Commercial Paper: A Primer
February 12, 2025
The Black Wednesday of 1992 refers to the momentous day when the British Pound was under attack by currency speculators. This day created history in the Foreign Exchange markets because of the fact that the Pound was considered to be one of the strongest fiat currencies in the world. In fact it was the reserve […]
Law Firms: Law firms all across the world practice job costing. Most law firms charge an hourly rate to their clients. This rate is derived on the basis of the same factors direct material, direct labour as well as overheads. In case of law firms, the direct material used is negligible. The majority of the […]
Most investors do not invest directly in the company i.e. they are not promoters of the company. Rather they invest in the company through the stock market. This means that they buy shares at a certain value and make a profit only when the price of the shares go up or they get regular dividends […]
Many economists have argued that profit maximization has brought about many disparities among consumers and manufacturers. In case of perfect competition it may appear as a legitimate and a reward for efforts but in case of imperfect competition a firm’s prime objective should not be profit maximization. In olden times when there was not too […]
There is a widely held view that creative destruction is the cause of all business cycles. This explanation is used to convince people that business cycles are a good phenomenon. On the other hand, this explanation does not provide any insight as to why business cycles have been there only for a couple of centuries […]
Money market instruments are considered to be very low-risk investments. This is because the money market as an asset class is considered to have a considerably low-risk profile as compared to other asset classes such as equity and debt.
The main reason for the low-risk profile is because money market instruments consist of a large number of high-quality debt instruments issued by strong counterparties. However, it would be naive for any investor to assume that money market investments do not carry any risks.
It is important for an investor to be aware of the various risks which are present in any money market investment. Money market risks can be broadly classified into four categories.
In this article, we will have a closer look at these four risk categories and how they impact money market investments.
Reinvestment risk refers to the risk that investors may not be able to obtain the same yield when they reinvest the funds after their initial investment in money market instrument matures.
Companies want to keep their funds liquid. Hence, they prefer financial instruments with lower maturity. However, lower maturities mean that the investors will be exposed to reinvestment risks.
In order to manage the reinvestment risks, the investors need to be aware of the current yield curve as well as how the macroeconomic factors will affect the yield curve in the near future. It is for this reason that investing in money market instruments cannot be considered to be completely straightforward.
It requires a certain amount of knowledge as well as skill on the part of the investor to successfully predict how interest rates are likely to change in the future.
It is common for investors to invest in short dates securities when the yield curve is flat. This is because there is no benefit to locking up funds for additional time in these cases. However, when the yield curve is steep, investors tend to lengthen their duration to increase the overall yield of the portfolio.
In most cases, these companies pay back the loans as agreed and the entire transaction is uneventful. However, in very rare cases, investors do not receive the agreed-upon cash flow. This is largely because of extreme external events.
For instance, when the 2008 credit crisis happened, banks that were considered to be financially strong started failing.
The Lehman collapse led to financial stress across the entire banking sector and a lot of investors who had invested in money market instruments had to take a haircut. Hence, it would be prudent for an investor to prepare for such black swan events and acknowledge that counterparty risks do exist in the money market.
For instance, in money markets, there are relatively high-risk instruments such as asset-backed commercial paper which are used. In such a case, it is possible that there might be financial stress or turmoil in this particular segment only. It is likely that other money market instruments such as certificates of deposits or treasury bills may remain unaffected but other assets may face duress causing investors to lose money.
Under normal circumstances, money markets offer unparalleled liquidity. However, in times of duress, liquidity may be a challenge.
Once again, the case of the 2008 credit crisis can be used to explain the point. During this crisis, banks as well as individuals were unable to liquidate their holdings and exit the market. There was a credit freeze for some time when investors were simply not able to find any counterparty. Later, they were able to find a counterparty. However, they had to undertake the transaction at a loss.
Of late, regulators have also introduced certain rules which have the potential to create liquidity problems.
For instance, money market funds have the right to impose an exit charge and even temporarily suspend the redemption of funds under certain circumstances. This will obviously exacerbate the liquidity issues. Hence, it is important for investors to be aware that such a situation is likely to arise and be prepared for the same.
The bottom line is that money markets also have significant risks. These risks are negligible under normal circumstances. However, this does not mean that the investors must simply ignore them.
Your email address will not be published. Required fields are marked *