THE Kenyan Money Market PDF

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THE MONEY MARKET 7.1 Meaning of the Money Market Money market is an intermediary where short-term financial instruments are traded. The life span of such financial instruments usually ranges from few hours to about one year. Money market can also be as the market where money is borrowed or invested/lent for periods of up to one year maturity. The institutions participating in the money markets are the discount houses, Deposit Money Banks (the erstwhile commercial and merchant banks), the Central Bank, the government, among other. They are brought into contract via sophisticated communication networks, available through modern technology. The activities in the money market center on borrowing and lending of funds, which have very low default risk. The money market deals in short-term government and private sector instruments. The instruments traded are readily convertible into cash. An individual, institution or government that requires funds, creates instruments with which to source such funds. The type of instrument is debt or loans instrument which are traded with different names e.g. treasury bills, etc. In Kenya, the money market was established and nurtured by the Central Bank, primarily for mobilizing domestic savings for productive investment as well as providing the government with funds to enable it implement its economic programs. These short-term instruments involve a small risk due to loss, because they are issued by obligators of the highest credit rating. The function of the money market as follows: 1. It provides the basis for operating and executing an effective monetary policy 2. To promote an orderly flow of short-term funds 3. To ensure supply of the necessary means of expanding and contracting credit. 4. Mobilization of funds from savers (lenders) and the transmission of such funds to borrowers (investors) 5. Cash management; 6. Risk management; 7. Speculation or position financing; 8. Signalling; 9. Providing access to information on prices. The Kenya money market is made up of two segments: the primary and the secondary markets. The primary market is the market for the issuance of new financial instruments while the secondary market is the market where existing or old financial instruments are traded. SELF ASSESSMENT EXERCISE 1 Define money market and highlight the function the Kenyan money market 7.2 Money market segments In a broad sense, money market consists of the market for short-term funds, usually with maturity up to one year. It can be divided into several major segments:

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Interbank market, where banks and non-deposit financial institutions settle contracts with each other and with central bank, involving temporary liquidity surpluses and deficits. Primary market, which is absorbing the issues and enabling borrowers to raise new funds. Secondary market for different short-term securities, which redistributes the ownership, ensures liquidity, and as a result, increases the supply of lending and reduces its price. Derivatives market – market for financial contracts whose values are derived from the underlying money market instruments. 7.3 Money market participants Money market participants include mainly credit institutions and other financial intermediaries, governments, as well as individuals (households). Ultimate lenders in the money markets are households and companies with a financial surplus which they want to lend, while ultimate borrowers are companies and government with a financial deficit which need to borrow. Ultimate lenders and borrowers usually do not participate directly in the markets. As a rule they deal through an intermediary, who performs functions of broker, dealer or investment banker. Important role is played by government, which issue money market securities and use the proceeds to finance state budget deficits. The government debt is often refinanced by issuing new securities to pay off old debt, which matures. Thus it manages to finance long term needs through money market securities with short-term maturities. Central bank employs money markets to execute monetary policy. Through monetary intervention means and by fixing the terms at which banks are provided with money, central banks ensure economy’s supply with liquidity. Credit institutions (i.e., banks) account for the largest share of the money market. They issue money market securities to finance loans to households and corporations, thus supporting household purchases and investments of corporations. Besides, these institutions rely on the money market for the management of their short-term liquidity positions and for the fulfilment of their minimum reserve requirements. Other important market participants are other financial intermediaries, such as money market funds, investment funds other than money-market funds, insurance companies and pension funds. Large non-financial corporations issue money market securities and use the proceeds to support their current operations or to expand their activities through investments. In general issuance of money market securities allow market participants to increase their expenditures and finance economic growth. Money market securities are purchased mainly by corporations, financial intermediaries and government that have funds available for a short-term period. . Individuals (or households) play a limited role in the market by investing indirectly through money market funds. Apart from transactions with the central bank, money-market participants trade with each other to take positions dependant upon their short-term interest rate expectations, to finance their 2

securities trading portfolios (bonds, shares, etc.), to hedge their longer-term positions with shortterm contracts, and to reduce individual liquidity imbalances.

7.4 Money Market Instruments The money-market instruments are often grouped in the following way:  Treasury bills and other short-term government securities (up to one year);  Interbank loans, deposits and other bank liabilities;  Repurchase agreements and similar collateralized short-term loans;  Commercial papers, issued by non-deposit entities (non-finance companies, finance companies, local government, etc. ;  Certificates of deposit;  Interest rate and currency derivative instruments. All these instruments have slightly different characteristics, fulfilling the demand of investors and borrowers for diversification in terms of risk, rate of return, maturity and liquidity, and also diversification in terms of sources of financing and means of payment. Many investors regard individual money market instruments as close substitutes, thus changes in all money market interest rates are highly correlated. Major characteristics of money market instruments are:  short-term nature;  low risk;  high liquidity (in general);  close to money. 7.4.1 Treasury bills and other government securities Treasury bills are short-term money market instruments issued by government and backed by it. Therefore market participant view these government securities as having little or even no risk. The interest rates on Treasury securities serve as benchmark default-free interest rates. A typical life to maturity of the securities is from four weeks to 12 months. As they do not have a specified coupon, they are in effect zero-coupon instruments and are issued at a discount to their par or nominal value, at which price they are redeemed. Any new issue with the same maturity date as an existing issue is regarded as a new tranche of the existing security. Question What are key characteristics of Treasury bills? Treasury bills are typically issued at only certain maturities dependant upon the government budget deficit financing requirements. Budget deficits create a challenge for the government. Large volumes of Treasury securities have to be sold each year to cover annual deficit, as well as the maturing Treasury securities, that were issued in the past. The Treasury offerings determines the maturity structure of the government’s debt.

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7.4.2. The interbank market loans Interbank market is a market through which banks lend to each other. Commercial banks are required to keep reserves on deposits within central bank. Banks with reserves in excess of required reserves can lend these funds to other banks. Traditionally this formed the basis of the interbank market operations. However, currently these operations involve lending any funds in reserve accounts at a central bank. Concept Interbank market is a market which involves bank borrowing and lending of any funds in reserve accounts at the central bank. The major characteristics of the interbank markets are:  The transfer of immediately available funds;  Short time horizons;  Unsecured transfers. Individual banks have a possibility to invest (lend) surplus funds and have a source of borrowing when their reserves are low, thus they manage their reserve position and fund their assets portfolio by trading at the interbank market. This is a wholesale market with deals usually in large denominations. It is used by all types of banks, involved in loans for very short periods, from overnight to fourteen days mostly. Then bank borrows in the interbank market, it is said to be a funds buyer. When bank lends immediately available reserve accounts, it is said to be a seller. Most banks simultaneously buy and sell funds all the time. By acting as dealers they make markets for funds by announcing willingness to buy or to sell at the current competitive interbank rate. The interbank interest rates and interest rates in the traditional market are interconnected. If banks are short of liquidity they will lend less to both markets and will cause interest rates to rise. When Central bank provides funds to the discount market, less attractive terms are offered by banks. Thus they may choose other markets to invest and will cause the drop in interest rates. 7.3.3. Commercial papers Commercial paper (CP) is a short-term debt instrument issued only by large, well known, creditworthy companies and is typically unsecured. The aim of its issuance is to provide liquidity or finance company’s investments, e.g. in inventory and accounts receivable. The major issuers of commercial papers are financial institutions, such as finance companies, bank holding companies, insurance companies. Financial companies tend to use CPs as a regular source of finance. Non-financial companies tend to issue CPs on an irregular basis to meet special financing needs. Thus commercial paper is a form of short-term borrowing. Its initial maturity is usually between seven and forty-five days.

7.4.4. Certificates of deposit Certificate of deposit (CD) states that a deposit has been made with a bank for a fixed period of time, at the end of which it will be repaid with interest. Thus it is, in effect, a receipt for a time deposit and explains why CDs appear in definitions of the money supply such as M4. It is not the certificate as such that is included, but the underlying deposit, which is a time deposit like other time deposits. 4

An institution is said to ‘issue’ a CD when it accepts a deposit and to ‘hold’ a CD when it itself makes a deposit or buys a certificate in the secondary market. From an institution’s point of view, therefore, issued CDs are liabilities; held CDs are assets. The advantage to the depositor is that the certificate can be tradable. Thus though the deposit is made for a fixed period, he depositor can use funds earlier by selling the certificate to a third party at a price which will reflect the period to maturity and the current level of interest rates. The advantage to the bank is that it has the use of a deposit for a fixed period but, because of the flexibility given to the lender, at a slightly lower price than it would have had to pay for a normal time deposit. 7.4.5. Repurchase agreements A repurchase agreement (REPO) is an agreement to buy any securities from a seller with the agreement that they will be repurchased at some specified date and price in the future. Concept Repurchase agreement (REPO) is a fully collateralize loan in which the collateral consists of marketable securities. In essence the REPO transaction represents a loan backed by securities. If the borrower defaults on the loan, the lender has a claim on the securities. Most REPO transactions use government securities, though some can involve such short-term securities as commercial papers and negotiable Certificates of Deposit. Since the length of any repurchase agreement is short-term, a matter of months at most, it is usually assumed as a form of short-term finance and therefore, logically, an alternative to other money market transactions. 7.4.6 Money at Call: Money at Call was money lent by the banks and could be called back at a short notice e.g. 24 hours in overnight. Call money was simply bank reserves that were loaned to banks with insufficient reserves and it helps potential erring banks acquire the legal reserves which the CBK examines require banks to maintain. They also serve as a buffer against stock of liquidating pressures in the market; thus, helping banks to manage new cash balance.

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