Money Market Basics Explained [BCS 3/15]

Financial markets are classified into two parts – money market and capital market. In this article, we will discuss the money market in a simple and easy way and try to understand its various important aspects.

Note – If you want to understand the basics of share market from zero level then you should start with Part 1. – 📈 Share Market and Related

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| Financial market and its classification

There are two types of people in any economy, people who have extra money, and people who need money. The market which helps in carrying out the transactions between these two groups is called the financial market.

Financial market is mainly classified into two parts – 1. Money Market 2. Capital Market . This article is on money market

| What is money market?

A part of the financial market where transactions take place for a short period of time. It is called money market. Transaction here means borrowing or lending and buying or selling. In other words, it is a market where the need of funds is met for a short period of time. What did it mean?

– Any person establishes a company by making long-term investment, but only that much does not work, obviously production will not start just with the establishment of the company.

To start the production or to continue it or to increase it, some expenses have to be incurred every day. works in. This working capital comes from the money market.

Overall, the money market is a short term financial market of an economy. In this market the exchange of money takes place between individuals or groups such as financial institutions, banks, governments, companies etc. Out of this, there will be one party which will have surplus currency and one party will be such that will need currency.

One thing to remember here is that money market meets short term capital requirements and this short term is usually up to 364 days i.e. if you take loan from anywhere for more than 364 days then that counts in long term capital requirement which is a part of the capital market.

|types of money market

There are two forms of money market – Unorganized money market and Organized money market.

Unorganized money market – This money market has been in existence since ancient times. how that? Suppose you do not have money to buy fertilizer for your farm, then you might think that let’s take it from someone from our neighborhood because it is only a matter of time. This transaction is called unorganized money market. That is, in other words, its activity is not regulated by any organization.

For example, take the village non-registered moneylender itself, there is no one to control it. They give their own money to anyone at as much interest rate as they want. That is why they are called unorganized money market.

Organized money market – As the name suggests, there is a recognized body to regulate this market. Suppose you took a loan from a bank for 2 months, then since the bank itself is a recognized institution and it is regulated by the Reserve Bank , which is a recognized institution. That is why the transactions that took place here are called organized money market.

Organized money market in India began to develop in the 1980s and has grown to a great extent today. Like the capital market, the money market also operates through different types of instruments or instruments , let us discuss them all in brief.

| Money market instruments

There are many money market instruments that are used in money market. Follow the below headings;

Treasury bills

Its practice started in 1986. It is also known as zero coupon bond . It is used by the Government of India to meet its short-term money requirement. It is issued by the Reserve Bank of India for the Government of India. Presently Treasury bills are issued by the Government of India for 91 days, 182 days and up to 364 days. Usually banks or financial institutions invest in it.

It is issued at a price which is less than its face value but is paid up to the face value. For example, suppose an investor buys a treasury bill of face value of Rs 2 lakh for Rs 1 lakh 90 thousand for 182 days. Let’s say that on keeping that bill with him till the maturity date, he gets Rs 2 lakh in return for it. Can’t get more than this as the face value is Rs 2 lakh.

In this way, the investor invested 1 lakh 90 thousand rupees, instead of which he got 2 lakh rupees i.e. 10 thousand rupees he got extra, he got it as interest.

Cash management bill – CMB

This is In vogue since 2010-11. It is similar to the Treasury Bill in a way because it is also used by the Government of India to meet the shortfall of immediate funds. But the only difference is that it is issued for a maturity period of less than 91 days.

Certificate of Deposit – CD

Its practice started in 1989. It is used by the banks of India to meet the shortfall of immediate funds. The bank issues it to its customers for a short period. It is tradable, so if the customer wants, he can also sell it in the market.

When the rate of depositing money in the bank decreases, while at the same time the demand for loans increases, then in such a situation it is issued by the bank to its customers. That is why it is called savings certificate or certificate of deposit .

Remember one thing on the memory that in 1993 RBI has allowed all India financial institutions to issue certificates of deposit also. At present, there are four All India Financial Institutions in India, these are – Exim Bank , NABARD , SIDBI and NHB .

These four institutions can issue certificates of deposit for up to 3 years, while all banks or financial institutions except this can issue for a maximum period of 364 days.

Commercial Paper – CP

Its practice started in 1990. It is also called trade letter. It is used to meet short term capital requirement by the corporate sector. But it can be issued by the same company which is listed on the stock exchange and its working capital is not less than Rs 5 crore. It is mandatory for such companies to obtain a certificate of credit from a credit rating agency recognized by the RBI .

For example, suppose a company needs capital for the long term, obviously this can be done from the capital market because the money market does not provide long term capital. In such a situation, when a company issues its shares to raise money from the capital market.

 So in this sequence that company has to waste a lot of amount as floatation cost . Actually, floatation cost is the amount that a company has to spend on brokerage, registration, printing of applications and advertisement etc. in order to issue its shares. To manage this floatation cost, the company issues commercial paper in the money market. This process is called bridge finance .

Commercial Bill – CB

This too came into play in the 1990s. It is used by all India financial institutions, non-banking finance companies, scheduled commercial banks, merchant banks, co-operative banks and mutual fund companies. This bill is short term and tradable.

It can be understood in this way – Suppose a seller gives some goods to a customer on credit. In such a situation, that seller has two options, either they wait for the day when the customer will return that money to him. 

Or the seller may use a bill and persuade the customer to accept it. If the customer accepts that bill, then that bill becomes a marketable form which is called a trade bill. 

The advantage of this will be that now if that seller needs short term money, then he can go to the bank with that business bill and get money in return. If the bank accepts that commercial bill, then it is known as commercial bill.

Money Market Mutual Funds

It is in practice since 1992. It facilitates short-term investment at the individual level. Its specialty is that even a person who does not have knowledge of the stock market can earn profit by investing money through this medium.

Well, mutual funds are for short term as well as long term. And it is usually used only to earn money in the long term. – [Mutual Fund Explained]

Repo and Reverse Repo

Repo was introduced by the Reserve Bank of India in the year 1992 and Reverse Repo in 1996. Under repo, RBI lends to banks for a short period. Whereas , under reverse repo, the bank lends to the RBI for a shorter period.

The interest rate at which RBI lends to banks for a short period is called the repo rate and the rate at which RBI borrows from banks for a short period is called the reverse repo rate.

This means that the RBI is able to establish a balance between excess and shortage of cash in the economy. When there is a shortage of cash in the economy, the RBI reduces the repo rate so that the appropriate amount of cash can come into the economy. 

Similarly, when there is an excess of cash in the economy, the RBI deposits the excess cash with itself.

In 2014, accepting the recommendations of the Urjit Patel Committee, monetary policy was released on a bimonthly basis. That is, now every two months RBI issues repo rate and reverse repo rate.

Call money market – CMM

It is an interbank money market because it is usually used for transactions between banks or financial institutions only. This market is famous for one day money transactions which is also called overnight borrowing or money at call.

By the way, lending is also given here for up to 14 days, which is called short notice . But it is usually used only for 3 days money arrangement. This is because as the day progresses, its interest rate also increases.

Usually Scheduled Commercial Banks and Co-operative Banks allot loans in this market as well as take loans from it, while LIC, IDBI, and NABARD only act as loan allottees in this market. Since the base of the interest rate is the repo rate of the RBI, it keeps on fluctuating.

It can be understood in this way – Commercial banks have to maintain a minimum amount, which is 4% nowadays, this is called Cash Reserve Ratio or CRR. This is done so that liquidity is ensured and it can be useful in case of bankruptcy.

It happens that RBI keeps on changing the cash reserve ratio from time to time, due to which the lending capacity of banks keeps on changing. Suppose the bank currently has Rs 100 out of which Rs 4 has to be kept as CRR. If RBI makes it 5 percent, then 5 rupees will have to be kept. The bank will not be able to give this 5 rupees to anyone as a loan. To deal with this short term problem, the bank uses money at call or quick term money.

Overall this is the concept of money market which is a part of financial market. Hope you have understood. ✔️Now in the next article we will learn about the second part of the financial market, the capital market , because this is the market from where the concept of the stock market originates.

Read from here – Capital Market Basics

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| Share Market Basic Concept Series (BCS)