign


exchange market
INSTRUMENTS /
PRODUCTS
OF
MONEY MARKET
Money Market Instruments/
Products
1. Treasury Bills (T-Bills)

2. Commercial Papers (CPs)

3. Commercial Bills (CBs)

4. Certificates Of Deposit (CDs)

5. Call/Notice Money Market

6. Collateralised Borrowing And Lending


Obligation (CBLO)

7. Money Market Mutual Funds (MMMFs)


1. Treasury Bills (T-bills)
A T-bill is an instrument of short-term
borrowing by the Government of India
to bridge seasonal/ temporary gaps
between receipts and expenditures.

It is issued by the RBI on behalf of the


Government.
1. Treasury Bills (T-bills) (cont.)

The features of T-bills are:


Negotiability,

Issued at discount and redemption at par


on maturity,
High liquidity,

Low transaction cost,

Absence of default risk,

Eligibility for inclusion in the SLR and


transaction through SGL account.
1. Treasury Bills (T-bills) (cont.)

Features of T-bills

Short-term instruments issued by RBI on


behalf of the government
Negotiable and highly liquid securities
Absence of default risk
Assured yield, low transaction cost
Security for SLR purposes
Not issued in scrip form
1. Treasury Bills (T-bills) (cont.)
Being a risk-free instrument, the yields
on T-bills at various maturities serve as
a benchmark and help in pricing
different floating rate instruments in the
market.

The T-bill market is the RBI's preferred


tool for intervention, to influence short-
term interest rates.
Types of T-bills
On tap bills

Ad hoc bills

Auctioned T-bills
91-day, 182-day, and 364-day T-Bills
Sale of T-bills

Conducted through an auction

Non-competitive bids also accepted

Types of auctions

Multiple Price Auction

Uniform Price Auction


T-Bills Zero Coupon
Bonds
T-bills are zero coupon bonds issued by
the RBI on behalf of the Government, in
the form of a promissory note.
It presently issues T-bills in two
maturities: 91 days and 364 days.
They are issued through auction.
The RBI declares the auction calendar at
the starting of the financial year, men
tioning the amount of issue, the day of
auction and the day of payment.
Types of Auctions
The 91 days T-bills are auctioned every
Wednesday.

The multiple price based auction technique


is used. Under this method (also known
as French Auction), all bids equal
to/above the cut-off price are accepted.

However, the bidder has to obtain the T-


bills at the price quoted by him.
Types of Auctions (cont.)

The 364 days T-bills are auctioned on the second


and fourth Wednesdays of the month, using the
uniform price based auction (also known as
Dutch Auction).

Under this system, all the bids equal to/above


the cut-off prices are accepted at the cut-off
level.

The bidder obtains the T-bills at the cut-off


(uniform) price and not at the price quoted by
Size of T-Bills Market (Rs in
Crores)
O/S 2002-03 2003-04 2004-05 2005-
06
91-day 10,672 7139 27792 16318
364-day 26126 26136 47132 45018
182-day
9771

Implicit yield at cut-off prices (Average)


91-day 5.24%
6.51%
364-day 5.63%
6.66%
182-day
6.42%
2. Commercial Paper
(CPs)
A CP is a short-term, unsecured,
negotiated instrument consisting of a
usance promissory note with a fixed
maturity.

It is not tied to any specific self-liquidating


trade transaction.

Depending on whether it is issued by the


company concerned directly or through a
dealer, the CP is called a direct paper or a
dealer paper respectively.
2. Commercial Paper
(cont.)
An unsecured short-term promissory
note issued at a discount

Issuers
Creditworthy Corporates
Primary Dealers
All India Financial Institutions
2. Commercial Paper
(cont.)

Largest issuers of CPsLeasing and


Finance companies

Usually privately placed with investors

Attracts stamp duty

Underwriting not mandatory


Benefits of Commercial
Papers (CPs)
As a short-term instrument, a CP offers
several advantages to the issuers as
well as the investors, such as
Simplicity,

Flexible Maturities,

Lower Cost,
Higher Credit Standing,

No Restriction On End-use Of Funds,

High Liquidity,

Higher Return And So On.


Process for Issuing CP
A resolution to be passed by the Board
of Directors

CP issue to be rated

Select an Issuing and Paying Agent for


verification of documents

Arrange for dealers for placement of


CP
Guidelines Relating to CPs
Corporates, primary dealers and all India
financial institutions eligible to issue a CP

Minimum credit rating P2 of Crisil

Maturity period of minimum of 7 days and


maximum up to one year from the date of issue

Minimum of Rs 5 lakh and multiples

To be issued in demat form

Banks can provide credit enhancement facility


Size of CP Market (Rs in
Crores)
2002-03 2003-04 2004-05 2005-06

O/S 5749 9131 14235 12693


Indian CP Market
The framework of the Indian CP market has
to conform to the RBI guidelines.

The main elements of the framework relate


to the

(i) Eligible issuers in terms of minimum


tangible networth, sanction of working
capital limits by banks/FIs and
classification of borrowal account as
standard asset,
Indian CP Market (cont.)

(ii) Instrument in terms of minimum


rating, denomination and stand-alone
character
(iii) Renewal of a CP
(iv) Eligible investors and
(v) Form of issue and so on.
3. Commercial Bills
A commercial bill is a short-term negotiable
and self-liquidating instrument.

It is a written instrument containing an


unconditional order signed by the maker
(seller of goods), directing the buyer to
pay a certain amount of money only to a
particular person or to the bearer of the
instrument.

The bills can be discounted in the bill


discount market.
3. Commercial Bills (cont.)

A short-term, negotiable and self liquidating


instrument with low risk.
Types
1. Demand bill
2. Usance bill
3. Clean bill
4. Documentary bill
5. Inland bill
6. Foreign bill
7. Hundi
8. Derivative Usance Promissory Note
Bills Rediscounting
Bill rediscounting, as a money market product,
has not become popular in India inspite of
several measures, including abolition of
stamp duty, taken by the RBI to develop bill
finance.

The main factors hindering the development


of the bill finance/culture are: system of cash
credit, small size of foreign trade, absence of
specialised discounting institutions, lack of
an active secondary market and so on.
4. Certificate of Deposits
(CDs)
A CD is a negotiable money market product,
issued in a demat form or as a usance
promissory note for funds deposited at a
bank/other eligible FIs for a specified time
period.

In other words, a CD is a marketable receipt


of funds deposited in a bank/FII, for a fixed
period, at a specified rate of interest.
4. Certificate of Deposits
(CDs) (cont.)
It is attractive both to the bank/FII and the
investors as the former does not have to
encash the deposit prematurely, while
the latter can sell it in the secondary
market before its maturity.

So, Certificate of Deposit (CD) is a short-


term tradable time deposit issued by
commercial banks and financial institutions
with following features:
Features of Certificate of
Deposits (cont.)
Issued at a discount to face value.
Minimum amount Rs 1 lakh and in multiples
thereof
Maturity period
7 days to one year for banks
1 to 3 years for FIs
No lock-in period
Transferable by endorsement
Banks to maintain appropriate reserve
requirement on issue of CDs.
Issued in demat form
Key investors--Mutual Funds
Cost attractive vis--vis time deposits
Size of CD Market

2002-03 2003-04 2004-05 2005-06


O/S 908 4764 12078 36931

Constitutes 4.3% of aggregate deposits


Certificate of Deposits (CDs)
in India
The framework of the issue of CDs in India is prescribed
by the RBI.

The main elements of the RBI guidelines relate to


Eligibility of issuers,
Aggregate amount of issue,
Minimum issue size and denomination,
Eligible subscribers,
Maturity,
Discount/ coupon rate,
Reserve requirements,
Transferability,
Loans/buy back and so on.
5. Call/Notice Money
Market
(Short-term Deposits/Term Money)

The call/notice money deals with


overnight/one-day (call) money and notice
money for upto 14 days.

Call money is required by banks to meet


their CRR requirements on a reporting
Friday.

The call market is a pure inter-bank market


now.
5. Call/Notice Money Market
(cont.)

There are also prudential limits on lending


and borrowing by banks.

The lending limit on a fortnightly average


basis is 25 per cent of owned funds.

The borrowing limits are the higher of 100


per cent of owned funds or 2 %of the
aggregate deposits of a bank.
Call/Notice Money Market (cont.)
Banks borrow/lend money for a period
ranging between 1 and 14 days.

No collateral security required

Highly liquid, risky, and volatile market

Banks trade money to adhere to CRR


requirement

Average daily turnover in March 2005


Rs15294 cr and in March 2006 Rs 18290 cr.
Call Rate
The interest rate paid on call loans is
known as the call rate.
The call rates are affected by a number of
factors such as easy/tight liquidity
conditions, reserve requirements, volatile
forex market conditions and so on.
The RBI moderates liquidity and volatility in
the call market through LAF, repo and
reverse repo and changes in CRR.
Factors Influencing Call Rate
Volatility
Liquidity conditions

Reserve requirement prescriptions

Structural factors

Investment policy of non-bank participants.

Liquidity changes and gaps in the foreign


exchange market
Measures for Curbing High
Volatility
Increasing the number of participants

Through repos

Freeing of inter-bank liabilities from


reserve requirements
6. Collateralized Borrowing and
Lending Obligations (CBLO)
Launched by CCIL

To provide liquidity to non-bank entities


No lock-in period
Original tenure varies between one day and
one year
Trading volumes have grown
Average daily turnover during March 2005 was
Rs 9625 crore which increased to Rs 35775
crore in March 2006
CBLO segment of CCIL increased from 110 as
7. Money Market Mutual
Funds (MMFs)
An MMMF is a conduit through which
small investors can participate in the
money market to earn the market-
related yield.

They are, however, a marginal product in


the Indian money market.
Money Market
The Intermediaries
Discount and Finance House of
India--set up in 1988 by RBI.
Role is to stimulate activity in money
market.
DFHI is an accredited primary dealer.
Money Market Mutual Funds:
Introduced in April 1991. Mobilize
savings from small investors.
Link Between Money Market and
Monetary Policy in India

Objectives of the monetary policy

Price stability
Growth
Instruments used to
influence monetary
conditions
Direct instruments Indirect
such as instruments such
as
Reserve Requirements,
Open Market
Limits On Refinance, Operation
Administrative Interest Repos
Rates,
Qualitative And
Quantitative
Restrictions On Credit
Tools for Managing Liquidity in
the Money Market

Reserve requirements: CRR (5%) &


SLR(25%)

Interest rates
Prime lending rate:10 .25% -10 .75%
Bank rate :6%(Long-term rate)

Refinance from RBI


Tools for Managing Liquidity in
the Money Market (cont.)
Liquidity Adjustment Facility: operates
through

Repo and Reverse Repo Auctions;


Coupled with OMOs and MSS

provides RBI greater flexibility in


managing liquidity
Tools for Managing Liquidity in
the Money Market (cont.)
Types of Repos:

Interbank repos,

RBI repos:
Reverse Repo (Borrowing of overnight
funds by RBI)- rate 6% and

Repo (Lending to banks)- rate 7%


(Short-term rates)
Tools for Managing Liquidity in
the Money Market (cont.)

Market Stabilization Scheme (MSS):

deals with enduring capital inflows


without affecting short-term liquidity
management role of LAF.
Money Market Derivatives

Interest Rate Swap

Forward Rate Swap

Interest Rate Futures


Money Market
Reforms
A ceiling of 10 per cent on call money rates
imposed by the Indian Banks Association was
withdrawn in 1989.

Initially, the participation in the call market was


gradually widened by including non-banks, such
as, financial institutions, non-banking finance
companies, primary/satellite dealers, mutual
funds, corporates (through primary dealers),
etc. The process of transformation of call money
market to a pure inter-bank market commenced
effective May 2001.
Money Market Reforms
(cont.)

The 182-day treasury bills were introduced


effective November 1986, followed
subsequently by phasing out of on-tap
treasury bills, introduction of auctioning
system in 91 day treasury bills since January
1993, and introduction of 14-day and 364-day
treasury bills. The system of ad hoc treasury
bills (with a fixed 4.6 per cent interest rate
since July 1974), which were issued by the
Central Government to the Reserve Bank, was
abolished effective April 1997. Currently only
the 91-day and 364-day treasury bills exist.
Money Market Reforms
(cont.)

Several new financial instruments were


introduced, such as inter-bank participation
certificates (1988), certificates of deposit
(June 1989), commercial paper (January
1990) and repos (December 1992).

Derivative products like forward rate


agreements and interest rate swaps were
introduced in July 1999 to enable banks, FIs
and PDs to hedge interest rate risks.
Money Market Reforms
(cont.)

A full-fledged Liquidity Adjustment Facility was


introduced on June 5,2000 with a view to modulating
short-term liquidity under diverse market conditions.

With a view to adopting the sound risk management


procedures and eliminating counter-party risk, the
Clearing Corporation of India Ltd. was set up on
February 15, 2002. The CCIL acts as a central
counter-party to all trades involving foreign
exchange, government securities and other debt
instruments routed through it and guarantees their
settlement.
Money Market Reforms
(cont.)

The Discount and Finance House of India (DFHI)


was set up in April 1988, and was allowed to
participate in the call/notice money market both
as a borrower and lender commencing from July
1988.

The segment refinance facility for banks is


gradually being phased out. Collateralized
Borrowing and Lending Obligations (CBLO) was
launched by CCIL in January, 2003.
Money Market Reforms
(cont.)

Institutionalization of the Clearing Corporation of


India Limited (CCIL) as a central counter party.

Issuance norms have been modified to


encourage wider participation while
strengthening the transmission of policy signals.

Upgradation of payment system technologies.


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